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THE EQUITY OPTIONS STRATEGY GUIDE
Isaac Pope 3 years ago Views:
1 THE EQUITY OPTIONS STRATEGY GUIDE
3 Table of Contents Introduction 2 Option Terms and Concepts 4 What is an Option? 4 Long 4 Short 4 Open 4 Close 5 Leverage and Risk 5 In-the-money, At-the-money, Out-of-the-money 5 Time Decay 6 Expiration Day 6 Exercise 6 Assignment 6 What s the Net? 7 Early Exercise/Assignment 7 Volatility 7 Strategies 8 Long Call 8 Long Put 10 Married Put 12 Protective Put 14 Covered Call 16 Cash-Secured Put 18 Bull Call Spread 20 Bear Put Spread 22 Collar 24 Glossary 26 For More Information 28 1
4 Introduction The purpose of this booklet is to provide an introduction to some of the basic equity option strategies available to option and/or stock investors. Exchange-traded options have many benefits including flexibility, leverage, limited risk for buyers employing these strategies, and contract performance guaranteed by The Options Clearing Corporation (OCC). Options allow you to participate in price movements without committing the large amount of funds needed to buy stock outright. Options can also be used to hedge a stock position, to acquire or sell stock at a purchase price more favorable than the current market price, or, in the case of writing (selling) options, to earn premium income. Options give you options. You re not just limited to buying, selling or staying out of the market. With options, you can tailor your position to your own financial situation, stock market outlook and risk tolerance. All option contracts traded on U.S. securities exchanges are issued, guaranteed and cleared by OCC. OCC is a registered clearing corporation with the SEC and plays a critical role in the U.S. capital markets as the exclusive clearinghouse for exchange-traded options. OCC s conservative financial and procedural safeguards, substantial and readily available financial resources, and its members mutual incentives protect the organization from settlement losses. OCC is the common clearing entity for all securities exchange-traded option transactions. Once OCC is satisfied that there are matching trades from a buyer and a seller, it severs the link between the parties. In effect, OCC becomes the buyer to the seller and the seller to the buyer. As a result, the seller can ordinarily buy back the same option he has written, closing out the initial transaction and terminating his obligation to deliver the underlying stock or exercise value of the option to OCC and this will in no way affect the right of the original buyer to sell, hold or exercise his option. All premium and settlement payments are made between OCC and its clearing members. In turn, OCC clearing members settle independently with their customers (or brokers representing customers). Whether you are a conservative or growth-oriented investor, or even a short-term, aggressive trader, your broker can help you select an appropriate options strategy. The strategies presented in this booklet do not cover all, or even a significant number, of the possible strategies utilizing options. These are the most basic strategies, however, and will serve well as building blocks for more complex strategies. Despite their many benefits, options are not suitable for all investors. Individuals should not enter into option transactions until they have read and understood the risk disclosure document, Characteristics and Risks of Standard ized Options, which outlines the purposes and risks thereof. Further, if you have only limited or no experience with options, or have only a limited understanding of the terms of option contracts and basic option pricing theory, you should examine closely another industry document, Understanding Equity Options. These documents, and many others, can be obtained from your brokerage firm or by either calling OPTIONS or visiting An investor who desires to utilize options should have well- 2
5 defined investment objectives suited to his particular financial situation and a plan for achieving these objectives. Options are traded on several U.S. securities exchanges. Like trading in stocks, options trading is regulated by the SEC. These exchanges seek to provide competitive, liquid, and orderly markets for the purchase and sale of standardized options. It must be noted that, despite the efforts of each exchange to provide liquid markets, under certain conditions it may be difficult or impossible to liquidate an option position. Please refer to the disclosure document for further discussion on this matter. There are tax ramifications of buying or selling options that should be discussed thoroughly with a broker and/or tax advisor before engaging in option transactions. OCC publishes another document, Taxes & Investing: A Guide for the Individual Investor, which can serve to enlighten both you and your tax advisor on option strategies and the issue of taxes. This booklet can also be obtained from your brokerage firm or by either calling OPTIONS or visiting All strategy examples described in this book assume the use of regular, listed, American-style equity options, and do not take into consideration margin requirements, transaction and commission costs, or taxes in their profit and loss calculations. You should be aware that in addition to Federal margin requirements, each brokerage firm may have its own margin rules that can be more detailed, specific or restrictive. In addition, each brokerage firm may have its own guidelines with respect to commissions and transaction costs. It is up to you to become fully informed on the specific procedures, rules and/or fee and commission schedules of your specific brokerage firm(s). The successful use of options requires a willingness to learn what they are, how they work, and what risks are associated with particular options strategies. Individuals seeking expanded investment opportunities in today s markets will find options trading challenging, often fast moving, and potentially rewarding. Note: An options contract may be for 100 shares of an underlying stock or exchange traded fund (ETF). For educational purposes, however, this booklet will refer to underlying shares simply as stock. March
6 Option Terms and Concepts What is an Option? Although this level of knowledge is assumed, a brief review of equity option basics is in order: An equity option is a contract which conveys to its holder (buyer) the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put) shares of the underlying security at a specified price (the strike price) on or before a given date (expiration day). After this given date, the option ceases to exist. The seller (writer) of an option is, in turn, obligated to sell (in the case a call) or buy (in the case of a put) the shares to (or from) the buyer of the option at the specified price upon the buyer s request. Equity option contracts usually represent 100 shares of the underlying stock. Strike prices (or exercise prices) are the stated price per share for which the underlying security may be purchased (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract. The strike price, a fixed specification of an option contract, should not be confused with the premium, the price at which the contract trades, which fluctuates daily. Adjustments to an equity option contract s size and/ or strike price may be made to account for stock splits, mergers or other corporate actions. Generally, at any given time a particular equity option can be bought with one of four expiration dates. Equity option holders do not enjoy the rights due stockholders e.g., voting rights, regular cash or special dividends, etc. A call holder must exercise the option and take ownership of underlying shares to be eligible for these rights. Buyers and sellers in the exchange markets, where all trading is conducted in the competitive manner of an auction market, set option prices. have purchased 1,000 shares of stock and are holding that stock in your brokerage account, or elsewhere, you are long 1,000 shares of stock. When you are long an equity option contract: You have the right to exercise that option at any time prior to its expiration. Your potential loss is limited to the amount you paid for the option contract. Short With respect to this booklet s usage of the word, short describes a position in options in which you have written a contract (sold one that you did not own). In return, you now have the obligations inherent in the terms of that option contract. If the holder exercises the option, you have an obligation to meet. If you have sold the right to buy 100 shares of a stock to someone else, you are short a call contract. If you have sold the right to sell 100 shares of a stock to someone else, you are short a put contract. When you write an option contract you are, in a sense, creating it. The writer of an option collects and keeps the premium received from its initial sale. When you are short (i.e., the writer of) an equity option contract: You can be assigned an exercise notice at any time during the life of the option contract. All option writers should be aware that assignment prior to expiration is a distinct possibility. Your potential loss on a short call is theoretically unlimited. For a short put, the risk of loss is limited by the fact that the stock cannot fall below zero in price. Although technically limited, this potential loss could still be quite substantial if the underlying stock declines significantly in price. Long With respect to this booklet s usage of the word, long describes a position (in stock and/or options) in which you have purchased and own that security in your brokerage account. For example, if you have purchased the right to buy 100 shares of a stock, and are holding that right in your account, you are long a call contract. If you have purchased the right to sell 100 shares of a stock, and are holding that right in your account, you are long a put contract. If you Open An opening transaction is one that adds to, or creates a new trading position. It can be either a purchase or a sale. With respect to an option transaction, consider both: Opening purchase a transaction in which the purchaser s intention is to create or increase a long position in a given series of options. Opening sale a transaction in which the seller s intention is to create or increase a short position in a given series of options. 4
7 Close A closing transaction is one that reduces or eliminates an existing position by an appropriate offsetting purchase or sale. With respect to an option transaction: Closing purchase a transaction in which the purchaser s intention is to reduce or eliminate a short position in a given series of options. This transaction is frequently referred to as covering a short position. Closing sale a transaction in which the seller s intention is to reduce or eliminate a long position in a given series of options. Note: An investor does not close out a long call position by purchasing a put, or vice versa. A closing transaction for an option involves the purchase or sale of an option contract with the same terms, and on any exchange where the option may be traded. An investor intending to close out an option position must do so by the end of trading hours on the option s last trading day. Leverage and Risk Options can provide leverage. This means an option buyer can pay a relatively small premium for market exposure in relation to the contract value (usually 100 shares of underlying stock). An investor can see large percentage gains from comparatively small, favorable percentage moves in the underlying equity. Leverage also has downside implications. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage can magnify the investment s percentage loss. Options offer their holders a predetermined, set risk. However, if the holder s options expire with no value, this loss can be the entire amount of the premium paid for the option. An uncovered option writer, on the other hand, may face unlimited risk. In-the-money, At-the-money, Out-of-the-money The strike price, or exercise price, of an option determines whether that contract is in-the-money, at-the-money, or outof-the-money. If the strike price of a call option is less than the current market price of the underlying security, the call is said to be in-the-money because the holder of this call has the right to buy the stock at a price which is less than the price he would have to pay to buy the stock in the stock market. Likewise, if a put option has a strike price that is greater than the current market price of the underlying security, it is also said to be in-the-money because the holder of this put has the right to sell the stock at a price which is greater than the price he would receive selling the stock in the stock market. The converse of in-the-money is, not surprisingly, out-of-the-money. If the strike price equals the current market price, the option is said to be at-the-money. The amount by which an option, call or put, is inthe-money at any given moment is called its intrinsic value. Thus, by definition, only in-the-money options have intrinsic value. An at-the-money or out-of-the-money option has no intrinsic value. This does not mean, however, these options can be obtained at no cost. Any amount by which an option s total premium exceeds intrinsic value (if any) is called the time value portion of the premium. It is the time value portion of an option s premium that is affected by fluctuations in volatility, interest rates, dividend amounts and the passage of time. The premiums of at-the-money and out-of-the-money options, by definition, consist entirely of time value. Equity call option: In-the-money = strike price less than stock price At-the-money = strike price same as stock price Out-of-the-money = strike price greater than stock price Equity put option: In-the-money = strike price greater than stock price At-the-money = strike price same as stock price Out-of-the-money = strike price less than stock price Option Premium = Intrinsic Value + Time Value 5
8 Time Decay Generally, the longer the time remaining until an option s expiration, the higher its premium will be. This is because the longer an option s lifetime, greater is the possibility that the underlying stock might make a favorable price move. All other factors affecting an option s price remaining the same, the time value portion of an option s premium will decrease (or decay) with the passage of time. Note: This time decay increases rapidly in the last several weeks of an option s life. When an option expires in-the-money, it is generally worth only its intrinsic value. Expiration Day The expiration date is the last day an option exists. For listed monthly equity options, this is the third Friday of the expiration month. Please note that this is the deadline by which brokerage firms must submit exercise notices to OCC; however, the exchanges and brokerage firms have rules and procedures regarding deadlines for an option holder to notify his brokerage firm of his intention to exercise. This deadline, or expiration cut-off time, is generally on the third Friday of the month at some time after the close of the market. Please contact your brokerage firm for specific deadlines. The last day expiring equity options generally trade is also on the third Friday of the month. If that Friday is an exchange holiday, the last trading day will be one day earlier, Thursday. Exercise If the holder of an American-style option decides to exercise his right to buy (in the case of a call) or to sell (in the case of a put) the underlying shares of stock, the holder must direct his brokerage firm to submit an exercise notice to OCC. In order to ensure that an option is exercised on a particular day other than expiration, the holder must notify his brokerage firm before its exercise cut-off time for accepting exercise instructions on that day. Note: Various firms may have their own cut-off times for accepting exercise instructions from customers. These cut-off times may be specific for different classes of options and different from OCC s requirements. Cut-off times for exercise at expiration and for exercise at an earlier date may differ as well. Once OCC has been notified that an option holder wishes to exercise an option, it will assign the exercise notice to a Clearing Member for an investor, this is generally his brokerage firm with a customer who has written (and not covered) an option contract with the same terms. OCC will choose the firm to notify at random from the total pool of such firms. When an exercise is assigned to a firm, the firm must then assign one of its customers who has written (and not covered) that particular option. Assignment to a customer will be made either randomly or on a first-in firstout basis, depending on the method used by that firm. You can find out from your brokerage firm which method it uses for assignments. Assignment The holder of a long American-style option contract can exercise the option at any time until the option expires. It follows that an option writer may be assigned an exercise notice on a short option position at any time until that option expires. If an option writer is short an option that expires in-the-money, assignment on that contract should be expected, call or put. In fact, some option writers are assigned on such short contracts when they expire exactly at-the-money. This occurrence is generally not predictable. To avoid assignment on a written option contract on a given day, the position must be closed out before that day s market close. Once assignment has been received, an investor has absolutely no alternative but to fulfill his obligations from the assignment per the terms of the contract. An option writer cannot designate a day when assignments are preferable. There is generally no exercise or assignment activity on options that expire out-of-themoney. Holders generally let them expire with no value. What s the Net? When an investor exercises a call option, the net price paid for the underlying stock on a per share basis will be the sum of the call s strike price plus the premium paid for the call. Likewise, when an investor who has written a call contract is assigned an exercise notice on that call, the net price received on a per share basis will be the sum of the call s strike price plus the premium received from the call s initial sale. When an investor exercises a put option, the net price received for the underlying stock on per share basis will be the sum of the put s strike price less the premium paid for the put. Likewise, when an investor who has written a put contract is assigned an exercise notice on that put, the net price paid for the underlying stock on per share basis will be the sum of the put s strike price less the premium received from the put s initial sale. Early Exercise / Assignment For call contracts, holders might exercise early so that they can take possession of the underlying stock in order to receive a dividend. Check with your brokerage firm and/or tax advisor on the advisability of such an early call exercise. 6
9 It is therefore extremely important to realize that assignment of exercise notices can occur early days or weeks in advance of expiration day. As expiration nears, with a call considerably in-the-money and a sizeable dividend payment approaching, this can be expected. Call writers should be aware of dividend dates, and the possibility of an early assignment. When puts become deep in-the-money, most professional option traders will exercise them before expiration. Therefore, investors with short positions in deep in-themoney puts should be prepared for the possibility of early assignment on these contracts. Volatility Volatility is the tendency of the underlying security s market price to fluctuate either up or down. It reflects the magnitude of price fluctuation; it does not imply a bias toward price movement in one direction or the other. Thus, it is a major factor in determining an option s premium. The higher the volatility of the underlying stock, the higher the premium because there is a greater possibility that the option will move in-the-money. Generally, as the volatility of an underlying stock increases, the premiums of both calls and puts overlying that stock increase, and vice versa. Strategies Each sample strategy is accompanied by a graph of profit and loss at the options expiration. The X-axis represents the price level of an underlying stock. The Y-axis represents profit and loss, above and below the X-axis intersection respectively. Each graph will be labeled with a break-even point (BEP) for the strategy being illustrated. These graphs are not drawn to any specific scale and are meant only for an illustrative and educational purpose. In addition, each strategy includes a discussion regarding an investor s alternatives before and at expiration. The alternatives mentioned are only among the more basic possibilities. With a fuller understanding of option concepts, an investor will appreciate that alternatives available to him are many. It is beyond the scope of this booklet to make any specific recommendations as to maintaining your option positions. Note: Net profit and loss amounts discussed in the following strategy examples do not include taxes, commissions or transaction costs in their formulations. Long Call Purchasing calls has remained the most popular strategy 7
10 with investors since listed options were first introduced. Before moving into more complex bullish and bearish strategies, an investor should thoroughly understand the fundamentals about buying and holding call options. Market Opinion? Bullish to very bullish. When to Use? Bullish Speculation This strategy appeals to an investor who is generally more interested in the dollar amount of his initial investment and the leveraged financial reward that long calls can offer. The primary motivation of this investor is to realize financial reward from an increase in price of the underlying security. Experi ence and precision are key to selecting the right option (expiration and/or strike price) for the most profitable result. In general, the more out-of-the-money the call, the more bullish the strategy, as bigger increases in the underlying stock price are required for the option to reach the break-even point. As Stock Substitute An investor who buys a call instead of purchasing the under- lying stock considers the lower dollar cost of purchasing a call contract versus an equivalent amount of stock as a form of insurance. The uncommitted capital is insured against a decline in the price of the call option s underlying stock, and can be invested elsewhere. This investor is generally more interested in the number of shares of stock underlying the call contracts purchased than in the specific amount of the initial investment one call option contract for each 100 shares he wants to own. While holding the call option, the investor retains the right to purchase an equivalent number Long Call + Profit Loss 0 Strike Price BEP Stock Price Lower Higher of underlying shares at any time at the predetermined strike price until the contract expires. Note: Equity option holders do not enjoy the rights due stockholders e.g., voting rights, regular cash or special dividends, etc. A call holder must exercise the option and take ownership of the underlying shares to be eligible for these rights. Benefit? A long call option offers a leveraged alternative to a position in the stock. As the contract becomes more profitable, increasing leverage can result in large percentage profits because purchasing calls generally requires lower up-front capital commitment than an outright purchase of the underlying stock. Long call contracts offer the investor a predetermined risk. Risk vs. Reward? 8 Maximum Profit: Unlimited Maximum Loss: Limited Premium Paid Upside Profit at Expiration: Stock Price Strike Price Premium Paid Assuming Stock Price above BEP
11 Your maximum profit depends only on the potential price increase of the underlying security; in theory, it is unlimited. At expiration an in-the-money call will generally be worth its intrinsic value. Though the potential loss is predetermined and limited in dollar amount, it can be as much as 100% of the premium initially paid for the call. Whatever your motivation for purchasing the call, weigh the potential reward against the potential loss of the entire premium paid. cut a loss. Alternatives at Expiration? At expiration, most investors holding an in-the-money call option will elect to sell the option in the marketplace if it has value, before the end of trading on the option s last trading day. An alternative is to exercise the call, resulting in the purchase of an equivalent number of underlying shares at the strike price. Break-Even Point (BEP) at Expiration? BEP: Strike Price + Premium Paid Before expiration, however, if the contract s market price has sufficient time value remaining, the BEP can occur at a lower stock price. Volatility? If Volatility Increases: Positive Effect If Volatility Decreases: Negative Effect Any effect of volatility on the option s total premium is on the time value portion. Time Decay? Passage of Time: Negative Effect The time value portion of an option s premium, which the option holder purchased when paying for the option, generally decreases, or decays, with the passage of time. This de crease accelerates as the option contract approaches expiration. Alternatives before Expiration? At any given time before expiration, a call option holder can either sell the call in the listed options marketplace or exercise the option to close out the position. This can be done to realize a profitable gain in the option s premium, or to Long Put A long put can be an ideal tool for an investor who wishes to participate profitably from a downward price move in the underlying stock. Before moving into more complex bearish strategies, an investor should thoroughly understand the fundamentals about buying and holding put options. Market Opinion? Bearish. When to Use? Purchasing puts without owning shares of the underlying stock is a purely directional strategy used for bearish speculation. The primary motivation of this investor is to realize financial reward from a decrease in price of the underlying stock. This investor is generally more interested in the dollar amount of his initial investment, and the leveraged financial reward that long puts can offer, than in the number of contracts purchased. Buying puts can also be used as an alternative to selling stock short. Experience and precision are key in selecting the right option (expiration and/or strike price) for the most profitable result. In general, the more out-of-the-money the put purchased, the more bearish the strategy, as bigger decreases in the underlying stock price are required for the option to reach the break-even point. 9
12 Benefit? A long put offers a leveraged alternative to a bearish short sale of the underlying stock, and offers less potential risk to the investor. As with a long call, an investor who purchased and is holding a long put has predetermined, limited financial risk versus the unlimited upside risk from a short stock position. Purchasing a put also generally requires lower up-front capital commitment than the margin required to establish a Long Put + Profit The maximum profit amount is limited only by the stock s potential decrease to no less than zero. At expiration an in-the-money put will generally be worth its intrinsic value. Though the potential loss is predetermined and limited in dollar amount, it can be as much as 100% of the premium initially paid for the put. Whatever the motivation for purchasing the put, the investor should weigh the potential reward against the potential loss of the entire premium paid. 0 BEP Strike Price Break-Even Point (BEP) at Expiration? BEP: Strike Price Premium Paid Loss Stock Price Lower Higher Before expiration, however, if the contract s market price has sufficient time value remaining, the BEP can occur at a higher stock price. short stock position. Regardless of market conditions, a long put will never require a margin call. As the contract becomes more profitable, increasing leverage can result in large percentage profits. Risk vs. Reward? Maximum Profit: Substantial Limited Only by Stock Declining to Zero Maximum Loss: Limited Premium Paid Downside Profit at Expiration: Strike Price Stock Price Premium Paid Assuming Stock Price below BEP Volatility? If Volatility Increases: Positive Effect If Volatility Decreases: Negative Effect Any effect of volatility on the option s total premium is on the time value portion. Time Decay? Passage of Time: Negative Effect The time value portion of an option s premium, which the option holder purchased when paying for the option, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration. A market observer will notice that time decay for puts occurs at a slightly slower rate than with calls. 10
13 Alternatives before Expiration? At any given time before expiration, a put option holder can either sell the put in the listed options marketplace, or exercise the option to close out the position. This can be done to realize a profitable gain in the option s premium, or to cut a loss. Alternatives at Expiration? At expiration most investors holding an in-the-money put will elect to sell the option in the marketplace if it has value, before the end of trading on the option s last trading day. An alternative is to purchase an equivalent number of shares in the marketplace, then exercise the long put and sell the stock to a put writer at the option s strike price. The third choice, one resulting in considerable risk, is to exercise the put, sell the underlying shares and establish a short stock position in an appropriate type of brokerage account. Married Put An investor purchasing a put while at the same time purchasing an equivalent number of shares of the underlying stock is establishing a married put position a hedging strategy with a name from an old IRS ruling. Market Opinion? Bullish to very bullish. When to Use? The investor employing the married put strategy wants the benefits of stock ownership (dividends, voting rights, etc.), but has concerns about unknown, near-term, downside market risks. Purchasing puts with the purchase of shares of the underlying stock is a directional, bullish strategy. The primary motivation of this investor is to protect his shares of the underlying security from a decrease in market price. He will generally purchase a number of put contracts equivalent to the number of shares held. Benefit? While the married put investor retains all benefits of stock ownership, he has insured his shares against an unacceptable decrease in value during the lifetime of the put, and has limited, predefined, downside market risk. The premium paid for the put option is equivalent to the premium paid for an insurance policy. No matter how much the underlying stock decreases in value during the option s lifetime, the investor has a guaranteed selling price for the shares at the put s strike price. If there is a sudden, significant decrease in the market price of the underlying stock, a put holder has the luxury of time to react. Alternatively, a previously entered stop loss limit order on the purchased shares might be triggered at a time and at a price unacceptable to the investor. The put contract has conveyed to him a guaranteed selling price, and control over when and/or if he chooses to sell his stock. Risk vs. Reward? 11
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14 Maximum Profit: Unlimited Maximum Loss: Limited Stock Purchase Price Strike Price + Premium Paid Upside Profit at Expiration: Gains in Underlying Share Value Premium Paid Maximum profit depends only on the potential price increase of the underlying stock; in theory it is unlimited. Married Put + Profit 0 Strike Price BEP Any effect of volatility on the option s total premium is on the time value portion. Time Decay? Passage of Time: Negative Effect The time value portion of an option s premium, which the option holder purchased when paying for the option, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration. A market observer will notice that time decay for puts occurs at a slightly slower rate than with calls. Loss Stock Price Lower Higher When the put expires, if the underlying stock closes at the price originally paid for the shares, the investor s loss would be the entire premium paid for the put. Break-Even Point (BEP) at Expiration? BEP: Stock Purchase Price + Premium Paid Volatility? If Volatility Increases: Positive Effect If Volatility Decreases: Negative Effect 12
15 Alternatives before Expiration? The investor employing the married put is free to sell his stock, sell his long put or exercise his long put at any time before expiration. For instance, if the investor loses concern over a possible decline in market value of his hedged underlying shares, the put option may be sold if it has market value remaining. Protective Put An investor who purchases a put option while holding shares of the underlying stock from a previous purchase is employing a protective put. Alternatives at Expiration? If the put option expires out-of-the-money and with no value, no action need be taken; the investor will retain his shares. If the option expires in-the-money, the investor can elect to exercise his right to sell the underlying shares at the put s strike price. Alternatively, the investor may sell the put option, if it has market value, before the market closes on the option s last trading day. Any profit realized from the long put s sale may at least partially offset any unrealized loss from a decline in underlying share value. Market Opinion? Bullish on the underlying stock. When to Use? The investor employing the protective put strategy owns shares of underlying stock from a previous purchase, and generally has unrealized profits accrued from an increase in value of those shares. He might have concerns about unknown, downside market risks in the near term and wants some protection for the gains in share value. Purchasing puts while holding shares of underlying stock is a directional bullish strategy. Benefit? Like the married put investor, the protective put investor retains all benefits of continuing stock ownership (dividends, voting rights, etc.) during the lifetime of the put contract, unless he sells his stock. At the same time, the protective put serves to limit downside loss in unrealized gains accrued since the underlying stock s purchase. No matter how much the underlying stock decreases in value during the option s lifetime, the long put guarantees the investor the right to sell his shares at the put s strike price until the option expires. If there is a sudden, significant decrease in the market price of the underlying stock, a put holder has the luxury of time to react. Alternatively, a previously entered stop loss limit order on the purchased shares might be triggered at both a time and a price unacceptable to the investor. The put contract has conveyed to him a guaranteed selling price at the strike price, and control over when and/or if he chooses to sell his stock. Risk vs. Reward? 13
16 Maximum Profit: Unlimited Maximum Loss: Limited Strike Price Stock Purchase Price + Premium Paid Upside Profit at Expiration: Gains in Underlying Share Value since Purchase Premium Paid Maximum profit for this strategy depends only on the potential price increase of the underlying stock; Protective Put + Profit Volatility? If Volatility Increases: Positive Effect If Volatility Decreases: Negative Effect Any effect of volatility on the option s total premium is on the time value portion. 0 Strike Price BEP Time Decay? Passage of Time: Negative Effect Loss Stock Price Lower Higher in theory it is unlimited. Losses are limited as long as the put is held. If the put expires in-the-money, any gains realized from an increase in its value may at least partially offset any decline in the unrealized profits from the underlying shares. On the other hand, if the put expires at- or out-ofthe-money, the investor will lose the entire premium paid for the put. Break-Even Point (BEP) at Expiration? BEP: Stock Purchase Price + Premium Paid The time value portion of an option s premium, which the option holder purchased when paying for the option, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration. A market observer will notice that time decay for puts occurs at a slightly slower rate than with calls. Alternatives before Expiration? The investor employing the protective put is free to sell his stock, sell his long put or exercise his long put at any time before expiration. For instance, if the investor loses concern over a possible decline in market value of his hedged underlying shares, the put option may be sold if it has market value remaining. Alternatives at Expiration? If the put option expires out-of-the-money and with no value, no action need be taken; the investor will retain his shares. If the option expires in-the-money, the investor can elect to exercise his right to sell the underlying shares at the put s strike price. Alternatively, the investor may sell the put option, if it has market value, before the market closes on 14
17 the option s last trading day. Any profit realized from the long put s sale may at least partially offset any unrealized loss from a decline in underlying share value. Covered Call The covered call is a strategy in which an investor writes a call option contract while at the same time owning an equivalent number of shares of the underlying stock. If this stock is purchased simultaneously with writing the call contract, the strategy is commonly referred to as a buy-write. In either case, the stock is generally held in the same brokerage account from which the investor writes the call, and fully collateralizes, or covers, the obligation conveyed by writing a call option contract. This strategy is the most basic and most widely used strategy combining the flexibility of listed options with stock ownership. Market Opinion? Neutral to bullish on the underlying stock. When to Use? Though the covered call can be utilized in any market condition, it is most often employed when the investor, while bullish on the underlying stock, feels that its market value will experience little range over the lifetime of the call contract. The investor desires to generate additional income (over dividends) from shares owned, and/or obtain a limited amount of protection against a decline in underlying stock value (limited to call premium received). Benefit? While this strategy offers limited protection from a decline in price of the underlying stock as well as limited upside profit participation with an increase in stock price, it generates income because the investor keeps the premium received from writing the call. At the same time, the investor can appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless he is assigned an exercise notice on the written call and is obligated to sell his shares. There is always a chance that a short call whose underlying stock is paying a dividend may be assigned prior to expiration. 15
18 Risk vs. Reward? Profit Potential: Limited Loss Potential: Substantial Upside Profit at Expiration If Assigned: Premium Received + Difference (if any) Between Strike Price and Stock Purchase Price Upside Profit at Expiration If Not Assigned: Any Gains in Stock Value + Premium Received Maximum profit will occur if the price of the underlying stock owned is at or above the call’s strike price, either at its expiration or when you might be assigned an exercise Covered Call + Profit Break-Even Point (BEP) at Expiration? BEP: Stock Purchase Price Premium Received Volatility? If Volatility Increases: Negative Effect If Volatility Decreases: Positive Effect Any effect of volatility on the option s price is on the time value portion of the option s premium. Time Decay? Passage of Time: Positive Effect Loss 0 BEP Strike Price Stock Price Lower Higher With the passage of time, the time value portion of the option s premium generally decreases a positive effect for an investor with a short option position. notice on the call before it expires. The risk of real financial loss with this strategy comes from the stock held by the investor. This loss can become substantial if the stock price continues to decline in price as the written call expires. At the call s expiration, loss can be calculated as the original purchase price of the stock less its current market price, less the premium received from initial sale of the call. Any loss accrued from a decline in stock price may at least be partially offset by the premium received from the call’s sale. As long as the underlying shares of stock are not sold, this would be an unrealized loss. Assignment on a written call is always possible. An investor holding shares with a low cost basis should consult his tax advisor about the tax ramifications of writing calls on such shares. 16
19 Alternatives before Expiration? If the investor s opinion on the underlying stock changes significantly before the written call expires, whether more bullish or more bearish, the investor can make a closing purchase transaction of the call in the marketplace. This would close out the written call contract, relieving the investor of an obligation to sell his stock at the call s strike price. Before taking this action, the investor should weigh any realized profit or loss from the written call s purchase against any unrealized profit or loss from holding shares of the underlying stock. If the written call position is closed out in this manner, the investor can decide whether to make another option trans action to either generate income from and/or protect his shares, to hold the stock unprotected with options, or to sell the shares. in this case. Alternatives at Expiration? As expiration day for the call option nears, the investor considers three scenarios and then accordingly makes a decision. The written call contract will either be in-themoney, at-the-money or out-of-the-money. If the investor feels the call will expire in-the-money, he can choose to be assigned an exercise notice on the written contract and sell an equivalent number of shares at the call s strike price. Alternatively, the investor can choose to close out the written call with a closing purchase trans action, canceling his obligation to sell stock at the call s strike price, and retain ownership of the underlying shares. Before taking this action, the investor should weigh any realized profit or loss from the written call s purchase against any unrealized profit or loss from holding shares of the underlying stock. If the investor feels the written call will expire out-of-the-money, no action is necessary. He can let the call option expire with no value and retain the entire premium received from its initial sale. If the written call expires exactly at-the-money, the investor should realize that assignment of an exercise notice on such a contract is possible, but should not be assumed. An investor should consult with his brokerage firm or a financial advisor on the advisability of what action to take 17
20 Cash-Secured Put According to the terms of a put contract, a put writer is obligated to purchase an equivalent number of underlying shares at the put s strike price if assigned an exercise notice on the written contract. Many investors write puts because they are willing to be assigned and acquire shares of the underlying stock in exchange for the premium received from the put s sale. For this discussion, a put writer will be considered covered if he has on deposit with his brokerage firm a cash amount (or other approved collateral) sufficient to cover such a purchase. assignment is always possible at any time before the put expires. In addition, he should be satisfied that the net cost for the shares will be at a satisfactory entry point if he is assigned. The number of put contracts written should correspond to the number of shares the investor is comfortable and financially capable of purchasing. While assignment may not be the objective at times, it should not be a financial burden. This strategy can become speculative when more puts are written than the equivalent number of shares desired to own. Cash-Secured Put + Profit Loss 0 BEP Strike Price Stock Price Lower Higher Benefit? The put writer collects and keeps the premium from the put s sale, no matter how much the stock increases or decreases in price. If the writer is assigned, he is then obligated to purchase an equivalent amount of underlying shares at the put s strike price. The premium received from the put s sale will partially offset the purchase price for the stock, and can result in a purchase of shares below the current market price. If the underlying stock price declines significantly and the put writer is assigned, the purchase price for the shares can be above current market price. In this case, the put writer will have an unrealized loss due to the high stock purchase price, but will have upside profit potential if retaining the purchased shares. Market Opinion? Neutral to slightly bullish. When to Use? There are two key motivations for employing this strategy: either as an attempt to purchase underlying shares below current market price, or to collect and keep premium from the sale of puts which expire out-of-the-money and with no value. An investor should write a covered put only when he would be comfortable owning underlying shares, because Risk vs. Reward? Maximum Profit: Limited Premium Received Maximum Loss: Substantial Upside Profit at Expiration: Premium Received from Put Sale Net Stock Purchase Price If Assigned: Strike Price Premium Received from Put Sale 18
21 If the underlying stock increases in price and the put expires with no value, the profit is limited to the premium received from the put s initial sale. On the other hand, an outright purchase of underlying stock would offer the investor un limited upside profit potential. If the underlying stock declines below the strike price of the put, the investor might be assigned an exercise notice and be obligated to purchase an equivalent number of shares. The net stock purchase price would be the put s strike price less the premium received from the put s sale. This price can be less than current market price for the stock when assignment is made. The loss potential for this strategy is similar to owning an equivalent number of underlying shares. Theoreti cally, the stock price can decline to zero. If assignment results in the purchase of stock at a net price greater than the current market price, the investor would incur a loss unrealized as long as ownership of the shares is retained. Break-Even Point (BEP) at Expiration? BEP: Strike Price Premium Received from Sale of Put Volatility? If Volatility Increases: Negative Effect If Volatility Decreases: Positive Effect Time Decay? Passage of Time: Positive Effect With the passage of time, the time value portion of the option s premium generally decreases a positive effect for an investor with a short option position. Alternatives before Expiration? If the investor s opinion about the underlying stock changes before the put expires, the investor can buy the same contract in the marketplace to close out his position at a realized profit or loss. After this is done, no assignment is possible. The investor is relieved from any obligation to purchase underlying stock. Alternatives at Expiration? If the short option has any value when it expires, the investor will most likely be assigned an exercise notice and be obligated to purchase an equivalent number of shares. If owning the underlying shares is not desired at this point, the investor can close out the written put by buying a contract with the same terms in the marketplace. Such a purchase would have to occur before the market closes on the option s last trading day, and could result in a realized loss. On the other hand, the investor is obliged to take delivery of the underlying shares at a possible unrealized loss. Any effect of volatility on the option s total premium is on the time value portion. 19
22 Bull Call Spread Establishing a bull call spread involves the purchase of a call option on a particular underlying stock, while simultaneously writing a call option on the same underlying stock with the same expiration month, at a higher strike price. Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts. This spread is sometimes more broadly categorized as a vertical spread : a family of spreads involving options of the same stock, same expiration month, but different strike prices. They can be created with either all calls or all puts, and be bullish or bearish. The bull call spread, as any spread, can be executed as a unit in one single transaction, not as separate buy and sell transactions. For this bullish vertical spread, a bid and offer for the whole package can be requested through your brokerage firm from an exchange where the options are listed and traded. Bull Call Spread + Profit BEP Risk Reduction An investor will also turn to this spread when there is discomfort with either the cost of purchasing and holding the long call alone, or with the conviction of his bullish market opinion. Benefit? The bull call spread can be considered a doubly hedged strategy. The price paid for the call with the lower strike price is partially offset by the premium received from writing the call with a higher strike price. Thus, the investor s investment in the long call, and the risk of losing the entire premium paid for it, is reduced or hedged. On the other hand, the long call with the lower strike price caps or hedges the financial risk of the written call with the higher strike price. If the investor is assigned an exercise notice on the written call and must sell an equivalent number of underlying shares at the strike price, those shares can be purchased at a predetermined price by exercising the purchased call with the lower strike price. As a trade-off for the hedge it offers, this written call limits the potential maximum profit for the strategy. 0 Lower Strike Price Higher Strike Price Risk vs. Reward? Upside Maximum Profit: Limited Difference Between Strike Prices Net Debit Paid Loss Stock Price Lower Higher Maximum Loss: Limited Net Debit Paid Market Opinion? Moderately bullish to bullish. When to Use? Moderately Bullish An investor often employs the bull call spread in moderately bullish market environments, and wants to capitalize on a modest advance in price of the underlying stock. If the investor s opinion is very bullish on a stock it will generally prove more profitable to make a simple call purchase. A bull call spread tends to be profitable when the under lying stock increases in price. It can be established in one transaction, but always at a net debit (net cash outflow). The call with the lower strike price will always be purchased at a price greater than the offsetting premium received from writing the call with the higher strike price. Maximum loss for this spread will generally occur as the underlying stock price declines below the lower strike price. If both options expire out-of-the-money with no value, the entire net debit paid for the spread will be lost. The maximum profit for this spread will generally occur as the underlying stock price rises above the higher strike price, and both options expire in-the-money. The 20
An option which has a common stock as its underlying security. Also known as stock option.
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Option Selling Strategies: A Tutorial
Why Sell Options?
Writing uncovered options has the traditional connotation of “picking up nickels in front of a steamroller”. So why would anyone in their right mind want to do it?
The unique properties of options means being on the sell side can add a new dimension to a trading strategy. Option selling can also be used as a strategy in its own right.
This tutorial will explore a few reasons why someone might consider selling options. To summarize the main reasons are:
- Income generation
- Exploiting changes in volatility
- Market neutrality
Let’s look at each one of these briefly.
Income generation: When you sell an option you collect the premium. That is real money in your account. Time decay is a certainty and that makes for a virtual daily income stream paid to the option seller.
Selling volatility: An option is more valuable when volatility in the underlying is high. Therefore traders prefer to sell options when volatility is high. By doing this they hope to profit from the collapse back to mean levels.
Market neutrality: Option selling provides a degree of market neutrality. As long as the strike level isn’t reached, a short option position generates the same cash flow, regardless of what the market does in between.
Options – The Basics
As a refresher, let’s first look at the basic properties of options. If you’re already well versed in this topic, you won’t miss anything by skipping to the next section.
What is an option? An option is a contract that gives the buyer the right, but not the obligation to either buy or sell an underlying asset.
The buy side
When you buy an option you can speculate on either a rise or a fall in the underlying asset price. An option buyer can buy a call option if he thinks the underlying’s price will rise. He can buy a put option if he thinks the underlying price will fall.
In both cases, the buyer has the right to either buy or sell the underling at a certain price and on a certain date. The strike price and the expiry date respectively and are two fundamental elements of any option contract.
When you buy an option, there usually isn’t any need for margin. This is because at no time can the option be worth less than zero – it always has some value.
When you buy and hold an option till expiry, one of two things can happen. Either it expires worthless or it expires in the money (ITM) in which case you profit from the difference between the strike price and the price of the underlying at expiry.
The sell side
On the other side to the buyer someone has to be willing to underwrite that commitment to deliver the underlying. This is the job of the option seller or “writer” of the option. The seller of an option contract is giving the buyer the right to either buy or sell from them, at a given price on a given date. The compensation for taking on this risk and commitment comes in the form of an option premium. The premium is paid by the buyer to the seller unconditionally.
Option cash flow example
It helps to look at the cash flows in a real example. Let’s take an American-style call option on GBPUSD. The GBPUSD spot price is 1.44. The call option is as follows:
Size: 1 x 100,000 USD
On day zero the price of the call option is $1624.94 (see this spreadsheet for the pricing). The option buyer pays this amount to the option seller. The table below shows the profit & loss on both sides of the transaction from the day the option is bought until expiry.
|Day||GBPUSD||Premium||Intrinsic||Time||Buyer P&L||Seller P&L|
Notice the two components of the option price which make up the premium; the intrinsic and the time value. The intrinsic is the amount by which the option is already in the money.
For a call option, when the spot price is below the strike price the option is out of the money. The time value or extrinsic value accounts for the fact that the option still has time to run. If it isn’t in the money now, there is still a probability that it could go into the money before expiry. If this happens the option seller would have to pay out.
Notice that the time value decreases during the life of the option. This amount “migrates” to the seller as time elapses. When you buy an option time is not on your side.
At day 30, the option expires worthless. The contract gave the holder the right to buy GBPUSD at 1.46 on day 30. But since the price is now less than this at 1.43, this contract is worthless. The seller therefore pockets the $1624.94 option premium because his obligation to deliver under the contract is annulled.
Let’s consider another example where GBPUSD rises to 1.48.
|Day||GBPUSD||Premium||Intrinsic||Time||Buyer P&L||Seller P&L|
On day 30, the option is in the money to the tune of $2,000. The seller however has by now made $1624.94 from the option premium. So his net loss is $375.06 ($1,624.94 – $2,000). This is the gain for the buyer.
There are a few ratios that traders use to understand options. These are referred to as “The Greeks”. The most important are:
Delta • Also called the hedge ratio. A measure of how sensitive the option price is to changes in the underlying. For example, when a call option has a delta of 0.8 this means that for every dollar rise in the underlying, the option rises by 80 cents. As a rule of thumb, traders use delta as the probability of the option expiring in the money. Thus an option with 0.8 delta, has an 80% probability of expiring in the money or becoming profitable.
Theta • A measure of time decay. Theta is the amount in dollars that the option loses each day. An option loses value quicker, the closer it gets to expiry. The option is also more sensitive to time the closer the spot price is to the strike price – when it’s at the money (ATM).
Vega • The sensitivity of the option price to implied volatility. The higher the volatility, the more expensive the option will be. This cost is reflected within the time value component. Vega peaks when the option is at the money. Longer dated options also have a higher vega than short dated options – all other things being equal.
If you are an option seller, delta and vega are especially important. This is because they are used in the determination of the amount of margin required. See the second part of this tutorial for an explanation of margin for option sellers.
Types of Options
If you’ve come from the equity trading side, trading options will be a different ballgame altogether. However if you’ve already traded futures, forex and CFD you will have an advantage. Because you should already be familiar with margin trading and leverage.
Options are available on virtually every type of asset, but the most popular options are on stocks, indices, bonds, commodity futures, interest and exchange rates. When selling options it’s wise to stick to highly liquid markets. If you need to get out, you want to be able to do so quickly and cheaply. This may not be the case with illiquid markets.
The beauty of options is that they are practically the same regardless of the underlying asset. For example futures options work virtually the same way as equity options, except the prices are derived from an underlying future, such as Light-Sweet Crude Oil, Soybeans, and E-mini S&P 500 contracts.
How and where to trade options
Most retail brokerages will require a risk appraisal before they’ll let you trade options. Extra checks may be required for short selling. Nonetheless, if you are aware of the risks and understand the concepts, options trading can open up a world of opportunity.
As always, it is important to find a reliable broker with low fees and good technology and trading platforms. Most retail brokerages that have futures trading also offer futures options trading.
You can trade options through a securities trading account available through major banks as well as online brokers such as TradeStation, and TD Ameritrade.
Risk and Rewards
The risks of selling options
When selling a call option there is an unlimited risk. This is because a stock or futures contract could technically trade to infinity. Similarly, when selling any put option the risk is the underlying instrument going to zero. Although this is extremely unlikely, it’s technically not impossible. Options traders need to be aware of the inherent risks when selling.
Selling options can be disastrous if risk factors aren’t properly understood and managed.
The reward: Time decay
The trade-off for this elevated amount of risk is a high probability of profit. All options are decaying instruments. Every day, there is money systematically being priced out of the option. This is regardless of the direction the underlying futures contract price. As the seller, this is money in your pocket.
This concept is known as “theta decay”. It is the main attraction to option sellers. Recall that theta is the time value in the option. Theta is a component of the overall premium. Taking advantage of this time decay aspect requires selling a sizeable amount contracts. Thankfully, because of SPAN margining, this is possible with futures options, and excellent theta decay can be achieved with relatively small amounts of capital.
For example as the above figure shows $105.13 in theta decay per day is achieved with selling a 10-lot of .04 delta Crude Oil puts, with a margin requirement of about $10,000. If the Crude Oil trades down by 10%, the options would still be out of the money and theta would increase, but so would the margin requirement.
Selling options can generate a much higher probability of profit than trading in the underlying. In order for the 10-lot of short Crude Oil contracts to lose money at expiration, the price of Crude Oil needs to be lower than the strike price minus the premium.
If a trader sells a .04 delta option there is theoretically only a 4% chance that option will expire in-the-money. In other words, the position has a 96% probability of profit, while the trader collects around $100 per day via theta decay. See Figure 4.
As I mentioned above one advantage of trading options is their common properties across asset classes. Many of the same option strategies can be used across the board without sacrificing any of the margin benefits. Short strangles, straddles, and iron condors can be used to create delta-neutral and theta-positive positions and capitalize during periods of increased implied volatility.
Moreover, a trader can also sell futures options for purposes beyond speculation. Traders can reduce their cost basis and hedge a long position in an underlying by selling futures calls. Or reduce their cost basis and hedge a short position by selling futures puts.
Due to the leverage and therefore inherent risk when using futures options, strategies such as iron condors and credit spreads might be more appealing for traders to limit risk or hedge existing short option positions.
For example if a short Soybean put position is losing money and a trader wants to hedge, he could leg into a credit spread by purchasing a further out-of-the-money put.
Although this would reduce the maximum profit, it would limit the loss of the entire position while still keeping a partially reduced margin requirement.
With options credit spreads, the margin requirement is often less than the width of the strikes. This results in less capital usage even for a risk-defined trade. Moreover, more time until expiration and a greater distance away from the money result in reduced margin requirements.
Of course if a short option position goes in your favor the margin requirement will be reduced.
Sell when volatility is high
If there’s one “golden rule” to selling options, it is that the best time to sell is when volatility is high. Option prices increase with volatility. When volatility is high, traders will pay more in option premium to hedge their positions and/or speculate.
One thing to keep in mind when selling options is that a rise in volatility can create a paper loss. This is true even if the underlying price remains the same. It can also increase margin requirements.
For example, think of Crude Oil futures before a scheduled OPEC meeting or before an output freeze discussion in Doha. Despite what the media or market pundits may tell you, no one really knows how the price of Crude Oil will be affected. Because the outcome of a binary event is expected to have a dramatic effect on the price of the underlying future, traders price in the potential for significant upside and downside.
Often there is a “skew” in one direction. This can see puts trading richer than calls or vice versa. This reflects the collective opinion of market participants. In fact put/call ratios are sometimes used as a signal of market sentiment.
This results in increased implied volatility and is reflected in the option prices. Therefore selling options before such turmoil could be a disastrous strategy.
When to close short option positions
When selling low delta options, there is by definition a high probability of making a profit. Theta decay as well as volatility contraction will reduce the extrinsic value of the option. Once most of this has gone, you the option seller have little more to gain. At this point it is wise to close out the position.
Keeping short options positions open that have returned most of their profit and are trading near or at a zero value is simply adding excess risk.
If a short futures option is worthless prior to expiration, it should be closed out for a small price, every time. Regardless of how far out of the money the options have become, if the option is worthless there is no profit left to make on the position. Yet there is an enormous potential loss waiting to happen.
All of this, of course, is assuming the position is profitable. On occasion, a short out of the money option can wind up in the money. The position will eventually need to be closed out for a loss prior to expiration. This however will depend on the delivery specifications of the future.
Some traders prefer to close out their short options when a profit target is reached. This can be around 75% of the maximum profit for the trade. Other traders like all the value of the option to be destroyed before they cover.
The moneygrubber will let his options expire worthless to save on commissions and extract every cent.
How you close the position depends on your individual trading style and appetite for risk.
Selling options is not an end-all strategy and route to early retirement on a tropical tax haven. However it can be an important part of a balanced investment plan. Going short options offers you a way to speculate and reduce your trading costs in commodities, index products and currencies. This can add a new and exciting dimension to your overall strategy.
Shorting options can generate profitable trades in markets where conventional methods fail. It also offers attractive use of capital and highly favorable outcomes. Despite this, option writing is best used in small doses. It wouldn’t be a good idea to have an entire portfolio full of short futures options – think Victor Niederhoffer circa 1997.
|Excel option pricer|