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A previous article on the diagonal spread trade pointed out how this strategy incorporates the best features of the vertical spread and the horizontal spread while avoiding some of the drawbacks of each. In the previous article and updates of that article, the diagonal spread trade was illustrated with Procter& Gamble (PG) call options. It was also discussed how the trade could be continued forward by utilizing weekly options. The discussion here provides a final update and conclusion of the diagonal spread. In early June with PG trading near $78, it was anticipated that the stock price might be moving up over the next six weeks in anticipation of a strong earning report on August 1. To guard against some time loss in a long call option while waiting for the stock to move up, a diagonal spread with PG call options was selected. Original Trade (6/11): Buy 1 July (monthly) 75 call for $3.60 and sell 1 June (monthly) 80 call for $.35 for a net cost of $3.25. First Continuation (6/21): With PG trading around $77.50, the June (monthly) 80 call expired worthless. The June (weekly exp 6/28) 80 call was sold for $.15, reducing the cost basis of the July (monthly) 75 call down to $3.10. Second Continuation (6/28): With PG trading around $77, the June (weekly exp 6/28) 80 call expired worthless. The July (weekly exp 7/5) 80 call was sold for $.10, reducing the cost basis of the July (monthly) 75 call down to $3.00. Third Continuation (7/5): With PG trading around $78.50, the July (weekly exp 7/5) 80 call expired worthless. The July (weekly exp 7/12) 80 call was sold for $.25, reducing the cost basis of the July (monthly) 75 call down to $2.75. Conclusion (7/12): During the week of July 8-12, there was a 4.1% surge in the price of PG stock which closed at $81.55 on Friday (7/12). With the July (weekly exp 7/12) 80 call in-the-money by $1.55, it was time to close the diagonal spread. Even though the long option in the diagonal spread still had another week before it expired, it was best to view the diagonal as a vertical spread that had achieved its maximum possible return. Under these circumstances, the only sensible action was to exit the trade. Near the close of trading on July 12, the diagonal spread could be closed for a net of $5.30. This included an extra $.30 of time value in the long call that still had another week before expiration. Using the cost basis of $2.75 going into the last week of the trade, the profit of $2.55 represented a yield of 93%. This PG trade was a good illustration of how the diagonal spread can utilize the best features of the horizontal and vertical spread strategies. Like a horizontal spread, it repeatedly captured premium from selling weekly options. Then when the stock price moved so that both legs were in-the-money, the diagonal spread functioned like a vertical spread that had achieved its maximum profit. ************************* ************************* ************************* ************************* Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education and trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com. Share .

Our previous article on the diagonal spread trade pointed out how this strategy incorporates the best features of the vertical spread and the horizontal spread while avoiding some of the drawbacks of each. In the previous article, the diagonal spread trade was illustrated with Procter & Gamble (PG) call options. It was also discussed how the trade could be continued forward by utilizing weekly options. The discussion here provides an update on the original diagonal spread and indicates how it could be continued forward toward the July 19 expiration date. In early June with PG trading near $78, it was anticipated that the stock price might be moving up over the next six weeks in anticipation of a strong earning report on August 1. To guard against some time loss in a long call option while waiting for the stock to move up, a diagonal spread with PG call options was selected. Original Trade (6/11): Buy 1 July (monthly) 75 call for $3.60 and sell 1 June (monthly) 80 call for $.35 for a net cost of $3.25. First Continuation (6/21): With PG trading around $77.50, the June (monthly) 80 call expired worthless. The June (weekly exp 6/28) 80 call was sold for $.15, reducing the cost basis of the July (monthly) 75 call down to $3.10. Second Continuation (6/28): With PG trading around $77, the June (weekly exp 6/28) 80 call expired worthless. The July (weekly exp 7/5) 80 call was sold for $.10, reducing the cost basis of the July (monthly) 75 call down to $3.00. Third Continuation (7/5): With PG trading around $78.50, the July (weekly exp 7/5) 80 call will expired worthless. The July (weekly exp 7/12) 80 call was sold for $.25, reducing the cost basis of the July (monthly) 75 call down to $2.75. Outlook (7/5 to 7/19): By selling weekly calls every Friday beginning with 6/21, the original cost of the July (monthly) call has been reduced from $3.60 down to $2.75 while waiting for the price of PG stock to move up. This continuation with weekly options has produced a profit when simply holding the long Jul 75 would currently reflect a small loss. Moreover, it has not been necessary to abandon the original viewpoint that PG stock would make a move up as we progress toward the expiration our July 75 call on 7/19. By continuing the diagonal spread with the selling of weekly options, sufficient compensation has been achieved to offset the time value lost in the long July (monthly) call. If at any time along the way, there had been a surge in the PG stock price to a level above $80, the diagonal spread could have been closed for a nice profit. Selling weekly options also allowed for a frequent re-evaluation of the long position to see if an early exit seemed appropriate. ****************************************************************************************************** Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education and trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com.

The diagonal spread offers a great compromise between the vertical spread and the horizontal spread. It incorporates the best features of each while avoiding some of the drawbacks of each. Let's briefly review the vertical and horizontal spreads including the shortcoming of each. For the discussion here, we will consider only debit spreads. VERTICAL SPREAD You buy a Call (Put) that has a delta of magnitude .45 to .65. Then you sell a Call (Put) with a higher (lower) strike price. Both Calls (Puts) will have the same expiration date. Ideally, you want the sale price of the short option to lower the cost of the long option by at least 30%. The Vertical Spread achieves its maximum return at expiration when the price of the underlying stock has moved beyond the strike price of the short option. Shortcomings of the Vertical Spread: Must wait until the expiration of both options to achieve the best profit. Profit is limited to the difference between the two strike prices less the net cost of the spread. HORIZONTAL SPREAD (also called a calendar spread or time spread) You buy a Call (Put) with a strike price that is near the current stock price. The expiration date of the long Call (Put) is typically 4-8 weeks in the future. Then you sell a Call (Put) with the same strike price and a closer expiration date. Ideally, you want the sale price of the short option to lower the cost basis by at least 30%. The Horizontal Spread achieves its maximum return if the stock price is very near the common strike price when the short Call (Put) expires. Shortcomings of the Horizontal Spread: The stock price must be very near the common strike price at expiration in order to have a reasonable profit. If the stock price is even modestly removed (up or down) from the strike price, the spread is unlikely to produce a profit. Must be wary of any event (earnings report, etc) that might cause a large move in the stock price prior to the near term expiration date. DIAGONAL SPREADS The compromise between the Vertical Spread and the Horizontal Spread. You buy a Call (Put) that has a delta of magnitude .45 to .65. Then you sell a Call (Put) with a higher (lower) strike price that has a closer expiration date. The Diagonal Spread has the advantage of directional movement offered by the Vertical Spread, while also providing the relatively quick expiration of the short option offered by the Horizontal Spread. If weekly options are available, there is substantial flexibility in selecting the time frame over which the trade can be maintained. ILLUSTRATION USING PROCTER & GAMBLE (PG) To illustrate the diagonal trade, let's consider a current trade on a popular Dow stock, Procter & Gamble Co (PG). Example Trade: In early June, PG was trading at $78 after a modest pullback. With an earnings report due on August 1, it was felt that PG would likely be moving up over the next six weeks. Trade: One July (monthly) 75 call was purchased for $3.60 and one June (monthly) 80 call was sold for $.35. Net cost of the trade was $3.25. Comment: Note that the premium received from the sale of June 80 call reduced the cost basis by about 10%, which is significantly less that what would be expected in a vertical or horizontal spread. The diagonal spread is typically more expensive than a vertical or horizontal spread, but that is offset by the potential to benefit from a quick directional move. Trade Evaluation: On the expiration date of the June (Monthly) 80 call, the trade will be at break-even or better if PG is above $77.50, and will show a profit of at least 40% if PG is above $79. If PG is at $80 or higher, the trade will have a profit of about 60%. Comment: At the June expiration date with the stock at $80, the July (monthly)75 call by itself would show a profit of only 46%. Trade Continuation: If PG has not reached $80 when the June expiration date arrives, the June (monthly) 80 call will expire worthless and the July (monthly) 75 call will have a reduced cost basis of $3.25. This option can then be held for unlimited future gains. Since PG has weekly options, there is an opportunity to continue this trade on a week-by-week basis as you wait for the PG stock price to move up. The premium received from the sale of a weekly call can help offset the time decay in the long option until PG makes its move. Trade Continuation with weekly options: If PG is below $80 at the June (monthly) expiration date, the June weekly 80 call might be sold for $.25. This will reduce the cost basis of the July (monthly) 75 call to $3.00 while still allowing for plenty of upside potential for a profit. Management of the Diagonal Spread: The key to the diagonal spread is keeping track of the deltas of the two options. When the trade is initially established, the short option will be out of the money and have a delta of lower magnitude than the long option. If the underlying stock moves quickly and extensively in the desired direction, it is possible for the delta of the short option to outpace that of the long option and even lead to a losing trade. This is the same problem seen in a horizontal spread. When setting up the trade, it is wise to consult a risk graph to determine the most extreme move of the underlying stock that will still yield a worthwhile profit in the diagonal spread. It may be necessary to move the strike price of the short option further out-of-the-money in order to guard against a losing trade when the underlying stock moves farther than anticipated. What stocks are most suitable for diagonal spreads? Stocks that offer numerous strike prices are best. This permits flexibility in selecting an option to short that will yield a reasonable premium while still allowing for ample price movement. Also, as mentioned above, stocks that have weekly options provide additional flexibility to adjust the trade regularly in response to price movement. ****************************************************************************************************** Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education and trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com.

For those new to options, our website, OlmsteadOptions.com, has a wealth of great resources geared to beginners and blog that you might find interesting. - Dr. Olmstead

A frequently mentioned strategy for acquiring shares of a desirable stock is that of selling naked puts and waiting to have the stock assigned. Advocates of this strategy argue that this is a great way to buy a stock at a discount price. While there is some potential value to this strategy, it is unclear that this approach is always a sound way to acquire a stock. Let’s look at a case that was recently profiled in the financial press to investigate the pros and cons of acquiring stock by selling naked puts. Astex Pharmaceuticals Inc (ASTX) is a popular stock with a price that has been in a steep decline since the beginning of May. Recently the stock price appears to have bottomed out near $4.50 per share. On June 11, with ASTX stock trading at $4.60 per share, a single order to sell 5000 contracts of the Jul 4.5 puts was filled at $.32 per share. There was no evidence that this was part of a spread order that would have hedged the short puts. Ostensibly, this order was placed by a put seller (firm or individual) that has some potential interest in owning 500,000 shares of ASTX stock. Positive side of this strategy The arguments in favor of this trade point out that if the stock price is above $4.50 at the July expiration date, the short naked puts will expire worthless and the seller keeps the $.32 per share. On the other hand, if the stock price is below $4.50, the seller will be assigned the stock and thereby acquire 500000 shares at the discounted price $4.18 per share [4.50 - .32 = 4.18]. An important point about this stock acquisition strategy is that while the put seller does not need to have all of the cash available to purchase the stock prior to the options expiration date, there will still be a substantial margin requirement imposed as soon as the puts are sold. Negative side of this strategy To see the negative side of this strategy of selling naked puts, suppose that ASTX stock has bottomed out near $4.50 a share and rises to $5.00 or higher by the July options expiration date. The put seller may regret not having decided to buy 500000 shares of stock at $4.60 per share while simultaneously selling the Jul 5 calls for $.35 per share. That combination represents a discounted stock price of $4.25 per share [4.60 - .35 = 4.25], and if the stock price is above $5.0 at the July options expiration, the stock will be called away for a total profit of $.75 per share [.35 + (5.00 -4.60) = .75]. On the other hand, if the stock price begins to fall, it may be possible to roll the short Jul 5 calls down to the Jul 4.5 calls so as to receive a total of say $.45 from the two short call transactions, thereby reducing the cost basis of the ASTX stock down to $4.15 per share [4.60 - .45 = 4.15]. Conclusion The primary point of this discussion is if you are bullish on a stock that is near a bottom in price, you may be better off buying the stock than going through the acquisition process of selling naked puts. If you are correct in your assessment that the stock is ready to start moving up, you are likely to achieve a better return by simply buying the stock and selling out-of-the-money calls. Even if the stock continues to fall a bit lower, your cost basis for stock ownership may be about the same as that of the put selling strategy. ************************************ Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education and trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com.

Shareholders are naturally concerned as the date of an earnings report for their favorite stock draws near. Stocks often experience their biggest declines in price after an earnings report fails to meet the expectations of investors. The recent price action in Apple Inc (AAPL) is a perfect illustration. This widely held stock lost more than 12% of its value following its most recent report. Now that many stocks have weekly options, there are new strategies available for earnings report protection. Weekly options can provide low-cost, short-term insurance to lock in a minimum sale price of a stock that is potentially vulnerable to an earnings setback. It has always been possible to use monthly put options to protect the price of a stock through the date of the company’s earnings report. The problem with monthly puts is that they can be quite expensive, particularly when the options expiration date is substantially later than the earnings report. Weekly options are cheaper and offer more flexibility in providing short-term protection. Not all stocks have weekly options, but when they are available, it is prudent to know how to employ them to circumvent an earnings report disaster. There is a cheap but effective strategy to protect the stock price through its earnings report by using a combination of weekly options. It is easiest to present this protective strategy as a combination of two separate trades. The first trade is the purchase of a weekly put option that expires on the closest Friday following the earnings report. For every 100 shares of stock, buy one contract with a strike price that is slightly below the current stock price. While this short-term, protective put provides for a minimum sale price of the stock, it may still seem relatively expensive because option prices often inflate ahead of an earnings report. A second trade is implemented to lower the cost basis of the protective put. The second trade uses weekly options that expire one week prior to the expiration date of the protective put. For every 100 shares of stock, sell one call contract with a strike price above the current stock price. Also sell an equal number of put contracts with a strike price that is one strike below that of the protective put. The premium received from the sale of these options will substantially lower the cost basis of the protective put. It is typically best to do these two trades about two weeks prior to the earnings report date. It is important to understand what has been achieved with these trades. The long stock together with the short call represents a covered call position. The long protective put together the short put represents a diagonal time spread. There is no margin requirement associated with either of these positions. Since the stock price tends to remain in a relatively narrow range prior to the earnings date, it is expected that both of the short options will expire worthless on the Friday prior to the earnings report date. This leaves the protective put in place for full effect through the following week. If the stock price falls significantly after the earnings report, there are two alternatives available to the shareholder. For those who are no longer interested in owning the stock, it can be liquidated at the strike price associated with the protective put. Some shareholders may want to maintain their stock position even after a pull back in price, in which case the protective put can be sold for a profit to offset most of the lost value in the stock. If the stock price soars after the report, the protective put will expire worthless, but there is no cap on the profit that can be achieved by the stock. Some comments are in order regarding the unexpected cases in which the stock price will have moved sufficiently (up or down) during the week before the earnings report that one of the short options will be in-the-money as its expiration date arrives. If the stock price is above the strike price of the short call, the shareholder can either buy back the short call and wait for the earning report or allow the stock to be called away for a profit. If the stock price is below the strike price of the short put, the short call will expire worthless and the diagonal put spread can be sold for a profit. In this latter case, the stock will no longer be protected through the earnings report. Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education and trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com.

For those of you who have been following the Facebook (FB) trade that was proposed in my blog entry of 8/15/12, the residual option position is now showing a profit of 76%. Since the residual position includes the long Jan 16 call that will be expiring this Friday (1/18/13), a decision needs to be made. The basic choices are: (i) sell the Jan 16 call and collect the profit, (ii) exercise the call to become the owner of 100 shares of FB stock at a price of $16 per share. (iii) roll the Jan 16 call into a later month. If you wish to continue participating in the price movement of FB, choice (iii) provides that opportunity without the need for extra capital to purchase the stock. Even after choosing (iii), there are further selections to be made in terms of which expiration month and which strike price should be used. Rolling the Jan 16 call into a June call option will provide for another five months of participation in the FB price movement. Here are a couple of possibilities involving June options : (iii-a) Roll the Jan 16 call into the Jun 17 call for a small profit that will cover your commission costs. The Jun 17 call has a delta of 0.96, which means that this option will capture essentially all of the price movement of the stock. (iii-b) Roll the Jan 16 call into the Jun 23 call, which will produce enough profit to cover the cost of your Jan 16 call and thus represents a free trade for the next five months. The Jun 23 call has a delta of 0.83, which will also mimic the price movement of the stock quite well. Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education material and option trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com.

Dr. W. Edward Olmstead Olmstead Options Trading Strategies Now that many stocks have weekly options, there are new strategies available to protect the price of a stock following an earnings report. Stocks often experience their biggest declines in price after an earnings report fails to meet the expectations of investors. Weekly options can offer cheap, short-term insurance to lock in a minimum sale price of a stock that might be vulnerable to an earnings setback. It has always been possible to use monthly put options to protect the price of a stock through the date of the company’s earnings report. The problem with monthly puts is that they can be quite expensive, particularly when the expiration date is substantially later than the earnings report. Weekly options are cheaper and offer more flexibility in providing short-term protection. Not all stocks have weekly options, but when a stock does have them, it is prudent to know how to employ them to circumvent an earnings report disaster. A timely illustration of a protective options strategy will be presented for Facebook Inc (FB), which has its next earnings report on January 23. FB stock is currently trading around $26, which represents a nice 30% increase since mid-November. With the company’s earnings report scheduled for January 23, there is concern about losing those recent gains if the report is less than spectacular. Let’s explore an inexpensive strategy to protect the price of FB by using a combination of weekly options. This protective strategy assumes the ownership of 100 shares of FB stock. While this trade may be appropriate for the protection of FB stock purchased at any price, it is designed primarily for stock purchased below the level of $25 per share. It is easiest to present this protective strategy as a combination of two separate trades. The first trade is the purchase of a weekly put that expires two days after the FB earnings report. For 100 shares of FB stock, buy one contract of the Jan 25.5 put that has an expiration date of January 25. The current cost of this put is $1.65 per share. This put will allow you to liquidate your stock for $25.50 per share if the earnings report on January 23 leads to a collapse of the FB stock price. The second part of the strategy is intended to lower the cost basis of the long Jan 25.5 put. In this second trade, sell one contract of the Jan 29 call and one contract of the Jan 24 put, each of which expires on January 18 (these particular weekly options coincide with the monthly options). Currently, the premium received from the sale of these two options is $.75 per share. This sale will reduce the cost basis of long put from $1.65 per share down to $.90 per share. The recent price range of FB stock will likely hold for the next few weeks leading up to the earnings report on January 23. This suggests that the short Jan 29 call and short Jan 24 put will expire worthless on January 18, five days before the earnings report. The residual option position will be long one Jan 25.5 put with a cost basis of $.90 per share that is valid through the week of January 21-25. With the FB earnings report on January 23, there will be two full days after the report to observe the response of the stock price. If the price of FB stock falls significantly after the report, the stockholder will have the choice of either (I) liquidating the stock at $25.5 per share or (ii) selling the Jan 25.5 put for a profit that will offset some of the loss in the stock price. Of course, it is possible that the price of FB stock will be either above $29 or below $24 when the expiration date of the short options arrives on January 18. If the stock price is above $29, the short put will expire worthless and the stock holder can choose to either buy back the short call or allow the stock to be called away for a nice profit. If the stock price is below $24, the short call will expire worthless and the diagonal spread composed of the long Jan 25.5 put and short Jan 24 put can be sold for a profit. While this weekly options strategy was presented as a protection for actual shares of FB stock, it applies equally well for an options position that represents synthetic stock. In an August 2012 blog entry (with follow up commentary), I presented an options approach to safely construct a synthetic long stock position in FB. The protection strategy presented here can be used in conjunction with that synthetic holding. Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education material and option trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com.

Dr. W. Edward Olmstead Olmstead Options Trading Strategies The basic goal of a calendar spread (also called a horizontal spread) is to sell a near-term option to collect premium in order to lower the cost basis of a longer-term option with the same strike price. The calendar spread can done with either calls or puts. The basic concept for this trade to be profitable is that the near-term option will lose all of its time value while the longer-term option retains a significant portion of its time value. Unfortunately, the profitability of this strategy also requires the price of the underlying stock to be sufficiently close to the common strike price as the near-term option reaches its expiration date. In the traditional version of the calendar spread, a front-month option is sold against a more distant monthly option with the same strike price. Holding this version of the trade for several weeks while waiting for the front-month option to lose its time value can become very frustrating as you watch the price of the underlying stock drift far from the common strike price into a range that is likely to produce a loss at expiration. Now that weekly options have become available on many stocks (and ETF’s), there are new opportunities for the calendar spread trader. It is no longer necessary for the near-term option in a calendar spread to be the front-month option. The short, near-term option could be a weekly option that expires in nine days or less. While a smaller premium is received from selling a weekly option, there are some compensating features that make this new version of a calendar spread worthy of consideration. By selling a weekly option, the opportunity to exit the trade arrives much sooner. When all of the time value in the weekly option has quickly decayed to zero, very little time value will have been lost in the long-term option. This offers the possibility of a quick exit for a profit that might be small, but also frees up capital to move on to a new trade. Even though a smaller premium is received from selling the weekly option, the possibility of repeating the process over 3-4 weeks could easily provide a total premium in excess of that received from the one-time selling of a front-month option. Here again there is the opportunity to close the trade at the end of any week in which it appears unwise to continue holding the long position. With a weekly option as the near-term component in the calendar spread, it becomes easier to convert the calendar spread into a diagonal spread. As one weekly option expires, it may be advantageous to roll into a new weekly option with a strike price that is further out-of-the-money. This might open up the opportunity for a bigger long-term profit if the price of the underlying stock keeps moving in a direction that favors the long-term option. There are currently well over 100 stocks and ETFs that trade weekly options. Popular stocks that have weekly options include, AAPL, AMZN, FB, GOOG, JNJ, QCOM and YHOO. Heavily traded index ETFs with weekly options include DIA, IWM, QQQ and SPY. Your broker should be able to provide a complete list. Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education material and option trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com.

The backspread trade is used to take advantage of a substantial move in the price of a stock or ETF. This trade is composed of more long options than short options, with the strike prices selected so that the cost of the trade is small and even possibly provides a credit. In order for the backspread trade to be successful, the expiration date of the options must allow sufficient time for the expected price move in the underlying stock or ETF to occur. It is possible to use weekly options for the backspread provided that the price move occurs within the brief lifetime of the options. A possible application of a backspread with weekly options is in anticipation of a special announcement or report that might produce a substantial price move. On September 12, Apple, Inc (AAPL) is expected to announce the details of its new iPhone 5. A company that may benefit from this announcement is Qualcomm, Inc. This makes a weekly backspread trade on QCOM look particularly attractive, since QCOM options offer more leverage than the corresponding AAPL weekly options. Let's consider a possible backspread trade with QCOM call options that will expire on September 14. Trade: Buy 3 September 62.5 weekly calls (expiration 9/14) at $.75 per share and sell 1 September 60 weekly call (expiration 9/14) at $2.60 per share. Credit = $35 [(2.60 X 100) - (.75 X 300) = 35] Maximum risk = $215 If the price of QCOM reaches $64.25 before the weekly options expire on September 14, the backspread trade can be closed for a profit of $135. That represents a 63% return relative to the maximum risk on the trade. The maximum loss occurs if the price of QCOM closes at exactly $62.5 as the call options expire on 9/14. If QCOM happens to close below $60 on 9/14, then all of the options expire worthless and the original credit of $35 becomes a profit. Disclosure: Olmstead Options owns monthly options in QCOM that expire Sept. 21. Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education material and option trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com.

The buy write trade you describe is also know as the covered call trade. Some investors are not aware that this trade carries exactly the same risk and reward profile as selling a naked put. Strangely, most brokers will allow a covered call trade in a retirement account, because it is a "conservative" trade, but not allow selling a naked put because it is a "high risk" trade. (??!). The problem with the buy write trade (covered call) arises when you reach the expiration date and the stock price is at an inconvenient level. Suppose the stock price is well below where you bought it. Then you sell an at-the-money call for the next cycle, but at the next expiration date the stock price has recovered back to the level you bought it and more. Now (i) you are going to give up your stock for much less than your purchase price, or (ii) you are going to buy back the short call for a big loss and hope that your stock continues to rise. Not a happy choice. Other difficulities arise if the stock price is well above your purchase price after the first cycle that you do the trade, although in this case you can give up the stock for a profit on the trade.

Dr. Edward Olmstead, Professor, Northwestern University Chief Options Strategist, Dr. Olmstead’s Options Trading Strategies There continues to be considerable interest in owning the stock of Facebook (FB) even though its performance has been a disappointment since its IPO in May. At its current level of $20.40, it might be a bargain, but it could also continue lower before it finds some significant support. Here is a cheap and safe way to own FB into January 2013 (and possibly beyond). This cheap and safe way to own FB into the beginning of 2013 uses a combination of options. Instead of buying the stock, a call option will used as a synthetic version of the stock that costs less than $6 per share while providing over 80% of the FB price movement. To protect the synthetic stock, a married put option will be used to limit loss in case the stock continues to move lower. Finally, the cost of the married put will be substantially reduced by selling a near-term strangle. Here are the details of the trade base upon a one contract position (100 shares): Buy 1 Jan (2013)16 call for $5.70 per share. Buy 1 Jan (2013) 20 put for $3.20 per share. To reduce the cost of the put, sell 1 Sept 22 call for $.90 per share and sell 1 Sept 18 put for $.70 a share. At the September expiration date (9/20), this trade will show a small profit if FB is trading between $18 and $26. After the September expiration date, this trade has the potential for unlimited profit with a maximum risk at the January expiration of only $3.30 per share. Actually, the maximum risk is less than $2.00 per share prior to the beginning of December. When the January expiration date is reached, you can continue following FB by repeating the synthetic stock/married put trade for another 5-6 months. You would also have the choice of buying FB stock for $16 per share. Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education material and option trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com.

Dr. Edward Olmstead, Professor, Northwestern University Chief Options Strategist, Dr. Olmstead’s Options Trading Strategies We've all experienced the situation in which we buy a stock only to see it undergo a significant pullback in price. We still like the stock and feel that it will recover at least some of the ground that it lost. There is a low-cost option strategy that can help you get back to a break-even status when the stock regains only part of its lost value. Holders of Facebook (FB) stock and those who are under water with Apple (AAPL) may find this strategy useful. The stock repair strategy uses options to assist in bringing your stock investment back to a break-even level. This strategy is structured to attain the break-even status at a stock price that is significantly lower than the original purchase price. The great appeal of this strategy is that it involves no additional risk since it can be applied for little or no additional expense. Note that to do the stock repair strategy for little or no cost, it typically requires options with at least two months until expiration. The more time allowed, the more likely a credit will be generated. Stock Repair Strategy For this strategy to work, it is necessary for your fallen stock to make at least a partial recovery. The stock repair strategy uses options to expand that partial recovery into a full recovery of your original investment, with little or no additional expense. If the stock price remains unchanged or continues to fall, this strategy offers no help. The basic plan is to buy one at-the-money call for each 100 shares of stock that you own. You are going to pay for this one long call by selling two out-of-the money calls with the same expiration date. The idea is to use the cash received from the two short calls to pay for the one long call. Choose an expiration month for the options that is far enough out in time for the price of your stock to recover back to the strike price of the short calls. Let's look at some examples to illustrate the stock repair strategy: ‑ Example 1. You bought 100 shares of XYZ back in December when it was $35. You watched it initially go up, but then *undergo a dramatic slide to its current price in early March of $23. You still like the stock and feel that there is some hope for a recovery, although getting back to break-even at $35 seems far away. Let's see how stock repair might help. ‑ Trade: Buy 1 Jun 25 call for $3.30 per share and sell 2 Jun 30 calls for $1.75 per share. This actually produces a net credit of $.20 per share [(1.75 ¥ 2) - 3.3 = .20]. Position: Along with an extra $.20 per share in your account, you hold the combination of a covered call (long 100 shares XYZ and short 1 Jun 30 call) and a bull call spread (long 1 Jun 25 call and short 1 Jun 30 call). See Figure. 16-1 for a risk graph that depicts this position. Payoff: If XYZ is above $30 at the June options expiration, the stock will be called away at $30 per share, for a $7 per share gain over its present price of $23. The bull call spread will be worth $5 per share. The total gain (including the $.20 credit received) is $12.20 per share [7.0 + 5.0 + .2 = 12.2], which is equivalent to a stock price of $35.20. Thus, you will have reached slightly better than break-even, although the stock is still as much as $5 below your original purchase price. ‑ Example 2. You bought 100 shares of YZX back in December when it was $19.50. Now in early March the stock is down 15 percent with a slide to $16.50. Let's see how stock repair can get you back to slightly better than break-even in only 10 weeks with the stock recovering just 6 percent from its *current level. Trade: Buy 1 May 15 call for $2.40 per share and sell 2 May 17.5 calls for $1.10 per share. This does require a small cash outlay, specifically $.20 per share [(1.1 ¥ 2) - 2.4 = -.2]. Position: It has cost you an extra $.20 per share to hold the combination of a covered call (long 100 shares of YZX and short 1 May 17.5 call) and a bull call spread (long 1 May 15 call and short 1 May 17.5 call). Payoff: If YZX is up by only 6 percent from its current level to $17.50 at the May options expiration, you will be slightly better than break-even. The stock will be called away at $17.50 per share for a $1 per share gain over its present price of $16.50. The bull call spread will be worth $2.50 per share. Allowing for the small extra cost to establish this trade, the net gain is $3.30 per share [1.0 + 2.5 - .2 = 3.3], which is equivalent to a stock price of $19.80. Thus, you have reached slightly better than break-even with the stock recovering less than half of its loss. In comparing Examples 1 and 2, note that the stock repair for 1 was done for a small credit, whereas 2 required a small debit. The explanation for this is the amount of time until the options expire (June versus May). Reminder: to do the stock repair strategy for little or no cost, it typically requires options with at least two months until expiration. The more time allowed, the more likely a credit will be generated. Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education material and option trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com.

Dr. Edward Olmstead, Professor, Northwestern University Chief Options Strategist, Dr. Olmstead’s Options Trading Strategies We recognize that when it comes to trading options, there's a lot of information to absorb and most people may not have the time to review every detail, so we put together a "cheat sheet" to help you get started. Should you want to explore any or all of these points further, more detail for each item on the check list is provided in our options blog. Following each of these steps does not guarantee a successful trade, but it reduces the risk of a bad trade and that can make a big difference in your overall trading record. Ten Things to Consider BEFORE You Buy an Option 1. Determine how much of your total investment funds you are willing to use for the high-risk trading of options. Once you have determined an appropriate amount for your options trading capital, allocate only about 15% of that capital per option trade. 2. Make sure you are using an options friendly broker. The trading platform for your account should display option prices in real time and easily allow you to execute a trade when the time is right. Live help should be readily available when you need it. Commissions should not be excessive. 3. Anticipate events that might impact the price action of the stock associated with your option. Check on upcoming earnings release dates, FDA decisions, court rulings, ex-dividend dates, etc. Such events can even be the basis for timing an option trade. 4. Review price trends, not only for your stock of interest, but also for the industry that includes your stock, as well as for the overall market. The cliché "The trend is your friend" is good advice in trading options. The more trends going your way, the better are your chances of success. 5. Select an option that gives you the best opportunity for a successful trade. The cheapest option is rarely the best choice. Choose an option with an expiration date that gives the underlying stock ample time to make the expected move in price. Keep in mind that in options trading, time is money. 6. Learn how to enter an option trade at the best available price. Follow options prices in real time, and enter a limit order that is most likely to be filled. Avoid market orders. 7. Set up a scheme to track your option trade with daily entries in a spreadsheet. It is important to develop a feel for how an option price changes in response to changes in the stock price and the passage of time. 8. Have an exit plan for profit. Decide on a reasonable move in the stock price for a suitable profit to be achieved in the option. The amount of profit will depend on how quickly the stock price reaches the desired level. If the profit comes quickly, you might consider holding on for a bigger gain, but remember that options are time limited. Don't be greedy. 9. Have an exit plan to limit loss. Identify a stock price level that suggests a failure of the move that had been anticipated. When the stock price reaches the failure level, exit the trade to limit loss. Not all option trades will be winners, so it's important to exit a losing trade early and preserve capital for future trades. 10. Gain access to a program that includes an options calculator or risk graph display. Having an unbiased source to check the profit and loss characteristics for your trade is a valuable tool. Some brokers provide such a tool on their trading platform. Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education material and option trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com.

Option Basics: How to Enter and Exit Option Trades Dr. W. Edward Olmstead Chief Options Strategist Olmstead Options Options Strategies Very often the success of an options trade will be strongly influenced by how carefully the entry and exit prices are negotiated. The gain or loss of $.10 per share in a stock trade is usually insignificant, whereas in an option trade it can make a huge difference. Suppose that you buy an option for $2.00 per share and later sell it for $3.00 per share. The profit of $1.00 per share represents a nice 50% return on your investment. If you could have shaved your entry price by $.10 to $1.90 and managed to pad your exit price by $.10 to $3.10, then your profit of $1.20 per share represents a dramatically improved 63% return. The point here is that, in options trading, it is very much worthwhile for you to work at achieving good entry and exit prices. Saving an extra $.10 on either the entry price or the exit price of a trade is usually enough to cover the brokerage fees on both ends of the trade. To begin, let’s review the basics of how options prices are maintained: The current decimal pricing of stocks and ETF’s is such that the price per share is typically quoted in $.01 increments. You will see this same pricing structure on some options, but certainly not all. Those options that cost less than $3.00 per share are typically priced in increments as small as $.01, although this is not always available. For options that cost $3.00 per share or more, the pricing will often be in $.05 increments, but here again there will be exceptions. For some high volume stocks and ETF’s with very liquid options, you may see $.01 increments in the pricing of its options that cost over $3.00 per share. Each option exchange will list a bid price (called the “Bid”) and an ask price (called the “Ask”) for every option that is available on a stock or ETF listed with that exchange. The Bid is the highest per share price that some trader (or market maker) is willing to pay to buy the option. The Ask is the lowest per share price that some trader (or market maker) is willing to accept for the purchase of an option. Most financial data feed services that provide options prices show only the best Bid and best Ask prices as selected from a survey of all the exchanges. The Ask is always greater than the Bid and the difference between the two prices is called the Bid/Ask spread, or more simply the “Spread.” Depending upon the liquidity of the option, the Spread may be as narrow as $.01 for options trading under $3.00 or as wide as $1.00 or even more for some illiquid options. Whenever the Spread is wide enough, there is the possibility of negotiating a more favorable price somewhere between the Bid and the Ask. Be wary of situations in which the Spread exceeds 15% of the average of the Bid and Ask prices. In such circumstances, check recent volume in the options to make sure of sufficient liquidity to justify trading them. The width of the Spread for an option is essentially controlled by the market maker. He earns his living by managing an appropriate Spread. His goal is to have someone buy an option from him at the Ask, while someone else is willing to sell him the same option at the Bid. The two option positions cancel each other and the market maker pockets a profit equal to the value of the Spread. This may seem like a small profit if the Spread is only $.01 to $.05, but when repeated over a large number of contracts it soon becomes substantial. In a non-volatile situation where there is a high volume demand for both buying and selling an option, the market maker is content with a narrow Spread, because it is easy to match up his long and short positions while repeatedly collecting the value of the Spread. In a highly volatile situation where there is a large but unbalanced demand for an option, or in a very low volume situation, the market maker maintains a wide Spread. In those situations, it is more difficult to find a matching trade and the market maker needs a wider Spread to offset his risk. Now let’s turn our attention to the details of entering and exiting a trade. For simplicity, we will confine our attention to the opening and closing of a long option position. That is, first buy an option in an “opening transaction” and then later sell the option in a “closing transaction.” Entering a Trade There are two main ways to initiate an “opening transaction” for an option trade. Similar to buying stock, the purchase of an option is typically accomplished by means of either (i) a market order or (ii) a limit order. Most option traders avoid a market order in an “opening transaction”. The best that you can do is to be filled at the Ask price, and quite often you will do worse. If your order is for several contracts, you may find that only a few contracts are filled at the Ask before that price slides to a higher level for the remaining fills. In a volatile market where option prices are changing quickly, you may feel that you will only succeed in entering the trade by the use of a market order. In such a situation, you will be placing yourself at the mercy of the market maker, who is allowed considerable latitude in filling market orders during fast conditions. This leaves the limit order as the principal way to buy an option. With the limit order, you select the price that you feel is reasonable to pay for the option and enter that price with the order. There is no guarantee that your order will be filled, but if it is, it must be at your price or lower. Let’s look at some examples to illustrate how to determine an appropriate price for a limit order to enter a trade. Example #1A: Bid = $2.40 and Ask = $2.42. There is almost no room for negotiation here. The Spread = $.02, which is almost the minimum possible for an option trading under $3.00 per share. Typically, the Spread is this tight only for highly liquid options. Place a limit order to buy at $2.42 and you should get a quick fill. Example #2A: Bid = $2.40 and Ask = $2.60. With the Spread = $.20, there is some room for negotiation. You could try to split the Spread in the middle with a limit order to buy at $2.50. Getting filled at that price under most conditions could be difficult. If you move the limit price up to $2.55, you are much more likely to get filled. Example #3A: Bid = $4.10 and Ask = $4.40. Since the option is trading over $3.00 per share, the minimum Spread might be no smaller than $.05. Here the spread is $.30, which suggests that there may be some room for negotiation. Typically, a limit order to buy at $4.20 is pointless, because you are asking the market maker to give up more than half the spread. A more realistic approach would be to place a limit order at $4.30. This gives the market maker a $.20 Spread, which should be enough to get the trade filled. Example #4A: Bid = $8.50 and Ask = $9.10. With a Spread = $.60, this is what you might see for a deep-in-the-money option that trades lightly. The market maker isn’t really interested in trading this option, but if you insist, he is going to make it worthwhile for himself. In this type of situation, be prepared to struggle to get a decent fill price. Exiting a Trade When exiting an option position, it is called a “closing transaction.” As with entering a trade, this can be done by means of either (i) a market order or (ii) a limit order. There are two additional ways to exit an option trade that are worthy of discussion, namely (iii) a stop loss order and (iv) a stop limit order. Most option traders use a market order to exit a trade only in extreme situations where it seems imperative to exit a trade immediately to avoid substantial loss. Keep in mind that the fill price you receive on a market order to sell an option will not be any higher than the Bid and will often be significantly lower. When using a limit order, the situation is analogous to that of entering the trade. You select a price that you feel is reasonable to sell your long option and enter that price with the limit order. You may not get a fill, but if you do, it must be at that price or higher. Let’s re-examine the above examples #1A – #3A to illustrate how to determine an appropriate price for a limit order to exit a trade. Example #1B: Bid = $2.40 and Ask = $2.42. Again, there is no room for negotiation here. The Spread = $.02, which is almost the minimum possible for an option trading under $3.00 per share. Place a limit order to sell at $2.40 and you should get a quick fill. Example #2B: Bid = $2.40 and Ask = $2.60. With the Spread = $.20, there is some room for negotiation. You could try to split the Spread in the middle with a limit order to sell at $2.50. Getting filled at that price under most conditions could be difficult. If you move the limit price down to $2.45, you are much more likely to get filled. Example #3B: Bid = $4.10 and Ask = $4.40. Since the option is trading over $3.00 per share, the minimum Spread might be no smaller than $.05. Here the spread is $.30, which suggests that there may be some room for negotiation. Typically, a limit order to sell at $4.30 is pointless, because you are asking the market maker to give up more than half the spread. A more realistic approach would be to place a limit order at $4.20. This gives the market maker a $.20 Spread, which should be enough to get the trade filled. Next, let’s examine the use of the stop loss order for selling an option. With this order, you indicate a trigger price at which you want the order to be initiated. The order to sell is then activated when either (i) the option trades at the trigger price or lower, or (ii) the Ask is at the trigger price or lower. Once the order is activated, it becomes a market order to sell the option. As with a straight market order, this means the fill will not be any better than the Bid when the order is activated and it may be substantially worse. Avoid using this type of order unless trying to avoid substantial loss. Finally, let’s consider the stop limit order for selling an option. As with a stop loss order, you indicate a trigger price at which you want the order to be initiated. But here you also indicate a limit price at which you wish to sell your long option. The order is activated under the same two conditions described above for the stop loss order. The difference here is that once the order is activated, it becomes a limit order to sell at the price you selected. Getting filled on a stop limit order can be tricky. You must carefully select your trigger price and your limit price in order to give yourself the best opportunity for a fill. If you set the limit price too close to the trigger price, you may not get a fill in circumstances where you definitely want to be filled. Let’s look at an example: Example #1C: You have a long call that is currently trading at $4.00. You want to try and protect this position with a stop limit order so that you will sell this option for no less than $3.50. Let’s see what might happen if you set a trigger price of $3.60 and a limit price of $3.50. Suppose it occurs that the option price drops until the Ask = $3.60 and the Bid = $3.40. Since the Ask has reflected your trigger price, your limit order to sell at $3.50 is then activated. Unfortunately, you will not get a fill here because the Bid is lower than your limit price. To avoid this situation, the gap between the trigger price and the limit price should be adjusted to reflect the anticipated Bid/Ask Spread when the order is activated. In this example, it looks as if the trigger should have been set at $3.70 so as to account for the Spread = $.20. Then, if the option price drops until the Ask = $3.70 and the Bid = $3.50, your order to sell will be activated with a limit price which is the same as the Bid. This provides a much better chance of being filled at your desired price of $3.50. ### Dr. Olmstead can be found at http://www.olmsteadoptions.com/options_blog/, an on-line options trading community, centered on options education material and option trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com

Dr. Edward Olmstead, Professor, Northwestern University Chief Options Strategist, Dr. Olmstead’s Options Trading Strategies The option strategies discussed here extend the discussion on covered calls, initiated in our article on Covered Calls posted last week. They present ways to enhance or recapture a return on stock you already own (underlying position), even if that stock is showing a loss in your portfolio. The stock enhancement strategy can be used to greatly improve the return on a stock that you own. This is an options strategy that can be implemented at no additional cost beyond the original expense stock ownership. It also has no margin requirement and hence can be done in a retirement account. This strategy can be viewed as an extension of the covered call concept, although the motivation and time frame for the trade are unlike that of the typical covered call. The same strategy can be used to accelerate the recovery in value of a stock that has suffered a significant drawdown. In this case the strategy is known as the stock repair strategy. Again, it is a no cost trade. Stock Enhancement Strategy For this strategy to work, it is necessary for your stock to make some reasonable gain over the next 5-6 months. This strategy is intended to convert a reasonable profit in the stock into an excellent overall return at no cost beyond what you paid for the stock. For each 100 shares of stock, the basic plan is to sell one out-of-the-money call with a strike price at the level you expect the stock to reach in 5-6 months. This combination is just a covered call trade, except that it goes much further out in time than you would expect with a typical covered call. Next, you use the proceeds from the sale of the covered call to pay for a one contract bull call spread. The upper strike for the bull call spread will be the same as the covered call, while the lower strike for the spread will be nearer the current price of the stock. Let's look at an example to illustrate the stock enhancement strategy: Example: Many analysts are forecasting significant gains in the prices of copper and gold over the next 5-6 months. A good way to play this forecast is to buy Freeport McMoran (FCX), a strong company that specializes in both metals. To boost the return in this investment, the Stock Enhancement Strategy can be employed. Trade: Buy 100 shares of FCX at $35.50 per share. Buy 1 Nov. 37 call for $2.3 per share and sell 2 Nov. 40 calls for $1.20 per share. The option transactions actually produce a net credit of $.10 per share to help pay for your commissions. Position: This holding can be viewed as a covered call (long 100 shares FCX and short 1 Nov. 40 call) and a bull call spread (long 1 Nov. 37 call and short 1 Nov. 40 call). Payoff: If FCX is above $40 at the November options expiration, the stock will be called away at $40 for a $4.5 per share gain over its purchase price. The bull call spread will be worth $3 per share. The total gain of $7.5 per share represents an excellent return of 21.1% on a stock that only needed to move up by 12.6%. Comment: Remember that this is a no-cost trade. If FCX does not reach $40 by the November expiration, the Nov. 37 call will still provide a profit if the stock price exceeds $37. An additional bonus on this particular trade is that FCX pays a nice annual dividend of which about half can be captured over the next 5 months. Stock Repair Strategy Using the same approach as the stock enhancement strategy, it is possible to recover the full value of a stock whose price has suffered a large pullback. For the repair strategy to be effective, it is necessary for the stock to make some modest gain in the next 3-4 months. Let’s look at an example to illustrate the stock repair strategy: Example: Those who bought 100 shares of Facebook Inc. (FB) at $38 per share during its IPO in May are now looking at a deflated price of $31.70 in mid-June. With a modest increase in the price of FB over the next 3 months, the Stock Repair Strategy can more than make up for the lost value. Trade: For each 100 shares you own, buy 1 Sept 32 call for $3.2 per share and sell 2 Sept 36 calls for $1.6 per share. This is a no cost trade. Position: This holding can be viewed as a covered call (long 100 shares FB and short 1 Sept 36 call) and a bull call spread (long 1 Sept 32 call and short 1 Sept 36 call). Payoff: If FB is above $36 at the September options expiration, the stock will be called away at $36 for a $4.3 per share gain over its mid-June price of $31.70. The bull call spread will be worth $4 per share. The total gain of $8.3 per share represents an equivalent stock price of $40.00, which is $2.0 per share better than the original purchase price. Comment: Remember that this is a no-cost trade. If FB only reaches $35 by the September expiration, the Sept 36 calls will expire worthless and the Sept 32 call will still provide enough profit to effectively raise the stock value back to its original price of $38. Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education material and option trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com.

Dr. Edward Olmstead, Professor, Northwestern University Chief Options Strategist, Dr. Olmstead’s Options Trading Strategies One of the first strategies that someone new to options hears about is the covered call trade. Frequently, this strategy is touted as a safe and simple way to make money with options. Many brokerage firms allow covered calls as the only options trade that can be made in a retirement account because it is “conservative.” Unfortunately, this description of covered call trades as conservative is highly misleading. Ask those same brokers who only allow covered call trades in retirement accounts how they feel about selling naked puts. They will explain how that type of trade is much too risky to be allowed in a retirement account. Well, at least they got that part correct ---- selling naked puts does involve significant risk. The truth is that a covered call trade has exactly the same risk and reward characteristics as selling a naked put. More about this later. In its simplest form, the covered call trade requires that you own 100 shares of stock. Then you can sell one call option contract with a strike price that is above the current stock price. In this situation, the call that you sold is said to be “covered” by the stock that you own. If it happens that the option is exercised, your brokerage account possesses the stock that must be made available for sale at the strike price. The cash received from selling the call is yours to keep no matter what happens. Here is the idealized description of what happens when the call option expires. If the stock price is above the strike price of the call at expiration, your stock will be called away for a price that is presumably higher than your original purchase price ---- you have made a profit on the price increase in the stock and you also have the cash received from the selling the option. If the stock price is below the strike price of the option at expiration, then the option expires worthless and you keep your stock ---- you again have the cash received from selling the option, and you are free to repeat the process by selling another call in the next option cycle. As you can see in this idealized version, the covered call trade has the potential to generate regular profits by repeatedly selling call options against stock that you own. Unfortunately, the covered call trade is not nearly as straightforward as the idealized description would suggest. Stock prices undergo considerable fluctuation over time and, all too frequently, the stock price on the expiration date will be either well above or well below the strike price of the short call. Both scenarios present a difficult decision going forward. If the stock price is much higher than the strike price of the call at expiration, you may be reluctant to give up your stock at a price that is well below its current level, and thus forego any future gains in the stock price. The only alternative is to buy back the short call for a significant loss in order to continue holding the stock. If the stock then fails to perform as expected, it may be quite difficult to make up for the loss incurred from buying back the short call. If the stock price is much lower than the strike price of the call at expiration, you keep the stock, but you are faced with the challenging decision of which call strike to sell for the next option cycle. If you sell a high strike in order to give the stock price room to move up, the cash received from the sale may be miniscule. On the other hand, if you sell a strike nearer to the current stock price in order to receive more cash, you lose the opportunity for the stock to regain all of its lost value. Now let’s get back to comparing a covered call with selling a naked put. To see that these two trades have the exactly the same risk and reward characteristics, examine cases in which the stock price at expiration is either above or below the strike price of the option. To make things definite, consider a specific example. Covered call: With XYZ at $53, you buy 100 shares of stock and sell one 55 call option for $2.0 per share. This means that you have equivalently purchased 100 shares of XYZ for $51 per share. If the XYZ has fallen to $40 per share at options expiration, you will have lost $1100 on this trade. The maximum reward that you can receive on this trade is $400, which occurs when the stock price exceeds $55 at expiration. Naked put: With XYZ at $53, you sell one 55 put option for $4.0 per share, which pays you $400. If XYZ has fallen to $40 per share at options expiration, the option will be exercised and you will be required to buy the stock for $55 per share. Subtract the $400 you received and your loss on this trade will be $1100. The maximum reward occurs when the stock price exceeds $55 at expiration and you get to keep the $400 received from the sale of the put. If you are going to do covered call trades, then be aware that it is not a conservative trade and be prepared to make a challenging decision when the options expiration date arrives. Here are some suggestions for handling covered call trades: 1. Since almost all of your risk is in what you paid for the stock, focus your attention on the stock price and to a much lesser extent on the option price. Decide on an appropriate stop loss price for the stock, and if it falls to that level, protect the major portion of your investment by selling the stock and buying back the call. Do not hang onto to a falling stock in order to collect an extra $.50 per share from the short option. 2. When deciding upon the strike price of the call that you are going to sell, make sure it is a price at which you will feel comfortable in giving up your stock if necessary. If your goal is to keep your stock under all circumstances, then select a higher strike price. If you are willing to sell your stock closer to its current value, then pick a nearby strike price to bring in more cash. 3. Do not sell a call with an expiration date too far out in time. Those juicy premiums in the longer-term options are tempting, but you will generally do better by selling the front month call. In today’s volatile market, a stock can have big moves (up or down) in 4-8 weeks. By selling near term options, you will be better placed to make an adjustment when the expiration date arrives. 4. Do not be greedy. If the stock price is above the strike price at expiration, take your profit and move on to a new trade. Avoid buying back the option for a loss unless you have a very compelling reason to do so. If you buy back the option for a loss and then the stock price subsequently collapses, you will have compounded a loss on the option with a loss on the stock. ### Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education material and option trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com