Monthly Archives: October 2011

Bull Put Spread ~ Put Options

Bull Put Spread

Put Spreads can be used when an investor is willing to accumulate stock, but have downside protection in case the underlying stock breaks below a pre-determined level. The strategy is called the bull put spread.

What you do is sell out of the money put options, but purchase further out of the money put options for downside protection in case the stock breaks down. For example if XYZ is trading at $25, the investor sells 1 $20 put option and buys one $15 put option for a net credit of $1.  If the stock stays above $20, the investor will keep the credit. If it goes below $20, the stock will be put to the investor, but the investor has downside protection at $15 so the maximum potential loss is capped at $4.

SPY Credit Put Spread

P/L Graph for SPY Bull Put Spread

The Calendar Spread ~ Call and Put

The calendar spread is an option strategy that involves
buying an option and selling an option simultaneously with the same strike
price, but different expiration dates. A calendar spread can be long or short. A calendar spread can be constructed with call options, put options or both which is known as a dual calendar spread.
A long calendar spread is done for a net debit and the risk is limited to the
amount of the debit. A short calendar spread is done for a net credit and is known as a credit spread. Investors can use calendar spreads to enter hedged stock or ETF positions. The long put calendar spread can be utilized to enter a long stock position with limited risk. If the investor has a market opinion that the underlying will stay below a certain strike in one month, and then rise the following month, a long put calendar spread may be a good choice, here’s how it works. XYZ stock is at 25, we think it will stay at 25 this month then rise next month with its earnings report. We’re going to sell the near term 26 put and buy a longer term 26 put. The net debit is $1. We’ll get assigned on the near term put, then hold a long stock position with an entry price of $27, but we have the right to sell it for $26 so our maximum loss is $1 and our maximum gain is unlimited. If xyz rises to $30 after the earnings report, we have a gain of $3 and have only risked $1. When there is a volatility skew between the expiration months, we can enter these positions with very tight spreads and very low risk. A volatility skew is defined as different expiration months have higher or lower levels of implied volatility. In the money options will have tighter spreads than at the money options, but will have a lower probability of success. Similarly the long call calendar spread can be used to enter a short underlying position with limited risk when one’s forecast calls for the underlying stock or fund to decline in value in the future. The spreads can be sold for a profit if the spreads widen or employed as a strategy to enter controlled risk positions for certain time periods. Calendar spreads can also be set up as diagonal spreads.
A typical diagonal spread will be long a far dated in the or at the money
option and will sell a near dated out of the money option. A diagonal spread
can be used as a covered call substitute with less risk and less capital outlay
than owning the underlying security. A long dated in the money call can be
purchased with a very long expiration like a LEAP and short dated current month or weekly out of the money options can be sold against the position for income.

Limiting risk with call options ~ How to Trade

The long call option is probably one of the simplest option positions to understand. The purchaser of a call is considered to be long a call option. The long call gives the investor exposure to the upside of the market while the risk is limited to the premium paid for the option. Long calls will have a positive delta and a negative theta. LEAPS or long term equity anticipation securities can be purchased up to three years out. If you are bullish on the market for example, but concerned about global events like
sovereign debt defaults, war or terrorism you could purchase a LEAP on an index like the S&P 500, if the market rises you’ll participate. In the event an unexpected event occurs and the market takes a big hit, your risk is controlled because what you have paid for the option is much less than if you had purchased the index fund outright. Considerations to be made when purchasing a long call include the price of the underlying, the implied volatility of the option, the strike price, expiration, delta and the theta or decay factor of the option. Remember the rate of decay accelerates rapidly in the final weeks prior to expiration. Investors buying call options as a limited risk stock substitute should use longer dated contracts to give the underlying more time to make the anticipated move and to minimize the negative effects of time decay. The options delta is also a primary factor to consider. The at the money call with have a delta near 50 which means that the option will move half of what the underlying does. Out of the money calls have lower deltas as they move out of the money, they also have lower prices which equates to less capital at risk but you also need a larger price movement in the underlying to profit. The delta is roughly equal to the probability of the option being in the money at expiration, so a call with a low delta, say a 25 delta call, will only have a 25% probability of being in the money at expiration. An in the money option will have a higher delta, but will also have a higher price meaning more
capital at risk. An in the money call with a 75 delta will have a 75% chance of being in the money at expiration. If the price of the underlying rises, that call’s delta will change at a rate given by the gamma and will go to 100 if the option goes deeper into the money. Generally tactical option investors buy high delta in the money calls as a stock or ETF substitute that have a high
probability of success. When buying deep in the money calls however, it almost never makes sense to pay more for the call than you would to purchase the underlying on margin or 50% of the price of the underlying.

SPY Long Call

SPY Long Call

Stock Repair with Options

The Stock Repair Strategy

Have you ever bought a stock and seen it go down? In need of stock repair? One way to try to recover is use the stock repair strategy. It can be used to lower your break-even point. What you do is sell a two by one call ratio spread on the underlying stock to adjust your cost basis lower. The trade can be put on for a small credit or a break even price. For example, our investor buys 200 XYZ at $27.50 for a total investment of $5,500 and it’s now at $20, or worth $4,000.  She would sell four $25 calls for $0.50 each and collect $200, then use those funds to buy two $22.50 calls for $1.  At no cost, the break-even point is now lowered to $25. If XYZ rises to $25 at expiration, the $22.50 calls would be worth $2.50 each or $500 and the $25 calls would expire worthless. So the 200 XYZ would be worth $5,000 and the two calls would be worth $500 for a total value of $5,500. The breakeven point has been lowered from the initial purchase price of $27.50 to $25.00 at no cost.

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