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Showing results for tags 'bullish option strategy'.
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Traders who carry out a costless collar (zero-cost collar) strategy are betting that the market price will go up for the assets owned in their portfolio. The method fully protects a nine-month to a two-and-a-half-year long position from market downturns, and it costs almost nothing to implement. The technique involves buying LEAP put options and writing (selling) the same amount of LEAP call options for the owned underlying asset. Entering this type of position limits the trader's potential profit. Definition - LEAP Options: Regular options expire in 30 days. Exchanges worldwide created Long-term Equity Anticipation Securities (LEAP) to give people more room to secure their portfolio's long positions. By offering LEAP options, investors can trade puts and calls that expire from nine months to two-and-a-half years. The Differences Between ITM, ATM and OTM for Puts and Calls There are five ways to define the relationship between an option's strike price and the market price of its underlying asset for puts and calls. Understanding the differences between the terms is important when considering the risks involved in implementing a costless collar (zero-cost collar) strategy. Put Options: ITM - In The Money: The underlying asset's market price is less than option's strike price. OTM - Out of The Money: The underlying asset's market price is more than option's strike price. Call Options: ITM - In The Money: The underlying asset's market price is more than option's strike price. OTM - Out of The Money: The underlying asset's market price is less than option's strike price. Both Put and Call Options ATM - At The Money: The underlying asset's market price equals the option's strike price. How to Implement a Costless Collar (Zero-Cost Collar) Strategy XYZ is worth $50 (market price) in June of 2006 1) Trader buys 100 shares of XYZ preferred stock and pays $5000 in June 2006. 2) Trader writes (sells) a call option: XYZ[Jul07]60($5) 50 - 100 shares of XYZ (LEAPS) stock - Strike Price $60 (OTM), expiring in 360 days - Premium Cost of $5 3) Trader buys a put option: XYZ[Jul07]50($5) - 100 shares of XYZ (LEAPS) stock - Strike Price $50 (ATM), expiring in 360 days - Premium Cost of $5 4) Trader pays nothing to enter the market, as the funds received from selling the call cover the amount paid for the put [($500 (received from the call) - $500 (paid for the put)] Total Investment cost in 2006: $5000 [100 (shares) x $50 (XYZ market price)] Result one: XYZ hits $70 in July of 2007 a) The put option expires worthless (OTM). b) The call option is ITM. The call buyer exercises his or her right to buy the writer's 100 shares at $60, and pays $6000 to the trader. c) The trader makes a total profit of $1000 after subtracting the total investment cost from the profit made on the call. [$1000 = $6000 (profit from call) - $5000 (cost of investment)] Result two: XYZ hits $40 in July of 2007 a) The call option expires worthless (OTM). b) The put option is ITM. The trader exercises his or her right to sell 100 shares at $50 and receives $5000 his or her shares. c) The trader loses nothing, since the amount received from the put equals the total cost of investment. [$0 = $5000 (received from put) - $5000 (cost of investment)] Result three: XYZ hits $50 in July of 2007 a) The put option expires worthless (OTM). b) The call option expires worthless (ATM). c) The trader loses nothing, since both options expire worthless and keeps his or her 100 shares. Advantage and Disadvantage of Implementing a Costless Collar (Zero-Cost Collar) Strategy: Pluses: The upside to this type of strategy is that the investor will always make a limited profit in a bull market. Another advantage in using the costless collar (zero-cost Collar) is that the trader fully protects their long positions at little to no cost, due to the offsetting premiums paid and received. Minuses: The downside in using a covered combination strategy is that the method limits an investor's profits. If the underlying asset's market value explodes, the trader would only receive what he or she gains from the call option.
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Traders who implement the collar strategy are betting that the market price will go up for the assets owned in their portfolio. The technique involves buying put options and writing (selling) the same amount of call options for the identical underlying asset. Traders use this method to protect their long position from a bear market. The potential profit and the potential loss are limited when entering this type of position. The Differences Between ITM, ATM and OTM for Puts and Calls There are five ways to define the relationship between an option's strike price and the market price of its underlying asset for puts and calls. Understanding the differences between the terms is important when considering the risks involved in implementing the collar strategy. Put Options: ITM - In The Money: The underlying asset's market price is less than option's strike price. OTM - Out of The Money: The underlying asset's market price is more than option's strike price. Call Options: ITM - In The Money: The underlying asset's market price is more than option's strike price. OTM - Out of The Money: The underlying asset's market price is less than option's strike price. Both Put and Call Options ATM - At The Money: The underlying asset's market price equals the option's strike price. How to Implement The Collar Strategy (OTM) XYZ is worth $48 (market price) 1) Trader buys 100 shares of XYZ preferred stock and pays $4800. 2) Trader writes (sells) a call option: XYZJul50($2) - 100 shares of XYZ stock - Strike Price $50 (OTM), expiring in 30 days - Premium Cost of $2 3) Trader buys a put option: XYZJul45($1) - 100 shares of XYZ stock - Strike Price $45 (OTM), expiring in 30 days - Premium Cost of $1 4) Trader receives a total credit of $100 in premiums [($200 (received from the call) - $100 (paid for the put)] Total Investment cost: $4700 [$4800 (paid) - $100 (premium credit)] Result one: XYZ hits $53 a) The put option expires worthless (OTM). b) The call option is ITM. The call buyer exercises his or her right to buy the writer's 100 shares at $50, and pays $5000 to the trader. c) The trader makes a total profit of $300 after subtracting the total investment cost from the profit made on the call. [$300 = $5000 (profit from call) - $4700 (cost of investment)] Result two: XYZ hits $43 a) The call option expires worthless (OTM). b) The put option is ITM. The trader exercises his or her right to sell 100 shares at $45 and receives $4500 his or her shares. c) The trader loses a total of $200 after adding after subtracting the total investment cost from the sale of the shares. [-$200 = $4500 (received from put) - $4700 (cost of investment)] Result three: XYZ hits $48 a) The put option expires worthless (OTM). b) The call option expires worthless (ATM). c) The trader makes a total profit of $100 after keeping the premium credit from the call and the put options. Advantage and Disadvantage of Implementing The Collar Strategy: Pluses: The upside to this type of strategy is that the investor will always make a limited profit in a bull market. Another advantage in using the collar strategy is that the trader also knows exactly how much he or she would lose if the market declines, since their loss risk is also limited by the terms of the put option. Minuses: The downside in using covered combination strategy is that the method limits an investor's profits. If the underlying asset's market value explodes, the trader would only receive what he or she gains from the call option.
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Traders who carry out a synthetic short put strategy are betting that the market price will go up for the shares owned in their portfolio. The technique involves writing (selling) call options for the owned underlying asset. The reason investors refer to this as a put strategy instead of a call is because the profit potential functions the same as it would in a short put approach. When implementing a synthetic short put, traders gain limited premiums as the market rises, but they expose themselves to unlimited loss risk when the market value of the option's underlying asset falls. Definition of ATM, ITM and OTM for Synthetic Short Puts There are three ways to define the relationship between a call option's strike price and the market price of its underlying asset. Understanding the differences between the terms is important because the risks involved in buying puts depend on these terms at the time of the purchase and when assigning assets. ATM - At The Money: The underlying asset's market price equals the option's strike price. Example: - Put Option XYZJan50 (strike price $50) - XYZ is trading at $50 ITM - In The Money: The underlying asset's market price is more than option's strike price. Example: - Put Option XYZJan50 (strike price $50) - XYZ is trading at $60 OTM - Out of The Money: The underlying asset's market price is less than option's strike price. Example: - Put XYZJan50 (strike price $50) - XYZ is trading at $40 How to Implement a Synthetic Short Put Strategy (ATM) XYZ is trading at $50 (market price) 1) Trader buys 100 XYZ shares for $5000 (100 x $50 share cost)). 2) Trader writes (sells) a call option: XYZJan50($3) - 100 shares of XYZ stock - Strike Price $50 (ATM), expiring in 30 days - Premium Cost of $3 3) Trader receives $300 from the buyer [100 x $3 (premium cost)]. Total Investment cost: $4700 ($5000-$300) Result one: XYZ hits $55 (ITM). The call buyer exercises the option to buy 100 shares at $55. The call seller sells his or her 100 shares and receives at $5500 for a total profit of $800 ($5500 received from buyer - $4700 total investment cost). Result two: XYZ hits $43 (OTM). The call buyer lets the contract expire. In this example, the option seller would keep the 100 shares and the $300 in premiums collected, but would suffer a $700 loss on paper ($4300 asset's worth -$5000 paid). The total loss reduces to $400 when adding the premiums received from the call. Result three: XYZ hits $50 (ATM). The call buyer lets the contract expire. In this example, the option seller would keep 100 shares and the premiums collected for a total profit of $300 ($300 received in premiums). Advantage and Disadvantage of a Covered Call Strategy: Pluses: The upside to this type of strategy is that traders get to earn a limited premium on top of any gain on paper from their owned assets. Another advantage to the synthetic short put strategy is that premiums earned can reduce any loss incurred from a decline in the underlying asset's market price, down to the investment's break even point. Minuses: The downside to implementing a synthetic short put strategy is that a trader's profits are limited to only the gain on paper plus the premiums received from the call buyer. The investor can not receive any profits from gains the underlying asset's market price because he or she would have sold the asset upon assignment. Finally, if the underlying asset's market value falls, the trader's risk becomes unlimited, as the asset's price could decline to a zero value.
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Traders who carry out a stock repair strategy try to recover losses on their long positions sustained from an earlier period. The technique involves implementing a call ratio spread, usually 2:1, consisting of buying one call option and selling two. A rise in the market repairs a trader's losses. The call ratio spread can repair losses in a bear market, up to the ratio's breakeven point. The Differences Between ITM, ATM and OTM for Puts and Calls There are five ways to define the relationship between an option's strike price and the market price of its underlying asset for puts and calls. Understanding the differences between the terms is important when considering the risks involved in implementing a stock repair strategy. Put Options: ITM - In The Money: The underlying asset's market price is less than option's strike price. OTM - Out of The Money: The underlying asset's market price is more than option's strike price. Call Options: ITM - In The Money: The underlying asset's market price is more than option's strike price. OTM - Out of The Money: The underlying asset's market price is less than option's strike price. Both Put and Call Options: ATM - At The Money: The underlying asset's market price equals the option's strike price. How to Implement a Stock Repair Strategy Precondition: **XYZ is worth $50 (market price) in May **Trader buys 100 XYZ shares for $5000 (100 x $50 share cost)) **XYZ declines to $40 (market price) in June **Trader loses $1000 on paper [-$1000 = $4000 (current market value) - $5000 (investment cost)] Stock Repair (2:1 Ratio): XYZ is worth $40 (market price) 1) Trader buys one call option: XYZJul40($2) - 100 shares of XYZ stock - Strike Price $40 (ATM), expiring in 30 days - Premium Cost of $2 2) Trader writes (sells) two calls options: XYZJul45($1) - 100 shares of XYZ stock - Strike Price $45 (OTM), expiring in 30 days - Premium Cost of $1 3) Trader pays nothing to repair the stock because the premiums offset each other [$200 (paid for call) - $200 (received from put)]. Result one: XYZ hits $45 a) The two call options sold expire worthless (OTM). b) The call option purchased is ITM. The trader exercises his or her right to buy 100 shares at $40, pays $4000 to the seller and sells the shares in the open market for $4500. c) The trader also sells his or her long position for $4500. d) The trader makes a total profit of $1000 [$1000 = $500 (profit from call) + $500 (profit from long)]. The $1000 repairs the trader's loss from a month earlier. Result two: XYZ hits $60 a) The two call options sold are ITM. The call buyer exercises his or her right to buy 200 shares at $45. b) The call option purchased is ITM. The trader exercises his or her right to buy 100 shares at $40, pays $4000 to the seller. c) The trader delivers 200 shares (100 from the long position and 100 from call purchase) to the call buyer, and he or she receives $9000. d) The trader makes a total profit of $5000 from the current month's trading [$9000 (received from call sale) - $4000 (paid for call purchase)]. e) The trader actually breaks even because the $5000 profit offsets the $5000 that trader paid to enter the market a month ago before the loss. [$0= $5000 (profit from current month) - $5000 (cost of investment)]. Result three: XYZ hits $30 a) The two call options sold expire worthless (OTM). b) The call option purchased expires worthless (OTM). c) The trader keeps his or her long position and loses another $1000 in paper value [-$2000 = $3000 (current market value) - $5000 (investment cost)]. Advantage and Disadvantage of Implementing a Stock Repair Strategy: Pluses: The upside to this type of strategy is that the investor pays nothing to repair the stock, and he or she will always recover losses in a bull market. Another advantage in using a stock repair strategy is that even if the market continues to fall, traders can still recover their losses up to the call ratio's break even point. Minuses: The downside in using a stock repair strategy is that if the market falls past the call ratio's break even point, the long position will continue to lose value.
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An uncovered put write, or a "naked put" as it is frequently called by investors, is an investing strategy which is fundamentally a bet on a stock either staying near its current price or going up. The put in this case is called uncovered because the put writer does not own the underlying stock. Instead, the option trader simply writes put contracts at a strike price and collects the premium. If the stock price stays at or above the strike price to expiration, then the trader collects the premium as profit. However, if the price falls below the strike price, then losses are unlimited (except for the premium) until the stock price reaches zero. To see how this works (see diagram) suppose stock XYZ is trading at $45 and the trader writes 1 uncovered put contract at a strike price of $45 for a premium of $2. This would cost $200 for a contract (1 contract=100 shares). If the stock price goes up or stays at $45 all the way to the option expiration date, the trader keeps the premium ($200) as the maximum profit. However, if the price falls below the strike price, then losses depend on the expiration price. For example, if the price at expiration is $40 then the loss would be $5 per share or $500 minus the premium price of $200 for a total loss of $300. Maximum loss would be if the stock price went to $0 which would be $45 per share or $4500 (minus the premium collected). When to use uncovered puts The best time to use uncovered puts is in periods of low volatility for a stock. If the trader feels there will be little price change in a stock over time, then uncovered puts are a valid strategy. Some traders use these instruments as a major source of income, collecting premiums from expired contracts month-after-month. However, uncovered puts do carry with them a high amount of downside risk if the price of a stock goes down rapidly. Therefore, it is best not to write uncovered puts before an earnings report, expected news release, or any other known factor that could rapidly move the stock price. There is also the risk that if the put is held to expiration, the put will be executed and the put writer will have to take delivery of the stock. The stock could then continue its decline and increase losses. Because of factors such as these, many brokers will not allow traders to write uncovered puts without a substantial amount of capital to serve as security in case of loss. Types of stocks that work well with uncovered puts The type of stocks that work well with the uncovered put strategy tend to be large, blue chip type stocks that have low volatility and a stable, long-term price trend. It is also wise to choose stocks such as these that are: (1) on a relative uptrend in terms of revenues and earnings or (2) have just been through a strong selloff as a way to hedge against any unforeseen downside price movement.
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Traders who carry out a synthetic long (split strikes) stock strategy are betting that the market price for an option's underlying asset will go up. The technique involves buying call options and writing (selling) the same amount of put options for the identical underlying asset. Traders who use this method enter the market receiving a credit or paying nothing. The synthetic long (split strikes) is a less aggressive strategy than its cousin, the synthetic long stock, giving the trader more of a cushion against minor market downturns. The potential profit and the potential loss are unlimited when entering this type of synthetic position. The Differences Between ITM, ATM and OTM for Puts and Calls There are five ways to define the relationship between an option's strike price and the market price of its underlying asset for puts and calls. Understanding the differences between the terms is important when considering the risks involved in implementing a synthetic long (split strikes) stock strategy. Put Options: ITM - In The Money: The underlying asset's market price is less than option's strike price. OTM - Out of The Money: The underlying asset's market price is more than option's strike price. Call Options ITM - In The Money: The underlying asset's market price is more than option's strike price. OTM - Out of The Money: The underlying asset's market price is less than option's strike price. Both Put and Call Options ATM - At The Money: The underlying asset's market price equals the option's strike price. How to Implement a Synthetic Long Stock Strategy (Split Strikes) (OTM) XYZ is worth $40 (market price) 1) Trader writes (sells) a put option: XYZJun35($1) - 100 shares of XYZ stock - Strike Price $35 (OTM), expiring in 30 days - Premium Cost of $1 2) Trader buys a call option: XYZJun45($.50) - 100 shares of XYZ stock - Strike Price $45 (OTM), expiring in 30 days - Premium Cost of $.50 3) Trader receives a total credit of $50 in premiums to enter the market [$100 (received from put) - $50 (paid for call)]. Result one: XYZ hits $45 (Moderate Bull Market) a) The put option expires worthless (OTM). b) The call option expires worthless (ATM). c) The trader makes a total profit of $50 after keeping the premium credit from the call and the put. Result two: XYZ hits $60 (Explosive Bull Market) a) The put option expires worthless (OTM). b) The call option is ITM. The trader exercises his or her right to buy 100 shares at $45, pays $4500 to the seller and sells the 100 shares in the open market for $6000. c) The trader makes a total profit of $1550 after adding the premium credit received when entering the market. [$1550 = $1500 (profit from call) + $50 (credit to enter market)] Result three: XYZ hits $20 (Market Crashes) a) The call option expires worthless (OTM). b) The put option is ITM. The put buyer exercises his or her right to sell 100 shares at $35. The trader pays $3500 to the put buyer and sells the 100 shares received from the buyer in the open market for $2000. c) The trader loses a total of $1450 after subtracting the premium credit received when entering the market. [$1450 = $1500 (loss from put) - $50 (credit to enter market] Advantage and Disadvantage of Implementing a Synthetic Long Stock Strategy (Split Strikes): Pluses: The upside to this type of strategy is that the investor can make unlimited profits in a bull market, since the potential growth of any underlying asset is infinite. Another advantage to this technique is that the investor can enter the market receiving a credit that she or she can use to offset minor market downswings. Minuses: The downside in using synthetic long (split strikes) strategy is when the underlying asset's market value falls dramatically. When this happens, the trader's loss risk becomes unlimited, as an asset's market price can decline to a zero value.
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Traders who implement a synthetic long stock strategy are betting that the market price for an option's underlying asset will go up. The technique involves buying call options and writing (selling) an equal amount of put options for the same underlying asset. Traders who use this method enter the market at low-to-zero cost. Both the potential profit and the potential loss are unlimited when entering this type of synthetic position. The Differences Between ITM, ATM and OTM for Puts and Calls There are five ways to define the relationship between an option's strike price and the market price of its underlying asset for puts and calls. Understanding the differences between the terms is important when considering the risks involved when implementing a synthetic long stock strategy. Put Options: ITM - In The Money: The underlying asset's market price is less than option's strike price. OTM - Out of The Money: The underlying asset's market price is more than option's strike price. Call Options ITM - In The Money: The underlying asset's market price is more than option's strike price. OTM - Out of The Money: The underlying asset's market price is less than option's strike price. Both Put and Call Options ATM - At The Money: The underlying asset's market price equals the option's strike price. How to Implement a Synthetic Long Stock Strategy (ATM) XYZ is worth $40 (market price) 1) Trader writes (sells) a put option: XYZJan40($1) - 100 shares of XYZ stock - Strike Price $40 (ATM), expiring in 30 days - Premium Cost of $1 2) Trader buys a call option: XYZJan40($1.50) - 100 shares of XYZ stock - Strike Price $40 (ATM), expiring in 30 days - Premium Cost of $1.50 3) Trader pays a total of $50 in premiums to enter the market [$150 (paid for call) - $100 (received from put)] Result one: XYZ hits $50 a) The put option expires worthless (OTM). b) The call option is ITM. The trader exercises his or her right to buy 100 shares at $40, pays $4000 to the writer, and immediately sells the shares in the open market for $5000. c) The trader makes a total profit of $950 after subtracting the premiums paid to enter the market. [$950 = $1000 (profit from call) - $50 (cost to enter market)] Result two: XYZ hits $30 a) The call option expires worthless (OTM). b) The put option is ITM. The put buyer exercises his or her right to sell 100 shares at $40. The trader pays $4000 to the put buyer and sells the 100 shares received from the buyer in the open market for $3000. c) The trader loses a total of $1050 after adding the cost to enter the market. [$1050 = $1000 (loss from put) + $50 (cost to enter market)] Advantage and Disadvantage of Implementing a Synthetic Long Stock: Pluses: The upside to this type of strategy is that the investor can make unlimited profits in a bull market, since the potential growth of any underlying asset is infinite. Another advantage to this technique is that the investor can enter the market at a very low cost. Minuses: The downside in using a synthetic long stock strategy is when the underlying asset's market value falls. When this happens, the trader's loss risk becomes unlimited, as an asset's market price can decline to a zero value.
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A synthetic long call is a synthetic trade meaning that it is a trade involving an underlying security compounded by derivatives (in this case options). The investor in this case has decided that the stock price will go up (hence the term "call") and buys the stock while simultaneously buying near-the-money puts. This type of position insures the stockholder a maximum loss of the put's strike price and at the same time unlimited potential profits. For example (see diagram) if the shareholder has 100 shares of stock XYZ with a share price of $52, then a contract (1 contract=100 shares) can be purchased to limit losses at the strike price of the option. Suppose the option strike price is $50, then the maximum loss per share is $2 plus the premium paid (the cost of purchasing a contract). Suppose the premium for a contract is $2 (1 contract =100 shares=$200), then the maximum loss in the trade is $400. On the other hand, the profit potential is unlimited if the share price goes up and the only loss is that of the premium paid of $200. If the stock reaches $54, then the shareholder has broken even in the trade and realizes only profit as the stock goes up. When are synthetic long calls a valid strategy? Synthetic long calls are a bullish position and are valid strategy for playing riskier, higher volatility stocks while at the same time reducing the amount of inherent risk in incurring a steep loss. Investors who desire to play such a stock for the chance of extreme profits (such as in a much-hyped tech stock) often use this strategy. In this case, the puts purchased provide a level of insurance in case the trade goes wrong and the stock gets crushed. Investors who use this strategy have to pay close attention to the amount of implied volatility (IV) in premium prices since the maximum loss incurred can be much more substantial with higher premium prices. The synthetic long call is also a valid strategy when more versatility is needed by the investor in assessing the stock's performance. For example, the investor can sell the put at any time, sell the stock at any time, or execute delivery at the strike price. This allows a change in overall strategy for the trade all the way until the option's expiration. Types of stocks in which to consider long call strategy Stocks that respond well to this strategy are oftentimes small to mid-cap sized stocks with moderate to high amounts of volatility. Stocks with higher price swings that have just been through a steep selloff or where good news is expected are good candidates for a long call. Volatile ETFs and index funds as well are candidates for this strategy. One of the keys to putting on the lowest risk trade with any of these stocks is to pay attention to implied volatility in premium prices and go for the lowest possible put option price in order to avoid sharp drops in implied volatility. This would minimize any loss should the stock trade sideways.
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Traders who implement a covered straddle strategy are betting that the market price will go up for the assets owned in their portfolio. The technique involves writing (selling) the same amount call and put options for owned shares. Traders gain limited premiums when the market rises, but they expose themselves to unlimited loss risk when the market value of the option's underlying asset falls. The covered straddle strategy is similar to placing two covered calls. The Differences Between ITM, ATM and OTM for Puts and Calls There are five ways to define the relationship between an option's strike price and the market price of its underlying asset for puts and calls. Understanding the differences between the terms is important because of the risks involved in when the market declines and when assigning assets. Put Options: ITM - In The Money: The underlying asset's market price is less than option's strike price. OTM - Out of The Money: The underlying asset's market price is more than option's strike price. Call Options: ITM - In The Money: The underlying asset's market price is more than option's strike price. OTM - Out of The Money: The underlying asset's market price is less than option's strike price. Both Put and Call Options: ATM - At The Money: The underlying asset's market price equals the option's strike price. How to Implement a Covered Straddle Strategy (ATM) XYZ is worth $54 (market price) 1) Trader buys 100 shares of XYZ preferred stock and pays $5400. 2) Trader writes (sells) a put option: XYZJan55($3) - 100 shares of XYZ stock - Strike Price $55 (ATM), expiring in 30 days - Premium Cost of $3 3) Trader writes (sells) a call option: XYZJan55($4) - 100 shares of XYZ stock - Strike Price $55 (ATM), expiring in 30 days - Premium Cost of $4 4) Trader receives $700 in premiums ($300 from put + $400 from call) Total Investment cost: $4700 [$5400 (paid) - $700 (premiums collected)] Result one: XYZ hits $57 a) The put option expires worthless (OTM), and the trader keeps the $300 in premiums. b) The call option is ITM. The call buyer exercises his or her right to buy the seller's 100 shares at $55, paying $5500 to the seller. c) The trader makes $800 after subtracting the amount received from the call option from the total cost of investment. [$800 = $5500 (call sale) - $4700 (cost of investment)] Result two: XYZ hits $45 a) The call option expires worthless (OTM), and the trader keeps the $400 in premiums. b) The put option is ITM. The put buyer exercises his or her right to sell 100 shares at $55. The writer sells his 100 shares in the open market receiving $4500 and adds $1000 out of his or her pocket to pay $5500 to the put buyer. c) The 100 shares received from the buyer suffer a $200 paper loss. [$4500 (current market value) - $4700 (cost of investment)] d) The trader loses a total of $1200 after adding the amount paid out-of-pocket to the paper loss on shares owned. [$1200 = $1000 (paid out-of-pocket) - $200 (paper loss)] Advantage and Disadvantage of Implementing a Covered Straddle Strategy: Pluses: The upside to this type of strategy is that the investor will always make a limited profit in a bull market. Another advantage in using a covered straddle strategy is that the premiums collected give the trader a discount on the total cost of the investment. Minuses: The downside in using a covered straddle strategy is that the method limits an investor's profits. Also, if the underlying asset's market value falls, the trader's risk becomes unlimited, as an asset's price can decline to a zero value.
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Traders who implement a covered combination strategy are betting that the market price will go up for the assets owned in their portfolio. The technique involves writing (selling) the same number of call and put options for shares owned of an underlying asset. Traders gain limited premiums when the market rises, but they expose themselves to unlimited loss risk when the market value of the option's underlying asset falls. The Differences Between ITM, ATM and OTM for Puts and Calls There are five ways to define the relationship between an option's strike price and the market price of its underlying asset for puts and calls. Understanding the differences between the terms is important because of the risks involved in when the market declines and when assigning assets. Put Options: ITM - In The Money: The underlying asset's market price is less than option's strike price. OTM - Out of The Money: The underlying asset's market price is more than option's strike price. Call Options: ITM - In The Money: The underlying asset's market price is more than option's strike price. OTM - Out of The Money: The underlying asset's market price is less than option's strike price. Both Put and Call Options ATM - At The Money: The underlying asset's market price equals the option's strike price. How to Implement a Covered Combination Strategy (OTM)XYZ is worth $52 (market price) 1) Trader buys 100 shares of XYZ preferred stock and pays $5200. 2) Trader writes (sells) a put option: XYZJan50($1) - 100 shares of XYZ stock - Strike Price $50 (OTM), expiring in 30 days - Premium Cost of $1 3) Trader writes (sells) a call option: XYZJan55($1) - 100 shares of XYZ stock - Strike Price $55 (OTM), expiring in 30 days - Premium Cost of $1 4) Trader receives $200 in premiums ($100 from the put + $100 from the call) Total Investment cost: $5000 [$5200 (paid) - $200 (premiums collected)] Result one: XYZ hits $57 a) The put option expires worthless (OTM). b) The call option is ITM. The call buyer exercises his or her right to buy the writer's 100 shares at $55, and pays $5500 to the trader. c) The trader makes a total profit of $500 after subtracting the amount received from the call from the total cost of the investment. [$500 = $5500 (received from call) - $5000 (cost to enter market)] Result two: XYZ hits $45 a) The call option expires worthless (OTM). b) The put option is ITM. The put buyer exercises his or her right to sell 100 shares at $50. The writer sells his or her 100 shares in the open market receiving $4500 and adds $500 out of his or her pocket to pay $5000 to the put buyer. c) The 100 shares received from the buyer suffer a $500 paper loss. [$4500 (current market value) - $5000 (cost of investment)] d) The trader loses a total of $1000 after adding the amount paid out-of-pocket to the paper loss on shares owned. [$500 = $1000 (paid out-of-pocket) - $500 (paper loss)] Advantage and Disadvantage of Implementing a Covered Combination Strategy: Pluses: The upside to this type of strategy is that the investor will always make a limited profit in a bull market. Another advantage in using a covered combination strategy is that the premiums collected give the trader a discount on the total cost of the investment. Minuses: The downside in using covered combination strategy is that the method limits an investor's profits. Also, if the underlying asset's market value falls, the trader's risk becomes unlimited, as an asset's price can decline to a zero value.
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Traders who sell index puts are betting that the market price of the index's underlying value will go up. The strategy involves selling a put that's associated with a stock market index. The index plays the same role as an underlying asset does in normal options trading. Investors settle their exercised index options in cash, so there are no assignments of assets. When traders sell index puts, they forecast that the option will expire OTM and worthless. The most a trader can gain is limited to the amount that he or she receives in premiums. At the same time, there is no limit to how much an investor can lose, since the potential decline of any stock index is infinite. Definition of ATM, ITM and OTM for Puts There are three ways to define the relationship between an option's strike price and the market price of the underlying index. Understanding the differences between the terms is important because the risks involved in selling index puts depend on these terms at the time of the sale and when settling for cash. ATM - At The Money: The underlying index's market price equals the option's strike price. Example: - Put Option DJX400 (strike price $400) - Index DJX is trading at $400 ITM - In The Money: The underlying index's market price is less than option's strike price. Example: - Put Option DJX400 (strike price $400) - Index DJX is trading at $380 OTM - Out of The Money: The underlying index's market price is more than option's strike price. Example: - Put Option DJX400 (strike price $400) - Index DJX is trading at $420 How to Sell Index Puts (ATM) The DJX is worth $400 (market price) 1) Trader writes (sells) an index put option: DJX400($4) - One Option with a contract multiplier of $100 - Strike Price $400 (ATM) - Premium Cost of $4 2) Trader receives $400 in premiums (100 x $4 (premium cost)). Result one: DJX hits $380 (ITM). The put buyer exercises his or her right to sell 100 shares at $40. The difference between the option's strike price and the DJX is $20 (Option $400 - DJX $380). Since there is no assignment of assets, the trader settles in cash for $2000 (100 x $20). The investor's total loss is reduced to $1600 after adding premiums received. Result two: DJX hits $420 (OTM). The put buyer lets the option expire, does not exercise his or her right to sell and loses the amount of premiums paid. In this example, the writer would profit $400 (premiums paid). Advantage and Disadvantage of Selling Index Puts: Pluses: The upside to selling index puts is that the investor can enter the market without paying cash. They in fact are issuing an IOU, hoping that the obligation will expire worthless. Minuses: The downside is that a trader's profits are limited to only the premiums received from the put buyer. Also, the potential loss risk in selling puts is unlimited, as an index can decline up to a zero value.
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Traders who enter married put strategies want to own an option's underlying asset, but are unsure if the asset's bullish trend will continue in the short-term. The strategy involves buying a put option ATM and buying the same number of regular shares of the underlying asset. When traders buy the put option, they are essentially purchasing insurance. The most a trader can lose is limited to the amount that he pays in premiums and the difference in the share price on paper. At the same time, there is no limit to how much an investor can gain, since the potential rise of any underlying asset is infinite. Definition of ATM, ITM and OTM for Married Puts There are three ways to define the relationship between a put option's strike price and the market price of its underlying asset. Understanding the differences between the terms is important because the risks involved in buying puts depend on these terms at the time of the purchase and when assigning assets. ATM - At The Money: The underlying asset's market price equals the option's strike price. Example: - Put Option XYZJan52 (strike price $52) - XYZ is trading at $52 ITM - In The Money: The underlying asset's market price is less than option's strike price. Example: - Put XYZJan52 (strike price $52) - XYZ is trading at $30 OTM - Out of The Money: The underlying asset's market price is more than option's strike price. Example: - Put Option XYZJan52 (strike price $52) - XYZ is trading at $70 How to Enter a Married Put Strategy (ATM) XYZ is worth $52 (market price) 1) Trader buys 100 shares of XYZ preferred stock and pays $5200. 2) Trader buys the put option: XYZJan50($2) - 100 shares of XYZ stock - Strike Price $50 (ATM), expiring in 30 days - Premium Cost of $2 3) Trader pays $200 in premiums (100 x $2 (premium cost)). Result one ITM: XYZ hits $30 (ITM) Any drop in price below $50 puts the option ITM. If this happens, the trader will exercise the right to sell his or her 100 shares for $50 and will receive $5000 from the put seller. The trader's total loss will equal the premiums paid ($200) plus the difference between the asset's purchase price and its selling price (Paid $5200 - Received $5000 = $200). In this case, the total loss is $400. Result two OTM: XYZ hits $70 (OTM) Any rise in price above $50 puts the option OTM. If this happens, the trader will not exercise the right to sell his or her 100 shares. His or her underlying asset will have a paper value of $1800 (100 (shares) x $70 (market price). The $200 in premiums paid reduces the trader's profit to $1600. Result three ATM: XYZ hits $52 (ATM) If XYZ remains at $52 when the put option expires, the trader will not exercise the right to sell his or her 100 shares, but loses the $200 in premiums paid (insurance). Advantage and Disadvantage of Implementing a Married Put Strategy: Pluses: The upside to this type of strategy is that there are no limits to the amount of profit an investor can make. If the underlying asset's market value takes off, the investor's shares will grow on paper. Another advantage in the married put strategy is that the cost of insurance (buying a put) is very low. As a result, a trader can go long and pay only a small fixed premium if things go wrong. Minuses: The downside in implementing a married put strategy is that the investor loses when the value of the option fall ITM. Although, the most an investor can lose is limited.
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Traders who use a long call strategy are betting that the market price of the underlying asset will go up. The strategy is one that's implemented most by investors and involves buying a regular call option. Call options carry a premium, which fluctuates during the life of the option. When traders implement a long call strategy, they enter the market at lower costs, which limits their risk and gives them leverage, as the underlying asset appreciates. The most a trader can lose is the amount that he or she pays in premiums. At the same time, there is no limit to how much profit an investor can make, since the potential growth of any underlying asset is infinite. Definition of ATM, ITM and OTM for Calls: There are three ways to define the relationship between an option's strike price and the market price of its underlying asset. Understanding the differences between the terms is important because the risks involved in implementing a long call strategy depend on these terms at the time of purchase. ATM - At The Money: The underlying asset's market price equals the option's strike price. Example: - Call Option XYZJan40 (strike price $40) - XYZ is trading at $40 ITM - In The Money: The underlying asset's market price is more than option's strike price. Example: - Call Option XYZJan40 (strike price $40) - XYZ is trading at $50 OTM - Out of The Money: The underlying asset's market price is less than option's strike price. Example: - Call Option XYZJan40 (strike price $40) - XYZ is trading at $30 How to Implement a Long Call Strategy (ATM): XYZ is trading at $40 (market price) 1) Option Available: XYZJan40($2)- 100 shares of XYZ stock - Strike Price $40 (ATM), expiring in 30 days- Premium Cost of $2 2) Trader buys 1 call option at $200 (100 x $2 (premium cost)). Result one: XYZ hits $50 (ITM). The call buyer exercises his or her right to buy 100 shares at $40, paying $4000 to the seller and immediately selling the 100 shares at market price for $5000. After subtracting the $200 in premiums paid, the long call strategy results in an $800 profit (20%). Result two: XYZ hits $30 (OTM). The buyer lets the option expire, does not exercise his or her right to buy and loses the amount of premiums paid. In this example, the option buyer would lose $200 (premiums paid). Advantage and Disadvantage of a Long Call Strategy: Pluses: The upside to this type of strategy is that there are no limits to the amount of profit an investor can make. If the underlying asset's market value takes off, the call will grow, and the trader will exercise it before the option expires. Another advantage to the long call strategy is that the cost of entering the market is very low. As a result, the lower buying cost limits a trader's overall risk and adds leverage to the investor's portfolio. Minuses: The downside to implementing a long call strategy is that the investor loses when the value of the option fall OTM. Although, the most an investor can lose is only the amount that he or she paid in premiums to buy the option. Examples of Implementing a Long Call Strategy
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Traders who implement an ITM covered call strategy writes (sells) a call option for leverage against potential losses on owned shares. They also gain a steady premium when the market rises. The strategy involves writing a call option ITM and buying the same number of regular shares of the underlying asset. A long call strategy guarantees traders a steady return in bull markets. Premiums received from writing the call cut losses, if the price of the underlying asset falls. Definition of ITM, ATM and OTM for Covered Calls There are three ways to define the relationship between an option's strike price and the market price of its underlying asset. Understanding the differences between the terms is important when considering the returns involved in implementing a covered call strategy. ITM - In The Money: The underlying asset's market price is more than option's strike price. Example: - Call Option XYZJan45 (strike price $45) - XYZ is trading at $50 ATM - At The Money: The underlying asset's market price equals the option's strike price. Example: - Call Option XYZJan45 (strike price $40) - XYZ is trading at $45 OTM - Out of The Money: The underlying asset's market price is less than option's strike price. Example: - Call Option XYZJan45 (strike price $40) - XYZ is trading at $55 How to Implement a Covered Call Strategy (ITM) XYZ is worth $50 (market price) 1) Trader buys 100 shares of XYZ preferred stock and pays $5000. 2) Trader writes (sells) a call option: XYZJan45($7) - 100 shares of XYZ stock - Strike Price $45 (ITM), expiring in 30 days - Premium Cost of $7 3) Trader receives $700 in premiums (100 x $7 (premium cost)). Total Investment cost: $4300 [$5000 (paid) -$700 (premiums collected)] Result one: XYZ hits $55 (ITM). The call buyer exercises his or her right to buy 100 shares at $45, paying $4500 for the seller's assets. After adding the $200 in premiums received, the trader's covered call strategy results in a $200 profit [$4500 (received) - $4300 (Paid)]. Result two: XYZ hits $45 (ATM). The call buyer lets the option expire and the writer keeps the premiums paid. The shares held by the writer loses $500 in paper value [$5000 (paid) -$4500 (worth on strike date)], but since the writer received $700 in premiums, he or she still makes a profit of $200. [$700 (premiums collected) -$500 (loss)] Result three: XYZ hits $40 (OTM). The call buyer lets the option expire and the writer keeps the premiums paid. The shares held by the writer loses $1000 in paper value [$5000 (paid) -$4000 (worth on strike date)], but since the writer received $700 in premiums, his or her loss reduces to $300. [$700 (premiums collected) -$500 (loss)] Advantage and Disadvantage of Implementing a Covered Call Strategy: Pluses: The upside to this type of strategy is that the investor will always make a profit when the price of the underlying asset rises. Another advantage in using a covered call strategy is that the investor can also profit from a drop in price of the underlying asset. Writing the call option leverages the investment against market downturns, and it gives the trader a cushion for reducing his or her losses. Minuses: The downside in using covered call strategy is that the method limits an investor's profits. If the underlying asset's market value takes off, the trader cannot take advantage of the gain because he or she must sell assets at a fixed price after assignment.
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A covered call strategy is an approach for traders who own an underlying asset. The method allows them to make a profit when the underlying asset's market price goes up moderately and to buffer losses if market prices go down. The strategy limits profits to only what is gained on paper plus any premiums earned. Loss potential is the same for any investor holding the underlying asset, but traders who leverage their assets by using a covered call strategy can cushion shortfalls in their portfolio. Definition of OTM and ITM for Covered Calls There are two ways to define the relationship between an option's strike price and the market price of its underlying asset. Understanding the differences between the terms is important because the risks involved in implementing a covered call strategy depend on these terms at the time of writing the option. OTM - Out of The Money: The underlying asset's market price is less than option's strike price. Example: - Call Option XYZJan55 (strike price $55) - XYZ is trading at $50 ITM - In The Money: The underlying asset's market price is more than option's strike price. Example: - Call Option XYZJan45 (strike price $40) - XYZ is trading at $50 How to Implement a Covered Call Strategy (OTM) XYZ is trading at $50 (market price) 1) Trader buys 100 XYZ shares for $5000 (100 x $50 share cost)). 2) Trader writes (sells) the option: XYZJan55($2) - 100 shares of XYZ stock - Strike Price $55 (OTM), expiring in 30 days - Premium Cost of $2 3) Trader receives $200 from the buyer (100 x $2 (premium cost)). Total Investment cost: $4800 ($5000-$200) Result one: XYZ hits $57 (ITM). The call buyer exercises the option to buy 100 shares at $55. The call seller sells his or her 100 shares and receives at $5500, for a total profit of $700 ($5500 received from buyer - $4800 total investment cost). Result two: XYZ hits $43 (OTM). The call buyer lets the contract expire. In this example, the option seller would keep the asset and the $200 in premiums, but would suffer a $700 loss on paper ($4300 asset's worth -$5000 paid). The total loss reduces to $500 when adding the premium. Advantage and Disadvantage of a Covered Call Strategy: Pluses: The upside to this type of strategy is that traders get to earn a premium on top of any paper gain their from owned assets. Another advantage to the covered call strategy is that premiums can reduce any loss incurred from a decline in the underlying asset's market price. Minuses: The downside to implementing a covered call strategy is that a trader's profits are limited to only the gain on paper plus the premiums received from the call buyer. The investor can not receive any future profits from gains the underlying asset's market price because he or she would have sold the asset upon assignment. Examples of Implementing a Covered Call Strategy ITM: In the example above the investor sold the call OTM. Traders can choose to write an option at ITM, which will give them more leverage against declining market prices. Example: XYZ is trading at $50 (market price) 1) Trader buys 100 XYZ shares for $5000 (100 x $50 share cost)). 2) Trader writes (sells) the option: XYZJan45($8) - 100 shares of XYZ stock - Strike Price $45 (ITM), expiring in 30 days - Premium Cost of $8 3) Trader receives $800 from the buyer (100 x $8 (premium cost)). Total Investment cost: $4200 ($5000-$800) Result: The trader's profits are reduced if the option expires ITM, but his or her losses also reduce if the underlying asset's market price falls, providing an $800 cushion instead of $200, compared to the example above.
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Traders who use a bull call spread strategy are betting that the market price of the underlying asset will go up moderately or substantially. The strategy involves buying a call option, and hedging it, by selling the same quantity of call options. A bull call spread strategy limits the investment's potential profit, but it also lowers the trader's exposure. Investors can trade options at a discount when using this strategy. It requires less cash to get into the market, which may help investors when trading options that they are less familiar with. How to Enter a Bull Call Spread A trader must perform two operations at the same time to enter a bull call spread. First, a trader will need to buy a call that's In-The-Money (ITM). Example: XYZ is trading at $42 (market price) Buying a Call 1) Call Option Available: XYZJan40 ($3) - ITM - One Option = 100 shares of XYZ stock - Strike Price $40/per share, expiring on 1/15 - Premium Cost of $3. 2) Trader buys one call option and pays $300 [100 x $3 (premium cost)]. Selling a Call Next, the trader will sell the same quantity of options that's Out-of-The Money (OTM). 1) Trader writes (sells): XYZJan45 ($1) - One Option = 100 shares of XYZ stock - Strike Price $45/per share, expiring on 1/15 - Premium Cost of $1. 2) Trader sells one call option and receives $100 [100 x $1 (premium cost)]. Result: The trader is in the options market for $200 (Amount Paid $300-$100 Amount Received). Advantage and Disadvantage of Bull Call Spread Pluses: The upside to this type of strategy is that the investor gets into the options market at a discount. Instead of paying the full price for a call, he or she can get a $100 discount from the short sale. This is also good for investors who prefer to watch the movement of an unfamiliar option. The investor is also controlling their losses. The most that a trader can lose in the example above is what he or she paid to enter the market, which is $200. Minuses: The downside in using a bull call spread is that it limits an investor's profit. Even if the price of the call option in the above example soars, the investor will only receive a fixed profit, which depends on the strike price of the call and buy orders. Examples Using the Buy and Sell Orders Above: XYZ Market price declines to $38. Result: Both the buy and sell call orders will expire OTM and worthless. The investor will receive no profit from the investment, and his or her total loss is $200, what was paid to enter the market. XYZ Market price increases to $46. Buy Order Result: The option expires ITM. The trader exercises his or her right to buy 100 shares at $40, and pays $4000 to whoever wrote the option. Sell Order Result: The option expires ITM. The trader sells the 100 shares to cover the call, and receives $4500 from the buyer. Total result: Trader receives $4500 (from sale) - Pays $4000(from buy) - $200 (to enter market) = $300 profit. Choosing the Correct Strike Price Looking at the example above, one can see that the strike price plays a significant role in profiting from a bull call spread. Choosing strike prices farther away from market prices can produce larger profits for investors, but they also take on more risk, since the option may not expire ITM when it expires.
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Traders who use a call backspread are betting that the market price of the underlying asset will go up substantially. The strategy involves buying two or more call options, and selling another, using the same underlying asset. Traders can decide which ratio works best for them, although the normal buy/sell ratio for this type of strategy is 2:1. Investors use a call backspread strategy to enter the market at low to no cost. Sometimes they even gain a credit, which they can use to offset any potential losses. At the same time, their returns are limitless, since the buy orders will always outweigh the sell orders. Thus, the maximum profit an investor can gain is infinite. How to Enter a Call Backspread A trader must perform two operations at the same time to enter a call backspread. Example: XYZ is trading at $43 (market price) Buying Two Calls First, a trader will need to buy two calls that are Out-Of-The-Money (OTM). 1) Call Option Available: XYZJan45 ($2) - One Option = 100 shares of XYZ stock - Strike Price $45/per share, expiring on 1/15 - Premium Cost of $2. 2) Trader buys two call options and pays $400 (200 x $2 (premium cost)). Selling a Call Next, the trader will sell a call that's In-The-Money (ITM). 1) Trader writes (sells) call option: XYZJan40 ($4) - One Option = 100 shares of XYZ stock - Strike Price $40/per share, expiring on 1/15 - Premium Cost of $4. 2) Trader sells one call option and receives $400 from the buyer. Result: The trader is in the options market, paying nothing to get in (Amount paid $400-$400 Amount Received). Advantage and Disadvantage of Call Backspread Pluses: The upside to this type of strategy is that there are no limits on the profit the investor can receive. If the market price of the underlying asset takes off, the investment will grow at the ratio implemented when entering the strategy, normally 2:1. Another advantage is that the cost of entering the market is either low to none, which depends on the difference between the two strike prices that the trader chooses when implementing the strategy. As a result, risk is limited. Minuses: The downside in using a call backspread is losing money when the price of the underlying asset falls. Losses start when the market price of the underlining asset is between the strike price of the sale order and the strike price of the buy order, plus the points necessary to cover the short. Examples Using the Buy and Sell Orders Above: XYZ Market price declines to $39. (OTM) Sell Order Result: The option expires OTM and worthless. Buy Order Result: The option expires OTM and worthless. Total result: The trader has no loss because he or she paid nothing to enter the market. If there was a credit in the account, the trader would keep it. If the trader paid more than he or she received to enter the strategy, the trader would lose that amount. XYZ Market price increases to $50. (ATM) Buy Order Result 1: The option expires ITM. The trader exercises his or her right to buy 200 shares at $45, and pays $9000 to whoever wrote the option. Sell Order Result: The option expires ITM. The trader uses 100 shares from the buy order to cover the call, and receives $4000 from whoever bought the option. Buy Order Result 2: The trader sells the remaining 100 shares at $50, market value and receives $5000. Total result: Trader receives $4000(from sale) - pays $9000 (from buy 1) + receives $5,000 (from buy 2) = $0 gain. Thus, the investment broke even when XYZ hit $50. XYZ Market price increases to $60. (ITM) Buy Order Result 1: The option expires ITM. The trader exercises his or her right to buy 200 shares at $45, and pays $9000 to whoever wrote the option. Sell Order Result: The option expires ITM. The trader uses 100 shares from the buy order to cover the call, and receives $4000 from whoever bought the option. Buy Order Result 2: The trader sells the remaining 100 shares at $60, market value and receives $6000. Total result: Trader receives $4000(from sale) - pays $9000 (from buy 1) + receives $6,000 (from buy 2) = $1000 gain. Choosing the Correct Strike Price In looking at the example above, one can see that the strike price plays a significant role in a call backspread strategy. If the trader had paid to enter the market, losses would occur when the market price of the underlying asset expires ITM for the sale order or below ATM for the buy order ($40-$50 respectively). Traders should choose strike prices that either gives him or her a credit or costs nothing when entering the market. Doing this will lower any potential loss if things go bad.
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Traders who buy index calls are betting that the market price of the underlying asset will go up. The strategy involves buying a call that's associated with a stock market index. The index will play the same role as the underlying asset does in normal options trading. Investors settle their exercised options in cash, so there are no assignment of assets. When traders buy index calls, they enter the market at lower costs, which limits their risk. The most a trader can lose is the amount that he or she pays in premiums. At the same time, there is no limit to how much profit an investor can make, since the potential growth of any stock index is infinite. How to Buy Index Calls A trader buys an index call in the same way that he or she would buy a regular call option, except that the underlying asset is not just one stock but rather a collection of many. Example: GOOG, is valued at $400 The following At-The-Money (ATM) call index option is available. GOOG Jan 400($4.50) - One Option contract - Strike Price $400, expiring on 1/15 - Premium Cost of $4.50 Trader buys one index call option and pays $450 [$100 x $4.50 (premium cost)]. Result: The trader is in the options market for $450, and he or she can exercise the GOOG option if it's In-The-Money (ITM) when it expires. Advantage and Disadvantage of Buying Index Calls: Pluses: The upside to this type of strategy is that there are no limits to the amount of profit an investor can make. If the stock index's value takes off, the investment will grow, and the trader will exercise and settle for cash when the option expires. Another advantage is that the cost of entering the market is very low. As a result, the lower buying cost limits a trader's overall risk and exposure. Minuses: The downside in buying index calls is the investor loses money when the value of the stock index falls. Although, the most an investor can lose is only the amount that he or she paid in premiums to buy the option. Examples of Buying an Index Call Using the (ATM) Order Above: GOOG increases to $420 (ITM). Result: The value of the option expires at $420 and is ITM. The investor will exercise the index call, receiving $2000 from the writer. [$420 (market value) - $400 (strike price) = 20 x $100] The trader's profit will total $1550, after subtracting the $450 in premiums paid. GOOG stays at to $400 (ATM). Result: The value of the option expires at $400, and even though it is breaks even-ATM, it's still worthless. The investor will receive no profit from the investment, and their total loss is $450, what was paid to enter the market. GOOG declines to $380 (OTM). Result: The value of the option expires worthless at $380 and is Out-of-The-Money (OTM). The investor will receive no profit from the investment, and their total loss is $450, what was paid to enter the market. Choosing the Correct Strike Price In looking at the example above, the trader bought the index call with a strike price ATM for $400. Investors can also buy index calls OTM, which are less expensive but carry more risk. Alternatively, a trader who purchases a call index with a strike price ITM will pay more, but they will also have a greater chance that the option will expire ITM. Examples of Buying an Index Call with Strike Price (OTM): GOOG is trading at $400. GOOG Jan 500($1.50) - One Option contract - Strike Price $500, expiring on 1/15 - Premium Cost of $1.50 Trader buys one index call option and pays $150 [$100 x $1.50 (premium cost)]. Result: The trader is in the options market for $150, but GOOG must increase to more than $501 (25%) for the above option to expire ITM. Examples of Buying an Index Call with Strike Price (ITM): GOOG is trading at $400. GOOG Jan 300($7) - One Option contract - Strike Price $300, expiring on 1/15 - Premium Cost of $7 Trader buys one index call option and pays $700 [$100 x $7 (premium cost)]. Result: The trader is in the options market for $700. GOOG can decrease to $371 (-23%) and the option above will still expire ITM. Any price above $371 will lead to substantial profits.
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Traders who use a bull put spread strategy are betting that the market price of the underlying asset will go up moderately or substantially. The strategy involves a selling put, and hedging it, by buying the same quantity of put options. The trader hopes that both options will expire Out-of-The-Money (OTM), allowing him or her to keep the premiums. Investors sometimes call a bull put spread strategy a credit spread, since premiums received from the put sale are larger than the cost of buying the put. Investors use this strategy to limit any potential losses. At the same time, the maximum profit an investor can gain is the amount of premiums the he or she collects. How to Enter a Bull Put Spread A trader must perform two operations at the same time to enter a bull put spread. Example: XYZ is trading at $43 Selling a Put First, the trader will sell a naked put that's In-The-Money (ITM). 1) Trader writes (sells) put option: XYZJan45 ($3) - One Option = 100 shares of XYZ stock - Strike Price $45/per share, expiring on 1/15 - Premium Cost of $3. 2) Trader sells one put option and receives $300 [100 x $3 (premium cost)]. Buying a Put Next, a trader will need to buy a put that's Out-Of-The-Money (OTM). 1) Put Option Available: XYZJan40 ($1) - One Option = 100 shares of XYZ stock - Strike Price $40/per share, expiring on 1/15 - Premium Cost of $1. 2) Trader buys one put option and pays $100 [100 x $1 (premium cost)]. Result: The trader is in the options market with a $200 credit in his or her account (Amount Received $300-$100 Amount paid). Advantage and Disadvantage of Bull Put Spread Pluses: The upside to this type of strategy is that the investor limits their losses. The most that a trader can lose will depend on the strike price of the put and buy orders. Minuses: The downside in using a bull put spread is that the investor's profit is also limited. The most that a trader can gain is what he or she collects in premiums after the buy and sell orders expire worthless. Examples Using the Buy and Sell Orders Above: Example: XYZ is trading at $43 XYZ Market price increases to $46. Result: Both the buy and sell put orders will expire OTM. The investor keeps the $200 credit in his or her account, collected from premiums when entering the market. XYZ Market price declines to $38. Sell Order Result: The option expires ITM. The trader buys 100 shares to cover the put, and pays $4500 to whoever bought the option. Buy Order Result: The option expires ITM. The trader exercises their right to sell 100 shares at $40, and receives $4000. Total result: Trader pays $4500(from sale order) - receives $4000(from buy order) + $200 (credit in account) = $300 loss. This amount is also the most the trader can lose on this investment. Choosing the Correct Strike Price Looking at the example above, one can see that the strike price plays a significant role in limiting losses from a bull put spread. Only expert traders should buy puts with strike prices closer to market prices when implementing a bull put spread strategy. Choosing an ATM buy order, instead of one that's OTM may reduce an investor's loss, but the person also takes on more risk, as strike prices closer from market prices, may not expire OTM.
