OPTION STRATEGIES
As we’ve discussed already, options are tools. What follows in this chapter are different strategies and their intended purposes. As with any tool, the wrong tool at the wrong time won’t do the job. Let’s get right into it.
The first strategy we will look at is called a buy/write or buy and write. Its purpose is to generate income. An investor, William Fold, purchases a stock for its income purposes, not for capital appreciation. Bill buys a stock, say, ZAP at $38 a share. The stock pays a dollar a share dividend annually, or a $0.25 dividend quarterly. Bill checks the quote for options and sees there is a three-month option with a strike price of 40, which means it is out of the money, and selling for a dollar ($1.00 × 100 shares = $100). Bill writes the option against the stock owned, and the short call position is known as a “covered call.” The broker-dealer is not exposed to any risk as Bill’s stock would be used to satisfy the short call should it be assigned, so all margin requirements, if they exist, flow to the stock. Provided the stock does not rise to over $40 a share over the next three months, the customer has just earned a hundred dollars from the premium, the dividend for the stock for a year, literally overnight.
If the stock does not trade above $40 per share for the next three months, the option will expire worthless. At that point, the client keeps the premium and does not have any further obligation, and the client can enter into a new buy/write strategy. This can be done over and over, as long as the relationship between the price of the underlying stock and the option premium makes it advantageous to do.
During this time Bill faces two risks with the buy/write positions. One is that should something good happen to the company and the stock rises above $40 per share, then Bill is left with a hundred dollars earned from the short call, plus any dividends that may have been paid, plus the 2 points when the stock gets called away at $40 a share. Bill made a total of 3 points on the entire transaction. If the stock goes from $38 per share to more than $40 per share, the customer has lost the opportunity of earning a greater profit. But remember, Bill did not think the stock was going to appreciate in terms of capital. Therefore, the option is doing exactly what it should be doing.
The other downside to a buy/write occurs when the stock starts to lose value. If it fell from 38 to 36 to 34, the customer still would have a call option outstanding, which is protected by the stock. Should they decide to liquidate the stock and limit their loss, they would have an uncovered out-of-the-money call for the duration of the option’s life. Maybe the stock would not turn around and run up in value, but maybe it would. If the client sells the stock, the short call option becomes “uncovered.” The client must post margin for the uncovered position, which is “marked to the market” daily and exposes the client to unlimited risk should the stock have a strong rally. If the stock price does turn around and begin to run up, the short call would be in the money once the stock was above $40 per share. Upon being exercised against, the client would have to go into the market and buy the stock at whatever price it is trading at. Then the client would have to deliver the newly acquired stock against the call at $40 per share.
Of course, while this was going on, the client could buy in the short call, closing out the option position, or buy back the sold stock to cover the option, or even do both, thereby developing an option-free long stock position. With commissions and other costs included, this last part could be very expensive.
The next strategy we will look at is a spread, which is both the purchase and sale of equal numbers of puts or calls, having the same underlying security but different series. Remember, the series is made up of the option’s expiration month and the strike price. The spread position can also be obtained if the missing “leg” enters the position through trading. In other words, if the client is long a call option on ZAP Oct 50, the long position would become a spread position automatically if the client sold a call on ZAP with some other series besides the one that is owned.
In a case of a spread, one option is the main option, or the driver, and the other option is either a premium reducer or used as a risk reducer. Let’s examine this distinction more closely.
Supposing a client, Nicole Endyme, believes ZAP, which is currently trading at $51 per share, may rise in value as high as $55 per share in the next three or four months. Nicole calls her broker and discovers that a $50 per share strike price call option with a tenor of six months is selling for 5 points. If she buys that option and she is correct and the stock does go to 55, at expiration she will just about cover the cost of the option. She then inquires as to the current premium of the next higher strike price option with the same tenor. She is told that there is a call with a strike price of $55 selling for 2 points. Nicole gives the order to buy the $50 strike price call option with a premium of 5 points and at the same time sell the $55 call with a premium of 2 points for a net difference of 3 points.
In these examples we ignore commissions; therefore, the position has cost Nicole 3 points, of which 1 point is already intrinsic value. (Long a call with a strike price of $50, the underlying stock is trading at $51.) If she is correct and the stock does rise to 55 and goes no higher, her long option with a strike price of 50 will be worth 5 points at expiration. The short option with a strike price of 55, which she sold, will be worthless. The position cost Nicole 3 points; it is worth 5 points, giving Nicole a 2-point profit. No matter how high the underlying stock price was to climb, the position that currently exists, she will have a 5-point window between the $50 and $55 options and a 2-point profit at $55. If the stock rose to $100 per share at the options’ expiration, Nicole would be ahead by 50 points on the $50 strike price option, but behind by 45 points on the $55 strike price option, for a gross profit of 5 points, less the 3-point cost for a net profit of 2 points. Therefore, for an investment of 3 points for six months, she is going to make 5 points for a net profit of 2 points, which is a return of 66⅔ percent on her investment. This is an example of an option being used as a premium reducer.
Let’s look at a spread where the secondary option is a risk reducer.
Ms. Randi Miles has been watching the common stock of Craig Incorporated for several months. The stock was dropping in value but has started to turn around and come back. Randi believes she has seen the bottom of the run. She wishes to sell puts and therefore as the stock continues to rise, the puts will go out of the money, leaving her with the premium received. The stock is currently at $62 a share. Randi searches with her iPad for a three-month put option and sees that, with a strike price of $60, it’s trading for 5 points. She decides to sell ten puts and deposit the margin required by her security account. If she is correct and the stock does not fall below $60 per share in the next three months, she will walk away with a $5,000 profit. However, what if she is wrong and the stock turns from $62 per share and starts to run down again? She could face a huge loss.
If Craig Inc. falls and reaches 55, her profit is wiped out, and after that, she will start to lose her money. So Randi goes into the market, looks at the $55 strike price put, which is trading at 1½ points, and buys ten puts. She now has a box of a 5-point loss. For Randi’s short $60 strike price put options she received $5,000 (5 points × 100 shares = $500 × 10 options = $5,000). For her $55 long put options, she paid $1,500 for a net of $3,500. If the stock value remains above $60 per share, she will keep $3,500 ($5,000 received from the puts she sold with the $60 strike price, less the $1,500 she paid for the puts she bought with the $55 strike price). However, if the stock starts to fall below 60, the picture changes rapidly. If the stock was to fall below $60 per share, let’s say to $57 at option expiration, those short puts with the $60 strike price would be assigned (exercised against) by holders of the 60 puts buying the stock at $57 per share and “putting” it out at $60. That is a 3-point loss to Randi per exercise ($3,000 − 10 puts 3 points each).
Randi will see her profit shrinking as the stock continues to fall. Once it goes below $55 per share, Randi can sustain no greater loss than the 5-point spread between the $60 and $55 per share. As she sold ten of the $60 strike price puts for 5 points = $5,000, and she bought ten of the $55 strike puts at a price of 1½ for a cost of $1,500, the net difference is $3,500, which she received. However, the 5-point difference ($5,000 loss) between the $60 and $55 strike price options could leave her with a $1,500 loss even if the stock went to zero. Without the purchase of the $55 strike price put option, Randi faced a potential loss of $55,000 ($60,000 from the $60 strike price put, less the $5,000 that she received from selling the ten puts). Randi would have to pay $60 per share for the 1,000 shares of worthless stock represented by the ten short $60 strike price puts.
Both this example and the previous one demonstrate how, in a spread, a secondary option is used either to reduce the premium or as a risk reducer. We will now go on to bull and bear spreads.
A bull spread is industry terminology for any spread where the benefit occurs if the stock rises. A bear spread is any spread where the benefit occurs if the price falls.
Here’s an example of a bull spread using calls.
Ruth Lest buys a six-month call on KOW with a strike price of $30. KOW is currently trading at $28 per share. The option premium is 4 points. Therefore, Ruth has bought an out-of-the-money call option that has 4 points of time value. Ruth believes that the underlying stock, which is currently at $28, may rise to $34 or $35 a share within six months. To reduce the premium cost, Ruth sells a $35 strike price call on KOW for 1 point, bringing the net cost to 3 points. At this point in the transaction, Ruth can sell a $35 call that goes farther out in time so that the premium received may be greater.
For the first six months, the short call is covered by the long call, but going long with the program as presented, Ruth would have to post margin now for the longer period short calls even though the long calls cover them for the next six months. If someone was able to exercise the $35 strike price call against Ruth, Ruth would call in the long $30 strike price call. However, after the long calls expire, Ruth is left with uncovered short calls. The margin rules mandate that she post margin for all the short calls now and not when the long calls expire.
Ruth has bought a $30 strike price call for 4 points and sold a $35 call for 1 point for a net cost of 3 points. The stock is out of the money by 2 points. If Ruth’s assessment of the situation is correct, the stock near expiration of the options will be at $34 or $35, or even higher. Ruth’s short $35 call position will kick in, value-wise, when the stock crosses $35. If the stock doesn’t reach $35 per share, the $35 strike price option will be worthless. Ruth’s main call is the $30 strike price call, which will be worth 4 or 5 points or more at expiration, if the stock is selling at $34 or $35.
If the stock was at $35 at option expiration, the $35 strike price call minus the $30 strike price call will leave Ruth with a maximum of a 5-point spread. Since it cost her 3 points to do this, her net return would be 2 points for a return of 150 percent on her investment. If the stock fell and was below $30 per share when the options expired, Ruth would have lost her investment. As the only way Ruth could have benefited from this position was if the stock rose in market value, it is considered a bull spread.
The previous example highlights a very important point. The spreads as we have presented them exist as long as there are two options, a long and a short option, and as long as the long option expires on or after the short option. Should the short option go out longer than the long option, there is a period of exposure when the long option no longer exists. For margin purposes, once a spread is composed of a short option that is out for a longer period of time than the long option, it is treated as an uncovered position from day one. Therefore, those investors who have spreads where the short option goes out longer than the long option have to post margin on the uncovered option, even though it is covered temporarily by the long option. As far as margin goes, any time the short option has more value than the long option, the person whose account it is must post margin; I will go into the margin computations later on.
Let’s see an example of a bull option, using puts. Remember that a bull spread is one that anticipates an increase in the value of the underlying security. Therefore, if Ms. Lest sold a three-month put on KOW with a strike price of $60 when the stock was trading at $62, she would be writing an out-of-the-money put option because no one would buy the stock at $62 and put it out at $60 per share. However, if for the other leg of the spread, she bought a KOW three-month put with a strike price of $55, that would act to protect the position should the stock fall in value instead of rise. Should the stock fall below $55 per share, Ruth would incur a 5-point loss, because she would have to receive the stock at $60 on the exercise of the $60 strike price put, but turn around and exercise her long put at $55, losing 5 points on the turnaround. That figure would also be less whatever she collected for the sale of the $60 put, it being more valuable than the buy of the $55 put.
However, if the stock did not drop below $60 per share, and instead increased in value, both options would expire, worthless, and Ruth would keep the difference between the premium she received for the $60 put and the premium she paid for the $55 put. Therefore, she would want the stock to go up to be profitable in that position, which is the hallmark of a bull spread.
We will now design spreads that expect the stock to go down. This type of spread is known as a bear spread.
Let’s suppose that RAM common stock is trading at $48 per share. Randi Miles sells a six-month RAM call with a strike price of $50. That option is out of the money by 2 points, as no one will call a stock in at $50 that is trading at $48. However, if the RAM stock should rise, Randi could have a rather extensive exposure once the underlying RAM stock crosses over $50 per share and the call option is in the money. Therefore, to protect her option position, she buys a six-month call with a strike price of $55. That move limits Randi’s loss to the difference between the premium she received when she sold the $50 strike price call option and the premium she paid when she bought the $55 strike price call option, subtracted from the 5-point loss Randi would occur if the stock rose above $55 per share. At that price or above, Randi would have to respond to option exercises. She had to deliver stock at $50 per share when the short call was exercised against her and receive stock at $55 per share as she exercised her long option. If, however, the stock never reaches $50, both options will expire out of the money and Randi will keep the difference between the $50 strike price option and the $55 strike price option premiums.
Given the time until expiration, the lower strike price call option will always have more value than the higher strike price call because it would be the one that goes from out of the money to in the money first. Likewise, the higher strike price put would have more value than a lower strike price put because it would go from out of the money to in the money first.
We will now look at a bear spread using puts. Again, long put options want the stock to go down in value.
With the stock at $62, Nicole Endyme buys a six-month put with the strike price of $60 for 3 points. That put is currently out of the money, as no one is going to pay $62 per share and put the stock out at $60. To lower her premium, Nicole sells a six-month $55 strike price put for ½ point as that put option is out of the money. The premium received from the $55 put reduces the cost of the $60 put.
As the stock loses value, from $62 down to $55, Nicole’s long put is increasing in value—intrinsic value—and the short put is currently at the money. Therefore, this is the maximum Nicole can earn on this position. What the put cost when it was out of the money by 2 points was 3 points. At expiration, it is worth 5 points. Nicole is now profiting on the $60 strike price put, because it is 5 points in the money at expiration and the premium on the $55 put is now zero; that option is now out of time and it is at the money. Nicole then keeps the 5-point profit from the $60 strike price put, less the 3 points she paid for it, plus the ½ point received when Nicole sold the $55 strike price for a net of 2½ points profit. This is a bear put spread.
The relationships and purpose of a spread are further defined where the difference between the long and short options, whether calls or puts, is the strike price. This type of spread is known as a vertical spread, a price spread, or a money spread. In the case where the options in a spread, whether puts or calls, have a difference in the expiration month, this type of spread is known as a horizontal spread, a time spread, or a calendar spread. Spreads in which the expiration month and the strike price are different are known as diagonal spreads.
We will now look at a strategy known as a “straddle.” This is accurately named because the individual is buying a put and buying a call or selling a put and selling a call on the same underlying product for the same period. Therefore, it appears that this investor is straddling the fence. To be accurate, if the description of the call series and the description of the put series are the same, it is called a straddle. If the series are different from each other, either in strike price, expiration month, or both, it is called a combination.
Assume a client, James Nasium, is buying a put and a call on the same underlying—either that, or he is selling a put and a call on the same underlying. The reason for this strategy has to do with the premiums received or the premiums paid. If the straddle is being purchased, then the expectations are that the premiums will increase either through volatility or movement of the underlying issues in one of the two directions. Whether the underlying issue goes up and the call increases in value and the put decreases in value, or the underlying issue goes down and the put increases in value and the call decreases in value, remember: the decreasing option, the one whose premium is decreasing, cannot go below zero.
The “leg” that is increasing on a call is limitless; if it’s the put that is increasing, the maximum is the difference between the strike price of the put and the underlying stock at zero. If the straddle is being sold the seller wants the premiums to decrease. The position seller would want the total premium to decrease. If it is volatility of the underlying issue that is causing the high option premiums, the straddle seller would want the volatility to decrease, causing the option premiums to decrease so that the position can be bought back at a lower price. If the rise in premiums in the options was caused by an anticipated event, should the event not occur the premiums would decrease, allowing the position to be bought in at a lower overall price. Also, if what is causing the current option premium to be inflated doesn’t happen during the life of the options, the time value that is in either or both of the options will dissipate, allowing the closing out of the position at a profit.
Here’s another example:
Ron Rin Inc. is rumored to be in talks with Ann Publishing about a possible merger. The common stock of Ron Rin is showing increased volatility and has risen 4 points since the rumors began. Research analysts are of the opinion that the combined companies could benefit. Thomas Aytto is of the opinion that if the merger goes through, Ron Rin will be worth 12 to 15 points more. If talks fall apart, the stock would lose the 4 points it gained and, perhaps, even more. Tom decides to buy a six-month call on Ron Rin with a strike price of $60 for 5 points and to buy a six-month put on Ron Rin with a strike price of $60 for 4 points. Ron Rin is currently trading at $60 per share. Tom is hoping to cover the 9-point cost as the talks develop. Tom can cover the cost if the stock rises or falls by 9 points, or experiences a combination of rising and falling a span of 9 points from high to low.
To Tom’s delight, two more companies enter the scene and the volatility of the stock rises and falls as each event unfolds or doesn’t. The underlying stock is now trading at $120 per share. Tom closes out the straddle with a nice profit. Meanwhile, Charles “Chuck” Staik has been following the events and thinks the wild times are calming down and that the put and call options on Ron Rin are overpriced. One or both of the options is due for a consolidation of its premium. He sells a six-month call on Ron Rin with a strike price of $120 for 15 points and sells a six-month put on Ron Rin with a strike price of $120 for 17 points. Now Chuck just sits there and hopes the situation stabilizes and things get back to normal. This would cause the time value in the options to decrease, and Chuck can now buy in the short options for less than he sold them for, taking a profit. If Chuck is wrong and the stocks continue to rise or fall, the 32 points Chuck received as a premium would be in jeopardy.