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Showing results for tags 'options strategy'.
Found 24 results
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"The iron condor is an option type with limited profit or loss potential. This strategy is mainly used when a trader has a neutral outlook on the movement of the underlying security i.e. the trader expects the asset to stay range-bound for the duration of the trade.
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Shareholders are naturally concerned as the date of an earnings report for their favorite stock draws near. Stocks often experience their biggest declines in price after an earnings report fails to meet the expectations of investors. The recent price action in Apple Inc (AAPL) is a perfect illustration. This widely held stock lost more than 12% of its value following its most recent report. Now that many stocks have weekly options, there are new strategies available for earnings report protection. Weekly options can provide low-cost, short-term insurance to lock in a minimum sale price of a stock that is potentially vulnerable to an earnings setback. It has always been possible to use monthly put options to protect the price of a stock through the date of the company’s earnings report. The problem with monthly puts is that they can be quite expensive, particularly when the options expiration date is substantially later than the earnings report. Weekly options are cheaper and offer more flexibility in providing short-term protection. Not all stocks have weekly options, but when they are available, it is prudent to know how to employ them to circumvent an earnings report disaster. There is a cheap but effective strategy to protect the stock price through its earnings report by using a combination of weekly options. It is easiest to present this protective strategy as a combination of two separate trades. The first trade is the purchase of a weekly put option that expires on the closest Friday following the earnings report. For every 100 shares of stock, buy one contract with a strike price that is slightly below the current stock price. While this short-term, protective put provides for a minimum sale price of the stock, it may still seem relatively expensive because option prices often inflate ahead of an earnings report. A second trade is implemented to lower the cost basis of the protective put. The second trade uses weekly options that expire one week prior to the expiration date of the protective put. For every 100 shares of stock, sell one call contract with a strike price above the current stock price. Also sell an equal number of put contracts with a strike price that is one strike below that of the protective put. The premium received from the sale of these options will substantially lower the cost basis of the protective put. It is typically best to do these two trades about two weeks prior to the earnings report date. It is important to understand what has been achieved with these trades. The long stock together with the short call represents a covered call position. The long protective put together the short put represents a diagonal time spread. There is no margin requirement associated with either of these positions. Since the stock price tends to remain in a relatively narrow range prior to the earnings date, it is expected that both of the short options will expire worthless on the Friday prior to the earnings report date. This leaves the protective put in place for full effect through the following week. If the stock price falls significantly after the earnings report, there are two alternatives available to the shareholder. For those who are no longer interested in owning the stock, it can be liquidated at the strike price associated with the protective put. Some shareholders may want to maintain their stock position even after a pull back in price, in which case the protective put can be sold for a profit to offset most of the lost value in the stock. If the stock price soars after the report, the protective put will expire worthless, but there is no cap on the profit that can be achieved by the stock. Some comments are in order regarding the unexpected cases in which the stock price will have moved sufficiently (up or down) during the week before the earnings report that one of the short options will be in-the-money as its expiration date arrives. If the stock price is above the strike price of the short call, the shareholder can either buy back the short call and wait for the earning report or allow the stock to be called away for a profit. If the stock price is below the strike price of the short put, the short call will expire worthless and the diagonal put spread can be sold for a profit. In this latter case, the stock will no longer be protected through the earnings report. Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education and trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com.
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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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Dr. Edward Olmstead, Professor, Northwestern University Chief Options Strategist, Dr. Olmstead’s Options Trading Strategies There continues to be considerable interest in owning the stock of Facebook (FB) even though its performance has been a disappointment since its IPO in May. At its current level of $20.40, it might be a bargain, but it could also continue lower before it finds some significant support. Here is a cheap and safe way to own FB into January 2013 (and possibly beyond). This cheap and safe way to own FB into the beginning of 2013 uses a combination of options. Instead of buying the stock, a call option will used as a synthetic version of the stock that costs less than $6 per share while providing over 80% of the FB price movement. To protect the synthetic stock, a married put option will be used to limit loss in case the stock continues to move lower. Finally, the cost of the married put will be substantially reduced by selling a near-term strangle. Here are the details of the trade base upon a one contract position (100 shares): Buy 1 Jan (2013)16 call for $5.70 per share. Buy 1 Jan (2013) 20 put for $3.20 per share. To reduce the cost of the put, sell 1 Sept 22 call for $.90 per share and sell 1 Sept 18 put for $.70 a share. At the September expiration date (9/20), this trade will show a small profit if FB is trading between $18 and $26. After the September expiration date, this trade has the potential for unlimited profit with a maximum risk at the January expiration of only $3.30 per share. Actually, the maximum risk is less than $2.00 per share prior to the beginning of December. When the January expiration date is reached, you can continue following FB by repeating the synthetic stock/married put trade for another 5-6 months. You would also have the choice of buying FB stock for $16 per share. Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education material and option trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com. -
Traders who implement a box spread or long box strategy are taking advantage of overpriced assets by instantly liquidating (arbitraging) them to fair market value. The technique involves simultaneously entering a bull call and a bear put spread, using options with parallel strike prices. Traders can earn risk-free profit, as long as the expiration value of the box exceeds the cost to enter the spread.Moneyness Review for Puts and Calls Call Options: In-The-Money (ITM) = Strike price (less than) Market Price Out-of-The Money (OTM) = Strike price (more than) Market Price Put Options: In-The-Money (ITM) = Strike Price (more than) Market Price Out-of-The Money (OTM) = Strike Price (less than) Market Price Both Put and Call Options: At-The-Money (ATM) Strike Price (equals) Market Price How To Set Up A Box Spread Strategy Disney stock is worth $45 (market price) in June. Entering the Bull Call Spread 1) The trader writes (sells) a call option: DISJan50($1) - 100 shares of Disney stock - Strike Price $50 (OTM), expiring in 30 days - Premium Cost of $1 2) The trader buys a call option: DISJan40($6) - 100 shares of Disney stock - Strike Price $40 (ITM), expiring in 30 days - Premium Cost of $6 3) The trader pays a total of $500 to enter the bull call spread [$600 (paid for call purchase) - $100 (received from call sale)] Entering the Bear Put Spread 1) Trader writes (sells) a put option: DISJan40($1.50) - 100 shares of Disney stock - Strike Price $40 (OTM), expiring in 30 days - Premium Cost of $1.50 2) Trader buys a put option: DISJan50($6) - 100 shares of Disney stock - Strike Price $50 (ITM), expiring in 30 days - Premium Cost of $6 3) The trader pays a total of $450 to enter the bull call spread [$600 (paid for call purchase) - $150 (received from call sale)] Total cost to enter the market (Box Spread Strategy): $950 [$500 (cost of bull spread) + $150 (cost of bear spread)] Computing Expiration Value To earn risk-free profit, the expiration value of the box must exceed the cost to enter the box spread. The expiration value is simply the difference between the higher and lower strike prices, multiplied by 100. This example's box spread expiration value is $1000 [$1000= $50 (high) -$40 (low) X 100], which is higher than the $950 cost to enter the market. Result one: Disney stays at $45 (ATM) in July. a) Both the put and 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. c) The put option purchased is ITM. The trader exercises his or her right to sell the 100 shares at $50, receives $5000 from the seller. d) The trader's profit is $50 after subtracting the cost to enter the market from the gain. [$50 = $5000 (received from put sale) - $4000 (paid to call seller) - $950 (cost to enter market)] Result two: Disney rallies to $50 in July. a) Both the put and 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. c) The put option purchased is ITM. The trader exercises his or her right to sell the 100 shares at $50, receives $5000 from the seller d) The trader's profit is $50 after subtracting the cost to enter the market from the gain. [$50 = $5000 (received from put sale) - $4000 (paid to call seller) - $950 (cost to enter market)] e) The trader's profit is $50 after subtracting the cost to enter the market from the gain. [$50 = $5000 (received from put sale) - $4000 (paid to call seller) - $950 (cost to enter market)] Result three: Disney falls (crashes) to $40 in July. a) The put and call options sold expire worthless (OTM), as well as the call option purchased. b) The put option purchased is ITM. c) The trader buys 100 Disney shares in the open market, paying $4000 d) The trader sells the 100 shares to the writer at $50, receiving $5000 from the seller. e) The trader's profit is $50 after subtracting the cost to enter the market from the gain. [$50 = $5000 (received from writer) - $4000 (paid for shares) - $950 (cost to enter market)] Advantages and Disadvantages of Implementing a Box Spread Strategy: Pluses: The upside to this type of strategy is that the investor will always make a small profit in any market situation, risk-free. The trader is just settling the overpriced options to fair market value. Minuses: There is no downside in carrying out a box spread strategy, since it risk-free. However, traders must be able to quickly recognize options with expiration values that exceed the investment's costs.
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Traders who implement an out-of-the-money naked call strategy are betting that the market price of an option's underlying asset will fall. The technique involves selling an out-of-the-money call option, hoping that it will expire out-of-the money. Traders who use this type of bear option strategy do not need cash to enter the market. However, the terms of their call sale will limit their profit potential. On the contrary, an investor's loss potential is infinite. If the market price rallies, traders who use this strategy will incur large monetary losses. Moneyness Review for Calls Out-of-The Money (OTM) = Strike price (more than) Market Price In-The-Money (ITM) = Strike price (less than) Market Price At-The-Money (ATM) Strike price (equals) Market Price How to Carry Out An Out-Of-The-Money Naked Call Strategy Disney stock is worth $48 (market price) in June. 1) Trader sells the call option: DISJul50($3) - 100 shares of Disney stock - Strike Price $40, out-of-the-money (OTM), expiring in 30 days - Premium Cost of $3 3) Trader receives a $300 credit when entering the market. [$300 (received from call buyer)] Total cost to enter the market: -$300 Result one: Disney stock rises (rallies) to $68 in July. a) The call option sold expires ITM, and the investor who bought the trader's call option exercises his or her right to buy 100 shares at $50. b) The trader purchases 100 Disney shares in the open market to cover the short sale, paying $6800, and then sells the shares to the buyer, receiving $5000. c) The trader loses a total of $1500 after adding the premium credit taken when entering the market to the loss. [-$1500 = $1800 (loss from call) + $300 (credit to enter market)] Result two: Disney stock falls (crashes) to $28 in July. a) The call option sold expires worthless. (OTM) b) The trader's profits totals $300 after keeping the credit earned when entering the market. Result three: Disney stock rises (moderately) to $53 in July. a) The call option sold expires ITM, and the investor who bought the trader's call option exercises his or her right to buy 100 shares at $40. b) The trader purchases 100 Disney shares in the open market to cover the short sale, paying $5300, and then sells the shares to the buyer, receiving $5000. c) The trader loses a total of $0 after adding the premium credit taken when entering the market to the loss. [$0 = $300 (loss from call) + $300 (credit to enter market)] Advantages and Disadvantages in Carrying Out An Out-Of-The-Money Naked Call Strategy Pluses: The upside to this type of strategy is that investors do not need cash to enter the market. They are betting that the asset's market value will crash and the call will expire OTM, allowing them to keep the credit earned when entering the market. Traders can also use the credit to offset losses in moderate bull markets or to reduce total loss if the underlying asset's value rallies. Minuses: The downside in using an out-of-the-money naked call strategy is that it exposes traders to infinite potential losses when the market rallies, since any asset's market price could theoretically rise as much as demand permits. The method also limits the trader's profit potential to only the premiums that he or she receives when entering the market.
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Traders who implement an in-the-money naked call strategy are betting that the market price of an option's underlying asset will fall. The technique involves selling an in-the-money call option, hoping that it will expire out-of-the money. Traders who employ this type of bear option strategy do not need cash to enter the market. However, the terms of their call sale will limit their profit potential. On the contrary, an investor's loss potential is infinite. If the market price rallies, traders who use this strategy will incur large monetary losses. Moneyness Review for Calls Out-of-The Money (OTM) = Strike price (more than) Market Price In-The-Money (ITM) = Strike price (less than) Market Price At-The-Money (ATM) Strike price (equals) Market Price How to Carry Out An In-The-Money Naked Call Strategy Disney stock is worth $48 (market price) in June. 1) Trader sells the call option: DISJul40($10) - 100 shares of Disney stock - Strike Price $40, in-the-money (ATM), expiring in 30 days - Premium Cost of $10 2) Trader receives a $1000 credit when entering the market [$1000 (received from call buyer)] Total cost to enter the market: -$1000 Result one: Disney stock rises (rallies) to $68 in July a) The call option sold expires ITM, and the investor who bought the trader's call option exercises his or her right to buy 100 shares at $40. b) The trader purchases 100 Disney shares in the open market to cover the short sale, paying $6800, and then sells the shares to the buyer, receiving $4000. c) The trader loses a total of $1800 after subtracting the premium credit taken when entering the market. [-$1800 = $1000 (credit to enter market) - $2800 (loss from call)] Result two: Disney stock falls (moderately) to $45 in July. a) The call option sold expires ITM, and the investor who bought the trader's call option exercises his or her right to buy 100 shares at $40. b) The trader purchases 100 Disney shares in the open market to cover the short sale, paying $4500, and then sells the shares to the buyer, receiving $4000. c) The trader's profit totals $500 after subtracting the loss from premium credit taken when entering the market. [$500 = $1000 (credit to enter market) - $500 (loss from call)] Result three: Disney stock falls (crashes) to $28 in July. a) The call option sold expires worthless (OTM). b) The trader's profits totals $1000 after keeping the credit earned when entering the market. Advantages and Disadvantages in Carrying Out An In-The-Money Naked Call Strategy Pluses: The upside to this type of strategy is that investors do not need cash to enter the market. They are betting that the asset's market value will crash and the call will expire OTM, allowing them to keep the credit earned when entering the market. Traders can also use the credit to gain a profit in moderate bull markets or to offset losses if the underlying asset's value rallies. Minuses: The downside in using an in-the-money naked call strategy is that it exposes traders to high-risk losses when the market rallies, since any asset's market price could theoretically rise as much as demand permits. The method also limits the trader's profit potential to only what he or she received when entering the market.
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Traders who implement covered put strategies are betting that the market price of an option's underlying asset will fall. The technique involves short selling owned assets and selling a put option for the same amount of shares. The loss-risk in this strategy is unlimited, if the market price of the underlying asset rises. Traders who employ covered put strategies use their assets as leverage to earn a fixed premium credit, which is received from the put buyer when entering the market. Moneyness Review for Puts Out-of-The Money (OTM) = Strike Price (less than) Market Price In-The-Money (ITM) = Strike Price (more than) Market Price At-The-Money (ATM) = Strike Price (equals) Market Price How to Carry out Covered Puts Strategies Disney stock is worth $45 (market price) in June. 1) Trader short sells 100 shares of Disney stock 2) Trader sells the put option: DISJul45($2) - 100 shares of Disney stock - Strike Price $45, at-the-money (ATM), expiring in 30 days - Premium Cost of $2 3) Trader receives a $200 credit when entering the market [$200 (received from put buyer)] Total cost to enter the market: -$200 Result one: Disney stock remains at $45 in July a) The put option sold expires worthless (OTM) b) The short sale realizes no gain. c) Trader profits total $200 after keeping the credit earned when entering the market. Result two: Disney stock falls to $40 in July. a) The short sale realizes a $500 gain, and the trader receives $500. b) The put option sold expires ITM. c) The investor who bought the trader's put option exercises his or her right to sell 100 shares at $45. The trader pays $4500 to the buyer, and receives 100 Disney shares. d) The trader immediately sells the 100 shares in the open market and receives $4000. e) The trader makes a total profit of $200 after keeping the credit earned when entering the market. [$200 = $4000 (received for 100 shares) + $500 (gain from short sale) + $200 (credit to enter market) - $4500 (paid for 100 shares)] Result three: Disney stock rises to $55 in July. a) The short sale realizes a $1000 loss, and the trader pays $1000. b) The put option sold expires worthless (OTM) c) The trader loses $800 after adding the credit earned when entering the market. [-$800 = $200 (credit to enter market) - $1000 (loss from short sale) ] Advantages and Disadvantages in Carrying Out Covered Put Strategies Pluses: The upside to this type of strategy is that the investor will gain limited profits if the put option expires at-the-money or expires at any price below it. Profits remain the same, independent of how low the market drops. Covered put strategies also earn traders a credit when entering the market, which can be used to offset losses if the underlying asset's market price rallies. Minuses: The downside in using covered put strategies is that the method has an unlimited loss-risk potential. The short sale exposes traders to high risk when the market rallies, since any asset's market price could theoretically rise as much as demand permits. The method also limits the trader's profit potential to only what he or she received when entering the market. Investors can not profit from their short sale if the market crashes because the put option would offset any gains.
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Traders who buy an index put are betting that the market prices of the index's underlying assets will fall. The strategy involves buying a put that's linked to a stock market index. The underlying index plays the same role as an asset does in options trading. Investors settle all index options in cash, and there are no assignments of assets. The profit potential and risk involved when using this strategy varies. Traders buying index puts limit their losses to only the amount paid in premiums when entering the market. On the contrary, the trader's profit potential is unlimited, since any stock index can theoretically fall up to a zero value. Moneyness Review for Puts Out-of-The Money (OTM) = Strike Price (less than) Market Price In-The-Money (ITM) = Strike Price (more than) Market Price At-The-Money (ATM) Strike Price (equals) Market Price Understanding the Differences Between Index Options and Regular Options Buying an index option functions the same way as in buying a regular option. The difference is that the underlying assets associated with index options are many compared to just the one underlying asset that's associated with a regular stock option. Example: The S&P500 is worth $4000 and its index option, SPX (Index Option), is valued at $400 (1/100 of the S&P500). How to Buy Index Puts (ATM) The S&P500 is worth $4000 (market price) in June. 1) Trader buys an index put option: SPXDec400($4.00) - One S&P500 index option with a contract multiplier of $100 - Strike Price $400, at-the-money (ATM), expiring in 180 days - Premium Cost of $4.00 2) Trader pays $400 for the put (100 x $4.00 (premium cost)). Total cost to enter the market: $400 Result one: SPX falls to $380 in December. a) The put option purchased expires ITM. The trader exercises his or her right to sell 100 shares at $40. b) The difference between the option's strike price and the SPX is $20 (strike price: $400 - SPX: $380). There is no assignment of assets, so the put seller uses the contract multiplier (CM) to figure the trader's cash settlement. c) The seller pays the trader $2000 [100 (CM) x $20 (difference in prices)]. Subtracting the $400 credit paid to enter the market reduces the trader's profit to $1600. Result two: SPX rises to $420 in December. a) The put option purchased expires worthless (OTM), and the trader lets the option expire. b) The trader loses the premiums paid to enter the market. In this example, the trader's total loss equals $400, which is the maximum loss for this type of trade, independent of how high the market rallies. Advantages and Disadvantages in Buying Index Puts: Pluses: The upside in buying index puts is that traders can control their losses. They pay a premium when entering the market, which is the maximum that they can lose. Another benefit in using this method is that traders can gain unlimited profits for a limited amount of risk. Minuses: The only downside in buying index puts happens when the market rallies and the put option expires worthless. In this case, the trader would lose what he or she paid to enter the market.
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Traders who implement a bear put spread are betting that the market price of an option's underlying asset will fall. The technique involves buying and selling put options for the same underlying asset. The profit potential and risk involved when using this strategy are both limited. The bear put spread strategy limits an investor's profits to the amounts received when settling the put options, and the maximum loss only equals what he or she pays to enter the market. Moneyness Review for Puts Out-of-The Money (OTM) = Strike price (less than) Market Price In-The-Money (ITM) = Strike price (more than) Market Price At-The-Money (ATM) Strike price (equals) Market Price How to Carry Out a Bear Put Spread Disney stock is worth $38 (market price) in June. 1) Trader sells a put option: DISJul35($1) - 100 shares of Disney stock - Strike Price $35, out-of-the-money (OTM), expiring in 30 days - Premium Cost of $1 2) Trader buys a put option: DISJul40($3) - 100 shares of Disney stock - Strike Price $40, in-the-money (ITM), expiring in 30 days - Premium Cost of $3 3) Trader pays a total of $200 to enter the market [$300 (paid to purchase put) - $100 (received from put sale)] Total cost to enter the market: $200 Result one: Disney falls to $34 a) The put option sold expires ITM. The investor who bought the trader's put option exercises his or her right to sell 100 shares at $35. The trader pays $3500 to the buyer, and receives 100 Disney shares. b) The put option bought is ITM. The trader exercises his or her right to sell 100 shares at $40 to the investor who wrote the put option. The trader sells his or her Disney 100 shares and receives $4000 from the writer. c) The trader makes a total profit of $300 after subtracting the costs to enter the market. [$300 = $4000 (received for 100 shares) - $3500 (paid for 100 shares) - $200 (cost to enter market)] Result two: Disney rises to $42 a) The put option bought expires worthless (OTM) b) The put option sold expires worthless (OTM) c) Trader loses a total of $200 after adding the amount paid to enter the market. Result three: Disney falls to $38 (Breakeven) a) The put option sold expires worthless (OTM) b) The trader buys 100 Disney shares in the open market for $3800. c) The put option bought is ITM. The trader exercises his or her right to sell 100 shares at $40 to the investor who wrote the put option. The trader sells his or her Disney 100 shares and receives $4000 from the writer. d) The trader breaks even, making a total profit of $0 after subtracting the costs to enter the market. [$0 = $4000 (received for 100 shares) - $3800 (paid for 100 shares) - $200 (cost to enter market)] Advantages and Disadvantages in Carrying Out a Bear Put Spread: Pluses: The upside to this type of strategy is that the investor knows exactly how much he or she will win or lose before carrying out the bear put spread strategy. The investor also knows the strategy's breakeven point, which is the strike price of the put option purchased subtracted from the cost to enter the market. Minuses: The downside in using bear put spread strategy is that the method limits an investor's profits. If the market value of the underlying stock falls significantly, the trader will only gain the price difference between the two put option's strike prices.
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Traders who implement a bear call spread strategy are betting that the market price of an option's underlying asset will fall. The technique involves selling two call options, hoping that both will expire out-of-the-money. Traders who employ this type of bear option strategy do not need cash to enter the trades and receive a credit when entering the market. The bear call spread limits both an investor's profit potential and their risk for losses. Moneyness Review for Calls Out-of-The-Money (OTM) = Strike price (more than) Market Price In-The-Money (ITM) = Strike price (less than) Market Price At-The-Money (ATM) Strike price (equals) Market Price How to Carry Out An Out-Of-The-Money Naked Call Strategy Disney stock is worth $37 (market price) in June. 1) Trader sells the call option: DISJul35($3) - 100 shares of Disney stock - Strike Price $35, in-the-money (ITM), expiring in 30 days - Premium Cost of $3 2) Trader buys the call option: DISJul40($1) - 100 shares of Disney stock - Strike Price $40, out-of-the-money (OTM), expiring in 30 days - Premium Cost of $1 3) Trader receives a $200 credit when entering the market. [$200 = $300 (received from call sale)- $100 (paid for call)] Total cost to enter the market: -$200 Result one: Disney stock falls (crashes) to $28 in July. a) The both of call option sold expires worthless. (OTM) b) The trader's profits totals $200 after keeping the credit earned when entering the market. Result two: Disney stock rises (rallies) to $42 in July. a) The call option purchased expires ITM, and the trader exercises his or her right to buy 100 shares at $40 from the investor who sold the call, paying $4000. b) The call option sold expires ITM, and the investor who bought the trader's call option exercises his or her right to buy 100 the shares at $35. c) The trader loses a total of $300 after adding the premium credit taken when entering the market to the loss. [-$300 = $4000 (paid for shares) - $3500 (received for shares) - $200 (credit to enter market)] Result three: Disney stock remains at $37 in July. a) The call option purchased expires worthless. (OTM) b) The call option sold expires ITM. c) The trader purchases 100 Disney shares in the open market to cover the short sale, paying $3700. d) The call option sold expires ITM, and the investor who bought the trader's call option exercises his or her right to buy 100 the shares at $35. e) The trader loses a total of $0 after adding the premium credit taken when entering the market to the loss. [$0 = $3700 (paid for shares) - $3500 (received for shares) + $200 (credit to enter market)] Advantages and Disadvantages in Carrying Out A Bear Call Spread: Pluses: The upside to this type of strategy is that investors do not need cash to enter the market and it limits the investor's potential for loss. They are betting that the asset's market value will crash and that both of the calls will expire OTM. This allows them to keep the credit earned when entering the market. Traders can also use the credit to offset losses in moderate bull markets. Minuses: The downside in using a bear call spread happens when the underlying asset's market price rallies above the short call's strike price, producing a loss. However, the strategy limits the trader's losses to only the strike price of the call purchased.
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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 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.
