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Showing results for tags 'bearish option strategy'.
Found 14 results
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Traders who sell index calls are betting that the market prices of the index's underlying assets will fall. The strategy involves writing a call that's linked to a stock market index. The underlying index plays the same role as an asset does in options trading. Investors settle all index options in cash and there are no assignments of assets. When traders sell index calls, they predict that the index option will expire out-of the money. The profit potential and risk involved when using this strategy varies. Traders selling index calls limited their profits to the amount that they receive in premiums when selling a call. On the contrary, the loss-risk potential is unlimited, since any stock index can rise to as much as demand permits. Moneyness Review for Calls Out-of-The Money (OTM) = Strike price (more than) Market Price In-The-Money (ITM) = Strike price (less than) Market Price At-The-Money (ATM) Strike price (equals) Market Price Understanding Index Options and Regular Options Selling an index option functions the same way as in selling a regular option. The difference is that the underlying assets associated with index options are many compared to just the one underlying asset that's associated with a regular stock option. Example: The NASDAQ is worth $4000 and its index option, NASX (Index Option), is valued at $400 (1/100 of the NASDAQ). How to Sell Index Calls (ATM) The NASDAQ is worth $4000 (market price) in June. 1) Trader sells an index call option: NASXDec400 ($4.50) - One NASDAQ index option with a contract multiplier of $100 - Strike Price $400, at-the-money (ATM), expiring in 180 days - Premium Cost of $4.50 2) Trader receives $450 for the sale (100 x $4.50 (premium cost)). Total credit to enter the market: $450 Result one: NASX rises to $420 (ITM) in December. a) The call option sold expires ITM. The buyer exercises his or her right to buy 100 shares at $40. b) The difference between the option's strike price and the NASX is $20 (NASX: $420 - strike price:$400). There is no assignment of assets, so the trader uses the contract multiplier (CM) to figure the cash settlement. c) The trader pays the buyer $2000 [100 (CM) x $20 (difference in prices)]. Adding the $450 credit received when entering the market reduces the trader's total loss to $1550. Result two: NASX falls to $380 (OTM) in December. a) The buyer lets the option expire and does not exercise the right to buy. b) The buyer loses the premiums paid to the trader to enter the market. In this example, the trader keeps the $450 credit, which is the maximum profit for this type of trade. Advantages and Disadvantages of Selling Index Calls: Pluses: The upside to selling index calls is that the trader can enter the market without paying cash. He or she receives a credit, keeping the premium when the index option expires worthless and using the credit to offset losses in a bull market. Minuses: The downside in selling index calls is that it limits a trader's profits to only the amount received when entering the market. If the market value of the underlying index bottoms out, the trader could not capitalize on the short sale. Also, the potential loss-risk in a selling call index is infinite, since any index could theoretically rise as much as its supply permits.
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A trader who implements a put backspread strategy is betting that an asset's value will fall. The technique involves selling more put options than purchased, usually 2:1, of the same underlying asset and with the same expiration. The profit potential is infinite when carrying out a put backspread, and investors control any potential losses by selling puts that satisfy the 2:1 ratio. Moneyness Review for Puts: In-The-Money (ITM) = Strike Price (more than) Market Price Out-of-The Money (OTM) = Strike Price (less than) Market Price At-The-Money (ATM) Strike Price (equals) Market Price How to Implement a Put Backspread Strategy Disney stock is worth $48 (market price) in June. 1) Trader buys two (2) put options: DISJul45($2.00) - 200 shares of Disney stock - Strike Price $45 (OTM), expiring in 30 days - Premium Cost of $2.00 2) Trader sells one (1) put option: DISJul50($4) - 100 shares of Disney stock - Strike Price $50 (ITM), expiring in 30 days - Premium Cost of $4 3) The trader pays $0 to enter the market. [$400 (paid for puts) - $400 (received from sale)] Result one: Disney stock remains at $45 in July. a) Both the put options purchased expire worthless. (OTM) b) The put option sold is ITM. The buyer exercises his or her right to sell the trader 100 shares at $50. The trader pays $5000 to the seller. c) The trader sells 100 Disney shares in the open market, receiving $4500. d) The trader loses a total of $500 after subtracting the prices paid for the shares from the share sale. [$500 = $5000 (paid for shares) - $4500 (received for shares)] Result two: Disney stock falls (moderately) to $40 in July. a) The put option sold is ITM. The buyer exercises his or her right to sell the trader 100 shares at $50. The trader pays $5000 to the seller and receives 100 shares. b) The trader buys 100 Disney shares in the open market, paying $4000. c) The two put options purchased are ITM. The trader exercises his or her right to sell the trader 200 shares at $45. The trader sells the 200 shares and receives $9000 from the buyer. d) The trader loses a total of $0 after adding and subtracting the prices paid for the shares from the exercised puts. [$0 = $5000 (paid for 100 shares) + $4000 (paid for 100 shares) - $9000 (received from puts purchased)] Result three: Disney stock falls (crashes) to $30 in July. a) The put option sold is ITM. The buyer exercises his or her right to sell the trader 100 shares at $50. The trader pays $5000 to the seller and receives 100 shares. b) The trader buys 100 Disney shares in the open market, paying $3000. c) The two put options purchased are ITM. The trader exercises his or her right to sell the trader 200 shares at $45. The trader sells the 200 shares and receives $9000 from the buyer. d) The trader loses a total of $1000 after adding and subtracting the prices paid for the shares from the exercised puts. [$1000 = $9000 (received from puts purchased) - $5000 (paid for 100 shares) - $3000 (paid for 100 shares)] Result four: Disney rallies to $50 in July. a) All the put options purchased expire worthless (OTM). b) The trader loses a total of $0 since there was no cost to enter the market. Advantages and Disadvantages of Implementing a Put Backspread Strategy: Pluses: The upside to this type of strategy is that the investor can make substantial profits with limited loss-risk. An investor's profit potential is infinite when market price crashes, since theoretically any asset can reach a zero value. Investors can also enter the market without paying cash. The put backspread also limits the trader's loss potential to the terms of the put option sold. In large market upswings, all options will expire OTM, resulting in no-loss, since there is no cost to enter the market in a 2:1 backspread. Minuses: The downside in using a put backspread strategy happens when the underlying asset's market price expires at-the money with the sold put. However, loss potential continues to decline any price in between the strike prices of puts sold and purchased
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A trader who implements a synthetic short stock (split strikes) is betting that an asset's value will fall. The technique involves buying the same number of call and put options for an underlying asset with the same expiration. Both the profit potential and the risk involved when using this strategy is unlimited. An investor who enters a synthetic short stock (split strikes) strategy can gain large profits if the market crashes but can also incur big losses if it rallies. Moneyness Review for Puts and Calls Call Options: In-The-Money (ITM) = Strike Price (less than) Market Price Out-of-The Money (OTM) = Strike Price (more than) Market Price Put Options: In-The-Money (ITM) = Strike Price (more than) Market Price Out-of-The Money (OTM) = Strike Price (less than) Market Price Both Put and Call Options At-The-Money (ATM) Strike Price = (equals) Market Price How to Implement a Synthetic Short Stock (Split Strikes) Strategy Disney stock is worth $40 (market price) in June. 1) Trader sells a call option: DISJul45($1) - 100 shares of DIS stock - Strike Price $45, out-of-the-money (OTM), expiring in 30 days - Premium Cost of $1.00 2) Trader buys a put option: DISJul35($0.50) - 100 shares of DIS stock - Strike Price $35, out-of-the-money (OTM), expiring in 30 days - Premium Cost of $1.00 3) The trader receives a $50 credit when entering the market. [$100 (received from sale) - $50 (paid for put)] Total cost to enter the market: -$50 Result one: Disney stock falls (moderately) to $35 in July. a) The call sold option expires worthless. (OTM) b) The put option purchased expires worthless. (OTM) c) The trader gains a total of $50 after keeping credit taken when entering the market. Result two: Disney stock rises (rallies) to $60 in July. a) The put option expires worthless. (OTM) b) The call option sold expires ITM. The investor who bought the trader's call option exercises his or her right to buy 100 shares at $45. c) The trader buys 100 Disney shares in the open market, paying $6000. d) He or she then sells them to the buyer, receiving $4500. e) The trader loses a total of $1450 after subtracting the premium credit taken when entering the market. [$1450 = $50 (credit to enter market) - $1500 (loss from call)] Result three: Disney stock falls (crashes) to $20 a) The call option expires worthless. (OTM) b) The put option expires ITM, so the trader buys 100 Disney shares in the open market, paying $2000 to cover the sale. c) The trader exercises his or her right to sell the 100 shares at $35 to the writer and receives $3500 from the seller. d) The trader gains a total of $1550 after adding the premium credit taken when entering the market. [$1550 = $1500 (profit from put) + $50 (credit to enter market)] Advantages and Disadvantages of Implementing a Synthetic Short Stock (Split Strikes): Pluses: The upside to this type of strategy is that the investor will always make a profit in a bear market, which can lead to unlimited profit potential if prices crash. The trader also can enter the market without paying cash. He or she receives a premium credit, keeping it when the index call option expires worthless, and using the credit to offset losses, if the asset's value rises. Minuses: The downside in using a synthetic short stock (split strikes) is that the method exposes the investor to unlimited risk. If the underlying asset's market value rallies, then he or she can lose large amounts of money, since an asset's price can theoretically rise as much as the demand permits.
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A trader who implements a synthetic short stock strategy is betting that an asset's value will fall. The technique involves buying the same number of call and put options for an underlying asset. The profit potential and risk involved when using this strategy is unlimited. An investor who enters a synthetic short stock strategy can gain large profits if the market crashes but can also incur big losses if it rallies. Moneyness Review for Puts and Calls Call Options: In-The-Money (ITM) = Strike price (less than) Market Price Out-of-The Money (OTM) = Strike price (more than) Market Price Put Options: In-The-Money (ITM) = Strike Price (more than) Market Price Out-of-The Money (OTM) = Strike Price (less than) Market Price Both Put and Call Options At-The-Money (ATM) Strike Price (equals) Market Price How to Implement a Synthetic Short Stock Strategy Disney stock is worth $40 (market price) in June. 1) Trader sells a call option: DISJul40($1.50) - 100 shares of DIS stock - Strike Price $40 (ATM), expiring in 30 days - Premium Cost of $1.50 2) Trader buys a put option: DISJul40($1.00) - 100 shares of DIS stock - Strike Price $40 (ATM), expiring in 30 days - Premium Cost of $1.00 3) The trader receives a $50 credit when entering the market [$150 (received from sale) - $100 (paid for put)] Result one: Disney stock rises (rallies) to $50 a) The put option expires worthless (OTM). b) The call option sold expires ITM. The investor who bought the trader's call option exercises his or her right to buy 100 shares at $40. c) The trader buys 100 Disney shares in the open market, paying $5000 d) He or she then sells them to the buyer, receiving $4000 e) The trader loses a total of $950 after subtracting the premium credit taken when entering the market. [$950 = $50 (credit to enter market) - $1000 (loss from call) ] Result two: Disney stock falls (crashes) to $30 a) The call option expires worthless (OTM). b) The put option expires ITM, and the trader buys 100 Disney shares in the open market, paying $3000 c) The trader exercises his or her right to sell the 100 shares at $40 to the investor who wrote the put option. d) The trader sells 100 Disney shares and receives $4000 from the writer. e) The Trader gains a total of $1050 after adding the premium credit taken when entering the market. [$1050= $1000 (profit from put) - $50 (credit to enter market)] Advantages and Disadvantages of Implementing a Synthetic Short Stock Strategy: Pluses: The upside to this type of strategy is that the investor will always make a profit in a bear market, which can lead to unlimited profit potential if prices crash. The trader also can enter the market without paying cash. He or she receives a premium credit, keeping it when the index call option expires worthless, and using the credit to offset losses, if the asset's value rises. Minuses: The downside in using a synthetic short stock strategy is that the method exposes the investor to unlimited risk. If the underlying asset's market value rallies, then he or she can lose large amounts of money, since an asset's price can theoretically rise as much as the demand permits.
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Traders who implement a synthetic short call strategy are betting that the market price of an option's underlying asset will fall. The technique involves short selling owned assets and selling a put option for the amount of shares owned. The loss-risk in this strategy is unlimited, if the market price of the underlying asset rises. Traders who employ a synthetic short call strategy use assets as leverage to earn a fixed premium credit, received from the put buyer when entering the market. Moneyness Review for Puts Out-of-The Money (OTM) = Strike Price (less than) Market Price In-The-Money (ITM) = Strike Price (more than) Market Price At-The-Money (ATM) = Strike Price (equals) Market Price How to Carry out a Synthetic Short Call Strategy Disney stock is worth $50 (market price) in June. 1) Trader short sells 100 shares of Disney stock 2) Trader sells the put option: DISJul50($3) - 100 shares of Disney stock - Strike Price $50, at-the-money (ATM), expiring in 30 days - Premium Cost of $3 3) Trader receives a $300 credit when entering the market [$300 (received from put buyer)] Total cost to enter the market: -$300 Result one: Disney stock remains at $50 in July a) The put option sold expires worthless (OTM). b) The short sale realizes no gain. c) The trader's profits total $300 after keeping the credit earned when entering the market. Result two: Disney stock falls to $40 in July. a) The short sale realizes a $1000 gain, and the trader receives $1000. b) The put option sold expires ITM. c) The investor who bought the trader's put option exercises his or her right to sell 100 shares at $50. The trader pays $5000 to the buyer, and receives 100 Disney shares. d) The trader immediately sells the 100 shares in the open market and receives $4000. e) The trader makes a total profit of $300 after keeping the credit earned when entering the market. [$300 = $4000 (received for 100 shares) + $1000 (gain from short sale) + $300 (credit to enter market) - $5000 (paid for 100 shares)] Result three: Disney stock rises to $60 in July. a) The short sale realizes a $1000 loss, and the trader pays $1000. b) The put option sold expires worthless (OTM) c) The trader loses $700 after adding the credit earned when entering the market. [-$700 = $300 (credit to enter market) - $1000 (loss from short sale) ] Advantages and Disadvantages in Carrying out a Synthetic Short Call Strategy Pluses: The upside to this type of strategy is that the investor will gain limited profits if the put option expires at-the-money or expires at any price below it, independent of how low the market drops. The synthetic short call strategy also earns the trader a credit when entering the market, which can be used to offset losses if the underlying asset's market price rallies. Minuses: The downside in using a synthetic short call is that the method has an unlimited loss-risk potential. The short sale exposes the trader to high risk when the market rallies, since any asset's market price could theoretically rise as much as demand permits. The method also limits the trader's profit potential to only what he or she received when entering the market. The investor can not profit from the short sale if the market crashes because the put option would offset any gains from the sale.
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Traders who implement a synthetic long put strategy are betting that the market price of an option's underlying asset will fall. The technique involves short selling owned assets and selling an ATM call option, hoping that it will expire OTM. Traders who employ this type of bear option strategy pay a premium to enter the market. However, gains from their call purchase will offset any potential loss from the short sale, thus, limiting the trader's losses. On the contrary, an investor's profit potential is infinite. If the market price crashes, traders who use this strategy can earn substantial gains. Moneyness Review for Calls Out-of-The Money (OTM) = Strike price (more than) Market Price In-The-Money (ITM) = Strike price (less than) Market Price At-The-Money (ATM) Strike price (equals) Market Price How to Carry out a Synthetic Long Put Disney stock is worth $40 (market price) in June. 1) Trader short sells 100 shares of Disney stock. 2) Trader buys the call option: DISJul40($2) - 100 shares of Disney stock - Strike Price $40, at-the-money (ATM), expiring in 30 days - Premium Cost of $2 3) Trader pays a total of $200 to enter the market. [$200 (paid to purchase one call option)] Total cost to enter the market: $200 Result one: Disney stock falls (crashes) to $30 in July. a) The call option purchased expires worthless (OTM). b) The short sale realizes a $1000 gain, and the trader receives $1000. c) The trader makes a total profit of $800 after subtracting the cost to enter the market. [$800 = $1000 (gain from short sale) - $300 (to enter the market)] Result two: Disney stock rises (rallies) to $50 in July. a) The short sale realizes a $1000 loss, and the trader pays $1000. b) The call option sold expires ITM. c) The trader exercises his or her right to buy 100 shares at $40 from the person who sold the call option. The trader pays $4000 to the buyer, and receives 100 Disney shares. d) The trader immediately sells the 100 shares in the open market and receives $5000. e) The trader losses $200 after adding the cost to enter the market. [-$200 = $5000 (received for 100 shares) - $4000 (paid for 100 shares) - $1000 (loss from short sale) - $200 (cost to enter market)] Result three: Disney stock falls (moderately) to $38 in July. a) The call option purchased expires worthless (OTM). b) The short sale realizes a $200 gain, and the trader receives $200. c) The trader makes a total profit of zero after adding the cost to enter the market. [$0 = $200 (gain from short sale) - $200 (to enter the market)]. Thus, $38 serves as this strategy's breakeven point, with any market value lower than $38 resulting in profits for the trader. Advantages and Disadvantages in Carrying Out A Synthetic Long Put Pluses: The upside to this type of strategy is that investors limit their losses when things go wrong. They also enter the market knowing where their break even point stands. Finally, the synthetic long put strategy gives investors the opportunity to realize large profits at a low and limited risk. Minuses: The only downside in carrying out this strategy happens when the market rallies and the call option expires ITM. However, investors would only lose what they paid in premiums to enter the market.
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Traders who implement a protective call strategy are protecting their short sales from surprise market rallies. The protective call acts as an insurance policy from price swings on shares owed. The technique involves short selling assets and purchasing a call option for the amount of shares owned. The protective call limits the investor's loss potential to only the premiums paid when buying the call. Thus, the investor controls their loss, which is set by the terms of the call option. On the contrary, an investor's profit potential is infinite. If the market price crashes, traders who use this strategy can earn substantial gains. Moneyness Review for Calls Out-of-The Money (OTM) = Strike price (more than) Market Price In-The-Money (ITM) = Strike price (less than) Market Price At-The-Money (ATM) Strike price (equals) Market Price How to Carry Out A Protective Call Strategy Disney stock is worth $50 (market price) in June. 1) Trader short sells 100 shares of Disney stock. 2) Trader buys the call option: DISJul50($2) - 100 shares of Disney stock - Strike Price $50, at-the-money (ATM), expiring in 30 days - Premium Cost of $2 3) Trader pays $200 to enter the market and to protect the short sale. [$200 (paid for call)] Total cost to enter the market: $200 Result one: Disney stock rises (rallies) to $70 in July. a) The short sale realizes a $2000 loss, and the trader pays $2000. b) The call option expires ITM. c) The trader exercises his or her right to buy 100 shares at $50 from whoever sold the call option. The trader pays $5000 to the seller, and receives 100 Disney shares. d) The trader immediately sells the 100 shares in the open market and receives $7000. e) The trader loses $200 after adding the cost to enter the market. [$200 = $7000 (share sale) - $5000 (paid for shares) – $2000 (short sale loss) - $200 (cost to enter market)] Result two: Disney stock falls to $30 in July. a) The short sale realizes a $2000 gain, and the trader receives $2000. b) The call option purchased expires worthless (OTM). c) The trader makes a total profit of $1800 after adding the cost to enter the protective call. [$1800 = $2000 (received from short sale) - $200 (paid for protective call)] Result three: Disney stock drops (moderately) to $48 in July. a) The short sale realizes a $200 gain, and the trader receives $200. b) The call option purchased expires worthless (OTM). c) The trader makes a total profit of $0 after adding the cost to enter the protective call. [$0 = $200 (received from short sale) - $200 (paid for protective call)] **Note: In this example, Disney stock at $48 is the breakeven point in this protective call example. Any rally above $48 will result in a loss for the trader. However, the protective call caps the maximum loss at $200. Advantages and Disadvantages in Carrying Out a Protective Call Strategy Pluses: The upside to this type of strategy is that the investor can gain unlimited profits if the call option expires any price below its breakeven point. The protective call also helps investors control losses from sudden market rallies, as they predetermine their maximum loss when they enter the market. Minuses: The downside in using a protective call happens when the market rallies and the investor losses the premiums paid to purchase the call.
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Traders who implement an out-of-the-money naked call strategy are betting that the market price of an option's underlying asset will fall. The technique involves selling an out-of-the-money call option, hoping that it will expire out-of-the money. Traders who use this type of bear option strategy do not need cash to enter the market. However, the terms of their call sale will limit their profit potential. On the contrary, an investor's loss potential is infinite. If the market price rallies, traders who use this strategy will incur large monetary losses. Moneyness Review for Calls Out-of-The Money (OTM) = Strike price (more than) Market Price In-The-Money (ITM) = Strike price (less than) Market Price At-The-Money (ATM) Strike price (equals) Market Price How to Carry Out An Out-Of-The-Money Naked Call Strategy Disney stock is worth $48 (market price) in June. 1) Trader sells the call option: DISJul50($3) - 100 shares of Disney stock - Strike Price $40, out-of-the-money (OTM), expiring in 30 days - Premium Cost of $3 3) Trader receives a $300 credit when entering the market. [$300 (received from call buyer)] Total cost to enter the market: -$300 Result one: Disney stock rises (rallies) to $68 in July. a) The call option sold expires ITM, and the investor who bought the trader's call option exercises his or her right to buy 100 shares at $50. b) The trader purchases 100 Disney shares in the open market to cover the short sale, paying $6800, and then sells the shares to the buyer, receiving $5000. c) The trader loses a total of $1500 after adding the premium credit taken when entering the market to the loss. [-$1500 = $1800 (loss from call) + $300 (credit to enter market)] Result two: Disney stock falls (crashes) to $28 in July. a) The call option sold expires worthless. (OTM) b) The trader's profits totals $300 after keeping the credit earned when entering the market. Result three: Disney stock rises (moderately) to $53 in July. a) The call option sold expires ITM, and the investor who bought the trader's call option exercises his or her right to buy 100 shares at $40. b) The trader purchases 100 Disney shares in the open market to cover the short sale, paying $5300, and then sells the shares to the buyer, receiving $5000. c) The trader loses a total of $0 after adding the premium credit taken when entering the market to the loss. [$0 = $300 (loss from call) + $300 (credit to enter market)] Advantages and Disadvantages in Carrying Out An Out-Of-The-Money Naked Call Strategy Pluses: The upside to this type of strategy is that investors do not need cash to enter the market. They are betting that the asset's market value will crash and the call will expire OTM, allowing them to keep the credit earned when entering the market. Traders can also use the credit to offset losses in moderate bull markets or to reduce total loss if the underlying asset's value rallies. Minuses: The downside in using an out-of-the-money naked call strategy is that it exposes traders to infinite potential losses when the market rallies, since any asset's market price could theoretically rise as much as demand permits. The method also limits the trader's profit potential to only the premiums that he or she receives when entering the market.
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Traders who implement a long put strategy are betting that the market price of an option's underlying asset will fall significantly. The technique involves buying one or more put option. If things go wrong and the market price of the underlying asset rallies, the trader's loss-risk is limited. Unlike short selling, put buying does not limit an investor's potential profit. However, a trader does run the risk of the asset expiring worthless, if the option's strike price remains above its breakeven point. Moneyness Review for Puts Out-of-The Money (OTM) = Strike Price (less than) Market Price In-The-Money (ITM) = Strike Price (more than) Market Price At-The-Money (ATM) Strike Price (equals) Market Price How to Carry Out a Long Put Strategy Disney stock is worth $40 (market price) in June. 1) Trader buys the put option: DISJul40($2) - 100 shares of Disney stock - Strike Price $40, at-the-money (ATM), expiring in 30 days - Premium Cost of $2 2) Trader pays a total of $200 to enter the market [$200 (paid to purchase one put option)] Total cost to enter the market: $200 Result one: Disney stock falls (crashes) to $30 a) The put option bought is ITM. b) The trader buys 100 Disney shares in the open market for $3000. c) The trader exercises his or her right to sell 100 shares at $40 to the investor who wrote the put option. The trader sells 100 Disney shares and receives $4000 from the writer. d) The trader makes a total profit of $800 after subtracting the costs to enter the market. [$800 = $4000 (received for 100 shares) - $3000 (paid for 100 shares) - $200 (cost to enter market)] Result two: Disney stock rises (rallies) to $50 a) The put option bought expires worthless (OTM) b) Trader loses a total of $200 after adding the amount paid to enter the market. Result three: Disney stock falls (moderately) to $38 a) The put option bought is ITM. b) The trader buys 100 Disney shares in the open market for $3800. c) The trader exercises his or her right to sell 100 shares at $40 to the investor who wrote the put option. The trader sells 100 Disney shares and receives $4000 from the writer. d) The trader makes a total profit of $0 after subtracting the costs to enter the market. Thus, $38 would serve as the break even point in this example. [$0 = $4000 (received for 100 shares) - $3800 (paid for 100 shares) - $200 (cost to enter market)] Advantages and Disadvantages of Carrying Out a Long Put: Pluses: The upside of this type of strategy is that the investor can gain unlimited profits with limited risk. The trader knows exactly how much he or she can lose before carrying out a long put strategy. He or she also knows the strategy's breakeven point when entering the market, which is the put option's strike price subtracted from the total cost to enter the market. Minuses: The downside of using a long put strategy is that the method has a time limit to realize profits. Most put options expire in thirty days. Thus, the market value of the put option's underlying asset must fall below the strategy's breakeven point within this time limit or the option will expire worthless.
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Traders who implement an in-the-money naked call strategy are betting that the market price of an option's underlying asset will fall. The technique involves selling an in-the-money call option, hoping that it will expire out-of-the money. Traders who employ this type of bear option strategy do not need cash to enter the market. However, the terms of their call sale will limit their profit potential. On the contrary, an investor's loss potential is infinite. If the market price rallies, traders who use this strategy will incur large monetary losses. Moneyness Review for Calls Out-of-The Money (OTM) = Strike price (more than) Market Price In-The-Money (ITM) = Strike price (less than) Market Price At-The-Money (ATM) Strike price (equals) Market Price How to Carry Out An In-The-Money Naked Call Strategy Disney stock is worth $48 (market price) in June. 1) Trader sells the call option: DISJul40($10) - 100 shares of Disney stock - Strike Price $40, in-the-money (ATM), expiring in 30 days - Premium Cost of $10 2) Trader receives a $1000 credit when entering the market [$1000 (received from call buyer)] Total cost to enter the market: -$1000 Result one: Disney stock rises (rallies) to $68 in July a) The call option sold expires ITM, and the investor who bought the trader's call option exercises his or her right to buy 100 shares at $40. b) The trader purchases 100 Disney shares in the open market to cover the short sale, paying $6800, and then sells the shares to the buyer, receiving $4000. c) The trader loses a total of $1800 after subtracting the premium credit taken when entering the market. [-$1800 = $1000 (credit to enter market) - $2800 (loss from call)] Result two: Disney stock falls (moderately) to $45 in July. a) The call option sold expires ITM, and the investor who bought the trader's call option exercises his or her right to buy 100 shares at $40. b) The trader purchases 100 Disney shares in the open market to cover the short sale, paying $4500, and then sells the shares to the buyer, receiving $4000. c) The trader's profit totals $500 after subtracting the loss from premium credit taken when entering the market. [$500 = $1000 (credit to enter market) - $500 (loss from call)] Result three: Disney stock falls (crashes) to $28 in July. a) The call option sold expires worthless (OTM). b) The trader's profits totals $1000 after keeping the credit earned when entering the market. Advantages and Disadvantages in Carrying Out An In-The-Money Naked Call Strategy Pluses: The upside to this type of strategy is that investors do not need cash to enter the market. They are betting that the asset's market value will crash and the call will expire OTM, allowing them to keep the credit earned when entering the market. Traders can also use the credit to gain a profit in moderate bull markets or to offset losses if the underlying asset's value rallies. Minuses: The downside in using an in-the-money naked call strategy is that it exposes traders to high-risk losses when the market rallies, since any asset's market price could theoretically rise as much as demand permits. The method also limits the trader's profit potential to only what he or she received when entering the market.
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Traders who implement covered put strategies are betting that the market price of an option's underlying asset will fall. The technique involves short selling owned assets and selling a put option for the same amount of shares. The loss-risk in this strategy is unlimited, if the market price of the underlying asset rises. Traders who employ covered put strategies use their assets as leverage to earn a fixed premium credit, which is received from the put buyer when entering the market. Moneyness Review for Puts Out-of-The Money (OTM) = Strike Price (less than) Market Price In-The-Money (ITM) = Strike Price (more than) Market Price At-The-Money (ATM) = Strike Price (equals) Market Price How to Carry out Covered Puts Strategies Disney stock is worth $45 (market price) in June. 1) Trader short sells 100 shares of Disney stock 2) Trader sells the put option: DISJul45($2) - 100 shares of Disney stock - Strike Price $45, at-the-money (ATM), expiring in 30 days - Premium Cost of $2 3) Trader receives a $200 credit when entering the market [$200 (received from put buyer)] Total cost to enter the market: -$200 Result one: Disney stock remains at $45 in July a) The put option sold expires worthless (OTM) b) The short sale realizes no gain. c) Trader profits total $200 after keeping the credit earned when entering the market. Result two: Disney stock falls to $40 in July. a) The short sale realizes a $500 gain, and the trader receives $500. b) The put option sold expires ITM. c) The investor who bought the trader's put option exercises his or her right to sell 100 shares at $45. The trader pays $4500 to the buyer, and receives 100 Disney shares. d) The trader immediately sells the 100 shares in the open market and receives $4000. e) The trader makes a total profit of $200 after keeping the credit earned when entering the market. [$200 = $4000 (received for 100 shares) + $500 (gain from short sale) + $200 (credit to enter market) - $4500 (paid for 100 shares)] Result three: Disney stock rises to $55 in July. a) The short sale realizes a $1000 loss, and the trader pays $1000. b) The put option sold expires worthless (OTM) c) The trader loses $800 after adding the credit earned when entering the market. [-$800 = $200 (credit to enter market) - $1000 (loss from short sale) ] Advantages and Disadvantages in Carrying Out Covered Put Strategies Pluses: The upside to this type of strategy is that the investor will gain limited profits if the put option expires at-the-money or expires at any price below it. Profits remain the same, independent of how low the market drops. Covered put strategies also earn traders a credit when entering the market, which can be used to offset losses if the underlying asset's market price rallies. Minuses: The downside in using covered put strategies is that the method has an unlimited loss-risk potential. The short sale exposes traders to high risk when the market rallies, since any asset's market price could theoretically rise as much as demand permits. The method also limits the trader's profit potential to only what he or she received when entering the market. Investors can not profit from their short sale if the market crashes because the put option would offset any gains.
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Traders who buy an index put are betting that the market prices of the index's underlying assets will fall. The strategy involves buying a put that's linked to a stock market index. The underlying index plays the same role as an asset does in options trading. Investors settle all index options in cash, and there are no assignments of assets. The profit potential and risk involved when using this strategy varies. Traders buying index puts limit their losses to only the amount paid in premiums when entering the market. On the contrary, the trader's profit potential is unlimited, since any stock index can theoretically fall up to a zero value. Moneyness Review for Puts Out-of-The Money (OTM) = Strike Price (less than) Market Price In-The-Money (ITM) = Strike Price (more than) Market Price At-The-Money (ATM) Strike Price (equals) Market Price Understanding the Differences Between Index Options and Regular Options Buying an index option functions the same way as in buying a regular option. The difference is that the underlying assets associated with index options are many compared to just the one underlying asset that's associated with a regular stock option. Example: The S&P500 is worth $4000 and its index option, SPX (Index Option), is valued at $400 (1/100 of the S&P500). How to Buy Index Puts (ATM) The S&P500 is worth $4000 (market price) in June. 1) Trader buys an index put option: SPXDec400($4.00) - One S&P500 index option with a contract multiplier of $100 - Strike Price $400, at-the-money (ATM), expiring in 180 days - Premium Cost of $4.00 2) Trader pays $400 for the put (100 x $4.00 (premium cost)). Total cost to enter the market: $400 Result one: SPX falls to $380 in December. a) The put option purchased expires ITM. The trader exercises his or her right to sell 100 shares at $40. b) The difference between the option's strike price and the SPX is $20 (strike price: $400 - SPX: $380). There is no assignment of assets, so the put seller uses the contract multiplier (CM) to figure the trader's cash settlement. c) The seller pays the trader $2000 [100 (CM) x $20 (difference in prices)]. Subtracting the $400 credit paid to enter the market reduces the trader's profit to $1600. Result two: SPX rises to $420 in December. a) The put option purchased expires worthless (OTM), and the trader lets the option expire. b) The trader loses the premiums paid to enter the market. In this example, the trader's total loss equals $400, which is the maximum loss for this type of trade, independent of how high the market rallies. Advantages and Disadvantages in Buying Index Puts: Pluses: The upside in buying index puts is that traders can control their losses. They pay a premium when entering the market, which is the maximum that they can lose. Another benefit in using this method is that traders can gain unlimited profits for a limited amount of risk. Minuses: The only downside in buying index puts happens when the market rallies and the put option expires worthless. In this case, the trader would lose what he or she paid to enter the market.
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Traders who implement a bear put spread are betting that the market price of an option's underlying asset will fall. The technique involves buying and selling put options for the same underlying asset. The profit potential and risk involved when using this strategy are both limited. The bear put spread strategy limits an investor's profits to the amounts received when settling the put options, and the maximum loss only equals what he or she pays to enter the market. Moneyness Review for Puts Out-of-The Money (OTM) = Strike price (less than) Market Price In-The-Money (ITM) = Strike price (more than) Market Price At-The-Money (ATM) Strike price (equals) Market Price How to Carry Out a Bear Put Spread Disney stock is worth $38 (market price) in June. 1) Trader sells a put option: DISJul35($1) - 100 shares of Disney stock - Strike Price $35, out-of-the-money (OTM), expiring in 30 days - Premium Cost of $1 2) Trader buys a put option: DISJul40($3) - 100 shares of Disney stock - Strike Price $40, in-the-money (ITM), expiring in 30 days - Premium Cost of $3 3) Trader pays a total of $200 to enter the market [$300 (paid to purchase put) - $100 (received from put sale)] Total cost to enter the market: $200 Result one: Disney falls to $34 a) The put option sold expires ITM. The investor who bought the trader's put option exercises his or her right to sell 100 shares at $35. The trader pays $3500 to the buyer, and receives 100 Disney shares. b) The put option bought is ITM. The trader exercises his or her right to sell 100 shares at $40 to the investor who wrote the put option. The trader sells his or her Disney 100 shares and receives $4000 from the writer. c) The trader makes a total profit of $300 after subtracting the costs to enter the market. [$300 = $4000 (received for 100 shares) - $3500 (paid for 100 shares) - $200 (cost to enter market)] Result two: Disney rises to $42 a) The put option bought expires worthless (OTM) b) The put option sold expires worthless (OTM) c) Trader loses a total of $200 after adding the amount paid to enter the market. Result three: Disney falls to $38 (Breakeven) a) The put option sold expires worthless (OTM) b) The trader buys 100 Disney shares in the open market for $3800. c) The put option bought is ITM. The trader exercises his or her right to sell 100 shares at $40 to the investor who wrote the put option. The trader sells his or her Disney 100 shares and receives $4000 from the writer. d) The trader breaks even, making a total profit of $0 after subtracting the costs to enter the market. [$0 = $4000 (received for 100 shares) - $3800 (paid for 100 shares) - $200 (cost to enter market)] Advantages and Disadvantages in Carrying Out a Bear Put Spread: Pluses: The upside to this type of strategy is that the investor knows exactly how much he or she will win or lose before carrying out the bear put spread strategy. The investor also knows the strategy's breakeven point, which is the strike price of the put option purchased subtracted from the cost to enter the market. Minuses: The downside in using bear put spread strategy is that the method limits an investor's profits. If the market value of the underlying stock falls significantly, the trader will only gain the price difference between the two put option's strike prices.
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Traders who implement a bear call spread strategy are betting that the market price of an option's underlying asset will fall. The technique involves selling two call options, hoping that both will expire out-of-the-money. Traders who employ this type of bear option strategy do not need cash to enter the trades and receive a credit when entering the market. The bear call spread limits both an investor's profit potential and their risk for losses. Moneyness Review for Calls Out-of-The-Money (OTM) = Strike price (more than) Market Price In-The-Money (ITM) = Strike price (less than) Market Price At-The-Money (ATM) Strike price (equals) Market Price How to Carry Out An Out-Of-The-Money Naked Call Strategy Disney stock is worth $37 (market price) in June. 1) Trader sells the call option: DISJul35($3) - 100 shares of Disney stock - Strike Price $35, in-the-money (ITM), expiring in 30 days - Premium Cost of $3 2) Trader buys the call option: DISJul40($1) - 100 shares of Disney stock - Strike Price $40, out-of-the-money (OTM), expiring in 30 days - Premium Cost of $1 3) Trader receives a $200 credit when entering the market. [$200 = $300 (received from call sale)- $100 (paid for call)] Total cost to enter the market: -$200 Result one: Disney stock falls (crashes) to $28 in July. a) The both of call option sold expires worthless. (OTM) b) The trader's profits totals $200 after keeping the credit earned when entering the market. Result two: Disney stock rises (rallies) to $42 in July. a) The call option purchased expires ITM, and the trader exercises his or her right to buy 100 shares at $40 from the investor who sold the call, paying $4000. b) The call option sold expires ITM, and the investor who bought the trader's call option exercises his or her right to buy 100 the shares at $35. c) The trader loses a total of $300 after adding the premium credit taken when entering the market to the loss. [-$300 = $4000 (paid for shares) - $3500 (received for shares) - $200 (credit to enter market)] Result three: Disney stock remains at $37 in July. a) The call option purchased expires worthless. (OTM) b) The call option sold expires ITM. c) The trader purchases 100 Disney shares in the open market to cover the short sale, paying $3700. d) The call option sold expires ITM, and the investor who bought the trader's call option exercises his or her right to buy 100 the shares at $35. e) The trader loses a total of $0 after adding the premium credit taken when entering the market to the loss. [$0 = $3700 (paid for shares) - $3500 (received for shares) + $200 (credit to enter market)] Advantages and Disadvantages in Carrying Out A Bear Call Spread: Pluses: The upside to this type of strategy is that investors do not need cash to enter the market and it limits the investor's potential for loss. They are betting that the asset's market value will crash and that both of the calls will expire OTM. This allows them to keep the credit earned when entering the market. Traders can also use the credit to offset losses in moderate bull markets. Minuses: The downside in using a bear call spread happens when the underlying asset's market price rallies above the short call's strike price, producing a loss. However, the strategy limits the trader's losses to only the strike price of the call purchased.
