Understanding Option Strategies

The following option strategies (and more) are included in my book, Understanding Options:

Did you know you can use options to make money every month or every quarter? And you can use options as insurance, for example, to protect your stock portfolio. And if, on occasion, you wanted to speculate, you could leverage your money to double or triple your profits. It will cost you a lot less than if you bought stocks. And finally, if you like to short stocks, it can be safer to use option strategies than to use the stock market.

Speaking of safety, with most option strategies you know how much you can lose in advance. If used properly, options can be used by all investors and traders to generate income, for insurance, and to speculate. By the time you finish this book, you should have a good idea what options can do for you and whether you want to participate.

Here are the strategies discussed below:

  1. Covered Calls
  2. Buying Calls
  3. Collars
  4. Straddles
  5. Bull Put Spread
  6. Bull Call Spread
  7. Bear Put Spread


Covered Calls

Options strategy: How to sell covered calls
Income potential, while theoretically reducing the risk of simply owning a stock.

If you’re looking for an options strategy that provides the ability to produce income but may be less risky than simply buying stocks, you might want to consider selling covered calls. As long as you’re aware of the potential risks — including transaction costs and tax and wash sale implications — this basic strategy is designed to help generate income from stocks you already own, even within an IRA.

Understanding covered calls
As you may know, there are only two types of options: calls and puts.

Calls: The buyer of a call has the right to buy the underlying stock at a set price until the option contract expires.
Puts: The buyer of a put has the right to sell the underlying stock at a set price until the contract expires.

Although many option strategies have exotic-sounding names, every strategy is based on the buying and selling of calls and puts.

When you sell a covered call, also known as writing a call, it means that you already own shares of the underlying stock and you are selling someone the right, but not the obligation, to buy that stock at a set price until the option expires—the price won’t change no matter which way the market goes. If you didn’t own the stock, it would be known as a naked call—a much riskier proposition.

Why would you want to sell the rights to your stock? Because you receive cash, also known as the premium. For some people, receiving extra income on stocks they already own sounds too good to be true, but like any options strategy, there are risks as well as benefits.

How this strategy works
Before you make your first trade, it’s essential that you understand how it works. For example, let’s say in February you already own 100 shares of XYZ, which is currently at $30 a share. You decide to sell (or write) one call, which covers 100 shares of stock. (If you owned 200 shares of XYZ, you could sell two calls.)

The strike price
You agreed to sell those 100 shares at an agreed-upon price, known as the strike price. When you look up the options quotes on your screen, you’ll see an assortment of strike prices. The strike price you choose determines how much premium you receive for selling the option. With covered calls, for a given stock, the higher the strike price is from the stock price, the less valuable the premium.

Therefore, a $32 strike price is more valuable than a $35 strike price. Why? Because it is more likely for XYZ to reach $32 than it is for it to reach $35, and therefore more likely that the buyer of the call will make money. Because of that, the premium is higher.

The expiration date
In addition to deciding on the most appropriate strike price, you also have a choice of an expiration date, which is the third Saturday of the expiration month. For example, let’s say in February you choose a March expiration date. On the third Friday in March, trading on the option ends and the following day it expires. Either your option is assigned and the stock is sold at the strike price or you keep the stock. Because some people don’t want to tie up their stock for too long, they may choose expiration dates that are only a month or two away. Hint: The further away the expiration date, the more valuable the premium because a longer time span gives the underlying stock more opportunity to reach the option’s strike price.

Note: It takes experience to find strike prices and expiration dates that work for you. As a new options investor, you may want to experiment with one options contract and different strike prices and expiration dates. Eventually you’ll find a combination that works for you.

Your first covered call trade
Now that you have a general idea of how this strategy works, let’s look at more specific examples.

Note: Before placing a trade, you must be approved for an options account.

In February, you own 100 shares of XYZ, which is currently at $30 a share. You sell one covered call with a strike price of $33 and an expiration date of March. The bid price (the premium) for this option is $1.25.

If you were willing to pay the additional commissions and initiated this trade over the phone, you’d say, “I’d like to sell one covered call for XYZ March 33 for a limit price of $1.25 good for the day only.” Hint: It’s suggested you place a limit order, not a market order, so that you can specify the price.

If the call is sold at $1.25, the premium you receive is $125 (100 shares x $1.25) less commission.

Now that you sold your first covered call, you simply monitor the underlying stock until the March expiration date.

Let’s take a look at what could go right, or wrong, with this transaction.

Example one: The underlying stock, XYZ, is above the $33 strike price on the expiration date.

If the underlying stock rises above the strike price at expiration, even by a penny, the stock will most likely be “called away” from you. In options terminology, this means you are assigned an exercise notice. You are obligated to sell the stock at the strike price (at $33 in this example) at expiration. If you sell covered calls, you must expect and plan to have your stock sold. Fortunately, after it’s sold, you can always buy the stock back and sell covered calls on it the following month.

One of the criticisms of selling covered calls is there is limited gain. In other words, if XYZ suddenly zoomed to $37 a share at expiration, the stock would still be sold at $33 (the strike price). You would not participate in the gains past the strike price. If you are looking to make a big score, then selling covered calls may not be an ideal strategy.

Benefit: You keep the premium, stock gains, and dividends, but the stock will be sold at the strike price.
Risk: You lose out on potential gains past the strike price. In addition, your stock is tied up until the expiration date.
Hint: Choose from your existing underlying stocks that are slightly bullish and not too volatile.

Example two: The underlying stock is below the strike price on the expiration date.

If the underlying stock is below $33 a share (the strike price) at expiration, the option has a greater likelihood to expire unexercised and you keep the stock and the premium. You could also sell another covered call for a later month. Although some people hope their stock goes down so they can keep the stock and collect the premium, be careful what you wish for. For example, if XYZ drops a lot, for example, from $30 to $25 a share, although the $125 premium you receive will reduce the pain, you still lost $500 on the underlying stock.

Benefit: The premium will reduce, but not eliminate, stock losses.
Risk: You lose money on the underlying stock when it falls.
Advanced note: If you are worried that the underlying stock might fall, you can always initiate a collar, that is, you can buy a protective put on the covered call, allowing you to sell the stock at a set price, no matter how far the markets drop.

Example three: The underlying stock is near the strike price on the expiration date.

Some might say this is the most satisfactory result for a covered call. If the underlying stock is slightly below the strike price at expiration, you keep the premium and the stock. You can then sell a covered call for the following month, bringing in extra income. If, however, the stock rises above the strike price at expiration by even a penny, the option will most likely be called away.

Benefit: You keep the stock and premium, and can continue to sell calls on the same stock.
Risk: The stock falls, costing you money.

Advanced covered call strategies
Some people use the covered call strategy to sell stocks they no longer want. If successful, the stock is called away at the strike price and sold. You also keep the premium for selling the covered calls.

If you want to avoid having the stock assigned and losing your underlying stock position, you can usually buy back the option in a closing purchase transaction, perhaps at a loss, and take back control of your stock.


Buying Calls

Options strategy: how to buy calls
Buying calls can help to increase the returns, and risks, of your investments.

If you’re looking for a strategy that gives you the potential for larger returns without having to invest a lot of money up front, you may want to consider buying call options. When you buy calls, you profit if the market or an individual stock rises far enough within a certain period of time. If you are right, you can participate in the rise of the stock without actually having to buy it, and only pay a fraction of the cost that would be involved if you purchased actual shares of the stock.

To be profitable, you must be correct both about both the direction and timing of the stock price change. For example, if you believe that a stock will go up within the next month, you could consider buying a call option rather than buying the stock. Like any strategy, the goal is to be profitable while minimizing risk. Buying calls has the potential to help you achieve this goal.

Understanding call options
Before you buy your first call, it’s essential that you understand how they work. For example, let’s say XYZ stock is $30 a share in February. If you wanted to buy 100 shares, it would cost you $3,000. Instead, you could buy one call option, which gives the right to buy 100 shares of the stock at a set price, known as the strike price. The cost of the option contract is usually a fraction of investing in the actual stock. So, in this hypothetical example, instead of paying $3,000 to own the stock, you might pay $300.

Say you are trying to decide between buying a call or the stock itself in the above example—100 shares would cost $3,000, and the option contract would cost $300. If the stock price goes from $30 to $35 by the options expiration, the shares of the stock would rise in value from $3,000 to $3,500, and you would make 17%, or $500, for this time period. As the stock price rises, the value of the option at expiration would rise from $300 to $500, a $200 gain, or a 67% return for the period that you held the option. But what if the stock price falls to $28? At expiration the option would expire worthless and you will lose 100% of your investment. Every options contract has a few key criteria that option traders must be aware of:

Strike price. When you buy a call, you have an opinion about the direction of the stock. Let’s say you believe that XYZ will rise from $28 to $32 a share within one month. Options contracts let you choose the best way to take advantage of your forecast by choosing the best strike price. The strike price is the price at which you can buy the underlying stock for call options. For example, the option may have strike prices of $30, $35, and $40. Every investor needs to review the available strike prices, and find one that matches their investment forecast. For instance, if you think the price of the underlying stock will reach $32, you may want to look at a $30 strike price.

Expiration date. When you buy calls, time is not on your side. In fact, as soon as you buy a call, the clock is ticking. All options contracts have an expiration date. The standard expiration date is the Saturday following the third Friday of the month. It is important that you choose the expiration date that is going to let your forecast be realized.

Commissions. As they do with most investments, brokerages charge commissions when you buy or sell options contracts. Those commissions—which aren’t reflected in the examples used in this article—can reduce your returns.

Buying your first call option
Now that you have a general idea of how this strategy works, let’s take a look at more specific examples.

Note: Before placing a trade, you must be approved to trade options in your account.

In February, you decide to buy one call option (equal to 100 shares) of XYZ, which is currently at $30 a share.

You choose an XYZ April 30 call option currently trading at $1.50.

If you initiated this trade over the phone, you’d say, “I’d like to buy (or go long) one XYZ April 30 call for a limit price of $1.50 good for the day only.” You may want to consider placing a limit order, not a market order, so that you can specify the price you are willing to pay.

If the call is bought at the limit price of $1.50, you will pay a total of $150 (100 shares x $1.50), plus commission.

Now that you bought your first call, you have to closely monitor the underlying stock until the April expiration date. Since time is not on your side, there are a number of choices you have to make.

How a trade may play out
Let’s take a look at what could go right, or wrong, with this transaction.

Example One: The underlying stock, XYZ, rises from $30 to $35 on the expiration date.

You expect and want the underlying stock to rise above the strike price. The higher the stock goes, the more valuable the call option. At any time before the expiration date, you can close your position and take the profits. Many option traders will lock in gains based on their profit forecast, because the price of the stock could fall. In this example, as XYZ rose to $35, the call option at expiration was worth $5 ($35 – $30). You decide to sell the call to close. You are left with a $350 profit ($5.00 gain – $1.50 premium = $3.50 net gain x 100 shares), less commissions.

Benefit: In this example, the call option had a larger return (by percentage) than the underlying stock, while requiring less capital to make the investment.
Risk: The stock could fall and you lose some if not all of the premium paid.
Caution: Although buying calls may look attractive when compared with buying stock, in real life there are many things to consider before making your investment.

Example Two: The underlying stock, XYZ, drops below $30 at or before expiration. If the underlying stock falls below your strike price at expiration, the option will be worthless. In fact, as the stock gets closer to the expiration date, the option can deteriorate quickly because of lost time value.

In this example, the underlying stock fell to $28 a share a few weeks later, causing a partial loss. You sold the call for $0.60 as your exit strategy ($150 investment – $60 sales price = $90 loss).

Risk: You could lose all or part of your $150 investment.

Example Three: The underlying stock, XYZ, is near the $30 strike price at or before expiration.

This scenario is similar to Example Two. Because of diminishing time value, the option may expire worthless. Therefore, in this example, you could lose your entire investment of $150. You always have the choice of selling the option before the expiration date and closing the position to minimize losses.

Risk: You could lose all or part of your $150 investment.

Exercising call options
In the first example, when the underlying stock rose above the strike price (the option is “in-the-money”), you can sell the call and take the profit. You also have another choice, and that is to exercise the option. In this example, you can convert the single call option into 100 shares of stock by paying the strike price. You might be interested in converting shares into stock if you think the stock will continue to rise, and are comfortable owning the stock in your portfolio.

Important: Although you have the right to exercise, many option traders simply buy and sell the option without exercising. By selling the option, the trader does not have to assume the risk and cost of owning the underlying stock.

Options and stocks don’t always move together
Although buying calls is usually a straightforward strategy, there is some nuance. For example, some people are confused when, on occasion, the stock goes up but the option doesn’t follow. “Sometimes a stock could rise in value but an ‘out-of-the-money’ call could drop,” says Joe Harwood, manager of the Options Industry Council (OIC) help desk. The solution is to take the time to learn how options are priced. “Many people think that options are pegged to the stock price, but they are not. Options are a derivative of stocks, but they are not pegged.” This means that prices fluctuate based on the options market and other forces, not purely on the price of the stock.

Bottom line
Buying calls can offer an alternative strategy to buying stock, for investors looking to increase the size of returns relative to the amount of money they choose to invest.


Collars

Put a collar on this market
Here’s a sophisticated options strategy designed to limit losses and protect gains.

The S&P 500® Index has gained 9% so far in 2012. That’s a huge gain over a very short period of time. You may have stocks that have generated strong returns in the rally, and such a big move might raise red flags for a potential correction. If you’re looking to protect gains on current stock positions, or you are moderately bullish on a particular asset but could be concerned about a potential downturn, consider the collar options strategy.

Getting to know collars
A collar is a relatively complex options strategy that puts a cap on both gains and losses (see graphic below). There are three components to constructing a collar:

Purchasing or having an existing stock position (e.g., owning shares of XYZ Company)

Selling a call (the seller of a call has an obligation to sell the stock at the strike price until expiration or until he or she closes the short call position)

Buying a put (the buyer of a put has the right to sell the stock at the strike price until the expiration or until he or she closes the long put position)

This strategy can help mitigate downside risk via the purchase of a put, and some or all of the cost for the purchased put may be covered by selling a covered call on a new or existing stock position.

The premium, or cost of the position, that you pay for the collar is similar to paying an insurance premium. The put could expire worthless if the underlying stock stays the same or rises, but may become more valuable if the underlying stock falls. This allows you to protect the value of the investment by limiting losses in the event of a decline. You are also selling a covered call (to cover some or all of the cost of the put), and become obligated to sell the underlying stock if it rises above your call strike at expiration or is assigned.

You might be asking yourself: Why buy protection for a stock you think might go down in value? Why not just sell the stock? One reason is that there might be significant tax consequences or transaction costs. You may prefer to maintain your position in a stock rather than selling it. However, sometimes selling the stock may be the right answer if you no longer are bullish on the stock.

Let’s take a closer look at collars
Now that you have a basic idea of how this strategy works, looking at a specific example will help you. Please note that before placing a collar, you must fill out an options agreement and be approved for the appropriate options trading level.

In our example, we will look at a hypothetical scenario for XYZ Company.

  1. In January, assume you decide to buy 100 shares of XYZ Company for $53 a share.
  2. Four months later, with the stock trading at close to $53, you become concerned about a potential stock market decline but do not want to sell the shares, so you decide to construct a collar. To do this, you buy a September 52 put selling at $2.45 per contract. Each options contract typically covers 100 shares, so you pay $245 ($2.45 per contract x 100 shares x 1 contract). This out-of-the-money put acts as an insurance policy, effectively protecting your XYZ shares in case of decline below $52.
  3. At the same time, you sell a call on XYZ at the September 55 strike price that costs $2.30 per contract. Each options contract typically covers 100 shares, so you receive $230 ($2.30 x 100 x 1 contract) in premium for this one contract. The primary purpose of selling this call is to cover some of the cost of buying the put.

You now have a collar on your XYZ shares. The net cost of options needed to create the collar is $15 ($245 – $230). The maximum gain on the position is now $185, which is equal to the call strike price ($55) less the purchase price of the underlying shares ($53), multiplied by 100, less the net cost of the collar ($15). The maximum loss is now $115, which is equal to the purchase price of the underlying shares ($53) less the put strike price ($52), multiplied by 100, plus the net cost of the collar ($15).

Breakeven, or the price at which the underlying asset must settle for the costs of the trade to equal profit, is equal to $53.15. This is calculated as the purchase price of the underlying shares ($53) plus the net cost of the collar per 100 shares ($0.15).

Managing the collar trade
Assume that the share price of XYZ rises to $57 on the expiration date. In all likelihood, the holder of the call option that you sold will exercise the call, so you are forced to sell the stock at the $55 strike price. On the other hand, the put would expire worthless because it is out of the money. Although you incurred a net debit of $15 to construct the collar, you made a two-point gain, or $200, on the underlying stock (bought at $53 and sold at the $55 strike price). In this example, the put acts as unused insurance protection.

Now suppose the share price of XYZ falls to $49 on the expiration date. The most obvious impact here is that the value of your stock position falls $400 ($53 to $49 price decline, multiplied by 100 shares you own). However, because XYZ is below $55 at expiration, the call you sold will expire worthless and you will keep the $230 premium received from the covered call. This offsets some of the loss you have experienced on the stock.

Also, while the covered call expires worthless, the put you bought rises in value. In this example the put premium price has risen from $2.45 to $3.00, so you realize a gain of $55 ($300 – $245). As the stock price falls, the put increases in value.

You still have a loss of $115 ($55 put option + $230 call option – $400 loss on the stock). This highlights how the collar provides protection in a down market.

Finally, let’s assume that XYZ rises to $54 on the expiration date. If XYZ moves between the strike price of the covered call ($55) and the strike price of the put ($52) at expiration, no action needs to be taken, as both options will expire worthless. In this event, you lose the $15 difference between the cost of the put and the money you took in for selling the call.


Straddles

Straddling the market for opportunities
Here’s an options strategy designed to profit when you expect a big move.

Stocks have been broadly advancing at a steady pace since mid-December of last year. But in the event that the rally slows or market volatility returns, what will you do? Well, when you aren’t sure which direction a stock is going to go but you are expecting a big move, you may want to consider an options strategy known as the straddle.

Getting to know straddles
You can buy or sell straddles. In a long straddle, you buy both a call and a put option for the same underlying stock, with the same strike price and expiration date. If the underlying stock moves a lot in either direction before the expiration date, you can make a profit. However, if the stock is flat (trades in a very tight range), you may lose all or part of your initial investment.

Here are a few key concepts to know about straddles:

They offer unlimited profit potential but with limited risk of loss.

The more volatile the stock or index (the larger the expected price swing), the greater the probability the stock will make a strong move.

Higher volatility may also increase the total cost of a long straddle position.

In comparison to other options strategies, the upfront cost of a straddle may be slightly higher because you are buying multiple options and volatility is typically higher.

The concept behind the long straddle is relatively straightforward. If the underlying stock goes up, then the value of the call option increases while the value of the put option decreases. Conversely, if the underlying stock goes down, the put option increases and the call option decreases. While it is possible to lose on both legs (or, more rarely, make money on both legs), the goal is to produce enough profit from the option that increases in value so it covers the cost of buying both options and leaves you with a net gain.

What to look for before making a trade
Our focus is the long straddle because it is a strategy designed to profit when volatility is high while limiting potential exposure to losses, but it is worth mentioning the short straddle. This position involves selling a call and put option, with the same strike price and expiration date. This nondirectional strategy would be used when there is the expectation that the market will not move much at all (i.e., there will be low volatility). With the short straddle, you are taking in upfront income (the premium received from selling the options) but are exposed to potentially unlimited losses and higher margin requirements.

Let’s dive into straddles
With a basic understanding of how this strategy works, let’s look at specific examples. Please note that before placing a straddle, you must fill out an options agreement and be approved for options trading.

In our example, we will look at a hypothetical scenario for XYZ Company.

In August, you forecast that XYZ, then trading at $40.75 a share, will either rise or fall sharply based on an earnings report that is set to be released in a week. Due to this expectation, you believe that a straddle would be an ideal strategy to profit from the forecasted volatility.

To construct a straddle, you buy 1 XYZ October 40 call for $2.25, paying $225 ($2.25 x 100). We multiply by 100 here because each options contract typically represents 100 shares of the underlying stock. At the same time, you buy 1 XYZ October 40 put for $1.50, paying $150 ($1.50 x 100). Note that in this example, the call and put options are at or near the money. Your total cost, or debit, for this trade is $375 ($225 + $150), plus commissions.

The maximum possible gain is theoretically unlimited because the call option has no ceiling (the underlying stock could rise indefinitely). The maximum risk, or the most you can lose on this trade, is the initial debit paid, which is $375, plus commissions. This would occur if the underlying stock closes at $40 at the expiration date of the options.

Let’s make use of breakeven here. In this example, the cost of the straddle (in terms of the total price for each contract) is $3.75 ($2.25 + $1.50). Breakeven in the event that the stock rises is $43.75 ($40 + $3.75), while breakeven if the stock falls is $36.25 ($40 – $3.75). With this information, you know that XYZ must close above $43.75 or below $36.25 at expiration to be profitable.

Managing a winning trade when things go right
Assume XYZ releases a very positive earnings report. As a result, XYZ rises to $46.30 a share before the expiration date. Because XYZ rose above the $43.75 breakeven price, our September 40 call option is profitable and might be worth $6.40. Conversely, our September 40 put option has almost no value; let’s say it is worth $0.05.

Before expiration, you might choose to close both legs of the trade. In the above example, you could simultaneously sell to close the call for $6.40, and sell to close the put for $0.05, for a gain of $645 ($6.40 + $0.05). Your total profit would be $270 (the gain of $645 less your initial investment of $375), minus any commission costs.

Now, consider a scenario where instead of a positive earnings report, XYZ’s quarterly profits plunged and the stock falls to $33 before expiration. Because XYZ fell below the $36.25 breakeven price, the September 40 put option might be worth $7.25. Conversely, the September 40 call option is worth just $0.15.

Before expiration, you might choose to close both legs of the trade by simultaneously selling to close the put for $725 ($7.25 x 100) as well as the call for $15 ($0.15 x 100). The gain on the trade is $740 ($725 + $15), and the total profit is $365 (the $740 gain less the $375 cost to enter the trade), minus commissions.

Managing a losing trade
The risk of the long straddle is that the underlying asset doesn’t move at all. Assume XYZ rises to $41 before the expiration date. Although the underlying stock went up, it did not rise above the $43.75 breakeven price. More than likely, both options will have deteriorated in value. You can either sell to close both the call and put for a loss, or you can wait longer and hope for a sudden turnaround.

Let’s assume that with just a week left until expiration, the XYZ October 40 call is worth $1.35, and the XYZ October 40 put is worth $0.35. Since XYZ didn’t perform as expected, you might decide to cut your losses and close both legs of the option for $170 ([$1.35 + $0.35] x 100). Your loss for this trade would be $205 (the $170 gain, minus the $375 cost of entering into the straddle), plus commissions.

The risk of waiting until expiration is the possibility of losing your entire initial $375 investment. Both options could expire worthless if the stock finishes at $40. This is called pinning: the stock finishes at the stock price.

Other considerations
Timing is an important factor in deciding when to close a trade. There are cases when it can be preferential to close a trade early, most notably “time decay.” Time decay is the rate of change in the value of an option as time to expiration decreases and, because of that and other reasons, traders might choose not to hold straddles to expiration. Instead, they might take their profits (or losses) in advance of expiration.

In addition to time decay, there are other factors that can influence options used in the straddle trade. Learn about the factors that influence options used in the straddle trade and keep the straddle in your trading arsenal in case high volatility makes a comeback.


Bull Put Spread

Limit your risk with the bull put spread
Capture profits from a rising stock while putting a limit on your losses.

Volatility in the market has calmed down from the heightened levels that we were experiencing in early fall. But the European debt crisis, higher oil prices, and other risks could renew the market’s uncertainty at any time. If volatility does come back, active investors may want to consider an options strategy called a bull put spread.

Why the bull put spread?
Picking the right stock, picking the right direction, and picking the right time to buy or sell can sometimes be difficult. This is why you may want to consider a bull put spread. A bull put spread offers limited risk, while giving you different ways to profit from volatility in the underlying asset. This strategy is particularly attractive for assets that are expected to rise slightly, may fall slightly, or may remain unchanged, and when volatility—the level of uncertainty in the market or a specific security—is high.

Establishing a bull put spread is relatively straightforward: sell one put option (short put) while simultaneously buying another put option (long put). A bull put spread is also known as a vertical spread strategy (buying and selling options of the same underlying asset and expiration date) and a credit spread (you receive money at the outset of creating the position, and this is the maximum profit for the position). Because you are selling one put option and buying another, you are effectively hedging your position. The result is that potential gains and losses are capped.

When this strategy works
The bull put spread is used if you are moderately bullish on a stock or index, and your preference is to limit risk exposure. The primary goal is to make a short-term profit while limiting risk. You want the underlying asset (stock, index, etc.) to rise above both put options so they are out of the money (strike price is below the current market price), and the contracts expire worthless. If the options expire, you keep the credit you received.

What to look for before you initiate the trade
Before you initiate a bull put spread, it’s important to know what to look for. Here’s some helpful guidance:

Underlying asset—First, you need to identify an underlying stock, index, or other asset that you believe will rise moderately or will remain unchanged over a specific period of time.

Expiration date—Look at the option chain (the listing of put and call options, which shows strike prices, option premium, expiration date, etc.) for your chosen security, and choose an expiration date that matches your expected time frame. In certain circumstances, it may be advantageous to having a shorter time frame for a strategy like a bull put spread. This will most likely reduce the amount of premium (the price of the option) that you take in, but also reduces the possibility of an unforeseen event affecting the outcome of your trade. Make the appropriate selection based on your risk tolerances and investment expectations.

Strike price—Next, assess the various strike prices of the option you choose. For example, you might select strike prices with at least a 5-point difference (i.e., buy the 30 put and sell the 35, or buy the 80 put and sell the 85). Choose strike prices that match your forecast for the underlying security and that may thus allow you to earn the maximum profit potential.

Volatility—This is an important consideration. Think about whether you would prefer to initiate the bull put spread when volatility is relatively high (likely increasing both the amount of premium taken in and the risk associated with the trade) or when volatility is low (possibly reducing the premium taken in and the risk associated with the trade).

Another set of tools at your disposal when trading options are greeks (i.e., delta, gamma, theta, vega, and rho).* Using greeks can help you forecast how changes in price, time, and volatility can affect the value of your spreads.

Once your position is initiated, you should monitor it closely. Action may have to be taken before the contracts expire (we will soon discuss when and how this can be done). The goal is to have both legs (each side of the spread, the buy side and the sell side) expire worthless to earn the maximum profit potential.

Bull put trade, in action
Now that you have a basic idea of how this strategy works, let’s look at a few specific examples.

(Note: Before creating a spread, you must fill out an options agreement and be approved for a Level 3 options account. )

In April, you believe that XYZ stock, which is currently at $33 per share, will rise moderately over the next month or two to $35 per share or higher. You decide to initiate a bull put spread.

4.You buy 1 XYZ May 30 put (long put) for $2.60, paying $260 ($2.60 x 100). Each options contract covers 100 shares, which is why you multiply the $2.60 premium by 100. At the same time, you sell 1 XYZ May 32 put (short put) for a limit price of $3.50, receiving $350 ($3.50 x 100). Our breakeven is $31.10 (highest strike price less the premium received). Notice in this example that the put we bought (long put) is out of the money and the put we sold (short put) is slightly out of the money. The stock could rise, remain unchanged, or fall slightly and still be profitable. Maximum profit: The credit received for this trade is $90 ($350–$260), less commission costs.

5.Maximum risk: The maximum risk is the difference between the two strike prices, minus the credit you received. Therefore, maximum risk for this trade is $110 ($200–$90), plus commission costs.

Now, let’s look closely at what could hypothetically go right or wrong:

A winning trade: The underlying stock, XYZ, stays above the $32 strike price at the expiration date.

If the underlying stock stays above $32 at or before expiration, both puts remain out of the money and will expire worthless.

How to close this type of winning trade
You have a couple of options. First, you can close both legs of the trade. In the above example, if you enter a limit order, an order is placed to buy to close the short put for $90, and sell to close the long put for $40. Your profit is $40: $90 (your original credit) minus $50 ($90 for short put minus $40 for long put). Second, if both options are out of the money, you can consider letting both legs expire worthless, achieving maximum profit. Depending on your specific risk and return objectives, you may want to consider closing both legs of the spread before expiration, once your profit goals are reached.

A losing trade: The underlying stock, XYZ, drops below the $32 strike price before the expiration date.

If the underlying stock drops below $30, and the option becomes in the money on or before expiration, both puts may rise in value. This is not what you expected or wanted. Your goal was to keep as much as possible of the $90 credit you originally received. However, as a trader, you should be prepared with a plan for exiting any strategy when things don’t quite go your way. Although the short put is costing you money, you are protected from the potentially substantial loss of that position by the long put. Nevertheless, in this scenario (both options are in the money), you can lose the maximum, or $110, if the stock drops below $30.

How to close a losing trade
It is worth looking at an example to see how you might close a losing trade like this. The short put might rise from $3.50 to $4.80, while the long put could rise from $2.60 to $3.20. Before expiration, you could close both legs. You would place an order to buy to close the short put for $480, and sell to close the long put for $320. In this example, you must pay $160 to exit the position ($480 – $320), but you previously received a credit of $90. As a result, your total loss is a more manageable $70.

If you wait until expiration, you could lose the entire $110. Depending on your risk tolerance and objectives for the trade, you might choose to close both legs of a losing spread before expiration, especially when you no longer believe the stock will perform as anticipated.

Options traders should always be aware of early assignment, as well. There’s a chance you’ll be assigned early (before expiration) on the short put. Actively monitor your option positions and learn to manage risk.

Investing implications
Options trading strategies have unique risks and rewards. They offer more ways to take advantage of a given forecast. A bull put spread is a great example of the many option strategies that investors have at their disposal.


Bull Call Spread

Options strategy: the bull call spread
A strategy designed to take advantage of price gains while potentially limiting risk.

Options traders looking to take advantage of a rising stock price while managing risk may want to consider a spread strategy: the bull call spread. This strategy involves buying one call option while simultaneously selling another. Let’s take a closer look.

Understanding the bull call spread 
Although more complex than simply buying a call, the bull call spread can help minimize risk while setting specific price targets to meet your forecast.

Here’s how it works. 
First, you need a forecast. Say XYZ is trading at $60 per share. You are moderately bullish and believe the stock will rise to $65 over the next 30 days.

A bull call spread involves buying a lower strike call and selling a higher strike call:

Buy a lower strike call at $60. This gives you the right to buy stock at the strike price.

Then:

Sell a higher strike call at $65. This obligates you to sell the stock at the stock at the strike price.

Because you are buying one call option and selling another, you are “hedging” your position. You have the potential to make a profit as the share price rises, but you are giving up some profit potential—but also reducing your risk—by selling a call. Selling a call reduces the initial capital involved. The trade-off is you have to give up some upside potential. One advantage of the bull call spread is that you know your maximum profit and loss in advance.

How this strategy works 
Before you construct a bull call spread, it’s essential to understand how it works. Normally, you will use the bull call spread if you are moderately bullish on a stock or index. Your hope is that the underlying stock rises higher than your breakeven cost. Ideally, it would rise high enough so that both options in the spread are in the money at expiration; that is, the stock is above the strike price of both calls. When the stock rises above both strike prices you will realize the maximum profit potential of the spread. As with any trading strategy it is extremely important to have a forecast. In reality, it is unlikely you will always achieve the maximum reward. Like any options strategy, it’s important to be flexible when things don’t always go as planned.

Before you initiate the trade: what to look for
Before you initiate a bull call spread, it’s important to have an idea of your criteria.

Underlying stock: First, you want to choose an underlying stock you believe will go up.

Expiration date: Choose an options expiration date that matches your expectation for the stock price.

Strike price: Choose offsetting strike prices that match your forecast For example, the stock is at $40. You believe it will rise to $45.

Volatility: Many traders will initiate the bull call spread when volatility is relatively high, which may reduce the cost of the spread.

Note: These are general guidelines and not absolute rules. Eventually, you will create your own guidelines.

Your first bull call trade
Before placing a spread, you must fill out an options agreement and be approved for spreads trading.

Now that you have a basic idea of how this strategy works, let’s look at more specific examples.

In June, you believe that XYZ, which is currently at $34 per share, will rise over the next three to four months to $40 per share or higher. You decide to initiate a bull call spread.

Options contracts: You buy 1 XYZ October 35 call (long call) at $3.40, paying $340 ($3.40 x 100 shares). At the same time, sell 1 XYZ October 40 call (short call) at $1.40, receiving $140 ($1.40 x 100 shares). Note: In this example, the strike prices of both the short call and long call are out of the money.

Cost: Your total cost, or debit, for this trade is $200 ($340 – $140) plus commissions.

Maximum gain: The maximum you can gain on this trade is $300. To determine your maximum reward, subtract the net debit ($3.40 – $1.40=$2 x 100 shares) from the difference in strike prices ($40 – $35=$5 x 100 shares). In this example, the maximum possible gain is $300 ($500 – $200).

Maximum risk: The most you can lose on this trade is the initial debt paid, or $200. Note: a bull call spread can be executed as a single trade. This is known as a multi-leg order.

Let’s take a look at what could go right, or wrong, with this strategy:

Example One: The underlying stock, XYZ, rises above the $35 strike price before the expiration date.

If the underlying stock rises above $35 before expiration, both legs of the spread (each side of the spread, the buy side and sell side, is called a leg) will rise in value, which is what you want. For example, the long call may rise from $3.40 to $5.10, while the short call may rise from $1.40 to $1.90. Note: Near expiration, as the long call option goes further in the money, the spread between the two call options widens, but it will not surpass the $5 maximum value.

How to close a winning trade
Before expiration, you close both legs of trade. In the above example, if you enter a limit order, you will buy back (buy to close) the short call for $190, and sell (sell to close) the long call for $510. That gives you a net sale of $320. You originally paid $200, leaving you with a net profit of $120. Important: remember that you can close both legs of the strategies as a multi-leg order.

Although some traders try to achieve maximum profit through assignment and exercise, if your profit target has been reached it may be best to close the bull call spread prior to expiration.

Example Two: The underlying stock, XYZ, drops below the $35 strike price before or near the expiration date.

If the underlying stock remains below $35 before expiration, both legs of the spread will drop in value due to time decay, which is not what you’d hoped to see. For example, the long call may fall from $3.40 to $1.55, while the short call may drop from $1.40 to $1.05.

To avoid complications, close both legs of a losing spread before expiration, especially when you no longer believe the stock will perform as anticipated. If you wait until expiration, you could lose the entire $200 investment.

How to close a losing trade
Before expiration, close both legs of the trade. Then you will buy back (buy to close) the short call for $105, and sell (sell to close) the long call for $155. In this example, your loss is $150: ($155 – $105) – $200 (your initial payment).

Early assignment
Although it’s unlikely, there’s always a chance you’ll be assigned early (before expiration) on the short call. If this occurs, you may want to exercise the long call.

Other factors to consider
Trading spreads involves a number of unforeseen events that can dramatically influence your options trades. Make an effort to learn about time decay and implied volatility, and other factors that affect an options price. This will help you understand how they can affect your trade decisions. You should also understand how commissions affect your trade decisions.


Bear Put Spread

Bear Put Spread: Profit from a falling stock price, while potentially limiting risk.
When the stock market is falling, some speculators may want to profit from the drop. But for some situations, simply shorting a stock or buying a put may seem too risky. In that case, the options strategy called the “bear put spread” may fit the bill. To use this strategy, you buy one put option while simultaneously selling another, which can potentially give you profit, but with reduced risk and less capital. Let’s take a closer look.

Understanding the bear put spread
Although more complex than simply buying a put, the bear put spread can help to minimize risk. Why? Because you are hedging your position by buying one put option and selling another put option, which can reduce losses but can also limit your potential profits. And, this strategy involves less capital than simply buying a put.

There is something else you should know about the bear put spread: Because you are paying out money to initiate this strategy, it’s called a debit spread. Your goal is to sell the combined position at a price that exceeds the overall purchase price, and thus make a profit.

Put Basics
A put is a contract that gives the owner the right to sell shares of a stock at a set price—known as the strike price. So buyers of puts hope stock prices fall below the strike price, giving them the potential to profit.

One advantage of the bear put spread is that you know your maximum profit (or loss) in advance. In fact, the maximum risk for this trade is the initial cost of the spread. Therefore, you have defined your risk in advance.

The nuts and bolts
Normally, you will use the bear put spread if you are moderately bearish on a stock or index. Your goal is for the underlying stock to drop low enough so that both options in the spread are in the money (when expiration arrives), that is, the stock is below the strike price of both puts. You want the stock to fall far enough to earn more than the cost of the spread. Here is one example of how it works:

Buy a put below the market price: You will make money (after commissions) if the market price of the stock falls below your breakeven price for the strategy.

Sell a put at an even lower price: You keep the proceeds of the sale—offsetting some of the cost of the put and taking some risk off the table. You also give up any profits beyond the lower strike price.

The best-case scenario: The stock price falls as you anticipated and both puts are in the money at expiration.

Before you initiate the trade—what to look for:
Before you initiate a bear put spread, it’s important to have an idea of your criteria. Here are some general guidelines.

Underlying stock: First, you need to choose an underlying stock that you feel is likely to fall in price.

Expiration date: Choose an options expiration date that matches your expectation for the stock price to fall.

Strike price: Next, you must decide which strike prices to choose.. For example, you may choose to buy the 45 put and sell the 40, or buy the 60 put and sell the 50. The larger the spread, the greater the profit potential, but the difference in premiums might leave you with more risk.

Volatility: Many traders prefer to initiate the bear put spread to help offset volatility or the cost of an option. Volatility is an important factor that will affect options price.

Your first bear put trade
Now that you have a basic idea of how this strategy works, let’s look at more specific examples of this strategy.

Note: Before placing a spread, you must fill out an options agreement and be approved for Level 3 options trading.

In June, you believe that XYZ, which is currently at $31 per share, will fall below $30 per share over the next two or three months. You decide to initiate a bear put spread.

You buy 1 XYZ October 30 put (long put) for $3.80 per share, paying out $380 ($3.80 x 100). At the same time, you sell 1 XYZ October 25 put (short put) for $1.60 per share, receiving $160 ($1.60 x 100). Note: In this example, the strike prices of both the short put and long put are out of the money.

Cost: Your total cost, or debit, for this trade is $220 ($380 – $160), plus commissions. To initiate this trade you can place them as one trade by using the multi-leg option ticket.

Maximum possible gain: The most you can gain from this trade is $280. To determine your maximum reward, subtract the net debit ($2.20 x 100) from the difference in strike prices ($5 x 100). In this example, it will be $280 ($500 – $220).

Maximum risk: The most you can lose on this trade is the initial debt paid, or $220.

Let’s take a look at what could go right (or wrong) with this strategy:

Example One: The underlying stock, XYZ, falls below the 30 strike price before the expiration date.

If the underlying stock falls below $30 before expiration, both legs of the spread (each side of the spread, the buy side and sell side, is called a leg) will rise in value.

For example, the long put may rise from $3.80 to $5.70, while the short put may rise from $1.60 to $2.10. Note: Near expiration, as the long put option goes further in the money, the spread between the two put options widens, but it never surpasses that $5 maximum value.

How to close a winning trade
Before expiration, you can close both legs of the online trade with the click of one button. In the above example, if you enter a limit order, you buy back (buy to close) the short put for $210, and sell (sell to close) the long put for $570. Your profit is $140: Sale price of $360 ($570 – $210) minus $220 (your original payment).

Although some traders try to achieve maximum profit through assignment and exercise, it may be risky—it could leave you exposed to a naked stock position. So it may be worth closing both legs of the spread before expiration once your profit goal is reached.

Example Two: The underlying stock, XYZ, remains above the 30 strike price before or near the expiration date.

If the underlying stock remains above $30 before expiration, both legs of the spread drop in value, which is not what you hoped to see. For example, the long put might fall from $3.80 to $2.10, while the short put may drop from $1.60 to $1.20. To avoid complications, you may want to close both legs of a losing spread before the expiration date, especially if you no longer believe the stock will perform as anticipated. If you wait until expiration, you could lose the entire $220 investment.

How to close a losing trade
Before expiration, close both legs of the trade. You will buy back (buy to close) the short put for $120, and sell (sell to close) the long put for $210. In this example, your loss is $130: ($210 – $120) – $220 (your initial payment).

Early assignment
Although it’s unlikely, there’s always a chance you’ll be assigned early (before expiration) on the short put. If this occurs, you may want to exercise the long put.

Other factors to consider
Trading spreads can involve a number of unforeseen events that can dramatically influence your options trades. Make an effort to learn about time decay and implied volatility, and how they can affect your trade decisions.

Should you think about trading currencies?

If you’ve been thinking of ways to trade the falling euro (EUR), or any other currency, you might consider the foreign exchange market. Forex, which is open 24 hours a day and five days a week, is the world’s most traded financial market and also the most liquid. This means you can quickly get into and out of a trade.

You also have a choice between trading in the currency futures market, which is a physical exchange, or the forex “spot” market, where you trade over the counter with a broker. Many beginners trade in the spot market because you need so little upfront money.

So if you’re certain that betting on a certain currency is a sure thing, see what’s involved.

The basics

Currencies are always traded in pairs. In other words, you buy one currency and sell the other. For example, you could sell the euro against the dollar (EUR/USD). In this case, you short the euro (you believe the euro will go down) but long the dollar (you believe the dollar will go up). Conversely, you could buy, or go long, the euro and short the dollar. Because there are 28 major pairs with eight major currencies, you have many choices.

If you’re a beginner, stick with the major currencies you know. “It’s recommended you start off with a liquid pair, like the euro or dollar,” says Tim Bourquin, co-founder of TraderInterviews.com and co-founder of Traders Expo and Forex Trading Expo. “Don’t start trading the Indian rupee versus the Iraq dinar, which has no liquidity and little information.”

Currencies move up and down by percentage in points, or pip, which is one-hundredth of 1 percentage point. When trading a dollar-based currency, one pip equals $10. Don’t get fooled by the small increments. Because of leverage, you can theoretically make or lose $3,000 or more in a day, depending on the size of your account.

The benefits

One of the benefits of trading currencies is the high leverage. Unlike in the stock market, where you can buy securities on margin with 2-to-1 leverage, in the currency market, you’re allowed 50-to-1 leverage. Therefore, for every $1 you invest, you control $50 worth of currency. That’s good, right?

“The high leverage can work for you or against you,” says Michael Archer, author of “Getting Started in Currency Trading: Winning in Today’s Hottest Marketplace.”

Archer says it’s not unusual for new traders to plunk down $500 (and control $25,000 in currencies), and then lose it all. Why? Because they don’t understand how leverage works. “Just because you have 50-to-1 leverage doesn’t mean you have to use it,” Archer cautions. Although it is possible to lose more than your initial investment, most online brokers close your position before that happens, Archer says.

What are the other benefits of trading currencies? John Jagerson, co-author of “All About Forex Trading,” says that currency trading “can be an extremely low-cost, efficient way for talented, short-term investors to make profits. It’s a fast market with super-tight spreads with no commissions.” In fact, most forex brokers don’t charge commissions, but they make profits off of the spreads between currencies.

The risks

One of the risks of forex is that it’s not transparent. “Currency traders are literally trading against the pros, who have control over where and when the order gets filled,” says Jagerson. “Nine times out of 10 it won’t matter, but there is a conflict of interest.”

The solution, Jagerson says, is to stick with big-name U.S. brokers, which are under stricter regulatory control. The ones you should avoid, he says, are brokers who operate in relatively unregulated territories such as Russia or Cyprus. “These brokers might pop up and then disappear with all of your money,” he warns.

Bourquin agrees. “If you stick with the big-spot forex traders like GFT, Forex.com and FXCM, they have enough volume so they don’t need to mess with the client’s pricing to make money.” In addition, Bourquin says, the National Futures Association, or NFA, started cracking down on rogue brokers, which forced a few to leave the country.

Another problem, Jagerson says, is that people don’t appreciate the risks of currency trading. “I tell aspiring traders to paper trade as long as possible in adverse market conditions,” he says. Paper trading enables novices to mimic the trading process without actually laying out any cash.

The most common reason for failure, Jagerson says, is people trade too large and too inconsistently. “Their analysis is often good, but their money management is so bad it sabotages them.”

Often, the biggest problem is with the trader. “Many people who enter the currency market have crazy expectations, such as making 5 percent to 10 percent a month or more,” says Jagerson. “I don’t know where they get those ideas.”

Trading currencies is more complex than many people realize. “Some firms have entire departments with professionals that have been trading currencies for 30 years,” says Bourquin. “It’s not just earnings or how many widgets XYZ is selling. Currencies involve complicated issues about interest rates and debt in Europe and Greece. People need to study that.”

Getting started

Before you start trading currencies, experts suggest you get an education, although with some caveats. “You have to be careful where you get your education,” says Bourquin. “The Internet is filled with get-rich programs. There’s no reason to pay $10,000 for a forex training program when most brokers offer the basics on their websites for free.”

Trading currencies is similar to trading stocks in one way: money management. “My suggestion is to start small and go slow,” says Archer. “Take six months to a year before you put real money on the line. Find a fairly simple trading technique, and develop trading rules that work for you.”

And learn to sit on your hands instead of constantly trading, he adds. “Wait for the right opportunity.”

Understanding Options Spreads

I wrote about the following options strategies for one of my clients, which is also posted on their web site. Basic strategies introduced here: http://bit.ly/SOjCU2

  1. Bull Put Spread
  2. Bull Call Spread
  3. Bear Put Spread

 

BULL PUT SPREAD

Limit your risk with the bull put spread
Capture profits from a rising stock while putting a limit on your losses.

Volatility in the market has calmed down from the heightened levels that we were experiencing in early fall. But the European debt crisis, higher oil prices, and other risks could renew the market’s uncertainty at any time. If volatility does come back, active investors may want to consider an options strategy called a bull put spread.

 

Why the bull put spread?
Picking the right stock, picking the right direction, and picking the right time to buy or sell can sometimes be difficult. This is why you may want to consider a bull put spread. A bull put spread offers limited risk, while giving you different ways to profit from volatility in the underlying asset. This strategy is particularly attractive for assets that are expected to rise slightly, may fall slightly, or may remain unchanged, and when volatility—the level of uncertainty in the market or a specific security—is high.

Establishing a bull put spread is relatively straightforward: sell one put option (short put) while simultaneously buying another put option (long put).

A bull put spread is also known as a vertical spread strategy (buying and selling options of the same underlying asset and expiration date) and a credit spread (you receive money at the outset of creating the position, and this is the maximum profit for the position). Because you are selling one put option and buying another, you are effectively hedging your position. The result is that potential gains and losses are capped.

 

When this strategy works
The bull put spread is used if you are moderately bullish on a stock or index, and your preference is to limit risk exposure. The primary goal is to make a short-term profit while limiting risk. You want the underlying asset (stock, index, etc.) to rise above both put options so they are out of the money(strike price is below the current market price), and the contracts expire worthless. If the options expire, you keep the credit you received.

 

What to look for before you initiate the trade
Before you initiate a bull put spread, it’s important to know what to look for. Here’s some helpful guidance:

Underlying asset—First, you need to identify an underlying stock, index, or other asset that you believe will rise moderately or will remain unchanged over a specific period of time.

Expiration date—Look at the option chain (the listing of put and call options, which shows strike prices, option premium, expiration date, etc.) for your chosen security, and choose an expiration date that matches your expected time frame. In certain circumstances, it may be advantageous to having a shorter time frame for a strategy like a bull put spread. This will most likely reduce the amount of premium (the price of the option) that you take in, but also reduces the possibility of an unforeseen event affecting the outcome of your trade. Make the appropriate selection based on your risk tolerances and investment expectations.

Strike price—Next, assess the various strike prices of the option you choose. For example, you might select strike prices with at least a 5-point difference (i.e., buy the 30 put and sell the 35, or buy the 80 put and sell the 85). Choose strike prices that match your forecast for the underlying security and that may thus allow you to earn the maximum profit potential.

Volatility—This is an important consideration. Think about whether you would prefer to initiate the bull put spread when volatility is relatively high (likely increasing both the amount of premium taken in and the risk associated with the trade) or when volatility is low (possibly reducing the premium taken in and the risk associated with the trade).

Another set of tools at your disposal when trading options are greeks (i.e., delta, gamma, theta, vega, and rho).* Using greeks can help you forecast how changes in price, time, and volatility can affect the value of your spreads.

Once your position is initiated, you should monitor it closely. Action may have to be taken before the contracts expire (we will soon discuss when and how this can be done). The goal is to have both legs (each side of the spread, the buy side and the sell side) expire worthless to earn the maximum profit potential.

 

Bull put trade, in action
Now that you have a basic idea of how this strategy works, let’s look at a few specific examples.

(Note: Before creating a spread, you must fill out an options agreement and be approved for a Level 3 options account. )

In April, you believe that XYZ stock, which is currently at $33 per share, will rise moderately over the next month or two to $35 per share or higher. You decide to initiate a bull put spread.

  1. You buy 1 XYZ May 30 put (long put) for $2.60, paying $260 ($2.60 x 100). Each options contract covers 100 shares, which is why you multiply the $2.60 premium by 100. At the same time, you sell 1 XYZ May 32 put (short put) for a limit price of $3.50, receiving $350 ($3.50 x 100). Our breakeven is $31.10 (highest strike price less the premium received). Notice in this example that the put we bought (long put) is out of the money and the put we sold (short put) is slightly out of the money. The stock could rise, remain unchanged, or fall slightly and still be profitable. Maximum profit: The credit received for this trade is $90 ($350–$260), less commission costs.
  2. Maximum risk: The maximum risk is the difference between the two strike prices, minus the credit you received. Therefore, maximum risk for this trade is $110 ($200–$90), plus commission costs.

Now, let’s look closely at what could hypothetically go right or wrong:

A winning trade: The underlying stock, XYZ, stays above the $32 strike price at the expiration date.

If the underlying stock stays above $32 at or before expiration, both puts remain out of the money and will expire worthless.

 

How to close this type of winning trade
You have a couple of options. First, you can close both legs of the trade. In the above example, if you enter a limit order, an order is placed to buy to close the short put for $90, and sell to close the long put for $40. Your profit is $40: $90 (your original credit) minus $50 ($90 for short put minus $40 for long put).

Second, if both options are out of the money, you can consider letting both legs expire worthless, achieving maximum profit. Depending on your specific risk and return objectives, you may want to consider closing both legs of the spread before expiration, once your profit goals are reached.

A losing trade: The underlying stock, XYZ, drops below the $32 strike price before the expiration date.

If the underlying stock drops below $30, and the option becomes in the money on or before expiration, both puts may rise in value. This is not what you expected or wanted. Your goal was to keep as much as possible of the $90 credit you originally received. However, as a trader, you should be prepared with a plan for exiting any strategy when things don’t quite go your way. Although the short put is costing you money, you are protected from the potentially substantial loss of that position by the long put. Nevertheless, in this scenario (both options are in the money), you can lose the maximum, or $110, if the stock drops below $30.

 

How to close a losing trade
It is worth looking at an example to see how you might close a losing trade like this. The short put might rise from $3.50 to $4.80, while the long put could rise from $2.60 to $3.20. Before expiration, you could close both legs. You would place an order to buy to close the short put for $480, and sell to close the long put for $320.

In this example, you must pay $160 to exit the position ($480 – $320), but you previously received a credit of $90. As a result, your total loss is a more manageable $70.

If you wait until expiration, you could lose the entire $110. Depending on your risk tolerance and objectives for the trade, you might choose to close both legs of a losing spread before expiration, especially when you no longer believe the stock will perform as anticipated.

Options traders should always be aware of early assignment, as well. There’s a chance you’ll be assigned early (before expiration) on the short put. Actively monitor your option positions and learn to manage risk.

 

Investing implications
Options trading strategies have unique risks and rewards. They offer more ways to take advantage of a given forecast. A bull put spread is a great example of the many option strategies that investors have at their disposal.

 

BULL CALL SPREAD

Options strategy: the bull call spread

A strategy designed to take advantage of price gains while potentially limiting risk.

Options traders looking to take advantage of a rising stock price while managing risk may want to consider a spread strategy: the bull call spread. This strategy involves buying one call option while simultaneously selling another. Let’s take a closer look.

Understanding the bull call spread: Although more complex than simply buying a call, the bull call spread can help minimize risk while setting specific price targets to meet your forecast.

Here’s how it works. 
First, you need a forecast. Say XYZ is trading at $60 per share. You are moderately bullish and believe the stock will rise to $65 over the next 30 days.

A bull call spread involves buying a lower strike call and selling a higher strike call:

Buy a lower strike call at $60. This gives you the right to buy stock at the strike price.

Then:

Sell a higher strike call at $65. This obligates you to sell the stock at the stock at the strike price.

Because you are buying one call option and selling another, you are “hedging” your position. You have the potential to make a profit as the share price rises, but you are giving up some profit potential—but also reducing your risk—by selling a call. Selling a call reduces the initial capital involved. The trade-off is you have to give up some upside potential. One advantage of the bull call spread is that you know your maximum profit and loss in advance.

How this strategy works Before you construct a bull call spread, it’s essential to understand how it works. Normally, you will use the bull call spread if you are moderately bullish on a stock or index. Your hope is that the underlying stock rises higher than your breakeven cost. Ideally, it would rise high enough so that both options in the spread are in the money at expiration; that is, the stock is above the strike price of both calls. When the stock rises above both strike prices you will realize the maximum profit potential of the spread.

As with any trading strategy it is extremely important to have a forecast. In reality, it is unlikely you will always achieve the maximum reward. Like any options strategy, it’s important to be flexible when things don’t always go as planned.

 

Before you initiate the trade: what to look for
Before you initiate a bull call spread, it’s important to have an idea of your criteria.

Underlying stock: First, you want to choose an underlying stock you believe will go up.

Expiration date: Choose an options expiration date that matches your expectation for the stock price.

Strike price: Choose offsetting strike prices that match your forecast For example, the stock is at $40. You believe it will rise to $45.

Volatility: Many traders will initiate the bull call spread when volatility is relatively high, which may reduce the cost of the spread.

Note: These are general guidelines and not absolute rules. Eventually, you will create your own guidelines.

 

Your first bull call trade
Before placing a spread, you must fill out an options agreement and be approved for spreads trading.

Now that you have a basic idea of how this strategy works, let’s look at more specific examples.

In June, you believe that XYZ, which is currently at $34 per share, will rise over the next three to four months to $40 per share or higher. You decide to initiate a bull call spread.

Options contracts: You buy 1 XYZ October 35 call (long call) at $3.40, paying $340 ($3.40 x 100 shares). At the same time, sell 1 XYZ October 40 call (short call) at $1.40, receiving $140 ($1.40 x 100 shares). Note: In this example, the strike prices of both the short call and long call are out of the money.

Cost: Your total cost, or debit, for this trade is $200 ($340 – $140) plus commissions.

Maximum gain: The maximum you can gain on this trade is $300. To determine your maximum reward, subtract the net debit ($3.40 – $1.40=$2 x 100 shares) from the difference in strike prices ($40 – $35=$5 x 100 shares). In this example, the maximum possible gain is $300 ($500 – $200).

Maximum risk: The most you can lose on this trade is the initial debt paid, or $200.

Note: a bull call spread can be executed as a single trade. This is known as a multi-leg order.

Let’s take a look at what could go right, or wrong, with this strategy:

Example One: The underlying stock, XYZ, rises above the $35 strike price before the expiration date.

If the underlying stock rises above $35 before expiration, both legs of the spread (each side of the spread, the buy side and sell side, is called a leg) will rise in value, which is what you want. For example, the long call may rise from $3.40 to $5.10, while the short call may rise from $1.40 to $1.90. Note: Near expiration, as the long call option goes further in the money, the spread between the two call options widens, but it will not surpass the $5 maximum value.

 

How to close a winning trade
Before expiration, you close both legs of trade. In the above example, if you enter a limit order, you will buy back (buy to close) the short call for $190, and sell (sell to close) the long call for $510. That gives you a net sale of $320. You originally paid $200, leaving you with a net profit of $120. Important: remember that you can close both legs of the strategies as a multi-leg order.

Although some traders try to achieve maximum profit through assignment and exercise, if your profit target has been reached it may be best to close the bull call spread prior to expiration.

Example Two: The underlying stock, XYZ, drops below the $35 strike price before or near the expiration date.

If the underlying stock remains below $35 before expiration, both legs of the spread will drop in value due to time decay, which is not what you’d hoped to see. For example, the long call may fall from $3.40 to $1.55, while the short call may drop from $1.40 to $1.05.

To avoid complications, close both legs of a losing spread before expiration, especially when you no longer believe the stock will perform as anticipated. If you wait until expiration, you could lose the entire $200 investment.

 

How to close a losing trade
Before expiration, close both legs of the trade. Then you will buy back (buy to close) the short call for $105, and sell (sell to close) the long call for $155. In this example, your loss is $150: ($155 – $105) – $200 (your initial payment).

 

Early assignment
Although it’s unlikely, there’s always a chance you’ll be assigned early (before expiration) on the short call. If this occurs, you may want to exercise the long call.

 

Other factors to consider
Trading spreads involves a number of unforeseen events that can dramatically influence your options trades. Make an effort to learn about time decay and implied volatility, and other factors that affect an options price. This will help you understand how they can affect your trade decisions. You should also understand how commissions affect your trade decisions.

 

BEAR PUT SPREAD

Bear Put Spread: Profit from a falling stock price, while potentially limiting risk.

When the stock market is falling, some speculators may want to profit from the drop. But for some situations, simply shorting a stock or buying a put may seem too risky. In that case, the options strategy called the “bear put spread” may fit the bill. To use this strategy, you buy one put option while simultaneously selling another, which can potentially give you profit, but with reduced risk and less capital. Let’s take a closer look.

 

Understanding the bear put spread
Although more complex than simply buying a put, the bear put spread can help to minimize risk. Why? Because you are hedging your position by buying one put option and selling another put option, which can reduce losses but can also limit your potential profits. And, this strategy involves less capital than simply buying a put.

There is something else you should know about the bear put spread: Because you are paying out money to initiate this strategy, it’s called a debit spread. Your goal is to sell the combined position at a price that exceeds the overall purchase price, and thus make a profit.

 

Put Basics
A put is a contract that gives the owner the right to sell shares of a stock at a set price—known as the strike price. So buyers of puts hope stock prices fall below the strike price, giving them the potential to profit.

One advantage of the bear put spread is that you know your maximum profit (or loss) in advance. In fact, the maximum risk for this trade is the initial cost of the spread. Therefore, you have defined your risk in advance.

 

The nuts and bolts
Normally, you will use the bear put spread if you are moderately bearish on a stock or index. Your goal is for the underlying stock to drop low enough so that both options in the spread are in the money (when expiration arrives), that is, the stock is below the strike price of both puts. You want the stock to fall far enough to earn more than the cost of the spread. Here is one example of how it works:

Buy a put below the market price: You will make money (after commissions) if the market price of the stock falls below your breakeven price for the strategy.

Sell a put at an even lower price: You keep the proceeds of the sale—offsetting some of the cost of the put and taking some risk off the table. You also give up any profits beyond the lower strike price.

The best-case scenario: The stock price falls as you anticipated and both puts are in the money at expiration.

 

Before you initiate the trade—what to look for:
Before you initiate a bear put spread, it’s important to have an idea of your criteria. Here are some general guidelines.

Underlying stock: First, you need to choose an underlying stock that you feel is likely to fall in price.

Expiration date: Choose an options expiration date that matches your expectation for the stock price to fall.

Strike price: Next, you must decide which strike prices to choose.. For example, you may choose to buy the 45 put and sell the 40, or buy the 60 put and sell the 50. The larger the spread, the greater the profit potential, but the difference in premiums might leave you with more risk.

Volatility: Many traders prefer to initiate the bear put spread to help offset volatility or the cost of an option. Volatility is an important factor that will affect options price.

 

Your first bear put trade
Now that you have a basic idea of how this strategy works, let’s look at more specific examples of this strategy.

Note: Before placing a spread, you must fill out an options agreement and be approved for Level 3 options trading.

In June, you believe that XYZ, which is currently at $31 per share, will fall below $30 per share over the next two or three months. You decide to initiate a bear put spread.

You buy 1 XYZ October 30 put (long put) for $3.80 per share, paying out $380 ($3.80 x 100). At the same time, you sell 1 XYZ October 25 put (short put) for $1.60 per share, receiving $160 ($1.60 x 100). Note: In this example, the strike prices of both the short put and long put are out of the money.

Cost: Your total cost, or debit, for this trade is $220 ($380 – $160), plus commissions. To initiate this trade you can place them as one trade by using the multi-leg option ticket.

Maximum possible gain: The most you can gain from this trade is $280. To determine your maximum reward, subtract the net debit ($2.20 x 100) from the difference in strike prices ($5 x 100). In this example, it will be $280 ($500 – $220).

Maximum risk: The most you can lose on this trade is the initial debt paid, or $220.

Let’s take a look at what could go right (or wrong) with this strategy:

Example One: The underlying stock, XYZ, falls below the 30 strike price before the expiration date.

If the underlying stock falls below $30 before expiration, both legs of the spread (each side of the spread, the buy side and sell side, is called a leg) will rise in value.

For example, the long put may rise from $3.80 to $5.70, while the short put may rise from $1.60 to $2.10. Note: Near expiration, as the long put option goes further in the money, the spread between the two put options widens, but it never surpasses that $5 maximum value.

 

How to close a winning trade
Before expiration, you can close both legs of the online trade with the click of one button. In the above example, if you enter a limit order, you buy back (buy to close) the short put for $210, and sell (sell to close) the long put for $570. Your profit is $140: Sale price of $360 ($570 –  $210) minus $220 (your original payment).

Although some traders try to achieve maximum profit through assignment and exercise, it may be risky—it could leave you exposed to a naked stock position. So it may be worth closing both legs of the spread before expiration once your profit goal is reached.

Example Two: The underlying stock, XYZ, remains above the 30 strike price before or near the expiration date.

If the underlying stock remains above $30 before expiration, both legs of the spread drop in value, which is not what you hoped to see. For example, the long put might fall from $3.80 to $2.10, while the short put may drop from $1.60 to $1.20.

To avoid complications, you may want to close both legs of a losing spread before the expiration date, especially if you no longer believe the stock will perform as anticipated. If you wait until expiration, you could lose the entire $220 investment.

 

How to close a losing trade
Before expiration, close both legs of the trade. You will buy back (buy to close) the short put for $120, and sell (sell to close) the long put for $210. In this example, your loss is $130: ($210 –  $120) –  $220 (your initial payment).

 

Early assignment
Although it’s unlikely, there’s always a chance you’ll be assigned early (before expiration) on the short put. If this occurs, you may want to exercise the long put.

 

Other factors to consider
Trading spreads can involve a number of unforeseen events that can dramatically influence your options trades. Make an effort to learn about time decay and implied volatility, and how they can affect your trade decisions.

Understanding Basic Options Strategies

UNDERSTANDING OPTION STRATEGIES

In my bestselling book, Understanding Options, I introduced a variety of option strategies. To help you understand these strategies in more depth, I wrote the following option articles for one of my corporate clients, which is also posted on their website.

Here are four basic options strategies:

PART ONE: BASIC STRATEGIES

  1. Covered Calls
  2. Buying Calls
  3. Collars
  4. Straddles

 

COVERED CALLS

Options strategy: How to sell covered calls
Income potential, while theoretically reducing the risk of simply owning a stock.

If you’re looking for an options strategy that provides the ability to produce income but may be less risky than simply buying stocks, you might want to consider selling covered calls. As long as you’re aware of the potential risks — including transaction costs and tax and wash sale implications — this basic strategy is designed to help generate income from stocks you already own, even within an IRA.

 

Understanding covered calls
As you may know, there are only two types of options: calls and puts.

Calls: The buyer of a call has the right to buy the underlying stock at a set price until the option contract expires.

Puts: The buyer of a put has the right to sell the underlying stock at a set price until the contract expires.

Although many option strategies have exotic-sounding names, every strategy is based on the buying and selling of calls and puts.

When you sell a covered call, also known as writing a call, it means that you already own shares of the underlying stock and you are selling someone the right, but not the obligation, to buy that stock at a set price until the option expires—the price won’t change no matter which way the market goes. If you didn’t own the stock, it would be known as a naked call—a much riskier proposition.

Why would you want to sell the rights to your stock? Because you receive cash, also known as the premium.

For some people, receiving extra income on stocks they already own sounds too good to be true, but like any options strategy, there are risks as well as benefits.

 

How this strategy works
Before you make your first trade, it’s essential that you understand how it works. For example, let’s say in February you already own 100 shares of XYZ, which is currently at $30 a share. You decide to sell (or write) one call, which covers 100 shares of stock. (If you owned 200 shares of XYZ, you could sell two calls.)

 

The strike price
You agreed to sell those 100 shares at an agreed-upon price, known as the strike price. When you look up the options quotes on your screen, you’ll see an assortment of strike prices. The strike price you choose determines how much premium you receive for selling the option. With covered calls, for a given stock, the higher the strike price is from the stock price, the less valuable the premium.

Therefore, a $32 strike price is more valuable than a $35 strike price. Why? Because it is more likely for XYZ to reach $32 than it is for it to reach $35, and therefore more likely that the buyer of the call will make money. Because of that, the premium is higher.

 

The expiration date
In addition to deciding on the most appropriate strike price, you also have a choice of an expiration date, which is the third Saturday of the expiration month. For example, let’s say in February you choose a March expiration date. On the third Friday in March, trading on the option ends and the following day it expires. Either your option is assigned and the stock is sold at the strike price or you keep the stock. Because some people don’t want to tie up their stock for too long, they may choose expiration dates that are only a month or two away. Hint: The further away the expiration date, the more valuable the premium because a longer time span gives the underlying stock more opportunity to reach the option’s strike price.

Note: It takes experience to find strike prices and expiration dates that work for you. As a new options investor, you may want to experiment with one options contract and different strike prices and expiration dates. Eventually you’ll find a combination that works for you.

 

Your first covered call trade
Now that you have a general idea of how this strategy works, let’s look at more specific examples.

Note: Before placing a trade, you must be approved for an options account.

In February, you own 100 shares of XYZ, which is currently at $30 a share.

You sell one covered call with a strike price of $33 and an expiration date of March. The bid price (the premium) for this option is $1.25.

If you were willing to pay the additional commissions and initiated this trade over the phone, you’d say, “I’d like to sell one covered call for XYZ March 33 for a limit price of $1.25 good for the day only.” Hint: It’s suggested you place a limit order, not a market order, so that you can specify the price.

If the call is sold at $1.25, the premium you receive is $125 (100 shares x $1.25) less commission.

Now that you sold your first covered call, you simply monitor the underlying stock until the March expiration date.

Let’s take a look at what could go right, or wrong, with this transaction.

Example one: The underlying stock, XYZ, is above the $33 strike price on the expiration date.

If the underlying stock rises above the strike price at expiration, even by a penny, the stock will most likely be “called away” from you. In options terminology, this means you are assigned an exercise notice. You are obligated to sell the stock at the strike price (at $33 in this example) at expiration. If you sell covered calls, you must expect and plan to have your stock sold. Fortunately, after it’s sold, you can always buy the stock back and sell covered calls on it the following month.

One of the criticisms of selling covered calls is there is limited gain. In other words, if XYZ suddenly zoomed to $37 a share at expiration, the stock would still be sold at $33 (the strike price). You would not participate in the gains past the strike price. If you are looking to make a big score, then selling covered calls may not be an ideal strategy.

Benefit: You keep the premium, stock gains, and dividends, but the stock will be sold at the strike price.

Risk: You lose out on potential gains past the strike price. In addition, your stock is tied up until the expiration date.

Hint: Choose from your existing underlying stocks that are slightly bullish and not too volatile.

Example two: The underlying stock is below the strike price on the expiration date.

If the underlying stock is below $33 a share (the strike price) at expiration, the option has a greater likelihood to expire unexercised and you keep the stock and the premium. You could also sell another covered call for a later month. Although some people hope their stock goes down so they can keep the stock and collect the premium, be careful what you wish for.

For example, if XYZ drops a lot, for example, from $30 to $25 a share, although the $125 premium you receive will reduce the pain, you still lost $500 on the underlying stock.

Benefit: The premium will reduce, but not eliminate, stock losses. 
Risk: You lose money on the underlying stock when it falls.

Advanced note: If you are worried that the underlying stock might fall, you can always initiate a collar, that is, you can buy a protective put on the covered call, allowing you to sell the stock at a set price, no matter how far the markets drop.

Example three: The underlying stock is near the strike price on the expiration date.

Some might say this is the most satisfactory result for a covered call. If the underlying stock is slightly below the strike price at expiration, you keep the premium and the stock. You can then sell a covered call for the following month, bringing in extra income. If, however, the stock rises above the strike price at expiration by even a penny, the option will most likely be called away.

Benefit: You keep the stock and premium, and can continue to sell calls on the same stock.

Risk: The stock falls, costing you money.

 

Advanced covered call strategies
Some people use the covered call strategy to sell stocks they no longer want. If successful, the stock is called away at the strike price and sold. You also keep the premium for selling the covered calls.

If you want to avoid having the stock assigned and losing your underlying stock position, you can usually buy back the option in a closing purchase transaction, perhaps at a loss, and take back control of your stock.

 

BUYING CALLS

Options strategy: how to buy calls
Buying calls can help to increase the returns, and risks, of your investments.

If you’re looking for a strategy that gives you the potential for larger returns without having to invest a lot of money up front, you may want to consider buying call options. When you buy calls, you profit if the market or an individual stock rises far enough within a certain period of time. If you are right, you can participate in the rise of the stock without actually having to buy it, and only pay a fraction of the cost that would be involved if you purchased actual shares of the stock.

To be profitable, you must be correct both about both the direction and timing of the stock price change. For example, if you believe that a stock will go up within the next month, you could consider buying a call option rather than buying the stock. Like any strategy, the goal is to be profitable while minimizing risk. Buying calls has the potential to help you achieve this goal.

 

Understanding call options
Before you buy your first call, it’s essential that you understand how they work. For example, let’s say XYZ stock is $30 a share in February. If you wanted to buy 100 shares, it would cost you $3,000. Instead, you could buy one call option, which gives the right to buy 100 shares of the stock at a set price, known as the strike price. The cost of the option contract is usually a fraction of investing in the actual stock. So, in this hypothetical example, instead of paying $3,000 to own the stock, you might pay $300.

Say you are trying to decide between buying a call or the stock itself in the above example—100 shares would cost $3,000, and the option contract would cost $300. If the stock price goes from $30 to $35 by the options expiration, the shares of the stock would rise in value from $3,000 to $3,500, and you would make 17%, or $500, for this time period. As the stock price rises, the value of the option at expiration would rise from $300 to $500, a $200 gain, or a 67% return for the period that you held the option. But what if the stock price falls to $28? At expiration the option would expire worthless and you will lose 100% of your investment. Every options contract has a few key criteria that option traders must be aware of:

Strike price. When you buy a call, you have an opinion about the direction of the stock. Let’s say you believe that XYZ will rise from $28 to $32 a share within one month. Options contracts let you choose the best way to take advantage of your forecast by choosing the best strike price. The strike price is the price at which you can buy the underlying stock for call options. For example, the option may have strike prices of $30, $35, and $40. Every investor needs to review the available strike prices, and find one that matches their investment forecast. For instance, if you think the price of the underlying stock will reach $32, you may want to look at a $30 strike price.

Expiration date. When you buy calls, time is not on your side. In fact, as soon as you buy a call, the clock is ticking. All options contracts have an expiration date. The standard expiration date is the Saturday following the third Friday of the month. It is important that you choose the expiration date that is going to let your forecast be realized.

Commissions. As they do with most investments, brokerages charge commissions when you buy or sell options contracts. Those commissions—which aren’t reflected in the examples used in this article—can reduce your returns.

 

Buying your first call option
Now that you have a general idea of how this strategy works, let’s take a look at more specific examples.

Note: Before placing a trade, you must be approved to trade options in your account.

In February, you decide to buy one call option (equal to 100 shares) of XYZ, which is currently at $30 a share.

You choose an XYZ April 30 call option currently trading at $1.50.

If you initiated this trade over the phone, you’d say, “I’d like to buy (or go long) one XYZ April 30 call for a limit price of $1.50 good for the day only.” You may want to consider placing a limit order, not a market order, so that you can specify the price you are willing to pay.

If the call is bought at the limit price of $1.50, you will pay a total of $150 (100 shares x $1.50), plus commission.

Now that you bought your first call, you have to closely monitor the underlying stock until the April expiration date. Since time is not on your side, there are a number of choices you have to make.

 

How a trade may play out
Let’s take a look at what could go right, or wrong, with this transaction.

Example One: The underlying stock, XYZ, rises from $30 to $35 on the expiration date.

You expect and want the underlying stock to rise above the strike price. The higher the stock goes, the more valuable the call option. At any time before the expiration date, you can close your position and take the profits. Many option traders will lock in gains based on their profit forecast, because the price of the stock could fall.

In this example, as XYZ rose to $35, the call option at expiration was worth $5 ($35 – $30). You decide to sell the call to close. You are left with a $350 profit ($5.00 gain – $1.50 premium = $3.50 net gain x 100 shares), less commissions.

Benefit: In this example, the call option had a larger return (by percentage) than the underlying stock, while requiring less capital to make the investment.

Risk: The stock could fall and you lose some if not all of the premium paid.

Caution: Although buying calls may look attractive when compared with buying stock, in real life there are many things to consider before making your investment.

Example Two: The underlying stock, XYZ, drops below $30 at or before expiration.

If the underlying stock falls below your strike price at expiration, the option will be worthless. In fact, as the stock gets closer to the expiration date, the option can deteriorate quickly because of lost time value.

In this example, the underlying stock fell to $28 a share a few weeks later, causing a partial loss. You sold the call for $0.60 as your exit strategy ($150 investment – $60 sales price = $90 loss).

Risk: You could lose all or part of your $150 investment.

Example Three: The underlying stock, XYZ, is near the $30 strike price at or before expiration.

This scenario is similar to Example Two. Because of diminishing time value, the option may expire worthless. Therefore, in this example, you could lose your entire investment of $150. You always have the choice of selling the option before the expiration date and closing the position to minimize losses.

Risk: You could lose all or part of your $150 investment.

 

Exercising call options
In the first example, when the underlying stock rose above the strike price (the option is “in-the-money”), you can sell the call and take the profit. You also have another choice, and that is to exercise the option. In this example, you can convert the single call option into 100 shares of stock by paying the strike price. You might be interested in converting shares into stock if you think the stock will continue to rise, and are comfortable owning the stock in your portfolio.

Important: Although you have the right to exercise, many option traders simply buy and sell the option without exercising. By selling the option, the trader does not have to assume the risk and cost of owning the underlying stock.

 

Options and stocks don’t always move together
Although buying calls is usually a straightforward strategy, there is some nuance. For example, some people are confused when, on occasion, the stock goes up but the option doesn’t follow. “Sometimes a stock could rise in value but an ‘out-of-the-money’ call could drop,” says Joe Harwood, manager of the Options Industry Council (OIC) help desk. The solution is to take the time to learn how options are priced. “Many people think that options are pegged to the stock price, but they are not. Options are a derivative of stocks, but they are not pegged.” This means that prices fluctuate based on the options market and other forces, not purely on the price of the stock.

 

Bottom line
Buying calls can offer an alternative strategy to buying stock, for investors looking to increase the size of returns relative to the amount of money they choose to invest.

 

COLLARS

Put a collar on this market
Here’s a sophisticated options strategy designed to limit losses and protect gains.

The S&P 500® Index has gained 9% so far in 2012. That’s a huge gain over a very short period of time. You may have stocks that have generated strong returns in the rally, and such a big move might raise red flags for a potential correction. If you’re looking to protect gains on current stock positions, or you are moderately bullish on a particular asset but could be concerned about a potential downturn, consider the collar options strategy.

 

Getting to know collars
A collar is a relatively complex options strategy that puts a cap on both gains and losses (see graphic below). There are three components to constructing a collar:

Purchasing or having an existing stock position (e.g., owning shares of XYZ Company)

Selling a call (the seller of a call has an obligation to sell the stock at the strike price until expiration or until he or she closes the short call position)

Buying a put (the buyer of a put has the right to sell the stock at the strike price until the expiration or until he or she closes the long put position)

This strategy can help mitigate downside risk via the purchase of a put, and some or all of the cost for the purchased put may be covered by selling a covered call on a new or existing stock position.

The premium, or cost of the position, that you pay for the collar is similar to paying an insurance premium. The put could expire worthless if the underlying stock stays the same or rises, but may become more valuable if the underlying stock falls. This allows you to protect the value of the investment by limiting losses in the event of a decline. You are also selling a covered call (to cover some or all of the cost of the put), and become obligated to sell the underlying stock if it rises above your call strike at expiration or is assigned.

You might be asking yourself: Why buy protection for a stock you think might go down in value? Why not just sell the stock? One reason is that there might be significant tax consequences or transaction costs. You may prefer to maintain your position in a stock rather than selling it. However, sometimes selling the stock may be the right answer if you no longer are bullish on the stock.

 

Let’s take a closer look at collars
Now that you have a basic idea of how this strategy works, looking at a specific example will help you. Please note that before placing a collar, you must fill out an options agreement and be approved for the appropriate options trading level.

In our example, we will look at a hypothetical scenario for XYZ Company.

  1. In January, assume you decide to buy 100 shares of XYZ Company for $53 a share.
  2. Four months later, with the stock trading at close to $53, you become concerned about a potential stock market decline but do not want to sell the shares, so you decide to construct a collar. To do this, you buy a September 52 put selling at $2.45 per contract. Each options contract typically covers 100 shares, so you pay $245 ($2.45 per contract x 100 shares x 1 contract). This out-of-the-money put acts as an insurance policy, effectively protecting your XYZ shares in case of decline below $52.
  3. At the same time, you sell a call on XYZ at the September 55 strike price that costs $2.30 per contract. Each options contract typically covers 100 shares, so you receive $230 ($2.30 x 100 x 1 contract) in premium for this one contract. The primary purpose of selling this call is to cover some of the cost of buying the put.

You now have a collar on your XYZ shares. The net cost of options needed to create the collar is $15 ($245 – $230). The maximum gain on the position is now $185, which is equal to the call strike price ($55) less the purchase price of the underlying shares ($53), multiplied by 100, less the net cost of the collar ($15). The maximum loss is now $115, which is equal to the purchase price of the underlying shares ($53) less the put strike price ($52), multiplied by 100, plus the net cost of the collar ($15).

Breakeven, or the price at which the underlying asset must settle for the costs of the trade to equal profit, is equal to $53.15. This is calculated as the purchase price of the underlying shares ($53) plus the net cost of the collar per 100 shares ($0.15).

 

Managing the collar trade
Assume that the share price of XYZ rises to $57 on the expiration date. In all likelihood, the holder of the call option that you sold will exercise the call, so you are forced to sell the stock at the $55 strike price. On the other hand, the put would expire worthless because it is out of the money. Although you incurred a net debit of $15 to construct the collar, you made a two-point gain, or $200, on the underlying stock (bought at $53 and sold at the $55 strike price). In this example, the put acts as unused insurance protection.

Now suppose the share price of XYZ falls to $49 on the expiration date. The most obvious impact here is that the value of your stock position falls $400 ($53 to $49 price decline, multiplied by 100 shares you own). However, because XYZ is below $55 at expiration, the call you sold will expire worthless and you will keep the $230 premium received from the covered call. This offsets some of the loss you have experienced on the stock.

Also, while the covered call expires worthless, the put you bought rises in value. In this example the put premium price has risen from $2.45 to $3.00, so you realize a gain of $55 ($300 – $245). As the stock price falls, the put increases in value.

You still have a loss of $115 ($55 put option + $230 call option – $400 loss on the stock). This highlights how the collar provides protection in a down market.

Finally, let’s assume that XYZ rises to $54 on the expiration date. If XYZ moves between the strike price of the covered call ($55) and the strike price of the put ($52) at expiration, no action needs to be taken, as both options will expire worthless. In this event, you lose the $15 difference between the cost of the put and the money you took in for selling the call.

 

STRADDLES

Straddling the market for opportunities
Here’s an options strategy designed to profit when you expect a big move.

Stocks have been broadly advancing at a steady pace since mid-December of last year. But in the event that the rally slows or market volatility returns, what will you do? Well, when you aren’t sure which direction a stock is going to go but you are expecting a big move, you may want to consider an options strategy known as the straddle.

 

Getting to know straddles
You can buy or sell straddles. In a long straddle, you buy both a call and a put option for the same underlying stock, with the same strike price and expiration date. If the underlying stock moves a lot in either direction before the expiration date, you can make a profit. However, if the stock is flat (trades in a very tight range), you may lose all or part of your initial investment.

Here are a few key concepts to know about straddles:

They offer unlimited profit potential but with limited risk of loss.

The more volatile the stock or index (the larger the expected price swing), the greater the probability the stock will make a strong move.

Higher volatility may also increase the total cost of a long straddle position.

In comparison to other options strategies, the upfront cost of a straddle may be slightly higher because you are buying multiple options and volatility is typically higher.

The concept behind the long straddle is relatively straightforward. If the underlying stock goes up, then the value of the call option increases while the value of the put option decreases. Conversely, if the underlying stock goes down, the put option increases and the call option decreases. While it is possible to lose on both legs (or, more rarely, make money on both legs), the goal is to produce enough profit from the option that increases in value so it covers the cost of buying both options and leaves you with a net gain.

 

What to look for before making a trade
Our focus is the long straddle because it is a strategy designed to profit when volatility is high while limiting potential exposure to losses, but it is worth mentioning the short straddle. This position involves selling a call and put option, with the same strike price and expiration date. This nondirectional strategy would be used when there is the expectation that the market will not move much at all (i.e., there will be low volatility). With the short straddle, you are taking in upfront income (the premium received from selling the options) but are exposed to potentially unlimited losses and higher margin requirements.

 

Let’s dive into straddles
With a basic understanding of how this strategy works, let’s look at specific examples. Please note that before placing a straddle, you must fill out an options agreement and be approved for options trading.

In our example, we will look at a hypothetical scenario for XYZ Company.

In August, you forecast that XYZ, then trading at $40.75 a share, will either rise or fall sharply based on an earnings report that is set to be released in a week. Due to this expectation, you believe that a straddle would be an ideal strategy to profit from the forecasted volatility.

To construct a straddle, you buy 1 XYZ October 40 call for $2.25, paying $225 ($2.25 x 100). We multiply by 100 here because each options contract typically represents 100 shares of the underlying stock. At the same time, you buy 1 XYZ October 40 put for $1.50, paying $150 ($1.50 x 100). Note that in this example, the call and put options are at or near the money. Your total cost, or debit, for this trade is $375 ($225 + $150), plus commissions.

The maximum possible gain is theoretically unlimited because the call option has no ceiling (the underlying stock could rise indefinitely). The maximum risk, or the most you can lose on this trade, is the initial debit paid, which is $375, plus commissions. This would occur if the underlying stock closes at $40 at the expiration date of the options.

Let’s make use of breakeven here. In this example, the cost of the straddle (in terms of the total price for each contract) is $3.75 ($2.25 + $1.50). Breakeven in the event that the stock rises is $43.75 ($40 + $3.75), while breakeven if the stock falls is $36.25 ($40 – $3.75). With this information, you know that XYZ must close above $43.75 or below $36.25 at expiration to be profitable.

 

Managing a winning trade when things go right
Assume XYZ releases a very positive earnings report. As a result, XYZ rises to $46.30 a share before the expiration date. Because XYZ rose above the $43.75 breakeven price, our September 40 call option is profitable and might be worth $6.40. Conversely, our September 40 put option has almost no value; let’s say it is worth $0.05.

Before expiration, you might choose to close both legs of the trade. In the above example, you could simultaneously sell to close the call for $6.40, and sell to close the put for $0.05, for a gain of $645 ($6.40 + $0.05). Your total profit would be $270 (the gain of $645 less your initial investment of $375), minus any commission costs.

Now, consider a scenario where instead of a positive earnings report, XYZ’s quarterly profits plunged and the stock falls to $33 before expiration.

Because XYZ fell below the $36.25 breakeven price, the September 40 put option might be worth $7.25. Conversely, the September 40 call option is worth just $0.15.

Before expiration, you might choose to close both legs of the trade by simultaneously selling to close the put for $725 ($7.25 x 100) as well as the call for $15 ($0.15 x 100). The gain on the trade is $740 ($725 + $15), and the total profit is $365 (the $740 gain less the $375 cost to enter the trade), minus commissions.

 

Managing a losing trade
The risk of the long straddle is that the underlying asset doesn’t move at all. Assume XYZ rises to $41 before the expiration date. Although the underlying stock went up, it did not rise above the $43.75 breakeven price. More than likely, both options will have deteriorated in value. You can either sell to close both the call and put for a loss, or you can wait longer and hope for a sudden turnaround.

Let’s assume that with just a week left until expiration, the XYZ October 40 call is worth $1.35, and the XYZ October 40 put is worth $0.35. Since XYZ didn’t perform as expected, you might decide to cut your losses and close both legs of the option for $170 ([$1.35 + $0.35] x 100). Your loss for this trade would be $205 (the $170 gain, minus the $375 cost of entering into the straddle), plus commissions.

The risk of waiting until expiration is the possibility of losing your entire initial $375 investment. Both options could expire worthless if the stock finishes at $40. This is called pinning: the stock finishes at the stock price.

 

Other considerations
Timing is an important factor in deciding when to close a trade. There are cases when it can be preferential to close a trade early, most notably “time decay.” Time decay is the rate of change in the value of an option as time to expiration decreases and, because of that and other reasons, traders might choose not to hold straddles to expiration. Instead, they might take their profits (or losses) in advance of expiration.

In addition to time decay, there are other factors that can influence options used in the straddle trade. Learn about the factors that influence options used in the straddle trade and keep the straddle in your trading arsenal in case high volatility makes a comeback.

Pros and Cons of Currency Trading

Here’s an article I wrote for Bankrate on the pros and cons of currency trading:

If you’ve been thinking of ways to trade the falling euro (EUR), or any other currency, you might consider the foreign exchange market. Forex, which is open 24 hours a day and five days a week, is the world’s most traded financial market and also the most liquid. This means you can quickly get into and out of a trade.You also have a choice between trading in the currency futures market, which is a physical exchange, or the forex “spot” market, where you trade over the counter with a broker. Many beginners trade in the spot market because you need so little upfront money. So if you’re certain that betting on a certain currency is a sure thing, see what’s involved.

The basics

Currencies are always traded in pairs. In other words, you buy one currency and sell the other. For example, you could sell the euro against the dollar (EUR/USD). In this case, you short the euro (you believe the euro will go down) but long the dollar (you believe the dollar will go up). Conversely, you could buy, or go long, the euro and short the dollar. Because there are 28 major pairs with eight major currencies, you have many choices.

If you’re a beginner, stick with the major currencies you know. “It’s recommended you start off with a liquid pair, like the euro or dollar,” says Tim Bourquin, co-founder of TraderInterviews.com and co-founder of Traders Expo and Forex Trading Expo. “Don’t start trading the Indian rupee versus the Iraq dinar, which has no liquidity and little information.”

Currencies move up and down by percentage in points, or pip, which is one-hundredth of 1 percentage point. When trading a dollar-based currency, one pip equals $10. Don’t get fooled by the small increments. Because of leverage, you can theoretically make or lose $3,000 or more in a day, depending on the size of your account.

The benefits

One of the benefits of trading currencies is the high leverage. Unlike in the stock market, where you can buy securities on margin with 2-to-1 leverage, in the currency market, you’re allowed 50-to-1 leverage. Therefore, for every $1 you invest, you control $50 worth of currency. That’s good, right?

“The high leverage can work for you or against you,” says Michael Archer, author of “Getting Started in Currency Trading: Winning in Today’s Hottest Marketplace.”

Archer says it’s not unusual for new traders to plunk down $500 (and control $25,000 in currencies), and then lose it all. Why? Because they don’t understand how leverage works. “Just because you have 50-to-1 leverage doesn’t mean you have to use it,” Archer cautions. Although it is possible to lose more than your initial investment, most online brokers close your position before that happens, Archer says.

What are the other benefits of trading currencies? John Jagerson, co-author of “All About Forex Trading,” says that currency trading “can be an extremely low-cost, efficient way for talented, short-term investors to make profits. It’s a fast market with super-tight spreads with no commissions.” In fact, most forex brokers don’t charge commissions, but they make profits off of the spreads between currencies.

The risks

One of the risks of forex is that it’s not transparent. “Currency traders are literally trading against the pros, who have control over where and when the order gets filled,” says Jagerson. “Nine times out of 10 it won’t matter, but there is a conflict of interest.”

The solution, Jagerson says, is to stick with big-name U.S. brokers, which are under stricter regulatory control. The ones you should avoid, he says, are brokers who operate in relatively unregulated territories such as Russia or Cyprus. “These brokers might pop up and then disappear with all of your money,” he warns.

Bourquin agrees. “If you stick with the big-spot forex traders like GFT, Forex.com and FXCM, they have enough volume so they don’t need to mess with the client’s pricing to make money.” In addition, Bourquin says, the National Futures Association, or NFA, started cracking down on rogue brokers, which forced a few to leave the country.

Another problem, Jagerson says, is that people don’t appreciate the risks of currency trading. “I tell aspiring traders to paper trade as long as possible in adverse market conditions,” he says. Paper trading enables novices to mimic the trading process without actually laying out any cash.

The most common reason for failure, Jagerson says, is people trade too large and too inconsistently. “Their analysis is often good, but their money management is so bad it sabotages them.”

Often, the biggest problem is with the trader. “Many people who enter the currency market have crazy expectations, such as making 5 percent to 10 percent a month or more,” says Jagerson. “I don’t know where they get those ideas.”

Trading currencies is more complex than many people realize. “Some firms have entire departments with professionals that have been trading currencies for 30 years,” says Bourquin. “It’s not just earnings or how many widgets XYZ is selling. Currencies involve complicated issues about interest rates and debt in Europe and Greece. People need to study that.”

Getting started

Before you start trading currencies, experts suggest you get an education, although with some caveats. “You have to be careful where you get your education,” says Bourquin. “The Internet is filled with get-rich programs. There’s no reason to pay $10,000 for a forex training program when most brokers offer the basics on their websites for free.”

Trading currencies is similar to trading stocks in one way: money management. “My suggestion is to start small and go slow,” says Archer. “Take six months to a year before you put real money on the line. Find a fairly simple trading technique, and develop trading rules that work for you.”

And learn to sit on your hands instead of constantly trading, he adds. “Wait for the right opportunity.”

3 mistakes that can harm your portfolio

MIAMI (MarketWatch) — Of all the mistakes I’ve made in the stock market, these three stood out.

1. Assuming you’re right

Of course everyone wants to be right. But the blind belief that you’re right about a stock can cost you money. I’ve been reading the best-selling book “The Big Short,” which profiles a handful of traders who were short subprime mortgages through credit-default swaps.

In 2007, certain bond traders concluded the mortgage market was on the verge of collapse. Before they placed their bets, two of these traders purposely searched for anyone with an opposing view. That’s right: They wanted to hear conflicting views before placing their trades. They were surprised that no one else in the industry seemed to detect the looming disaster. When the traders realized the counterargument was weak, they invested millions on short positions, betting against most of the large Wall Street bond firms.

I’ve always said that you should talk to short sellers if you want to hear the truth. Surrounding yourself with cheerleaders may feel good, but it won’t help you to detect potential land mines. No matter what your business, take the time to listen to other opinions.

Another strategy: Some traders enter a new trade assuming they are wrong. They enter the market as a pessimist, and let the facts guide them to the truth.

2. Not doing your research

To paraphrase Peter Lynch, people will spend two weeks researching a $500 refrigerator, but spend thousands on a stock without a second thought. Years ago, I invested $20,000 in a small cell-phone company based on a tip from an acquaintance. Within three months, I lost nearly $15,000. At the very least, I could have glanced at a chart or done basic fundamental analysis. For $300, I could have flown to the company’s headquarters. As it turned out, I blindly bought the pump-and-dump stock and paid the price.

Do you walk into a car dealership and pay list price? Hopefully not. Don’t expect guidance from the salespeople, who will gladly sell you a car for the highest price. When you’ve done your research, tips, hype or emotion won’t sway you.

Another lesson: Be wary of sources with ulterior motives. In “The Big Short,” the traders assumed that many bond salesmen were lying about subprime mortgages. To find out the truth, the traders spent hours reading mind-numbing contracts. They were surprised that few salespeople even knew what was in the contracts. The so-called experts were as clueless as the public.

3. Following the crowd

I’ve always been fascinated by crowd behavior. In 2006, when people were day-trading houses, few recognized they were on the edge of a cliff. The crowd was in a buying frenzy, and the stock market climbed along with housing.

If you look around and see everyone making the same trade as you, be cautious. Often the crowd is right, but only for a while. When people are making a lot of money, it’s easy to miss the warning signs.

Recently, the “crowd” has been in an ornery mood. Many experts are making wild doom-and-gloom predictions based on opinion and conjecture.

Before you sell all your stocks and hide in a cave, read what author and billionaire Ken Fisher told me for my book, “All About Market Indicators”: “When people approach me with predictions, I ask, ‘Has this happened a lot in history? What do you base that on?’ And if it never happened before in history, they are making a very strong statement. And if it has never happened before, you’d better have some powerful evidence to make me believe this event will happen. People tell me things all the time that are so improbable because they have happened so rarely in history. People who bet on the black swan will get their neck chipped.”

To avoid losing money, follow the three lessons above: Do your own research (and find evidence to support or disprove your view), don’t follow the crowd and listen to people with opposing views.

Michael Sincere is the author of Start Day Trading Now (Adams Media, 2011), All About Market Indicators (McGraw-Hill, 2010), and Understanding Stocks (McGraw-Hill, 2003).

3 Mistakes That Can Ruin Your Portfolio

MIAMI (MarketWatch) — Of all the mistakes I’ve made in the stock market, these three stood out.

1. Assuming you’re right

Of course everyone wants to be right. But the blind belief that you’re right about a stock can cost you money. I’ve been reading the best-selling book “The Big Short,” which profiles a handful of traders who were short subprime mortgages through credit-default swaps.

In 2007, certain bond traders concluded the mortgage market was on the verge of collapse. Before they placed their bets, two of these traders purposely searched for anyone with an opposing view. That’s right: They wanted to hear conflicting views before placing their trades. They were surprised that no one else in the industry seemed to detect the looming disaster. When the traders realized the counterargument was weak, they invested millions on short positions, betting against most of the large Wall Street bond firms.

I’ve always said that you should talk to short sellers if you want to hear the truth. Surrounding yourself with cheerleaders may feel good, but it won’t help you to detect potential land mines. No matter what your business, take the time to listen to other opinions.

Another strategy: Some traders enter a new trade assuming they are wrong. They enter the market as a pessimist, and let the facts guide them to the truth.

2. Not doing your research

To paraphrase Peter Lynch, people will spend two weeks researching a $500 refrigerator, but spend thousands on a stock without a second thought. Years ago, I invested $20,000 in a small cell-phone company based on a tip from an acquaintance. Within three months, I lost nearly $15,000. At the very least, I could have glanced at a chart or done basic fundamental analysis. For $300, I could have flown to the company’s headquarters. As it turned out, I blindly bought the pump-and-dump stock and paid the price.

Do you walk into a car dealership and pay list price? Hopefully not. Don’t expect guidance from the salespeople, who will gladly sell you a car for the highest price. When you’ve done your research, tips, hype or emotion won’t sway you.

Another lesson: Be wary of sources with ulterior motives. In “The Big Short,” the traders assumed that many bond salesmen were lying about subprime mortgages. To find out the truth, the traders spent hours reading mind-numbing contracts. They were surprised that few salespeople even knew what was in the contracts. The so-called experts were as clueless as the public.

3. Following the crowd

I’ve always been fascinated by crowd behavior. In 2006, when people were day-trading houses, few recognized they were on the edge of a cliff. The crowd was in a buying frenzy, and the stock market climbed along with housing.

If you look around and see everyone making the same trade as you, be cautious. Often the crowd is right, but only for a while. When people are making a lot of money, it’s easy to miss the warning signs.

Recently, the “crowd” has been in an ornery mood. Many experts are making wild doom-and-gloom predictions based on opinion and conjecture.

Before you sell all your stocks and hide in a cave, read what author and billionaire Ken Fisher told me for my book, “All About Market Indicators”: “When people approach me with predictions, I ask, ‘Has this happened a lot in history? What do you base that on?’ And if it never happened before in history, they are making a very strong statement. And if it has never happened before, you’d better have some powerful evidence to make me believe this event will happen. People tell me things all the time that are so improbable because they have happened so rarely in history. People who bet on the black swan will get their neck chipped.”

To avoid losing money, follow the three lessons above: Do your own research (and find evidence to support or disprove your view), don’t follow the crowd and listen to people with opposing views.

Michael Sincere ( www.michaelsincere.com ) is the author of “Understanding Options,” “Understanding Stocks” and “Start Day Trading Now.”