High Probability Option Trading: Covered Calls and Credit Spreads

Steve Lentz Director of Education and Research OptionVue Research, Inc.

Disclaimer
Option trading can involve highly volatile returns and unlimited risk. Option trading is not suitable for every investor.

Overview
Introduction to Options and Graphical Analysis Why Trade Option Spreads The Role of Volatility Advantages of Selling Premium Covered Calls Credit Spreads Obtaining Candidate Stocks

Introduction to Options and Graphical Analysis

Call Option Right but not obligation to buy stock at a certain price on a certain date Put Option Right but not obligation to sell stock at a certain price on a certain date

IBM
Last Change Trade

2/18/03

Bid

Ask

MIV

Trade

Bid

Ask

MIV

Trade

IBM
Last Change Trade

2/18/03

Bid

Ask

MIV

Trade

Bid

Ask

MIV

Trade

IBM

2/18/03

IBM
Last Change Trade

2/18/03

Bid

Ask

MIV

Trade

Bid

Ask

MIV

Trade

IBM

2/18/03

Todays Risk/Reward Line

IBM

2/18/03

Risk/Reward Line for 16 Days Away

IBM

2/18/03

1st Standard Deviation of Possible Price Outcomes Based on Last Month of Trading

IBM

2/18/03

Risk/Reward Line for Expiration in 32 Days

Why Trade Option Spreads ? To Obtain Favorable Risk/Reward Ratios

IBM

2/18/03

IBM

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IBM
Long 100 Shares of Stock

2/18/03

Long 1 Call Option 16 Days Out

IBM

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Long Stock 1:1 Risk/Reward Ratio

IBM

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Long Option Negative Risk/Reward Ratio On Normal Sized Moves

IBM

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Long Option Positive Risk/Reward Ratio Only on Big Moves

Option Spreads Help Create Positive Risk/Reward Ratios On Normal Sized Moves

IBM
Option Spreads Positive Risk/Reward Ratio Only on Normal Moves

2/18/03

Advantages of Selling Premium: Adopt the role of insurance company Time is on your side Through risk management, the long-term odds can be in your favor

The Role of Volatility

IV

SV

IMPLIED VOLATILITY (IV) Measures the volatility of the underlying asset implied by current option prices Higher IV Means More Time Premium to Sell

STATISTICAL VOLATILITY (SV) Measures how much the price of the asset itself has bounced around recently Higher SV Means a Wider Standard Deviation of Possible Price Outcomes

Percentile Rankings

Knowing a Good Premium Selling Situation

Expensive vs. Inexpensive Overvalued vs. Undervalued

Expensive = High IV Percentile

Inexpensive = Low IV Percentile

IV Percentile Rankings
100% EXPENSIVE 70%

30% INEXPENSIVE 0

Overvalued = High IV/SV Ratio

Undervalued = Low IV/SV Ratio

Knowing a Good Premium Selling Situation

Sell Expensive and Overvalued Options Purchase Inexpensive and Undervalued Options

Covered Calls for the Stock Investor

IBM

2/18/03

IBM
Last Change Trade

2/18/03

Covered Call
Bid Ask MIV Trade

Bid

Ask

MIV

Trade

IBM
Last Change Trade

2/18/03

Covered Call
Bid Ask T.Prem Trade

Bid

Ask

T.Prem

Trade

IBM

2/18/03

Todays Risk/Reward Line

IBM

2/18/03

Risk/Reward Line for 16 Days Away

IBM

2/18/03

Risk/Reward Line for Expiration in 32 Days

IBM

2/18/03

73% Probability of Profit

IBM
Last Change Trade

2/18/03

Covered Call
Bid Ask T.Prem Trade

Bid

Ask

T.Prem

Trade

IBM

2/18/03

IBM

2/18/03

Vertical Credit Spreads for the Option Trader

IBM
Last Change Trade

2/18/03

Vertical Credit Spread

Bid Ask MIV Trade

Bid

Ask

MIV

Trade

IBM
Last Change Trade

2/18/03

Bid

Ask

MIV

Trade

Bid

Ask

MIV

Trade

IBM
Last Change Trade

2/18/03

Vertical Credit Spread

Bid Ask MIV Trade

Bid

Ask

MIV

Trade

IBM

2/18/03

IBM

2/18/03

IBM
Last Change Trade

2/18/03

Vertical Credit Spread

Bid Ask MIV Trade

Bid

Ask

MIV

Trade

IBM

2/18/03

81% Probability of Profit

IBM

2/18/03

IBM
Last Change Trade

2/18/03

Vertical Credit Spread

Bid Ask MIV Trade

Bid

Ask

MIV

Trade

IBM

2/18/03

Position Requirements

IBM
Last Change Trade

2/18/03

Covered Call
Bid Ask T.Prem Trade

Bid

Ask

T.Prem

Trade

Stock Position:
100 shares X $79.33 = $7,933 Margined Position: $7,933 X 50% = $3,967 Minus $330 Credit for The Sold Call Total = $3,637

IBM
Last Change Trade

2/18/03

Vertical Credit Spread

Bid Ask MIV Trade

Bid

Ask

MIV

Trade

Spread - Credit:
Spread = $10 X 100 shrs = $1000 Credit = $390 Collected - 115 Paid Out $275 $1000 - $275 = $725

IBM

2/18/03

Covered Call: $3,637

Vertical Credit Spread: $725

IBM

2/18/03

Covered Call: $3,637

Vertical Credit Spread: $725

Obtaining Candidate Stocks

High Probability Option Trading: Covered Calls and Credit Spreads

Steve Lentz Director of Education and Research OptionVue Research, Inc.