Trading Options Developing A Plan

Trading Options - Developing A Plan
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Table of Contents Home Advertise About Us 1. Calls 2. Covered Calls 3. Naked Puts SPONSORS Stricknet.com Option Money 4. Calculating the yield 5. Puts 6. Selling Naked Calls 7. Credit Spreads 8. Debit Spreads 9. Long Strangles 10. Short Strangles 11. Long Iron Butterfly
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Buying Calls
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Success in call buying primarily depends on your ability to select stocks that will go up in price and to time your selection fairly well. Most investment strategies are designed to remove some of the risk and exactness in stock picking, thus allowing you to have some room for error and still make a profit. But that doesn't exist with pure play call buying. Your total investment could be lost in an option play, even if the stock goes up. It has to go up enough and quickly enough to be profitable. For this reason, one should only use risk money when buying calls. The potential rewards in buying calls are so attractive to many investors and speculators that it is the most used options strategy by the investing public. The attraction of call buying is the leverage it gives a speculator. One could potentially realize large percentage profits from only a modest rise in price by the underlying stock. And even though they may be large percentage gains, the risks cannot exceed the fixed amount paid for the option originally. Calls have to be paid in full and cannot be bought on margin. Nor do they have any margin value nor contribute any equity to your margin account. Illustration of how a call purchase might work: Assume that ABC stock is selling at 48 and the 6-month call, the July 50, is selling for 3. With an investment of $300, the call buyer may participate, for 6 months, in a move upward in the price of the stock. If ABC should rise in price by 10 points (just over 20%), the July 50 call will be worth at least $800 and the call buyer would have a 167% profit on a move in the stock of just over 20%. This is the leverage that attracts speculators to calls. At expiration, if ABC is below 50, the buyer's loss is total, but is limited to his initial investment of $300, even if the stock declines substantially. Although this risk is equal to 100% of his investment, the dollar amount is still small. You should never risk more than 15-20% of your risk capital in call buying because of the high percentage risks involved.
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Some investors invest in call options on a very limited basis to add some upside potential to their portfolio. While investing in conservative stocks, and covered calls, they invest a small portion in buying calls on more volatile stocks. The investor will have a limited dollar risk by owning the option instead of the stock. It is very important to understand that the buyer of calls will only make money if the price of the underlying stock goes up.
Risk/Reward The cold, hard fact for the call buyer to recognize is that you will only make money if the stock rises in price. All the analysis in the world trying to decide which option to buy will not produce profits if the stock declines. However, this fact shouldn't dissuade you from making reasonable analyses in your call buying selections. Further, many times a speculator will pick the right stock, but the wrong option. The stock will go up, but not enough to be in-the-money, or not soon enough (prior to the expiration of the option). Since the only ally the call buyer has is upward movement in the underlying stock, the selection of the underlying stock is the most important choice you have to make. Since timing is so important too, technical analysis and current news, are more reliable indicators than fundamentals. You must be bullish on the stock to consider purchasing calls. Only after the stock has been selected can you begin to consider other important factors, such as strike price and expiration months. The purchase of an out-of-the-money call has both greater potential gains and risk than does an in-the-money call. Many call buyers will only buy out-of-the-money calls simply because they are cheaper. But the dollar amount should never be the deciding factor for which option to buy. If your funds are so low that you can only afford to buy out of the money calls, then you should not be investing in calls. The risks are too great. If a stock advances substantially, the out of the money calls will provide the best returns, but if it only advances moderately, then the in the money will perform better. Example: Assume ABC stock is at 60, the December 55 calls are at 5 and the Dec 65 calls are 2. If the stock moves up to 63 relatively slowly, the Dec 65 (out of the money) calls may actually experience a loss, even if the call has not yet expired. But the Dec 55 (in the money) calls will definitely have a profit because the call will sell for at least 8 points since that's its intrinsic value. So percentage-wise, an in the money call will have a better return if the stock moves modestly, while an out of the money call will have a better return if the stock moves up a great deal.
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An in the money call clearly has less risk. Timing is also a critical element. If you're relatively certain the stock will move up in the near future, then a short-term option offers the best deal. You won't be paying as much in time-premium. But if you're uncertain about the timing, then a farther out option is the better strategy.
Strategies Component Potential profit
Long Call Buy call When the stock price is above the break-even point Unlimited, equals to the prevailing stock price minus break-even point
Maximum loss Time value impact Break-even
Total premium paid Negative Strike price plus premium paid
Example: Component Net Premium Break-even Profit when Potential Profit Potential Loss Time Value Impact
Buy ABC June $200 Call Pay $20 $200+$20=$220 Stock price is above $220 Stock price - $220 $20 Negative
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http://www.graymetalbox.com/tutorial/cc_tutorial.htm
Covered Calls
The primary objective of the covered call writer is increased income through stock ownership. Coupled with that is the desire to minimize inherent risks of the market. There are various strategies for covered call writers. Some strategies could satisfy the most conservative investor while others would challenge the most aggressive. We offer this tutorial to teach some of the strategies that are relatively unknown by the vast number of covered call writers. We do not contend that this is an all-inclusive authority on the subject, but a brief tutorial only. All covered calls involve selling an option on a stock that you currently own. But there are two broad terms that "categorize" your position: In-The-Money and Out-Of-The-Money. If you own a stock that is trading at 19 and sell the 20 call, then the option is deemed "out of the money". There is no intrinsic value in the option. The only value it has is time value. If you sold a 15 call on the 19 stock that you own, then the option is said to be "in the money". It is in the money by 4 dollars. The option of course would be worth more than 4, depending on the amount of time left before expiration. Typically, writing a covered call by selling an out-of-the-money option offers the highest returns, while writing a covered call with in-the-money strikes offer the highest degree of safety. The deeper in the money the safer. There are also combination strategies to maintain a high degree of safety, and obtain higher yields as well.
Out of the Money Example: ABC stock is selling for 22 1/2 and the January 25 call is selling for 1. If you were to buy the stock for 22 1/2 then sell the $25 option you would receive the premium for the option and have the potential capital appreciation in the stock, up to the strike price of 25. So you could earn 3 1/2 points on this trade. If
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you purchased one round lot (100 shares) and sold one contract your return would be $350. Now if you maximized your leverage and purchased the stock using 50% margin, you would purchase the stock for $1125. So the gain of $350 on an $1125 investment equals 31.1% return. That is assuming the stock price rises to at least 25 and you're called out. Any gain above the strike price doesn't benefit you, but the holder of the option. If the stock price remains flat until expiration and you aren't called out, you still earn the option premium of one dollar. So a $100 return on an $1125 investment equals 8.8%, even if the stock price doesn't move. At the expiration you can then sell another option or sell the stock and look for another one. But wait! What if the stock price falls? That's always the risk, isn't it? But even then, the price could drop to 21 1/2 and you'd still break even. You gained the $1 premium for the option. It is this principle that makes covered calls safer than most investments. But what if the stock price falls below the break-even point, you're doomed right? Not necessarily. There are some protective actions you can take. The simplest thing to do is close out the position. This should be your action if you think the price will continue to decline. Bite the bullet, pull the trigger, move on. Another action you could take is roll down. When the underlying stock drops in price, buy back the original call -- it will certainly be less than you sold it for since the underlying stock has declined -- then sell a call with a lower strike price. This could give you some more downside protection and might turn the deal into a profit. Example: If you bought ABC stock for 25 1/2 and sold the May 25 call at 3, you would have maximum profit potential at expiration of 2 1/2 points. Your downside protection is 3 points, down to a price of 22 1/2. If the stock price drops to 22 1/2 the May 25 call might be selling for 1/2, and the May 22 1/2 call might be around 2. At this point, you'd be 2 1/2 points below the strike price and have a 1/2 point unrealized loss. If the stock should continue to fall from this level, you could have a greater loss at expiration. What to do? Here's one salvage technique. You could buy back the original call for 1/2 (you sold it for 3, remember), then sell the 22 1/2 call for 2. Now your downside breakeven point is 21 since you rolled down. Further if the stock remained unchanged (exactly at 22 1/2) until expiration you would make an additional $150. If you had not rolled down, and ABC remained at 22 1/2, the most you could have made would be the remaining 1/2 from the May 25 call. So rolling down gives you a little more downside protection and might produce additional income if the stock price firms. The only time it doesn't pay to roll down is when the stock reverses and begins to climb. There just is no way around the equation: lower risk = lower potential return, higher risk = higher potential return.
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What if the stock rises? A more pleasant problem to deal with is one in which the underlying stock rises in price after the covered position is in place. You might decide to do nothing and let the stock be called away, thus earning exactly what you anticipated when you entered the position. On the other hand, you might try to squeeze another point or two out of it. Let's say you bought ABC stock for 25 and sold a Nov 25 call for 3 points. Your maximum profit potential is 3 points and your breakeven point is 22. Suppose the stock rallies to 30 in a short period of time. With the stock at 30 the Dec 25 might be selling for 5 1/2 and the Dec 30 might sell for 3 1/2. What you might consider is buy back the original Dec 25 call for 5 1/2 and sell the Dec 30 for 3 1/2. This would increase your profit potential. In your original position, if ABC were called away you would have earned 3 points. By rolling up you would have earned the original 3 points plus the 3 1/2 points gained in the roll up, minus the 5 1/2 you had to pay to buy back the original call. You also would gain the 5 points increase in the stock price. So add the 5 points earned on the stock plus the 1 profit on the options, and your net return is 6 points, as long as the stock remains above 30. To increase your profit potential in this manner, you give up some of your downside protection. This element of risk should always be considered. Generally you should not roll up if you think the stock can't handle a 10% correction and still leave you in good shape.
In-The-Money Covered call writing is generally considered to be a conservative strategy. This is because the covered writer would fair better in a stock decline than the stockholder who won't receive any premiums from covered writes. But clearly, some covered writes are more conservative than others. It may be surprising, but writing an out-of-the-money option on a conservative stock is NOT as conservative as writing an in-the-money option on a volatile stock. An in-the-money write, when properly chosen is a totally conservative position. Now surely, you can't write them too deeply in the money allowing for total protection, the yields would be so low that you might as well leave your money in the bank. The conservative covered call writer strives to make an above average return with above average protection. Example: Assume ABC stock is selling for 22 1/2 and the Jun 20 call is selling at 4. By using leverage from your margin account, the stock could be bought for $1125. You would receive $400 for the option. When you're called out you will have to sell your stock for $20, that's 2 1/2 points less than you paid for it. So your net is 1 1/2 points ($150) on an $1125 investment. That equals 13.3% yield. Now look at the protection you have. The stock price
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can fall 2 1/2 points and the trade still work out as planned. You will be called away and you've earned the premium. If the stock is at-the-money and you're not called out, then you can sell the stock or do another covered write. Your breakeven point is 18 1/2 which means the stock would have to fall nearly 20% for this to turn into a losing trade. The downside to in-the-money covered calls is that you don't benefit from any upside potential of the stock. But in a flat market, or even a bearish market, there is great comfort in those in-the-money covered calls. Great comfort. Many investors reconcile themselves that they are after 8-15% per month and want safety first. They never concern themselves with the rising price of a stock. They simply want to get called out of their position and look for another trade that will earn them another 8-10% in a month or so, and they consistently have yields of 100% per year.
Strategies Component Potential Profit
Covered Call Writing Long Stock + Short Call Buy stock and sell at-the-money call When stock price is above break-even point Limited to premium received
Maximum Loss When stock price is below break-even point Substantial, equals to break-even point minus stock price Time Value Impact Break-even Positive Strike price minus premium received The combined position is a synthetic short put. Compared with holding stock only, loss would be reduced by the amount of premium received when the stock price drops. But profit is limited to premium received.
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Example: Component Net Premium Break-even Profit when Potential Profit Potential Loss Time Value Impact Buy ABC stock at $200 and sell ABC Jan $200 Call, receive $15 Receive $15 $200-$15=$185 Stock price is above $185 $15 $185 - stock price Positive
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http://www.graymetalbox.com/tutorial/naked_puts_tutorial.htm
Naked Puts Selling puts is a bullish or neutral strategy where profits are earned by receiving premium for the put option. It's frequently used instead of a covered call. Not everyone can sell naked puts. First your broker is going to want to know if you have any experience with options, and he's going to require a certain amount of cash or equities in your account, and that amount can vary from broker to broker. This review is not intended as an in depth study on the subject, but as a brief review. If you have an interest in selling naked puts, I suggest you first begin by studying the subject. Don't just dive in. There are many good books available on the subject. Let's work through an example. On Sep 18th Compaq Computer closed at 30 5/8. The Oct 35 Put closed at 4 5/8. If you're bullish on this stock you could do several things. But we'll discuss a bullish position by selling puts. If you thought the stock would reach or go beyond 35, you'd sell the Oct 35 Put. Once your brokerage account is set up and funded, you would call your broker (or do it online), place an order to sell the Oct 35 Put. This is a "Sell to Open" order. You are selling something to open a position. If you sold 10 contracts, $4,625.00 would be deposited into your account the next day. This will show up as a short position on your statement from your broker. Now, if the stock has risen above the 35 strike price on expiration day, the option expires worthless and the entire $4625 is yours to keep (less commissions of course.) But you don't have to wait until expiration date to do something with it. If you sold options at 4 5/8 and the stock price jumped very quickly such that the option price has now fallen to 1 or 1 1/2, you can buy them back and close out the position. Your profit is the difference in what you sold them for and what you had to pay to buy them back to close the position. Frequently, options are sold many times prior to expiration date. What happens if the price of the stock drops after the position is opened? First, if you're the seller of the puts, and you
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haven't closed out the position on expiration day, the stock can be put to you. That means you have to buy the stock at the strike price. If you sold the Oct 35 Put and the price of the stock fell to 29, you'd have to buy the stock for 35. Of course, the cost of the stock would be offset with the premium you received in the first place. You could choose to buy the put back just before expiration so that the stock would not be put to you. The Put price would be 6, and maybe a little change, since the put is 6 dollars in the money, right at expiration. You sold the puts for 4 5/8, had to buy them back for 6, so you have a loss of 1 3/8, right? Well that's right if you leave it there, but a salvage technique is to buy the put back for six, then immediately sell the next month put at the same strike price. You'd sell the November 30 put for 6 dollars (the intrinsic value) plus you'd get additional premium for the time-value. So the put might sell for 8 dollars. Now you've got another month for the stock price to rise. If it rises above 35, at expiration the option would expire worthless and the premium is completely yours to keep. This cycle could go on many times. Selling puts can be very profitable, but like all option trading there is risk. It is possible to sell a put, and the stock price fall to zero. Your liability would be the entire strike price. Now let's be real, how many stocks really fall to zero? Not many, but it can happen. So when choosing the stocks on which to sell puts, use the same care that you would if you were buying call options.
Short Put Sell put When the stock price is above the break-even point Limited to the premium received
Maximum loss Substantial, equals to break-even point minus stock price Time value impact Break-even Positive Strike price minus premium received
Example:
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Component Net Premium Break-even Profit when Potential Profit Potential Loss Time Value Impact
Sell ABC Feb $200 Put Receive $20 $200-$20=$180 Stock price is above $180 $20 $180 - stock price Positive
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http://www.graymetalbox.com/tutorial/put_yield.htm
Calculating the Yield Unlike many investments where the yields are simple and concrete, yields from Naked Puts can be more difficult to figure, and will vary from broker to broker, depending on his margin requirements. The yields listed in our Naked Puts section are calculated on a 30%+ margin requirement. Many brokers' margin requirements are less than that, so your yields could be even greater that listed. Ameritrade is one of the large online brokers and in their MARGIN ACCOUNT HANDBOOK margin requirements are spelled out as follows: "The writing of uncovered puts and calls requires an initial deposit and maintenance of 100% of the current market value of the contract plus 30% of the underlying stock value less the out-of-the-money amount, if any, to a minimum of the option market value plus 10% of the underlying stock value." This rather complicated formula really isnt that difficult to understand. Basically, your broker will require 30% of the stock price plus the cost of the option to sell a put that is at the money. If the option is out of the money, then theyll give you credit for the out of the money portion. Armed with that info we can calculate what the yield would be if we were to sell various options. Example: Lets say that ABC stock is selling at 42. Its the end of July and the August 40 Put is selling for 1 7/8. If we wanted to sell the Aug 40 Put, our broker would require on deposit the following funds: 30% of the stock price (which equals $12.60) plus the cost of the option ($1.88), minus the out of the money amount ($2.00) -- 12.60 + 1.88 2.00 = 12.48 Since one option is for 100 shares of the underlying stock, then 12.48 * 100 = $1,248. Your broker will require $1,248 cash or equities in your account to sell 1 Jan 40 Put option. The premium youd receive is 1 7/8 * 100 = $188. To figure your yield divide $188 by $1248, and you get 15%. So as long as the stock price remains above 40, youd keep the entire premium and earn 15% in one month. This is a very lucrative from of trading. When you compare it to buying options, it can be safer as well. The stock would have to drop
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http://www.graymetalbox.com/tutorial/put_yield.htm
below 40 for your yield to be less than 15%, and could drop all the way to 38 1/8 and youd still break even (commissions not included).
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http://www.graymetalbox.com/tutorial/puts_tutorial.htm
Buying Puts
Success in put buying primarily depends on your ability to select stocks that will go down in price and to time your selection fairly well. Most investment strategies are designed to remove some of the risk and exactness in stock picking, thus allowing you to have some room for error and still make a profit. But that doesn't exist with pure play put buying. Your total investment could be lost in an option play. It has to go down enough and quickly enough to be profitable. For this reason, one should only use risk money when buying puts. The potential rewards in buying puts are very attractive. Illustration of how a put purchase might work: Assume that ABC stock is selling at 52 and the 6-month put, the July 50, is selling for 3. With an investment of $300, the put buyer may participate, for 6 months, in a move downward in the price of the stock. If ABC should drop in price by 10 points (just over 20%), the July 50 put will be worth at least $800 and the put buyer would have a 167% profit on a move in the stock of just over 20%. This is the leverage that attracts speculators to options. At expiration, if ABC is above 50, the buyer's loss is total, but is limited to his initial investment of $300, even if the stock rises substantially. Although this risk is equal to 100% of his investment, the dollar amount is still small. You should never risk more than 15-20% of your risk capital in call puts because of the high percentage risks involved. It is very important to understand that the buyer of puts will only make money if the price of the underlying stock goes down.
Strategies
Long Put
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http://www.graymetalbox.com/tutorial/puts_tutorial.htm
Component Potential profit
Buy put When the stock price is below the break-even point Limited to break-even point minus stock price
Total premium paid Negative Strike price minus premium paid
Buy ABC Mar $200 Put Pay $20 $200-$20=$180 Stock price is below $180 $180 - stock price $20 Negative
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http://www.graymetalbox.com/tutorial/naked_calls_tutorial.htm
Selling Calls Selling calls is a bearish or neutral strategy where profits are earned by receiving premium for the call option. Not everyone can sell naked calls, nor should they. The risk potential is unlimited. Your broker is going to want to know if you have any experience with options, and he's going to require a certain amount of cash or equities in your account, and that amount can vary from broker to broker. Let's work through an example. Suppose XYZ stock is at 40. The Oct 40 call is at 3 1/2. If you're bearish on this stock you could do several things, but let's assume that you are an experienced trader and understand the risk involved and prefer to sell premium, that is, sell a call option for a given amount of money in hopes that the option will expire worthless and you get to keep the money you took in. Once your brokerage account is set up and funded, you would call your broker (or do it online), place an order to sell the Oct 40 Call. This is a "Sell to Open" order. You are selling something to open a position. If you sold 10 contracts, $3,500.00 would be deposited into your account the next day. This will show up as a short position on your statement from your broker. Now, if the stock falls below the 40 strike price on expiration day, the option expires worthless and the entire $3500 is yours to keep (less commissions of course.) But you don't have to wait until expiration date to do something with it. If you sold options at 3 1/2 and the stock price fell quickly, the option price would fall quickly too. You could buy it back and close out the position for a quick profit. Your profit is the difference in what you sold them for and what you had to pay to buy them back to close the position. Frequently, options are sold many times prior to expiration date. What happens if the price of the stock goes up after the position is opened? First, if you're the seller of the calls, and you haven't closed out the position on expiration day, the stock can be called from you. That means you have to buy the stock at the current market price and sell it for the strike price. This is where the unlimited risk comes in. If you sold the Oct 40 Call
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http://www.graymetalbox.com/tutorial/naked_calls_tutorial.htm
and the price of the stock went up to 45, you'd have to buy the stock for 45 and it would called from you at 40, causing you a loss of 5 points. Of course, the cost of the stock would be offset with the premium you received in the first place, so you loss would actually be 1 1/2 points. You could choose to buy the call back just before expiration so that the stock would not be called from you. The Call price would be 5, and maybe a little change, since the call is 5 dollars in the money, right at expiration. You sold the calls for 3 1/2, had to buy them back for 5, so you have a loss of 1 1/2. Selling calls can be very profitable, but it is very risky. Only the well capitalized and experienced traders should participate in these types of trades.
Short Call Sell call When the stock price is below the break-even point Limited to the premium received
Maximum loss Unlimited, equals to stock price minus break-even point Time value impact Break-even Positive Strike price plus premium received
Sell ABC Sep $200 Call Receive $25 $200+$25=$225 Stock price is below $225 $25 Stock price - $225 Positive
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http://www.graymetalbox.com/tutorial/credit_spread_tutorial.htm
Credit Spreads (Bull Put Spreads, Bear Call Spreads) A credit spread is one in which you sell an option and buy a lower price option, thus generating a net credit to your account. Credit spreads can be bearish or bullish. If you're bullish one strategy might be to sell a bull put spread. Assume the stock is at 62. If you think the stock will go higher, you could sell the 60 put, say for 4 and buy the 55 put maybe for 2 1/2. So you'd take in $400 for sell the 60 strike and you'd have to pay $250 for the 55. Your net credit would be $150, or 1 1/2 points. Your margin requirement is $500. That's the difference in the strike prices. That's the absolute most that you can lose on the trade. If your broker requires more than $500 to execute a 5-point spread, fire him! Your total risk would be $500. No one should require more than that. Further, if your account is set up to buy options at all, you should be able to open spreads without filling out any other forms or anything else. So you can participate in selling of puts without selling naked puts. Now, what can happen in this trade? First, if the stock goes higher or at least remains above 60 on expiration date, then both puts will expire worthless and the $150 credit you received is yours to keep. There's nothing to do, no need to call your broker or anything else. They'll just expire and the money stays in your account. How much would you have made? You would have made $150 on a $500 investment. What?!!! Yep, your broker requires $500 in your account to collect $150. Do the math --- $150 divided by $500 = 30%. Thirty percent for about a month's trade. Do you see how selling puts and spreads can be lucrative? Many traders prefer selling puts to writing covered calls. I do both. Now I have left out one thing... the commissions. And yes, you will be charged 2 commissions. One for selling the put, and one for buying the other put. So you do have to consider commissions in here. If you were trading just one option, then the commissions might cut in to your profits so much that it's not worth it. But if you were selling 10 then you can see how it gets better. You'd collect $1500 on a $5000 cash requirement in your account. Now commissions don't take such a bite. Now the down side... Let's say the stock tumbles.... going down, drops below 60, keeps dropping, goes to 50, keeps going, drops all the way to
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zero. What happens? You close out the trade. The 60 Put that you sold is biting you in the butt, but the 55 is your salvation. Whatever you have to pay to buy back the 60, is offset by the 55 Put, less the 5 point spread. So your total loss can only be 5 points, even if the stock goes to zero. If this is all new to you, then paper trade some spreads and get the feel for it. If you trade online, the first time you execute a spread, call your broker on the phone and get him to open the trades for you. You want to make sure that you open and close both sides of the trade at the same time. Otherwise, you could get caught "naked".
Bull Put Spread Buy lower strike price put, sell higher strike price put of the same month When the stock price is above the break-even point Limited to the net premium received
Limited to the difference between the two strike prices minus the net premium received Neutral Higher strike price minus net premium received As different from a Bull Call Spread which would result in net premium paid, a Bull Put Spread would result in net premium received, as the premium for the lower strike price put is lower than that of the higher strike price put.
Example:
Component Net Premium Break-even Profit when Potential Profit
Buy ABC May $180 Put, pay $10, and sell ABC May $210 Put, receive $30 Receive $30-$10=$20 $210-$20=$190 Stock price is above $190 $20
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Potential Loss Time Value Impact
($210-$180)-$20=$10 Neutral
Bear Call Spread:
Strategies Component
Bear Call Spread Sell lower strike price call, buy higher strike price call of the same month
Potential profit When the stock price is below the break-even point Limited to the net premium received Maximum loss The difference between the two strike prices minus the net premium received Time value impact Neutral Break-even Lower strike price plus net premium received As different from a Bear Put Spread which would result in net premium paid, a Bear Call Spread results in net premium received, as the premium for the lower strike price call is higher than that of the higher strike price call.
Example:
Sell ABC Jan $190 Call, receive $30, and buy ABC Jan $220 Call, pay $10 Receive $30-$10=$20 $190+$20=$210 Stock price is below $210 $20
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($220-$190)-$20=$10 Neutral
Copyright 2000
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http://www.graymetalbox.com/tutorial/debit_spread_tutorial.htm
Debit Spreads (Bull Call Spreads, Bear Put Spreads) A debit spread is one in which you buy an option and then sell a lower priced option, thus generating a net debit to your account. Debit spreads can be bearish or bullish.
Bull Call Spread Buy lower strike price call, sell higher strike price call of the same month When the stock price is above the break-even point Limited to the difference between the two strike prices minus the net premium paid
Net premium paid Neutral Lower strike price plus net premium paid As different from a Bull Put Spread which would result in net premium received, a Bull Call Spread would result in net premium paid, as the premium for the lower strike price call is higher than that of the higher strike price call.
Example:
Component
Buy ABC May $190 Call, pay $30, and sell ABC May $220 Call, receive $10
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Net Premium Break-even Profit when Potential Profit Potential Loss Time Value Impact
Pay $30-$10=$20 $190+$20=$210 Stock price is above $210 ($220-$190)-$20=$10 $20 Neutral
Bear Put Spread Sell lower strike price put, buy higher strike price put of the same month When the stock price is below the break-even point Limited to the difference between the two strike prices minus the net premium paid
Net premium paid Neutral Higher strike price minus net premium paid As different from a Bear Call Spread which would result in net premium received, a Bear Put Spread results in net premium paid, as the premium for the lower strike price put is lower than that of the higher strike price put.
Example:
Sell ABC Mar $180 Put, receive $10 and buy ABC Mar $210 Put, pay $30 Pay $30-$10=$20 $210-$20=$190 Stock price is below $190 ($210-$180)-$20=$10
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$20 Neutral
Copyright 2000
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http://www.graymetalbox.com/tutorial/long_strangle_tutorial.htm
Long Strangle A Long Strangle is used when an large move is anticipated in a stock price, but it's unknown as to which direction the stock might move. It's often used around earnings announcements. Traders think that if a company beats their earnings expectations the stock will rocket upward, but if the miss the number then it will really take a hit and drop drastically.
Long Strangle Buy lower strike price put, buy higher strike price call of the same month When the stock price is below the lower break-even point, substantial and equals to lower break-even point minus stock price When stock price is above the upper break-even point, unlimited and equals to stock price minus upper break-even point
Total premium paid Negative The lower break-even point equals to lower strike price minus total premium paid The upper break-even point equals to higher strike price plus total premium paid Compared with Long Straddle, Long Strangle is less expensive to establish but requires higher market volatility to be profitable.
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http://www.graymetalbox.com/tutorial/long_strangle_tutorial.htm
Example:
Component Net Premium Break-even
Buy ABC Jan $180 Put, pay $5, and buy ABC Jan $200 Call, pay $10 Pay $5+$10=$15 Lower: $180-$15=$165 Upper: $200+$15=$215
Profit when Potential Profit
Stock price is below $165 or above $215 When the stock price is below $165, $165 - stock price When the stock price is above $215, stock price - $215
$15 Negative
Copyright 2000
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http://www.graymetalbox.com/tutorial/short_strangle_tutorial.htm
Short Strangle A Short Strangle is used when a stock is expected to remain flat. Traders will sell both a put and a call for the purpose of collecting premiums.
Short Strangle Sell lower strike price put, sell higher strike price call of the same month When the stock price is between the upper and lower break-even points Limited to total premium received
Maximum loss When the stock price is below the lower break-even point, substantial and equals to lower break-even point minus stock price When stock price is above the upper break-even point, unlimited and equals to stock price minus upper break-even point Time value impact Break-even The lower break-even point equals to lower strike price minus total premium received The upper break-even point equals to higher strike price plus total premium received Positive
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http://www.graymetalbox.com/tutorial/short_strangle_tutorial.htm
Compared with Short Straddle, Short Strangle has less premium receivable but requires higher market volatility to result in a loss.
Example: Component Net Premium Break-even Lower: $180-$15=$165 Upper: $200+$15=$215 Profit when Potential Profit Potential Loss When the stock price is below $165, $165 - stock price When the stock price is above $215, stock price - $215 Time Value Impact Positive Stock price is between $165 and $215 $15 Sell ABC Jun $180 Put, receive $5, and sell ABC Jun $200 Call, receive $10 Receive $5+$10=$15
Copyright 2000
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http://www.graymetalbox.com/tutorial/butterfly_tutorial.htm
Long Iron Butterfly A favorite strategy among professional option traders, the long iron butterfly has the best chances of success in most markets. This strategy sounds quite complicated but it's really very simple once you let it soak in. It's sometimes referred to as the "secret weapon of option traders". A long iron butterfly trade makes 3 assumptions: 1. Stocks mostly trade within a range. 2. Option sellers usually make more money than option buyers. 3. Selling naked options is too risky. If those 3 things are mostly true, then the iron butterfly trade. Suppose ABC stock trading around 50 per share. Maybe it drops to the 42-43 range sometimes and goes as high as 56-57. So it usually trades between 40-60. Lots of stocks trade in a range like that. One thing we could do to play this stock is sell the naked put with a strike of 40. Right? If the stock remains above 40 on expiration day, the put expires and we keep the premium. Another thing we could do is sell a naked call. Maybe sell the 60 strike. Then if the stock doesn't go over 60, the option expires worthless and we keep the premium. Well, why not do both? We could sell the put and the option. As long as the stock closes between 40 and 60 then both options expire worthless and we keep all the premium. That's a naked strangle. If we take it one step further we can set up a long iron butterfly and not have the awful risk of having naked options as a liability. We could sell the 40 put, then buy the 35 put for insurance against a market collapse. Our risk could be no more than 5 points. Essentially we have have sold a bull put spread. At the same time, we sell the 60 call and buy a 65 call, thus setting up a bear call spread, and again minimizing our risk since we are not now in a naked option position. Did that soak in? Let me summarize.... If you think a stock will trade within a range, you can sell out of the money options, both puts and calls, and collect the premiums. But instead of selling them naked, you do it in the form of a spread to eliminate most of the risks. If you think a stock will stay around 80, then you sell the 70 put (then buy the 65) and simultaneously sell the 90 call (and buy the 95). You're selling a spread on each side of the stock price. Even if the stock goes against
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you, it can't go against you in both directions. This is why professionals love this strategy. If the stock goes down the put spread may hurt you, but the call spread will be a success. The stock is either down or up. It can't be both. So even if you take a loss on one side of the trade, the profit from the other side will help offset that.
Strategies Component
Long Iron Butterfly Sell out of the money bull put spread, sell out of the money bear call spread. Both spreads expiring the same month. When the stock price is between the short put and the short call.
Potential profit
Maximum loss When the stock price is below the lower strike of the put spread, or when the stock price is higher than the higher strike price of the call spread. Limited to the point spread of just one of the spreads. Time value impact Break-even The lower break-even point equals to the short put strike price minus total premium received The upper break-even point equals to the short call strike price minus total premium received Positive
Compared with Short Strangle, the Long Iron Butterfly does not sell naked options. One sells the strangle, but buys farther out of the money options for protection.
Example: Component Sell ABC Jun $60 Put, receive $4, and buy ABC Jun $55 Put, pay $2 1/2 for a credit of 1 1/2
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Sell ABC Jun $75 Call, receive $5, and buy ABC Jun $80 Call, pay $3 1/2 for a net credit of 1 1/2 Net credits = 3 points Net Premium Break-even Lower: $60-$3=$57 Upper: $75+$3=$78 Profit when Potential Profit Potential Loss When the stock price is below $60 When the stock price is above $75 Time Value Impact Positive Stock price is between $60 and $75 $3 Receive $1.5 +$1.5=$3.0
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