strategies for options

It’s one thing to invest in stocks, it’s another to trade them.  Trading implies a shorter time frame.  Investing means looking for price appreciation.  Dividends play an important part to many investors.  Most traders have never received a dividend, nor do they miss them.

Investors are willing to tie up most of their money.  Their gains are the product of appreciation and time.  They look for better than average returns to maximize their investments.  As well as selecting plays, traders manage money.  They tie up as small an amount as possible.  Their gains are the product of repeatability and speed.

An option’s limited time frame match better to the trader mentality.  Most option traders have a much smaller time horizon than the long term buy and hold investors.  Trading options adds leverage to the mix.  Options fit perfectly to the trader time and money management mentality.

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To trade successfully, option buyers need to be right and right on time.  Buying options resembles betting on direction.  Buy Calls on bullish expectations.  Buy Puts on bearish expectations.

Options cost money, their premium pays for the potential stock price movement.  Potentially up for Calls, potentially down for Puts.  You need big fast price moves to make any money trading options.  If a stock doesn’t move far or fast enough, you will lose money.

If you buy the right option, the stock may only need to move a little before being profitable.  Buy the wrong option, the stock will need to move farther and/or faster to make a profit.  Playing the right stock may heal any wounds caused by picking the wrong option.

Option buyers have rights which if the option is as little as 1 penny in the money get exercised automatically.  The seller, also known as writer, has an obligation.  Call options give the right to buy stock and the obligation to sell.  Put options give the right to sell stock and the obligation to buy.

If we buy Calls on bullish expectations, why not sell them on bearish expectations?  If we buy Puts on bearish expectations, why not sell them when bullish?  Remember, until the option is closed, there can be no profit.

If we sell a Call option we are obligating ourselves to deliver stock at the strike price anytime until the option expires.  For that obligation we collect a premium.  If we already own the stock, it’s known as a Covered Call.  Our obligation to deliver is covered, guaranteed by the fact we already own the stock.  Our broker should put a lien against our stock.  They won’t let us sell it to anyone else.  In the end, they are responsible.  When you think about it, they are covered.

The profit in Covered Calls potentially comes two ways, from the premium collected and from any appreciation in the stock’s price.  Like long term investors, Covered Call writer’s gains come from appreciation and time.  Only, not from the multiplication of time on a return, but from the decay of time’s value on options.

Selling an uncovered, or naked, Call is the riskiest of all option strategies.  The seller, or writer, of uncovered calls is obligated to sell stock they don’t own.  If the price skyrockets, their losses take off.

Selling Put options obligates the writer to buy the stock at a set price for a specific period of time.  Think of a Put option as an insurance policy.  The buyer of the policy pays the insurance company a premium, for that premium they can insure against loss.  Unlike naked Calls, which have unlimited risk, uncovered Puts maximum risk is if the stock becomes bankrupt.

Put selling profits comes from two sources.  Time’s passage deflates the value of options.  Time passing is truly the only guarantee in life.  When you buy them, they decay on you.  When you sell them, they decay on you.  The other profit doesn’t come from appreciation, but the lack of depreciation.  If buying Puts is a bet the stock will go down, selling Puts is not a bet it will go up but a bet it won’t go down.

Selling Covered Calls and selling Naked Puts have the same risk curve, but not the same reward curve.  Our example will be a $20 stock, one position will be buying the stock and selling the $20 Covered Call.  The other position will be selling the $20 Naked Put.

Buying the stock for $20 and selling the $20 Covered Call gives no room for appreciation, the only profit comes from the premium collected.  The only Profit from selling a $20 Put would be the premium.

In either case, if the stock were to go above $20, you would not own the stock.  The Call buyer would call you out on the Covered Call.  The Put buyer would have their option expire worthless.  If the stock closed below $20 before option expiration, either position would end up owning stock.  The Call Buyer wouldn’t exercise.  The Put buyer would force the Put seller to buy the stock.

A great strategy combining both would be to initially sell a Put Option – I prefer selling a Weekly Put Option.  If the Put Option expires worthless then you get to keep the premium and repeat for the next week.  If the Put gets exercised you end up with the stock and then the next step is to sell a Call – resulting in a Covered Call.  Let me know what you think!

Percentage movement is meaningless in stocks.  Own 1000 shares of a $10 stock and you have the same $10,000 tied up as owning 500 shares of a $20 stock.  The same $10,000 buys you 100 shares of a $100 stock.  If any of these stocks move up 10%, a $10,000 position would increase to $11,000.

Percentage movement for option is essential.  Stocks need to make decent price moves in order for its options to have their prices affected.

Strike price choices on a $10 stock maybe limited to $7.50, $10, and $12.50.  Going two strikes In or Out of The Money (ITM, OTM) would add the $5 and $15.  Both of which are 50% from the current price.

The $20 stock would have $17.50, $20 and $22.50 strike prices.  If two strikes In or Out of The Money (ITM, OTM) are available, they would only be 25% from being At The Money (ATM).

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The $100 stock’s strike price availability would all be closer in terms of a percentage.  The $90 and $110 choices would be two In or Out (ITM, OTM), yet they would only be 10% In or Out (ITM, OTM).

If a $100 stock moves 10%, it will pass through two strike prices.  If it moves 10% down, it would pass through the $95 and $90 strikes.  If it moved up, it passes through the $105 and the $110 strikes.

If a $20 stock moves 10% it comes close to moving one strike.  It would still be $0.50 away from either the $17.50 or the $22.50.  Close, but not close enough.

A 10% move on a $10 stock doesn’t get the price much closer at all to the next strike price.  Less expensive priced stocks need bigger percentage movements.

The significance of strike price distance versus stock prices as terms of a percentage should be clearer.  All equal percentage price movements affect all stocks equally, they do not affect options the same.  A 10% move is a big thing to options on high priced stocks, but lower priced stocks require larger percentage moves to affect their options.

If a stock’s price is too low, you may consider buying the stock as opposed to trading options on it.  You should certainly rule out trading Out of The Money (OTM) options on them.  Match the strategy to the stock price.

Margin requirements vary on plays.  Buying options requires the money to pay for them.  Buying stock either requires full payment, or you may purchase them on margin.  (Check with your broker for specific margin requirements.)  Generally speaking stocks need to be around $5 minimum in price to be optionable.  In such case the typical margin is 50%.  That is, you need to have half the money available, your broker will loan you the other half.

When you sell options, you will need to put something up as collateral.  With Covered Calls, the most often sold option, the collateral is the stock the option is written against.  You either need to pay for the stock in full, or buy it on margin.  By putting up only 50% of the cost and selling the option and receiving 100% of the premium you may more than double your return.

Naked Puts have more aggressive margin still.    Many brokers only require 25% security for the value of the stock.  Successful Naked Put selling may have less commissions than Covered Calls.  Naked Puts done right cost one commission versus Covered Calls three.

Always run through different strategies and pick the best one depending on your risk tolerance, account size and your expected move in the asset.

We’re not talking Bikinis, we mean highs and lows.  Not as in buy low-sell high, but as in trends and chart patterns.

A stock industry maxim reads, “The public is right in the middle, but wrong on the ends.”  Spelled out, many fortunes will be lost by buying when one should ultimately be selling, or by selling when one should buy.

Many analysts try to predict tops and bottoms with price targets.  Their predictions may pan out with amazing accuracy.  Some well-followed analysts’ predictions become self-fulfilling prophecies.

Have you ever bought a stock at the bottom?  Or better still, sold at the top?  How did you know at the time it was one of the extremes?  Luck or genius?  If someone bought at the bottom, then someone sold to them.  For every seller at the top, there was an unlucky buyer.  Have you ever been on the wrong side of a transaction at either end?  Misfortune or ignorance?

Buying near the bottom is easier than selling at the top.  An absolute bottom exists, zero.  The ultimate top is unknown.  Theoretically a stock could trade to infinity.  Although I’ve never seen infinity on a chart.

Honestly, you could sell at the top.  As an example; selling into a merger or takeover.  When a company tries to take over another company, they have to pay above the then current market price to motivate shareholders to approve the sale.  If they don’t offer enough, they don’t get the votes.  Typically, a buy out offer will be the highest price in a specific time period.  Creating a top.

Some people trade blindly, others with blinders on, still others just need a different pair of glasses.  If you look at things in a different light, you should become better traders.

An old adage claims, “He who defines the terms, wins the argument.”  So don’t send me an e-mail disagreeing.  Some of this will be completely new.

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No one can buy bottoms or sell tops.  Transactions require two parties, buyers and sellers.  There has to be someone on the other side of a trade.  Without a willing seller, a buyer keeps his money.  Without a buyer, no sale takes place.  Tops and bottoms have only one willing party.

Commonly known as the bottom, it should truly be known as the lowest price.  The highest price is not the top, but just the highest price.  Bottoms are lows that don’t go lower.  Tops are highs that don’t trade higher.  They can only be confirmed after the fact.  Not during or before, but after.

Prices decline because of concentrated selling with scattered buying.  Translated, more sellers than buyers.  Prices fall with lower sellers; a rush to the exit.  To fall further it needs a seller at a lower price.  If a seller at a lower price doesn’t exist, the decline will stop.  Even with ready and willing buyers, no transaction will take place without sellers. The absence of sellers indicates the bottom, a theoretical point just after the lowest price.

Until prices increase a bottom hasn’t been made, only a new low.  The price may stay flat, forming a solid bottom to rise from.  Only after the prices rise can one look back and see the bottom.  It must turn back upward.

Trying to buy a bottom is like “trying to catch a falling knife”.  More often than not, you’ll injure yourself.  Often a stock that you thought was trading near a bottom will fall even further.  Stocks bottom out when there is no one left to sell any lower.  You will be a better trader if you let the stock turn to the upside before buying.  Don’t get greedy.

The opposite extreme to the bottom is the top.  If prices decline because of selling pressure, then prices rise due to buying pressure.  Concentrated buying with scattered selling, more buyers than sellers.  A high is only a high until replaced with a new higher high.  A high becomes a top after it peaks and turns down.  A top is the absence of buyers.  No one to pay more.  Without buyers, sellers can not trade.

You may trade at the ultimate extremes in price, but you can not trade at the tops or bottoms.  There’s no one to take the opposite side.  If you traded at the extremes it’s not because of genius or stupidity, it’s because of luck.  Good or bad.  The good news is, you can create luck with knowledge and technical analysis.

All investments have risk.  Real estate, stocks, and mutual funds have risk, and of course options have risk.  But have you ever considered the risk of cash?  Not the risk of someone breaking into your house and stealing the money under your mattress, but the risk your money in the bank doesn’t retain buying power.

This week we’ll discuss option trading accounts and how brokerages look at them.  If you lack an option trading account, knowing almost everything about them won’t help you make any money.  This will not be a recommendation to any specific broker or brokerage.  Its an individual decision, like picking a favorite flavor of ice cream, my favorite flavor shouldn’t be yours, no matter how much I know about ice cream.

You shouldn’t chose a broker by low commission rates, but the trading authority they will allow.  If you have a more complicated or “more risky” strategy that consistently has made money in the past and your broker won’t let you trade it, you need a new broker.  In defense of the broker, if you’re consistently betting the milk money on “long shot losers”, he doesn’t need the risk of a lawsuit for allowing you to speculate away your grocery money.  Don’t laugh, brokers get sued all the time.  Good brokers don’t want the label of a churn and burner, using tactics making more commissions than profits.  Brokerage won’t allow everyone shovels to dig themselves holes they can’t get out.

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By reading these articles, many of you will know more about options than your broker.  If they won’t allow you to trade strategies they don’t understand, no matter how much you understand, consider changing.

Different brokerage firms might have different rules and requirements, but this is as close to industry standard as it gets.  There are five levels of option trading authority.  These levels are based on risk and complications.  Risk to you the trader, but more important the perceived risk to the broker.  Some strategies are complicated, both to the investor and the broker.

The five levels are:

Level One; selling covered calls.
Level Two; buying puts and calls.
Level Three; spreads.
Level Four; selling uncovered (naked) puts.
Level Five; selling uncovered (naked) calls.

Options are a contract between two parties.  The buyer has rights, the seller has obligations.  Call options give the buyer the right to buy a stock at a predetermined price (the strike price) within a predetermined time period (the expiration date).  The seller, also known as the writer, is obligated to deliver the stock if the buyer exercises his right.

Most investors should easily attain Level One trading authority. Considered so safe a strategy, the IRS allows it in IRA accounts.  When a investor owns stock, he may sell a call, giving the buyer the right to purchase the stock.  The brokerage liens the stock, they won’t allow you to dispose of it since it guarantees your ability to perform your part of the contract.  Think of it this way, the broker is covered.  The chain of events flows.  If the call buyer exercises his right, the broker doesn’t have to contact you.  The stock is sold automatically.  The broker takes it out of your account, and puts in money.  If the call buyer doesn’t exercise his rights before the call expires, the lien disappears.  You’re free to sell the stock, or another covered call.  Pretty safe, pretty simple.  Covered calls have two risks, both related to market fluctuations.  First, like owning stock, you run the risk of the stock price declining.  You also run the risk of not participating if the stock makes a major upward move.

Level Two is buying options.  The option purchaser pays the option premium hoping for a favorable move in the underlying stock.  The investor actually speculates the value of the option will rise.  It’s not a complicated scenario, try to buy low, sell high.  Buying options is less complex and less commission intensive than covered calls.  The pitfall requires risking entire amount ventured.  If an option runs out of time and has no intrinsic value then it’s worthless.  Zip, Zero!  Because of the possibility of total loss, not everyone will be allowed Level Two authority.  Not difficult to get, but with few exceptions not allowed in retirement accounts.  The determining factor generally is account size.  It’s the grocery money issue.

Levels Three through Five require a margin account.

Level Three:  spreads.  In my opinion, the least risky, but most complex of all transactions.  A brief explanation; a spread is a position with two or more components.  Simultaneously buying or selling two different options changes the risk/reward curve.  Spreads can have predetermined risk with predetermined reward, but done right, unlimited possibility!  My attempt, this week, is not to teach spreads, but to help you know about setting up your account.  I would encourage all option investors to have spread writing authorization.  Make it a goal.  If you don’t have it set up, find out what it takes for approval.  Be aware, many brokerages require one year prior account activity before okaying spreads.  If your broker demands more time than your account has been open don’t fret, you’ll be given the tools to profitable trade until such time.

Level Four, selling uncovered (naked) puts.  Think of it this way, the seller acts as the insurance company, the buyer is the policy holder, the put sold the policy, the strike price equals policy value, and the option premium collected the insurance premium.  The policy states that if on or before expiration the stock price is below the strike price, the policy holder may sell the stock at policy value, regardless the actual market value.  The put seller obligates himself to buy the stock no matter how low the price drops.

A funny thing about Level Four naked puts, without margin, the risks are identical to Level One covered calls.  Think about it, in both, if the stock price is above the strike price the option seller won’t own the stock.  If the stock price is below the strike price, the covered call writer keeps his stock; the naked put writer is obligated to buy the stock.  The reality is naked puts have lower margin requirements, and therefore higher leveraged potential returns.  Everybody knows with higher rewards, there must be higher risk.  I like naked put selling, but I feel the same high returns are available, with less danger with put spreads (Level Three).

Level Five, selling uncovered (naked) calls.  Only money guarantees your ability to deliver the stock, and it takes a lot!  Technically this strategy has unlimited risk.  The sky is the limit.  The seller is obligated to deliver stock he doesn’t own.  Unless you have a lot of experience and a ton of money, your broker won’t allow you to sell naked calls.  Don’t ask.  The bright side is, I only know one circumstance worth considering using Level Five authority.  If you have a calendar spread on expiration Friday, with the short option out of the money, consider selling the next month’s call without waiting until the following Monday.  You won’t lose two days of time decay nor have unknown market exposure.  You’re entering into a new spread without closing the old one.

Often out of the money options have too much value on the ask side on expiration day.  Market makers know most option traders can’t sell uncovered options, and to keep a spread hedged over the weekend following expiration Friday, option traders need to buy back their short position to close.  Hence, they overcharge for them.  Market makers are not stupid.

If you can’t understand this situation, don’t worry, you don’t want Level Five authority, nor will your broker approve.

Some stocks went up.  (Hopefully yours.)  Some stocks traded lower.  Some stock prices stayed the same.  (A few flat lined dead on arrival, many roller coasted up and down back to the starting point.)

I was just recently in Las Vegas, for business of course.  I enjoy going by the gaming tables.  Market research, crowd psychology.  Seeing how people bet their cash.  Well chips anyway, if bettors had to use real money, they might recognize how much money they just lost.

Ever watch people learning to play craps?  They’ll use real money.  Haven’t they heard of paper trading?  Maybe because the pit boss and the other casino employees are always willing to help.  Lots of assistance available to make a bet.  No matter what color the chips.

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Gambling and specifically craps have much in common with options: complex risk reward curves.  Since the IRS doesn’t allow deducting crap table loses from your income taxes, why would anyone want to throw dice.  They can bet options, I mean trade options.

Many amateur options traders invest as if they were at a casino.  No regards for the odds, just mesmerized by the big potential payoff.

Anyone who has been around Wall Street any length of time knows there isn’t many “sure things.”  Truly, time’s passing is the only safe bet.

In this example we will trade based on Theta alone.  We will consider the other “Greeks” asleep.  In reality, they are NOT dormant.  The fact is, you could set your trades up to minimize their effects.  Remember it’s best not to awaken a sleeping giant if at all possible.

Our hypothetical example will be four At the Money (ATM) options on a single stock:

One month option = $ 1.00
Two month option = $ 1.41
Three month option = $ 1.73
Four month option = $ 2.00

With these hypothetical examples, let’s enter a simple time or calendar spread.  We will buy the four month option for $ 2.00 while simultaneously selling the one month option for $ 1.00.  Our net cost would be $ 1.00 ($ 2.00 less $ 1.00).  Again for demonstration purposes we will not take commissions nor the bid/ask spread into consideration. And also ignore strike prices as well.

If everything remained the same except for time’s passage, after one month the option we sold (short position) would be worthless to the buyer.  An At the Money (ATM) option has no value at expiration.  A $ 1.00 profit to us, offset by the $ .27 loss on our four month turned three month option, brings our position value to $ 1.73.

Anyone who can find situations where all the variables remain constant for one month deserves to make 73% on their money.

In our perfect example situation, we could now sell another one month option for another Dollar. After the second month, the option we originally bought would have lost half its time, but only $ .59 of its value.  Now priced at $ 1.41, the income would be equal to its original cost, $ 2.00.  Our cost would be zero.  Our profits infinite.

Closer to expiration, owning options costs more.  Inversely, selling options closer to expiration can pay more.

If the one month ATM option is $ 1.00, and the four month equals $ 2.00, then the nine month option would be priced at $ 3.00.  Continuing forward, the 16 month option’s price would be $ 4.00 and $ 5.00 would buy the 25 month option.

If we could sell one month of time for $ 1.00, we could pay for the 16 month option in four months.  Giving us a year of potential for free.

Please don’t base trades on any one option pricing component, while ignoring the others.  You’ve been given enough information to be dangerous.  If you trade with blinders on, you tend to get blind sided.

Knowledgeable traders earn the right to have less money at risk and greater potential for profits.  Knowledge comes with experience, and experience comes with time, regardless of real chips or paper trades.

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