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Option Trading Strategies - John Carter

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Struther's Option Report

HOW THE PROS MAKE MONEY IN OPTIONS Part 2

STRATEGIES - Part 2

Now lets get down to some actual strategies. There are many strategies and variations with stocks and options. In this report, I will explain some of the most common and my favourites. I will also touch briefly on some
others.

BUYING CALLS

This is the most popular strategy and my opinion the least profitable. The reason for this is, if you follow the options markets you will see the option volumes pick up when a stock becomes volatile. The time premium is becoming more expensive as what I call the greed factor taking hold. Investors see the volatilitly of the stock
increasing and think the easy money to be made is to buy the Calls. While volatility is one of the factors to increase your chances in  making profitable trades in Call options, these other factors must also be considered.

  •  The market price of the underlying security should be close to the bottom of its recent trading range
  • A striking price close to the market price
  •  The time according to the expectations of the Call buyer as it relates to the intrinsic value. Call buyers must make certain of the time span they are willing to pay for. If on March 1, a Call buyer thought Barrick Gold would rise 15% in price before April expiration, the buyer would not purchase July or October Calls. However, if the buyer needs extra time for the stock to move, buy longer term Calls.
  •  As low an option price as possible based on the projected time span of the stock movement, where the stock is headed and the risk involved. For example on june 10th Seagram trades at 62 1/2. If the Call buyer thought
  • Seagram would trade at 80 by July expiration, he might buy a July 75 trading at 1/2. By expiration the Calls would trade for 5, for a profit of 900%

The Call buyer is not only predicting where the stock will move; but, an exact time span. A miscalculation will bring reduced profits or substantial losses.

 

There are three basic choices in buying Calls

  •  Deep in the money
  •  In (or at) the money
  •  Out of the money

Lets look at this example and consider these three choices

Facebook share price on Sept 30th was $53 5/8 and increased by Oct 8th to $60 1/8

The following options are available

                  Prices                Prices

                  Sept 30             Oct 8             Profit                 % return
Oct 50           4 1/8               10 1/2           6 3/8                     154
Oct 60 (R)       7/16               2 1/4
Oct 70 (R)       1/16               1/16              
Jan 50             7                  13 3/4            6 1/4                      89
Jan 60           2 3/4                5 3/4             3                         109
Jan 70            7/8                   2                1 1/8                     129
Apr 50            9                    14                 5                          56
Apr 60           4 1/2               7 1/2             3                          67
Apr 70           2                     3 1/4             1 1/4                    63

 

In this example Oct 50, Jan 50 and April 50 are deep in the money. Oct 60, Jan 60 and Apr 60 are close to or at the money. Oct 70, Jan 70 and Apr 70 are out of the money.

These results occured while the underlying stock rose from 53 3/8 on Sept 30 to 60 1/8 on Oct 8 - a 12.1% rise.

Deep in the money

These options usually react very closely to the movements of the underlying stock.

If an investor feels that a stock, for example Facebook, is going much higher in the near future, he would purchase the option with the nearest expiration date that is deepest in the money ( the Oct 50's). In buying this
option he is actually agreeing to pay $50 plus $4 1/8 or $54 1/8, for the shares that are trading for $53 5/8. For this small premium of 1/2 he will realize virtually the same increase as the underlying shares and for a much
smaller investment.

In the actual case provided the same result would have been obtained from buying the Jan 50's ( which still have 3 1/2 months to go until expiration). More premium is attached to the longer outstanding calls, and this 'time
factor' usually partially discounts the increase of values of outstanding Calls with the longest expiration dates. Notice the Apr 50 only advanced 5 points during the same period.

The value of this time factor works against the option holder who anticipates a sudden rise in the underlying stock in that it lowers the percentage rate of return (less leverage). Therfore, bullish Call buyers should make certain of the exact time span they are willing to pay for. In other words, if you think Facebook on Oct 2, is going to rise 10% or more before the end of October expiration date, buy October Calls: do not buy January or April Calls. However, if you think it would be worth the price (the time factor discounting) or need the extra time for the stock to move, then buy longer term Calls.

In or at the Money

This position is probably the most difficult decision an option buyer has to make. In fact, to be profitable, almost every individual situation has to be carefully evaluated at the very moment that the order is to be entered.
There are many considerations and theories to examine which can be quite complex.

The main problem is establishing probabilities. The rate of change of the price of the option relative to the rate of change of the price of the underlying shares (the delta factor) not only changes according to the trend of the stock, but also dramatically as the stock approaches and passes a strike price. The delta may help the call buyer decide which option to buy.

 

Out of (and Deep out of) the Money

These options offer the highest percentage return on your money (leverage) provided the price of the underlying stock increases to near or above the strike price. It is also possible to benefit from the time factor of the longer term options once they move into the money.

Restricted Option Rule: (R) - I believe with increased volatility in markets this rule no longer applies or has changed. If you do get a restriction this is how it use to be set. You cannot make an opening purchase on any
option that, based on the previous closing prices, is selling for less than 1/2 and simultaneously is more than $5 out of the money. Example is the Facebook options above, Oct 60 and Oct 70. Note that once the stock rises
above $55 the Oct 60's will no longer be restricted.

The investor buying a Call option should be trying to take advantage of a quick, short-term movement in the chosen stock, lasting two or three days to three weeks at the longest. The success rests with the ability to select
bullish stocks and the time it takes for the stock to move.

  Synthetic Put strategy
 
 Some other uses of Call options, may be for a speculator who has sold short a stock, could buy Call options as a hedge. The speculator would buy a Call option at a price equal to or above the price the short sale was made. If the prediction of the short sale is wrong and the stock moves up, only the cost of the option is lost. If the price moves down as expected, the profit from the short sale is reduced by the amount of the option premium. This strategy is known as a 'Synthetic Put'. The Synthetic Put is only a viable strategy if the underlying stock has no listed puts. The same results can be acheived by buying a Put and for less money.
 
If you had a temporary shortage of funds and you expect the value to rise and you want to make a straight stock purchase, you could take out a Call option until the funds are available. Then you have the choice of exercising the option if the stock price has gone up or buying the stock outright and selling the option at a partial loss if the price has gone down.
 

   LEAPS

  The only difference with leaps is the expiration date, which can go out two or three years. This gives the Call buyer lots of time to realize the desired movement in the stock price. A strategy would be to buy deep in the money Calls, with an expiration of maybe two years out. In six months time, if the shares have moved up, your Call option will reflect this rise and the time premium will not have eroded significantly. This way you can participate in the price appreciation of the stock for less capital outlay.

 BUYING PUT OPTIONS

The Put is an option to sell a stock (the reverse of a Call). The same factors and decisions apply to Puts as Calls, the difference being is you are betting on the stock to move the opposite direction, down.

Obviously, you buy a Put if you think the underlying stock is going to go down. Another strategy is as a hedge, if you are holding a stock in your portfolio, you believe the stock may move down temporarily, but want to hold
the stock and avoid sell and buy commissions, you could buy a Put at around the current price of the stock. If the stock moves down, you can sell the Put for a profit to offset the paper loss on the stock. If you have a
portfolio of several stocks and you expect the stock market as a whole to drop, you could buy a Put on one of the stock indexes, such as the S&P 500. This Put would move up in value as the market fell and compensate you for losses on your stock holdings.

Buying a Put and writing a Call are different. Both are a contract to sell, but note the differences. In buying a Put you pay for the privilige of selling shares but the final decision of whether you exercise that privilege is yours. In writing a Call you are paid for your promise to sell shares at a certain price within specific time limits; the decision on whether you must in fact sell the shares is up to the Call buyer, not to you.

While it is possible for 'American Style' options such as those that trade on stocks to be exercised any time before expiration, European style options such as index options on the S&P 500 'SPX/CBOE', and the
Dow Jones 'DJX/CBOE' cannot be exercised before maturity. Further clarification at CBOE

 

 WRITING COVERED CALL OPTIONS

This is one of the strategies I prefer. As an investor, if you write an option, you get the premium as an immediate and permanent cash payment. In return you promise to sell 100 shares of stock at a set price at any time during the life of the option. The only exception to this is if you offset your option by closing your position on the secondary market. You do this by buying a Call option of the same strike price and expiry date as you wrote.
The transaction does not necessarily have to be conducted with the original investor who purchased the Call that you wrote, this is all settled by the Option Clearing Corp.

The advantage of writing is, you get the cash from writing the option and stock dividends from holding the shares which you can use in any manner. You can use this strategy if you don't think the stock is going to be making a
big move upwards during the life of the option. You make extra income from the shares by writing an option on them. The strategy of covered writing is also to provide downside protection. If you write a Call option with a
premium of $4, you have downside protection of $4 compared to just holding the shares without writing a Call option. If your shares drop $10, your loss is only $6 (10 -4) assuming you closed out all positions.

The disadvantage is, if the shares move up dramatically your shares will be called away at the strike price you wrote the option at. For example, if you bought Barrick Gold at $30 and wrote a covered call with a strike price
of $32 and received the premium of $2. Barrick moved up to $40. Your profit would be $32-30 = 2 (the price called away at minus your original cost of the shares) plus the $2 premium received for a total of $4. If you had not writen the Call you could sell Barrick for $40 and realize the total $10 profit.

However, if Barrick did not move above $32, the $2 premium is already yours, you still own the stock and you can do the process all over again and receive another premium of $2 or so.

In writing a covered option, the ideal situation would be one where there is a large time premium, a short time left before expiration and an underlying stock with low volatility. Obviously this doesn't always occur, but I like to pick stocks that meet the first two criteria, a large time premium and a short time to expiration. I like to call this options being overpriced because of the greed factor. My favourite example, goes back many years when Corona and Lac Minerals were in a legal battle over a gold mine. The final ruling on the case was to come out in a two weeks, the majority consensus was that Corona would win the case and their shares would jump upwards as the stock would have much more value with ownership of this mine settled in their favor.

All kinds of Call options were being bought, as investors figured there was quick easy money to be made (the greed factor had taken hold). Of course there was an equal number of investors on the other side of the transaction, the Call writers (I like to refer to as the Pros). Corona stock was trading for around $9, the $9 Call option (at the money), with an expiration of about 5 weeks out was fetching a premium of about $1.50 ( this was a 16.5% time premium for 5 weeks). My strategy was to buy the stock and write the Covered Calls, with this strategy, your broker will only require about 30% margin. Assuming you put up 33% margin and bought 3000 shares at $9 and wrote 30 calls for $1.50. This works out to $9000 margin required and a total premium received of $4500 (each Call gives you a premium of $150 X 30). This is a 50% return in 5 weeks, good enough for me. Also with this strategy you have downside protection of $1.50 if the court ruled against Corona and the stock dropped, as well in 5 weeks time you could write 30 options again for additional premium if your shares were not called away.

 As it turned out, the court ruled in favor of Corona, but the shares went nowhere, they stuck around $9, the only winners were the Call writers. With this strategy, we can also see when it might be appropriate to close out your position on the Calls by buying them back. After a few weeks time, the shares were still around $9 and the time premium of the options had fallen to around 0.20 with just two weeks to go before expiration. If you wanted to hold the shares, you might as well buy back the Call options for 0.20, you still have realized most of your premium $1.30 (1.50 - .20) and you do not risk having your shares called away if the stock moves above $9 in 
the last two weeks before the option expires. Of course this example ignores commissions which will have a bearing on the figures.
 
 Writing Calls could be used if you wanted to sell your stock and receive some additional income from the sale. You would do this by writing at the  money or deep in the money Calls, as long as the stock was above the strike price, the stock would be called away. However, if you wanted to keep the  shares and still receive additional income, you would write out of the money Calls whenever the stock approached the top of its trading range.
 
It is very common to find Call options with 10% to 20% premiums with 2 months or less left to expiration in todays volatile market. With some margin you can easily make a 30% return on your money in 2 months. You
can do this several times per year with the same capital and a 100% return is not that difficult with small risk.
 

WRITING UNCOVERED CALL OPTIONS or NAKED OPTIONS

The definition of a naked option, is to write an option without owning  the underlying shares. This strategy, is not recommended, as the risk is unlimited. For example if you wrote a naked Call option to sell IBM at $80 and IBM rose to $150. The Call option would be exercised and you would haveto come up with the IBM shares to sell at $80, This would mean buying at  $150, For a loss of $70 a share. The risk is unlimited, as in theory the shares could rise to whatever value.

WRITING UNCOVERED PUT OPTIONS

This is another strategy I prefer, If you write/sell a Put, you are paid for your promise to buy the stock at a predetermined price within a specific time period. This is an excellent way to try and buy shares at current market prices or below market price and receive extra income. You would deploy this strategy on a stock that you wanted to buy. To buy the stock at below market value, you write a Put with a strike price below the current stock price and deposit your money to buy the shares perhaps in a T Bill account earning interest. While your waiting for the expiration date, your money is earning interest and you received income from writing the Put. Obviously, if the stock moves up, it will not be "put" to you, if it declines below the strike price it will be. With this strategy, you win either way, if the stock moves up, you pocket the money, or if it moves down, you pick up the shares below the previous market value and still pocket the Put premium.

If you wanted to increase your chances of obtaining the shares, you would write Puts at the money or with a strike price above the current stock price (in the money). Now assuming the shares are "put" to you, at this time you could write a Covered Call for more income. You can see from using these two strategies, that you can make substantial income on stocks, especially if the options have high time premiums. After writing the Call, if the shares are called away, you can write the Put again, if they are not called, you can write another Call. These strategies could be used several times on one stock within a year to obtain some pretty hefty returns and at the same time being quite a conservative investment approach. To increase returns, as well as risk, you can deploy these strategies on margin.

RATIO WRITING

Ratio writing involves combining covered options with uncovered options. The most common ratio is 2:1 and involves owning 100 shares of stock and selling 2 Calls of the same expiration date and strike price, which is relatively close to the stock price. The resulting position will have both unlimited upside risk, as the case of the Naked Call and limited downside risk, as in the case of the Covered Call. The 'ratio write' will generally give a larger profit than either covered writing or a Naked Call, if the stock remains relatively unchanged until expiration. An investor would use this strategy if the outlook for the stock was neutral.

However, if the stock were between two strike prices, you may do a 'variable write', which involves owning 100 shares of stock and writing 1 in the money Call and 1 out of the money Call. Example: IBM is trading at $85.
A variable write would involve writing 1 Call IBM Oct 80 for $10 and 1 Call IBM Oct 90 for $6. This would be a viable strategy after careful consideration of profit potential, risks, downside and upside break even points.

STRATEGIES FOR SPREADS

Spread strategies, are where you simultaneously buy and write Calls on the same underlying security. The rational is based on the fact that, for each stock, there are so many different striking prices and expiry dates that one may take advantage of different premiums to reduce risk in a spread strategy. There are many variations, but every spread falls into one of three basic categories: time only spreads, striking-price only spreads and a combination of these two.

Time Spreads

The only difference between the short and long options in a time spread is the expiration date. This strategy involves going short 1 Call with a nearer expiration date than the 2nd Call purchased but with the same exercise price. The risk is limited to the debit of the spread. The time spread's maximum profit is the price of the short call minus the reduction in value of the long call at expiration of the short call. This spread is designed to take advantage of the constantly diminishing time premium of the short term option. The drawback is that an investor must demand that the price action to take place within a narrowly defined time span. You should be concerned with the short term market only and anticipate no or slight upward movement in the stock.

Example

In October IBM is at $59 3/4

Sell 1 call IBM January 60 for $4
Buy 1 call IBM July 60 for $8

Maximum risk until January is $4

If IBM remains at $60 on January expiry, the Jan 60 will expire unexercised and the July 60 could theoretically drop to say $6 1/8. Your profit in January could be $4 +$8 minus $6 1/8 for a profit of $2 1/8, assuming you closed out all IBM positions and sold the July option

If IBM moves dramatically up or down, the spread will tend to narrow and the maximum loss will decrease accordingly. The maximum loss still remains at $4.

 

Price Spreads

Spreads in the striking prices of options are termed vertical spreads. In these spreads the time is the same but the strike prices are different, for example IBM July 80 and IBM July 90. These price differences can be used by the option investor to limit the risk of option trades, but also can limit profitability.

Vertical Bull spreads are the most common. This is a price spread where you expect the stock price to rise; you must buy the Call option with the lower strike price and write the Call option with the higher strike price.

Example

You  buy IBM July 80 for $7
You write IBM July 90 for $3 1/8

Maximum loss on this transaction is $3 7/8 (the risk of the vertical spread).

 
     Depending on where IBM shares go, you can expect these outcomes
 
     1.  If share price falls to $70
           - neither option is exercised and the net loss is $3 7/8
 
     2.  If share price is $80
           - same as #1 outcome
 
     3.  If the share price is $90
           - profit of $10 on call option
           - written option expires
           - maximum profit $10 - $3 7/8 = $6 1/8
 
     4.  If the share price is $100
           - profit of $20 on call option
           - loss of $10 on written option
           - net profit ($20 - $10) - $3 7/8 = $6 1/8
 
You can see the maximum profit is limited to the difference in the exercise price minus the risk. The investor who feels that IBM will rise may be willing to forego some potential profit to reduce risk by doing a vertical price bull spread. To realize maximium profit the stock must close at or only slightly above, the strike price of the written option. If the stock rises far above the strike price, the investor would have had greater  profit from a direct share purchase

Combined Price and Time Spreads

Combinations: There are many complex strategies which a speculator can deploy. These involve a put and a call in the same strategy.

A straddle consists buying or selling both a put and a call with the same underlying stock, strike price and expiration date.

We could go on forever with different variations and scenarios of various spreads. Although BreX was never recommended in my newsletter, it was a very popular stock and you probably remember it

With popularity it had high option premiums. When the stock was around $20 (after the split from $200) risks were high and I outlined an option strategy where investors were totally protected on the downside while maintaining some upside potential. Any investor who used this option strategy would have not lost any money when the stock collapsed.

From this report, you should know how options work and have a good understanding of some strategies and the potential in option trading. However some homework doing some trades on paper and calculating the outcome
is excellent practice before you dive into these markets.

Good luck with your option trades, with the help of this report, your success rate should increase. Ocassionaly, in my newsletter, I will mention  using some of these strategies, you can refer back here to see if the strategy fits your investment goals.

 

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