Boot Camp #3 The Option Pit Method Stock and Options

Boot Camp #3

The Option Pit Method

Stock and Options

Outline• Why options exist• Basic Option Terminology and P&L• Calls, Puts, Stocks and their relationships • Putting options together• Create the synthetic relationships through risk

and P/L charts• Use of Options and Stock together for directional

trading• Use of options to replace stocks• The Wheel

The Option

• If I were to describe options in 1 word, what word would I use?– Insurance

• Calls insure against the loss of dollars in a long position

• Puts insure against the loss of dollars in a short position

Long Stock vs Call

Short Stock vs Puts

Stocks, Calls, And Puts

• One thing that is important about options is that they can be used to recreate the underlying

• Additionally, with the use of the underlying calls or puts can convert to one and other

• Here is how

Relating an option to the Stock• Why combine calls and puts together with stock?

Simple Put/Call Parity

Call – Put = Stock – Strike + Carrying cost or

C – P = S – X + (I –D)

• This Formula is like the duct tape: it holds the whole option world together

Making a Long Call

• How do you make a synthetic call?– For a long call, add together 1 long put and long

100 shares of stock. – C-P = S - X => C= P + S -X• Price it in the market:

– OPT is trading $21– The OPT Nov 20 put is trading for $1

Adding Risk Graphs Together

The risk on the downside is fixed leaving the long stock and long put on the upside.

Making a Short Call

• How do you make a synthetic short call?– For a short call, add together 1 short put and short

100 shares of stock. – C - P = S - X => -C = -P - S + X• Price it in the market:

– OPT is trading $21– The OPT Nov 20 put is trading for $1

Adding Risk Graphs Together Short Calls

The profit on the downside is fixed leaving risk of the short stock and short put on the upside.

Making a Long Put

• How do you make a synthetic put?– For a long put, add together 1 long call and short

100 shares of stock for a synthetic put• C – P = S – X => P = C – S + X• Price it in the market:

– OPT is trading $21– The OPT Nov 20 call is trading for $2

Adding Risk Graphs Together

The risk on the upside cancels out leaving the short stock to control the downside.

Making a Short Put

• How do you make a synthetic short put?– For a short put, add together 1 short call and long

100 shares of stock for a synthetic put• C – P = S - X => -P= -C + S – X => P=C-S+X• Price it in the market:

– OPT is trading $21– The OPT Nov 20 call is trading for $2

Adding Risk Graphs Together: Short Puts

The risk is on the downside with the upside canceling out the long stock and short call.

Making Long Stock with a Call and Put

• How do you make synthetic stock?– For a 100 shares of long synthetic stock add

together 1 long call and 1 short put. – C-P = S - X• Price it in the market:

– OPT is trading $21– The OPT Nov 20 call is trading for $2– The OPT Nov 20 put is trading for $1

Long Call and Short Put Synthetic Short Stock

Note the Long Call and Short Put converge on the breakeven of stock where the short put controls the downside and the long call the upside

Making Short Stock with a Call and Put

• How do you make synthetic stock?– For a 100 shares of short synthetic stock add

together 1 short call and 1 long put. – C-P = S => -C+P = -S• Price it in the market:

– OPT is trading $21– The OPT Nov 20 call is trading for $2– The OPT Nov 20 put is trading for $1

Short call and Long Put Synthetic Short Stock

Note the Short Call and Long Put converge on the breakeven of stock where the long put controls the downside and the short call the upside.

Quick Review

• LONGS:– Long Stock+Long Put=Long Call– Long Call+Short Stock=Long Put– Long Call+Short Put=Long Stock

• Shorts– Short Put+Short Stock=Short Call– Short Call+Long Stock=Short Put– Short Call+Long Put=Short Stock

Insurance

• Do insurance policies last forever?• If I cancel a policy to I get all of my money

back?• Options, like all insurance decay in value over

time (this is sometimes called theta)

Decay and a Long Call

Premium Selling

This is a chart of option premium time decay:

30 Days vs. 8 Days

Stock and Options

• There are several ways to use stock and options together

• The 1st and most common is the covered call• The 2nd most common is the short put for

income• The way I would like to see traders trade is the

wheel trade

Making a Covered Call

• A covered call starts with a long stock position, in this case we can use MMM for 97.29

• When we sell a call, we get to collect ‘time premium’. We sell a call at 1.63

.

Selling A Call

Combined

• By owning a stock and then selling a call the combination creates a graph that looks like this: Notice our break even is now below $95.66

What is the Net of the Trade• We collected premium on the trade, which

lowers our cost basis on our stock• We limited our upside, because if the stock

moves above our call’s strike price, our stock will be ‘called away’

• It’s like taking the points on a football game rather than playing the money line

• Our Break even is now 95.66, but the most we can make on the stock/call combo is 99.13

The Low Down• What is the yield of the trade on a takeout? – Stock price is $97.29– Strike price is 97.5– Option price is $1.63

Total Return= (Strike + Option Price – Stock Price)/ Stock Price

(97.5 + 1.63 – 97.29)/97.29Total Return $1.84 or 1.8%

My minimum is 1% per month on short puts, full margin.

Mechanics• A covered call can be done with an existing

stock position, simply pick a call you want to sell against stock you might own

• It can also be done as a package in a trade called a buy-write– The trader buys stock– Sells a call– As a package

• A buy-write can become a covered call trade

Management Mechanics

• If you do not get the stock called away, buy the call back and sell another expiration

• If you can buy the call back for .05 or less, buy it back and sell another expiration

• If the stock runs through the call – let the stock get called away– take a day or two– THEN decide to enter the trade again

The Perfect Covered Call

• In a perfect world: – The underlying stock would ‘creep’ higher every

month, but would not sky rocket higher– The trader would be able to consistently sell calls

at a higher and higher strike price• This helps build yield in the trade

– The stock is never ‘called away’– The stock pays a dividend, further increasing yield

Short Put

• A short put is kind of like selling a slightly in the money covered call every month

• The trader never really owns the stock, because his calls are in the money– If there is a dividend the stock will get called

away, but the trader would keep the premium

Short Put

The Low Down

• A trader sells a put a Sep 185 put at 2.51• If the stock settles above 185, I keep all of the

premium• I keep some of the premium if the underlying

settles less than 2.51 below 185 dollars– My break even is 182.49

Mechanics• A short put should be sold in a stock that one

wants to own• The strike selection and premium selected

should be at a level that the trader would be willing to take delivery even if its less than that net price

• It is important to keep track of the total net premium collected on each put sale. This is the true underlying price if deliver is taken

Premium• I have 6 sales in IBM

• Apr collected 2.20• May collected 2.15• June collected 1.55• July collected 1.85• Aug collected 2.50

• With If I took delivery on my Sep 185 put sale at 2.51, what is my NET ownership price– 185-12.76=172.24– Not bad if the underlying is 180 (terrible if its 140)

The Perfect Short Put

• In a perfect world: – The underlying stock would ‘creep’ higher every

month, but would not sky rocket higher– The trader would be able to consistently sell puts

at a higher and higher strike price• This helps build yield in the trade

– The stock is never ‘delivered’– The stock pays a no dividend or the div is reduced

The Wheel

• Now that we have seen covered calls and short puts, lets discuss the wheel trade

• The wheel is a combo of short puts in order to take delivery on a stock

• Then a sale of covered calls to get out of a stock

• Hopefully there is a collectible dividend too

Mechanics

• Sell a put in FB• Can be done weekly or monthly• Weekly is more active, will create income– More flexible on strike selection– More Dynamic

• Monthly is easier, collects a larger ‘bulk’ premium– But less overall in a stable stock

Wheel

• If the trader takes delivery, the trader then sells calls till the stock gets called away

• Hopefully there is a dividend and the trader can collect that while he or she sells covered calls

• Trader should ensure that he or she does not get ‘called away’ at a loss

Keys• Keep track of all premium collected• Wait for a dip before starting• Make sure one knows the net ownership price• Hopefully take delivery at a low in the stock– When a stock is below the strike it MIGHT make sense

to buy the stock• Do not sell calls at levels where the trader will

lose– Might sell call spreads instead to insure ‘reentry’

• Hopefully sell at the top

Perfect Wheel

• Low Vol Stock• Delivery on the bottom• Slow rally back• Sells the top

PUT/BXY Study

• Russell Rhoads of CBOE and I have conducted several studies involving the BXY and the Put Write index

• Our most recent study that has not been released (till tomorrow) involved a wheel trade in SPX

The Study

• We began by selling an ATM Put in SPX• We continue to sell a put until the SPX Total

Return index goes negative on the month• We then ‘take delivery’ and then begin to run

BXY• When SPXTR increases more than 2% in a

month switch back to PUT WRITE• Done over and over again over 25 years

Results

• Unlevered the system trade delivered• 10.49% return (300 BP better than the SPX TR)• STD of 12.44% (25% less than the volatility of

the SPX TR)

The Retail Trade• In an IRA, Roth IRA or 401-k, it might make sense

to do this using SPY: – as a broad market exposure replacement

• Sell ATM SPY puts until they go into the money• Then take delivery• Begin selling 2% OTM Calls against stock on hand• Outside of an IRA the use of Futures and SPX

Options probably makes the most sense for potential tax purposes (consult your accountant).

Equity Wheel Candidates

• XOM• GE• CSX• ORCL• AAPL• MSFT• F

Review

• Calls and Puts are insurance contracts• Put-Call Parity is super important• Covered Calls an Short Puts are pretty similar• The wheel enhances both

Boot Camp 3 Quiz

• Describe the components of a synthetic long call.

• What is the Wheel Trade?• Is Time Decay a factor in a buy write? If the

answer is yes, why?• Describe the components of a synthetic short

put.