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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
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.
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.
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
2) Short stock
3) Long Call
4) Short Call (Write a Call)
5) Long Put
6) Short Put (Write a 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.
The last post talked about buying a PUT. Also in a previous post I described how the risk/return graph changes when we take an opposite position.
Lets use the same INTC March $12 Put (symbol NQOM). If you buy the Put (Long the Put) your risk/reward at expiration looks like this:
$12 March 2009 INTEL Put
And if you sell the Put (Short the Put) your risk/reward at expiration looks like this:
$12 March 2009 Intel Put - Short
For this example I have assumed that you can sell the option for the same price that you can buy it. In reality, if you look at these bid/ask prices in the previous post, you can sell the option for $0.72, a 3 cent difference. Also, because the spread is 3 cents, it MAY be possible to buy or sell this option for $0.73 or $0.74.
Notice that the graph is just mirrored about the x-axis.
If INTC closes above $12 at expiration, you will have a gain of $0.75, if INTC closes at $11.25, you will not gain or lose anything. As GE goes below $11.25, you will start to have a loss, with the maximum loss being unlimited (to INTC going to $0, which would be a loss of $11.25). And if INTC closes between $11.25 and $12.00 at expiration, you will have some gain.
If you sell the Put, also known as WRITING a Put, you have an OBLIGATION to purchase the underlying stock, in this example INTC, for $12.00 if the holder of the option exercises the option. It is the buyer of the Option that has a choice, or option.
I do NOT recommend writing NAKED options, because the maximum loss is unlimited. Naked means that you do not have another position that limits the downside risk. Understand how options work and paper trade them before taking any positions.
To be continued–
If you buy a PUT option on that stock, you have the right to sell that stock at a certain price by a certain date. You do not have an obligation to sell the stock, it is your choice. There are a few variables that go into the price of the put option the same as a CALL option. The main variables are the Strike Price, the Expiration Date and the Price of the Stock.
Lets look at Intel Corporation (INTC) as an example. On February 23, 2009 INTC closed at $12.07Bid/$12.10Ask. The following is a list of near the money Call options that expire in March 2009.
Put Options - Intel February 23, 2009
If you purchased one March $12 Put (symbol NQOM) for $0.75 (plus transaction costs) today, you would have until the March 20th (the third friday of March) Expiration date to EXERCISE the option. If you exercise the option, you would give your broker 100 shares of Intel (INTC) and your broker would pay you $12/share (plus transaction costs).
Why would you do this?
Perhaps you think INTC is going to announce something that will make the stock FALL between now and when the option expires. If you think the stock is going to fall, then you can do a few things. The first would be to SHORT the stock (see earlier posts) or you could purchase a PUT. (There are other things as well that I will discuss later)
If INTC makes an announcement and the stock falls to $10.00/share, you will have a gain of $2.00/share less what you paid for the option ($0.75), for a total gain of $1.25/share (less transaction costs). If INTC stays above $12.00 you will not exercise the option and it will expire worthless, for a maximum loss of $0.75. If INTC falls to $11.25, you will break even (not including transaction costs). If you had shorted the stock, and it rises to $13.00, you would have lost $1.00, and it could go higher.
Lets look at the risk/reward graph, at the expiration date.
$12 March 2009 INTEL Put
If INTC stock is below $11.25 (less transaction costs) the options will produce a gain. If INTC stock is above $12, the options will expire worthless, and the maximum loss of $0.75 will be realized. In between $11.25 and $12.00 the options will incur some gain.
If we compare the graph for being SHORT (selling) a stock vs. buying a Put, one can see that we have limited the downside, while maintaining an unlimited upside potential (Not necessarily unlimited as the price of a stock can only go down to $0), by buying a Put.
CONS: The put option has a time limit. If we purchased the $12 put (symbol NQOM) for $0.75 and the stock were to stay above to $12.00 the put will expire worthless and we will lose $0.75 at expiration.
Do not be disappointed yet, remember, I am trying to explain the basics before I explain more complex combinations.
To be continued—
The last post talked about buying a CALL. Also in a previous post I described how the risk/return graph changes when we take an opposite position.
Lets use the same GE March $5 Call (symbol GEWCE). If you buy the Call (Long the Call) your risk/reward at expiration looks like this:
$5 March 2009 GE Call
And if you sell the Call (Short the Call) your risk/reward at expiration looks like this:
$5 March 2009 GE Call - Short
For this example I have assumed that you can sell the option for the same price that you can buy it. In reality, if you look at these bid/ask prices in the previous post, you can sell the option for $5.10, a 10 cent difference. Also, because the spread is 10 cents, it MAY be possible to buy or sell this option for $5.15.
Notice that the graph is just mirrored about the x-axis.
If GE closes below $5 at expiration, you will have a gain of $5.20, if GE closes at $10.20, you will not gain or lose anything. As GE goes above $10.20, you will start to have a loss, with the maximum loss being unlimited. And if GE closes between $5.00 and $10.20 at expiration, you will have some gain.
If you sell the Call, also known as WRITING a Call, you have an OBLIGATION to purchase the underlying stock, in this example GE, for $5.00 if the holder of the option exercises the option. It is the buyer of the Option that has a choice, or option.
I do NOT recommend writing NAKED options, because the maximum loss is unlimited. Naked means that you do not have another position that limits the downside risk. Understand how options work and paper trade them before taking any positions.
To be continued–
Options Investing 
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