Amar Mahallati asked:


When venturing into the options market, the best way to get the lay of the land is to be acquainted with at least some of the more elementary concepts. These will aid the new investor in successfully executing basic trading strategies.

Two basic terms, the call and the put, are the epicenter of the trading strategies. To buy a call confers the right, not the obligation, to buy at a price that is pre set. Conversely, puts give the buyer the right to sell at a pre set price. Options are both sold and bought, meaning that the seller grants the buyer the right and takes on an obligation to fulfill the other side of the trade.

The variations to this maneuver include:

Long Calls

The long call is the easiest to understand and is the most basic concept. MSFT (Microsoft) traded at $28 with June 31 options that were to expire on the third Friday of June. The strike price was $31, meaning that it was pre set so if exercised it had to be bought at that price.

Short (Naked) Calls

When the writer, the person selling the option, does not own the underlying stock and the option is exercised, then he or she is obligated to sell. Under those circumstances, that action is considered a naked call. Because the person is on the selling side of the contract, his position is considered to be short.

The short call status incurs the most profit by the amount of the premium if the market price of the underlying asset decreases. When the price exceeds the strike price by more than the premium, then the short position takes a loss.

Long Put

When a trader anticipates that the future market price of an asset, such as a stock, will fall before the expiration date is able to sell the stock at a fixed price. The buyer, put buyer, is not obligated to sell the stock, but he or she does have the right.

If the market price does drop below the strike price before the option expires and the decrease is more than the premium paid, then the seller profits. If the price increases or fails to drop enough to cover the premium then the trader will allow the contract to expire worthless.

Short Put

When a trader speculates that the future market price will rise, they can sell the right to sell an asset at the predetermined price.

If the asset’s market price increases, the short put position incurs a profit that is equal to the amount of the premium. This amount excludes any transaction costs and commissions. However, if the price drops below the strike price by more than the premium amount then the writer loses the money.

There are several trading strategies that are basic to the market. These strategies employ the characteristics of four basic trading positions. These strategies have one of several outcomes: pure profit plays, speculating on gaining a profit or creating a combination of speculation and hedging.

When positions move in opposite directions, it is called hedging. Hedging bears a profit less that sheer speculation, but they do compensate by offloading a certain degree of the risk.

Bull spreads and bear spreads are common strategies that can help the trader manipulate the market, depending on the market emotion. Bull spreads utilize a long call with a low strike price and combine it with a short call at a higher strike price and a short put with a higher strike price. On the other hand, bear spreads use a short call with a low strike price and a long call with a high strike price. Alternatively, the short put can be used with a low strike price and a long put can be used with a higher strike price.

There is a great deal of software on the market that can aid in these types of trades. Options trading software can offer users concrete demonstrations of the how these strategies work. They show how they behave under different assumptions regarding future prices, volume and other factors, combined with various expiration dates and strike prices to show how these different scenarios can result in a profit or a loss.



Amely Riskin

James Thomas asked:


You may or may not have heard of credit spread option trading but they can be used to profit in bullish, neutral or bearish conditions.

They are a cashflow generating strategy that involves both the buying and selling of either calls or puts of different strike prices but same expiration date to establish an overall ‘credit’ i.e. spendable cash.

It is a great option trading strategy for taking advantage of the ‘time decay’ that option selling provides, but with limited risk.

The amount of potential profit of course is limited to the credit received when the trade is first made.

Let me give you an example of this powerful, yet underutilized option trading strategy.

Let’s say that the QQQQ (The Nasdaq 100 tracking unit) is trading at $30.50 and we believe that it will continue to go up in price.

To create a vertical credit spread using puts (selling puts is profitable if the market rises), we could do the following:

1) Sell the $30 put (expiring this month).

and

2) Buy the $29 put (expiring this month).

TIP:

In my experience, it’s always best to sell short-term, ‘Out-of-the-money‘ option premium for 3 main reasons:

1) Out of the money options have lower deltas, meaning the stock has to move further before the value of our sold option increases (remember we want it to decrease).

2) Selling ‘current month’ options (30 days or less to expiry) is when time decay is at it’s most rapid and the value of our sold option is eroding away with each day.

3) Contrary to buying options, if the stock does moves very little or not at all, we win!

Let’s say we received $0.90 cents per contract for selling the $30 puts and we paid $0.40 cents per contract by buying the $29 puts.

This transaction gives us an overall credit of $0.50 cents per contract ($0.90-$0.40).

If we sold 20 contracts of the $30 Put and bought 20 contracts of the $29 Put, this would give us a total credit of $1,000 (2000 shares x $0.50 cents).

So basically, if QQQQ expires at any price above $30 we will make our maximum profit, which is the initial credit we received ($0.50 cents).

On the other hand if QQQQ expires at any price below our breakeven point of $28.50, we will be facing a loss.

Let’s look at all the possibilities.

Once we have entered the trade the QQQQ can either:

1)Go up a little bit.

2)Go up a lot.

3)Go sideways.

4)Go down a little bit.

5)Go down a lot.

The beauty of this style of trading is that we will win in four out of five of these situations, and in many instances we can even win in all five!

Let me demonstrate how.

The QQQQ is trading at 30.50, if it moves up a little bit to say $30.80, our sold option ($30 Put) will expire worthless and we will keep all of the premium.

If the QQQQ moves up a lot to say $32, the same will occur and we will get to keep the premium.

If the QQQQ moves sideways and stays around $30.50, again the ($30 Put) will expire worthless and we will get to keep the premium.

If the QQQQ goes down a little bit to say $30.15, the same will occur and we will keep the premium.

OK, so far so good!

The only way we can LOSE in this trade is if the QQQQ goes down a lot to below $29.50 (which is the higher strike price minus the premium).

If it were the end of the month of expiry and the QQQQ was trading below $30 (our sold option strike price) we would be exercised and our total loss would be the difference between the sold option strike price and the current stock price less the total credit we received.

Our maximum loss will be realized at any price at or below our bought option strike price.

$30 - $29 = $1, less the premium of $0.50 cents = a maximum loss of $0.50 cents per contract or $1000 (20 contracts - 200 shares x $0.50 cents)

However, before it gets to this point, we would intervene. If the QQQQ is falling strongly then we were obviously wrong in our initial analysis.

Before we entered the trade though, we decided that if the QQQQ fell through support at $30 (which it does) we would move to plan B.

At this point we can do a little ‘magic’.

With the click of a mouse through our online broker, we can instantly jump from the bullish camp to the bearish camp!

We do this by buying back the options that we sold which in this case is the $30 puts, and this removes all of our obligation.

At this point though, we have taken a loss BUT, we are still long the $29 puts which would have already increased in value.

If the QQQQ wants to go down, then we are going to let it and just ride the $29 puts as far as they will go.

The more the QQQQ falls in price, the more our option will increase in value.

If it falls far enough, which in this case it does, (falling to $28.50) then we will not only make all our money back, we will start to move into a profitable position.

With credit spreads, we give ourselves the flexibility to change our position mid stream, and the chance to not only recoup some of our losses (if we get it wrong), but to possibly move from a loss into a PROFIT!

And this is just the plan B if things go wrong. Plan A, on it’s own, has statistically, a very high probability of success.

If on the other hand we had the view that the QQQQ would go down, we would simply construct a vertical spread with Out-of-the-money Calls.

We would sell the $31 Call and buy the $32 Call for an overall credit and should the QQQQ close below $31 by the end of the month, the spread would expire worthless and we would simply keep the premium.



Cory