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June 29, 2001
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Money > Options Trading Strategy Guide June 29, 2001 |
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Options Trading Strategy Guide: Option Trading StrategiesHiten Jhaveri/StockWhizo As we described earlier, four possible option selections exist for a trader: (1) long a call, (2) long a put, (3) short a call, and (4) short a put. These four can be used independently, together, or in conjunction with other financial instruments to create a number of option-trading strategies. These combinations enable a trader to develop an option-trading model which meets the trader's specific trading needs, expectations, and style, and enables him or her to anticipate every conceivable situation in the market. This trading structure can be adapted to handle any type of market outlook, whether it be bullish, bearish, choppy, or neutral. Options are unique trading instruments. They can be used for a multitude of purposes, providing tremendous versatility and utility. Among their multiple applications are the following: to speculate on the movement of an asset; to hedge an existing position in an asset; to hedge other option positions; to generate income by writing options against different quantities of options strategies that arise from these applications and the fact that the scope of this book is limited, we will devote coverage to a cursory explanation of two of the most popular strategies which are designed to take advantage of market movement: spreads and straddles. SPREADS Option spreads are hedged positions that can be utilized to control a trade's risk, while at the same time limiting gains. They accomplish this goal by simultaneously taking positions on both sides of the market. A call option spread is the simultaneous purchase and sale of call options with different strike prices, different expiration dates, or with both different strike prices and different expiration dates. Likewise, a put option spread is the simultaneous purchase and sale of a put option with different strike prices, different expiration dates, or with both different strike prices and different expiration dates. Spreads with different strike prices are referred to as price spreads or vertical spreads because the strike prices are stacked vertically on top of each other in financial listings. Spreads with different expiration months are referred to as calendar spreads, horizontal spreads, or time spreads because the options expire at different times. A spread where both the strike price and expiration month are different is referred to as a diagonal spread. Option spreads can be used when one has an inclination as to where the underlying market is heading, but is somewhat uncertain. Because the position is hedged, a spread allows the trader to participate in the market while effectively containing risk, sometimes even more so than with single option positions. Option spread can also be used when a trader has particular price targets in mind - because spreads limit gains as well as losses, spreads can be initiated that will enable the trader to take advantage of these targets while at the same time keeping risk at a minimum. Vertical / Price Spreads As is the case with options, any of four possible vertical option spreads can be selected depending on what a trader expects will happen in the market: one can buy a call spread, one can sell a call spread, one can buy a put spread, or one can sell a put spread. A long call spread and short put spreads are considered bull spreads because they are used when a trader's market outlook is positive, or bullish. A short call spread and long put spreads are considered bear spreads because they are used when a trader's outlook is negative, or bearish. Horizontal / Time Spreads The four types of spreads just mentioned were vertical spreads, or price spreads. Another group of spreads is referred to as horizontal spreads, time spreads, or calendar spreads. Whereas vertical spreads are used to take advantage of price movements in the underlying security, horizontal spreads are used to take advantage of time erosion and the pricing discrepancies that arise from movements in the underlying market. A horizontal spread involves the simultaneous purchase and sale of an option contract of the same asset, type, and strike price but with different expiration dates. As we indicated earlier, the option's time value erodes toward zero as time passes toward option expiration. The erosion occurs more rapidly as the option's life decreases and the expiration date comes into view. A calendar spread is intended to take advantage of this decline in an option's premium. Typically, a trader will sell an option with the closer expiration month and purchase an option with the distant expiration month to take advantage of the fact that the latter position will retain more of its value. Since the near-month option has less time to expiration than the back-month option, the premium the trader receives will be less than the premium the trader must pay for the spread. Therefore, this spread is considered a debit spread. Also, because one option expires before the other, oftentimes one or both legs of the calendar spread are offset by trading out of the position. SELECTING AN OPTION TRADE Given the wide assortment of possible option expirations and strike prices, which is the preferable option contract selection for a trader? This answer is not black and white and varies depending upon the goals of the trader. For those option traders who believe that the trend of an underlying security has been or soon will be established for some time to come, they may wish to hold the option until it approaches expiration and a significant profit is captured. These individuals are referred to as position traders. Other traders are not concerned with long-term projections in the underlying security and are only interested in what will occur on a particular trading day. These individuals are referred to as day traders. Position traders and day traders have two very different approaches and attitudes when selecting the appropriate option contract to trade. Most position traders typically choose an expiration month and a strike price matches their price target and the time frame in which they believe that target will be reached. Day traders, on the other hand, are not concerned with which expiration month or strike price they should choose, all they are concerned with is being on the right side of the market in the option that will bring them the greatest return. When day trading options, various time and price considerations are not as important as they would be to a long-term option trader. Since option positions are held for such a short period of time, the impact of time decay is negligible when day trading and does not really work for or against the trader (unless it is the day of option expiration or one or two trading days before expiration, where time premium typically erodes more rapidly). Although our opinion is by no means absolute, we suggest that when one wishes to day trade options or intends to hold an option position for no more than one to two trading days, that one trade the nearby (closest expiration month) option contract which is at- or slightly in-the-money, when the underlying security has, or is just about to, exceed the exercise price. As we discussed earlier, as the price of the underlying security trades through the exercise price and proceeds to move in-the-money, the time value initially contracts and then begins to move almost one for one in lockstep with the price of the underlying security. Because the impact of time premium is generally minimal, day trading an at-the-money or slightly in-the-money option is essentially the same as trading the underlying asset, only for much less money, with a greater profit potential, and with a defined level of risk. Another factor that must be considered when deciding which option contract to day trade is option liquidity. Typically, the nearby, closest to at-the-money option is the most actively traded option and has the greatest volume and open interest. This liquidity is important, not only when entering the trade, but also when exiting the trade as well, especially for a day trader. Inactive, light-volume, and low-liquidity markets are difficult to trade and large concessions must be made by the trader to obtain market positions, since the spread between bid and risk in these situations is typically wide and the increment within which a trader is able to transact is small. We cannot stress enough the significance of the market liquidity to a day trader in the selection of option trading candidates. A familiarity with the recent volume and open interest for a particular option is crucial in determining the size of the commitment a trader should make to a specific option market. How much to buy? Perhaps the best advice we can provide to beginning traders is to manage your trades. This is especially true when trading options. One of the biggest problems option traders face is that they allow their emotions to dictate when they make their purchases and do so with reckless abandon. Since they are accustomed to paying so much more for other assets, they typically spend a comparable amount of money on options, leveraging their positions to the maximum, and hoping for the sizable price "pop" which will catapult their profits into orbit. However, this is the worst mistake an option buyer can make. If these large positions are not timed accurately, a trader can lose a large amount of money. Most people justify their option position size by rationalizing that they would have spent the same amount as they had on the underlying security, but now they are controlling more of the underlying security. What they don't always realize is that options do not retain their value like these other assets, because the passage of time will always have a negative effect upon the option. That is why options cannot be considered investments; they are simply trades. Our suggestion in determining how much of an option to purchase is this: a prudent option trader will limit his or her exposure to any particular trade. The prerequisite for proper money management is different for a day trader versus a trader who holds the option position overnight or longer. While it is not our role to determine a trader's exposure to a market, we feel it is crucial to address this matter, as we have seen a number of traders execute imprudent option trades and money management. A good rule of thumb is that a day trader should not risk more than 2 percent of his or her portfolio in any one trade, and a position trader should not risk more than 4 percent of his or her portfolio in any one trade. If traders prefer to exceed these prescribed limits, we recommend that the traders protect their positions with offsetting option trades and definitely with stop losses. Placing option orders Before participating in a market, regardless of which one, it is important that one become familiar with may of the trading nuances and aspects which apply to that specific market. This is especially true when trading options. Once these variables are addressed and an option contract is selected, the trader must then place the order. When placing an option order, a trader must make certain to supply the following trading instructions to the broker: 1. Whether the option order is a buy or a sell
Reading an option price table Many major newspaper and trading publications today provide option-pricing tables so traders can track and follow the activity of certain listed options on a day-to-day basis. While the organization of these price table may differ slightly for stock options, they all usually contain the security that the option covers, the prior day's closing price of the underlying asset, the varying strike prices and expiration months, the prior day's volume and closing prices for each call option, and the prior day's volume and closing prices for each put option. Other option listings, such as those for indices, also include items such as the net price change of the option from the previous day's closing price and the open interest of the call or put option. When not to buy an option? It is also important to consider the time or the date at which one should enter the option market. While these option-buying suggestions are presented in the context of day trading options, they apply equally as well to option position trading. When day trading, a trader must give the market adequate time to perform. Consequently, eliminate day trading within the final hour of trading. If one is position-trading options, this suggestion should not be a concern.
Be careful when holding long option positions beyond Friday's trading day's close unless one is option position trading. Many option theoreticians recalculate their volatility, delta, and time decay numbers once a week, usually after the close of trading on Fridays or over the weekend. The resulting adjustments in these values most often have a negative effect on the value of the long option, which may be acceptable when holding an option over an extended period of time but is detrimental when day trading. Each sample strategy is accompanied by a graph of profit and loss at the options' expiration. The X-axis represents the price level of an underlying stock. The Y-axis represents profit and loss, above and below the X-axis intersection respectively. Each graph will be labeled with a Break-Even Point (BEP) for the strategy being illustrated. These graphs are not drawn to any specific scale and are meant only for an illustrative and educational purpose. In addition, each strategy includes a discussion regarding an investor's alter-natives before and at expiration. The alternatives mentioned are only among the more basic possibilities. With a fuller understanding of option concepts, an investor will appreciate that alternatives available to him are many. It is beyond the scope of this booklet to make any specific recommendations as to maintaining your option positions. Note: Net profit and loss amounts discussed in the following strategy examples do not include taxes, commissions or transaction costs in their formulations. LONG CALL Purchasing calls has remained the most popular strategy with investors since listed options were first introduced. Before moving into more complex bullish and bearish strategies, an investor should thoroughly understand the fundamentals about buying and holding call options.
Market Opinion? Bullish to very bullish. When to Use? Bullish Speculation This strategy appeals to an investor who is generally more interested in the Rupee amount of his initial investment and the leveraged financial reward that long calls can offer. The primary motivation of this investor is to realize financial reward from an increase in price of the underlying security. Experience and precision are key to selecting the right option (expiration and/or strike price) for the most profitable result. In general, the more out-of-the-money the call is the more bullish the strategy, as bigger increases in the underlying stock price are required for the option to reach the break-even point. As Stock Substitute An investor who buys a call instead of purchasing the under-lying stock considers the lower Rupee cost of purchasing a call contract versus an equivalent amount of stock as a form of insurance. The uncommitted capital is "insured" against a decline in the price of the call option's underlying stock, and can be invested elsewhere. This investor is generally more interested in the number of shares of stock underlying the call contracts purchased than in the specific amount of the initial investment - one call option contract for each 100 shares he wants to own. While holding the call option, the investor retains the right to purchase an equivalent number of underlying shares at any time at the predetermined strike price until the contract expires. Note: Equity option holders do not enjoy the rights due stockholders - e.g., voting rights, regular cash or special dividends, etc. A call holder must exercise the option and take ownership of the underlying shares to be eligible for these rights. Benefit? A long call option offers a leveraged alternative to a position in the stock. As the contract becomes more profitable, increasing leverage can result in large percentage profits because purchasing calls generally requires lower up-front capital commitment than an outright purchase of the underlying stock. Long call contracts offer the investor a predetermined risk. Risk vs. Reward? Maximum Profit: Unlimited
Your maximum profit depends only on the potential price increase of the underlying security; in theory, it is unlimited. At expiration an in-the-money call will generally be worth its intrinsic value. Though the potential loss is predetermined and limited in rupee amount, it can be as much as 100% of the premium initially paid for the call. Whatever your motivation for purchasing the call, weigh the potential reward against the potential loss of the entire premium paid. Break-Even Point (BEP) at Expiration?
Before expiration, however, if the contract's market price has sufficient time value remaining, the BEP can occur at a lower stock price. Volatility?
Any effect of volatility on the option's total premium is on the time value portion. Time Decay?
The time value portion of an option's premium, which the option holder has "purchased" by paying for the option, generally decreases, or decays, with the passage of time. This de-crease accelerates as the option contract approaches expiration. Alternatives before expiration? At any given time before expiration, a call option holder can sell the call in the listed options marketplace to close out the position. This can be done to either realize a profitable gain in the option's premium, or to cut a loss. Alternatives at expiration? At expiration, most investors holding an in-the-money call option will elect to sell the option in the marketplace if it has value, before the end of trading on the option's last trading day. An alternative is to exercise the call, resulting in the purchase of an equivalent number of underlying shares at the strike price. LONG PUT A long put can be an ideal tool for an investor who wishes to participate profitably from a downward price move in the underlying stock. Before moving into more complex bearish strategies, an investor should thoroughly understand the fundamentals about buying and holding put options. LONG PUT
Market Opinion?
When to Use? Purchasing puts without owning shares of the underlying stock is a purely directional strategy used for bearish speculation. The primary motivation of this investor is to realize financial reward from a decrease in price of the underlying security. This investor is generally more interested in the Rupee amount of his initial investment and the leveraged financial reward that long puts can offer than in the number of contracts purchased. Experience and precision are key in selecting the right option (expiration and/or strike price) for the most profitable result. In general, the more out-of-the-money the put purchased is the more bearish the strategy, as bigger decreases in the underlying stock price are required for the option to reach the break-even point. Benefit? A long put offers a leveraged alternative to a bearish, or "short sale" of the underlying stock, and offers less potential risk to the investor. As with a long call, an investor who purchased and is holding a long put has predetermined, limited financial risk versus the unlimited upside risk from a short stock sale. Purchasing a put generally requires lower up-front capital commitment than the margin required to establish a short stock position. Regardless of market conditions, a long put will never require a margin call. As the contract becomes more profitable, increasing leverage can result in large percentage profits. Risk vs. Reward? Maximum Profit: Limited Only by Stock Declining to Zero
The maximum profit amount can be limited by the stock's potential decrease to no less than zero. At expiration an in-the-money put will generally be worth its intrinsic value. Though the potential loss is predetermined and limited in Rupee amount, it can be as much as 100% of the premium initially paid for the put. Whatever your motivation for purchasing the put, weigh the potential reward against the potential loss of the entire premium paid. Long Put Break-Even Point (BEP) at Expiration?
Before expiration, however, if the contract's market price has sufficient time value remaining, the BEP can occur at a higher stock price. Volatility?
Any effect of volatility on the option's total premium is on the time value portion. Time Decay?
The time value portion of an option's premium, which the option holder has "purchased" when paying for the option, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration. A market observer will notice that time decay for puts occurs at a slightly slower rate than with calls. Alternatives before expiration? At any given time before expiration, a put option holder can sell the put in the listed options marketplace to close out the position. This can be done to either realize a profitable gain in the option's premium, or to cut a loss. Alternatives at expiration? At expiration most investors holding an in-the-money put will elect to sell the option in the marketplace if it has value, before the end of trading on the option's last trading day. An alternative is to purchase an equivalent number of shares in the marketplace, exercise the long put and then sell them to a put writer at the option's strike price. The third choice, one resulting in considerable risk, is to exercise the put, sell the underlying shares and establish a short stock position in an appropriate type of brokerage account. MARRIED PUT An investor purchasing a put while at the same time purchasing an equivalent number of shares of the underlying stock is establishing a "married put" position - a hedging strategy with a name from an old IRS ruling. MARRIED PUT
Market Opinion? Bullish to very bullish. When to Use? The investor employing the married put strategy wants the benefits of stock ownership (dividends, voting rights, etc.), but has concerns about unknown, near-term, downside market risks. Purchasing puts with the purchase of shares of the underlying stock is a directional and bullish strategy. The primary motivation of this investor is to protect his shares of the underlying security from a decrease in market price. He will generally purchase a number of put contracts equivalent to the number of shares held. Benefit? While the married put investor retains all benefits of stock ownership, he has "insured" his shares against an unacceptable decrease in value during the lifetime of the put, and has a limited, predefined, downside market risk. The premium paid for the put option is equivalent to the premium paid for an insurance policy. No matter how much the underlying stock decreases in value during the option's lifetime, the investor has a guaranteed selling price for the shares at the put's strike price. If there is a sudden, significant decrease in the market price of the underlying stock, a put owner has the luxury of time to react. Alternatively, a previously entered stop loss limit order on the purchased shares might be triggered at a time and at a price unacceptable to the investor. The put contract has conveyed to him a guaranteed selling price, and control over when he chooses to sell his stock. Risk vs. Reward? Maximum Profit: Unlimited
Your maximum profit depends only on the potential price increase of the underlying security; in theory it is unlimited. When the put expires, if the underlying stock closes at the price originally paid for the shares, the investor's loss would be the entire premium paid for the put. Break-Even Point (BEP) at Expiration? BEP: Stock Purchase Price + Premium Paid Volatility? If Volatility Increases: Positive Effect
Any effect of volatility on the option's total premium is on the time value portion.
Time Decay?
The time value portion of an option's premium, which the option holder has "purchased" when paying for the option, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration. A market observer will notice that time decay for puts occurs at a slightly slower rate than with calls. Alternatives before expiration? An investor employing the married put can sell his stock at any time, and/or sell his long put at any time before it expires. If the investor loses concern over a possible decline in market value of his hedged underlying shares, the put option may be sold if it has market value remaining. Alternatives at expiration? If the put option expires with no value, no action need be taken; the investor will retain his shares. If the option expires in-the-money, the investor can elect to exercise his right to sell the underlying shares at the put's strike price. Alternatively, the investor may sell the put option, if it has market value, before the market closes on the option's last trading day. The premium received from the long option's sale will offset any financial loss from a decline in underlying share value. PROTECTIVE PUT An investor who purchases a put option while holding shares of the underlying stock from a previous purchase is employing a "protective put." PROTECTIVE PUT
Market Opinion? Bullish on the underlying stock. When to Use? The investor employing the protective put strategy owns shares of underlying stock from a previous purchase, and generally has unrealized profits accrued from an increase in value of those shares. He might have concerns about unknown, downside market risks in the near term and wants some protection for the gains in share value. Purchasing puts while holding shares of underlying stock is a directional strategy, but a bullish one. Benefit? Like the married put investor, the protective put investor retains all benefits of continuing stock ownership (dividends, voting rights, etc.) during the lifetime of the put contract, unless he sells his stock. At the same time, the protective put serves to limit downside loss in unrealized gains accrued since the underlying stock's purchase. No matter how much the underlying stock decreases in value during the option's lifetime, the put guarantees the investor the right to sell his shares at the put's strike price until the option expires. If there is a sudden, significant decrease in the market price of the underlying stock, a put owner has the luxury of time to react. Alternatively, a previously entered stop loss limit order on the purchased shares might be triggered at both a time and a price unacceptable to the investor. The put contract has conveyed to him a guaranteed selling price at the strike price, and control over when he chooses to sell his stock. Risk vs. Reward?
Potential maximum profit for this strategy depends only on the potential price increase of the underlying security; in theory it is unlimited. If the put expires in-the-money, any gains realized from an increase in its value will offset any decline in the unrealized profits from the underlying shares. On the other hand, if the put expires at- or out-of-the-money, the investor will lose the entire premium paid for the put. Break-Even Point (BEP) at Expiration? BEP: Stock Purchase Price + Premium Paid Volatility? If Volatility Increases: Positive Effect
Any effect of volatility on the option's total premium is on the time value portion. Time Decay? Passage of Time: Negative Effect The time value portion of an option's premium, which the option holder has "purchased" when paying for the option, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration. A market observer will notice that time decay for puts occurs at a slightly slower rate than with calls. Alternatives before expiration? The investor employing the protective put is free to sell his stock and/or his long put at any time before it expires. For instance, if the investor loses concern over a possible decline in market value of his hedged underlying shares, the put option may be sold if it has market value remaining. Alternatives at expiration? If the put option expires with no value, no action need be taken; the investor will retain his shares. If the option closes in-the-money, the investor can elect to exercise his right to sell the underlying shares at the put's strike price. Alternatively, the investor may sell the put option, if it has market value, before the market closes on the option's last trading day. The premium received from the long option's sale will offset any financial loss from a decline in under-lying share value. COVERED CALL The covered call is a strategy in which an investor writes a call option contract while at the same time owning an equivalent number of shares of the underlying stock. If this stock is purchased simultaneously with writing the call con-tract, the strategy is commonly referred to as a "buy-write." If the shares are already held from a previous purchase, it is commonly referred to an "overwrite." In either case, the stock is generally held in the same brokerage account from which the investor writes the call, and fully collateralizes, or "covers," the obligation conveyed by writing a call option contract. This strategy is the most basic and most widely used strategy combining the flexibility of listed options with stock ownership. COVERED CALL
Market Opinion? Neutral to bullish on the underlying stock. When to Use? Though the covered call can be utilized in any market condition, it is most often employed when the investor, while bullish on the underlying stock, feels that its market value will experience little range over the lifetime of the call con-tract. The investor desires to either generate additional income (over dividends) from shares of the underlying stock, and/or provide a limited amount of protection against a decline in underlying stock value. Benefit? While this strategy can offer limited protection from a decline in price of the underlying stock and limited profit participation with an increase in stock price, it generates income because the investor keeps the premium received from writing the call. At the same time, the investor can appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless he is assigned an exercise notice on the written call and is obligated to sell his shares. The covered call is widely regarded as a conservative strategy because it decreases the risk of stock ownership.
Risk vs. Reward?
Maximum profit will occur if the price of the underlying stock you own is at or above the call option's strike price, either at its expiration or when you might be assigned an exercise notice on the call before it expires. The risk of real financial loss with this strategy comes from the shares of stock held by the investor. This loss can become substantial if the stock price continues to decline in price as the written call expires. At the call's expiration, loss can be calculated as the original purchase price of the stock less its current market price, less the premium received from initial sale of the call. Any loss accrued from a decline in stock price is offset by the premium you received from the initial sale of the call option. As long as the underlying shares of stock are not sold, this would be an unrealized loss. Assignment on a written call is always possible. An investor holding shares with a low cost basis should consult his tax advisor about the tax ramifications of writing calls on such shares. Break-Even Point (BEP) at Expiration? BEP: Stock Purchase Price - Premium Received Volatility? If Volatility Increases: Negative Effect
Any effect of volatility on the option's price is on the time value portion of the option's premium. Time Decay? Passage of Time: Positive Effect With the passage of time, the time value portion of the option's premium generally decreases - a positive effect for an investor with a short option position. Alternatives before expiration? If the investor's opinion on the underlying stock changes significantly before the written call expires, whether more bullish or more bearish, the investor can make a closing purchase transaction of the call in the marketplace. This would close out the written call contract, relieving the investor of an obligation to sell his stock at the call's strike price. Before taking this action, the investor should weigh any realized profit or loss from the written call's purchase against any unrealized profit or loss from holding shares of the underlying stock. If the written call position is closed out in this manner, the investor can decide whether to make another option transaction to either generate income from and/or protect his shares, to hold the stock unprotected with options, or to sell the shares. Alternatives at expiration? As expiration day for the call option nears, the investor considers three scenarios and then accordingly makes a decision. The written call contract will either be in-the-money, at-the-money or out-of-the-money. If the investor feels the call will expire in-the-money, he can choose to be assigned an exercise notice on the written contract and sell an equivalent number of shares at the call's strike price. Alternatively, the investor can choose to close out the writ-ten call with a closing purchase transaction, canceling his obligation to sell stock at the call's strike price, and retain ownership of the underlying shares. Before taking this action, the investor should weigh any realized profit or loss from the written call's purchase against any unrealized profit or loss from holding shares of the underlying stock. If the investor feels the written call will expire out-of-the-money, no action is necessary. He can let the call option expire with no value and retain the entire premium received from its initial sale. If the written call expires exactly at-the-money, the investor should realize that assignment of an exercise notice on such a contract is possible, but should not be assumed. Consult with your brokerage firm or a financial advisor on the advisability of what action to take in this case. COVERED PUT According to the terms of a put contract, a put writer is obligated to purchase an equivalent number of underlying shares at the put's strike price if assigned an exercise notice on the written contract. Many investors write puts because they are willing to be assigned and acquire shares of the underlying stock in exchange for the premium received from the put's sale. For this discussion, a put writer will be considered "covered" if he has on deposit with his brokerage firm a cash amount (or other approved collateral) sufficient to cover such a purchase. COVERED PUT
Market Opinion? Neutral to slightly bullish. When to Use? There are two key motivations for employing this strategy: either as an attempt to purchase underlying shares below current market price, or to collect and keep premium from the sale of puts which expire out-of-the-money and with no value. An investor should write a covered put only when he would be comfortable owning underlying shares, because assignment is always possible at any time before the put expires. In addition, he should be satisfied that the net cost for the shares will be at a satisfactory entry point if he is assigned an exercise. The number of put contracts written should correspond to the number of shares the investor is comfortable and financially capable of purchasing. While assignment may not be the objective at times, it should not be a financial burden. This strategy can become speculative when more puts are written than the equivalent number of shares desired to own. Benefit? The put writer collects and keeps the premium from the put's sale, no matter how much the stock increases or decreases in price. If the writer is assigned, he is then obligated to purchase an equivalent amount of underlying shares at the put's strike price. The premium received from the put's sale will partially offset the purchase price for the stock, and can result in a purchase of shares below the current market price. If the underlying stock price declines significantly and the put writer is assigned, the purchase price for the shares can be above current market price. In this case, the put writer will have an unrealized loss due to the high stock purchase price, but will have upside profit potential if retaining the purchased shares. Risk vs. Reward? Maximum Profit: Limited
If the underlying stock increases in price and the put expires with no value, the profit is limited to the premium received from the put's initial sale. On the other hand, an outright purchase of underlying stock would offer the investor unlimited upside profit potential. If the underlying stock declines below the strike price of the put, the investor might be assigned an exercise notice and be obligated to purchase an equivalent number of shares. The net stock purchase price would be the put's strike price less the premium received from the put's sale. This price can be less than current market price for the stock when assignment is made. The loss potential for this strategy is similar to owning an equivalent number of underlying shares. Theoretically, the stock price can decline to zero. If assignment results in the purchase of stock at a net price greater than the current market price, the investor would incur a loss - unrealized as long as ownership of the shares is retained. Break-Even Point (BEP) at Expiration?
Volatility? If Volatility Increases: Negative Effect
Time Decay? Passage of Time: Positive Effect With the passage of time, the time value portion of the option's premium generally decreases - a positive effect for an investor with a short option position.
Alternatives before expiration? If the investor's opinion about the underlying stock changes before the put expires, the investor can buy the same con-tract in the marketplace to "close out" his position at a realized loss. After this is done, no assignment is possible. The investor is relieved from any obligation to purchase underlying stock. Alternatives at expiration? If the short option has any value when it expires, the investor will most likely be assigned an exercise notice and be obligated to purchase an equivalent number of shares. If owning the underlying shares is not desired at this point, the investor can close out the written put by buying a contract with the same terms in the marketplace. Such a purchase would have to occur before the market closes on the option's last trading day, and could result in a realized loss. On the other hand, the investor is obliged to take delivery of the underlying shares at a possible unrealized loss. BULL CALL SPREAD Establishing a bull call spread involves the purchase of a call option on a particular underlying stock, while simultaneously writing a call option on the same underlying stock with the same expiration month, at a higher strike price. Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts. This spread is sometimes more broadly categorized as a "vertical spread": a family of spreads involving options of the same stock, same expiration month, but different strike prices. They can be created with either all calls or all puts, and be bullish or bearish. The bull call spread, as any spread, can be executed as a "unit" in one single transaction, not as separate buy and sell transactions. For this bullish vertical spread, a bid and offer for the whole package can be requested through your brokerage firm from an exchange where the options are listed and traded. BULL CALL SPREAD
Market Opinion? Moderately bullish to bullish. When to Use? Moderately Bullish An investor often employs the bull call spread in moderately bullish market environments, and wants to capitalize on a modest advance in price of the underlying stock. If the investor's opinion is very bullish on a stock it will generally prove more profitable to make a simple call purchase. Risk Reduction An investor will also turn to this spread when there is discomfort with either the cost of purchasing and holding the long call alone, or with the conviction of his bullish market opinion. Benefit? The bull call spread can be considered a doubly hedged strategy. The price paid for the call with the lower strike price is partially offset by the premium received from writing the call with a higher strike price. Thus, the investor's investment in the long call, and the risk of losing the entire premium paid for it, is reduced or hedged. On the other hand, the long call with the lower strike price caps or hedges the financial risk of the written call with the higher strike price. If the investor is assigned an exercise notice on the written call and must sell an equivalent number of underlying shares at the strike price, those shares can be purchased at a predetermined price by exercising the purchased call with the lower strike price. As a trade-off for the hedge it offers, this written call limits the potential maximum profit for the strategy. Risk vs. Reward? Upside Maximum Profit: Limited
A bull call spread tends to be profitable when the under-lying stock increases in price. It can be established in one transaction, but always at a debit (net cash outflow). The call with the lower strike price will always be purchased at a price greater than the offsetting premium received from writing the call with the higher strike price. Maximum loss for this spread will generally occur as the underlying stock price declines below the lower strike price. If both options expire out-of-the-money with no value, the entire net debit paid for the spread will be lost. The maximum profit for this spread will generally occur as the underlying stock price rises above the higher strike price, and both options expire in-the-money. The investor can exercise the long call, buy stock at its lower strike price, and sell that stock at the written call's higher strike price if assigned an exercise notice. This will be the case no matter how high the underlying stock has risen in price. If the underlying stock price is in between the strike prices when the calls expire, the long call will be in-the-money and worth its intrinsic value. The written call will be out-of-the-money, and have no value. Break-Even Point (BEP) at Expiration? BEP: Strike Price of Purchased Call + Net Debit Paid Volatility? If Volatility Increases: Effect Varies
The effect of an increase or decrease in the volatility of the underlying stock may be noticed in the time value portion of the options' premiums. The net effect on the strategy will depend on whether the long and/or short options are in-the-money or out-of-the-money, and the time remaining until expiration. Time Decay?
The effect of time decay on this strategy varies with the underlying stock's price level in relation to the strike prices of the long and short options. If the stock price is midway between the strike prices, the effect can be minimal. If the stock price is closer to the lower strike price of the long call, losses generally increase at a faster rate as time passes. Alternatively, if the underlying stock price is closer to the higher strike price of the written call, profits generally increase at a faster rate as time passes. Alternatives before expiration? A bull call spread purchased as a unit for a net debit in one transaction can be sold as a unit in one transaction in the options marketplace for a credit, if it has value. This is generally the manner in which investors close out a spread before its options expire, in order to cut a loss or realize profit. Alternatives at expiration? If both options have value, investors will generally close out a spread in the marketplace as the options expire. This will be less expensive than incurring the commissions and transaction costs from a transfer of stock resulting from either an exercise of and/or an assignment on the calls. If only the purchased call is in-the-money as it expires, the investor can either sell it in the marketplace if it has value or exercise the call and purchase an equivalent number of shares. In either of these cases, the transaction(s) must occur before the close of the market on the options' last trading day. BEAR PUT SPREAD Establishing a bear put spread involves the purchase of a put option on a particular underlying stock, while simultaneously writing a put option on the same underlying stock with the same expiration month, but with a lower strike price. Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts. This spread is sometimes more broadly categorized as a "vertical spread": a family of spreads involving options of the same stock, same expiration month, but different strike prices. They can be created with either all calls or all puts, and be bullish or bearish. The bear put spread, as any spread, can be executed as a "package" in one single transaction, not as separate buy and sell transactions. For this bearish vertical spread, a bid and offer for the whole package can be request-ed through your brokerage firm from an exchange where the options are listed and traded. BEAR PUT SPREAD
When to Use?
An investor often employs the bear put spread in moderately bearish market environments, and wants to capitalize on a modest decrease in price of the underlying stock. If the investor's opinion is very bearish on a stock it will generally prove more profitable to make a simple put purchase. Risk Reduction An investor will also turn to this spread when there is discomfort with either the cost of purchasing and holding the long put alone, or with the conviction of his bearish market opinion. Benefit? The bear put spread can be considered a doubly hedged strategy. The price paid for the put with the higher strike price is partially offset by the premium received from writing the put with a lower strike price. Thus, the investor's investment in the long put and the risk of losing the entire premium paid for it, is reduced or hedged. On the other hand, the long put with the higher strike price caps or hedges the financial risk of the written put with the lower strike price. If the investor is assigned an exercise notice on the written put, and must purchase an equivalent number of underlying shares at its strike price, he can sell the purchased put with the higher strike price in the marketplace. The premium received from the put's sale can partially offset the cost of purchasing the shares from the assignment. The net cost to the investor will generally be a price less than current market prices. As a trade-off for the hedge it offers, this written put limits the potential maximum profit for the strategy. Risk vs. Reward? Downside Maximum Profit: Limited
A bear put spread tends to be profitable if the underlying stock decreases in price. It can be established in one transaction, but always at a debit (net cash outflow). The put with the higher strike price will always be purchased at a price greater than the offsetting premium received from writing the put with the lower strike price. Maximum loss for this spread will generally occur as the underlying stock price rises above the higher strike price. If both options expire out-of-the-money with no value, the entire net debit paid for the spread will be lost. The maximum profit for this spread will generally occur as the underlying stock price declines below the lower strike price, and both options expire in-the-money. This will be the case no matter how low the underlying stock has declined in price. If the underlying stock is in between the strike prices when the puts expire, the purchased put will be in-the-money, and be worth its intrinsic value. The written put will be out-of-the-money, and have no value. Break-Even Point (BEP) at Expiration? BEP: Strike Price of Purchased Put - Net Debit Paid Volatility? If Volatility Increases: Effect Varies
The effect of an increase or decrease in the volatility of the underlying stock may be noticed in the time value portion of the options' premiums. The net effect on the strategy will depend on whether the long and/or short options are in-the-money or out-of-the-money, and the time remaining until expiration. Time Decay?
The effect of time decay on this strategy varies with the underlying stock's price level in relation to the strike prices of the long and short options. If the stock price is midway between the strike prices, the effect can be minimal. If the stock price is closer to the higher strike price of the purchased put, losses generally increase at a faster rate as time passes. Alternatively, if the underlying stock price is closer to the lower strike price of the written put, profits generally increase at a faster rate as time passes. Alternatives before expiration? A bear put spread purchased as a unit for a net debit in one transaction can be sold as a unit in one transaction in the options marketplace for a credit, if it has value. This is generally the manner in which investors close out a spread before its options expire, in order to cut a loss or realize profit. Alternatives at expiration? If both options have value, investors will generally close out a spread in the marketplace as the options expire. This will be less expensive than incurring the commissions and trans-action costs from a transfer of stock resulting from either an exercise of and/or an assignment on the puts. If only the purchased put is in-the-money and has value as it expires, the investor can sell it in the marketplace before the close of the market on the option's last trading day. On the other hand, the investor can exercise the put and either sell an equivalent number of shares that he owns or establish a short stock position. COLLAR A collar can be established by holding shares of an underlying stock, purchasing a protective put and writing a covered call on that stock. The option portions of this strategy are referred to as a combination. Generally, the put and the call are both out-of-the-money when this combination is established, and have the same expiration month. Both the buy and the sell sides of this combination are opening transactions, and are always the same number of contracts. In other words, one collar equals one long put and one written call along with owning 100 shares of the underlying stock. The primary concern in employing a collar is protection of profits accrued from underlying shares rather than increasing returns on the upside. COLLAR
* Graph assumes accrued stock profit when establishing combination Market Opinion? Neutral, following a period of appreciation. When to Use? An investor will employ this strategy after accruing unrealized profits from the underlying shares, and wants to protect these gains with the purchase of a protective put. At the same time, the investor is willing to sell his stock at a price higher than the current market price so an out-of-the-money call contract is written, covered in this case by the underlying stock. Benefit? This strategy offers the stock protection of a put. However, in return for accepting a limited upside profit potential on his underlying shares (to the call's strike price), the investor writes a call contract. Because the premium received from writing the call can offset the cost of the put, the investor is obtaining downside put protection at a smaller net cost than the cost of the put alone. In some cases, depending on the strike prices and the expiration month chosen, the premium received from writing the call will be more than the cost of the put. In other words, the combination can sometimes be established for a net credit; the investor receives cash for establishing the position. The investor keeps the cash credit, regardless of the price of the underlying stock when the options expire. Until the investor either exercises his put and sells the underlying stock, or is assigned an exercise notice on the written call and is obligated to sell his stock, all rights of stock ownership are retained. See both Protective Put and Covered Call strategies presented earlier in this book. Risk vs. Reward? This example assumes an accrued profit from the investor's underlying shares at the time the call and put positions are established, and that this unrealized profit is being protected on the downside by the long put. Therefore, discussion of maximum loss does not apply. Rather, in evaluating profit and/or loss below, bear in mind the underlying stock's purchase price (or cost basis). Compare that to the net price received at expiration on the downside from exercising the put and selling the underlying shares, or the net sale price of the stock on the upside if assigned on the written call option. This example also assumes that when the combined position is established, both the written call and purchased put are out-of-the-money. Net Upside Stock Sale Price
Net Downside Stock Sale Price
If the underlying stock price is between the strike prices of the call and put when the options expire, both options will generally expire with no value. In this case, the investor will lose the entire net premium paid when establishing the combination, or keep the entire net cash credit received when establishing the combination. Balance either result with the underlying stock profits accrued when the combination was established. Break-Even Point (BEP) at Expiration? In this example, the investor is protecting his accrued profits from the underlying stock with a sale price for the shares guaranteed at the long put's strike price. In this case, consideration of BEP does not apply. Volatility? If Volatility Increases: Effect Varies
The effect of an increase or decrease in the volatility of the underlying stock may be noticed in the time value portion of the options' premiums. The net effect on the strategy will depend on whether the long and/or short options are in-the-money or out-of-the-money, and the time remaining until expiration. Time Decay? Passage of Time: Effect Varies The effect of time decay on this strategy varies with the underlying stock's price level in relation to the strike prices of the long and short options. If the stock price is midway between the strike prices, the effect can be minimal. If the stock price is closer to the lower strike price of the long put, losses generally increase at a faster rate as time passes. Alternatively, if the underlying stock price is closer to the higher strike price of the written call, profits generally increase at a faster rate as time passes. Alternatives before expiration? The combination may be closed out as a unit just as it was established as a unit. To do this, the investor enters a combination order to buy a call with the same contract and sell a put with the same contract terms, paying a net debit or receiving a net cash credit as determined by current option prices in the marketplace. Alternatives at expiration? If the underlying stock price is between the put and call strike prices when the options expire, the options will generally expire with no value. The investor will retain ownership of the underlying shares and can either sell them or hedge them again with new option contracts. If the stock price is below the put's strike price as the options expire, the put will be in-the-money and have value. The investor can elect to either sell the put before the close of the market on the option's last trading day and receive cash, or exercise the put nd sell the underlying shares at the put's strike price. Alternatively, if the stock price is above the call's strike price as the options expire, the short call will be in-the-money and the investor can expect assignment to sell the underlying shares at the strike price. Or, if retaining ownership of the shares is now desired, the investor can close out the short call position by purchasing a call with the same con-tract terms before the close of trading. QUICK SNAPSHOT OF OPTION TRADING STRATEGIES Please note: All or part of your investments using Bullish Strategies have greater risk of loss in falling market. Investments using Neutral Strategies have greater risk of loss in volatile markets Investments using Bearish Strategies have greater risk of loss in rising markets. BULLISH STRATEGIES LONG CALLS For aggressive investors who are bullish about the short-term prospects for a stock, buying calls can be an excellent way to capture the upside potential with limited inside risk. COVERED CALLS For conservative investors, selling calls against a long stock position can be an excellent way to generate income without assuming the risks associated with uncovered calls. In this case, investors would sell one call contract for each 100 shares of stock they own. PROTECTIVE PUT For investors who want to protect the stocks in their portfolio from falling prices, protective puts provide a relatively low-cost form of portfolio insurance. In this case, investors would purchase one put contract for each 100 shares of stock they own. BULL CALL SPREAD For bullish investors who want to a nice low risk, limited return strategy without buying or selling the underlying stock, bull call spreads are a great alternative. This strategy involves buying and selling the same number of calls at different strike prices to minimize both the cash outlay and the overall risk. BULL PUT SPREAD For bullish investors who want a nice low risk, limited return strategy, bull put spreads are another alternative. Like the bull call spread, the bull put spread involves buying and selling the same number of put options at different strike prices. Since puts with the higher strike are sold, the trade is initiated for a credit. CALL BACK SPREAD For bullish investors who expect big moves in already volatile stocks, call back spreads are a great limited risk, unlimited reward strategy. The trade itself involves selling a call (or calls) at a lower strike and buying a greater number of calls at a higher strike price. NAKED PUT For bullish investors who are interested in buying a stock at a price below the current market price, selling naked puts can be an excellent strategy. In this case, however, the risk is substantial because the writer of the option is obligated to purchase the stock at the strike price regardless of where the stock is trading. BEARISH STRATEGIES LONG PUT For aggressive investors who have a strong feeling that a particular stock is about to move lower, long puts are an excellent low risk, high reward strategy. Rather than opening yourself to enormous risk of short selling stock, you could buy puts (the right to sell the stock). While risk is limited to the initial investment, the profit potential is unlimited. NAKED PUT Selling naked calls is a very risky strategy which should be utilized with extreme caution. By selling calls without owning the underlying stock, you collect the option premium and hope the stock either stays steady or declines in value. If the stock increases in value this strategy has unlimited risk.
PUT BACKSPREAD For aggressive investors who expect big downward moves in already volatile stocks, backspreads are great strategies. The trade itself involves selling a put at a higher strike and buying a greater number of puts at a lower strike price. As the stock price moves lower, the profit potential is unlimited. BEAR CALL SPREAD For investors who maintain a generally negative feeling about a stock, bear spreads are a nice low risk, low reward strategies. This trade involves selling a lower strike call, usually at or near the current stock price, and buying a higher strike, out-of-the-money call. This spread profits when the stock price decreases and both calls expire worthless. BEAR PUT SPREAD For investors who maintain a generally negative feeling about a stock, bear spreads are another nice low risk, low reward strategy. This trade involves buying a put at a higher strike and selling another put at a lower strike. Like bear call spreads, bear put spreads profit when the price of the underlying stock decreases. NEUTRAL STRATEGIES REVERSAL Primarily used by floor traders, a reversal is an arbitrage strategy that allows traders to profit when options are underpriced. To put on a reversal, a trader would sell stock and use options to buy an equivalent position that offsets the short stock. CONVERSION Primarily used by floor traders, a conversion is an arbitrage strategy that allows traders to profit when options are overpriced. To put on a conversion, a trader would buy stock and use options to sell an equivalent position that offsets the long stock. THE COLLAR For bullish investors who want to nice low risk, limited return strategy to use in conjunction with a long stock position, collars are a great alternative. In this case, the collar is created by combining covered calls protective puts. LONG STRADDLE For aggressive investors who expect short-term volatility yet have no bias up or down (i.e., a neutral bias), the long straddle is an excellent strategy. This position involves buying both a put and a call with the same strike price, expiration, and underlying. The potential loss is limited to the initial investment. The potential profit is unlimited as the stock moves up or down. SHORT STRADDLE For aggressive investors who don't expect much short-term volatility, the short straddle can be a risky, but profitable strategy. This strategy involves selling a put and a call with the same strike price, expiration, and underlying. In this case, the profit is limited to the initial credit received by selling options. The potential loss is unlimited as the market moves up or down. LONG STRANGLE For aggressive investors who expect short-term volatility yet have no bias up or down (i.e., a neutral bias), the long strangle is another excellent strategy. This strategy typically involves buying out-of-the-money calls and puts with the same strike price, expiration, and underlying. The potential loss is limited to the initial investment while the potential profit is unlimited as the market moves up or down. SHORT STRANGLE For aggressive investors who don't expect much short-term volatility, the short strangle can be a risky, but profitable strategy. This strategy typically involves selling out-of-the-money puts and calls with the same strike price, expiration, and underlying. The profit is limited to the credit received by selling options. The potential loss is unlimited as the market moves up or down. THE BUTTERFLY Ideal for investors who prefer limited risk, limited reward strategies. When investors expect stable prices, they can buy the butterfly by selling two options at the middle strike and buying one option at the higher and lower strikes. The options, which must be all calls or all puts, must also have the same expiration and underlying. RATIO SPREAD For aggressive investors who don't expect much short-term volatility, ratio spreads are a limited reward, unlimited risk strategy. Put ratio spreads, which involve buying puts at a higher strike and selling a greater number of puts at a lower strike, are neutral in the sense that they are hurt by market movement. CONDOR Ideal for investors who prefer limited risk, limited reward strategies. The condor takes the body of the butterfly - two options at the middle strike - and splits between two middle strikes. In this sense, the condor is basically a butterfly stretched over four strike prices instead of three. CALENDAR SPREAD Calendar spreads are also known as time or horizontal spreads because they involve options with different expiration months. Because they are not exceptionally profitable on their own, calendar spreads are often used by traders who maintain large positions. Typically, a long calendar spread involves buying an option with a long-term expiration and selling an option with the same strike price and a short-term expiration. OPTION TRADING STRATEGY FORMULAS MARRIED PUT
PROTECTING UNREALIZED PROFIT
COVERED CALL POTENTIAL
BULL SPREAD (LONG CALL SPREAD)
BULL SPREAD (SHORT PUT SPREAD)
BEAR SPREAD (LONG PUT SPREAD)
BEAR SPREAD (SHORT CALL SPREAD)
RATIO BULL SPREAD (LONG)
RATIO BULL SPREAD (SHORT)
RATIO BEAR SPREAD (LONG)
RATIO BEAR SPREAD (SHORT)
LONG STRADDLE
SHORT STRADDLE
LONG STRANGLE
SHORT STRANGLE
LONG BUTTERFLY
SHORT BUTTERFLY
LONG IRON BUTTERFLY
SHORT IRON BUTTERFLY
LONG CONDOR
SHORT CONDOR
RISK COLLAR / FENCE (RISK CONVERSION)
RISK COLLAR / FENCE (RISK REVERSAL)
INTRINSIC AND PREMIUM FORMULAS
CALL INTRINSIC VALUE
PUT INTRINSIC VALUE
All options include premiums or values over and above the option's intrinsic value. Premium values vary based on three factors: the market anticipation of the volatility of the underlying security; the time remaining until the option's expiration; and current interest rates. (Premium value is also known as time value or extrinsic value.) CALL PREMIUM VALUE
PUT PREMIUM VALUE
RULES FOR BUYING CALLS AND PUTS Rule No. 1: Buy calls when the overall market is down; buy puts when the overall market is up. By and large, when the stock market rallies, most stocks rally, and when the stock market declines, most stocks perform likewise. The extent of this movement can easily be measured by observing stock indices. We recommend using the advance/decline index as a proxy for the overall market. However, if this is unavailable, one could also use the net price change of a comprehensive market average, such as the BSE SENSEX and NSE NIFTY. For the overall market to rally, the majority of individual stocks must rally, too. Sure there are days in which the market is rallying even though the number of advancing issues is less than the declining issues but this cannot last long if the stock market is to mount a sustainable advance. Similarly, on the downside, the market cannot undergo an extended decline unless the numbers of declining stocks outnumber the advancing stocks. When the overall market trades lower, call option premiums typically decrease. Therefore, by requiring the market index to be down for the day at the time a call is purchased, the prospects for a decline in a call's premium are enhanced. Similarly, when the overall market trades higher, put option premiums typically decrease. Therefore, by requiring the advance/decline market index to be up for the day at the time a put is purchased, the prospects for a decline in a put's premium are enhanced similarly. Since most stocks rise and fall with the general market - with the possible exception of gold stocks - this provides a measure of much-needed discipline and helps prevent emotional, uncontrolled option buying. Rule No. 2: Buy calls when the industry group is down; buy puts when the industry group is up. Just as most stocks move in phase with the market, most industry group components move in sync with their counterparts within their specific industry as well. Therefore, when one stock within an industry group is down, chances are the others are down as well. It's the exception when one component of an industry advances while all the other members decline, or vice versa, especially over an extended period of time. For example, situations can arise where a buyout occurs and the accumulation of one company's stock causes it to outperform the others within the industry group. However, announcements such as these typically cause the other stocks within the same industry group to participate in the movement since the market's perception is that all companies within the group are likely acquisition candidates and their stocks are "in play," so to speak. Rule No. 3: Buy calls when the underlying security is down; buy puts when the underlying security is up. In order to time the purchase of calls, we look for the price of the underlying security to be down relative to the previous trading day's close. If the stock's current market price is less than the previous day's close, most traders extrapolate that the downtrend will continue. It is also possible to relate the stock's current price with its opening price level to make this rule more stringent. Either relationship, that is, current price versus yesterday's close or current price versus the current day's open, can be applied or a combination of the two can be used to insure that the composite outlook for the market is perceived bearish by most traders. In order to time the purchase of puts, we look for the price of the underlying security to be up relative to the previous trading day's close. If the stock's current market price is greater than the previous day's close, most traders extrapolate that the up trend will continue. It is also possible to relate the stock's current price with its opening price level to make this rule more stringent. Either relationship, that is, current price versus yesterday's close or current price versus the current day's open, can be applied or a combination of the two can be used to insure that the composite outlook for the market is perceived bullish by most traders. Rule No. 4: Buy calls when the option is down; buy puts when the option is down. Just as the previous series of rules required that specific relationships be fulfilled, so too must this prerequisite be met. In fact, of all rules listed, this requirement is singularly the most important. The option's price, be it a call or a put, must be less than the previous day's close. As an additional requirement, it may also be less than the current day's opening price level as well. Obviously, if an option's price is inevitably going to rally, it is smarter to buy as low as possible. Further, if the call or the put unexpectedly continues to decline to zero, then the loss incurred is nevertheless less than if one had chased the price upside and purchased the option when it was trading above the previous day's close. The combination of the preceding rules serves to remove a degree of emotionalism from operating in the options markets and instills a level of discipline in the trading process. We can't tell you how long it took to acquire and apply these important rules to our trading regimen. Obviously, the risk always exists that despite the fact that all the previously described rules may be met, option prices may continue to decline, and as a result purchasing the call options or the put options will translate into a losing proposition. That's a concern that can only be diminished by introducing a series of sentiment measures or various market-timing indicators to confirm option buying at a particular point in time. The integration of these together with market sentiment information comparing put and call volume and the information regarding various indicators presented in the other chapters within this book enhance the timing and selection results further by concentrating upon ideal candidates which are low-risk opportunities based upon all four requirements. Copyright 2001 by Hiten Jhaveri, StockWhizo Investments. All rights reserved worldwide. |
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