So You Want To Learn Options?

[stockzilla]

Hi, some have asked me about options so I thought I'd pass on some things I've learned about them. Please excuse the appearance as I am copying some notes I saved. I'll try to clean it up when I get a chance.

Options Levels
L1=Covered Calls
L2=Long calls and Puts
L3 Spreads
L4 Short Calls and Puts
L5 Short Index Options

[stockzilla]

Basics
An option is a contract that gives the owner the right, but not the obligation, to buy or sell a stock at a set price by a set date.
An option is a piece of paper that allows you if you own the contract to buy or sell a stock at a set price before the contract expires, or to buy or sell the contract at any time prior to expiration..
ctrct=contract
a Purchased Call option gives you the right to buy a stock a t a set price for a set period of time.
A Purchased Put option gives you the right to SELL a stock at a certain price by a set date.
Option carry the risk of total loss of your investment.
Options have leverage. When you buy 1 contract, you control 100 shares of the stock at a fraction of the price
5 Ingredients to Option Pricing
The current stock price.
The strike price you are trading.
The time till the option expires.
The cost of the money.
The stocks volatility.
Every Option has 2 Parts
Intrinsic vale
Value if the current value of the opt if it were to be exercised today.
Time value
Value if the amount you pay to exercise your contract within the next few months.
Time Value(TV) is the additional amount the MM's add to the premium, it's like a car dealers mark up price.
Example
a. Intrinsic value + Time value = option price
b. Stock=$26
c. I want to buy the $25 calls
d. The intrinsic value = $1 (26-25)
e. If the option quote price of the $25 call is 2.50, then the time value is $1.50 (see F)
f. 2.50-1.00=1.50
g. If stock is $27, Intrinsic Value=$2.00
h. Option Quote - Intrinsic Value = Time Value

Theoretical Value
1. Is the fair value of an option.
2. It not only tells us if the stock is overvalued or undervalued, but it also tells us exactly what price we should be paying for an option.
3. This T-value is derived from the BSC.
Example
a. Lets say we are looking at a 60.00 stock and the Tval is listed at .65.
b. Ask price for the strike price and the exp month is .70 for the Nov 60.00 call option.
c. If we pay .70 to buy the option and the Tval is .65 we will pay 7.6% more than we should.
d. There is a normal premium built into most options as the MM's will try to see how much more you are willing to pay.
e. As a general rule of thumb, make sure the ask price of an option is not trading more than 20% premium of the T-Val.

[stockzilla]

Decision Factors
A huge factor in deciding whether or not to purchase an option rests in the expected volatility (price movement) vs. the stock's historical volatility.
Volatility = magnitude of a stock move, this can be up or down.
If stock has low historical volatility, that means investors are willing to hold the stock and not trade it.
This usually indicates the stock will see low volatility in the future.
The 12m calculation for historical volatility is a good indicator.
Implied volatility measures the current expected volatility of the stock.
When we measure the historic against the implied, we can see if the stock's expected (implied) volatility is above or below normal historical volatility.
If implied volatility is higher than historic volatility, the option is overvalued.
If implied volatility is lower than historic volatility, the option is undervalued.
If implied volatility is close to the historic volatility, the option is fair valued.
All of this is done for you with a calculator called the Black Shoales Calculator.
The BSC allows you to project the future value of an option by allowing you to manually change the Strike price, share price , time to expiration, volatility, annual interest rate.
http://www.blobek.com/black-scholes.html.
Forecasting
Each time you invest, you must choose a strategy that takes advantage of your forecast for the market or a particular stock.
This is a tremendous challenge and is impossible to be right 100% of the time.
To make a forecast, use the best available info and tools and then apply your individual; interpretation of them.
Always forecast before making a trade. Most option traders focus on short time frames for their forecasting (generally 3 months or less).
As option traders we try to use the leverage of an option to profit from a short term move in the market or individual stock.
Rules
The Trend is your friend. Never buck the trend or you lose.
Spot trend of the major indexes first: DOW<S&P500,NASDAQ.
Keep in mind that the trend tells you WHAT to do, and the Indicator tells you WHEN to do it.
ALWAYS - check the trend before you check the indicator.

[stockzilla]

Buying a Call
You pay a premium for the right, but not the obligation to buy a stock at any time before the expiration date.
You also have in your contract the right to sell that contact ANY TIME before expiration date.
Your 5K premium is known as “as risk.” You can lose all of this investment.
So in order to make money when we purchase a call option, the price of the stock must go up over the stock price + the premium we paid per share.
Buying A Put

Same procedure as buying a call except you are betting that the stock will decrease in value. Profit is made once the stock price goes below the Strike price + the cost of your premium.


Example of Buying a Call (real estate example)
1. On August 23rd you pay a 5K nonrefundable premium to buy my house for 100K on January 1st, 2008.
2. When Jan 1st comes, if my house is worth 150K, you have the option to buy it for 100K and sell it for 150k, resulting in a 45k gain using a 105k investment. This is a gain of 43%.
3. When Jan 1st comes, if my house is worth less than 100K, you do NOT have to buy it. You would lose the premium.
4. If anytime before Jan 1st my house is worth more then 100K, you can sell the contract and take the profit. Using the example above, we can sell the option for 50k and make a 45k profit. This is the beauty of options. You use 5k to make a profit of 45k (a 900% gain) instead of using 105k to make the same profit.You make the same profit without having to purchase and sell the equity. This is known as leverage.

Selling a Put
You are credited the premium when you sell the contract.
As long as the stock stays above the strike price, the contract will expire worthless and you will make the premium.
So in order to make money, when we sell a put, we want the stock price to stay above the strike price.
You only sell Puts when you are comfortable owning the underlying stock (at a discount)
Example of Selling a Put
1. The current price of LEND is at $6 a share.
2. We sell the $2.50 strike price put for September. The premium on this sell is .80 cents per share (.80/share).
3. We sell 100 contracts (100 contracts * 100 shares = 10,000 shares).
4. The amount credited to our account for the sell is 10,000 shares X .80/share = 8,000 dollars.
5. As long as the price of LEND stays above $2.50, we get $8,000 on the expiration date.
6. Now what happens if the stock drops to $2.50? We have to buy the stock back!
7. We buy the stock back at the Strike Price – Premium.
8. For LEND that would be 2.50 - .80 = $1.70 per share.
9. The JUICY part is that when the stock fell to $2.50, we bought it at $1.70, which means that we can turn around and sell the stock at the market price of… lets say $2.45… and still make a sizeable profit (7,500).
10. (2.45-1.70) * 10,000 shares = 7,500.

[stockzilla]

Credit Spreads

Basics
Credit spreads have a maximum profit potential.
Credit Spreads require level 3 options trading authority
Tip: If you think the stock is going to make a dramatic move up, you would be better playing a long call
But what is really cool is that you can make money with a credit spread even if the stock stays flat and may even take a small profit even if it goes down only a little bit
Spreads have a max loss potential
Spreads have a max profit potential
When playing options, you should ALWAYS have your stop set as soon as you place your order
The are two different types of Credit Spreads
Bull Put
i. Bull Put= stock should be trending up or at least sideways
ii. So the same rules would apply to playing a bull put spread as if you were buying a bullish stock (You would want to enter the trade at support and exit at resistance)
iii. You will most likely achieve the max profit in a Bull Put spread if the stock is trending up.
iv. Because one of the two positions in a bull put spread is naked, you should enter the long side first
v. You can then enter the short side without needing naked option writing approval
vi. many platforms allow you to make a single credit spread now where both are executed simultaneously
How to play a Bull Put spread
Buy a put on a bullish stock, with a strike price below the current trading price of the stock.
Sell a put on the same stock with a strike price above the strike price that you bought the first put.
Example
a) Lets say a stock is bouncing off support at $54
b) You buy the 50 put and sell the 55 puts
c) When you buy the 50 puts- you pay .25
d) When you sell the puts at 55 you bring in 2.50
e) 2.50-.25=2.25/sh
f) Your max profit is your credit, so the max profit=225/contract
g) Max Loss = Difference between the spread less the net credit
h) 55-50=5.00
i) 5.00-2.25=$2.75/sh or -$275.00 /contract
j) If the stock closes 55.50 on exp date
i. Both puts expire worthless
ii. and you keep max gain of 225/contract
k) If the stock closes at 35
i. You would assume the max loss of $ 275/contract
l) The reason you get max gain is because both options expire worthless= $0.00 in commissions
m) Breakeven= Higher Strike price - Net credit= 55.00- 2.25=$52.75 assuming all options are worth their intrinsic value at expiration.

[stockzilla]

How to exit a trade early because we have made a profit
a) When we exit early, we have to physically close the trades=commissions
b) So let’s say the stock we spread traded is sitting at 55.00 within two weeks to expiration.
c) Now we have a profit, and even though it isn’t max profit we still grabbed 35-50% of our max profit
d) We should look to exit because the risk reward ratio starts to turn against us
e) We are holding something that might bring another 10-15% more but holding 50% gain to make that 10 –15%gain
f) I am not willing to give up a gain for the small added value it would bring
g) We entered the spread with a 2.25 credit, and we want out
a. so we buy back the $55 put and it costs us $1.00 ($1 is the ask price we bought the $55.00 put we sold earlier)
b. and we sell the $50 put for +.15
c. this gives us a profit of 1.40 or 140/contract
$2.25 - $1.00 +$0.15= $1.40/sh or $140/contract

Bear Call
i. Bear Call Credit spread=Stock should be trending flat to down
ii. You want to enter when the stock is bouncing off resistance (just as if you were shorting a stock)
How to play a Bear Call
1. You Buy a call above the current share price
2. And you sell a call below the strike price you bought.
3. This will bring a credit into your account, just like the bull put spread did
Example
1. imaginary stock ZILL is trading at 76.00/share
2. You buy the $80 call for -.50
3. You sell the $75 call for 3.00
4. Net credit= 3.00-.50=2.50
5. Net credit is you MAX GAIN= 2.50
6. Assume ZILL drops dramatically to 60 on exp date, you would get the max gain.
7. MAX LOSS= Difference between the Strike Prices-Net Credit
8. max loss=$250/contract 80 – 75 =5 – 2.50 = 2.50/sh
9. Breakeven= Lower Strike Price+credit recieved= 75+2.50=$77.50 assuming all options are worth their intrinsic values at expiration.

[stockzilla]

Debit Spreads
1. Basics
a. These are very similar to credit spreads with a couple of exceptions
i. In a debit spread we pay out $$$$$$ first and collect after the trade is closed
ii. You buy a higher priced option while simultaneously selling a lower priced option
iii. Some debit spreads must be closed manually by expiration date.
2. Bull Call
a. Bull Call spreads allow you to make money on stocks that are trending up or remain sideways.
b. We enter the trade on a bounce off support and exit at resistance or exit once we make our spread profitable
c. The max profit is equal to the spread between the two strike prices minus the initial debit
d. Select an expiration date of 20-40 days away.
e. As a rule, if the maximum profit potential is at least 30% to 50% of the maximum loss potential, the spread is acceptable. To determine the Return on an investment you divide the maximum potential profit and divide it by the nest debit (max potential loss).
f. When volatility rises, buying an out of the money spread may be less attractive because premiums are higher.
g. You would attain the max profit at expiration if the stock closes above the sell call strike price ($37 in example below).
h. An out of the money spread unlike a bull put spread will only be profitable if the underlying stock price increases. Conservative investors should buy In The Money options. Aggressive investors should buy Out of the Money options.
i. The max profit would be the difference between the strike prices less the net debit.
j. If the stock closes in between the strike prices, you must exit the In The Money call manually. Do not expect your broker to sell your in the money option on expiration date
k. The max loss is the net debit
l. You can also exit early if your profit target has been reached
m. Assume the stock rises to 36.80 with a week or two until expiration (see example below)
i. The differences in the long and short call premiums will have changed
ii. We would buy back the 37.00 call for -.0.10
iii. And we would sell the 36.00 call for +0.85
iv. or a profit of .10
v. or 10.00/contract
vi. -.65 +.85 -.10=.10

[stockzilla]

How to Play a Bull Call Debit Spread.
If you cannot do this trade as a single transaction, always enter the BUY (LONG) side before selling the call.
1. We sell a call above the current trading price
2. We buy a call below the strike you sold
3. ENTER THE BUY FIRST OR YOU ARE NAKED
4. ALWAYS ENTER THE LONG SIDE FIRST

Example
1. Current stock price is at $36.70
2. We sell a 37 call for .20
3. We Buy a 36 call for -.85
4. This results in a -.65/share debit, or -$65 per contract
5. Max profit = 36 – 37 = 1, 1-.65 = .35 or 35/ per contract. Max profit occurs when the stock closes above the 37 strike price on expiration. Both calls expire in the money.
6. Max loss = 65/ contract= Net Debit
7. Assume Stock is at $34 on expiration date…
a. Both calls expire worthless and you assume max loss
8. To determine the breakeven point, take the net debit, multiply it by –1 and add it to the lower strike price.
In this case:
-.65 x –1= .65.
36.00 + .65=36.65



Exiting the Spread

1.Same Day Substitution- his describes the process that takes place when the option buyer exercises the short option, causing your broker to immediately exercise the long option to offset your obligation in the trade. This means you wil not have to buy the stock. Your broker will automatically liquidate your position. Always contact your broker prior to playing credit spreads to make sure they offer same day substitution.

2.If the stock closes through the spread (above the higher strike price) on expiration date, both calls will expire In The Money and you will achieve max profit and will need to take no other action if your broker offers same day substitution.

3. If on expiration date the stock closes between the two strike prices, the spread could break even or even be slightly profitable.

Bull Call Spread Review

*Find optionable stocks in a bullish to neutral trend with good fundamentals


* Conduct TA on those stocks. Concentrate on support and resistance.

*Buy a call option option (either in or out of the money) with a strike price close to the current trading price of the stock. Then sell a call with a strike price above the strike price that is higher than the call you purchased. This transaction will create a debt. An extremely bullish investor would buy the call with a strike price above the current trading price of the stock.

*Enter the spread with a “buy to open” for the call with the lower strike price and a “sell to open” for the call with the higher strike price. If possible, enter the trade as a single position instead of legging into the trade one side at a time.

*Monitor the trade daily. Watch the price of the stock. If it drops unexpectedly, consider exiting the trade.

*Exit the spread by entering a “But to Close” order to exit the short call and a “sell to Close” order to exit the long call, by letting both options expire worthless, or by allowing the spread to be exercised.

[stockzilla]

Bear Put Debit Spreads


you sell call at a strike above the current trading price
you buy a call below the strike price you bought
:the stock should be trending UP or at least sideways

we are talking vertical spreads

You play a vertical spread for 20-40 days

its a short term trade

Bear = trending down

With a spread, you can make a profit even if the stock trends sideways
And may even break even if it the stock moves up a small amount
You would use a Bear Put spread in the same conditions you would play a
long Put.
: You would want to enter the trade at a bounce off resistance or a break of
Remember with any spread, one side of the trade is SHORTor NAKED
So you should ALWAYS enter the trade on the Long Side(Buy) first if you use
a single entry platform
You can then enter on the Short (Sell) side without needing Naked Option
Writing approval
The Long side will COVER the short side if the contract is assigned
unexpectedly
You can use spread stategies in any market condition, but remember, if you
are expecting your stock to move violently in either direction, you may be better off playing straight
calls or puts

How to Play a Bear Put Spread:
You buy a Put option on a bearish stock. This option should have a strike price that is higher than the strike price of the Put that will be sold in the next stepThen you sell a Put option with a strike price that is lower than the current trading price of the underlying stock.

example
Stock price= 49.12
Buy a put for 50.00 = -2.10
Sell a 47.50 Put= +.85

Net Debit= -$1.25/share or -$125.00/contract 2.10- .85= 1.25

Max Profit Potential= Difference between the spread minus the initial net debit
50.00 - 47.50 - 1.25 = 1.25/share or $125.00/contract

Maximum Loss= Net Debit
[n this case Max. Loss= 1.25
: No matter how far the stock rises, you cannot lose more than 125.00/contract
Breakeven Point= Upper Strike Price-Net Debit= $50-$1.25=$48.75
As a rule, if the max potential profit is at least 100% of the max potential loss , the spread is acceptable

When volatility rises, buying an out of the money spread will bring in higher premiums
Be careful though,
Volatility often rises prior to any major news. and the stock could move against you lightning fast and you lose


Lets assume the stock falls to 48 with 20 days till expiration
The premiums for both the long put and the short put wil have changed
If the difference between the two premium prices is larger than the net debit, you can close the trade for a profit
Its a good idea to have an optional profit target of 30-50% of the maximum potential gain
Exiting early lets you take gains sooner and enter another trade
Because a Bear Put Spread is a Debit spread, you pay up front so you must have the funds available in your account to make the trade
But there is no margin requirement as there is in a credit spread

stock is at 48.00
We buy back the 47.50 put = -$0.50
and we sell the 50.00 put for +$2.65
We entered the spread with a net debit of -1.25
2.65 - .50 - 1.25= +.90 or $90.00/contract


example 2:

Current stock= 72.45
We Buy the 70.00 put for -2.50
We sell the 65.00 put for +0.95
Net Debit= -1.55
Max Profit- 70.00 - 65.00 - 1.55 = 3.45

Lets assume the stock drops drastically to 58.00/share on exp date- you would get the max profit

Max Loss
The max loss is equal to the net debit
in this case tha max loss would be 155.00/contract

Return on Investment:
ROI= Max potential profit/Max potential loss
3.45/1.55=233%
which is well above the acceptable 100% ROI mentioned earlier

Assume the stock rises to 72.00 unexecpectedly and stays there until expiration
Since the stock closed above both strike prices, both options will expire out of the money : and the spread will realize the maximum loss : because both puts expire worthless

Exiting at Expiration
If the stock closed "through the spread" (below the lower strike price) on exp. date, both calls will expire In The Money, you will achieve max gain and will not need to exit the trade. That is how you make the max profit, because there are no commissions


Exiting If the Stock Moves Higher by Expiration:
[f on expiration day the stock closes below the higher strike price, but above the lower strike price, the spread could still break even or even be a little profitable


Break Even Price
Subtract the net debit from the higher strike price
70.00-1.55=68.45. As long as the stock fallss below 68.45 you can break even or make a small profit


Whenever the stock closes in between the stock prices you need to close the trade manually. This is very important:
To capture any value from the spread, you will have to sell the option you purchased (70) with a "Sell To Close" order and allow the lower strike price (65) to expire worthless
DO NOT EXPECT YOUR BROKER TO AUTOMATICALLY SELL YOUR IN-THE-MONEY OPTION SIMPLY BECAUSE IT STILL HAS VALUE ON EXPIRATION DATE
You must manually close the trade

Exiting a Bear Put Spread early is appropriate under the right conditions.
Exiting early can prevent you from taking the Max loss
Lets say the stock drops slightly then rises back above the breakeven price of 68.54
with no signs of resuming the downtrend, it is a good idea to exit early
Stock falls to $66.00 during the next few weeks then climbs up too 69.00 with one week till expiration
The short put (sell) would have lost some of it's valuue due to time melting away
The long (buy) put will have added some intrinsic value and will most likely still have some time value left
You buy back the short put and sell the Long put to exit the trade

69.00 is above the breakeven price of 68.45
You sell the 70 put for +$1.00
And you buy back the 65 put for -$0.05
Your net loss would be -$0.50
Our intial net debit was -1.55
-1.55 +1.00 - .05= -0.50


Review:
1. Find an optionable stock in a bearish trend. Fundametals are not important.
2. Perform TA, enter at a bounce off resistance or a break of support
3. Sell a put option with a strike price that is below the current trading price of the stock ( do this only after entering the long leg) and buy a put with a strike price that is higher than the put we sold: this creates a debit
An extremely bearish investor might buy a strike price that is out of the money
4. Enter the trade by "buying to Open" the put with the hiher strike price and "Selling to Open" the put with the lower strike price. If possible, enter the trade as a single position instead of legging into the trade (one side at a time)
5. Monitor your trade on a daily basis
6. Close out the trade if the stock starts to show signs of strength or is rising unexpectedly
Exit by "Sell To Close" the put with the higher strike price and "buy to close" the put with the lower strike price
7. Always find out what your brokers rules for exercising a spread are just in case the call you sold is exercised.

An Easy way to remember how to play credit or debit spreads:

When it is a bullish spread, you Buy a Strike price below the stock price and you sell above the price you bought. These are known as Bull Put (credit) and Bull Call (debit).

When the spread is bearish, you sell a strike price below the stock price and buy above the price you sold. These are known as Bear Call (credit) nd Bear Put (debit).

That is the final chapter for vertical spreads!

[stockzilla]

Diagonal Spreads


Basics
You create a Diagonal Spread by buying a long-term option while simultaneously selling a shorter-term option with a different strike price.
There is a maximum profit potential, like a vertical spread
There is also a maximum loss potential
You can trade the same diagonal spread for multiple months in a row
There are NO margin requirements
You must have Level 3 options trading authority
The difference between diagonal spreads and vertical spreads is that the two trades involved in the Diagonal have different expiration dates
Diagonals are also called Calendar Spreads or Time Spreads too
Diagonal Spreads allow you to offsetting the costs of entering a long option position. But by doing so, you put a cap on the max gain potential
If the spread you are considering will consist of the major % of the existing open interest, the market may move to meet the order and the spread could be entered at an unfavorable price
Always check the open interest and make sure the number of contracts you want to play does not exceed 1-2% of the open interest
Open interest of 100 contracts or more is desirable
Diagonal Bull Calls
Diagonal Bull Spread- Stock should be neutral to up trending
You will get the max gains if the stock is trending up
Use in the same conditions that you would play a covered call or a long call.
If the short call expires worthless, you can generate monthly income by selling another call for the next month and the next, and so on.
Advantage of a Diagonal Spread over a covered call: The Diagonal Bull Spread is much cheaper to get into.
The long side will cover the short side if the contract is assigned unexpectedly.
Conservative investors should buy In The Money Options
The long call should be 4-6 months away
The short call should be 20-40 days till expiration
How to play a Diagonal Bull Call spread
1. Buy a Long-Term option on a Bullish stock at a Strike price below the current trading price of the stock.
2. Sell a shorter-term call option that is higher than the stike price of the call you purchased.
3. When you purchase the option lower than the Share price, this allows you to buy the stock from someone else at a lower price as long as the stock remains above the strike price.
4. You achieve max profits if the stock closes above the higher strike price on expiration date


Diagonal Spreads Cont.

Example
1. Sept. 5 trade date
2. Stock =31.00
3. Feb $25 call is bought for -$7.00
4. Sept $35 call is sold for +.50
5. Net Debit= - $6.50
6. Maximum Profit potential: = Difference in the Strike Prices less the net Debit
7. $35.00- $25.00= $10.00 // $10.00-$6.50=$3.50
8. Max Profit=$3.50/share or $350.00/contract
9. Max Loss= Net Debit= $6.50/share or $650.00/contract
10. Assume the stock drops to $20.00 tomorrow and remains below $25.00 through Feb = You would get the max loss
11. Lets assume the stock climbs quickly to 38.75 on day 10 with a week left until expiration
12. You buy back the $35 call for -2.00
13. You sell the Feb $25 call for +11.90
14. 11.90 -6.50 - 2.00= $3.40 Profit