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In trades were traders either receive or pay premiums on trades, it is necessary to know which of the trades initiated involves long trades. These are the long legs of the trades.

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

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

Purchasing a put and selling a call at a lower strike price is an example of a zero cost collar trade.

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

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

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

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