Introduction to Japanese Candlestick

 

 

Common Candlestick Patterns

Candlestick patterns are a very popular tool in trading, and because of their appealing names and easily identifiable shapes, they are one of the most powerful tools a swing trader can use. If so with swing trading, so much more with option trading! Here are some of the most common patterns, and how they are generally interpreted: 1. The Doji Pattern – Doji, Dragonfly Doji and Gravestone Doji The Doji is characterised as having no or almost no body, meaning that the open and close are very close. A Doji on its own does not mean much, but it is important in the context of preceding bars, and you must also gives consideration to the length of the shadows. A Doji is usually Transitional. A plain Doji at the top of a uptrend or after a few long white bars show that the buyers are “tired” and have run out of steam. In fact, a Doji in this position is sometimes called the “Evening Star” or the “Death Cross” – it shows that a major reversal is about to take place. A plain Doji in a sideways trend shows that volatility is low. A few days like this usually leads to a major move, either up or down. A Dragonfly Doji, with a long downwards tail, means that the open, high and close are the same or very close. Sellers tried to push the price down, but buyers pushed it back up again. In a downtrend, this could mean that buyers are emerging to reverse the trend. In an uptrend, it means that buyers could not push the price to a new high, and the sellers may be gaining strength – a trend reversal could be about to take place. A Gravestone Doji has long upper shadow, which means that the open, low and close are the same, but that buyers were trying to push the price higher, to be overwhelmed by sellers at the end of the day. This could signal the weakening of an uptrend or a reversal of a downtrend. 2. Hammer, Hanging Man and Shooting Star These three are similar to the Doji, but with a bit more body. They usually identify emotional extremes in trading trends. For the same reasons as you find with the Doji patterns, these three show that either buyers or sellers tried to gain the upper hand, and then were overwhelmed, and a trend reversal follows. 3. Harami Harami means “pregnant” in Japanese, and this pattern is characterised by small bodied candlestick coming AFTER a large bodied one. Imagine a pregnant woman walking from left to right! If the colour of the two bars are different, and they come at the top of an uptrend or the bottom of a downtrend, then this is a strong indicator of a trend reversal. 4. Engulfing Engulfing patterns are the exact opposite of the harami, and also strongly signify a trend reversal. The body of the candlestick is much bigger than that of the day before, indicating increased volatility, and more tussling between the buyers and sellers. The previous trend is being “engulfed” by a new direction. 5. Piercing Pattern and Dark Cloud Pattern These two patterns are similar but opposite. A Piercing pattern shows a large bodied red or black candle in a downtrend is followed by a lower but larger white bodied candle which closes at least half way into the first candle. A powerful reversal pattern! The Dark Cloud means gloom for an uptrend – a large bodied white candle is followed by a higher but red or black candle that closes at least half way into the first candle. Great set up for a short trade! Final Note: Candlestick patterns in isolation do not mean a lot. They must always be interpreted in the context of a prevailing trend. If you apply them to swing trading principles, then you must look for these combinations happening within the confines of the 10ma and the 30 ema, which is a pivot point or the “Trader’s Action Zone”. If you can master these indicators in this context, you are now very ready to start applying swing trading principles to buying Options- this is where your REAL profit will come from.

The Secret of Successful Stock-Picking for Options Trading

We’ve been talking about options so much lately that I’d like to take this opportunity today to get “back to basics.” Even if (or when) you get to a point where you’re using options most of the time — or even all of the time — knowing how to identify a stock’s next movement is key to helping you pick the best way to play that move.

Keep Profits ‘On The Move’ With Moving Averages

The concept of trading with the trend is the main premise of technical analysis.  Specifically, it’s necessary when using a shorter-term trend to time your entry (or exit) points to determine the next longer trend. 

For example: Short-term dips should be used as entry points if the intermediate trend is up and, when the intermediate trend is down, short-term pops should be viewed as short-selling opportunities. 

Once you get clear picture of whether a stock is trading in an uptrend or a downtrend, the next thing you want to look at are its moving averages.

‘Moving’ Along…

Moving averages are the lines on a chart that track the average price of a stock or index over a specific number of time periods (e.g., days, weeks, months, etc.) during a particular time frame.  Remember, each bar in a chart represents a time period. (In a daily chart, for example, each time period represents one day, etc.)

Moving averages are generally used to smooth out the “noise” of the short-term volatility and, therefore, more easily identify major trends.  They are also used to gauge the changes of momentum in an index or security.

The most basic kind of moving average, the “Simple Moving Average” (SMA), attributes equal weight to all time periods and averages out the sum.  So, a 20-day moving average would typically average the closing price of each of the last 20 trading days. 

There are several other types of moving averages, but the “Exponential Moving Average” (EMA) attributes more weight to the recent price activity.  Some believe it makes more sense to use EMA over the SMA, as recent price is more relevant, but it’s really a matter of personal preference. Personally, I prefer the EMA, although there is a place for both when doing technical analysis for your own portfolio.

Which time periods should be used to identify which trends?

• To identify the short-term trend, a 10-day (or 2-week) MA is typically used.
   
• To identify the intermediate trend, a 50-day (or 10-week) MA is typically used.
   
• To identify the long-term trend, a 200-day (or 40-week) MA is typically used.
   

Keep in mind that the direction of a trend can be defined either by the direction of moving averages or by highs and lows.  For example, higher highs and higher lows typically constitute an uptrend, and vice versa.  But for the purpose of this discussion, we’ll focus on moving averages.

I have read, and I can also write, hundreds or probably a thousand pages on moving averages, but let’s stick to the basics here.

Below is a one-year daily chart on Cisco Systems (and what a beautiful chart it was, when it was in this formation).  The dark brown line shows the long-term (200-day) moving average, the blue is the intermediate (50-day) moving average, and the light brown line that’s hard to see, but has a green arrow pointing to it, is the short-term (10-day) moving average.

The smaller the trend (the smaller the moving average), the more volatile it will be.

During this particular 12-month period:

The long-term trend (200-day moving average) was up the entire time. 

The intermediate trend (50-day moving average) from the beginning of the chart was up.  The upside momentum was increasing as evidenced by the faster, intermediate moving average diverging from the slower long-term one. 

Then, in January, upside momentum decreased, signaling expected weakness in the stock.  At the same time, the intermediate trend (50-day moving average) was slightly down to flat until June when it started to move upward again as the stock started to gain upside momentum again.

The short-term trend (10-day moving average) is by far the most volatile.  It was up from August through October when it took a breather.  The short-term trend was down from mid-October to early November.  The shorter-term trend was also down for half of January, late February/early March, for a couple of weeks in late March, and again in May.  I highlighted these downward slopes in very light red.

You might notice that the stock seems to find support at each of the three moving averages, and when the support is broken, it seems to find support at the next moving average.

From August through mid-October, Cisco bounced off of the 10-day moving average, and, after violating that level in late October, it bounced off of the 50-day moving average with a strong move higher. 

After staying above the 10-day moving average until January, Cisco first violated the 10-day, and then also violated the 50-day.  After a failed recovery (in early February, it failed to break through its January high to continue its uptrend), it turned around and moved back below the 50-day moving average which, for the month of March, acted as a resistance point. 

Notice that in January, the stock tested the 50-day moving average like a child challenging its parent.  Once the stock proved that it could get away with the violation, it seemed to walk all over the 50-day moving average (or, I should say, walk right through) as the 200-day moving average became the new support level.

A trading novice/skeptic might see this and think, “All this M.A. stuff is more like B.S.  Why would the price of a stock bounce off of an imaginary line, and then use the next imaginary line as support once the first one is violated?”  That’s an understandable point. 

But there are two forces that make moving averages stronger support and resistance levels than ever before. 

One is the fact that so many technical traders are watching these moving averages that the bounce becomes a self-fulfilling prophecy.  When a support level is violated, millions of people are staring at the next “support level” and wondering if the stock will find strength there.  They’re also watching to see whether the moving average that used to be the support level will start acting as a resistance level.

The second is the fact that there are so many computerized trading systems nowadays that automatically buy and sell stocks when they reach certain points.  Oftentimes, these automatic triggers are at or near these popular moving averages.

Moving Averages in Motion

Below is a two-year chart on Cisco Systems.  I want you to focus now on the angle of the slopes in each of the moving average’s thrusts.  Notice the difference in the angles of the moving averages during the early-year rally (which failed) and the late-year rally. 

The initial thrust in the two faster moving averages was much steeper in the second rally.

Also note that in the second rally, the moving averages’ pulses are longer, especially the short-term (10-day) one.  As a rule of thumb, the steeper the thrust, and the longer the pulse, the more likely it is that the trend will continue.  (That goes for both uptrends and downtrends.)

If you understand charting, then you can find a number of other clues in this chart, and this article can only be so long

Options Spread- Key Strategies of Making Consistent Income

Options Spreads

If you find yourself thinking “how can I ever understand or remember this?” keep in mind that it doesn’t matter how many options strategies there are, there are only two basic types of options: Calls and Puts. A spread trade is a variation that involves the buying and selling of options simultaneously on the same underlying.

There are specific advantages to spread trades, each strategy having a specific application. In general, spread strategies should be used when the outlook for a particular stock is neutral to slightly bullish or neutral to slightly bearish. The key word to remember here is “neutral.” Spreads can be a great way to make money when you think a stock will remain in a fairly narrow trading range. However, since most spread strategies involve both Calls and Puts, you tend to limit your profits if a stock moves quickly in one direction or the other.

A particularly bullish outlook on a given stock is best served when you buy a Call option rather than play a spread, with which you’d likely dilute your gains with an incremental loss on the wrong side of the spread. Of course, the same is true when you’re very bearish on a particular stock

Bull Call Spread

Picking up from our strategy discussions in Section Four, the next type of spread trade we’ll discuss is a Bull Call Spread. This is a debit-type spread, as opposed to the credit-type spreads we have discussed to this point.

Background:

The application for this type of trade is similar to a Bull Put Spread in that you are essentially neutral to bullish on the stock. The difference is in the type of option you will employ in the spread. What’s important is that you expect the stock to close above the strike price that you sell.

The Bull Call Spread can be a great strategy to employ when you find that the premium for the Call options are undervalued, and it tends to work especially well when you don’t have enough cash in your account to purchase enough shares for a potentially profitable position with a covered Call.

Case Study:

Here’s how it works: as with previous examples, we’ll assume that you have Level 3 trading authority from your broker. One other thing: the figures used in the following example were drawn from the options chain figures for an actual stock at the time this material was written, in case you were wondering where this information was generated.

Let’s suppose you find a stock trading near $26.00 and are considering writing a Covered Call on the stock. You notice you do not have enough cash in your account to buy enough shares to make the trade profitable, so you enter into a Bull Call Spread instead.
With the stock trading for $26.00, you buy the Call option two strike prices below the current price of the stock, with the August $22.50 Calls at $3.75. This gives you the right to buy the stock for $22.50 per share.

Next you sell the August $25.00 Calls for $2.00. This gives you the obligation to sell the stock for $25.00 per share in the event the stock rises above $25.00 per share.

After spending the $375 per contract to buy the $22.50 Calls and collecting the $2.00 per share for the $25 strike price options you sold, the total debit from your account is $1.75 per share. This is now your maximum potential loss on the trade.

Maximum Profit:

Your maximum profit for this transaction is $0.75 per share. This maximum will be achieved if the stock closes above the $25 strike price that you sold on expiration Friday.

Here’s how the trade results in your maximum profit:

If the stock closes above the $25.00 Call option you sold, the Options Clearing Corporation will go into your account on Saturday following the third Friday of the month to purchase the stock for $25.00. When they see that you do not own the stock, they will automatically exercise the August $22.50 Calls and buy the stock for $22.50 and sell it for $25.00.

Your account will then show you bought the stock for $22.50 and sold it for $25.00 for a $2.50 gain. The trade cost you $1.75 to enter into so your total profits now come to $0.75 per share.

A side note: You are not required to have the funds in your account to purchase the stock for $22.50 since you will immediately sell it for $25.00.Your original transactions resulted in a net debit to your account of $1.75 per share. The difference between the original debit and the credit you receive upon the sale of your stock is the maximum profit of $0.75 per share, or $75 per contract.

Maximum Loss:

You bought the August $22.50 Calls for $375 per contract. If the trade goes completely against you, take the original $2 profit per share you made when you sold the August $25.00 Calls.Use this to offset the cost to buy the stock for $22.50 per share.The most you can lose is the $1.75 per share difference between the Call option you bought for $3.75 and the Call option you sold for $2.00.

 

Maximum Return on Risked Capital:

The maximum return on risked capital for this trade is calculated by taking the profit for the trade ($0.75) divided by the cost to enter the trade ($1.75) ($0.75/$1.75 = 0.428 or 42.8% return).

Potential Play Directions:

At this point, the stock will move in one of three ways:up,down,or sideways.The next few pages detail how to handle each of these scenarios.

Stock Price Rises:

In the event the stock price closes above the strike price you sold on expiration Friday, then “Same-Day Substitution” (SDS) will occur. Same-Day Substitution means that a change will occur in your account that will not result in a net change to the value of the account. What it really means is that the Options Clearing Corporation will go into your account and see that you don’t own the stock, although you have sold the $25 Call options. The OCC will exercise the $22.50 Call that you bought, and then sell the stock for $25 that same day.This all takes place in your account automatically.You don’t have to worry about placing any orders to make this happen, and what’s even better, you don’t even have to have the cash in your account in order to buy the stock at $22.50. The computer recognizes that the sale of the stock for $25.00 will result in a net profit to your account and acts accordingly.

Stock Price Drops Slightly:

In the event the stock price drops slightly below the strike price you sold, but stays above the strike price you bought, the options you sold will expire worthless. However, before expiration Friday, you need to sell the options for the strike price you bought, for whatever value they still hold.Your profit on the trade comes from any profit you retain on the sale of the options purchased less the cost to first enter the trade.

Using the price examples above, this is how the scenario would work:
the stock has fallen slightly below $25 per share. The $25 strike price Calls that you originally sold will expire worthless.Before expiration Friday, you would need to sell the $22.50 strike price Calls you originally purchased as part of the spread for whatever value you can get. As long as the stock stays above $22.50, you will earn something from the intrinsic value of the $22.50 option. In the event that this intrinsic value is more than the original price you paid for the options, you will walk away with a profit.

Another important consideration here is your level of trading authority. If you’re only approved for Level 3 options-trading authority, you’ll need to buy back the $25 Calls before you’ll be able to sell the $22.50 Call, otherwise you’ll find yourself in a naked trade.The order of transactions is irrelevant if you have Level 4 trading authority.

 

Stock Price Drops Heavily:

Should the stock drop heavily on bad news with a negative outlook, sell to close the option that you originally purchased for as much as you can get for it. Any potential profit is dependent upon you selling your option for as much as you can get in order to offset the original cost to enter the rade.

Again, your level of options-trading authority is of primary consideration. With Level 3, you’ll need to buy back the Call options you sold before you can sell the $22.50 Calls. The good news is that the $25 strike price Calls are likely to be very inexpensive.

 

Summary:

Although it’s a debit type spread, where you are initially required to pay more to enter the trade than you initially make in revenue, a Bull Call Spread can be a great way to earn income in a manner similar to a Covered Call, without having to go through the trouble of buying the stock in the first place. The Bull Call Spread also works great in the event you don’t have enough capital in your account to go out and purchase the stock for a Covered Call.

You would consider using a Bull Call Spread if you are neutral to mildly bullish on a stock.

To place a Bull Call Spread trade, first make a purchase of at least one call option two strike prices in-the-money below the current price of the stock. Next, sell at least one call option one strike price in-the-money.

If the stock closes above the Call option you sold, the Options Clearing Corporation will go into your account on Saturday following the third Friday of the month to purchase the stock for the strike price you sold. When they see that you do not own the stock, they will automatically exercise the Call you bought. Since the Call you bought was deeper in-the-money than the Call you sold, your account receives a net profit for the transaction. The net profit for the exercise of your options, minus the net debit to your account on the initial transaction, results in your maximum potential profit. This maximum only occurs if the stock closes above the strike price you sold by expiration Friday.

If things go wrong, and the stock closes below the strike price you sold, your actions depend upon your level of options-trading authority. If you have Level 3 authority, you will have to buy back the options you sold first, and then sell the option you originally purchased. In the examples used in this section, if the stock price closes below the $25 strike price you sold, you would have to buy them back first, before you could sell to close the $22.50 strike Calls you still own for any value they still may hold.

With Level 4 trading authority, you can simply allow the $25 strike price options you sold to expire worthless, and sell the $22.50 strike price options for whatever you can get.

Bull Put Spread

 

Armed with an understanding of the vocabulary and techniques of basic options strategies, you can now move on to more advanced applications. Thus, the first true spread strategy to consider is the Bull Put Spread.

As with most options strategies discussed here, the key to understanding how a Bull Put Spread works is to analyze the name. The term “bull” refers to your sentiment on the likely trend of the stock. Thus, you’re hoping the stock goes up, but not too much.

Note:

spread strategies are best used in sideways/neutral markets. If you’re fairly certain a stock will increase in price, you’re probably better off buying the Call option on that stock than using a spread and potentially putting a cap on potential gains.
Here’s how a Bull Put Spread works:

How the Bull Put Spread Works

Let’s suppose you find an optionable stock that’s trading in a sideways pattern. You’ve checked the news and you know when the next earnings announcement is expected. You’ve determined there shouldn’t be any surprise announcements that could unexpectedly move the price of the stock over the next few weeks.

Now, let’s say the stock you’re considering is currently trading for $26 per share. You don’t own the stock, but you’re considering an options play on it, for the sole reason that your neutral expectation for the stock price doesn’t justify purchasing the stock itself.

If you think the stock will continue to trade flat or in a very slight up-trend, you can generate a bit of income while minimizing your risk using Put options. This means you’re not expecting the stock to drop, so the Put contracts you trade should expire worthless. The reason the Bull Put Spread strategy is considered a “credit” spread is that once all the transactions are complete for entrance into the position, you have a net credit to your account.

The Process

If you are already approved for Level 4 trading authority, which allows you to sell naked Puts, your first step is to sell the $25 strike Put. Let’s say the bid price for the $25 Put is $2 per share ($200 per contract). Upon completion of the transaction, you now assume the obligation to purchase the stock for $25 per share if the stock price closes below $25 by expiration. You receive $200 to motivate you to accept the obligation.
Now, take the $200 revenue you received from selling the $25 Put and use it to buy the Put option one strike price lower at $22.50 (note: if you are only approved for Level 3 trades, your broker won’t allow you to sell a Put first). To buy a Put, you need to pay the ask price, which acts as a covering asset for the deeper in-the-money Put you sell. Thus, to buy the $22.50 Put option, you’ll pay the ask price of $1 ($100 per contract). You spend $100 of the initial $200 you received to buy the $22.50 Put, leaving a surplus of $100. Hold on to that surplus, you may need it later.

To this point, you’ve assumed the obligation to buy the stock for $25 per share and you have purchased the right to sell the stock for $22.50.

Potential Profit:

Your maximum profit from this transaction is the $100 surplus you retain after buying the $22.50 Puts. As long as the stock goes along with your neutral to slightly up-trending forecast, you’re able to keep that surplus.

Potential Risk:

If the stock falls below the $25 strike price, you’ll be assigned the stock or obligated to buy it for $25 per share. To avoid this, you can buy the Put back, thereby removing your obligation – but this may not be in your best interest. As the stock falls, the value of the $25 Put increases. It’s likely you’ll have to pay more to buy it back than you received in revenue from the transactions you’ve made up to this point. However, remember that you still hold the Put contract you purchased at the $22.50 strike price. This gives you the right to sell your stock for $22.50 per share. The worst-case scenario consists of buying the stock at $25 per share and exercising the $22.50 Put to sell the stock at $22.50 per share, for a total loss of $250.

To get this figure, note that you have been required to buy the stock at $25 per share, while you can sell the stock at $22.50 per share ([$22.50 x 100 shares = $2,250] – [$25 x 100 shares = $2,500] = -$250); this represents a loss of $250. Now, you could take the $100 surplus you received from the sale of the $25 Puts and use it to ease the $250 loss, reducing your “worst-case scenario” maximum loss to $1.50 per share, or $150 total.

The return on risked capital for this transaction is calculated by taking the return revenue ($100) divided by the maximum potential loss ($150): $100 / $150 = 66% return.

Let’s examine another example using real figures drawn from the Website tools. For this example, let’s assume you have Level 3 trading authority, which requires that you purchase one or more Put contracts before you sell the Puts for another strike price.

 

 

 

Case Study:

Through a search, you find the stock for the biotechnology company XYZ (symbol: XYZ) trading in a slight upward trend at a price of $33.51 per share. You decide to enter into a Bull Put Spread by first buying the $25 strike price Put. You pay the ask price of $0.15 per share, or $15 per contract. Then you sell the $30 Put for a bid price of $1.15 per share, or $115 per contract. Subtract the cost of the $25 Put you sold from the $30 Put you bought for $100 in revenue ($115 – $15 = $100).

The maximum risk for this play is the $500 difference in price of the $30 per-share Put paid to purchase the stock if it closes below $30 per share by expiration ($3,000), and the $25 per-share price received when you exercise the $25 Put you purchased ($2,500). To ease the $500 loss, subtract the $100 in revenue you received from the sale of the $30 Put, minus the price to buy the $25 Put. Your maximum loss is $400 ($500 – $100 = $400). The return on risked capital is calculated by taking the amount of revenue you received ($100), divided by the maximum loss ($400): $100 / $400 = 25% potential return.

Your maximum potential gain is the $100 left after buying the $25 strike price Put.

At this point, the stock will move in one of three directions: up, down, or sideways. Here is how to handle each of these scenarios:

XYZ Corporation (XYZ) Moves Upward:

If the stock price goes up, the Put option expires worthless and you keep your $100 profit. Your potential return on risked capital is 25%.

 

 

XYZ Corporation (XYZ) Moves Sideways:

In this case, again the Put expires worthless since the stock price never falls below the $30 strike price you sold. You keep the $100 in profit for a return on risked capital of 25%.

XYZ Corporation (XYZ) Slightly Falls, to $29.50:

If the stock drops slightly below the strike price of the Put you sold but stays above the strike price you bought, you could buy-to-close the Put option you sold. The Put you bought will expire worthless.

For example, if XYZ falls to $29.50 on expiration Friday, buy-to-close the $30 Put you originally sold in order to avoid being assigned the stock. Since the stock is now trading for $29.50 and the options are due to expire that same day, there is no time value remaining. The only component still influencing the price of the option is the intrinsic value of $0.50 per share ($30 – $29.50 = .50). Thus, you’ll need to pay $50 per contract to buy back the Put. Since you originally held $100 in profit from the first set of transactions, your net profit from the trade drops to $50 ($100 – $50 = $50).

XYZ Corporation (XYZ) Drops to $28.50:

If XYZ falls to $28.50 on expiration Friday, as with the previous case, buy back the $30 Put to avoid being assigned the stock. With the stock now $1.50 below the strike price, you will have to pay $150 per contract to buy the option back. Subtracting this cost from the initial revenue you received from the sale of the options of $100, you would experience a net loss of $50 per contract on the trade ($150 – $100 = $50).

Comparing these examples, it becomes clear that if the stock falls below your strike price and the sooner you’re able to buy back the Put, the better.

XYZ Corporation (XYZ) Falls to $24:

Let’s say XYZ falls to $24 by expiration Friday. To avoid catastrophic losses, consider buying back the $30 Put to avoid being assigned the stock. With a stock price of $24 per share, there is $6 per share of intrinsic value to the Put ($30 – $24 = $6), requiring a payment of $600 per contract to remove your obligation to purchase the stock for $30 per share. Though this is probably upsetting, remember, you still own the $25 strike price Put. So as the stock has fallen, this has increased in value. With the stock price sitting at $24 per share, your $25 Puts have gained $1 per share in intrinsic value. If you sell them now, you will receive $100 per contract. This revenue, coupled with the original $100 in revenue you received from the initial transactions, means you could ease the $600 loss from the buy-to-close transaction to back out of the $30 Put. Your maximum loss for the transaction is now reduced to $400 ($100 + $100 – $600 = $400).

 

XYZ Falls to $28:

In this scenario, you may want to consider backing out of the $30 Put you sold and letting the $25 Put appreciate on the forecast of continued weakness, especially if the stock looks to continue appearing weak for the next few weeks or days leading to expiration Friday. The key here is the amount of time remaining until expiration.

If the stock falls to $28, you will have to spend a little more than $2 per share to buy the Put back, as there is still some time value prior to expiration. Remember, whatever price you pay to buy back the $30 Put counts against your profit. To execute this strategy, place a buy-to-close order to back out of the $30 Put and leave the $25 Put to appreciate in value as the stock price continues to fall. Even though you’ve taken a bit of a loss in backing out of the $30 Put, you may end up profitable overall. The $25 Put will continue to increase in value, depending on how far and fast the stock price falls before expiration. Regardless of how profitable the $25 Put becomes, you must sell it before the trading day ends on expiration Friday or the entire position is lost.

Assigned Early:

If the stock price falls below the $30 strike price you’ve sold, you run the risk of being assigned the stock. This can happen at any time prior to expiration Friday, although this isn’t likely to happen.

The reason you’re not likely to be assigned prior to expiration is due to the person on the other end of your transaction. As the Put seller, you assume the obligation to purchase the stock for $30 per share at any time the Put buyer decides to exercise his or her option. The Put option buyer has all the advantages. In other words, the person who bought your Put contract is bearish on the stock. He or she expects the stock to drop in value below the $30 strike price; his or her profit is determined by how far the stock falls – the further it falls, the greater the profit. If the option is exercised early, he/she throws away any potential for the stock to generate further profit.

If you find you’ve been assigned the stock, you’ll receive notice from your broker after the market closes. You’ll have until the next trading day to buy or sell the stock, paying the difference between the assignment price and the price at which you are able to sell the stock.

Summary:

With a Bull Put Spread, you are expecting the stock to increase in value or remain neutral. A Put is the type of option often used for this strategy and it is called a spread because you plan to use two different Put option strike prices to generate revenue and help protect yourself against a severe drop in the price of the stock.

If you have Level 4 trading authority, you can first sell a Put option contract one strike price lower than the current price of the stock, which gives you cash up-front, and then purchase a Put contract of the next lower strike price using the revenue collected from the sale of the Put. If you are only authorized for Level 3 trades, consider purchasing the Put contract first, covering your position, and then sell the Put contract one strike price below the at-the-money strike. Whether or not you first buy the Put or sell the Put, it will likely result in a net profit for the position from the start. Hold on to this profit, you might need it later.

If the stock price stays neutral, the Put you sold expires worthless, but that’s not a bad thing since you were paid up-front. The Put you bought also expires worthless. Thus, the net effect is your maximum profit.

In the event the stock price falls below the strike price you sold, you may want to act quickly to back out of the trade by placing a buy-to-close order. This removes your obligation on the Put you sold to avoid being assigned the stock.

If the stock falls below the strike prices of both the contract you sold and the contract you bought, first identify how much time remains until expiration. If you have several days before expiration Friday, consider a buy-to-close order for the Put you sold and let the Put you bought run until expiration, or for as long as the price of the stock continues to drop. This may result in an increase in the value of the Put you bought sufficient to offset the loss incurred when you bought back the Put you sold.

If you don’t have enough time until expiration, buy-to-close the Put you sold and then sell the Put you originally purchased for whatever you can get for it. This results in the maximum loss for this trade

Bear Call Spread

Just as the name implies, the Bear Call Spread can be a great strategy to employ when you believe that a stock is likely to remain neutral, or perhaps drop in price.

Background

Suppose you find an optionable stock with a sideways trend in a weaker industry group, or under weak market conditions. These factors may have a negative effect on the price of the stock. The plan for this trade is to sell Call options to someone right before the stock falls, making it unlikely for the options to be exercised. Since you’re not certain that the stock will fall, you’ll purchase a bit of insurance against the possibility of the stock rising in price.

Since you’re bearish on the stock, you would likely first buy at least one Call option contract two strike prices above the current price of the stock for the current expiration month. As the option buyer, you would expect to pay the Ask price for the option. Next, you would sell at least one Call option one strike price above the current price of the stock for the same expiration month. This may actually be the at-the-money option, depending on the price of the underlying stock.

Case Study

 

Suppose the current price of the stock you’re considering is $29.00 per share. In order to place a Bear Call Spread, you would first buy the $35.00 strike price Calls for an Ask price of $0.25 per share or $25 per contract. Next, sell the $30 strike price Calls for a Bid price of $1.00 per share.

Maximum Profit

After placing the two trades, the net credit to your account is $75 per contract. This is the maximum profit you can expect from this trade.

Maximum Loss

The worst-case scenario for this trade is for the stock to rise above the $30 strike price you sold. This could present a problem, as you don’t currently own the stock. Suppose the stock were to rocket upward to $50 per share. You would be forced to go out and buy the stock for $50 per share…that is you would be forced to buy it at $50 per share if it weren’t for the fact that you own the Call option, which gives you the right to buy the stock for $35 per share. The fact that you essentially bought insurance against the stock rising in price means that the most you could lose is the $5 per share difference in price, between the $35 per share you are forced to spend to buy the stock and the $30 per share you are able to make selling the stock to someone else. This $500 loss per contract is mitigated by the $75 per contract credit to your account when you first placed the trades. This limits your maximum loss to $425 per contract.

Maximum Return on Risked Capital

The maximum return on risked capital for this trade is calculated by taking the maximum potential profit for the trade ($0.75) divided by the maximum potential loss for the trade ($4.25), or $0.75/$4.25=0.176 or 17.6% potential return on risked capital. This maximum return on risked capital occurs in the event that the stock closes under the $30 strike price you sold.

At this point, the stock will move in one of three ways: up, down, or sideways. Here is how to handle each of these scenarios.

Stock Moved Down

If the stock price moves down below the strike price you sold, both the Call options expire worthless. Using the figures from the example above, if the stock closes below the $30 strike price you sold, both the $35 strike price options you bought and the $30 strike price options you sold expire worthless. You keep your $75-per-contract profit. Your potential return is 17.6%. No further action is required.

Stock Moves Up Slightly

In this scenario, the stock rises in price above the option that you sold. This requires that you place a buy-to-close order to remove your obligation on the contracts you sold. Using the example above, you would place a buy-to-close order for the $30 strike price Calls in order to avoid being called out. If the stock continues to increase in price, let the $35 Calls rise in value with the price of the stock. At the first sign of weakness in the stock, usually initiated by profit taking, you might sell the $35 strike price options in an effort to lock in your maximum profit.

Summary

A Bear Call Spread is generally a short-term trade, so you don’t have a lot of time to sit and wait for a stock to head in the direction you are expecting. Exit the short side of the trade at the first sign of weakness to avoid being called out and being forced to buy the stock to cover the trade.

Once you have bought to close the short side of the spread, you can leave the long side open to increase in value as the stock continues to move higher. When executing this time of strategy, be sure to sell-to-close the long side options on or before expiration.

Ratio Spreads

Expect a stock price to remain relatively stable? Consider taking in a little premium by writing Calls or Puts to profit, while limiting your risk by hedging yourself with a few long contracts.

Ratio Call Spread

This is also referred to as the Call Back Spread

• Sell call with lower strike price
• Buy 2 or more calls with higher strike price

Ratio Put Spread

 

This is also refer to as a Put Back Spread

Ratio spreads should be done with either all Calls or all Puts. The expiration months should be the same, and should reflect how long you expect the price of the underlying stock to be stable. These spreads are like long vertical spreads with extra short options to increase profits. Relative profits can be greater, but these extra short contracts are uncovered. If the stock moves against you, you’re exposed to increased risk on the upside (for a Call spread) and downside (for a Put spread). Depending on the expiration month you choose, and the strike prices relationship (i.e., above or below) to the current stock price, these spreads may be put on for either a net debit or a net credit for the transaction.

• Sell 1 put with higher strike price
• Buy 2 or more puts with lower strike price

Maximum Profit Potential – Limited

You should see your maximum profit if the underlying stock closes exactly at the written options strike price at expiration.

Loss Potential

Call Spread

Upside unlimited; downside limited to net debit paid for the spread As the underlying stock price goes above the short calls strike price, your extra short contract(s) expose you to unlimited potential loss. If the stock closes below both strike prices, all contracts will expire out-of-the-money, should be worthless, and your loss is limited to the net debit paid for the spread. Under the same circumstances, if you put the spread on for a net credit and all options expire worthless, you keep this credit and the position makes a profit.

Put Spread

Downside substantial; upside limited to net debit paid for the spread As the underlying stock drops below the short puts strike price, your extra short contract(s) expose you to potentially substantial losses. If the stock closes above both strike prices, all contracts will expire out-of-the-money, should be worthless, and your loss is limited to the net debit paid for the spread. Under the same circumstances, if you put the spread on for a net credit and all options expire worthless, you keep this credit and the position makes a profit.

Break-Even Point (B.E.P.) at Expiration

 

Call Spread

Upside B.E.P. = underlying stock price = short strike + (maximum profit number of naked calls)

If debit paid for spread: Downside B.E.P. = underlying stock price = long strike price + debit paid

Your primary risk comes from the upside, and a rising stock price. Remember, you’re short at least one naked call contract a risky situation.

 

Put Spread

Downside B.E.P. = underlying stock price = short strike (maximum profit number of naked puts)

If debit paid for spread: Upside B.E.P. = underlying stock price = long strike price debit paid

Calendar Spread

 

A calendar spread involves buying and selling options with different expirations, but the same strike price with the intention of capitalizing on the differing rates of time decay on the two legs of the spread, which can consist of either Calls or Puts. Construction of a simple long calendar spread calls for buying an option with a longer expiration and selling an option with the same strike price but a shorter expiration. For this strategy to be successful, the shorter expiration Call must lose its time premium faster than its further-out companion, allowing the spread between them to increase. Also known as a time or horizontal spread, this is considered a neutral strategy because any substantial swing in the price of the underlying stock will cause the spread to lose value in other words, volatility is no friend of the long calendar spread

• For example, imagine that Dell Computer (DELL) is trading for $10 per share. To initiate a calendar spread, you might sell the Dell June 10 Calls and buy the July 10 Calls.
• DELL trading @ $10 June July
• Dell 10 Calls 4.50 6.50
• Time to Expiration 2 months 3 months
• Spread value: $2 (6.50 – 4.50)

Like most long positions, there is a cost to put on this trade. In this case, the cost is $2. For the time spread to work, the June option must lose its time premium faster than the July option. If the stock price remains relatively stable as the June expiration approaches, the value of the spread should increase. With only one month remaining before the June expiration, the option prices might look like this.

• DELL trading @ $10 June July
• Dell 10 Calls 1.50 4.50
• Time to Expiration 1 months 2 months
• Spread value: $3 (4.50 – 1.50)

In this case, the position could be closed for a one-point profit by selling the July Calls and buying back the June Calls.

For long calendar spreads to work, the underlying stock price must remain relatively stable. Any swings in either direction will negatively impact the time value of both options causing the spread to lose value.

A short calendar spread would simply reverse the setup in the above scenario, selling the option with a longer expiration and buying one with the same strike price and a shorter expiration. The short variation of this strategy also holds the opposing view of volatility – the more the underlying stock price moves, the greater the likelihood of success for a short calendar spread.

 

 

Time Diagonal Put Spread

This strategy is very similar to the Bull Put Spread. The major difference is that in a Time Diagonal Spread, you don’t use Put contracts within the same expiration month.

Background:

As with the Bull Put Spread, a Time Diagonal Spread requires that you consider a stock trading in a general sideways pattern. The advantage to the Time Diagonal Spread is the additional time it allows for your intended play to work to your advantage.

Case Study:

Here’s how it works: let’s say you’ve identified a stock currently trading for $26 per share, and that the current option expiration month is August. You’re slightly bullish to neutral on the forecast for the movement of the stock. For this example, once again, assume you have Level 3 trading authority, which means you aren’t authorized to trade naked Puts, so you must first cover your position with a Put purchase.

The first step is to buy the Put option at least one strike price out-of-the-money for the September expiration. With the stock trading at $26 per share, purchase the $22.50 Put for expiration next month. Suppose the ask price for the Put is $1.50 per share. As the option buyer, you will pay the ask price for the option contract.

If the current stock price is $26 per share and you sell the $25 at-the-money Put, you can expect to make a reasonable premium for the contract. If the bid price for this option is $2.25 per share, you will generate $225 per contract on the sale.

The next step is to take the $225 in revenue from selling the option and purchase a Put option one strike price further out-of-the-money for the next month’s expiration. This is where the Time Diagonal Put Spread differs from the Bull Put Spread. Using the $225 revenue generated from the sale of the Put, purchase the $22.50 Put for next month out with an ask price of $1.50, which leaves you with $0.75 per share in revenue ($2.25 – $1.50 = $.75 or $75 per contract).

To this point, you’ve assumed the obligation to buy the stock for $25 per share, and you’ve purchased the right to sell the stock for $22.50 per share.

Potential Profit:

Your maximum profit from this transaction is the $75 surplus you retain after buying the Put. As long as the stock plays along with your neutral to slightly up-trending forecast, you’re able to keep that surplus.

 

 

Potential Risk:

In the event the stock falls below the $25 strike price, you’ll be assigned the stock or forced to buy it for $25 per share. However, you could buy the Put back, thereby removing your obligation. It’s likely you will have to pay more to buy it back than you received in revenue from the transactions you’ve made to this point ($75). But remember, you still hold the Put contract you purchased at the $22.50 strike price. This gives you the right to sell the stock for $22.50 per share, should the stock fall below this strike price. The worst-case scenario is buying the stock at $25 per share and exercising the $22.50 Put to sell the stock at $22.50 per share.

Now you are required to buy the stock at $25, while selling the stock at $22.50. This represents a loss of $250 ($25 x 100 shares = $250). Now, take the $75 surplus from the original sale of the $25 Put and use it to offset the $250 loss, reducing the maximum loss to $175 or $1.75 per share ($250 – $25 = $175). To calculate the return on risked capital for this transaction, divide the return revenue ($100) and divide it by the maximum potential loss ($150): $75 / $175 = 42% return on risked capital.

Let’s examine another trade, using an example from the Web site tools.

Suppose you’ve found the stock Charles River Laboratories (ticker symbol CRL), in a neutral trend, with little expectation of a large movement in either direction. CRL has a strong Phase 2 score with prospects for an uptrend in the stock price, as influenced by the industry group. The news looks good, with compelling evidence the stock shouldn’t fall before expiration Friday. The stock is currently trading for $37.13 per share.

To establish a Time Diagonal Put Spread trade, first sell a Put option contract with a strike price just below the current price of the stock for the current month’s expiration. In the example of CRL, this would be the Put contract with the $35 strike price. As the Put option seller, you are assuming the obligation to purchase the stock at a price of $25 per share in the event the stock falls below $35 per share anytime between now and options expiration. The bid price for the $35 Put is $1.55 per share or $155 per contract, which gives you a profit of $155.

Consider using the $155 in revenue to purchase a Put contract the next month out and one strike price out-of-the-money. In this example, that is the $30 Put for September. As the option buyer, you need to pay the ask price for the option, which is $0.45 per share, or $45 per contract. Using the $155 revenue from the sale of the $35, spend $45 to purchase the $30 Put for September, leaving you with $110 net credit to your account.

Maximum Potential Return:

The maximum potential return for this trade is the $110 from the sale of the August $35 Put and the purchase of the September $30 Put.

Maximum Potential Loss:

The maximum potential loss for the trade is $3.90 per share or $390 per contract. This represents the difference between the price of the stock you may be obligated to purchase ($35) and the $30 per-share price you may receive if you exercise the $30 Put you purchased, less the $110 in initial profit from the original transactions.

Maximum return on risked capital:

To find the maximum return on risked capital for this transaction, take the maximum potential profit ($110) and divide it by the maximum potential loss ($390): $110 / $390 = 28.2% return on risked capital.

At this point, the stock will move one of three ways: up, down, or sideways. As we did with the Bull Put Spread, following are examples of how to handle each scenario in a Time Diagonal Put Spread.

CRL Moves Up:

If the stock price moves up, close the September $30 Put while it still has value. The $35 Put for August you sold expires worthless, allowing you to keep the initial $110 in revenue. Also, you keep any remaining revenue from the original sale of the $30 Put. You make 28.2% return on your risked capital, possibly more depending on how much you are able to recover from the $30 Put you sell.

CRL Moves Sideways:

In this case, again the $35 Put you sold will expire worthless, as the stock price has never fallen below the $35 strike price you sold. Sell the $30 Put for any remaining value. Keep the $110 in profit for a return on your risked capital of at least 28.2%, plus whatever additional revenue you are able to make from the sale of the $30 Put.

CRL Drops Slightly to $34.50, Though You’re Still Bullish:

If CRL falls to $34.50 on expiration Friday, buy-to-close the $35 Put you originally sold in order to avoid being assigned the stock. Since the stock is now trading at $34.50 and the options are due to expire that same day, there is no time value remaining. The only component still influencing the price of the option is the loss in intrinsic value of $0.50 per share. You can expect to pay $50 per contract to buy back the Put. Since you originally held $110 in profit from the first set of transactions, your net profit from the trade is now $60 ($100 – $50 = $60). Since you’re still bullish on the stock and you own the $40 Put for September, consider “rolling” into a Bull Put Spread by placing a new sell-to-open trade for the September $35 Put.

CRL Drops Slightly, Your Forecast Is Now Neutral:

CRL falls to $34.50 on expiration Friday. As with the previous scenario, you need to buy back the $35 Put to avoid being assigned the stock. Since the options expire the same day, once again, time value has eroded to nothing. However, since the stock is now $.50 below the strike price, you need to pay $50 per contract to buy the option back. Subtract this cost from the initial revenue received from the original sale of the options ($110), for a net profit of $60 per contract on the trade. Next, sell the September $30 Put for whatever remaining value you can get.

Looking at this example, if the stock falls below your strike price, the sooner you buy back the Put, the better.

CRL Falls Heavily To $32, Your Forecast Is Bearish:

CRL falls to $32 on bad news and continues to look bearish. Buy back the $35 Put to avoid being assigned the stock. With the stock price now at $32 per share, a total of $3 per share of intrinsic value has been lost on the Put, requiring that you pay $300 per contract to remove your obligation to purchase the stock for $35 per share.

Now remember, you still own the $30 strike price Put. However, even though the stock has fallen, the $30 Put you sold doesn’t have any intrinsic value. This won’t happen until the stock price falls below $30 per share. Since there isn’t any intrinsic value, the only value is time value. Depending on how close you are to expiration for the $30 Put, there may or may not be enough profit to cover your commissions, let alone make you a profit. If your forecast continues to be bearish, consider keeping the $30 Put, as it should increase in value, especially if the stock price falls below the $30 strike price.

Your total profit or loss for the transaction will be determined once all of the positions have been sold.

Summary:

The advantage to a Diagonal Put Spread is much the same as that of the Bull Put Spread. Specifically, you are assuming that a given stock will move in a direction consistent with your forecast. The difference between the Time Diagonal Put Spread versus the Bull Put Spread is whether or not you wish to buy more time for your protection. The time diagonal aspect of the trade refers to the fact that you use option strike prices spread over two subsequent expiration months.

To execute a Diagonal Spread, simply buy a Put option contract one strike price further out-of-the-money than the current stock price for the next expiration month. Then, sell an at-the-money Put option for the current expiration month. Once you’ve purchased the out-of-the-money Put for next month, sell the at-the-money Put for the current expiration month. The difference should result in a net profit – hold on to this profit.

In the event the stock stays neutral in price, the Put you sold expires worthless (just remember, you were paid up-front for this). The Put you bought also expires worthless. Thus, the net effect is your maximum profit.

In the event the stock price falls below the strike price you sold, you may want to act quickly to back out of the trade by placing a buy-to-close order with your broker to remove your obligation on the Put you sold and avoid being assigned the stock.

If the stock falls below the strike price of both the contract you sold and the contract you bought, first identify how much time remains until expiration. If you have several days before options expiration Friday, consider a buy-to-close order for the Put you sold and let the Put you bought run until expiration or for as long as the stock price continues to drop. The Put you bought may increase in value enough to offset the loss incurred in buying back the Puts you sold. If you have enough time remaining until expiration, consider rolling out by selling an at-the-money Put once again, only this time, sell the contract for the same month as the contract you purchased (you should still have the one you purchased). Selling another contract for the same month as the Put you purchased makes the trade a Bull Put Spread.

If you don’t have enough time until expiration, buy-to-close the Put you sold and then sell the Put you originally purchased for whatever you can get for it. This results in the maximum loss for this trade

Straddles and Strangles

Straddles and strangles are not as popular as spreads. However, they can offer a distinct advantage: your profit is not capped at the start of the trade. Thus, you could potentially show unlimited gains.

Unlike spreads, a straddle or strangle involves trading both a Call option and Put option on the same security.

The downside to this trade is that it can get expensive and your losses can be much higher than with a simple spread.

As with spreads, there are distinct applications of straddles and strangles, depending on how the underlying stock is performing.

Here are the different types of straddles and strangles, as well as their applications:

 

 

 

Long Straddle

 

Buy one Call option and one Put option at the same strike price for the same expiration date.

With the Long Straddle, you’re expecting the stock to make a dramatic move either up or down – the direction doesn’t matter. With a Long Straddle, you buy both a Call and a Put contract. The options themselves aren’t too expensive.  However, they can become expensive if the stock doesn’t move far enough in the forecasted direction to make a profit above the expense of the options.

Short Straddle

 

Sell one Call and one Put at the same strike price for the same expiration date.

The Short Straddle is used when you expect the stock to move in a flat trading range. This strategy requires you have at least Level 4 and possibly Level 5 trading authority. With the Short Straddle strategy, sell both a Call and Put. This play uses naked positions and is considered a very risky transaction, resulting in the higher required trading authority.

Long Strangle

 

Buy one out-of-the-money Call and one out-of-the-money Put with the same expiration date.

To use a Long Strangle, your forecast for the stock is the same as it is for the Long Strangle. It doesn’t matter whether the stock moves up or down, as long as it moves significantly in one direction or the other. One application for this strategy is the time period leading up to an earnings announcement. In this case, you don’t have to be certain the stock will have a positive earnings announcement, as long as the stock moves either up or down due to the announcement.

Short Strangle

 

Sell one out-of-the-money Call and one out-of-the-money Put with the same expiration date.

As with the short straddle scenario, you are expecting the stock to trade in a flat range. It’s considered a short trade because it involves selling a naked Call and a naked Put. The contracts you sell are a bit out-of-the-money for each position, giving you some flexibility for the stock to run, while allowing you the ability to potentially generate a nice profit. Please note that the naked Call and Put you sell will require a higher level of trading authority.

Long Straddle

Background

When trading a Long Straddle, you’re either bullish or bearish. The stock may be coming up on a major news announcement and you are unsure as to which way the stock will react to the news. With a Long Straddle, the ideal situation results in a significant move in the price of the stock one direction or the other. This offsets the price paid for both the Call and Put options. The trading day before an earnings announcement, the day of the announcement, and the day after the earnings announcement are quite frequently the most volatile periods in the price movement of a stock. This period of volatility often results in a very significant opportunity.

Have you ever found yourself in disbelief when what seems to be a great earnings announcement for a stock you own results in the stock falling 20%?  If so, the Long Straddle may be the strategy for you.

There are many reasons why a stock will still fall in price even after what seems to be a positive earnings announcement is issued. It may be as simple as this: a few months ago, Yahoo!, Inc. announced positive earnings.  Despite the good news, the stock fell significantly. Why? Although the announcement showed positive earnings for the quarter, earnings came in under analyst expectations. Because the analysts had anticipated an even larger figure for quarterly earnings, when Yahoo missed, shareholders sold, driving the price of the stock down.

But here’s the beautiful part: In this example, had you placed a Long Straddle on Yahoo, you would have made a nice profit, regardless of the fact the stock fell.

Case Study

When a stock approaches a significant news event, such as an earnings announcement, you’re not certain which direction the stock will move because you don’t know what the news will be.

Let’s say the stock is currently trading for $29.50 per share. Now, follow these steps:

1. Since the stock may increase in price with a positive news announcement, place a buy-to-open order for the at-the-money Call option. In this example, the at-the-money Call has a $30 strike price. With a current ask price of $1.75 per share, you pay $175 per contract up-front to place the order. You expect the news to occur within the next few days and that the effect of the announcement will present a very short-term opportunity.  Buy the at-the-money Call for the current expiration month. For the purpose of this example, the current expiration month is August.

2. Since the stock can also easily drop in price due to the announcement, make sure to protect yourself as well. Place another buy-to-open order to buy the $30 strike price Put option with the same expiration month as the Call you just purchased.  The current ask price for the $30 Put is $1.25 per share ($125 per contract) for this side of the position.

Now you’re covered regardless of which direction the stock moves, as long as it moves significantly enough in one direction to make a profit. Such a move will clear the overhead expenses paid to enter the trade in the first place.

Maximum Loss:

The maximum loss on the Long Straddle trade occurs if the stock fails to move significantly one direction or the other.

If the stock continues to trend in a neutral direction, the Call option you paid $1.75 per share to purchase ($175 per contract) and the Put option you paid $1.25 per share to purchase ($125 per contract) expire worthless. Your total loss for the trade is $3, the cost of the Call plus the cost of the Put ($1.75 + $1.25 = $3), or $300 for the contracts.

To recover this expense, the stock price must move $3 above the strike price you purchased ($33 per share in this example) or down below the strike price you purchased ($27 per share in this example). If the stock price remains within the range of $27 to $33 per share, you incur the maximum loss for the trade, which is $300.

Maximum Profit

The advantage to the Long Straddle is that as long as the stock price moves outside of the $27 to $33 price range, your potential profit is essentially unlimited.

Exit Your Trade

Now that you’re covered regardless of the direction the stock moves, you need to understand how and when to exit the trade.

The key to the highest profitability in the Long Straddle is to keep an eye on the direction the stock moves just after the announcement. If the announcement is released after the market closes, watch closely to see which direction the stock moves at the opening of the next trading day. Once you’re certain of the direction the stock takes, you may want to immediately sell the losing option. Consider doing so as soon as possible, as it helps make the position profitable more quickly. The losing option will immediately begin to fall in value, as shareholders react to the stock price. Once you sell the losing option, consider holding the winning option for as long as the run lasts. Just be careful to that you sell the winning option prior to expiration day to help ensure your profits.

The following are some examples of the actions you’ll need to take in the event the stock moves in either direction:

The Stock Rises in Price

If the stock dramatically increases in price, consider quickly selling the Put for whatever you can get for it. Using our example, sell the $30 August Put as soon as possible. This allows the $30 Call you purchased to increase in value. The more it increases in value, as it follows the increase in the price of the stock, the greater your potential return. There is no limit to your potential return, so long as you remember to sell the Call option once the rally appears to be over or just before the August expiration Friday – whichever comes first.

The Stock Drops in Price

If the stock drops in price, the result is an instant drop in value of the $30 Call. Thus, it may be critical to sell the Call option as soon as you can. The Put option will then increase in price with the drop in value of the underlying stock. Hold on to the Put at this point, allowing it to increase in value as the stock falls. Keep the Put for as long as the drop lasts or just before August expiration Friday – whichever comes first.

Note

In the event the stock drops, the Put option could actually result in a higher profit than if the stock had risen on good news. The reason: bad news tends to have a magnified effect on the price movement of a stock. If the stock falls, the Put will probably make more money for your trade.

Short Straddle

Background

 

In a Short Straddle, your expectation is for the stock to remain in a flat trend – meaning you don’t expect any wide movements in the stock, as you would with a Long Straddle. With a Short Straddle, you sell naked options, in which you assume the obligation to sell someone the stock for an agreed upon strike price. Thus, make sure to choose a stock that has a narrow trading range and low volatility, as this helps to ensure that you aren’t likely to be forced to honor your obligations. This strategy requires at least Level 4 trading authority and that you identify that the options are overvalued for the stock in question.

Since the stock has a narrow trading range and low volatility, Consider selling the at-the-money Call and the at-the-money Put.  The ideal result for this strategy is for the stock to close exactly at the strike price you sell for both the Call and the Put. Since this rarely occurs, you’ll probably be forced to buy-to-close one side of the trade prior to expiration (note: the Short Straddle strategy is intended only for neutral-trending stocks and isn’t widely used).

The hard part is identifying a stock that will continue in a sideways trend. The best place to find one is when pending corporate announcements are published, such as possible mergers, in which you can typically identify the following pattern:

The company making the purchase is likely to drop in price, since the merger may affect the cash reserves for the purchasing company. The company being purchased usually experiences a spike in price after the announcement. The period between the spike of the merger announcement and the execution of the merger itself often presents a period of several weeks to several months when the stock price trends sideways, with virtually no daily fluctuation. Since you paid up-front for the sale of the Call and Put options, you shouldn’t be concerned whether or not the stock moves too far, as long as the stock doesn’t move in either direction beyond the strike price you sell. For this reason, it’s absolutely imperative you make a daily check on the status of your positions.

Case Study

To implement a Short Straddle position, first identify a stock you’re very confident will remain in a sideways-trending pattern for the next several weeks. For example, let’s say the stock is currently trading for $29.50 per share. Now, follow these steps:

1. The first step is to sell the $30 strike price Call option (closest to the stock price) for the current expiration month (note: you could earn a greater premium by selling the option with a later expiration date, but don’t fall victim to the temptation). The further out you go in time, the greater the risk that you will be forced to close one of the option positions at a loss. In this example, let’s say the $30 strike price option has a bid price of $1.50 per share for the August expiration. Upon completion of the transaction (selling the $30 Call), you receive a credit of $150 per contract.

2. Next, complete the sale of the $30 Put option contract. Let’s say the bid price for this put is $1 per share, making your net credit $100 per contract.

Maximum Profit

The sum of the credits to your account of $2.50 per share ($1.50 Call + $1 Put = $2.50) represents the maximum profit for the transaction. To find the lower stock price trading range for this play, take the profit and subtract it from the strike price you sold ($30 – $2.50 = $27.50). To find the upper stock price trading range, take the profit and add it to the strike price you sold ($30 + $2.50 = $32.50). As long as the stock closes between the range of $32.50 and $27.50 on expiration Friday, you’re able to keep the entire $2.50 per share in profit ($250).

Maximum Loss

With the Short Straddle, there is no theoretical limit to your potential loss. This occurs in the event the stock moves dramatically in either direction. For example, if the company suddenly announces some surprising bad news (e.g., a corporate officer is accused of fraud), the stock price will most likely drop sharply, possibly falling from $29.50 per share at the time you sold the $30 strike Puts to $20 per share in a matter of just hours.

By the time you learn of the announcement, the stock could have already fallen, potentially resulting in your being assigned the stock as the $30 strike price. This means you assume the obligation to buy the stock at $30 per share, even though it’s now worth only $20 per share, giving you a loss of $10 per share on the value of the stock. Your only alternative is to hold on to the stock in hopes that eventually it will increase in price at some point. The fall in value of the stock also results in a virtual elimination of any value in the Call option you sold.

The reverse situation results in an unlimited loss, as well. For example, if the company issues good news, the stock price could rapidly increase by the close of the market from the $29.50 strike price to a 52-week high of $40 per share. In this case, the $30 Puts are worthless and you’re likely to be called out of the $30 Call option, forcing you to purchase the stock at its current trading price of $40 per share and then turn around and sell it for the $30 strike price. In this example, you don’t even have the luxury of holding on to the stock in hopes of things eventually improving to your benefit down the road. Once you’re called out, you’re forced to honor the obligation to sell the stock at $30 per share.

Exiting the Trade

If the stock begins to move in either direction, close out the losing side of the trade to avoid being assigned or called out of the stock. Close out the second half of the trade if needed before expiration. If the stock moves higher and closes above the August $30 Call option you sold, you may need to buy-to-close the August $30 Call option. If the stock moves lower and closes below the August $30 Put option you sold, you may need to buy-to-close the August $30 Put option.

The ideal scenario for profitability on the Short Straddle is for the stock to close exactly at $30 per share on expiration. If this doesn’t happen, following are the scenarios according to the situation:

Stock Closed Above $30, but Below $32.50 on Expiration

On expiration Friday, if the stock is trading at $30.50, buy-to-close the August $30 Calls for $0.50, the intrinsic value remaining in the option ($30.50 – $30 = $0.50). This leaves you with a $2 profit from the original $2.50 you received. The August $30 Puts would expire worthless.

Stock Closes Below $30, but Above $27.50 on Expiration

On expiration Friday, if the stock is trading at $29.50, buy-to-close the August $30 Puts for $0.50 (intrinsic value). This leaves you with a $2 profit from the original $2.50 you received. The August $30 Calls would expire worthless.

Calculating the Lower and Upper Price Bounds

There is another situation that requires action. Remember, you calculated an upper and lower boundary for the stock movement. To get the upper boundary, you took the strike price for the options you sold ($30 in this example) and added the profit per share received from the sale of the options ($2.50). Thus, the upper boundary for the stock price is $32.50 per share. To get the lower boundary for the stock price, you subtracted the profit per share ($2.50) from the strike price ($30), for a $27.50 lower boundary in this example.

Now, if the stock price moves beyond the upper or lower boundary, you must act quickly to remove your obligations. If the stock price closes above your upper boundary, you could be called out, forcing you to buy the stock to satisfy the obligation. Conversely, in the event the stock price closes below your lower boundary, you must act quickly to remove your obligation or risk being assigned the stock. Following are two examples using these scenarios:

The Stock Rises in Price Above You Upper Boundary

You originally received a total of $250 for the sale of the Call and Put contracts. If the stock price starts to increase above the upper boundary previously calculated ($30 strike price Call sold, plus the $2.50 per share profit, for $32.50 per share), you need to act quickly to remove your obligation from the sale of the Call. Thus, buy-to-close the $30 Call option and leave the $30 Put to expire worthless. Any profit from the transaction results in the difference between the cost to buy back the $30 Call and the $250 received from the initial transactions.

The Stock Price Falls Below Your Lower Boundary

Should the stock price fall below the lower boundary you previously calculated ($30 strike price Put sold, minus the $2.50 per share profit, for $27.50 per share), you may need to buy-to-close the $30 Put to avoid being forced to buy the stock for $30 per share. Consider letting the $30 Call expire worthless. Any profit from the transaction is the difference between the cost to buy back the $30 Put and the $250 received from the initial transactions.

Summary

The Short Straddle is a neutral strategy that isn’t used very often. The sale of the Call and Put options used with this strategy require Level 4 or possibly even Level 5 trading authority.

The ideal situation that allows for maximum profitability for the Short Straddle is for the stock price to close exactly at the strike price you sell on options expiration day. Since this doesn’t always happen, you must monitor the trade closely. Review the position on a daily basis to make certain you aren’t at risk of being called out or assigned the stock.

You may choose to calculate an upper and lower boundary for the stock price movement. To calculate the upper boundary, take the strike price you sell and add the profit per share received from the original transaction. If the stock price goes above this upper boundary, you run the risk of being called out and forced to buy the stock. To calculate the lower boundary, take the ask price you sell and subtract the profit per share received from the original transaction. If the stock price falls below this point, you run the risk of being assigned the stock.

The instant you see the stock price move above or below your calculated boundaries, act immediately: buy-to-close the appropriate option. If the stock moves above the upper boundary, buy-to-close the Call option. If the stock falls below the lower boundary, buy-to-sell the Put option – this removes your obligation.

 

Long Strangle

 

Much like a Straddle, a Strangle trade is used when you’re forecasting a large move in the stock price in one direction or the other before expiration. The difference between a Straddle trade and a Strangle trade are the strike prices of the options purchased.

When you’re expecting a major news announcement for a particular stock, but you’re not quite certain how investors will react to that news, this is the time to consider using the Long Strangle. A good example of this is the price movement of a stock in reaction to an earnings announcement.

Background

Suppose you’ve identified a stock with an expected news announcement due any day. That stock is currently trading for $30 per share, but you aren’t certain which direction the stock will move in reaction to the news. Thus, in order to protect yourself regardless of the direction the stock takes, you decide to hedge your position with both a Put and a Call. Using a Long Strangle like this, a large swing in the stock price is essential in order to potentially profit, so be sure to find a stock with a high degree of volatility before entering the trade.

Case Study

With the stock trading for $30 per share, place two trades: one to give you an advantage if the stock price goes up, and the other to benefit you if the stock price goes down. Since you are expecting the news announcement to have a short-term effect on the price of the stock, you choose to purchase the options for the current expiration month (August, in this example). In this case, you don’t plan to hold the options long enough to justify the expense of a later expiration month.

1. The first step to a Long Strangle play is to place a buy-to-open trade to purchase the out-of-the-money call contract for the $35 strike price for the current expiration month.  Since the call is out-of-the-money, it can be purchased for a relatively low price. Suppose the ask price for the $35 strike price call is $0.50 per share, or $50 per contract.

2. Next, you would likely purchase the out-of-the-money put contract for the $25 strike price in order to help protect your investment in the event the stock drops in price. Let’s assume the ask price for the $25 strike price is currently $0.25 per share or $25 per contract.

Your overall investment in the stock is now the $0.50 per-share price you paid for the call ($50) plus the $0.25 per-share price you paid for the put ($25), or $0.75 per share total ($75).

Using this figure, you can calculate an upper and lower boundary for the stock’s price movement. These boundaries are the price points at which your trade becomes profitable.

Upper Boundary

To calculate the upper boundary, take the strike price for the Call option you purchased, $35 in this example, and add to it the cost per share you paid to enter the trade, which is $0.75 in this example. This means the stock price needs to go up to $35.75 or higher per share before you begin to profit with the Call option side of the Strangle.

Lower Boundary

The lower boundary is calculated in a similar fashion. Take the strike price for the Put contract you purchased, $25 in this example, and subtract the cost per share you paid to enter the trade, which is $0.75. This tells you the stock needs to fall below $24.25 for the Put option side of the equation to begin to profit.

Since the stock is now trading for $30 per share and the upper and lower boundaries are significantly higher and lower than the current stock price, it becomes essential that you identify an extremely volatile stock in order to ensure the greatest potential for a profitable trade.

Exiting the Trade:

Be careful when deciding to exit the trade. Even a significant price move doesn’t necessarily guarantee a profit. Let’s consider the example above:

The stock is trading for $30 per share

You purchase the $35 strike price Call for $0.50 per share

($50 per contract)

You purchase the $25 strike price Put for $0.25 per share

($25 per contract)

Your total investment is $0.75 per share ($75)

Now, if the stock rises in price and closes at $35.50 per share on expiration Friday, this represents an 18% increase in the stock price. However, this means nothing to you. Although the stock has experienced a relatively significant increase in price, your $35 Call has only earned $0.50 per share of intrinsic value ($50 per contract) and the Put expires worthless. The $50 in revenue you make on the sale of the Call won’t cover the $75 you originally invested to enter the play.

When the news you’ve been expecting is finally released, you would close out the losing position that results from the price movement. Be careful not to exit this side of the trade too soon. If the stock price is slowly creeping upward, don’t close out the Put side of the Strangle. You might want to wait until the news is released, since it may actually have a negative effect on the price of the stock.

Maximum Profit

One advantage to a Long Strangle is that there is no limit to your potential gain. For example, using the numbers from above, suppose the stock reacts poorly to bad news and falls quickly to close at $23 per share on options expiration Friday.  This leaves the Put option you purchased at the $25 strike price with $2 of intrinsic value, for $200 profit ($2 x 100 shares = $200). Once you subtract your initial investment of $75, this leaves a $125 profit or a 166% return on your investment.

Once the news is announced and the trend of the stock becomes apparent, leave the appropriate option in place for as long as you can. And remember, you must place a sell-to-close order to get out of the trade once the move is over or before expiration – whichever comes first.

Maximum Loss

The maximum loss you can sustain using a Long Strangle is the cost of the initial investment. This occurs when the stock fails to move either above or below your upper or lower boundaries by expiration Friday. In this case, your options expire worthless, or retain so little value it would cost you more in commissions to exit the trade than you would be able to make on the sale of the options.

Summary

The Long Strangle is often used when you are expecting an extreme movement in a stock in one direction or the other. It doesn’t matter which direction the stock moves, as long as the movement is large. The strategy typically works best when you plan your trade in conjunction with expected news announcements that could have a significant bearing on the price movement of the stock, such as an earnings announcement.

To place a Long Strangle trade, first purchase a Call option one strike price out-of-the-money above the current price of the stock. Then, purchase a Put contract one strike price out-of-the-money below the current price of the stock.

Calculate the lower and upper boundaries for the trade by taking the price paid for both the call and put contracts and adding it, per share, to the stock price for the upper boundary or subtracting the price paid, per share, from the stock price to find the lower boundary. The stock price must move either above or below these boundaries before expiration Friday for the trades to become profitable.

A Long Strangle play limits the maximum loss you will experience, even if the trade goes completely against you, while there is an unlimited potential gain for the trade. However, the stock itself must be extremely volatile in nature in order to ensure the greatest potential profit.

Short Strangle

 

As with a Short Straddle discussed previously, a Short Strangle is a strategy that lends itself to sideways-trending stocks.  Similar to a Long Strangle, a Short Strangle employs option strike prices out-of-the-money above and below the current price of the stock.

An advantage of the Short Strangle is that by using out-of-the-money strike prices for the trade, the stock has some moving room before action needs to be taken to close the trade to avoid being called out or assigned the stock.

Another advantage with a Short Strangle is that you don’t have to identify a stock with very low volatility. In fact, a stock with some degree of volatility will most likely result in a higher premium for the options you sell, resulting in a higher potential profit.

Background

With a Short Strangle, you’re forecasting the stock trend to remain neutral for the next few weeks. Since you’re selling naked options on the stock, you will need to have at least Level 4 trading authority to place the trades.

Once again, you need to calculate an upper and lower boundary for the price movement of the stock in order to measure the points at which you will need to take action to minimize your risks.

Case Study

1. In order to place a Short Strangle trade, begin with a stock that is expected to remain neutral or not move very much. Sell the out-of-the-money Call and the out-of-the money Put on either side of the current stock price to help generate a profit.

2. Monitor the trade daily to ensure that you aren’t in danger of being assigned the stock or being called out.

Let’s say you have a stock currently trading for $30 per share. You want to limit your liability in the trade, so you sell the options for the current expiration month (for this example, the current expiration month is August).

Placing the Order

There are two steps to placing a Short Strangle trade:

1. First, sell the Call option for the first strike price out-of-the money for the current August expiration. Using the example above, the current stock price is $30 per share. Thus, you need to sell the $35 strike price call option. If the bid price is $0.50 per share, you can expect to earn $50 per contract for the sale of the Call option.

2. Next, sell the $25 Put option for the August expiration. Let’s say the bid price is $0.35 per share, which results in a credit to your account of $35 per contract for the sale of the Put contract.

The total credit to your account now totals $85 ($50 + $35 = $85).

Upper and Lower Price Boundaries

Since you’ve sold both the Call and Put options, you’re expecting the stock won’t move outside of the strike prices you’ve sold, meaning it shouldn’t go above $35 or $25. The strike prices of the Call and the Put you sold become the upper and lower price bounds for the trade. Now, as long as the stock remains between $35 and $25 per share by options expiration, your contracts expire worthless, allowing you to retain the entire premium you received from the initial sale of the options.

Maximum Profit

Your maximum profit on the trade is the $85 received from the sale of the options themselves. As long as the stock price stays between the strike price for the Call ($35) and the strike price for the Put ($25) you retain your full profit from the trade.

Maximum Loss

Since you’re expecting the stock to make only small moves between the two option strike prices, you’ll experience a loss if the stock moves dramatically beyond those strike prices.

Stock Price Rises Above the Strike Price of the Call

In the event the stock price rises above the $35 strike price Call option you sold, you may want to act immediately and consider placing a buy-to-close order to back out of the position. This removes your obligation on the trade and prevent you from being forced to buy the stock to cover the trade. The Put contract you sold would expire worthless. The profit from the short strangle, if any, is whatever funds remain from the initial credit you received, minus the cost to buy back the Call option contract to remove your obligation.

Stock Price Falls Below the Strike Price of the Put

If the stock price falls below your $25 strike price Put option, act immediately and place a buy-to-close order with your broker to back out of the Put trade, removing your obligation to buy the stock for $25 per share. The Call you sold will expire worthless. The profit from the short strangle, if any, is whatever remains from the initial credit you received, minus the cost to buy back the Put option to remove your obligation.

Summary

The Short Strangle has an advantage over the Short Straddle, in that you sell the Call and Put options at strike prices that are further away from the stock price. This provides flexibility for a small movement in the stock price before you are forced to take action to remove your obligation.

As long as the stock reaches expiration Friday at a price somewhere between the strike price of the Call and the strike price of the Put you sold, you retain your maximum profit.

If the stock price moves above or below these price boundaries, you must act quickly to place a buy-to-close order to remove your obligation on the options.

This is an aggressive strategy, and requires at least Level 4 trading authority, as you are selling both a naked call and a naked put

Butterfly

 

This popular credit spread allows a moderately bearish investor to potentially capitalize on an expected decline in the price of an underlying stock by selling Call options at one strike price while buying the same number of Calls at a higher strike. If the stock price closes below the in-the-money (lower) strike price on expiration, this strategy reaps the maximum profit available. If, however, the stock increases above the out-of-the-money (higher) strike, you will lose the difference between the two strike prices, minus the net premium received when you established the spread.

• Profit potential: Call premium received Call premium paid
• Loss potential: Difference between Call strike prices net premium received

 

 

 

 

 

 

 

 

Condor

This bullish strategy seeks to benefit from an expected rise in the price of an underlying stock by purchasing Put options at one strike price while selling the same number of Puts at a higher strike. In a successful Condor scenario, the stock price remains above the higher of the two put strike prices. In turn, the short option expires worthless, and the investor keeps the premium. Some traders seek out this type of low-risk credit spread exclusively.

• Profit potential: Put premium received Put premium paid 
• Loss potential: Difference between Put strike prices net premium received
• Break-even point: Higher strike price net premium received

• Break-even point: Lower strike price + net premium received

Reversals

Reversals are often used by savvy traders in an attempt to capitalize on minor price discrepancies between Calls and Puts. Like other arbitrage strategies, a reversal involves buying something in one market and simultaneously selling it in another to capitalize on whatever small discrepancy exists between the two.

When options are relatively underpriced, a trader would sell stock on the open market and buy the options equivalent in the option market to establish a reversal. Theoretically, this is a strategy with very little risk because the profit is locked in immediately. The idea here is to create a synthetic long position and offset it with a short position in the same underlying stock. The synthetic long position is created by buying a Call and selling a Put with the same strike price and expiration.

Combining a synthetic long position with a short stock position creates a reversal:

• long call + short put + short stock
• Profit potential: Limited
• Loss potential: Limited
• Break-even point: call price – put price = stock price – strike price

 

 

 

 

 

Conversions

 

Like Reversals, conversions are often used by savvy traders in an attempt to capitalize on minor price discrepancies between Calls and Puts. Like other arbitrage strategies, a conversion involves buying something in one market and simultaneously selling it in another to capitalize on whatever small discrepancy exists between the two.

When options are relatively overpriced, a trader would buy stock on the open market and sell the equivalent position in the option market. Theoretically, this is a strategy with very little risk because the profit is locked in immediately. The idea here is to create a synthetic short position and offset it with a long position in the same underlying stock. The synthetic short position is created by selling a Call and buying a Put with the same strike price and expiration.

Combining the synthetic short position with a long stock position creates a conversion:

• Short call + long put + long stock 
• Profit potential: limited
• Loss potential: limited
• Break-even point: Call price – put price = stock price – strike price

Index Options

By definition, an index is a group of stocks traded or listed as one entity, such as the Dow Jones Industrial Average (DIA) or the S&P 500 (SPX). There are literally hundreds of different indexes traded throughout the world, with many tied to securities on the U.S. exchanges.

There are several advantages associated with trading the indexes themselves, as well as a number of different investment vehicles available with which to trade them. Some of these investment vehicles include: managed index funds – where your contributions are managed within a mutual fund that specifically targets the various funds themselves; or index tracking stocks (also known as exchange traded funds or ETFs), or the most exciting vehicle of all, index options.

Most index options are heavily traded and carry large premiums. This makes them ideal for selling time, as with a Covered-Call, or to show dramatic increases in the option value for a given movement in the underlying index by virtue of the leverage associated with options.

Unfortunately, not all indexes are optionable. For the purposes of our discussion, we’ll only focus on optionable indexes.

Most Common Optionable Indices:

It’s probably safe to assume you are somewhat familiar with most, if not all, of the indexes. However, let’s quickly review the names and common ticker symbols for the optionable indexes we’ll be discussing (notice that many of the indexes listed have more than one ticker symbol).

Complete definitions for these indexes can be found at the CBOE Web site at http://www.cboe.com.

You may be wondering why there are so many different ticker symbols for the various indexes listed. The reason is that each of the different ticker symbols represents a completely different security, tracking the same base set of stocks, but often following a completely different pricing structure.

Here’s an example: the SPX tracks the performance of the top 500 companies in the Standard & Poor’s index. The XSP also tracks the S&P 500, but at 1/10th of the value of the SPX.

Another possible variation between option types is their exercise style: American-style options vs. European style options. There are advantages and disadvantages to each discussed below.

American vs. European Style Options

Many European investors also trade on the U.S. exchanges, enjoying the protection of the U.S. regulated markets and the wide variety of financial instruments available. Many European traders are also attracted to the trading flexibility possible with American-style options.

The main difference between an American style option and a European style option is when they can be exercised. European-style options can only be exercised on the day they expire, which tends to reduce the risk to the option seller. With either American or European-style options, you have the ability to buy or sell the options at any time prior to expiration – it’s the freedom to exercise the options that is the real difference.

Most options based upon an underlying stock are American-style options. American-style options can be bought and sold or exercised to take possession of the underlying stock at any time prior to expiration. Since most index options are tied to the value of a basket of stocks, there is no physical stock to possess – these options are cash-settled. Most cash-settled options are of the European variety.

If you imagine yourself as the seller of an index option, (think Covered Call) you can see how advantageous it could be to know with certainty that you won’t awaken early one morning to find that your index option contracts have been exercised, leaving you on the hook for a hefty cash settlement. You only need to worry about settlement on the day of expiration and at no other time. This gives you the comfort of knowing that you’re free to “buy-to-close” your contracts to cover an upside-down trade and limit your losses rather than being forced to turn over a large cash sum – as long as you do it before expiration day. This protection from potential down-side risk clearly works to the advantage of the option seller. Sellers of American-style options run the risk of being “called out” and having their options exercised at any time. For this reason, American-style options have a greater premium than European-style options for a given option position.

SPX:

One of the most actively traded indexes and some of the most actively traded options contracts come from the S&P 500. This benchmark index is generally traded by large institutional traders with plenty of cash at their disposal. The options contracts are expensive and volatile. It is not unusual to see the SPX index move anywhere from 2 to 30 points in a single day.

The SPX trades as a European-style option and can only be exercised on expiration day. The last day you can actually trade the SPX is the Thursday of the week the contracts expire. The options are cash settled at the price of the open on expiration Friday. SPX options are pricey, but each point in movement of the S&P 500 index is equal to a $100 movement in the SPX.

Other than the European-style exercise date for the SPX, the options are just like any regular option, officially expiring on the Saturday following the third Friday of the option’s expiration month. Options in the SPX are traded through the Chicago Board Options Exchange (CBOE) and are traded in the Central time zone from 8:30 a.m. to 3:15 p.m., Monday through Friday.

XSP (aka Mini-SPX):

The XSP follows the same core basket of stocks as the SPX, but at only 1/10th of the cost. This brings the option much closer to the price range of individual investors, resulting in fairly significant daily trading volumes. For example, if the SPX were currently valued at $1500, the XSP would have a value of $150.

DIA:

Mention the U.S. stock market anywhere in the world and people will likely think of the Dow Jones Industrial Average (DIA). This index is one of the more popular with investors worldwide due to its versatility and diversity. The stock symbol DIA can be traded as an Exchange Traded Fund (ETF), just like an individual stock. The DIA, along with all other ETFs, is traded on the American Stock Exchange. Information regarding the DIA, as well as other ETFs, can be found on the American Stock Exchange Web site at http://www.amex.com.

One strong benefit of ETFs like the DIA is the diversity they offer. With one position, you have a portfolio diversified among 30 stocks. Plus, it can be shorted on a downtick.

You can play options on the index as well. Since the DIA acts like any other optionable stock, Covered Calls are an effective way to leverage your investments.

Options on the DIA are American-style, meaning they can be exercised any time prior to options expiration. Since the underlying stock can be bought and sold, DIA options result in physical settlement of the option trades. Thus, in the event you sell a Covered Call and you are called out, you need to sell the underlying stock to the option buyer to settle the transaction.

DIA options are also traded on the CBOE, which is open Monday through Friday from 8:30 a.m. to 3:15 p.m., Central Time. DIA options can be traded up to the closing bell on expiration Friday for their individual expiration month (though the true expiration date is the third Saturday of the month the options expire).

DJX:

Investors who prefer to trade indexes as a straight index and not as an ETF can trade the Dow Jones Industrial Average as an index option with the DJX. This option trades at roughly 1/100 of the Dow and follows the rules of a European-style option. Thus, the last day to trade the DJX is the Thursday before expiration, with the settlement price locked in at the open on expiration Friday. The DJX is traded on the CBOE, so trades are processed from 8:30 a.m. to 3:15 p.m., Central Time, Monday through Friday.

QQQQ:

Investors wanting to trade the NASDAQ 100 (NDX) can trade the index as a stock using the ticker symbol QQQQ. This index is often referred to as the Q’s, or the triple Q. This ETF carries the same characteristics as a normal stock, yet provides you with a diversified portfolio of 100 of the NASDAQ’s largest companies.

The QQQQ offers options with a physical settlement. So if you exercise options on the QQQQ, you can take physical possession of the stock by purchasing the shares at the option strike price. The QQQQ is traded on the CBOE.

The QQQQ tracks the average price of the top 100 companies of the NASDAQ. At the time of this printing, the QQQQ was averaging about $35 per share. This means that not only is the stock relatively affordable but the options aren’t all that expensive either.

NDX:

If you’re approved for Level 5 trading authority, you may want to consider the advantages of trading naked index options on the NDX, one of which is a much higher premium. Also, because there is no stock to own, options on the NDX are cash settled. Another characteristic of the NDX is that is a European-style option.

If you have Level 5 trading authority, the premium associated with NDX options can be quite attractive. If you were to look at the premium for the at-the-money Call for next expiration month on the QQQQ and the at-the-money Call for next month on the NDX, you would see that the difference in premium is significantly higher for the NDX.

RUT:

The Russell 2000 (RUT) is an index that continues to gain popularity. The RUT actually tracks the smallest 2,000 of the 3,000 largest stocks in the U.S. markets. It’s a European-style option that is cash settled on expiration Friday. As with the previous examples, the RUT is traded on the CBOE, open for trading from 8:30 a.m. to 3:15 p.m., Monday through Friday, Central Time.

Caution: Only experienced investors who understand how to make volatility work for them should trade index options. Index options can be quite volatile and expensive, so if you’re a novice to options investing, this shouldn’t be the first strategy you try.

Practice before entering your first index option trade. There isn’t anything wrong with paper-trading index options until you’re more confident in how an index moves.

 

Advantages of Index Options:

You may ask yourself, “Why would I want to invest in index options?” There are some very distinct and profitable opportunities associated with index options. Here are a few:

Index options can be traded both on the long side and the short side for profits in either an up or a down market.

Since you are trading an index, you no longer need to scour the markets for a stock. This helps make more efficient use of your research time.

Each index is a combination of many different stocks, so fundamental analysis is not necessary. Also, index options are short-term plays, so you’re only concerned with the stock’s technical merit.

Because index options are generally traded by large institutional investors who move hundreds of contracts at a time, they are extremely liquid. Individual investors have the ability to move in and out of index options without attracting any attention.

An index represents a wide-ranging group of stocks, so your portfolio is immediately diversified.

Risks of Index Options:

Although index options have many benefits, they also carry some risks:

l Index options can be very expensive, which can lead to big losses. It only takes one or two of big losses to empty an options account.

l Index options are heavily traded and are subject to high volatility. Wide price swings in the SPX and XSP in particular are not unusual and can result in extraordinary price ranges throughout the day. Unless you’re able to track options price quotes throughout the day, you may be in for a surprise at the end of the day when you discover an unexpectedly large loss in your trading account.

l The volatility of some exchanges can leave an index that started in a positive position at a large loss by the end of the day. The Dow has been known to swing from a gain to a 100-point loss in just a few trading hours.

l If you are a buyer of time (Calls), an option could fall in value even if the index is steadily moving higher. This is due to the fact that index options are extremely overvalued and that time value erodes quickly as the index nears expiration day.

How Does an Index Option Compare to a Stock?

Until you compare the two, the differences between stock options and index options can be difficult to visualize. But let’s see how the two react to price movements. For this example, let’s consider options on the OEX and Ford Motor Company.

With the OEX trading at $498, the closest Call option is the $500 Call with an option premium of $10. The $500 Put premium is trading at $12.

On the other hand, Ford is trading at $10.77. The $10 Call option is trading at $1, even though it has $0.77 of intrinsic value. The $10 Put for Ford is trading at $0.20.

The OEX options are more expensive because the value of the OEX is tied to the S&P 100 index (which is made up of 100 stocks). By contrast, options on Ford are tied to the value of a single stock. This is an important factor to consider. Although the OEX options look expensive, the premiums are large because traders think there is a chance to profit from the transaction.

When to buy CALLS or PUTS??

When to BUY PUT and when to BUY CALL

Many people ask me each day when to sell/buy, how do you know when to sell or buy….well here goes

What people usually do to sell a stock is …find the next resistance (for example stock ABC next resistance is @ .015) sell right BEFORE the resistance because stocks will usualy hit resistance then fall DOWN. So sell right before resistance then buy back at support. If the stock breaks resistance then you buy after the bid side has broken the resistance and you ride it to the next level of resistance, with the old resistance now acting as support. And the old old support as support level 2

BUY PUT at:
1. just prior to resistance levels
2. when your stock has lost support (then look to add at support level 2)
3. when a stock has formed a base then has lost that support
4. when your UP!!!

BUY CALL at:
1. support levels
2. breaks of resistance on the bid side (clearly, dont buy if the bid cracks resistance for 1 second )
3. when a stock is basing after a long downtrend and the bearish are done pissing on your parade

What acts as support and resistance?

Support
1. Any prior lower low then the current price
2. Any moving average that is lower then the current price
3. A major resistance level that was broken to the upside and then comes down to this (old) major resistance level, this will now be support
4. Bottom channel lines

Resistance
1. Any prior higher high then the current price
2. Any moving average that is higher then the current price
3. A major support level that was broken to the downside and then comes up to this (old) major support level, this will now be resistance
5. Top channel lines

Conclusion: BUY PUT AT RESISTANT LEVEL AND BUY CALLS WHEN AT SUPPORT LEVEL.

12 Compelling Reasons To Decide On Which Discount Broker

Having a good stock broker is very important for any investor. Paying high commissions and receiving little on the research side won’t do much in the long term. This article presents 12 key factors to help compare all online stock brokers and ultimately find the best broker to suite your needs.Comparing Online Stock Brokers

This list of 12 factors to help you compare online stock brokers are not in any particular order. Every investor is different and as a result factor 1 (trade costs) may not mean nearly as much as factor 11 (account security). It all depends on personal preference.

1. Trade Commissions

What does it cost to buy shares of stock? Does the fee change based on the type of order or size of order? For example, does it cost less to place a market order than it does to place a limit order or stop loss order? The best any investor can get from a broker are what are known as flat-fee trades, charging a flat rate regardless of the type, price of the stock, or size of the order.

Our Recommendation: InteractiveBrokers

2. Customer Service

When picking up the phone or emailing a broker, is a well trained customer service representative ready to assist? How any investor is treated as a client is more important to some than others. But, even for those that don’t rely on customer support that often, to know that they have award winning service there when they need it is comforting.

Our Recommendation: InteractiveBrokers

3. Trading Tools

Trading successfully is a lot easier when investors have great tools at their disposal. Whether paid or free, a great broker should offer access to a wide variety of tools to help make the most of each and every trade. From real time streamers to last sale tickers, live news feeds, and for some even level II quotes. Tools are essential for the active investor.

Our Recommendation: OptionsXpress

4. International Exposure

When comparing brokers find out where they offer services and make sure they offer services in your country. For investors in the United States this is not a problem, but for nearly everywhere else finding a good broker that offers international trading can be difficult.

Our Recommendation: Etrade

5. Account Minimums

One of the most common catches of an online broker comes tied in with the account minimum. Investors may think they signed up for $1 trades but once they place that first order and are charged $20.00 they are be in for a rude awakening (simplified example). A good broker will have a minimum deposit of less than $5,000 to gain access to ALL services, tools, and most importantly flat fee commissions.

Our Recommendation: InteractiveBrokers or OptionsXpress

6. Other Fees

Fees beyond trade commissions include not maintaining a minimum balance, transferring money in and out, or having an overall inactive account. While over time most brokers have grown to exclude any such maintenance fees it is still important to understand as every broker is different. Just like a bank account stock brokers also make a portion of their profits of extra service fees.

7. Market Research

A good discount broker will provide a variety of both free and paid market research tools. The key to finding great market research is by looking at the most well known brokers. Etrade, Scottrade, TD Ameritrade, Fidelity, and several other discount brokers all provide fantastic research tools due to the excess capital they have to spend.

Our Recommendation: Etrade

8. Investment Options

A stock broker should offer access to not only trading stocks, but also mutual funds, ETFs, and options. Most brokers offer these investment options as standard but some will go out and beyond to make the overall experience great. Scottrade offers a well known mutual funds center for example and TD Ameritrade has its own Independence ETFs available to all of its clients.

Our Recommendation: Etrade

9. Retirement Accounts

Funding a Roth IRA or other retirement account is an extra plus that some online brokers offer. Most brokers will go out of their way to try and market retirement accounts to their clients. Logging into an account and having one click access to both trading and retirement accounts is a nice convenience for any investor.

Our Recommendation: Etrade

10. Banking

The emerging trend for the larger online brokers is to offer banking and other financial services. This goes beyond money market accounts and CDs. Checking accounts and even home mortgages are now more widely available. Brokers engaged in the banking business also have service centers across the country where any client can go in to receive live personalized assistance.

Our Recommendation: OptionsXpress

11. Account Security

As a growing concern for all investors due to the advancements in computer hacking, scams, and credit fraud, online brokers are investing heavily into account security. Most brokers will have account security information featured on their site and before opening an account take a few minutes to read through their policies. Etrade for example offers clients a security key that changes passwords every minute, and InteractiveBrokers have a security card which is being issued to account holders to key in a different password for every access. It acts more like a additional access security function.

Our Recommendation: Etrade or InteractiveBrokers

12. Speed

For the active trader execution speed is absolutely critical. We won’t rat out any brokers here but we have tested and tried most of them and there can be noticeable differences in trade execution times. While it may be difficult for investors to really find out the execution speed until they open the account, it is something to keep a eye out for if the broker does market itself for such an asset.

Our Recommendation:InteractiveBrokers

The Basic Understanding of Options

The Definition of an Option

So, What is an Option?

An Option is a contract between a buyer and a seller.This contract gives the buyer… the right, but not the obligation to buy (or sell) an asset at a fixed price before a predetermined date. For those of you unfamiliar with options this definition may seem complex at first, but don’t be discouraged.  You’ll see as we walk through it step by step that it’s actually quite simple. Let’s look at a possible situation in real estate to explain how options work.   Example: Bill, a home owner on the coast of Bahamas, purchased a home several years ago.  His home has increased in value nicely in the last few years, but he feels that the local real estate market is getting soft.  He believes that in the next 6 months the market value of his home will either remain at current prices or perhaps even decrease slightly.  At this point Bill begins to wonder if he should consider putting his home on the market to lock in his gains with the proceeds from the sale.   Meanwhile Jennifer, a prospective buyer in Bill’s area, is looking to buy a home but she won’t have the complete down payment saved for several more months. Contrary to Bill’s opinion, she believes that the local real estate market will continue to rise at a fast pace in the next 6 months. Around the Holidays, Jennifer hears through a mutual friend that Bill is considering selling his house.  She knows the house well and has had her eye on it for some time.  So she approaches Bill with an idea.  Jennifer is willing to pay Bill a premium to keep his home off the market while she finishes saving up a down payment.  All she asks for in return is the right to purchase Bill’s house at predetermined value any time before July 1st.  (Remember, Jennifer believes the home will be worth much more in 6 months time.)  If she chooses not to purchase Bill’s home, he gets to keep the premium that Jennifer paid him. Because Bill believes that the market price of his home will not increase during this period he sees this as a great deal.  Jennifer will only choose to buy his home if it has appreciated, which he is quite confident it won’t.  Either way, he keeps the premium Jennifer pays him.  In his mind this is a great way to pick up some additional income over the next 6 months. On January 1st, Bill sells Jennifer an option contract on his house for $5,000 giving Jennifer the right, but not the obligation, to buy Bill’s home for $400,000 until July 1st. (About 6 months). Revisiting the definition of an option from above, the option (contract) that Jennifer purchased provides for… the right, but not the obligation to purchase an asset (Bill’s house) at a fixed price ($400,000) before a fixed date (before July 1st ) Call Options In the world of options trading, the option contract Jennifer purchased on Bill’s house would be termed a Call option.  A Call option is a bullish option contract.  In other words, the buyer of a Call option believes the underlying asset will increase in value.  In this case, Bill’s house would be that asset.  Let’s review the terms of the Call option for the buyer and the seller in our house example: BUYER (Jennifer)  the right, but not the obligation  to purchase the asset (Bill’s house)  at a fixed price ($400,000)  before a fixed date (July 1st ) SELLER (Bill)  the obligation (if the buyer – Jennifer – chooses to exercise his/her right to purchase)  to sell the asset (Bill’s house)  at a fixed price ($400,000)  before a fixed date (July 1st) Results at Expiration of a Call Option Below are three possible scenarios that may occur at the expiration of the house Call option contract on July 1st: 1) The house is now worth $440,000. Jennifer exercises her option and buys Bill’s house for $400,000. Her total cost is $405,000 ($400,000 for the house + the $5000 premium she paid Bill for the option). At this point Jennifer has made a profit of $35,000.  ($440,000 market value – $405,000 cost) 2) The house is now worth $405,000. Jennifer exercises her option and buys Bill’s house for $400,000. Her total cost is $405,000 ($400,000 for the house + the $5000 premium she paid Bill for the option).  At this point Jennifer has broken even ($405,000 market value – $405,000 cost) and she owns the house which has the potential to continue to increase in value in the future. 3) The house is now worth $380,000. Because the market value of Bill’s house is now less than $405,000 (Jennifer’s breakeven point) she does not exercise her option and lets the contract expire worthless since she could buy Bill’s home on the open market for less than $400,000. Jennifer loses the $5000 she spent on the option, but she can still afford to buy a home with her down payment. Bill keeps the $5000 he received for the option which reduces his losses and he still owns his home. Basic Call Option Terms Strike Price: Price at which you have the right to buy the underlying asset (e.g. Bill’s house at $400,000) Option Premium: The price of the option (contract) that you purchase. (e.g.  The $5000 to buy Bill’s house at a fixed price of $400,000.) Expiration Date: The date at which the option contract (and the buyer’s right to exercise their option) expires. (e.g. The July 1st expiration of Jennifer’s option contract on Bill’s house). Exercising an Option: Buying the asset from the seller at the fixed price on or before the expiration date. (e.g. Buying Bill’s house for $400,000 on or before July 1st.) Breakeven: The value that the asset must reach for your option to become profitable. (e.g. $400,000 Strike Price + $5,000 Option Premium = $405,000 Breakeven)