Smart Options

Option Delta

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The delta of an option is the sensitivity of an option price relative to changes in the price of the underlying asset. It tells option traders how fast the price of the option will change as the underlying stock/future moves.

The above graph illustrates the behaviour of both call and put option deltas as they shift from being out-of-the-money (OTM) to at-the-money (ATM) and finally in-the-money (ITM). Note that calls and puts have opposite deltas - call options are positive and put options are negative.

Option delta is represented as the price change given a 1 point move in the underlying asset and is usually displayed as a decimal value. Delta values range between 0 and 1 for call options and -1 to 0 for put options. Note - some traders refer to the delta as a whole number between 0 to 100 for call options and -100 to 0 for put options. However, I will use the decimal version of -1 to 0 (puts) and 0 to 1 (calls) throughout this site.

Call Options

Whenever you are long a call option, your delta will always be a positive number between 0 and 1. When the underlying stock or futures contract increases in price, the value of your call option will also increase by the call options delta value. Conversely, when the underlying market price decreases the value of your call option will also decrease by the amount of the delta.

The above graph shows how the delta of a call option changes as the underlying price changes.

When the call option is deep in-the-money and has a delta of 1, then the call will move point for point in the same direction as movements in the underlying asset.

Put Options

Put options have negative deltas, which will range between -1 and 0. When the underlying market price increases the value of your put option will decreases by the amount of the delta value. Conversely, when the price of the underlying asset decreases, the value of the put option will increase by the amount of the delta value.

The above graph shows how the delta of a put option changes as the underlying price changes. So, when the underlying price rallies, the price of the option will decrease by delta amount and the put delta will also decrease as the option moves further out-of-the-money.

Source : http://www.optiontradingtips.com

Why Trade Options?

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Option trading provides many advantages over other investment vehicles. Leverage, limited risk, insurance, profiting in bear markets, each way betting or market going nowhere are only a few. But let's look at a couple:

Leverage

One thing to note before we go on is that the buyer of an options contract pays an amount, known as the premium, to the option seller. An option seller is also known as the writer of the option. The option premium is simply the amount paid for the option - but there is more about this under the Pricing link.

When you buy an option contract from an option seller, you aren't actually buying anything - no asset is actually transferred until the buyer chooses to exercise. It is just an agreement where the buyer has the option to decide if the transfer is to take place. But the option contracts value is determined by the underlying asset - Microsoft Shares as an example.

Options give the buyer the right to buy a number of shares of the underlying instrument from the option seller. The amount of shares (or futures contracts) to buy is determined by;

The number of option contracts, multiplied by
The contract multiplier

The contract multiplier (also called contract size) is different for most classes of options and is determined by each exchange. In the US, the contract size for options on shares is 100.

This means that every 1 option contract gives buyer the right to buy 100 shares from the option seller.

So, if you buy 10 IBM option contracts, it means that you have the right to buy 1,000 IBM shares at expiration if the price is right (10 x 100).

Note: In other countries such as Australia, the contract multiplier for stock options is 1,000, which means the every option contract you buy entitles you to 1,000 underlying share contracts. So pay attention to the contract specs before you begin option trading.

This also means that the price of the option is also multiplied by the contract multiplier. For example, say in the above you purchased 10 options contracts that were quoted in the marketplace for 15c, then you would actually pay the seller $150.

This is a crucial concept to understand. If you go out and buy 5 IBM share options for 15c that have a Strike Price of $25, then you will;

Pay the option seller $75
If you decide to exercise your right and buy the shares, you will have to buy 500 (5 x 100) (100 being the contract size) shares at the exercise price of $25, which will cost you $12,500.

In this case, your initial investment of $75 has given you $12,500 exposure in the underlying security.

Option trading is very attractive for the small investor as it gives him/her the opportunity to trade a very large exposure whilst only outlaying a small amount of capital.

Say you bought a $25 call option for $1 while the underlying shares were trading at $26. If the market rallies to $27 the option must at least be worth $2 because you can exercise your right at $25. So, even though the shares only went up 3.8% you DOUBLED your money because you can now sell back the option for $2.

Penny stocks are also known to carry this type of risk/reward profile. Penny Stocks are companies that have very low share prices. You can buy some stocks for as little as 10c. It is much more common for a penny stock to trade from 10c to 20c than it is for Microsoft to trade from $25 to $50!

For this reason penny stock trading is becoming very lucrative for online speculators. They can still trade the stocks outright as well as making massive returns if they are correct about their view on market direction.

The only drawback with penny stocks is trying to pick which stocks to buy. I'm not that familiar with trading penny stocks, however, I know of a great site that provides stock picks for penny stocks every two weeks - . They have a free trial, so you can see for yourself whether penny stock trading is for you or not.

Penny stocks can be risky though - there's a reason why they're so cheap, nobody wants them! So, be careful to act on the right information.

Limited Risk

One of the biggest advantages option trading has over outright stock trading is to be able to take a view on market direction with limited risk while at the same time having unlimited profit potential. This is because option buyers have the right, not the obligation, to exercise the contract for the underlying at the exercise price. If the price is not right at the time of expiration, the buyer will forfeit his/her right and simply let the contract expire worthless. Let me give you an illustration.

Remember our initial example of Peter buying a Microsoft Call option? Here are the details of that trade provided with the appropriate jargon;

Underlying: MSFT

Type: Call Option

Position: Long (i.e. bought the contract)

Strike Price: $25

Expiry Date: 25th May

At the time of the trade, Microsoft shares (the Underlying) were trading around $30. The Call option contract had been valued and was trading at $6.5 - known as the premium, but more on this under pricing.

So, from the above information we can conclude that after the 25th May, if Microsoft is trading above $31.50 we can make a profit on this.

Why $31.50? Because we paid $6.50 for the right to have this option in the form of a premium to the option seller. This means we must consider this in our profit estimate. Therefore we add the option premium to the strike price to determine our break even point.

A profitable trade

If Microsoft shares are trading at $40 by the 25th May, then we will elect to exercise our right to Call the shares from the option seller. Then we will be assigned Microsoft shares at the exercise price of $25, which is the same as if we actually bought Microsoft shares for $25.

Note: If we exercise our right and take delivery of the shares, this means that we will have to pay the full amount for the shares. So, the number of option contracts bought multiplied by the contract size multiplied by the exercise price. If you are planning to hold onto option contracts until expiry and take delivery, make sure you have the cash!

But, they are now trading at $40 at the stock exchange! So, you have Microsoft shares in your trading account with a purchase value of $25, yet they are trading at $40. So, you can sell them at $40 and make $8.50 per share.

Why $8.50? Remember the premium we paid? We have to consider that with our profit estimate.

Think about what happens as the underlying price continues to rise. You continue to make more and more money once the stock price has exceeded the strike price.

But what about the downside risk?

A losing trade

Let's imagine at expiration Microsoft shares are trading below our exercise price of $25 at, say, $20. Will we decide to exercise our right and take delivery of the shares and pay $25 per share? No way, because they're only worth $20.

So, we will just do nothing and let the option contract expire worthless.

What have we lost though? We lose the premium that we paid to the seller, which in this example was $6.5. That's it. A lot less than if the stock plummeted and we lost our entire investment.

What about if there is a stock market crash and Microsoft Shares are trading at $5 at the time of expiration? The same as if the shares are trading at $20 - nothing. We just let the option contract expire worthless and lose our premium - $6.5.

Limited Risk AND Unlimited Profit Potential

Can you see now how this type of strategy gives you the best of both worlds - both limiting your risk and at the same time leaving you open to make unlimited profit if the market rallies?

Not all option strategies have this payoff benefit. Only if you are buying options can you limit your risk. For option sellers, this is the reverse - they have unlimited risk with limited profit potential.

So, why would anybody want to sell options? Because options are a decaying asset, which you can read more about under the Time Decay section.

Insurance

Another reason investors may use options is for portfolio insurance. Option contracts can give the risk averse investor a method to protect his/her downside risk in the event of a stock market crash.

Where are Options Traded?

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Option contracts are traded either;

on a public stock exchange (also known as ETO's (Exchange Traded Options))
implicity agreed between two parties (also known as OTC's (Over The Counter options)).

The majority of options, however, are traded via public exchange houses and these will be the options discussed throughout this web site. The OTC market is a complicated one, where traders from large institutions can create and trade non-standard option derivatives. They can, for example, add their own special rules such as: if the underlying stock trades as high as x then the contract terminates and the option is then worthless. This is known as a Knockout Option or a Barrier Up and Out Option.

Options are listed and standardized by the stock exchange and are traded by what is known as Serial Months. By standardized, I mean that the specifications that make up the option contracts are set by the stock exchange and cannot be changed.

Here is a snapshot of the August 2005 options for IBM.

The Call options are on the left, while the Put options are listed on the right. Notice the strike prices down the middle? In this case there are 24 contracts available for the public to trade that expire in August 2005. The total number of listed options for IBM at the time of writing (3rd July 2005) are 230. That's 115 call options and 115 put options.

What are Options ?

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An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties.

Calls and Puts

The two types of options are calls and puts:

A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires.

A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.

Participants in the Options Market

There are four types of participants in options markets depending on the position they take:

1. Buyers of calls

2. Sellers of calls

3. Buyers of puts

4. Sellers of puts

People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions.

Here is the important distinction between buyers and sellers:

Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose.

Call writers and put writers (sellers) however are obligated to buy or sell. This means that a seller may be required to make good on their promise to buy or sell.

For this reason we are going to look at options from the point of view of the buyer. Selling options is more complicated and can thus be even riskier. At this point it is sufficient to understand that there are two sides of an options contract.

The Lingo

To trade options, you'll have to know the terminology associated with the options market.

The price at which an underlying stock can be purchased or sold is called the strike price. This is the price a stock price must go above (for calls) or go below (for puts) before a position can be exercised for a profit. All of this must occur before the expiration date.

An option that is traded on a national options exchange such as the CBOE is known as a listed option. These have fixed strike prices and expiration dates. Each listed option represents 100 shares of company stock (known as a contract).

For call options, the option is said to be in-the-money (ITM) if the share price is above the strike price. A put option is in-the-money when the share price is below the strike price. The amount by which an option is in-the-money is referred to as intrinsic value.

The total cost (the price) of an option is called the premium or option premium. This price is determined by factors including the stock price, strike price, time remaining until expiration (time value), and implied volatility.

simulator.investopedia.com

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Trading options is a bit more complicated than trading stocks. This page will guide you through the process at http://simulator.investopedia.com.

Click on "Trade Options" when on the portfolio page.
Enter the stock symbol for the company you wish to buy the options on. For example if you want to buy options on Microsoft, enter "MSFT" and highlight the option button as in the image below.
Now you should have an option chain similar to the one below. Select the expiry month that you wish to trade the option in, and then click on the highlighted symbol that corresponds with the strike price you wish to trade at. Call options are always listed on the left hand side of the page, and puts

For example, in the option chain below, if you wanted to buy a June 03 call option on MSFT with a strike price of 22.50, then you would click on on the right. MQF FX. Notice that the last trade of this particular option is quoted at 2.45 per share. This means that the total price of 1 option contract, which represents 100 shares, is $245 (2.45*1*100).
The ticker symbol, expiry, strike, and type of option are already entered in for you. Just enter the number of contracts you wish to buy and click review order.
Take a look at the review page, if everything looks good, then click on the "Submit Trade" button.
As long as there isn't any problem with the trade, your order will be executed and the option will be placed in your portfolio.

Bear Put Spread

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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 requested through your brokerage firm from an exchange where the options are listed and traded. Also since the higher strike premium is higher than the lower strike premium this is a debit spread.

Market Opinion? Moderately Bearish to Bearish

When to Use?

Moderately Bearish

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.

Chart: Bear Put Spread

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

Difference Between Strike Prices - Net Debit Paid

Maximum Loss: Limited

Net Debit Paid

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 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)?

BEP: Strike Price of Purchased Put - Net Debit Paid

Volatility

If Volatility Increases: Effect Varies

If Volatility Decreases: Effect Varies

The effect of an increase or decrease in either 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 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 only the purchased put is in-the-money and has value as it expires, the investor can sell it in the market place 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.

Bear Call Spread

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When the market is volatile and you are moderately bearish on it, you might consider a Bear Call Spread. This strategy involves selling a call option at one strike price and buying a call on the same asset at a higher strike price (further out-of-the-money). Usually both options will have the same expiration date. This is also referred to as a Bearish Credit Spread.

This strategy has a profit/loss picture that is similar to a Bear Put Spread, however in this case, there is a net premium that goes into your trading account when you establish the position, whereas with the Bear Put Spread, you are paying out a premium when you establish the position. Like the Bear Put Spread, this strategy has limited risk but also limited profits.

This strategy is a bearish strategy, like selling naked calls, that places premium into your account when you establish the position. However it limits your risk by the purchase of lower priced calls, protecting you if the price goes up significantly.

With this strategy, your potential profit is limited to the premium you collected for the calls you sold less commissions and the premium you paid for the calls you bought. Your potential losses are limited to the difference between the strike prices multiplied by 100 times the point value of the contract, less the cost of establishing the position. An option calculator such as Option-Aid performs these calculations for you instantaneously.

When we initiate a Bear Call Spread, the call we buy has the same expiration date, with a higher strike price (at a price point that we feel sufficiently limits our risk, without significantly lowering the premium we are collecting.

It is also important to cover risks and caveats of this strategy.

The risk of this position is limited and known risk as described above. Remember that the commission you pay for this position will be higher than the commission for a straight option play, because you are initiating two related option transactions.

When you initiate a Bear Call Spread, you are limiting your upside potential. If the asset price drops significantly, then you aren't able to fully participate in that gain like you would if you had purchased a put.

It is important to analyze your expectations for the underlying asset and for the market before selecting your strategy.

Selling Calls

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When you are bearish on the market and feel confident that it won't rise in the short term, you might consider selling calls to generate additional income. When you hold the assets for which you are selling the calls, then they are covered calls and there is limited risk. If you do not hold the assets, you are selling naked calls and your risk is unlimited, although your profits are limited. You must be careful when selling naked calls.

With this strategy, you are selling someone the right to buy an asset at a fixed price (the strike price), on or before the expiration date of the option. It is a bearish strategy or bearish directional strategy. You are a call writer (selling the call).

This strategy has some nice benefits.

You receive a premium for selling someone the right to purchase an asset at a particular price that you feel it will stay below. If the asset price is below the strike price at expiration, then the calls that you sold are not exercised and the premium that you collected provides additional income for you, increasing your rate-of-return. If you are writing calls or out-of-the-money calls, the asset may continually increase in value, yet the options may never get exercised, allowing you to do this over and over again. This generates continuous income for you, increasing your portfolio and generating cash flow for other investments.

If the calls that you sold do get exercised, then you are obligated to sell the asset at the exercise price. But you essentially sell the asset at a premium from the asset price that existed when you sold the calls, because you collected the option premium. You have already agreed that you would like to sell the asset at the exercise price and the price is augmented by the option premium that you collected.

Since you are the seller of the option, the time decay of the option works in your favor. The time-value portion of the call premium constantly declines with time, going to zero on the expiration date. The rate of decay is predictable and is easily calculated by options analysis programs such as Option-Aid. As the expiration date approaches, the rate of decay increases. For this reason, it is often better to sell calls with one month or less until expiration. After they expire, you can sell calls on the next month out and collect another premium if you still have the same view of the market at that time.

It is also important to cover risks and caveats of this strategy.

If the asset price rockets skyward and stays above the strike price at expiration, then the option will probably be exercised and you will be obligated to sell the asset at the agreed-on strike price or cover the option, incurring a loss. If you sold naked calls, your risk is unlimited.

It is important to analyze your expectations for the underlying asset before selling the call. If you expect the asset price to remain stable, you can write the call approximately at-the-money and collect a larger premium. If you sell an in-the-money call, the premium you collect will be even larger, but you run a greater risk of the option being exercised.

Long Put

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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 puts and holding put options.

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 dollar 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 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

Maximum Loss: Limited
Premium Paid

Upside Profit at Expiration: Strike Price - Stock Price at Expiration - Premium Paid
Assuming Stock Price Below BEP

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 dollar 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.

Break-Even-Point (BEP)?

BEP: Strike Price - Premium Paid

Before expiration, however, if the contract's market price has sufficient time value remaining, the BEP can occur at a higher stock price.

Volatility

If Volatility Increases: Positive Effect
If Volatility Decreases: Negative 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?

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.

Calendar Spread

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When you are fairly neutral on the market and you want to generate additional income from your investments, there is an option strategy that is worth your consideration. This strategy involves selling an option with a nearby expiration, against the purchase of an option (with the same strike price) which has an expiration date that is further out.

A Calendar Spread is an option spread where the strike prices are the same, but they have different expiration dates. These spreads are also referred to as:

Horizontal trade
Delta neutral trade
Sideway trade
Non-directional trade
Time spread

Calendar spreads can provide a way to add value to your portfolio through your purchase of a long term option with a reduced cost basis, provided by a near term option that you sold.

One very favorable point to a Calendar Spread is the value of time decay. Although both options lose time value as time passes, the option you sold loses value much more quickly than the option you bought. Therefore, if your prediction of a neutral market is correct, the value of your Calendar Spread will increase as time passes. A Calendar Spread takes advantage of time value differentials during neutral markets.

When the near term option expires, you have several alternatives. If you are still predicting a neutral market, you can hold on to your long position, if there is sufficient time left on it, and sell another short term option against that long position. If you are dealing in calls and you fear that the market may go down, you can close out your long position and take the profits. If you are dealing in calls and you predict a more bullish market, you could just hang on to your long position and take a larger profit in the future. In any of the cases, your cost basis on your long position was reduced by the premium you collected from the option you sold.

It is also important to cover risks and caveats of this strategy. Your loss is limited to the net premium you paid (the money you paid for the option you purchased minus the money you received for the near-term option you sold.

There are many different ways to implement a Calendar Spread, depending on your goals and your market outlook. When we implement spreads of this nature, we try to buy long term options that are undervalued.

One popular implementation of the Calendar Spread is try to generate income similar to a Covered Call strategy, but involves buying LEAPS (Long Term Equity Anticipation Securities) instead of the actual stock. So calls are sold against the LEAPS instead of the actual stock. This is done because the LEAPS can be purchased much more cheaply than the actual stock, which can generate much higher returns on invested capital. The risk with this implementation is that the underlying stock goes down in price instead of staying neutral, causing your LEAPS to go down in value. If the underlying stock goes up in price at expiration of the near term option (instead of staying neutral), you could buy back the option you sold and then sell another option, one or more months out.

When you implement this type of spread, you are hoping that the near term option you sold expires worthless. Then you can sell more options a little further out and continue to collect more premium. This either decreases the cost basis of the LEAPS you purchased, or produces recurring income for you.

It is important to analyze your expectations for the underlying asset and for the market before selecting your strategy.

Sell Straddle

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When the market has just made a dramatic move and you are expecting it to consolidate - you might consider selling a straddle. This strategy involves selling a call option and a put option on the same asset at the same strike price and expiration date. This gives you a known, but limited gain, but does expose you to unlimited risk - so you must be careful with this position and be confident of your assumptions. It is not suitable for all investors.

With this strategy, your gain is composed of the premium you received for the call and the put, less the commissions.

When we sell Straddle, the put and call that we sell are normally on over priced options that are at-the- money or close to it. We consider doing this after a dramatic move in the market, when we are expecting it to consolidate the move and digest its gains before moving again. Because of the dramatic move that was made, volatility is high, making the options we sell very expensive. Then as the market consolidates, volatility decreases and lowers the price of the options, increasing our profits when we buy back the options at a lower price to close our position. Decay also works in our favor with this position.

But be ready to buy back one of the options if there is any indication that the market will resume its trend or reverse direction. If it looks like the market will trend up, buy back the call; if it looks like the market will trend down, buy back the put.

It is also important to cover risks and caveats of this strategy.

The risk of this position is unlimited so you must be very careful. Remember that the commission you pay for this position will be higher because you are initiating two related option transactions.

It is important to analyze your expectations for the underlying asset and for the market before selecting your strategy.

Covered Call

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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 contract, 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.

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 contract. 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.

Covered Call

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: Limited

Maximum Loss: Substantial

Upside Profit at Expiration if Assigned: Premium Received + Difference (if any) Between Strike Price and Stock Purchase Price

Upside Profit at Expiration if Not Assigned: Any Gains in Stock Value + Premium Received

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 for 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)?

BEP: Stock Purchase Price - Premium Received

Volatility

If Volatility Increases: Negative Effect

If Volatility Decreases: Positive 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 written 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. Basically this is call writing against a stock you own

Bull Put Spread

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When the market is volatile and you are moderately bullish on it, you might consider a Bull Put Spread. This strategy involves selling a put option at one strike price and buying a put on the same asset at a lower strike price (further out-of-the-money). Usually both options will have the same expiration date. This strategy is also referred to as a Bullish Credit Spread.

This strategy has a profit/loss picture that is similar to a Bull Call Spread, however in this case, there is a net premium that goes into your trading account when you establish the position, whereas with the Bull Call Spread, you are paying out a premium when you establish the position. Like the Bull Call Spread, this strategy has limited risk but also limited profits.

This strategy is a bullish strategy, like selling naked puts, that puts premium into your account when you establish the position. However it limits your risk by the purchase of lower priced puts, protecting you if the price drops significantly.

With this strategy, your potential profit is limited to the premium you collected for the puts you sold less commissions and the premium you paid for the puts you bought. Your potential losses are limited to the difference between the strike prices multiplied by 100 times the point value of the contract, less the cost of establishing the position. An option calculator such as Option-Aid performs these calculations for you instantaneously.

When we initiate a Bull Put Spread, the put we buy has the same expiration date, with a lower strike price (at a price point that we feel sufficiently limits our risk, without significantly lowering the premium we are collecting.

It is also important to cover risks and caveats of this strategy.

The risk of this position is limited and known as described above. Remember that the commission you pay for this position will be higher than the commission for a straight option play, because you are initiating two related option transactions.

When you initiate a Bull Put Spread, you are limiting your upside potential. If the asset price rockets skyward, then you aren't able to fully participate in that gain like you would if you had purchased a call.

It is important to analyze your expectations for the underlying asset and for the market before selecting your strategy.

Bull Call Spread

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When the market is volatile and you are moderately bullish on it, you can minimize your cash invested in a position, and minimize your risk while still reaping high profit potential by utilizing a Bull Call Spread. This strategy involves buying a call option at one strike price and selling a call on the same asset at a higher strike price. Usually both options will have the same expiration date. This is a debit spread because you will be paying a higher premium for the lower strike call than the premium you receive from the higher strike call.

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
Difference Between Strike Prices - Net Debit Paid

Maximum Loss: Limited
Net Debit Paid

A bull call spread tends to be profitable when the underlying 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)?

BEP: Strike Price of Purchased Call + Net Debit Paid

Volatility

If Volatility Increases: Effect Varies
If Volatility Decreases: 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 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.

Selling Puts

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Aka: Uncovered Put, Short Put, Writing Put, Naked Put

Summary

A Naked Put involves writing a Put option without the reserved cash on hand to purchase the underlying stock.

This strategy entails a great deal of risk and relies on a steady or rising stock price. It does best if the option expires worthless. The only motive for writing an uncovered Put is to earn premium income.

Overview

A Put writer (seller) who has no desire to own the underlying stock, and no earmarked resources for settling should the shares be assigned, is undertaking a highly risky strategy.

An uncovered Put strategy expects the Put to expire worthless, allowing the writer to keep the premium received at the outset. With a lot of luck, the strategy might work, but an unexpected outcome could be catastrophic. Considering the limited income potential and enormous downside risk, this strategy is not suitable for most investors. There are no guarantees against assignment, short of closing out the Put. As for that solution, it might be difficult and costly just when the investor would most want to exit: when the stock moves sharply downward.

How can a short Put writer at least reign in the risk of this risky investment? First, the investor could set aside the financial resources to take ownership of the stock at any time if assigned. Second, the investor could select a strike price more cautiously; not on grounds of maximizing premium income. Obviously, the higher the strike price, the greater the premium, but the higher the risk of assignment, too.

Cash-Secured Puts are the same as Naked Puts, but with two vital exceptions. First, the Naked Put writer has not set aside the cash to buy the stock if assigned. As a result, assignment would require urgent and possibly costly maneuvers to get hold of enough cash by settlement. Second, the Naked Put writer has no interest in acquiring the underlying stock. If assigned, the goal would be to resell the stock as quickly as possible to minimize the duration and risk of stock ownership.

Maximum Risk

The maximum theoretical loss is limited, but it is very substantial. The worst that can happen is for the stock price to fall to zero, in which case the investor would be obligated to buy a worthless stock at the strike price. The effective purchase price, however, would be reduced somewhat by the premium received from selling the Put option.

It is conceivable that the investor might have to incur some additional expenses to come up with enough cash to honor the contract on the settlement day.

Maximum Gain

The maximum gains are very limited, especially relative to the extent of risk. If the position is still open at expiration, the best that can happen is for the stock price to be above the strike price. In that case, the option expires worthless and the investor pockets the premium received for selling the Put option.

Profit/Loss

The potential profit is extremely limited. No matter how high the stock price rises, the most this investor can hope to earn is the initial premium. The best scenario for the Put writer would be a steady or rising stock price for the whole term, with no news announcements or other events to trigger greater volatility. If time passes and the Put remains out-of-the-money, it would be increasingly likely to expire worthless, relieving the investor of all obligations.

Since the premium constitutes the only benefit, some writers are tempted to write contracts with longer terms and higher strike prices. Both would increase the odds of assignment, which in this case is a very undesirable outcome. The investor would have to scramble to deliver the cash by settlement day, and make urgent plans to resell the stock afterward. The delay between assignment and notification add to the overall risk.

Potential losses are extremely large, limited only by the fact that the stock's value cannot fall below zero. At that point, the loss would be the strike price, less the initial premium received.

Break Even

At expiration, the strategy breaks even if the stock price is below the strike price by the amount of the premium received, i.e., the option's intrinsic value equals the price at which the option was sold.

Breakeven = Strike – Premium

Volatility

An increase in implied volatility would have a negative impact on this strategy, all other things being equal. Even if the investor felt that it had no correlation to a greater future risk of assignment, it would normally raise the cost of buying the Put back to close out the position.

Time Decay

The passage of time will have an extremely positive impact on this strategy, all other things equal. Every passing day diminishes the mathematical likelihood of an at-the-money or out-of-the-money Put becoming ITM by expiration.

As expiration approaches the option moves toward its intrinsic value, which for out-of-money Puts is zero.

Assignment

Yes. The risk of assignment, whether early or at expiration, is this investor's chief worry, since the investor has neither the ready cash for this purpose nor a desire to own the underlying stock. A cautious selection of strike price and careful ongoing monitoring are the best ways to decrease the odds of a costly surprise, but closing the Put out is the only way to eliminate this risk. Early assignment, while possible at any time, generally occurs when the option goes deep into-the-money.

And be aware, any situation where a stock is involved in a restructuring or capitalization event, such as for example a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock.

Expiration Risk

This risk applies, too. The option writer cannot know until the Monday following expiration whether assignment occurred or not. Since the goal is to resell the assigned stock as soon as possible, the delay of a weekend exposes the investor to interim stock price risk, as well as possible inconveniences in bridging the need for cash from option settlement until the subsequent stock sale settlement.

Long Call

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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?

This strategy appeals to an investor who is generally more interested in the dollar 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 underlying stock considers the lower dollar 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 with an outright purchase of the underlying stock. Long call contracts offer the investor a pre-determined risk.

Risk vs. Reward

Maximum Profit: Unlimited

Maximum Loss: Limited

Net Premium Paid

Upside Profit at Expiration: Stock Price - Strike Price - Premium Paid

Assuming Stock Price above BEP

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 dollar 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)? BEP: Strike Price + Premium Paid

Before expiration, however, if the contract's market price has sufficient time value remaining, the BEP can occur at a lower stock price.

Volatility

If Volatility Increases: Positive Effect

If Volatility Decreases: Negative 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" by paying for the option, generally decreases, or decays, with the passage of time. This decrease 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.