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Thread: Options

  1. #1
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    Options


    1 - Call Options

    =============================



    a - Buying Call Options


    Buying call options is a bullish strategy using leverage and is a risk-defined alternative to buying stock. Foregoing the abstract "call options give the buyer the right but not the obligation to call away stock", a practical illustration will be given:

    A trader is very bullish on a particular stock trading at $50.
    The trader is either risk-averse, wanting to know before hand their maximum loss or wants greater leverage than simply owning stock.
    The trader expects the stock to move above $53.10 in the next 30 days.

    Given those expectations, the trader selects the $52.50 call option strike price which is trading for $0.60. For this example, the trader will buy only 1 option contract (Note: 1 contract is for 100 shares) so the total cost will be $60 ($0.60 x 100 shares/contract). The graph below of this hypothetical stock is given below:





    there are numerous reasons to be bullish: the price chart shows very bullish action (stock is moving upwards); the trader might have used other indicators like MACD (see: MACD), Stochastics (see: Stochastics) or any other technical or fundamental reason for being bullish on the stock.
    Options offer Defined Risk

    When a call option is purchased, the trader instantly knows the maximum amount of money they can possibly lose. The max loss is always the premium paid to own the option contract; in this example, $60. Whether the stock falls to $5 or $50 a share, the call option holder will only lose the amount they paid for the option. This is the risk-defined benefit often discussed about as a reason to trade options.
    Options offer Leverage

    The other benefit is leverage. When a stock price is above its breakeven point (in this example, $53.10) the option contract at expiration acts exactly like stock. To illustrate, if a 100 shares of stock moves $1, then the trader would profit $100 ($1 x $100). Likewise, above $53.10, the options breakeven point, if the stock moved $1, then the option contract would move $1, thus making $100 ($1 x $100) as well. Remember, to buy the stock, the trader would have had to put up $5,000 ($50/share x 100 shares). The trader in this example, only paid $60 for the call option.
    Options require Timing

    The important part about selecting an option and option strike price, is the trader's exact expectations for the future. If the trader expects the stock to move higher, but only $1 higher, then buying the $52.50 strike price would be foolish. This is because at expiration, if the stock price is anywhere below $52.50, whether it be $20 or $52.49, the call option will expire worthless. If a trader was correct on their prediction that the stock would move higher by $1, they would still have lost.

    Likewise, if the stock moved to $53 the day after the call option expired, the trader still would have lost all their premium paid for the option. Simply stated, when buying options, you need to predict the correct direction of stock movement, the size of the stock movement, and the time period the stock movement will occur; this is more complicated then stock buying, when all a person is doing is predicting the correct direction of a stock move.
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  2. #2
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    b - Call Options Profit, Loss, Breakeven



    The following is the profit/loss graph at expiration for the call option in the example given on the previous page.



    Break-even

    The breakeven point is quite easy to calculate for a call option:

    Breakeven Stock Price = Call Option Strike Price + Premium Paid

    To illustrate, the trader purchased the $52.50 strike price call option for $0.60. Therefore, $52.50 + $0.60 = $53.10. The trader will breakeven, excluding commissions/slippage, if the stock reaches $53.10 by expiration.
    Profit

    To calculate profits or losses on a call option use the following simple formula:

    Call Option Profit/Loss = Stock Price at Expiration - Breakeven Point

    For every dollar the stock price rises once the $53.10 breakeven barrier has been surpassed, there is a dollar for dollar profit for the options contract. So if the stock gains $5.00 to $55.00 by expiration, the owner of the the call option would make $1.90 per share ($55.00 stock price - $53.10 breakeven stock price). So total, the trader would have made $190 ($1.90 x 100 shares/contract).
    Partial Loss

    If the stock price increased by $2.75 to close at $52.75 by expiration, the option trader would lose money. For this example, the trader would have lost $0.35 per contract ($52.75 stock price - $53.10 breakeven stock price). Therefore, the hypothetical trader would have lost $35 (-$0.35 x 100 shares/contract).

    To summarize, in this partial loss example, the option trader bought a call option because they thought that the stock was going to rise. The trader was right, the stock did rise by $2.75, however, the trader was not right enough. The stock needed to move higher by at least $3.10 to $53.10 to breakeven or make money.
    Complete Loss

    If the stock did not move higher than the strike price of the option contract by expiration, the option trader would lose their entire premium paid $0.60. Likewise, if the stock moved down, irrelavent by how much it moved downward, then the option trader would still lose the $0.60 paid for the option. In either of those two circumstances, the trader would have lost $60 (-$0.60 x 100 shares/contract).

    Again, this is where the limited risk part of option buying comes in: the stock could have dropped 20 points, but the option contract owner would still only lose their premium paid, in this case $0.60.

    Buying call options has many positive benefits like defined-risk and leverage, but like everything else, it has its downside, which is explored on the next page.
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  3. #3
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    c - Downside of Buying Call Options



    Take another look at the call option profit/loss graph. This time, think about how far away from the current stock price of $50, the breakeven price of $53.10 is.



    Call Options need Big Moves to be Profitable

    Putting percentages to the breakeven number, breakeven is a 6.2% move higher in only 30 days. That sized movement is possible, but highly unlikely in only 30 days. Plus, the stock has to move more than that 6.2% to even start to make a cent of profit, profit being the whole purpose of entering into a trade. To begin with, a comparison of buying 100 shares outright and buying 1 call option contract ($52.50 strike price) will be given:

    100 shares: $50 x 100 shares = $5,000
    1 call option: $0.60 x 100 shares/contract = $60; keeps the rest ($4,940) in savings.

    If the stock moves 2% in the next 30 days, the shareholder makes $100; the call option holder loses $60:

    Shareholder: Gains $100 or 2%
    Option Holder: Loses $60 or 1.2% of total capital

    If the stock moves 5% in the following 30 days:

    Shareholder: Gains $250 or 5%
    Option Holder: Loses $60 or 1.2%

    If the stock moves 8% over the next 30 days, the option holder finally begins to make money:

    Shareholder: Gains $400 or 8%
    Option Holder: Gains $90 or 1.8%

    It's fair to say, that buying these out-of-the money (OTM) call options and hoping for a larger than 6.2% move higher in the stock is going to result in numerous times when the trader's call options will expire worthless. However, the benefit of buying call options to preserve capital does have merit.
    Capital Preservation

    Substantial losses can be incredibly devastating. For an extreme example, a 50% loss means a trader has to make 100% profit on their next trade in order to breakeven. Buying call options and continuing the prior examples, a trader is only risking a small 1.2% of capital for each trade. This prevents the trader from incurring a single substantial loss, which is a real reality when stock trading. For example, a simple small loss of 5% is easier to take for an option call holder than a shareholder:

    Shareholder: Loses $250 or 5%
    Option Holder: Loses $60 or 1.2%

    For a catastrophic 20% loss things get much worse for the stockholder:

    Shareholder: Loses $1,000 or 20%
    Option Holder: Loses $60 or 1.2%

    In the case of the 20% loss, the option holder can strike out for over 16 months and still not lose as much as the stockholder. Moreover, the stockholder now has to make over 25% on their stock purchases to bring their capital back to their previous $5,000 level.
    Moral of the story

    Options are tools offering the benefits of leverage and defined risk. But like all tools, they are best used in specialized circumstances. Options have many variables. In summary, the three most important variables are:

    The direction the underlying stock will move.
    How much the stock will move.
    The time frame the stock will make its move.
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    2 - Put Options
    ==============



    a - Buying Put Options

    Buying put options is a bearish strategy using leverage and is a risk-defined alternative to shorting stock. An illustration of the thought process of buying a put is given next:

    A trader is very bearish on a particular stock trading at $50.
    The trader is either risk-averse, wanting to know before hand their maximum loss or wants greater leverage than simply shorting stock.
    The trader expects the stock to move below $47.06 in the next 30 days.

    Given those expectations, the trader selects the $47.50 put option strike price which is trading for $0.44. For this example, the trader will buy only 1 put option contract (Note: 1 contract is for 100 shares) so the total cost will be $44 ($0.44 x 100 shares/contract). The graph below of this hypothetical situation is given below:



    there are numerous reasons, both technical and fundamental, why a trader could feel bearish.
    Options offer Defined Risk

    When a put option is purchased, the trader instantly knows the maximum amount of money they can possibly lose. The max loss is always the premium paid to own the option contract; in this example, $44. Whether the stock rises to $55 or $100 a share, the put option holder will only lose the amount they paid for the option. This is the risk-defined benefit often discussed about as a reason to trade options.
    Options offer Leverage

    The other benefit is leverage. When a stock price is below its breakeven point (in this example, $47.06) the option contract at expiration acts exactly like being short stock. To illustrate, if a 100 shares of stock moves down $1, then the trader would profit $100 ($1 x $100). Likewise, below $47.06, the options breakeven point, if the stock moved down $1, then the option contract would increase by $1, thus making $100 ($1 x $100) as well.

    Remember, to short the stock, the trader would have had to put up margin requirements, sometimes 150% of the present stock value ($7,500). However, the trader in this example, only paid $60 for the put option and does not need to worry about margin calls or the unlimited risk to the upside.
    Options require Timing

    The important part about selecting an option and option strike price, is the trader's exact expectations for the future. If the trader expects the stock to move lower, but only $1 lower, then buying the $47.50 strike price would be foolish. This is because at expiration, if the stock price is anywhere above $47.50, whether it be $75 or $47.51, the put option will expire worthless. If a trader was correct on their prediction that the stock would move lower by $1, they would still have lost.

    Similarly, if the stock moved down to $46 the day after the put option expired, the trader still would have lost all their premium paid for the option. Simply stated, when buying options, you need to predict the correct direction of stock movement, the size of the stock movement, and the time period the stock movement will occur--more complicated then shorting stock, when all a person is doing is predicting that the stock will move in their predicted direction downward.
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    b - Put Option Profit, Loss, & Breakeven


    The following is the profit/loss graph at expiration for the put option in the example given on the previous page.



    Break-even

    The breakeven point is quite easy to calculate for a put option:

    Breakeven Stock Price = Put Option Strike Price - Premium Paid

    To illustrate, the trader purchased the $47.50 strike price put option for $0.44. Therefore, $47.50 - $0.44 = $47.06. The trader will breakeven, excluding commissions/slippage, if the stock falls to $47.06 by expiration.
    Profit

    To calculate profits or losses on a put option use the following simple formula:

    Put Option Profit/Loss = Breakeven Point - Stock Price at Expiration

    For every dollar the stock price falls once the $47.06 breakeven barrier has been surpassed, there is a dollar for dollar profit for the options contract. So if the stock falls $5.00 to $45.00 by expiration, the owner of the the put option would make $2.06 per share ($47.06 breakeven stock price - $45.00 stock price at expiration). So total, the trader would have made $206 ($2.06 x 100 shares/contract).
    Partial Loss

    If the stock price decreased by $2.75 to close at $47.25 by expiration, the option trader would lose money. For this example, the trader would have lost $0.19 per contract ($47.06 breakeven stock price - $47.25 stock price). Therefore, the hypothetical trader would have lost $19 (-$0.19 x 100 shares/contract).

    To summarize, in this partial loss example, the option trader bought a put option because they thought that the stock was going to fall. By all accounts, the trader was right, the stock did fall by $2.75, however, the trader was not right enough. The stock needed to move lower by at least $2.94 to $47.06 to breakeven.
    Complete Loss

    If the stock did not move lower than the strike price of the put option contract by expiration, the option trader would lose their entire premium paid $0.44. Likewise, if the stock moved up, irrelavent by how much it moved upward, then the option trader would still lose the $0.44 paid for the option. In either of those two circumstances, the trader would have lost $44 (-$0.44 x 100 shares/contract).

    Again, this is where the limited risk part of option buying comes in: the stock could have risen 20 points, potentially blowing out a trader shorting the stock, but the option contract owner would still only lose their premium paid, in this case $0.44.

    Buying put options has many positive benefits like defined-risk and leverage, but like everything else, it has its downside, which is explored on the next page.
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    c - Downside of Buying Put Options



    Take another look at the put option profit/loss graph. This time, think about how far away from the current stock price of $50, the breakeven price of $47.06 is.


    Putting percentages to the breakeven number, breakeven is a 5.9% move downward in only 30 days. That sized movement is realistically possible, but highly unlikely in only 30 days. Plus, the stock has to move down more than the 5.9% to even start to make a cent of profit, profit being the whole purpose of entering into a trade. To begin with, a comparison of shorting 100 shares and buying 1 put option contract ($47.50 strike price) will be given:

    100 shares: $50 x 100 shares = $7,500 margin deposit ($5,000 received for sold shares + 50% of the $5,000 as additional margin)
    1 call option: $0.44 x 100 shares/contract = $44; keeps the rest ($7,456) in savings.

    If the stock moves down 2% in the next 30 days, the shortseller makes $100; the call option holder loses $44:

    Shortseller: Gains $100 or 1.3%
    Option Holder: Loses $44 or 0.6% of total capital

    If the stock moves down 5% in the following 30 days:

    Shortseller: Gains $250 or 3.3%
    Option Holder: Loses $44 or 0.6%

    If the stock moves down 8% over the next 30 days, the option holder finally begins to make money:

    Shortseller: Gains $400 or 5.3%
    Option Holder: Gains $106 or 1.4%

    It's fair to say, that buying these out-of-the money (OTM) put options and hoping for a larger than 5.9% move lower in the stock is going to result in numerous times when the trader's call options will expire worthless. However, the benefit of buying put options to preserve capital does have merit.
    Capital Preservation

    Substantial losses can be incredibly devastating. For an extreme example, a 50% loss means a trader has to make 100% profit on their next trade in order to breakeven. Also, it is important to emphasize that shorting stock is very risky, since, theoretically, stocks can increase to infinity. This means shorting stock has unlimited risk to the upside.

    Buying put options and continuing the prior examples, a trader is only risking a small 0.6% of capital for each trade. This prevents the trader from incurring a single substantial loss, which is a real reality when stock trading. For example, a simple small loss from a 5% move higher is easier to take for an option put holder than a shortseller:

    Shortseller: Loses $250 or 3.3%
    Option Holder: Loses $44 or 0.6%

    For a catastrophic 20% move higher in the stock, things get much worse for the shortseller:

    Shortseller: Loses $1,000 or 13.3%
    Option Holder: Loses $44 or 0.6%

    In the case of the 20% stock move higher, the option holder can strike out for over 22 months and still not lose as much as the shortseller.
    Moral of the story

    Options are tools offering the benefits of leverage and defined risk. But like all tools, they are best used in specialized circumstances. Options require a trader to take into consideration:

    The direction the stock will move.
    How much the stock will move
    The time frame the stock will make its move
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  7. #7
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    3 - Bull Call Spread
    ================================



    a - Bull Call Spread

    A Bull Call Spread, also known as a call debit spread, is a bullish strategy involving two call option strike prices:

    Buy one at-the-money or out-of-the money call.
    Sell one call further away from the money than the call purchased.

    A trader would use a Bull Call Spread in the following hypothetical situation:

    A trader is very bullish on a particular stock trading at $50.
    The trader is either risk-averse, wanting to know before hand their maximum loss or wants greater leverage than simply owning stock.
    The trader expects the stock to move above $52.92 but not higher than $55.00 in the next 30 days.



    Buy One Call - Sell One Call

    Given those expectations, the trader selects the $52.50 call option strike price to buy which is trading for $0.60. For this example, the trader will buy only 1 option contract (Note: 1 contract is for 100 shares) so the total cost will be $60 ($0.60 x 100 shares/contract).

    Also, the trader will sell the further out-of-the money call strike price at $55.00. By selling this call, the trader will receive $18 ($0.18 x 100 shares/contract). The net effect of this transaction is that the trader has paid out $42 ($60 paid - $18 received).

    In this situation, the trader is bullish: for example, the price chart shows very bullish action (stock is moving upwards); the trader might have used other technical or fundamental reasons for being bullish on the stock.
    Risk Defined & Profit Defined

    When a Bull Call Spread is purchased, the trader instantly knows the maximum amount of money they can possibly lose and the maximum amount of money they can make. The max loss is always the premium paid to own the option contract minus the premium received from the off-setting call option sold; in this example, $42 ($60 - $18).

    Whether the stock falls to $5 or $50 a share, the call option holder will only lose the amount they paid for the option spread ($42). This is the risk-defined benefit often discussed about as a reason to trade options. Similarly, the Bull Call Spread is profit-defined as well. The max the trader can make from this trade is $208. How this max profit is calculated is given in detail on the Bull Call Spread profit and loss graph on the next page.
    Bull Call Spread requires Accurate Predictions

    The important part about selecting an option strategy and option strike prices, is the trader's exact expectations for the future. If the trader expects the stock to move higher, but only $1 higher, then buying the $52.50/$55.00 Bull Call Spread would be foolish. This is because at expiration, if the stock price is anywhere below $52.50, whether it be $20 or $52.49, the spread strategy will expire worthless. Therefore, if a trader was correct on their prediction that the stock would move higher by $1, they would still have lost.

    Moreover, if the trader is exceptionally bullish and thinks the stock will move up to $60, then the trader should just buy a call rather than purchase a Bull Call Spread. In this example, the trader would not gain anymore profit once the stock moved past $55. This is explained on the next page.
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  8. #8
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    b - Bull Call Spread Profit, Loss, & Breakeven


    The following is the profit/loss graph at expiration for the Bull Call Spread in the example given on the previous page.




    Break-even

    The breakeven point for the bull call spread is given next:

    Breakeven Stock Price = Purchased Call Option Strike Price + Net Premium Paid (Premium Paid - Premium Sold).

    To illustrate, the trader purchased the $52.50 strike price call option for $0.60, but also sold the $55.00 strike price for $0.18, for a net premium paid of $0.42. The strike price paid was the $52.50. Therefore, $52.50 + $0.42 = $52.92. The trader will breakeven, excluding commissions/slippage, if the stock reaches $52.92 by expiration.
    Max Profit

    The max profit for a bull call spread is as follows:

    Bull Call Spread Max Profit = Difference between call option strike price sold and call option strike price purchased - Premium Paid for bull call spread.

    To illustrate, the call option strike price sold is $55.00 and the call option strike price purchased is $52.50; therefore, the difference is $250 [($55.00 - $52.50) x 100 shares/contract]. The net premium paid for the bull call spread is $42. Consequently, the max profit is $208 ($250 - $42). As a sidenote, this max profit occurs when the stock price is at $55.00 (the upper call strike price) or higher at expiration.
    Partial Profit

    Partial profit is calculated via the following, assuming the stock price is greater than the breakeven price:

    Bull Call Spread Partial Profit = Stock price - Breakeven price

    For instance, the stock closed at $54.00 at expiration. Hence, the stock price at expiration ($54.00) minus the breakeven stock price ($52.92) would mean the trader profited $108 [($54 - $52.92) x 100 shares/contract]
    Partial Loss

    A partial loss occurs between the lower purchased call strike price and the breakeven stock price. The calculation is given next:

    Bull Call Spread Partial Loss = Breakeven price - Stock price

    For example, a closing stock price at expiration of $52.75 is between the lower strike price of $52.00 and the breakeven of $52.92 and is therefore going to be a partial loss. When calculated, the loss is $17 [($52.92 - $52.75) x 100 shares/contract]
    Complete Loss

    A complete loss occurs anywhere below the lower purchased call strike price ($52.50) which amounts to the entire premium paid of $42.
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    c - Bull Call Spread & Call Option Comparison

    The Bull Call Spread is liked by many traders more than simply buying a call option for two main reasons:

    Reduces the capital spent/lower breakeven price.
    Is a strategy than incorporates reality.

    Lower Cost, Lower Breakeven Price

    Because a bull call spread involves the selling of an option, the money required for the strategy is less than buying a call option outright. Moreover, the breakeven price is lowered when implementing a bull call spread. To illustrate the cash outlay and breakeven prices for a bull call spread and just a call option are given next:

    Bull Call Spread: cost $42; breakeven price $52.92
    Call Option: cost $60; breakeven price $53.10

    In percentage terms, the bull call spread is 30% cheaper than purchasing only the call option.
    Realistic Expectations

    The second advantage/disadvantage of a bull call spread is that this strategy considers the reality and probabilities of a potential move. Theoretically, buying a call strategy has unlimited profit potential. However, successful option traders generally focus on probabilities and take into consideration reality. A stock move from $50 to $55 is a 10% move. This has to occur in the time before expiration, in the example 30 days. In order for a rational options trader to buy just a call, the option trader has to expect a stock move greater than 10% within 30 days.

    In conclusion, the bull call spread is a great alternative to simply buying a call outright: the bull call spread reduces the breakeven price and decreases the capital required to be bullish on a stock, it also is a strategy that takes into consideration realistic expectations.

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    4 - Bear Put Spread

    =================================


    a - Bear Put Spread



    A Bear Put Spread, also known as a put debit spread, is a bearish strategy involving two put option strike prices:

    Buy one at-the-money or out-of-the money put
    Sell one put further away from the money than the put purchased

    A trader would use a Bear Put Spread in the following hypothetical situation:

    A trader is very bearish on a particular stock trading at $50.
    The trader is either risk-averse, wanting to know before hand their maximum loss or wants greater leverage than simply owning stock.
    The trader expects the stock to move below $47.15 but not lower than $45.00 in the next 30 days.


    Buy One Put - Sell One Put

    Given those expectations, the trader selects the $47.50 put option strike price to buy which is trading for $0.44. For this example, the trader will buy only 1 option contract (Note: 1 contract is for 100 shares) so the total cost will be $44 ($0.44 x 100 shares/contract).

    Also, the trader will sell the further out-of-the money put strike price at $45.00. By selling this put, the trader will receive $9 ($0.09 x 100 shares/contract). The net effect of this transaction is that the trader has paid out $35 ($44 paid - $9 received).
    Risk Defined & Profit Defined

    When a Bear Put Spread is purchased, the trader instantly knows the maximum amount of money they can possibly lose and the maximum amount of money they can make. The max loss is always the premium paid to own the option contract minus the premium received from the off-setting put option sold; in this example, $35 ($44 - $9).

    Whether the stock rises to $95 or $55 a share, the put option holder will only lose the amount they paid for the option spread ($35). This is the risk-defined benefit often discussed about as a reason to trade options. Similarly, the Bear Put Spread is profit-defined as well. The max the trader can make from this trade is $215. How this max profit is calculated is given in detail on the next page.
    Bear Put Spread requires Accurate Predictions

    The important part about selecting an option strategy and option strike prices, is the trader's exact expectations for the future. If the trader expects the stock to move lower, but only $1 lower, then buying the $47.50/$45.00 Bear Put Spread would be foolish. This is because at expiration, if the stock price is anywhere above $47.50, whether it be $125 or $47.51, the spread strategy will expire worthless. Therefore, if a trader was correct on their prediction that the stock would move lower by $1, they would still have lost.

    Moreover, if the trader is exceptionally bearish and thinks the stock will move down to $40, then the trader should just buy a put rather than purchase a Bear Put Spread. In this example, the trader would not gain anymore profit once the stock moved below $45. This is explained on the next page.
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