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This trade assumes that the underlying stock will NOT move down more than 42% in the next month.  If these trades are done together (as I am illustrating) it is an INCREASED risk position.  This is a Bull Put Spread (Credit Spread)

Position:

Buy QIUUA September 5 Put for          $0.35

Sell QIUUU September 7.5 Put for      $1.20

Net                                                                    $0.85

Break even for this position is OSIR trades for $6.65 ($7.50 – $0.85) on expiration.  Today OSIR is trading for $11.75.  This would be a decline of $5.10 in the next month, or 43%.  Possible, but not likely.

Maximum Loss would be $1.65/share (+ trading costs) OSIR – $5.00 or less.

Maximum Gain would be $0.85/share (- trading costs) OSIR – $7.50 or higher. 

Assuming $.15/share trading costs the gain would be $0.70 ($0.85- $.15) for a return of 28% ($0.70/$2.50) in one month, or 336% APR.

The Bear Put Spread is set up by buying a Higher strike Put while simultaneously selling a LOWER strike Put, both with the SAME expiration date.  The Bear Put Spread is a Debit Spread, meaning you will pay a higher price for the Put that you purchase than the price of the Put that you sell.

In order to enter this position the investor will have some beliefs.

          1)  She believes that the underlying security will stay the same or go down.  Depending on the strikes chosen, the underlying security can go up a little and this position will still make money.  That is why this position has the word Bear in the name, it has a bearish bias.

          2)  The investor understands that IF the underlying stock moves counter to the postion, in this case, up, the position can lose 100% of the money invested.  The good thing about a vertical spread, however, is that the options WILL retain some value, up until, expiration.  This means that a 100% loss can be avoided. 

Lets look at an example:

Lets assume that GE (General Electric) fits the criteria.  GE is trading for $10.78 on March 27, 2009.  I would buy an April 2009 $12 Put, for $1.55, while selling an April 2009 $11 Put, for $0.90 .  Here is the Risk/Reward graph for this position.

 

Bear Put Spread - GE

The Maximum Loss is $0.65 (+ Trading Costs), and this will occur if GE is above $12 at the expiration, April 18, 2009.

The Maximum Gain is $0.35 ($1 difference in strikes -$0.65 premium paid) (- Trading Costs), and this will occur if GE is below $11 at the expiration, April 18, 2009.

If GE is between $11 and $12 at expiration, April 18, 2009, then the gain/loss will be -$0.65 (the cost of the spread) – the price of GE + $12 (the price that you can sell (put) GE).  Therefore the breakeven point for this position is $11.35 (-$0.65 – $11.35 + $12 = $0) (not including trading costs).

This trade would be entered when GE was trading for $10.78.  This means that if GE stays the same or goes down OR goes up $0.22 (2.0%) this position will still make the maximum gain.  GE has to go up to $11.35, a gain of $0.57(or 5.3%), for this position to start to lose money. 

This position cost us $0.65/share and has an upside potential profit of $0.35/share.  That would be a 54% gain in less than 1 month.  Which is an approximate 650% APR (Annual Percentage Rate).

The Bull Call Spread is set up by buying a LOWER strike Call while simultaneously selling a HIGHER strike Call, both with the SAME expiration date.  The Bull Call Spread is a Debit Spread, meaning you will pay a higher price for the Call that you purchase than the price of the Call that you sell.

In order to enter this position the investor will have some beliefs.

          1)  She believes that the underlying security will stay the same or go up.  Depending on the strikes chosen, the underlying security can go down a little and this position will still make money.  That is why this position has the word Bull in the name, it has a bullish bias.

          2)  The investor understands that IF the underlying stock moves counter to the postion, in this case, down, the position can lose 100% of the money invested.  The good thing about a vertical spread, however, is that the options WILL retain some value, up until, expiration.  This means that a 100% loss can be avoided. 

Lets look at an example:

In a previous Trade Idea I suggested a Vertical Spread.  I said to buy a July 2009 $35 Call while selling a July 2009 $55 Call on SRS  (Proshares Ultrashort Real Estate Fund).  Here is the Risk/Reward graph for this position.

SRS - Bull Call Spread

The Maximum Loss is $7.80 (+ Trading Costs), and this will occur if SRS is below $35 at the expiration, July 18, 2009.

The Maximum Gain is $12.20 ($20-$7.80) (- Trading Costs), and this will occur if SRS is above $55 at the expiration, July 18, 2009.

If SRS is between $35 and $55 at expiration, July 18, 2009, then the gain/loss will be -$7.80 (the cost of the spread) – $35 (the price that you can buy (call) SRS) + the price of SRS.  Therefore the breakeven point for this position is $42.80 (-$7.80 – $35 + $42.80 = $0) (not including trading costs).

This trade was entered when SRS was trading for $59.44.  This means that if SRS stays the same or goes up OR goes down $4.44 (7.5%) this position will still make the maximum gain.  SRS has to drop to $42.80, a loss of $16.64 (or 28%), for this position to start to lose money.  The 52 week low for this ETF is $48.00.

This position cost us $7.80/share and has an upside potential profit of $12.20/share.  That would be a 256% gain in approximately 6 months.  Which is an approximate 500% APR (Annual Percentage Rate).

One other note on this example:  This position is called a Bull Call Spread, that means that I was “bullish” on SRS.  However, SRS is an “Ultrashort” ETF, which means that it moves up when some index, in this case the real estate fund, goes down.  In essence, this position was a “bearish” position.  I hope I have not confused the situation.

Many traders start their Option trading with one of two very simple positions.  The two positions are the Covered Call and the Married Put. 

The Covered Call Strategy involves writing (selling) a call against stock that is already owned.  If you write a Call without owning the stock it is called a “naked” call.  The Covered Call Strategy can be a procedure that makes any stock a “dividend” stock.  This strategy is perfect for a buy and hold investor.  This strategy makes a few assumptions:

     1)  The investor likes the stock and wants to own it.

     2)  The stock is not too volatile, meaning the price of the stock does not vary much, or stays within a channel.

     3)  The investor is willing to accept the full risk of a downward move in the stock.

There are two types of positions that can be employed when using the Covered Call Strategy.  The first, which is the one I will discuss here in detail, is selling near the money options that expire in the next month or two, and the second is selling extended duration options that are deep in the money.  If people want examples of strategy #2 please leave a comment.  In strategy #1, we sell options that expire in a month or two in order to capture the time value of the option.  The time value of an option accelerates to $0 as the option approaches expiration. 

For this discussion, lets look at Archer Daniels Midland (ADM).  Here is a chart of the last three months (I am using the last three months, because before that three months everything fell dramatically, and I am using current examples)

 

3 month Chart of ADM March 13, 2009

3 month Chart of ADM March 13, 2009

As you can see ADM has basically stayed between $24 and $30, so lets say we buy 100 shares today at $27.76 (full cost would be $2,776.00 + trading costs).  Here is a list of the near the money Call options expiring in April.

April Call Options - ADM

We could write (sell) the ADMDF $30 strike option for $0.95 (I would try a limit order at $1.00).  This $0.95 represents time value as there is NO intrinsic value in this option because it is Out of  the Money (OTM).  The ADMDE option priced at $3.50 has $2.76 of intrinsic value ($27.76 – $25.00) and $0.74 of time value ($3.50 – $2.76).  At this point we want ADM to continue to appreciate, slowly.  Remember, the investor wants to own this stock (would own it without writing calls).  Here is the risk/return graph for this position.

ADM Covered Call

At this point, there are two possible outcomes:

     1)  ADM stays below $30, then the option expires worthless and we can sell the next option.  The return for the month is $0.45 ($0.95 less trading costs, I will assume $0.50, and this includes the trading costs on the stock, which is only paid in the first month) option premium received for a return of 1.6% for the month ($0.70 if we do not include the trading costs of the stock, for a 2.52% return for the month).  This as a simple Annual Percent Return (APR) of 19.45% (or 30.26%) not including compounding.

     2)  ADM is above $30, then the option will be exercised.  We sell ADM for $30 (this is the strike price of the option that we sold).  The return for the month is $2.44 ($30 Strike price – $27.76 Purchase price + $0.95 Option premium received – $0.75 trading costs) or 8.79% for the month (105.48% APR).  If this happens we can decide to repurchase ADM or look for another opportunity.

These outcomes do not include any dividends received for owning the stock through an ex-dividend date, if this were the case the dividend would need to be included as a gain in the calculation.

The worst case for this strategy is for the stock to decline drastically.  If this happens, the investor will need to decide whether to sell options that could produce a realized loss, sell the stock for a loss or hold the stock and hope for a positive return.

Next the Married Put…

So far we have learned about the six different basic positions of the stock market and options.  We have a basic three instruments, they are stock, calls and puts, and we can be either long or short.  So we have six basic positions, and these are the risk/reward graphs:

     1) Long stock

long-stock

     2) Short stock

short-stock

     3) Long Call

long-call

     4) Short Call (Write a Call)

short-call

     5) Long Put

long-put

     6) Short Put (Write a Put)

short-put

If you are Long or Short Stock, or Short a Call or Short a Put you have an unlimited loss potential (or down to $0 on the price of the stock).  If you are Long a Call or Long a Put you have a limited loss.  If you are Long or Short Stock or Long a Call or Long a Put you have an unlimited gain potential. 

Next we will start to combine these positions, to see the true power of options and ways to use them effectively.