Option Trading Strategy

Basic Concepts in Option Trading Strategies

There are several basic Options Trading strategies, but in order to execute any of them successfully an investor new to options will need to know some elementary concepts.
The most basic Option trading strategy are the call and the put.
Buying a call confers the right, but not the obligation, to buy at a pre-set price.
Puts grant the buyer the right to sell at a pre-set price. But options are sold as well as bought.
That seller grants the buyer the right, and takes on an obligation to fulfill the other side of the trade.
There are several basic Option trading strategy variations:

Long Calls

The most basic, and easiest to understand, is the (long) call. MSFT (Microsoft), currently trading at $28, have June 31 options that expire on the third Friday of June, with a strike price (pre-set, 'if exercised, must-be-bought-at-price') of $31.

Short ('Naked') Calls

When the option seller (the 'writer') doesn't own the underlying stock he's obligated to sell (if the option is exercised), he is said to be selling a 'naked' call. Since he's on the selling side of the contract, his position is said to be 'short'.
If the market price of the underlying asset decreases, the short call position will profit by the amount of the premium. The price rises above the strike price by more than the premium, the short position incurs a loss.

Long Put

Traders who anticipate that the future market price of an asset, say a stock, will fall prior to expiration can buy the right to sell the stock at a fixed price. The put buyer has no obligation to sell the stock, but simply the right.
If, in fact, the market price does fall below the strike price (prior to expiration of the option) by more than the premium paid, he profits. If the price increases, or doesn't fall enough to cover the premium, the trader lets the contract 'expire worthless'.

Short Put

Traders who speculate that the future market price will increase, can sell the right to sell an asset at a pre-determined price.
If the asset's market price rises, the short put position makes a profit equal to the amount of the premium. (Excluding any transaction costs, such as commissions.) If the price falls below the strike price by more than the premium, the 'writer' loses money.
Several basic trading strategies utilize the characteristics of these four basic positions. These strategies are either pure profit plays - speculating on coming out on the plus side of the equation - or combinations of speculation and hedging.
Hedging involves taking positions that tend to move in opposite directions. They profit less than pure speculation, but make up for it by offloading some risk.
'Bull spreads', for example, use a long call with a low strike price in combination with a short call at a higher strike price and a short put with a higher strike price.
'Bear spreads', by contrast, involve a short call with a low strike price and a long call with a higher strike price. An alternative method uses a short put with low strike price and a long put with a higher strike price.
Options trading software can demonstrate several concrete examples of how any of these - under different assumptions about future prices, volume, etc in combination with different expiration dates and strike prices - can result in profit (or loss).

Profit and Risk

Risk isn't inherently bad. Without it, there would be far fewer opportunities for profit. In particular, there would be no options market at all. No one would have to speculate on price direction or other factors, since risk always implies uncertainty about the future.
But risks come in different flavors and degrees. Let's examine some trading strategies with an eye toward risk...
Long Calls
The simplest options trade, the one usually first executed by investors moving beyond stock or bond investing, is the long call. A call is a contract that confers the right to buy an underlying instrument at a set price, the strike price. For this right, the buyer pays a 'premium' - the cost of the option.
When that strike price is below the current market price, the option is said to be 'in the money', when above it's 'out of the money'. But whatever the market price when the option is purchased, the buyer is speculating that the market price will be above his cost (strike price + premium + commission) before the option expires.
The amount by which the market price is above that cost determines the amount of profit. Since, in theory, the market price can rise indefinitely, the profit potential is called 'uncapped'.
Unlimited potential profit, but not without risk. As the famous banker J.P. Morgan said when asked what the stock market would do: 'Prices will rise, and prices will fall.' When the price falls below, or fails to rise above the cost of the option the investor loses money. In this case, however, the risk is obviously limited to the amount of the option (plus a small commission).
These kinds of options make for wise investments for those with limited experience but who want to take advantage of the additional leverage provided by options. Leverage is the ability to control more than you own. Since the option price is typically around 5% of that of the underlying stock, the leverage is 20:1. This multiplier effect is one thing that makes options so attractive.
Be sure the option has adequate liquidity, though. Open interest (the total outstanding contracts) should be no less than 100. The higher the better.
Long Puts
J.P. Morgan was right, prices sometimes fall. Sometimes they fall far and for a long time. When an investor judges this is likely, the next simplest options trading strategy can be employed: buying a put.
A put is a contract granting the right to sell an asset at a set price before or by expiration. It's slightly more difficult to understand, since the idea of selling something you don't own is odd.
Just like shorting stock, the trade (imagining the option were exercised) actually involves effectively borrowing the shares then immediately selling them. However, the investor never sees the underlying mechanics. As with shorting stock, the investor is on the hook for the 'borrowed' amount.
In this scenario the put buyer is speculating that the market price will fall below the strike price.
This is another situation in which the maximum risk is capped, this time by the price paid for the put. The reward too is capped, since the market price can't fall below zero. The maximum profit in that case is the strike price minus the cost of the put.
As with calls, ensure you choose an underlying instrument with adequate liquidity, preferably shares of over 500,000 ADV (Average Daily Volume). Look for open interest amounts over 100.
When trading options always be sure to select those with enough time left to judge the market trend. An option near expiration will be cheaper (options contracts are themselves actively traded), but carry higher risk.

Options Trading 101

Stock and Bond trading strategies run the gamut from the simple 'buy and hold forever' to the most advanced use of technical analysis. Options trading has a similar spectrum.
Options are a contract conferring the right to buy (call option) or sell (put option) some underlying instrument, such as a stock or bond, at a predetermined price (the strike price) on or before a preset date (the expiration date).
So-called 'American' options can be exercised anytime before expiration, 'European' options are exercised on the expiration date.
Though the history of the terms may lie in geography, the association has been lost over time. American-style options are written for stocks and bonds. The European are often written on indexes.
Options officially expire on the Saturday after the third Friday of the contract's expiration month. Few brokers are available to the average investor on Saturday and the US exchanges are closed, making the effective expiration day the prior Friday.
With some basic terminology and mechanics out of the way, on to some basic strategies.
There are one of two choices made when selling any option. Since all have a set expiration date, the holder can keep the option until maturity or sell before then. (We'll consider American-style only, and for simplicity focus on stocks.)
A great many investors do in fact hold until maturity and then exercise the option to trade the underlying asset. Assume the buyer purchased a call option at $2 on a stock with a strike price of $25. (Typically, options contracts are on 100 share lots.) To purchase the stock the total investment is:
($2 + $25) x 100 = $2700 (Ignoring commissions.)
This strategy makes sense provided the market price is anything above $27.
But suppose the investor speculates that the price has peaked prior to the end of the life of the option. If the price has risen above $27 but looks to be on the way down without recovering, selling now is preferred.
Now suppose the market price is below the strike price, but the option is soon to expire or the price is likely to continue downward. Under these circumstances, it may be wise to sell before the price goes even lower in order to curtail further loss. The investor can, at least, minimize the loss by using it to offset capital gains taxes.
The final basic alternative is to simply let the contract expire. Unlike futures, there's no obligation to buy or sell the asset - only the right to do so. Depending on the premium, strike price and current market price it may represent a smaller loss to just 'eat the premium'.
Observe that options carry the usual uncertainties associated with stocks: prices can rise or fall by unknown amounts over unpredictable time frames. But, added to that is the fact that options have - like bonds - an expiration date.
One consequence of that fact is: as time passes, the price of the option itself can change (the contracts are traded just like stocks or bonds). How much they change is influenced by both the price of the underlying stock and the amount of time left on the option.
Selling the option, not the underlying asset, is one way to offset that premium loss or even profit.

Options Trading 102

Options trading can become very complicated very quickly. There areLEAPS (long-term contracts), choosers, barriers, compounds (exotics) and a host of technical parameters to measure volatility and predict price movements.
Some of these complications can be simplified into a number of simpler trading strategies.
Most revolve around using the fact that options have a contractually specified expiration date and strike price.
This makes trading in Otions subject to some techniques not available in regular stock investing.

Calendar Spread

The 'calendar spread' or 'time spread' strategy involves simultaneously buying and selling two options of the same type, with the same strike price, but different expiration dates.
For example, purchase two calls of MSFT (Microsoft) at a strike price of $27, but one set to expire on April 15, the other on June 17. The idea is to attempt to gain from the difference in price as each contract advances closer to maturity.

Straddle

In a 'straddle' strategy the investor holds both a call and a put (on the same underlying asset, of course) with the same strike price and expiration date.
At first blush, this seems like betting against oneself. No matter which way the price goes, the investor loses. But, it's also true that no matter which way the price goes the investor gains.
It's this feature that makes a straddle a kind of hedging strategy. Since price direction and amount can only be predicted to some degree of probability, the investor is 'hedging his bets'.
While risky, the strategy can produce profits when price movements are large. Offsetting those potential profits is the fact that, where others are also betting on a large price movement, these options contracts tend to be priced higher.

Strangle

Yet another variation is the 'strangle'. The investor holds both call and put options with the same maturity, but with different strike prices.
These contracts are purchased 'out of the money' and therefore cost less to buy. ('Out of the money' means the strike price of the underlying asset is – higher (for a call) or lower (for a put) – than the market price.) Their purchase price (premium) is lower since if the option were exercised immediately the investor would experience an immediate loss.
Suppose Microsoft (MSFT) is currently trading at $30 per share. Buy one call at $3 and one put at $2 with the call having a strike price of $35, the put $25. (Total Investment = ($3 x 100) + ($2 x 100) = $500.)
If the price over the length of the contracts stays between $25 and $35 the total possible loss = $500, the cost of the options.
Suppose the price drops, though, to $15. The call is worthless, but the put is worth ($25-$15) x 100 = $1000 - ($2 x 100) = $800. Subtract the cost of the call, $800 - $300 = $500. This represents the net profit (ignoring commissions and taxes) on the trades.
Definitely do try this at home, but wear a safety helmet... in the form of following carefully the movements of both the options and the underlying assets.

08/12/2011