Option Strategies
Covered Calls

Low Volatility Strategy

  • To profit from neutral to bullish price action in the underlying stock.
  • A bull put spread consists of one short put with a higher strike price and one long put with a lower strike price.
  • Both puts have the same underlying stock and the same expiration date.
  • Establish for a net credit (or net amount received) and profits from either a rising stock price or from time erosion or from both. Potential profit is limited to the net premium received less commissions and potential loss is limited if the stock price falls below the strike price of the long put.
  • A bull put spread earns the maximum profit when the price of the underlying stock is above the strike price of the short put (higher strike price) at expiration. Therefore, the ideal forecast is “neutral to bullish price action.”

Strategy discussion

  • The bull put spreads is a strategy that “collects option premium and limits risk at the same time.”
  • They profit from both time decay and rising stock prices.
  • A bull put spread is the strategy of choice when the forecast is for neutral to rising prices and there is a desire to limit risk.

Maximum profit

  •  ( Strike price – Share price ) + premium sale price x 100
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Maximum risk

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Breakeven stock price at expiration

  • Share purchase price – premium 
  • 100-5 = 95
  • A bull put spread benefits when the underlying price rises and is hurt when it falls. 
  • This means that the position has a “net positive delta.” Delta estimates how much an option price will change as the stock price changes, and the change in option price is generally less than dollar-for-dollar with the change in stock price. 
  • Also, because a bull put spread consists of one short put and one long put, the net delta changes very little as the stock price changes and time to expiration is unchanged. 
  • In the language of options, this is a “near-zero gamma.” Gamma estimates how much the delta of a position changes as the stock price changes.
  • Putting percentages to the breakeven number, breakeven is a 6.2% move higher in only 30 days. That sized movement is possible, but highly unlikely in only 30 days. Plus, the stock has to move more than that 6.2% to even start to make a cent of profit, profit being the whole purpose of entering into a trade. To begin with, a comparison of buying 100 shares outright and buying 1 call option contract ($52.50 strike price) will be given: 100 shares: $50 x 100 shares = $5,000 1 call option: $0.60 x 100 shares/contract = $60; keeps the rest ($4,940) in savings. If the stock moves 2% in the next 30 days, the shareholder makes $100; the call option holder loses $60: Shareholder: Gains $100 or 2% Option Holder: Loses $60 or 1.2% of total capital If the stock moves 5% in the following 30 days: Shareholder: Gains $250 or 5% Option Holder: Loses $60 or 1.2% If the stock moves 8% over the next 30 days, the option holder finally begins to make money: Shareholder: Gains $400 or 8% Option Holder: Gains $90 or 1.8% It’s fair to say, that buying these out-of-the money (OTM) call options and hoping for a larger than 6.2% move higher in the stock is going to result in numerous times when the trader’s call options will expire worthless. However, the benefit of buying call options to preserve capital does have merit
  • Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. 
  • As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. 
  • Since a bull put spread consists of one short put and one long put, the price of a bull put spread changes very little when volatility changes and other factors remain constant. 
  • In the language of options, this is a “near-zero vega.” 
  • Vega estimates how much an option price changes as the level of volatility changes and other factors are unchanged.
  • The time value portion of an option’s total price decreases as expiration approaches. 
  • This is known as time erosion. 
  • Since a bull put spread consists of one short put and one long put, the sensitivity to time erosion depends on the relationship of the stock price to the strike prices of the spread. 
  • If the stock price is “close to” or above the strike price of the short put (higher strike price), then the price of the bull put spread decreases (and makes money) with passing of time. This happens because the short put is closest to the money and erodes faster than the long put. 
  • However, if the stock price is “close to” or below the strike price of the long put (lower strike price), then the price of the bull put spread increases (and loses money) with passing time. This happens because the long put is now closer to the money and erodes faster than the short put. If the stock price is half-way between the strike prices, then time erosion has little effect on the price of a bull put spread, because both the short put and the long put erode at approximately the same rate.
  • Stock options in the United States can be exercised on any business day, and holders of a short stock option position have no control over when they will be required to fulfill the obligation.
  • Therefore, the risk of early assignment is a real risk that must be considered when entering into positions involving short options.
  • While the long put (lower strike) in a bull put spread has no risk of early assignment, the short put (higher strike) does have such risk.
  • Early assignment of stock options is generally related to dividends, and short puts that are assigned early are generally assigned on the ex-dividend date.
  • In-the-money puts whose time value is less than the dividend have a high likelihood of being assigned.
  • Therefore, if the stock price is below the strike price of the short put in a bull put spread (the higher strike), an assessment must be made if early assignment is likely.
  • If assignment is deemed likely and if a long stock position is not wanted, then appropriate action must be taken.
  • Before assignment occurs, the risk of assignment can be eliminated in two ways.
  • First, the entire spread can be closed by buying the short put to close and selling the long put to close.
  • Alternatively, the short put can be purchased to close and the long put open can be kept open.
  • If early assignment of a short put does occur, stock is purchased. If a long stock position is not wanted, the stock can be sold either by selling it in the marketplace or by exercising the long put.
  • Note, however, that whichever method is chosen, the date of the stock sale will be one day later than the date of the stock purchase. This difference will result in additional fees, including interest charges and commissions.
  • Assignment of a short put might also trigger a margin call if there is not sufficient account equity to support the stock position.
  • There are three possible outcomes at expiration.
  • The stock price can be at or above the higher strike price, below the higher strike price but not below the lower strike price or below the lower strike price.
  • If the stock price is at or above the higher strike price, then both puts in a bull put spread expire worthless and no stock position is created.
  • If the stock price is below the higher strike price but not below the lower strike price, then the short put is assigned and a long stock position is created.
  • If the stock price is below the lower strike price, then the short put is assigned and the long put is exercised. The result is that stock is purchased at the higher strike price and sold at the lower strike price and the result is no stock position.
  • Substantial losses can be incredibly devastating. For an extreme example, a 50% loss means a trader has to make 100% profit on their next trade in order to breakeven. Buying call options and continuing the prior examples, a trader is only risking a small 1.2% of capital for each trade. This prevents the trader from incurring a single substantial loss, which is a real reality when stock trading. For example, a simple small loss of 5% is easier to take for an option call holder than a shareholder: Shareholder: Loses $250 or 5% Option Holder: Loses $60 or 1.2% For a catastrophic 20% loss things get much worse for the stockholder: Shareholder: Loses $1,000 or 20% Option Holder: Loses $60 or 1.2% In the case of the 20% loss, the option holder can strike out for over 16 months and still not lose as much as the stockholder. Moreover, the stockholder now has to make over 25% on their stock purchases to bring their capital back to their previous $5,000 level.
Option Strategies
FAQs

Covered Calls

If you already own 100 shares of a stock and you think that the stock might go down or at least stay neutral, setting up a covered call by SELLING a call option above the stock price for which you will collect premium, compensate you some for the loss of some of your stock value if the stock goes down.

Example:

If the stock price moves down:

  • If you owned a stock that is worth 100 dollars and the stock went down by 10 dollars to 90 dollars, you would have lost 10 dollars per share.
  • If you hedged that position buy selling a call above the stock price at lets say 120 dollars for a 5 dollar premium, you have just hedged your losses by 5 dollars per share.  
  • Where you would have lost 10 dollars a share without buying the covered position, you only lost 5 dollars with the covered position.  
If the stock price moves up against you beyond the strike price to 300

 

  • You get to keep the premium
  • You get to keep the profits up to the strike price ( 120-100 ) = 20 dollars / share
  • You will lost any benefit of the stock price moving up beyond the 120 strike price to 300 which while it is not a loss, but a loss in “potential” of 300-120= 180
  • You still made money but only 20 dollars per share
  • You would have lost out on any of the profits 

If the stock price move up and beyond the covered call strike price, the option will be EXERCISED.  This means the buyer will have to buy 100 shares of stock at the STRIKE Price and… 

You, the short seller, will have to sell 100 shares of stock at the STRIKE price.  The buyer will essentially either take your actual stocks or just collect the value of the stock without actually owning them.

If you really wanted to keep the actual stock, you will have to buy back the stock at the NEW stock price which might have moved really far against you BUT it is also possible that it went against you by maybe 1% which is not much.  And even in this scenario, you will still be profiting overall from the covered call position.

You would have collected the premium as well as any profit up to the strike price

 

Maximum profit

  • Potential profit is limited to the net premium received less commissions
  • this profit is realized if the stock price is at or above the strike price of the short put (higher strike) at expiration and both puts expire worthless
 

Maximum risk

  • To calculate profits or losses on a call option use the following simple formula: Call Option Profit/Loss = Stock Price at Expiration – Breakeven Point For every dollar the stock price rises once the $53.10 breakeven barrier has been surpassed, there is a dollar for dollar profit for the options contract. So if the stock gains $5.00 to $55.00 by expiration, the owner of the the call option would make $1.90 per share ($55.00 stock price – $53.10 breakeven stock price). So total, the trader would have made $190 ($1.90 x 100 shares/contract)
 

Breakeven stock price at expiration

  • The breakeven point is quite easy to calculate for a call option: Breakeven Stock Price = Call Option Strike Price + Premium Paid To illustrate, the trader purchased the $52.50 strike price call option for $0.60. Therefore, $52.50 + $0.60 = $53.10. The trader will breakeven, excluding commissions/slippage, if the stock reaches $53.10 by expiration
Complete Loss If the stock did not move higher than the strike price of the option contract by expiration, the option trader would lose their entire premium paid $0.60. Likewise, if the stock moved down, irrelavent by how much it moved downward, then the option trader would still lose the $0.60 paid for the option. In either of those two circumstances, the trader would have lost $60 (-$0.60 x 100 shares/contract). Again, this is where the limited risk part of option buying comes in: the stock could have dropped 20 points, but the option contract owner would still only lose their premium paid, in this case $0.60. Buying call options has many positive benefits like defined-risk and leverage, but like everything else, it has its downside, which is explored on the next page. Downside of Buying Call Options Take another look at the call option profit/loss graph. This time, think about how far away from the current stock price of $50, the breakeven price of $53.10 is.
  • A bull put spread benefits when the underlying price rises and is hurt when it falls. 
  • This means that the position has a “net positive delta.” Delta estimates how much an option price will change as the stock price changes, and the change in option price is generally less than dollar-for-dollar with the change in stock price. 
  • Also, because a bull put spread consists of one short put and one long put, the net delta changes very little as the stock price changes and time to expiration is unchanged. 
  • In the language of options, this is a “near-zero gamma.” Gamma estimates how much the delta of a position changes as the stock price changes.
  • Putting percentages to the breakeven number, breakeven is a 6.2% move higher in only 30 days. That sized movement is possible, but highly unlikely in only 30 days. Plus, the stock has to move more than that 6.2% to even start to make a cent of profit, profit being the whole purpose of entering into a trade. To begin with, a comparison of buying 100 shares outright and buying 1 call option contract ($52.50 strike price) will be given: 100 shares: $50 x 100 shares = $5,000 1 call option: $0.60 x 100 shares/contract = $60; keeps the rest ($4,940) in savings. If the stock moves 2% in the next 30 days, the shareholder makes $100; the call option holder loses $60: Shareholder: Gains $100 or 2% Option Holder: Loses $60 or 1.2% of total capital If the stock moves 5% in the following 30 days: Shareholder: Gains $250 or 5% Option Holder: Loses $60 or 1.2% If the stock moves 8% over the next 30 days, the option holder finally begins to make money: Shareholder: Gains $400 or 8% Option Holder: Gains $90 or 1.8% It’s fair to say, that buying these out-of-the money (OTM) call options and hoping for a larger than 6.2% move higher in the stock is going to result in numerous times when the trader’s call options will expire worthless. However, the benefit of buying call options to preserve capital does have merit
  • Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. 
  • As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. 
  • Since a bull put spread consists of one short put and one long put, the price of a bull put spread changes very little when volatility changes and other factors remain constant. 
  • In the language of options, this is a “near-zero vega.” 
  • Vega estimates how much an option price changes as the level of volatility changes and other factors are unchanged.
  • The time value portion of an option’s total price decreases as expiration approaches. 
  • This is known as time erosion. 
  • Since a bull put spread consists of one short put and one long put, the sensitivity to time erosion depends on the relationship of the stock price to the strike prices of the spread. 
  • If the stock price is “close to” or above the strike price of the short put (higher strike price), then the price of the bull put spread decreases (and makes money) with passing of time. This happens because the short put is closest to the money and erodes faster than the long put. 
  • However, if the stock price is “close to” or below the strike price of the long put (lower strike price), then the price of the bull put spread increases (and loses money) with passing time. This happens because the long put is now closer to the money and erodes faster than the short put. If the stock price is half-way between the strike prices, then time erosion has little effect on the price of a bull put spread, because both the short put and the long put erode at approximately the same rate.
  • Stock options in the United States can be exercised on any business day, and holders of a short stock option position have no control over when they will be required to fulfill the obligation.
  • Therefore, the risk of early assignment is a real risk that must be considered when entering into positions involving short options.
  • While the long put (lower strike) in a bull put spread has no risk of early assignment, the short put (higher strike) does have such risk.
  • Early assignment of stock options is generally related to dividends, and short puts that are assigned early are generally assigned on the ex-dividend date.
  • In-the-money puts whose time value is less than the dividend have a high likelihood of being assigned.
  • Therefore, if the stock price is below the strike price of the short put in a bull put spread (the higher strike), an assessment must be made if early assignment is likely.
  • If assignment is deemed likely and if a long stock position is not wanted, then appropriate action must be taken.
  • Before assignment occurs, the risk of assignment can be eliminated in two ways.
  • First, the entire spread can be closed by buying the short put to close and selling the long put to close.
  • Alternatively, the short put can be purchased to close and the long put open can be kept open.
  • If early assignment of a short put does occur, stock is purchased. If a long stock position is not wanted, the stock can be sold either by selling it in the marketplace or by exercising the long put.
  • Note, however, that whichever method is chosen, the date of the stock sale will be one day later than the date of the stock purchase. This difference will result in additional fees, including interest charges and commissions.
  • Assignment of a short put might also trigger a margin call if there is not sufficient account equity to support the stock position.
  • There are three possible outcomes at expiration.
  • The stock price can be at or above the higher strike price, below the higher strike price but not below the lower strike price or below the lower strike price.
  • If the stock price is at or above the higher strike price, then both puts in a bull put spread expire worthless and no stock position is created.
  • If the stock price is below the higher strike price but not below the lower strike price, then the short put is assigned and a long stock position is created.
  • If the stock price is below the lower strike price, then the short put is assigned and the long put is exercised. The result is that stock is purchased at the higher strike price and sold at the lower strike price and the result is no stock position.
  • Substantial losses can be incredibly devastating. For an extreme example, a 50% loss means a trader has to make 100% profit on their next trade in order to breakeven. Buying call options and continuing the prior examples, a trader is only risking a small 1.2% of capital for each trade. This prevents the trader from incurring a single substantial loss, which is a real reality when stock trading. For example, a simple small loss of 5% is easier to take for an option call holder than a shareholder: Shareholder: Loses $250 or 5% Option Holder: Loses $60 or 1.2% For a catastrophic 20% loss things get much worse for the stockholder: Shareholder: Loses $1,000 or 20% Option Holder: Loses $60 or 1.2% In the case of the 20% loss, the option holder can strike out for over 16 months and still not lose as much as the stockholder. Moreover, the stockholder now has to make over 25% on their stock purchases to bring their capital back to their previous $5,000 level.

Popular strategy for long term investors

  • In exchange for capping any profits above the strike price in exchange for collecting premium
  • Reduce the loss potential on the shares
  • Creates a stream of income on shares as long as the price doesn’t increase too aggressively
  •  Easy for most retail investors to understand

The strategy consists of 2 components

  • First, you have to own 100 shares of the stock.  If you don’t own the stock then, the shares will need to be purchased.
  • Second, you will sell ONE call option against the shares above the stock price ( ITM )

Note that selling call options without owning any shares of stock is a highly risky strategy ( unlimited loss potential in theory ) because:

The call options increase in value as the share price rises

Since there is no upper tock price limit, there is no limit to a call option’s value

 

  • Example of Selling a naked call option
  • Initial Stock Price XYZ is 250 dollars
  • Option Price:  Sell 275 Call expiring in 30 days for 5 dollars ( premium collected )
      • In exchange for collecting 5 dollars in premium, the SELLER is forfeiting any potential gains in the stock beyond the strike price of 275
      • You would only do this trade if the seller does NOT believe that the stock will not increase beyond the strike price
      • Ideally, then, the Seller wants the stock to stay below the strike price, and the seller can then repurchase another covered call option
        If the stock price surpasses the strike price, the Seller is obligated to Sell the stock at the strike price ( But keeps the increase in stock appreciate UP TO the strike price ) IN ADDITION to the premium originally collected
 

Scenario:

Good news causing the stock price to surge to 350 dollars before expiration

 
  • If you were, instead of a covered call, were to buy the LONG Stock option, and the price increased to 350 dollars
  • P/L ( long option ) = (  initial stock price – present stock price ) x 100 = 350-250 = 100 x 100 = 10,000  profit
  • P/L ( covered call ) = ( strike price – initial stock price ) + premium x 100 = 275-250 ) + 5 = 3000 profit
  •  You will have the “obligation” to sell the 100 shares of at the strike price ( 275 dollars / share )   2,500 dollar gain on the shares
  • You will not only lose the 100 shares of stock, but you will have to PAY the difference between the [ ( new stock price and the old stock price ) minus premium ]
 
Break Even Point
( The debit price of purchasing the Long stock ) – ( Call Sale Premium )