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There is far more to options than just buying a put or a call and waiting for the market to move. In fact, once retail investors learn the ropes, they can quickly become adept at using basic strategies to control risk and enhance potential profits.
The options plays you execute will depend largely upon two things: your risk tolerance and your portfolio goals. Risk and reward are directly proportional – the higher one is, the higher the other is as well. If you have a high risk-tolerance and your aim is to make 200 percent on your money, then you’re probably going to follow and aggressive option strategy. If your risk tolerance and your investment goals are more middle-of-the-road – meaning, you’ll be satisfied with say, a 30 percent return and don’t want to risk more capital than is absolutely necessary – then you’re likely to adhere to a more conservative spreading technique.
Spreading, which involves selling one type of option and buying another, is one of the most common ways to create positions that match your outlook for a given stock or index and limit your risk. Depending on the type of strategy you choose, these spreads can limit your upside potential as well. But the trade-off of capping your risk, in return for a limit on the upside, usually is one that many investors are willing to make. Consider, for example, buying an out-of-the-money (OTM) call at the 55 strike with a $5 premium that’s two months out and selling a nearby OTM call at the 65 strike for $2. The worst thing that can happen, no matter how much the market moves, is you might lose $3, the difference between the $5 you paid and the $2 you received. And the most you can make, no matter if the stock doubles in price, is $7, the difference in price between the strike you purchased and the strike you sold.
Spreading is a very appealing way of controlling risks, hedging positions, and ultimately preserving capital. I believe it is a less risky way to speculate in a stock, rather than just buying the shares outright. For example, say IBM is trading at $100 a share. Do you want to hold the stock and commit that much of your capital? Or do you want to buy a call to be long IBM for a $5 premium (each option is 100 shares, so such a position would cost 100 x 5 or $500 per contract), which you hope will increase in value as the stock price rises and the option moves further into the money. Or, do you want to take the next step, and not only buy the $100 call for a $5 premium, but sell a $110 call and collect a $2 premium?
I do not advocate retail investors selling options naked, but using conservative strategies, such as the bull-call spread, the investor owns one option for each he or she has sold, so they are not naked any contracts. Collecting the premium when you sell an option may look as easy as picking up dimes on the pavement. But, if you’re not careful, a bulldozer rumbling down the street could knock you down. The only time a retail investor should sell options is when it’s part of a carefully constructed spreading strategy.
Another popular hedged strategy is known as the covered call spread, in which the investor sells an option against stock that they own. The value of an option erodes very quickly in its last weeks and days. This time decay, as we call it, not only eats away at the premium, it also helps move the odds in your favor, as the option has fewer days to move against the seller.
As the seller of an option, you are granting the right for someone else to be long (if you sell a call), or short (if you sell a put). For example, let’s say you sell a call with a $100 strike price and collect a $4 premium. That means when the stock rises above $104 and the holder of that option exercises it, you are obliged to deliver shares at $100. Unless you purchased the stock previously, you are obligated to deliver shares that you must now purchase in the open market for $104. If the stock is trading higher than $104, you are still obligated to deliver 100 shares per short option, but any price higher than $104 means you’re losing money, as you only took in $4 for the $100 call. Now remember that every option is worth 100 shares. If you sell four calls, you may have to buy 400 shares, and if that stock is trading over $104, then the loss compounds four times as fast. That’s how risk compounds quickly with uncovered options.
But when you sell a call as part of a spread trade that potential loss can be defined when you enter the trade and offset by the calls in your own portfolio. And, in a covered call strategy, most of us prefer to sell calls that are ready to expire. Remember, time is the enemy for the options buyer. As time runs out, there is less and less opportunity for an option to be in the money for the buyer. But, time is an options seller’s friend!
Thus, with a covered call, your strategy is to buy an option with a longer time horizon of at least several months – and perhaps one to two years, known as a long-term equity anticipation security (LEAP) – and sell one with only a few weeks left to expiration.
Here’s an example: IBM is trading at $111 a share. A two-year call option to buy IBM for $120 a share is selling for $23, and a one-year $120 call is selling for $17. Let’s take a look at this. The price differential for two years versus one year is $6. So for $6 more you can control the stock for an extra year. As a buyer of a call, you must determine which is the better buy – the one-year or the two-year, depending on your outlook for the stock and your expectation for how much the call option could appreciate in value.
Now, let’s take a look at the short-term options. A $120 call option that has 45 days left to expiration has a premium of $3.75. When you consider the eight purchases of such a 45-day option – which would represent one year of purchase of a 45-day option – would cost $27.60, you can see why the LEAP is such an attractive alternative. The same call option that expires in two weeks is priced at 7/8. The shortest-term option is the cheapest because you only have two weeks for a $9-a-share move to occur (from $110 to $120). So as the seller of the option, that limited amount of time and time erosion are your friends.
Among these various options, you must then find the best value. In general, your strategy will be to buy the long-term call option and sell a short-term one against it. So you buy 10 of the $120 calls for a premium of $17 a share. That’s equivalent to getting 7-to-1 leverage (120/17) for the equivalent of 1,000 shares of IBM. You then turn around and quickly sell the $120 call that expires in 45 days and collect the $3 ¾ premium.
Now, let’s say in the next 45 days IBM shares rise from $111 to $117. The 45-day call you sold for 3 ¾ expires worthless, and you get to keep all of the premium. Meanwhile, the one-year $120 call you bought for $17 may have lost a little value to, say $15. But the $2 lost on that LEAP is more than offset by the $3.75 in premium that you kept from the short-term call that you sold:
BOUGHT: $120 one-year LEAPS for $17 premium SOLD: $120 45-day calls and collected $3.75 premium
With this strategy, known as a time spread, the calls that you buy and sell always have the same strike price: Stock rose from $111 to $117, 45-day calls expire, allowing you (the seller) to keep the $3.75 premium. Premium on the one-year LEAP declines from $17 to $15. Total net profit on this trade is $1.75 per share. Remember, the key to the time spread strategy is to buy a long-term option or LEAP that has slow time decay, and sell a short-term option that has fast time decay.
The LEAP-Covered Call strategy is used when an investor is bullish on a stock over a time horizon of at least a few months. In theory, the same sort of strategy could be used with puts – buying the long-term and selling the short-term – if you had long-term bearish prospects for a company. But, generally speaking, investors rarely employ such a put strategy. Puts are bought primarily for downside protection. Although vulture investors do actively speculate in put options, very rarely do most investors buy puts to bet on a downside of a company the way they buy calls to speculate on the upside.
Another options investment strategy is the Bull Spread, which, as the name implies, may be used if you have a bullish bias for a stock. Let’s say you’re interested in the Internet auction company eBay, which is trading at $150 a share. Buying 1,000 shares would require a staggering investment of $15,000. Instead, an investor might buy $150 at-the-money calls that expire in two months, and sell the $160 calls against them. You paid a premium of $11 a share for the $150 calls and collected $8.25 for the $160 calls, for a net cost of $2.75 a share. On a 10 lot (1,000 shares), that’s a net price of $2,750.
Now, instead of investing $150,000 outright to buy 1,000 shares of eBay, you have a $2,750 net investment. Here’s what happens under two possible scenarios:
BOUGHT: $150 calls for $11 premium SOLD: $160 calls for $8.25 premium
Within two months, eBay falls to $125 a share. The $150 call that was purchased is worthless. You keep the $8.25 premium collected on the $160 calls. The net loss is $2.75 a share, or $2,750 – the maximum that can be lost regardless of how far the stock drops. However, if you had purchased the 1,000 shares outright, you would have lost $25 a share or $25,000 under this scenario.
BOUGHT: $150 calls for $11 premium SOLD: $160 calls for $8.25
Within two months, the stock trades up to $175 a share. The $150 calls that you purchased are worth $25, reflecting their intrinsic value (the stock is $25 over the strike price). Similarly, the $160 calls that you sold are worth $15. Thus, the spread between those two options has gone to $10 a share or $10,000. Your net cost, however, was $2.75 a share or $2,750 (which is the maximum you can lose on the trade). Thus, you’re looking at a net profit of $7,250 – nearly tripling your initial investment amount. The stock investor, however, made $25,000, which based on a $150,000 outright purchase of shares, is a return of about 17 percent. So, based on the rates of return and the ability to sleep at night because of a limit on risk, it’s easy to see why options spreads like this one are so popular with knowledgeable investors.
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