Weekly options: A business approach

Step by step guide for how to Trade Futures 1.

These next terms are really just another, more detailed, way of saying that… An option's premium consists of three parts: 

The Power of Options… to Juice Up Your Profits Done right, options can create a cash cow in your portfolio — often quickly, and often at considerable levels.

The Power of Options… to Juice Up Your Profits 

Options Trading Buying Calls and Puts gives traders fantastic and incredible profit opportunities of making huge profits with small amounts of money.

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Traders need to identify the best opportunities via a qualitative and systematic approach to trading in futures, futures options, commodities generally and equity and stock indexes majorly. For a beginner in Futures Trading Futures trading is a complicated business and it is different from investing in the bond or stock markets as we do not own the actual asset. Normally, by selling two calls and buying one, we create a situation that looks like this: I used to work in an emergency room.

Hmmm… At first blush, the Ratio Call Spread play looks like the riskiest of propositions. But what if this play was done in the context of owning the underlying stock? Because I know what you are thinking: But owning the stock in the first place sure had some risk to it! That's because, when properly designed, a covered call generates profits no matter how the stock price moves. Are you starting to see the beauty of options? It consists of owning shares and selling being "short" one call against those shares.

It's for a trader who believes the stock price will go down. The position is "covered" in the sense that, if the call is exercised, the stock is called away, but you don't lose even though the stock's value will be higher than the strike. The idea is that the assurance of known profits from the covered call is worth the occasional lost opportunity.

You have to be cautious in how you set up the covered call to make sure that you "program" net gains no matter what. With the covered call, you create a "cushion" with the premium you receive, so that your breakeven is below your original cost per share.

For example, if you sell a call and get three points, that moves your breakeven down to three points below your cost. That is the initial benefit to selling covered calls. But it does not address the larger market risk of having long stock. If the price falls below your strike, you lose. The short call is not a culprit in this scenario; in fact, the call reduces your exposure. But it does not eliminate the market risk, and that's the point I want you to keep in mind.

On the upside, you face a different risk — that the underlying price could move well above the strike, meaning the call will be exercised, and your shares called away at the strike. Since the market price would be higher at this point, it creates a loss — the difference between the fixed strike and the underlying current value.

Is this potential loss acceptable to you, or not? If not, then you should not write covered calls. But realistically, it's unusual for the underlying price to soar so far above the strike.

Most of the time, the short call is going to expire worthless, or can be closed at a profit, or can be rolled forward. Yet even if none of these can occur, you can exercise the call at any time before expiration. To ensure the greatest success in writing covered calls, follow these guidelines: Focus on very short-term contracts.

Returns on short-term calls are better than on longer-term ones, because time value declines at an accelerated rate. If you sell covered calls that expire in one to two months, you can maximize your annualized return we covered that term in Chapter 2.

Even though you get more cash premium selling longer-term contracts, you make more in the end with short-term ones. You are better off writing six two-month calls than one month short call. Another reason to avoid longer-term covered calls is that they keep you and your cash tied up that much longer. Anything can happen, but in the market, the longer you remain exposed, the greater the risk. Buy the right strikes. The ideal short call is going to be slightly out of the money.

This is where the premium is at its best. Far OTM calls are going to have dismal premium in comparison, especially for soon-to-expire contracts. An ITM premium will be higher, but more likely to get exercised. Slightly OTM is the way to go. Remember, exercise can happen at any time.

The most likely day of exercise is on the last trading day for any ITM option. The second most likely date is going to be on or right before the ex-dividend date. Traders exercise to become stockholder of record and get the current quarter's dividend. So if you want to avoid early exercise, stay away from covered calls on stocks with ex-dividend in the current month.

Pick strikes above your basis in the underlying so that you get a capital gain, and not a capital loss, when exercise occurs. This is often overlooked, but it is essential.

Now, there is an exception: You can sell covered calls below your basis, so long as premium is rich enough and exceeds the loss. The 40 call is not attractive, but the 35 call can be sold at 5. If the call is exercised, you will lose two points in the stock, but the net outcome is a three-point profit. Another easily overlooked aspect of covered call selling is the stock, ETF, or index you select. You're going to find the most attractive premiums in the most volatile underlying.

Lower premiums are symptoms of low-volatility issues. This is yet another balancing act. High-volatility underlying issues are higher-risk, so if you buy shares solely to write covered calls, you expose yourself to higher market risk — a problem that can easily offset the benefits of the covered call.

You can also "cover" a short call by offsetting it with a later-expiring long call, or with a call that expires at the same time, but at a higher strike.

However, these forms of cover are difficult to make practical; the cost element net of outcomes will usually be negative. A lot of people wonder if you can create a "covered put" in the same way as a covered call. If you have shorted stock, a short put protects you to a degree, in the event the stock price rises; it's kind of like insurance. But on a practical level, a long call provides better protection because it will offset loss in the stock all the way up. A put protects you only to the extent of the premium you receive.

And if the stock declines as short sellers want, the short put is at risk of exercise. So, realistically, all short puts are uncovered. And the bigger risk is going to be found in the uncovered, or "naked" call.

When you sell a call naked without owning shares of stock , you face a bigger risk. In theory, a stock's value could rise indefinitely; but at exercise, you have to satisfy exercise at the strike price. Of course, it's pretty unusual for stock prices to rise so dramatically. But it could happen. And therein lies the risk. Every short put is uncovered, unless you offset it with a later-expiring long put. However, the risk is much smaller. Can you guess why? Even in the very worst-case scenario, a stock's value cannot fall below zero.

So risk is quantified as the difference between the strike and zero. Actual risk is much less, of course. The true risk to an uncovered put is the difference between the strike and tangible book value per share again, less the premium received. Realistically, a stock is very unlikely to fall lower than its tangible book value.

The risk, in all short options, is exercise. For covered call writing, exercise can be desirable since it produces a net yield; but for other covered call writers, as well as virtually every uncovered option writer, exercise is not desirable. It can be delayed or avoided by rolling forward. See the sidebar on page 24 for more. You can also take the covered call up a notch — creating even more profit in exchange for somewhat higher risks — with a ratio write.

This is just a covered call involving more calls than you cover with shares. For example, if you own shares and sell three calls, you set up a 3: For this reason, many covered call writers like the ratio write, and accept the risk. You can address the risk, somewhat, too. If the underlying begins moving up, you can partially close the ratio write to eliminate risk.

Or you can roll forward one or more of the short positions. Given the fast decline in time value, there is a reasonable chance that the premium value of the calls is going to fall enough to wipe out the risk.

Close the extra leg of the shorts and take a small profit. An even better variety is the variable ratio write. The risks with this one are very small compared to the straightforward covered call — which makes it a desirable expansion of the strategy.

The "variable" portion refers to the strike. You set up the ratio, but use two different strikes. Rolling Forward In a roll, you close the current short position and replace it with a later-expiring new position. If you also increase the call's strike or decrease the put's strike, you achieve two benefits.

You defer exercise and you also reduce the loss or increase the profit if and when exercise does occur. Covered call writers are avid rollers. However, I want to warn you that rolling forward can sometimes be a mistake. The roll produces a profit, sure. But if you roll to a different strike and take a loss, you may be rationalizing a future net loss. So before undertaking this, a sensible step is to compare outcomes. Call writers may do best to simply accept exercise and then move on to another position.

The roll extends the amount of time your capital is committed. The desirable short- term covered call is converted to a longer- term one, which may reduce annualized returns with little or no net reward later. There's a nasty little tax surprise: A forward roll can convert a qualified covered call into an unqualified one.

Capital gain on the stock upon exercise could be treated as short-term, even when held for more than a year. As long as an unqualified covered call remains open, the required one-year clock is tolled. Before rolling, be sure you and your tax pro take a look at the quirks of option taxation.

The covered call and, possibly, rolling techniques, make selling options challenging and exciting. Like a naked dip in the neighbor's pool, there's always the risk of getting caught… but most options traders are willing to live on the edge just a little, so this danger is more appealing than troubling.

You can set up a variable ratio write by selling two 40 callsand two Now your premium income is increased, but your risk is not that much higher, because all of the calls are OTM. Short puts Remember, with the call, you offset the exercise risk by owning shares of underlying for each call sold.

When you sell a short put, however, you cannot cover the position in the same way. But uncovered puts are not as risky as uncovered calls. That's because the underlying price cannot fall indefinitely, though the price can rise indefinitely at least in theory. So in the worst case, your risk with the short put is the difference between the strike price and zero. The price can't go negative. However, the true maximum risk is the difference between strike and tangible book value per share.

A couple of rules here. First, focus on puts expiring within one month. That will help you maximize your profit potential. Time value is going to evaporate very quickly, so even if the stock price falls below the strike, you can close the short put often at a profit ITM.

You can also roll forward the short put. However, the likelihood of expiring worthless is quite high, so the short put, like the covered call, is a potential cash cow. Second, the risk here is exercise, in which case you have to buy shares at the strike, which will be above market value. So if you are going to write short puts, make sure you consider the strike a good price for the underlying; be realistic about the potential of exercise at any time; and be willing to either hold onto shares or develop a strategy for offsetting the paper loss.

Insurance puts You already know how the insurance put works. You buy the long to offset possible losses in the underlying. If the price falls below the put's strike, the intrinsic value of the put rises for each point lost in the underlying. The downside, of course, is that you have to pay the premium for the put — meaning the cost of insurance reduces any potential net gain in the underlying.

With this in mind, the insurance put makes sense when a specific condition exists: The current price of the underlying is higher than your basis and the paper profits should be higher than the cost of the put ; at the same time, you do not want to sell the underlying, because you think more upside potential is likely. You can buy a 44 put for 2. However, if the stock's value continues to rise, you make more profit in the future and the cost of the insurance put is absorbed through higher profits in the underlying.

Again, you can always close the insurance put at a profit if the market value of the underlying declines. In this scenario, the underlying loss is offset by the put gain. It also leaves in place the potential profits if the underlying rebounds. As an alternative, if you decide the underlying is simply too weak to keep, you can also exercise the put and sell your shares at the strike. LEAPS options This one can be an attractive alternative to the otherwise very short lifespan of most options.

They are available, as calls and puts, on 20 indexes and approximately equities. In the options world, that is something akin to "forever. You can open long LEAPS call positions as a "contingent purchase" strategy, so shares can be bought in the future; or you can buy puts as insurance or as contingent sales positions.

The big disadvantage of a long-term option is going to be the very high time value — you have to pay for the luxury of a long-term play. This is true, at least, if you buy long-term contracts. But if you sell them instead, that high time value works in your favor.

Your return can be significant. And the premium provides a cushion that makes LEAPS sales very desirable, especially if it's part of a long-term contingency plan. If you are willing to sell shares at a specific price at any time between now and two years from now, selling a LEAPS option brings in high current income and a desirable exposure to exercise.

Let me show you how this works. In mid-February , shares of Google Inc. If you sell that call, that's an 8. In that case, the premium value of the call would decline, and you could close your position for a profit. Finally, I'm going to explain the basics of spreads and straddles.

That's where the hedging potential of these combined strategies comes in… 7. Spreads You enter a spread by buying and selling an equal number of calls or puts on the same underlying, but with a different strike or expiration. Spreads come in many variations. But there are some common features, like the combined positioning of offsetting calls, puts, or both, and in configurations both above and below the current value.

This price cushion makes spreads attractive on both long and short sides. The best way to analyze spreads, and to decide which one is a good match for you, is to study "profit zones" and "loss zones.

Of course, you will pay a premium to own both. This sets up a "loss zone" in a middle range between the two strikes, and extending above and below those strikes the number of points paid for the options. If you open a long spread, you have to expect considerable price movement before expiration. A short spread also creates income from selling both a call and a put.

Your "profit zone" is created both above the top strike and below the bottom strike, equal to the premium you get when you open the short spread. So long as the underlying market price remains in between the strikes, there is no exercise risk. Even in the event of exercise within this range, of either option, the premium income covers you. However, if the underlying price moves above or below this middle-range profit zone, then it becomes a loss zone.

And the farther it moves, the greater the loss. On short spreads, you can mitigate or defer that loss zone by either closing one of the short positions, rolling forward, or covering the short with stock purchase in the event of the short call, or in either case with a later-expiring long option. Spreads of this type — with the same expiration but different strikes — are called vertical spreads.

Horizontal spreads also called calendar or time spreads have the same strike but different expirations, and can be either long or short. I'll give you an example of one in the next chapter. Spreads with different expiration and different strike are called diagonal spreads, and also can be either long or short. Straddles Straddles are similar to spreads, but they have the same strike and expiration.

What's especially appealing about straddles is, you can profit based on how much the underlying moves — regardless of the direction of the price movement. A long straddle will have a middle-range loss zone extending both above and below the strike by the number of points you pay for the two options.

If the underlying price moves above or below this middle loss zone before expiration, your profit zone is set up. Long straddles can also be timed to take advantage of volatile price swings in the underlying. In a short straddle, the premium you get for selling the call and the put set up a profit zone extending from the strike, both above and below. The zone covers the same number of points as the premium you received.

If the underlying closes within this range, you earn a profit. The short straddle can avoid exercise on both sides. Either side can be rolled forward if the underlying price moves too far in the money it will always be ITM on one side or the other. It can also be closed; if time value has evaporated, even an ITM short option might be closed at a small profit.

Or, as long as the price is within the profit zone, accepting exercise produces a net profit due to the combined premium income from selling the two options. Chapter 5 — Time to Cash in on the Opportunities "Thou strong seducer, opportunity!

Long calls The long call is not expensive, so it is quite possible to squeeze double-digit returns out of one. Here's an example of a very successful long call. GDX for a long call.

Here was his reasoning: Yesterday, both Barrick Gold Corp. KGC announced major write-downs on their assets.

 

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