Options Framework

Week 1

1. Options 101 2. Best Strategy 3. Option Approval Levels4. Show or Fill Rule 5. Bid-Ask Exercise

6. Whiplash Orders 7. Buy-Writes 8. Early Exercise 9. No Options for Me Self-Test 1

Week 2 1. Leverage 2. Open Interest 3. Large Bid-Ask Spreads

4. Profit and Loss Diagrams 5. Are Options Good For The Market Self-Test 2

Gearing Up For Trading

Week 3

1. Buy or Sell 2. Types of Orders

3. Time Value & Intrinsic Value 4. Fair Value Self-Test 3

Week 4

1. Put-Call Ratio 2. Percent to Double

3. Hedging 4. Options Expiration Cycles Self-Test 4

Week 5

1.Basic Options Pricing 2. Black-Scholes 3. Implied Volatility

4. Delta Gamma 5. More on Deltas Self-Test 5

Basic Strategies

Week 6

1. Call Options 2. Put Options 3. Covered Calls

4. Straddles & Strangles 5. Strips & Straps Self-Test 6

Intermediate Strategies

Week 7

1. Equity Collar 2. Spreads

3. Deep-In-The-Money Covered Calls 4. Selling Options on Expiration Day Self-Test 7

Week 8

1. Ex-Dividend Dates 2. Dividend Play 3. Option Repair 4. Naked Put Alternatives

5. Ratio Spreads 6. Christmas Tree Self-Test 8

Advanced Strategies & Topics

Week 9

1. Calendar Spreads 2. Butterfly

3. Condor Self-Test 9

Week 10

1. Backspreads 2. Box Spreads Self-Test 10

Week 11

1. Synthetic Options 2. Synthetic Short 3. Systematic Writing

4. Jelly Rolls 5. Wrangles Self-Test 11

Options 101: We cover the very basics of options. What is an Option?

While options may seem mysterious to most investors at first, the basics are actually quite simple to understand.

Options are simply legal contracts between two people to buy and sell stock for a fixed price over a given time period.

These contracts are standardized, meaning they control a fixed amount of shares and expire at the same time. Because of this standardization, they are traded on an exchange, just like shares of stock. The contracts are usually highly liquid, which means there are many buyers and sellers standing by who are willing to buy or sell. You can buy an option contract with the same speed it takes you to call your broker and buy stock.

There are two types of options: calls and puts.

Long Call Options

A call option gives the owner the right, but not the obligation, to buy stock ("call" it away from the owner) at a specified price over a given time period.

In trading lingo, any asset that you buy is called a longposition. If you buy a call option, you are the owner, and are long the contract. Notice that the owner, the long position, has the right, but not the obligation, to buy stock. You are allowed to purchase the stock for a fixed price, but are not required to do so. In other words, you have the option to buy -- which is where these financial assets get their name.

The price at which you can buy the stock is called the strike price, which is kind of a slang term that came into use, because that's the price where the deal -- the contract -- was struck. Generally, each contract controls 100 shares of stock, called the underlying stock, which we will talk more about later. For now, just understand that unless otherwise stated, each contract controls 100 shares.

Each contract is good only for a certain amount of time. Usually you can find contracts with as little as a couple of weeks and as long as three years of time remaining. However, these are standardized time frames, so you don't get to pick the exact date you want it to expire.

Just as stock is traded in shares, options are traded in units called contractsSee Trading Units contracts.

If you buy one IBM March $100 call option (one contract), you have the right, but not the obligation to buy 100 shares of IBM (the underlying stock) for $100 per share (the strike price) through the expiration date in March, which is usually the third Friday of the month[1].

If you think about the definition of a call option, you have probably encountered similar agreements outside the financial markets. Your local pizza place may have a coupon good for the next 30 days that allows you to buy a large pizza for $10. That's similar to a call option. It's like a contract locking in your purchase price over a fixed time period. After that time period, the option to buy at that price expires. While the pizza shop may make an exception and allow you to use

the coupon after the expiration date, there is no such thing with a call option. Once it's expired, it's gone.

Think of a call option as a coupon giving you the right to buy stock at a fixed price through an expiration date. The big difference between a coupon and a call option is that you must pay for the option while coupons are generally handed out for free.

Long Put Options

A put option allows the owner to sell their stock ("put" it back to someone else) for the strike price within a given time. As with call options, the put buyer (long position) has the right, but not the obligation. If you buy an IBM March $100 put, you have the right, but not the obligation, to sell 100 shares of IBM for $100 per share through the third Friday in March.

Buying a put option is similar to buying an auto insurance policy. You can buy a policy for a premium and collect the insurance value if you wreck your car. If you don't wreck your car, you are only out the amount of the premium. Likewise, you can buy a put option for a premium and turn it back to the insurer (the put seller) if your stock should crash (fall below the strike price). If the stock stays above the strike, you would let the "insurance" expire and lose only the premium you paid.

Short Calls and Puts

Notice that with either calls or puts the buyers (the "long positions) have the right, but not the obligation, to buy or sell. The investor on the other side (the seller of the option, also called the "short position) has the obligation to fulfill the contract; he or she has no choice. If a long call owner decides to buy the stock, the short call trader must oblige and sell. Likewise, if long put owners decide to sell their stock, the short put traders must purchase the stock. Regardless of whether the short option seller is forced to buy or sell stock, the premiumreceived from the initial short trade is theirs to keep. That's their compensation for accepting the risk.

Call Option Put Option Long position (the buyer)

Right, but not the obligation, to buy stock at the strike price

Right, but not the obligation, to sell stock at the strike price

Short position (the seller)

Possible obligation to sell stock at the strike price

Possible obligation to buy stock at the strike price

The Options Clearing Corporation (OCC)

Many new traders to options may be concerned that the short side will not deliver. In other words, if you want to use your option to either buy or sell shares, is there a risk of the short seller refusing?

There is no need to worry about contract performance from the short seller. In other words, if you decide you want to purchase 100 shares of IBM at $100 with your call option, there is no need to worry about the seller of the call (the short call position) not delivering the shares. This is because an intermediary called the Options Clearing Corporation (OCC is really the buyer to every seller and the seller to every buyer. The OCC is well capitalized and does not run the risk of default. Because of this, investors do not even need to know who is on the other side of the trade, as the OCC guarantees contract performance. Ever since the inception of the OCC in 1973, no investor

has ever lost money due to default by the other party. Keep in mind this does not mean the OCC guarantees contract profitability but only that you are guaranteed to buy or sell shares with your long option position if you decide to do so.

The function of the OCC is to provide investor confidence, thereby providing better prices and liquidity .

Exercising Options

If you wish to buy stock with your call option or sell stock with your put option, you simply call your broker and tell them you want to exercise the option. Three business days later, the transaction will take place. For example, if you own a $50 call option and decide to exercise it, your account will be debited for $5,000 ($50 per share times 100 shares per contract) plus commissions and credited 100 shares of stock on the third business day. Similarly, if you own a $50 put and exercise it, you will receive $5,000 minus commissions and will be debited for 100 shares of stock on the third business day. Keep in mind that you cannot exercise portions of an option -- you either buy or sell in lots of 100 shares. For instance, if you own one contract, you cannot call your broker and use it to only buy 75 shares. You either buy all 100 or none at all. Of course, if you own more than one contract, you can certainly exercise only a portion. If you have five contracts, you could certainly, for example, only exercise two of them and buy 200 shares.

What If I Want Out Of My Contract?

You can always get out of any contract -- long or short -- by executing an offsetting position. For example, if you are long a March $50 call, you can simply sell a March $50 call (called "selling to close") and you no longer have the right to purchase the stock for $50. If you have sold a $75 put (called "selling to open") and no longer want the obligation to buy the stock for $75, you can simply buy a $75 put (buy to close), which relieves you of your obligation. Bear in mind that the price you receive or pay is determined by the market and can be very different from where you entered the contract.

For instance, if you sell a $75 put with the stock at $80, you may receive a small amount, say $2. Later, if the stock is trading for $70, you may wish to get out of the contract. However, that $75 put may now be trading for $6 meaning you sold for $2 and had to pay $6 to exit for a loss of $4 per contract.

In fact, most options are closed out in the open market this way. It's probably less than 5% of the time that contracts are actually exercised. Just be aware that you can always get out of a contract at any time -- it just may cost a lot to do it.

How are Options Similar to Stocks?

• Options are securities. • Options trade on national SEC See Securities Exchange Commission" (Securities

Exchange Commission Securities Exchange Commission" )-regulated exchanges. • Option orders are transacted through market makers and retail participants with bids to

buy and offers to sell, and can be traded like any other security.

How Do Options Differ From Stocks?

• Options have an expiration date, whereas common stocks can be held forever (unless the company goes bankrupt). If an option is not exercised on or before expiration, it no longer exists and expires worthless.

• Options only exist as "book entry, which means they are held electronically. There are no certificates for options like there are for stocks.

• There is no limit to the number of options that can be traded on an underlying stock. Common stocks have a fixed number of shares outstanding.

• Options do not confer voting rights or dividends. They are strictly contracts to buy or sell the underlying stock or index. If you want a dividend or wish to vote the proxy, you need to exercise the call option.

[1] Technically, options expire on the Saturday following the third Friday of the expiration month. However, this is for clearing purposes and there is nothing the option trader can do with an option on Saturday. The third Friday of expiration month is the last trading day so, for practical purposes, it is the day you want to consider as expiration.

What's The Best Option Strategy? You've probably heard many opinions as to which option strategies are the best: Covered calls are best because they reduce the risk but still allow for a profit. Naked puts are the best because you're getting paid to buy stock. Straddles are the best because they allow you to make money whether the market is going up or down.

If you've been trading options for a while, you no doubt have heard many others. But, when you hear comments such as these, all you're hearing are opinions of one trader's preference for a particular risk-reward profile. In order to really understand option trading, you need to understand that all option strategies come with their own sets of risks and rewards and the market will price them accordingly. Be careful of anyone telling you that a particular strategy is superior to another; they either do not fully understand options or are trying to sell you something.

Traders who tout superior option strategies focus on one aspect of the strategy -- either the risk or reward side -- and completely neglect the counterpart. They will make comments such as, "Calls are superior to stock because the return on investment is much higher." It's easy to make them consider the risk side by replying, "Sure, but lottery tickets are superior to calls because the return on investment is even higher!"

The best option strategy is the one that directly matches your set of risk and reward tolerances for a given outlook on the underlying. This is the level of option trading you want to achieve. Learn to dissect a position into its component parts and see if you are willing to accept the associated risks. Learn the various strategies and how to further tailor them to match your needs better. Don't spend your time looking for the superior option strategy. It doesn't exist.

Understanding risk and reward

To fully understand the relationships between risk and reward with options, we need to look at profit and loss diagrams. (Please see our section next week on "profit and loss diagrams" if you are not familiar with them. We will show you in detail how to construct and read them next week.)

If you compare the profit and loss diagrams of any two strategies, there will always be a part of the diagram where each strategy dominates.

For example, let's revisit the earlier comment. Are call options superior to stock? Assume one investor buys stock for $50 and another buys the $50 call for $5.

We can plot the profit and loss at expiration for each position, and we will get the following diagram:

For example, the trader who buys stock at $50 will make $5 profit if the stock is trading for $55. If you look at the above chart, you can see that the profit and loss line (red) crosses the $5 profit line for a stock price of $55. Likewise, if the stock is trading for $45, the trader will incur a $5 loss.

The diagram also shows that the long $50 call buyer (blue) will lose $5 if the stock is $50 or below and will break even if the stock is $55. At a stock price of $60, the $50 call buyer will make $5 profit (the call option will be worth $10 but the trader paid $5)

Notice the profit and loss diagram for stock (red). It is superior to (lies above) the profit and loss line for the long call (blue) for all stock prices above $45. This is because the call option buyer is effectively paying $55 for the stock ($50 strike for a cost of $5). If the stock stays above $45, the long stock position is the better strategy (the red line is above the blue line). But if the stock falls below $45, the call option becomes the better strategy (the blue line is above the red line), as the most the long call will lose is the premium. It should be evident that one strategy is not better than the other; it depends on your outlook of the stock and the amount of risk you are willing to accept.

An investor who believes the stock will stay above $50 is better off buying stock. Of course, there is a tradeoff of accepting a potential $50 maximum loss. Conversely, an investor who believes the stock is heading higher but doesn't want the exposure to the downside is better off buying the call. The tradeoff is that he will pay $55 for the stock instead of $50, but in return, only be subjected to a $5 maximum loss.

If traders are more concerned with the downside risk, they will bid up the price of the call. If they feel the price of the call is too high relative to the stock, they will sell the call (either naked or covered). These actions will price the call fairly with respect to investors' opinions, and neither strategy will be superior to the other.

What about naked puts? They must be better than stock because you are actually getting paid to buy the stock, right?

Let's look at the profit and loss diagram between stock purchased for $50 and a naked $50 put sold for $5:

Again, in some areas of the chart the long stock position dominates, and in others it does not. The long stock position is better for stock prices above $55. With the stock above $55, the long stock investor will realize unlimited profits, while the naked put will profit only by the premium received from the sale of the put.

However, if the stock is below $55, the naked put is the better strategy. Below a $50 stock price, both investors lose but the naked put seller is ahead by the premium.

Maybe a long call is better than a naked put? Some may reason that the long call position makes more money than the short put if the stock rises and loses less if it falls, so it is a better strategy. Let's assume a long $50 call and short $50 put are each traded for $5:

Looking at the above chart we see that the long call position (red) does dominate for all stock prices above $60 and below $40. But if the stock stays between these prices, the naked put is clearly the better choice. Your outlook on the stock and tolerance for risk will determine which strategy is best for you.

Pick any two strategies and look at their profit and loss diagrams. You will always see that each strategy will dominate over a given range of stock prices. Try switching one position from long to short. Try changing strike prices. You will soon see that it does not matter; one strategy cannot dominate another for all stock prices.

Strategies come in all shapes and sizes. Now you should have a better understanding why. Different strategies alter the risk-reward relationships and it is up to you, the trader, to decide which is best. Do not be afraid to alter the strategy to meet your taste -- that is what option trading is all about. If you accept somebody's strategy as the "best," you are, by default, accepting his or her risk tolerances too. If those tolerances are not in line with yours, you will eventually learn, the expensive way, that no strategy is superior to another.

Option Approval Levels In order to trade options, your broker will undoubtedly require you to fill out an options application and assign you one of several option approval levels based on your needs, knowledge, and other factors, including net worth.

Often times people wonder why they must be approved for options trading even though they may "completely" understand the particular strategy they are trying to execute. The reason is that there can be substantial risks in options, especially from factors outside the strategy.

For example, most people believe that the most you can lose from a long call position is the amount of the premium -- the amount you paid to buy it. While it is true that a long call can never have negative value by itself, the mechanics of the options markets do allow for further losses if you do not understand them as shown in the following example.

Example:

I actually witnessed this trade at a brokerage firm. A trader was long 20 calls at $4. In his mind, the most he could lose was $8,000, which was the total paid for the contracts.

However, if an equity option expires 3/4 of a point or more in-the-money, the Options Clearing Corporation (OCC) will automatically exercise the option for you.

On the last trading day, the customer thought the option would expire worthless, as it was slightly out-of-the-money. A small rally in the stock pushed it to just over 3/4 of a point in-the-money at the close. Because he did not close out the option or contact his broker with instructions to not exercise, the option was automatically exercised and the customer was long 2,000 shares on Monday morning. Unfortunately, the stock opened down 15 points on bad news and the customer sold the stock at a $38,000 loss ($30,000 from the 15-point decline and $8,000 for the cost of the option to acquire the stock!).

This is a perfect example of how large losses can occur if you do not understand the strategies, risks and mechanics of the options markets, and exactly why your broker will require (or at least should require) you to fill out an approval form.

Once you are approved, your broker will assign you one of several option approval levels. While there is no official standard, the following list should serve as a general industry guideline as to the permissible strategies under each level. Check with your broker for specific details with their firm.

Option approval levels

There are usually four option approval levels available through most brokerage firms. For whatever reason, option levels are generally ranked from 0 to 3 although some firms do use 1 to 4. Level 0 is considered to be a basic level and level 3 is the highest. The levels are cumulative meaning that, for any given level, all strategies below that level are acceptable too. For example, all strategies allowed under level 0 and level 1 will be allowed in under level 2.

Here is a list of the basic definitions and strategies allowed under each level:

Level 0

Covered calls

Allows you to buy stock and write calls against it.

Long protective puts

Allows you to buy puts but only for a specific stock and in the amounts you hold. For example, if you have 500 shares of INTC, you could purchase up to 5 put contracts to protect your position.

Note: Some firms will allow index puts to provide overall protection, especially for large accounts, where buying puts on each position would be cost prohibitive.

Short puts against short stock

Allows the investor to sell puts if the stock is short in the account. Careful, a lot of brokers will tell you that short puts require level 3 but this is considered to be covered (by the short stock) which is why it is generally allowed in a level 0. If your broker does not sound sure, have them check with a manager.

This is generally the only level that will be approved for Individual Retirement Accounts (IRAs), but there are some firms that will allow level 1 in an IRA.

Level 1

Long calls and puts

Allows the outright purchase of a call or put. Level 0 also allows the purchase of a put too but only for protective purposes. Level 1 allows you to speculate that a stock or index will fall.

Plus all strategies under level 0

Note: There is a strategy called a "rollup" where you sell one option and buy another. For example, you may be long 10 $50 strike calls and the stock is now trading at $60. One strategy is to sell the $50 strike to close and buy the $60 strike to open. You can send these orders as a spread to the market maker in hopes of a better deal; after all, it is a spread order as you are buying one option and selling another. But it is not a spread position, because once the order is executed, you will just be long 10 $60 strikes; there will be no short positions in the account. This is because one trade was to close and the other to open.

This is a very powerful strategy and one discussed in a later article. Just be careful if you use this strategy in a level 1 account, that your broker doesn't reject the trade becaues he thinks it's a level 2 transaction.

Level 2

Spreads

Allows the investor to buy and sell options as a basic spread position with limited risk. So, the basic bull and bear spreads and long calendar spreads (buy a far month and sell a near month) will qualify. You cannot have a short calendar spread (buy near month and sell far month) or do ratio spreads (such as buy 10 $50 strikes and sell 20 $60 strikes) as this would expose you to potentially unlimited losses.

Plus all strategies under levels 1 and 0

Level 3

Uncovered (also called naked) positions

This is the highest approval level and anything goes -- as long as you have the equity to do it. Here, the investor can sell a call or put with no corresponding long or short position, respectively, to cover. Short calendar spreads and ratio spreads are all approved.

All strategies under levels 0, 1 and 2

Note: Many investors like the strategy of naked puts, as it is effectively a way to get paid to buy stock you like. In order to do this, level 3 is generally required. However, if you do not qualify for level 3 and have a lot of equity (usually $500,000 or more but entirely up to the brokerage firm) you may be able to get approved for "cash secured puts." The firm will hold cash to the side assuming you will be assigned. That way, the firm is protected under the worst possible circumstances. I just mention this here as many investors attempt approval for level 3 for the sole purpose of naked puts, and are disappointed if they do not get it. If this happens to you, you may want to check to see if the brokerage firm will allow cash secured puts.

Getting started

If you are new to options, do not be concerned if your broker does not give you the desired approval level immediately. Often times they want to see some option trading history before increasing your approval level. For example, you may want to execute spread orders and need to be approved for level 2. Your broker may require you to start at level 0 or 1 and then increase you to a higher level in six months or so with a successful demonstration of option trading at the given level.

Please understand that option approval levels exist for a reason. If you are not immediately approved for your desired level, there are plenty of option strategies you can use with the level you receive.

"Show Or Fill" Rule This is a great little tip for all option investors -- especially those who trade smaller numbers of contracts, say 1 to 5.

It is known as the "Limit Order Display Rule" or sometimes called the "Show or Fill Rule" (the official name is "Exchange Act Rule 11Ac1-4). It is not a rule that the market makers make very well known for obvious reasons, as we shall soon see. However, knowing this rule can make a big difference in your option profits!

Before we look at the rule, we need to understand some basics to the quoting system used for stocks and options.

Let's say you get a quote on an option as follows:

BID $5 ASK $5-3/4

What exactly does this mean? It means the market makers are "bidding" $5 for the option; this is the price they are willing to pay. They are "asking" $5 3/4; this is the price where they are willing to sell. There is often a lot of confusion to these terms but they are really quite simple if you think of the following analogy. If you sell your house, you are "asking" a certain price, right? If you are buying a house, you put in a "bid" for it. Bid means buy, ask (sometimes called the offer) means sell.

The reason for the confusion is this: Retail investors who buy options are used to paying the "asking" price so they often think the ask price represents the buyers. Similarly, if they sell their option, they are used to receiving the bid price so they think the bid price represents the sellers.

But think about this. If you are buying the option, you need a seller to take the other side of the trade. The reason you can buy the option at the ask price is because the market maker, the person on the other side of the trade, is willing to sell for that price. Now you have a buyer matched with a seller and the trade can be executed. Likewise, if you sell your option, you can be matched with the buyer at the bid.

When you get a quote, the bid price represents the highest bidder and the ask price represents the lowest offer or seller*. This makes sense, as we are not concerned with the person who is willing to sell that same option for some higher amount, say $10, or the one who is willing to buy it for a lower amount such as $1.

Trading "in between" the BID-ASK spread

Let's go back to the original quote:

BID $5 ASK $5-3/4

Say you wanted to buy the option and did not want to pay $5-3/4 but were willing to pay $5-1/2. You could put in a bid (remember, you are buying the option so you would be a bidder) simply by calling your broker and instructing them to buy at a limit of $5-1/2. Prior to the "show or fill" rule, the market maker could leave the quote unchanged, letting your high bid of $5-1/2 not be shown as follows:

BID $5 ASK $5-3/4

Say you wanted to buy the under the "show or fill" rule. The market maker must do one of two things: either fill your order or show your order as follows:

BID $5-1/2 ASK $5-3/4

You are now posted as the highest bidder, have narrowed the spread, and have given someone the incentive to sell because of the now higher bid. The markets always benefit from narrow spreads.

Let's say another trader comes along who does not want to sell at the $5-1/2 bid price, but is willing to receive $5-5/8. This trader could put in an order to sell their contracts at a limit of $5-5/8. Assuming the market maker does not fill the trade, the quote now looks like this:

BID $5-1/2 ASK $5-5/8

Again, the spread has been narrowed further and a stronger incentive is now given to the market to buy since the asking price has just been reduced from $5-3/4 to $5-5/8

KEY POINT: It is an exchange policy (at least for the major ones) to have all quotes good for at least 20 contracts.

Here's how you can benefit from this knowledge!

Going back to the original quote:

BID $5 ASK $5-3/4

Say you want to buy a small number of contracts such as 3. Now, if you put in a bid of $5-1/2, the market maker either needs to fill you or show you.

Now, obviously, the market maker does not want to sell you the option at $5-1/2 because he's asking $5- 3/4. But, if he doesn't fill you, he must show your order and change the quote to:

BID $5-1/2 ASK $5-3/4

Here's the benefit! The market maker is thinking: "If I show the order and post the bid at $5-1/2, I may have to buy another 17 contracts since my quotes must be good for at least 20 contracts. I'm really only willing to bid $5, so let me fill this order to get it out of the way!"

How can you profit from this? Think of all the times you bought at the ask price or sold at the bid. Those 1/4 and-1/2 (or much more) point spreads on both sides really start to add up. Placing trades "in between" the bid and ask can make all the difference on your profits, especially for smaller numbers of contracts.

* Technically, the BID and ASK represent the best bid and offer at the margin, the point where price is determined. For example, someone could come in and bid $6 but would be filled at $5- 3/4 because they are outside the margin. The quote would not jump to $6 on the bid even though they are, technically, the highest bidder. It's a technical point, but for our purposes, you can think of the BID as the highest bidder and the ASK as the lowest offer.

Bid-Ask Exercise If you're still confused with bids and offers, don't feel bad -- the concept throws many new (and even advanced) investors. Here's a little workshop that coaches you through getting the quotes posted that should bring you a new level of understanding (or confusion!) to you.

Let's start by assuming I am the market maker for ABC stock. I post bids to buy the stock and offers to sell the stock. If you wish to buy or sell, you can either put in a "market" order or a "limit" order. If you're not familiar with market and limit orders, don't worry. We'll cover those in detail in the next course. All you need to know for now is that market orders are guaranteed to execute, which means you will likely buy at the asking price or sell at the bid price. If you want to try for a better price, you can enter a limit order. With a limit order, you specify the price but your order will not execute unless you can be filled for that price (or a more favorable price).

The Day Begins

The market has just opened and I have no customer orders on the books. Let's assume that I'm willing to buy up to 500 shares at $30 and I'm willing to sell up to 500 shares for $30.50. Notice how the price I'm willing to pay is less than the price I'm trying to sell them for. This is analogous to a car dealer who buys used cars at wholesale and then sells them at retail, keeping the difference as profit.

I therefore start the day by entering quotes into my system, posting a bid of $30 and an asking price of $30.50.

I log online and get a quote for ABC stock. My screen looks like this:

ABC STOCK BID $30 ASK $30.50

SIZE 500 x 500

The "size" field shows the number of shares available at the bid and ask prices respectively. This would be read as "500 by 500" and means that 500 shares are on the bid and 500 on the ask. Most quote systems give this information but, if not, your broker will certainly have it.

Now let's see what happens as orders come to me from retail customers. We'll show how they affect my books as well as the quotes I get online. Let's start by assuming you have some shares you'd like to sell.

Order #1

You have 200 shares but you do not want to sell at my bid price of $30. You decide to put in a sell limit order at $30.40, which is in between the bid and ask prices.

At this point, I see your order and realize that it is more competitive than my offer (you are willing to sell for less than $30.50). So I must do one of two things: Either fill it at $30.40 (or higher) or display it so that other investors may see it.

Key Point

Any time a limit order is placed in between the bid and ask, that limit order is a more competitive price. That's because, by definition, it must be a price that is higher than the bid and lower than the ask, which are both more favorable to the market.

Let's assume I decide to not fill the order.

The quote you're watching will change to reflect the lower asking price. The quote you get from your broker or online is called the "inside quote" and reflects the best bid and offer. Your screen now changes to this:

ABC STOCK BID $30 ASK $30.40

SIZE 500 x 200

Notice how the asking price is reduced from $30.50 to $30.40 (that's your order) as well as the size. Your order is only good for 200 shares so the size of the offer falls from 500 to 200.

Any time an order is placed "in between" the bid and ask without it being filled, it will result in a changing of the quote!

Because I am the market maker, I must keep track of all quotes even though I only show the best bid and offer. My computer software will show this:

ABC STOCK BIDS 500 $30.50

500 $30 200 $30.40 OFFERS

Basically all that happens is that the bids or offers that are "away" from the market get shifted. When we say "away" from the market, we mean that they are not as favorable a price. In this case, my offer of $30.50 (shown in red) is shifted higher and your order takes its place.

Notice too how your quote system online only shows the one row of my book (in blue). That is all you will ever see even though there are many quotes above and below that. Once again, this is because the market is really only concerned with the highest bid and lowest offer (the inside quote).

Let's run through a few more examples so we can get some orders on the books. Then we'll look at how to fill orders based on the book.

Order #2

Another investor comes along and enters an order to buy ABC stock. They think it will fall a bit first and place a limit order to buy 400 shares at $29.

Once again, I get this order and notice that it is not as competitive as my bid of $30 so will just move that order out in the "wings" to be filled at hopefully a later time. In other words, because this new order is not in between the bid and ask, it is therefore less competitive and just gets pushed aside for now. My system now looks like this:

ABC STOCK BIDS 500 $30.50

500 $30 200 $30.40 400 $29 OFFERS

The lower bids (worse for the market) get moved lower and the higher offers (worse for the market) get moved higher. Remember, the market is only concerned with the highest bid and the lowest offer. All others get "swept aside" for the meantime. This practice always keeps the best bid and offer in the middle of my screen.

Order #3

A new order comes in to buy 100 shares at $28.50. This buyer is the weakest of all bidders (the lowest), so it gets moved to the very bottom. My system now looks like this:

ABC STOCK BIDS 500 $30.50

500 $30 200 $30.40 400 $29 100 $28.50

OFFERS

Notice how the "buy" orders are always placed under the "bid" column and the "sell" orders are always under the "offers." This is in line with what we said earlier: The bid price represents buyers and the offer price (asking price) represents the sellers.

Order #4

Hopefully you're getting the idea of how this works so let's go ahead with several orders and assume the following orders are received:

• Sell 300 shares at $30.75 • Sell 150 shares at $30.45 • Buy 250 shares at $29.50

The first order to sell 300 shares at $30.75 is the highest of all current offers, so they go to the very back of the line:

ABC STOCK 300 $30.75 BIDS 500 $30.50

500 $30 200 $30.40 400 $29 100 $28.50

OFFERS

The next order is to sell 150 shares at $30.45. They are higher than the best offer of $30.40 but are not the worst one either. They get wedged between the offers of $30.40 and $30.50 as shown below. The same idea applies to the last order to buy 250 at $29.50. They get wedged between the orders to buy 400 at $29 and 500 at $30:

ABC STOCK 300 $30.75 500 $30.50 BIDS 150 $30.45

500 $30 200 $30.40 250 $29.50 400 $29 100 $28.50

OFFERS

This process continues with all bids and offers are placed in descending order. If an order comes in that is the most competitive bid or offer, it will be placed at the very front of the line. Otherwise, the order takes its appropriate place in line.

Let's do one more like that to be sure you understand.

Order #5

An order comes in to buy 100 shares at $30.20, which is in between the current quote of $30 to $30.40. Therefore, the order jumps to the front of the line as shown. In other words, because it is are now the highest bid, it moves to the front of the line. The only way to get moved to the front of the line, whether buying or selling, is to place a limit order in between the bid and ask. My computer screen now looks like this:

ABC STOCK 300 $30.75 500 $30.50 BIDS 150 $30.45

100 $30.20 200 $30.40 500 $30 250 $29.50 400 $29 100 $28.50

OFFERS

Filling Orders

Now let's look at some orders that actually get filled. The reason that none of the orders got filled in the first examples is because none of the buyers accepted the offer price (called "taking the offer" in trader's jargon) or sold at the bid (called "hitting the bid"). All orders were either "in between" the bid and ask or away from the market. Now we're going to focus on what happens when orders actually get filled.

Order #1

An order comes in to buy 200 shares "at market."

Because those investors listed in the "offers" column are sellers, I know I can match this buy order with the person there and fill the order. The trade "200 at $30.40" is removed from my books and all the offers are now shifted down. The best offer is now $30.45:

ABC STOCK 300 $30.75

BIDS 500 $30.50 100 $30.20 150 $30.45 500 $30 250 $29.50 400 $29 100 $28.50

OFFERS

Of course, your screen will reflect this change as well. You will now see:

ABC STOCK BID $30.20 ASK $30.45

SIZE 100 x 150

The buyer receives a confirmation from his broker that he bought 200 shares at $30.40, and the seller receives a confirmation of the sale under the same terms.

Order #2

An order comes in to buy 350 shares at market. Market orders must be filled, so I look at my books and will have to split some orders. I will give the person 150 shares at $30.45 and 200 shares from the order above it at $30.50 as shown by the arrows:

ABC STOCK 300 $30.75

BIDS 500 $30.50

Only 200 shares get filled from here

100 $30.20 150 $30.45

We'll use all 150 of these

500 $30 250 $29.50 400 $29 100 $28.50

OFFERS

After that order is filled, my screen looks like this:

ABC STOCK

BIDS 300 $30.75

100 $30.20 300 $30.50 500 $30 250 $29.50 400 $29 100 $28.50

OFFERS

The person who had the order to sell 500 shares at $30.50 will receive a confirmation from his broker that 200 shares were sold at $30.50, and he will still have an open order to sell the remaining 300 at $30.50.

The investor who placed the order to buy 350 shares at market will also receive partial fills. Their broker will inform them that they bought 150 shares at $30.45 and 200 shares at $30.50. This explains why it is not uncommon to see "partial fills" on your account!

Your screen now reflects the new inside quote and size:

ABC STOCK BID $30.20 ASK $30.50

SIZE 100 x 300

Order #3

See if you can handle this next order. An order comes in to sell 700 shares at market. How would you fill it? Look at the chart below and see if you can figure it out then continue reading to see if you have the correct answer.

ABC STOCK

BIDS 300 $30.75

100 $30.20 300 $30.50 500 $30 250 $29.50 400 $29 100 $28.50

OFFERS

The market order must be filled so we find some buyers (bidders) to match up to this seller. Specifically, we need 700 shares. We look in the bid column and will fill:

• 100 shares at $30.20 • 500 shares at $30 • 100 shares at $29.50

Now, in reality, the market maker will usually step in and provide some liquidity. For instance, I could decide to fill 100 shares at $30.20 and 600 shares at $30, thus giving up 100 shares from my own account. It is not required, but is usually done to provide more liquid markets. For now, let's assume that the order is filled as we originally stated in the bullet points above. My books now look like this:

And your quotes will now show:

ABC STOCK

BIDS 300 $30.75

150 $29.50 300 $30.50

400 $29

100 $28.50 OFFERS

ABC STOCK BID $29.50 ASK $30.50

SIZE 150 x 300

Notice how the spread -- the difference between the bid and ask -- has widened to $1. At the very beginning of this exercise, the quote was $30 to $30.50, which is only a half-point spread. The spreads will generally widen if the market maker only fills orders based on the book like we've been doing in these examples. This is why market makers usually step in and provide some liquidity to keep an orderly market. If they didn't, the spreads would just keep getting wider and wider as orders are filled.

Hopefully this exercise sheds some light on what happens with the bids and offers and how the orders are handled. More importantly, you just need to be aware that when your broker quotes you a bid price, that is the price of the highest buyer and, consequently, the price where you can currently sell. Likewise, if you get a quote on the ask, that is the price of the lowest selling price and, consequently, the price where you can currently buy.

Whiplash Orders When you place an option order, there are many types of orders and contingencies from which to choose. For example, there are market orders and limit orders, day and good-til-canceled, all-or-none and many others. Most traders are very familiar with these and they can greatly help your trading skills by making use of each of them under various conditions.

However, there is one type of order that is rarely talked about, in fact, it is even unknown by most brokers. It is called a whiplash order. It can be one of the most valuable option trading tools available to you.

A refresher on limit orders

Before we get into the whiplash order, it is important to understand the basic limit order.

A limit order is when you specify the price at which you are willing to buy or sell. For example, you can tell your broker to buy 10 contracts at a limit of $3. This means the order cannot be filled unless it is for $3 (or less). The drawback is that the order may never fill. Likewise, you can place an order to sell your contracts at a limit of $15; now your order will not fill unless you get $15 (or higher). Limit orders guarantee the price but not the execution.

One reason that options are so difficult to trade with limit prices is because the option is tied to an underlying stock. Many traders, especially with index options, like to sell their options when the stock or index hits a certain level. For example, say the OEX is trading at 725 and you hold 10 OEX Dec $730 calls. You want to sell them when the index hits 735. The question now is how much will the calls be worth?

Many traders often refer to the Black-Scholes Option Pricing Model to figure out what the limit price should be. The problem with this is that we do not know when the index will hit that level. If it happens quickly, the option will be worth much more than if happens over the course of a month. Further, we do not know what the implied volatility level will be. In short, we have no way to determine a good estimate.

So, what can a trader do?

Whiplash order

This is where the whiplash order comes in handy. The trader in the above example could tell his broker to sell 10 $730 OEX calls When Level of Stock Hits 735, or WLSH = 735. The letters WLSH resemble a shortened version of the word "whiplash," hence the name. By the way, most brokerage firms will require whiplash orders to be at least 10 contracts.

Now, when the index hits 735, this order will become a market order and be sold. Keep in mind, this order does not guarantee a profit. Why? Say the trader paid $20 for the contract and the index hits $735 with only a few days to expiration; the call may only be $5 leaving the trader with a net loss of $15.

The WLSH order can be modified with a greater than (>) or less than (<) sign too. For example, a trader can instruct his broker to sell the contracts WLSH > 735 (or WLSH >= 735) or buy WLSH < 715.

You can get fancy and cross stocks or indices if you prefer. As some examples, you can sell your OEX calls when NDX hits a certain level. Likewise, you can sell your MSFT calls when the NDX hits a certain level or maybe buy INTC when MSFT goes below a certain level.

Crossing indices (or stocks) is probably not the best way to trade, but there may be certain circumstances where it may be warranted.

You should contact your broker to see if they handle whiplash orders or similar orders under a different name. They can be an invaluable tool for the option investor!

Buy-Writes And Sell-Writes A buy-write (also called a covered-write) is simply a covered call -- long stock plus a short call (please see our section during week 6 on covered calls for more details).

The difference in the buy-write is in the way the order is handled.

Most investors who enter covered call positions buy the stock first, then sell the call at a later time. The problem with delaying the sale of the calls -- even if it's only a matter of seconds -- is that you will be exposed to market movement and downside risk in the interim.

Example:

Say a stock is trading for $100 and a $100 call is trading for $5.

An investor wants to enter into a covered call position. They feel that effectively paying $95 for the stock and selling it for $100 over the next month will be adequate potential profit relative to the risk they are taking. So they put in a market order to buy the stock, but get filled at $101 because heavy trading caused the stock to move up. Then they immediately put in the order to sell the call. The stock starts to fall and they sell the call for $4-1/2.

The five-point profit they were seeking has now been reduced to $3-1/2. They bought stock for $101 and sold the call for $4-1/2 effectively paying $96-1/2 for the stock instead of the desired $95 at the outset.

This is very common for people who enter covered calls in this manner. This is sometimes called "legging in" to a covered call because each of the "legs" -- the long stock and the short call -- is entered as a separate order.

To prevent this risk, known as execution risk, the above investor could have entered a buy-write. There are two ways to enter a buy-write order: (1) As a market order (2) As a limit order

If the investor enters the buy-write "at market," this means the entire order -- both the long stock and short call -- must get filled simultaneously and the investor is willing to take the prevailing prices at the time their order arrives to the floor or market makers. In the above example, had the investor entered a buy-write, they may have paid $101 for the stock but also may have received $5-1/2 for the call for a net debit of $4-1/2. This is still not the $5 point profit they were expecting, but certainly better than the $3-1/2 they got.

If the investor enters a buy-write as a "limit order," they will specify the price they want to pay. The risk here is that the order does not get filled. However, if it does, you know the price will be at your limit or lower.

Example:

Say we see the following quotes:

Bid Ask XYZ Stock $95-3/4 $100 XYS Mar $100 Call option $5 $5-1/2

If the investor were able to get filled at the current prices, this buy-write would fill for a net debit of $95. This is because the investor can currently buy the stock for $100 (the ask) and sell the call option for $5 (the bid). This is also called "the natural" quote because a debit of $95 is where the buy-write would be filled naturally if the trade could be executed immediately.

The investor may tell their broker, "I'd like to place the following buy-write: Buy 500 XYZ and sell the Mar $100 calls for a net debit of $95." Now, the only way the trade can get filled is if the buy-write is filled at this price or lower.

Remember, this is the net debit the investor is willing to pay so the order could come back filled as:

Stock purchased for - $101 Call sold for + $6 For net debit of $95

(or any other number of combinations of stock and option prices as long as the net debit does not exceed $95).

If you enter a limit order on a buy-write, it must always be entered as a net debit for the fact that the price of the call can never exceed the price of the stock. (Please see our section on "Basic Option Pricing" during week 5 for more information.)

Placing a buy-write with the market maker is similar to trading in a car. If your car is worth $10,000 and you are trading it in on a $25,000 car, you may tell the dealer, "I want to buy that one and sell this one for a net cost of $15,000."

Now, it should make no difference to you if they charge you $26,000 for the new car as long as they give you $11,000 for your trade. Or, the dealer may only want to give you $9,000 for your trade, but then must be willing to sell you the new car for $24,000. You are doing the same thing with the market maker on a buy-write limit order; you are specifying the net difference you are willing to pay for buying the stock and selling the call.

Of course, you may decide to try for a little better deal. Using the above quotes again, you may see the "natural" is $95, but tell your broker to place the order for a net debit of $94-3/4.

Regardless, any time you put in a limit order, you may not get filled. So you need to decide which is more important -- getting filled or getting the price you want. You can only guarantee the execution or the price, not both.

By the way, if you do enter into a buy-write, you can close it out anytime with a simultaneous order too. You can tell your broker to sell the stock and buy back the call which is called an unwind. Unwinds will always be executed for net credits.

Sell-write

Many investors do not know this, but there is a trade opposite the buy-write, which is known as a sell-write. To enter a sell-write, the investor simultaneously shorts the stock (sells it) and then writes the put. The resulting position is a covered put; the sell-write is just a method of executing the two trades together to avoid execution risk.

Now, if the stock falls, which is what the investor is betting on, he may be assigned on the short put and be forced to buy the stock. But this is what the trader desires, as he can profitably cover

the short stock position through the assignment of the put. As with the buy-write, the short option position is considered "covered" because the risk of the short put -- the downside -- is covered by the short stock. This does not mean this strategy is risk-free; the trader has unlimited liability to the upside. The short put just provides a little upside hedge.

Example:

A trader is bearish on XYZ trading at $100. He decides to place a sell-write. What is the "natural" based on the following quotes?

Bid Ask XYZ Stock $95-3/4 $100 XYS Mar $95 put option $5 $5-1/2

The natural is $100-3/4 because the trader can currently sell the stock for $95-3/4 and sell the put for $5 for a total credit of $100 3/4. Notice what the sell-write accomplishes. The trader now has a higher net credit, which is what you want when you are short-selling. If the trader were just shorting the stock, he or she would only receive $95-3/4 but instead, with the sell-write, receives $100-3/4. Remember, when short-selling, you sell high and buy low. The sell-write gives you a higher credit.

Because of this higher credit, the sell-write provides a little upside hedge for the trader. If the trader is wrong about the direction of the stock, he or she can afford for the stock to now move up $5 -- the premium received for the put -- to a level of $100-3/4 before heading into losses. The trader who only shorts the stock will be exposed to losses for any price above $95-3/4.

What if the stock falls? If the stock falls far enough, the sell-write trader may be forced to buy the stock at $95 due to the short $95 put. But, as the trader sees it, that's okay because he or she was going to have to buy it to cover the short stock position anyway.

The trade-off with this strategy is this: Say the stock crashes to a price of $50. The short seller would gain the full profit of $45-3/4 (shorts the stock at $95-3/4 and buys it back for $50). The sell-write trader, even though the stock is trading at $50 will be required to pay $95. The maximum the covered put writer could ever make, in this example, is $100-3/4 - 95 = $5-3/4.

Again, it's all about risk and reward. Neither strategy is superior to the other.

There is another important point to consider with the sell-write. In the above example, we said the trader might have to pay $95 with the stock at $50, right? Remember, it is the long put position that decides whether or not to exercise it. So, while you may be ready to close out the sell-write, even though you must pay $95 with the stock trading at $50, you do not have the choice! It is up to the person who is long the put. In these cases, it is sometimes best to simultaneously buy back the put and buy the stock, or unwind the position, even though it will result in less profit.

I have seen it happen where investors enter a sell-write, watch the stock plummet, and then wait to get assigned on the stock yet never do. In the meantime, the stock runs back up, sometimes into losses, and they never get to profitably close out the trade.

Buy-writes and sell-writes are nice strategies to understand because they allow you to get more favorable pricing from the market makers. After all, you are presenting them with two trades rather than one so you can definitely give yourself an edge. In addition, you are aiding the market

makers in their "three-sided positions" (please see our section during week 11 on synthetics), so they are eager to work with multiple orders.

If you like covered calls, you should take the time to explore buy-writes! The 1/4 and -1/2-point differences (or more) can make a huge difference at the end of a trading year.

Early exercise with options Call options allow the buyer to purchase stock at a specified price over a specified time. However, there are two types of call options, one known as American style and the other known as European style.

An American style option allows the buyer to exercise early while the European counterpart requires the buyer to wait until option expiration before purchasing stock with the call option. The question now is this: Is it ever advantageous to exercise an American style call option early; that is, prior to expiration?

The answer will be very obvious to you once we go through some analogies, but surprisingly, this is one of the most common sources of option errors.

If you trade options, be sure you understand this section, as it will keep you from making one of the costliest mistakes in option trading.

Exercising early

Let's start with the answer and then we will show why it is true:

It is never optimal to exercise a call option early except to capture a dividend.

There are many ways to show this is true. Unfortunately, most of the methods involve fairly complicated methods comparing two different portfolios of stocks and options,then comparing them after early exercise to see if one portfolio has an advantage over the other. I don't particularly like these methods as proofs for most investors, as they can get complicated, but we will show you one of these methods at the end anyway. For now, let's show why you should never exercise a call option early (except to capture a dividend) by using a simple story.

Say your broker calls you one day with a hot deal. He has 1,000 shares of ABC stock that he must get rid of. The stock has moved up sharply over the past couple of weeks, from $30 to the current price of $75. He tells you, "This is the hottest stock on the market and is certain to move higher. If you buy it now, I will not charge you a commission."

You think it doesn't sound like such a bad deal. You have been hearing about the company in the news lately and were thinking of buying shares anyway. You tell your broker, "I do not like to make these kinds of decisions in such a short time. I'd really like to research the stock to see exactly what this company does."

Because you have been a customer of the brokerage firm for so long, the broker makes you this final offer. "I will give you 10 days to research the stock and, if you decide that you want to buy it, I will reserve the shares for you at the current price of $75. If, after 10 days, you decide you do not want them, just let me know and I will not charge you anything."

On your first day of research, you come to the conclusion that this company will be bigger than Microsoft and Intel combined. You will be wealthy beyond your wildest dreams if you could just purchase this stock. You must have the shares!

Now, here's the question: Do you call your broker after the first day and buy the shares? Remember that he has given you 10 days to make up your mind and will reserve the $75 price for you.

Hopefully you realize the answer -- you wait until the tenth day. Why? There are two reasons. One, because the brokerage firm is holding the stock and they are the ones at risk! If the stock falls, you will just tell your broker you don't want the shares at $75, as you will just purchase them in the market yourself.

Second, as with any payment, you should prefer to pay as late as possible so that you can earn interest on your money in the meantime. Your purchase price will be $75,000 regardless of whether you buy today or on the tenth day. The answer is clear; you wait as long as possible and call your broker on the tenth day to purchase the stock.

This example may seem blatantly obvious -- almost absurd -- as to the correct answer. But don't laugh; many advanced option traders make this mistake every single day. The situation we just described above is a call option and many traders, mistakenly, elect to call the shares away early.

How is it a call option? Think about what your rights are with a call. You have the right, but not the obligation, to purchase stock for a fixed price over a specified time frame. In the example above, you had the right with no obligation to purchase the shares for $75 for a period of ten days. The reason the example seemed absurd is because you were not required to pay any fees for the privilege of locking in the $75 price.

In fact, if your broker required you to pay a fee, you would exactly have a call option (technically it would be called a forward agreement since the "call option" was not purchased as a standardized contract).

Insights Into Option Pricing

If your broker did decide to take a fee for the arrangement, is there a price where he must accept? Yes, and that price is $75. At $75, you have effectively removed all risk to the brokerage firm so they would have no reason to not accept this bid. In fact, if you read our section on "Option Pricing Basics" during week 5, you will see that the highest price a call can trade is the price of the stock and now you know why. This is also why buy-writes (buying stock and selling calls simultaneously) must be entered as a net debit because the price of the option can never exceed the price of the stock.

Why traders feel they must exercise early

Traders who exercise early make the mistake of not realizing exactly what is happening in a call option agreement. Often, this is how they view the situation. Say the trader purchases a $100 call option for $15. The stock is now $130 with over a month left of time. The option is trading for $32. Here is the mistake: The trader often feels he does not want to "lose" the value of the call option. So, before the market gets the best of him, he decides to exercise it and walk away the winner. Wrong! Remember that the trader is locked into the price of $100. The stock can be trading for $200 and have split twice by expiration, and the stock price is still $100 to the owner of the call option. If he exercises early, however, the stock could completely collapse and he would have been better off not exercising. Also, by not exercising early, the $100 stays in the money market longer to earn more interest.

So what should you do if you feel your option is really high in value and you want to get out before it falls? Sell the call to close. Why? In this example, the trader exercised early and received stock worth $130, but paid only $100 for a gain of $30. After subtracting the cost of the call, $15, his net gain is $15. But if he sold the call to close in the market, he would receive $32 for a net gain of $17 after subtracting out the $15 cost. In other words, if you exercise your call option, you will only receive the stock in exchange for the strike price; you receive only the intrinsic amount. If you sell the call to close, you will collect the intrinsic amount plus the time premium. You will always be better off selling the call to close if you do not want to continue holding the call option.

The last thing you want to hold is the stock; that is the reason you buy the call option in the first place!

Trading Example

One day a trader called in complaining after viewing his balances on the computer that morning. His net worth on the account was $120,000. It was $124,000 the day before yet all of his stocks were trading about the same price or a little higher.

After searching through the transactions, it was discovered that he exercised 10 calls the day before. The option was 20 points in-the-money but the call was selling for $24 the previous day. When he exercised, the four points of time premium were wasted and that's what happened to his $4,000! If he had sold the contracts to close the previous day, his balance would still have been $124,000.

Remember, when you exercise a call, you only receive the difference between the stock price and the exercise price; if you sell the call to close, you receive that same amount plus some time premium.

Still not convinced?

If you are still not sure whether or not that you should exercise a call option early, think about this scenario. Say a trader has a covered call position and bought stock at $100 per share and sold a 1-year $100 call for $25. Now, if they get assigned, they will lose the stock but make a 33% profit (effectively buying the stock for $75 and selling it for $100 a year later). An investor who enters this trade considers the 33% profit a good deal, based on the risk of the stock, for one year's time.

Now, think about this, what is the best thing that could happen to this trader? The best thing would be for him to check his account the next day and see the stock called away. Now he has received 33% in a day instead of a year, which is a much better return (too big to print!). Well, if it's a better deal for the short call position to be called early, it must be an equally bad deal for the long call. This is because options are a zero-sum game; that is, the one trader's gains are exactly the other trader's losses.

Because the long call has control, that investor will do what is best for him -- he will wait until the very end of the year to exercise the call and receive the stock.

Mathematical models

It was mentioned at the beginning that we would look at a mathematical model in addition to the simplistic proofs covered so far. Here, we will look at one of many mathematical proofs that show it is never optimal to exercise a call option early on a non-dividend paying stock.

Consider two portfolios, A and B.

Portfolio A: Present value of exercise price in cash + call option

Portfolio B: Stock

At expiration, the cash will grow to be worth E, the exercise price. Portfolio A will use this cash to secure the exercise price. If the stock is above the strike price and Portfolio A exercises the call, the investor will receive the value of the stock price minus the exercise price (S - E) plus E from the cash which can be written: S - E + E = S. So, if Portfolio A exercises at expiration, Portfolio A is worth the stock price -- exactly as Portfolio B, which contains only the stock.

However, if the stock price falls below the exercise price, E, at expiration, then Portfolio A will lose the value of the call and only be worth E, the cash. Portfolio B will be worth less than Portfolio A because the stock price is below the exercise price.

So, Portfolio A is always worth at least as much as Portfolio B.

But if Portfolio A exercises early, the portfolio is worth S minus E (from the exercise) minus the present value of E, which must be less than S. Why? Because you are subtracting off E and then adding back a number a little smaller than E (because it's the present value). Now, this is the only time Portfolio B can dominate Portfolio A, so A should not exercise early.

I told you I don't like these proofs and now you probably see why!

If you read our section on synthetics during week 11, you will recognize that Portfolio A is really a synthetic call option. By exercising early, Portfolio A gives up the protective value of the put. So no matter which method you use, it is never optimal to exercise a call option on a non-dividend paying stock early.

Capturing a dividend

We have been saying to never exercise a call option early except to capture a dividend. Why would an investor want to do that? There are a couple of reasons. One, the stock may have announced a huge, special dividend. As a call option owner, you are not entitled to anything other than the price appreciation in the stock above the strike price. If the dividend is large enough, you may find it beneficial to exercise the call early in order to be the owner of the actual stock and therefore be entitled to the dividend. In this case, the investor should wait as long as possible and exercise the call the day before ex-dividend date.

The second reason that investors will exercise the call option early is to reduce a loss due to a dividend. Say a stock is trading at $100 and will pay a $1 dollar dividend tomorrow. A trader bought a $95 call a while back for $10, and it is now trading for $5 plus a little time premium. The option will expire in a relatively short time.

However, the stock will be trading for $99 tomorrow morning ex-dividend (the price of the stock is reduced to reflect the dividend payment from the company). What will happen to the call? It will trade for $4 because the stock is down $1, so the trader may elect to exercise the call early to reduce the loss.

So exercising early to capture a known dividend is really a loss reduction strategy as opposed to a profit-seeking one.

One exception for margin traders

Here is a great tip you will not see in any books or hear from brokers. Say you trade on margin (borrowed funds) and are holding a very deep-in-the-money call, maybe a $30 call with the stock trading for $100. Assume there is some time left on the option; it could be a few days or even months.

If you exercise early, you will meet the Fed call for the stock just by exercising! This is because the call is so deep-in-the-money. Because you are receiving stock so highly valued relative to the strike, your margin cash available and buying power will explode to the upside. So if you are in a situation where you need to generate cash available or buying power to take advantage of a certain stock, or perhaps to meet a margin call, exercising early may be your answer!

The reason you never see this in the textbooks is because, by itself, exercising early gains you nothing in the asset. It is only due to other market mechanics of margin trading where it may benefit you. So, keep that in the back of your mind if you ever are lucky enough to have a call option go very deep-in-the-money and need to trade on margin. You should definitely check with your broker for specific details.

Early exercise with puts

Early exercise with puts, unlike calls, may be advantageous to the long position. This is because put options represent a cash inflow to your account. If the put option is very deep-in-the-money (technically where delta is equal to one), the put should be exercised. As an example, assume you are holding a $100 put option with 3 months of time remaining. The stock is trading at $40 and you see no hopes of it coming back above $100 by expiration. If you wait until expiration, you will receive $100 for your stock. If you exercise now, you will receive $100 for your stock. Which do you prefer? As with any cash inflow, we prefer to have it paid earlier as opposed to later, so we exercise the put and take our $100 now.

Although options can be used as a tool to buy or sell stock, most option contracts, somewhere in the neighborhood of 98%, never become exercised. This is because most option traders use them as a hedge. For example if an option trader has 100 shares of stock at $50 and also has a $50 put. The stock closes at $40. Rather than using the put to sell the stock, the option trader will close out the put for a $10 gain and use that to offset the $10 loss in the long position. Because of this fact, most option traders are not very familiar with exercising options. Make sure you become very aware with when and why to exercise. Not understanding can be costly.

No Options For Me! (Think twice -- you may already be using them)

Speculation still seems to be a forbidden word with the financial press. Magazines, television shows and many professionals alike will tell you that speculation is bad for the market and is the cause of the recent volatility.

There are so many investors who adamantly believe this and refuse to buy or sell options; they insist on holding only stocks. But if you refuse to use options, you are speculating. How? Options were created as hedging tools. Whenever you hedge, you give up some upside profits in exchange for some downside protection (the opposite if you are short the stock). So if you buy stock and refuse to buy or sell options, you are speculating that nothing will go wrong with your long stock position. You are willing to hold out for more profit at the expense of downside exposure to a price of zero. In fact, it can be argued that investors who don't use options are among the most speculative of all!

If you're still in doubt, would you believe that stock can be viewed as an option?

Valuing corporate securities as options

When Black and Scholes developed their famous option-pricing model, they were certain there were many uses for it other than just valuing call options. One of the uses they suggested was in valuing corporate securities.

Consider a firm that has issued one zero-coupon bond that matures to a value of $1,000,000 in five years. With this money, the firm produces things and hopes to have a value in excess of this $1,000,000 in five years, and pays off their debt, leaving the stockholders with whatever remains in value. However, if the firm's value is less than $1,000,000 at maturity of the bond, the stockholders will simply turn over the assets to the bondholders and will be free of further liability.

Let's look at the payoffs for stockholders and bondholders at maturity:

If value of the firm is less than $1,000,000, say, $800,000: Bondholders get: $800,000 Stockholders get: $0 Total value of firm = $800,000

If the value of the firm is greater than $1,000,000, say $1,500,000 at maturity: Bondholders get: $1,000,000 Stockholders get: $500,000 Total value of firm is $1,500,000

We see with the above payoffs that the total value of the firm is partitioned between the stockholders and bondholders. Notice how the stockholders get nothing at expiration if the value of the firm is below the value of the matured debt. But if the value of the firm is greater than the matured debt, stockholders receive the excess value.

Now compare this to options.

You own a $100 call option that someone has written as a covered position:

At expiration, if the value of the stock is less than $100, say $80: Call writers get: $80 Call owners get: $0 Total value of firm is $80

In other words, if the value of the stock is below the strike at expiration, the covered call writer is left with the stock at its current value of $80. The long call position receives nothing.

If the value of the stock is greater than $100, say $150 at expiration: Call writers get: $100 Call owners get: $50 Total value of firm is $150

If the value of the stock is above the strike at expiration, the covered call writer will be assigned and receive the $100 strike price. The call owners will receive the stock and pay the strike for a value of the stock price minus the strike price. The stockholders, in this case, receive what's left over after the bondholders are paid.

If you look closely, you will see that the payoff for the call option above exactly resembles the payoffs to the stockholders for the corporation discussed earlier.

Using the Black-Scholes Model

If you read our section on synthetics, you may recall the put-call parity formula:

Stock + Put - Call = Present value of the exercise price

We can rewrite this for the above corporation as:

Stock + Put - Call = Present value of the debt

This can be rewritten at maturity as:

Stock - Call = Value of debt - Put

So the Black-Scholes Option Pricing Model tells us that the value of the covered call position (left side of equation) in our hypothetical firm is equal to the debt at maturity with a put written against it (right side of equation).

This means the bondholders have, in essence, written a put against the firm. How? In other words, if the value of the firm is less than the debt that is due at maturity, you "put" the firm back to the bondholders and walk away losing only what you paid for the stock -- just as when you buy a call option.

The value of this put is part of what gives your stock its value!

If you like owning stocks for this reason, you should consider using options in some fashion. Options allow you to do exactly what you're doing with stock -- but for a lot less money. They can also be used to create downside hedges in exchange for upside

profits. Because of these uses, you can create better risk-reward profiles that are simply not possible with stock alone.

There are many fascinating insights that can be learned from the Black-Scholes model. Once you have a better understanding of options, you will start to see that stockholders are option players in disguise and the Black-Scholes Model can be used to value corporate securities too. If you acknowledge this, you may start to open your eyes to the world of options, and create new trading opportunities that you never thought possible.

Option Exam 1 - Week 1 1) Which of the following is a covered call position?

a) Buy stock and sell a call

b) Buy call and buy a put

c) Buy calls and sell stock

d) Buy stock and buy puts

2) An investor is long stock at $100 and short the $100 call. Later the stock is trading for $110 and the investor buys the $100 call to close and simultaneously sells to open the $115 call. This investor has executed a(n):

a) Rolldown

b) Rollup

c) Unwind

d) Sell-write

3) An investor buys stock for $50 and writes a $55 call for $2. What is the cost basis for the stock?

a) $52

b) $55

c) $48

d) $57

4) What is the risk of a covered call position?

a) The stock rises and you are forced to sell it

b) The stock sits still

c) There is no risk

d) The stock falls

5) An investor wishes to buy stock currently trading for $100 and write the $100 calls currently trading for $7. In order to not face execution risk, the investor can enter a(n):

a) Buy-write

b) Sell-write

c) Unwind

d) Rollup

6) Which of the following styles of options can exercise early?

a) Asian

b) American

c) European

d) Australian

7) You purchased a $50 call and the stock is now trading at $65. You are a little nervous that the stock may fall, so you want to secure some profits. You should:

a) Sell the call to close

b) Exercise early

8) The quote on an option is currently bid $7 and asking $7-1/2. If you place a limit order to buy 1 contract at $7-1/4, what will the new quote be (assuming the order is not filled)?

a) Bid $7, asking $7-1/4

b) Bid $7-1/4, asking $7

c) Bid $7-1/4, asking $7-1/2

d) Bid $7, asking $7-1/2

9) The quote on an option is bid $10 and asking $10-1/2. If you place a limit order to sell 1 contract at $10-1/4, what will the new quote be (assuming the order is not filled)?

a) Bid $10-1/2, asking $10-1/4

b) Bid $10, asking $10-1/2

c) Bid $10-1/4, asking $10-1/2

d) Bid $10, asking $10-1/4

10) You just placed an order to sell naked puts, but your brokerage firm rejected it. You have plenty of cash in the account. What is a possible problem?

a) You do not have the proper option approval level b) It is not possible to sell naked puts c) Naked puts can only be sold against short stock d) You must sell the puts on an uptick

Measuring The Leverage Of Options You have probably heard that one of the biggest advantages of trading options is leverage. By leverage we mean that for a given percentage change in the stock, the option will increase by a larger percentage, thus leveraging, or magnifying, the return on investment.

For example, say a stock is trading for $100 and a $100 call is trading for $5. If the stock closes at $115 at expiration, a 15% move, the option will be worth $15, a 200% move.

One way to view this leverage is to realize that the option trader, in this example, has leveraged the returns by a factor of twenty. In other words, for every 100 shares the stock investor buys ($10,000 worth), the option buyer can buy 20 contracts ($10,000 / $500 per option = 20).

If the stock trader invested $10,000, it would grow by 15% to a value of $10,000 * (1.15) = $11,500, or a profit of $1,150. The option trader's account will be worth $10,000 x 200% increase= $30,000. If we multiply the profit of the stock trader, $1,500, by 20, we end up with $30,000, which is the value of the option trader's position. In this example, the option trader's total account value will always be worth 20 times the stock trader's profit, assuming the $100 call option has intrinsic value.

Gearing

The leverage described above is known as gearing, and is actually just an old British term that means leverage. It is not uniquely defined, but the two most common definitions are (1) The stock price divided by the option price or (2) The strike price, divided by the option price.

Using definition 1, the way to find it is to simply divide the stock price by the option price:

Gearing = stock price / option price

In our example, the stock was $100 and the option was $5, so $100/$5 = 20.

This is just another way of saying the stock trader required twenty times the amount of capital to control the same amount of shares.

Using the second definition, gearing would be:

Gearing = strike price / option price

This gives the same answer of 20. But what if the strike was $110? Now the gearing is $110/$5 = 22. In this way, the option trader may pay $110 for the stock but is controlling it for $2, so is leveraged by a factor of 22.

Omega

There is another term you may encounter that describes leverage and is called omega. Omega measures the relative percentage changes between the stock and the option -- called an elasticity measure. For instance, assume the call in the above example has a delta of 1/2. With the stock at $100 and the call at $5, if the stock were to move $1 (a 1% move) the call will move roughly 1/2 point for a 10% increase. Because the option moved 10 times faster relative to the stock (10% compared to 1%), the elasticity, or omega, is 10.

Omega = Delta / option price 1 / stock price

This can also be written: (stock price / option price) * delta

Using the above formula in our example, we have a $100 stock price divided by a $5 call option with delta of 1/2, so:

$100/$5 * 1/2 = 10

Regardless of which measure you use, the higher the leverage the more speculative the position.

It should also be noted that option traders should invest in the equivalent share amount as they would a stock purchase, and not the equivalent dollar amount. For example, the trader above invested $10,000 on 100 shares. If he elected to use the call option instead, it is advisable to purchase one contract representing 100 shares as opposed to buying $10,000 worth of the $5 option or 20 contracts.

The reason is due to the leverage. If a trader is not used to dealing in 2,000 share orders (20 contracts), the leverage and losses can become too great too fast. By using share equivalents, the stock and option positions will behave similarly and not leave the trader with losses he was not prepared to take.

Leverage can be a very powerful -- and destructive -- tool. If you understand the various ways to measure leverage, it will make you more comfortable with your option picks and strategies!

Open Interest You will often hear the term "open interest" in option trading. It can be very helpful to understand what this means, and how the number is either increased or decreased.

Because of the way options are traded, the Options Clearing Corporation (OCC) must account for the total number of outstanding contracts. To do so, one could either tally all long positions or all short positions and get the total number of outstanding contracts. This is because each contract has a buyer and a seller (a long and a short position). Some people mistakenly believe that the

open interest is the total number of long and short positions. However, this would double count the actual number of open contracts.

For example, say there are currently no contracts at all trading on a particular stock. If Larry decides to buy 10 contracts, he must find someone who is willing to sell 10 contracts. If Moe would like to sell them, then a buyer and seller can be matched and the total open interest is now 10 contracts.

Notice how open interest is not the total long and short positions. If we count all longs and shorts using the above example, we have 10 contracts long and 10 short, which give us a total of 20 -- exactly double the correct answer.

Now say another trader, Curly, wants to buy 10 contracts. If he "buys to open" and Larry "sells to close," then, in effect, all that has happened is that Larry and Curly have switched places and there are still only 10 contracts outstanding. Why? Because Larry originally "bought to open" and then "sold to close," so he's out of the picture altogether. Now Moe and Curly are effectively matched.

Whenever one party is opening a position and the other party is closing a position, open interest remains unchanged.

Should Moe be concerned that Larry is not on the other side of the trade anymore? No, because technically, OCC acts as a middleman and is the buyer to every seller and the seller to every buyer. The trades are all guaranteed (for contract performance, not profit!) by the OCC.

Let's say Larry wants back in the action and "buys to open," but this time, another trader "sells to open." Assuming this trade was also for 10 contracts, the total open interest is now 20 contracts.

Whenever both parties are opening positions, open interest will increase by the amount of the contracts traded.

In the above example, Moe and Curly have open positions and are accounting for 10 of the 20 contracts in open interest. If Moe "buys to close" and Curly "sells to close," the total open interest will fall to 10.

Whenever both parties are closing, open interest will decrease by the amount of the contracts.

New traders are often confused with situations similar to this: Say a new trader "buys to open" 10 contracts on an option that has no other volume for the day, and the option had 100 open interest yesterday. The next day, open interest still shows 100. The new trader often thinks that a mistake has been made because they "bought to open" 10 contracts, so the open interest must surely be 110 now. Hopefully it is evident to you now why this may happen -- the other side of the transaction must have been "selling to close" keeping the open interest unchanged.

How to read the open interest numbers

The open interest figures for a particular contract are counted as round lots of 100 -- just like the option contracts. So if you see open interest of 250, this really means that a total of 250 *100 (or the equivalent of 25,000 shares) is being traded in this option.

This is important to understand for trading purposes, especially if you are placing large dollar amounts in a particular option. Say an option shows 3,500 contracts open interest (or a total of

350,000 shares) being represented. On the surface, there appears to be a lot of liquidity in this option. However, a better method is to take the 350,000 shares and multiply it by the market price of the option. Whether you use the bid, ask, or last trade usually won't make a huge difference unless there is a very high bid-ask spread. Let's say the last trade was 1/8. In terms of total dollars in the contract, that's only $43,700, which by market standards, is not too liquid.

Conversely, the Nasdaq 100 Index (NDX) is currently trading around 3,320 with the Nov $3,350 call trading about $186 (yes, this index is extremely expensive due to the volatility!). There are "only" 558 open interest, which doesn't appear to be too liquid. But if we take 558 * 100 * $186, we see there is over $10,000,000 in liquidity.

Before you place relatively large option orders, check the liquidity by calculating the total dollars in open interest in that option.

Example:

You are bullish on MRVC trading around $38-1/2. You want to "buy to open" 30 contracts of the Dec $30. Are there potential liquidity problems?

Checking open interest we see there are only 8 contracts for a total of 800 shares represented by this contract. The price is $12-1/4, which is 800 * $12-1/4 = $9,800 dollars being represented. This appears to be a potential liquidity problem at this point. This is not to say that things cannot change as December expiration approaches, as they certainly can. However, it is important to make your decisions with all available relevant information. Would you feel comfortable with a trade this large and only $9,800 worth of liquidity?

If not, it may be best to spread your risk through other strikes or expirations.

Large Bid-Ask Spreads Often when you are trading options, you will notice that the bid-ask spreads can become quite large -- as much as three or four points and more for some of the more volatile indices. These large spreads are usually found for deep in-the-money options and long term LEAPS®.

Understanding why this happens will help you with trading as well as understanding the importance of not placing market orders for options that fall into these categories.

To start, you need to understand how prices are determined.

How prices are determined

All prices are determined by equating supply and demand. Although there are substantial differences in the way various securities markets go about equating these two forces, the basic idea applies. For example, option equilibrium is determined in the opening rotation, by the specialist for the New York Stock Exchange and by numerous market makers for the Nasdaq market. All methods have their own benefits and drawbacks but the effects are the same -- they try to determine the fair price of the security.

Let's start with a simple example of how prices are determined, then include the assumption of a bid-ask spread later.

Say there are 11 people who are bidding (wanting to buy) for a particular option and 11 people offering to sell. The following chart shows their bid and offer limit orders. Also, to make things easier, we will assume all participants are placing equal numbers of contracts.

Bids Offers 7 1/8 5 7/8

7 6 6 7/8 6 1/8 6 3/4 6 1/4 6 5/8 6 3/8 6 1/2 6 1/2 6 3/8 6 5/8 6 1/4 6 3/4 6 1/8 6 7/8

6 7 5 7/8 7 1/8

Keep in mind that a bid of $7-1/8, for example, means that is the highest price that person is willing to pay; they will gladly pay less, just no higher. An asking price (or offer) of $7-1/8 is the lowest for which that person is willing to sell; they will surely sell for more, just not less.

The question now is what is the fair price for the option? Again, to make things a little easier, we will assume no bid-ask spreads at this point.

Say the option opens up with a price of $7-1/8, the highest bid. Because we are assuming there is no bid or ask spread, any buyer can buy for $7-1/8 and any seller may sell for the same price. What will happen? If you look closely at the above chart, you will see that there is only one buyer (the one bidding $7-1/8) but 11 sellers. Why 11 sellers? Obviously, the lowest offer of $5-7/8 will certainly be willing to sell for $7-1/8. So all 11 offers will want to sell, but only one person is willing to buy -- you have unequal supply and demand.

What happens if you have unequal supply and demand numbers? If you have unequal numbers, in this case more sellers than buyers, the sellers will start competing for that buyer's business and the price will fall. In order to keep buying or selling pressure from being prevalent, there must be equal numbers of buyers and sellers. It can also be shown, although we will not do it here, that when the numbers are equal, that will be the point of maximum profit for the market makers, so they have great incentive to find this point.

Back to the example, what if the option price opens at $6? Now there will be 10 buyers; all of them will buy except for the person who bid $5-7/8. For the sellers, only two people will sell: the

person who is willing to sell for $5-7/8 and the one willing at $6. Again, we have unequal balance between supply and demand except, this time, there are more buyers. The buyers will start to compete for the business of the two people willing to sell and the price will be bid up.

The price where there is no imbalance is $6-1/2. If the option's price is $6-1/2, you will have 6 buyers and 6 sellers.

Looking at our bids and offers in the above chart graphically:

We see that at a price of $6-1/2, we can exactly clear the market; there is a buyer for every seller at that price.

However, because of the nature of the markets, market-makers will put in bid-ask spreads as a profit margin for matching buyers and sellers. So they may post this option as bid $6-3/8 and offered at $6-5/8. Now, because of the bid-ask spread, we have three forms of inefficiencies, and investors must now:

1) Pay a higher price ($6- 5/8 vs. $6-1/2) 2) Sell for a lower price ($6-3/8 vs. $6-1/2) 3) Have less volume (5 instead of 6)

These are the three inefficiencies created by bid-ask spreads.

Now, think about this: What would happen if the volume were reduced to only four buyers and sellers?

If the volume is reduced to four contracts, the bid-ask spread will widen as shown by the dotted gray line above. Notice how much wider the dotted line is compared to the red line that represented the initial bid-ask spread (shown in red).

Often you will hear that the large spreads are a result of market-makers "playing games," or trying to cheat you on your order. Bear in mind that the only way they make money is to fill orders, not just produce quotes. If the spreads are too wide, investors will not be attracted to the security and will produce no volume. In addition, if the spreads are unfairly too wide, you can be assured another market maker will compete for the business and narrow the spread. Market makers are reflecting the liquidity risks by the bid-ask spreads and their ability to spread the risk by hedging the position. If you feel a bid-ask spread is too wide, remember, you are always free to "tighten the spread" by either bidding higher or selling for less (please see our section on "Show or Fill Rule".)

So, what you want to get from all this is that the market determines the bid-ask spread--not the market-makers. So if you see an option (or stock, for that matter) with a large bid-ask spread, just understand that this is the sign of a potential liquidity problem. If placing orders in these securities, it is generally advisable to consider going "in between" the bid-ask spreads to improve your trading results.

For example, say the quote is bid $6-1/4 and ask $6-3/4. If you want to buy, you can buy at the asking price and pay $6-3/4. Or you can put in a bid above the current bid of $6-1/4. Say you put in a bid of $6-1/2. The quote will now jump to bid $6-1/2 and ask $6-3/4. Notice that your higher bid has tightened the spread. There is now a higher bidder on the market (that's you) at $6-1/2, which gives a seller incentive to sell because of the higher price. The reverse holds true for sellers. If a seller places an offer below the $6 3/4 quote, say $6-5/8, the quote will now become bid $6-1/2 and ask $6-5/8. The new lower asking price will give another investor incentive to

buy. Notice how the spread has been further narrowed from the original 1/2 point spread (bid $6 1/4 and ask $6-3/4) to a 1/8th point spread (bid $6-1/2 and ask $6-5/8).

Large bid-ask spreads can be frustrating, especially when using options, because of the leverage. Use this information before entering into the position and do not be afraid to compete for a better price (unless there is some reason you absolutely must have the trade). If you do not get the option, this only represents a lost opportunity, which is usually better than a lost profit from being forced to exit a position that holds large bid-ask spreads.

Profit And Loss Diagrams As the saying goes, a picture is worth a thousand words. This is so true when it comes to profit and loss diagrams on options. By looking at a picture, you can immediately see where your max profit and loss is, feel how the position will behave, and know where the danger zones are for any strategy.

Unfortunately, there are basically two types of option investors. Those who can read profit and loss diagrams, and those who can't!

Being able to read and understand the profit and loss diagram is critical for understanding options.

Important Note: Before we get started, there is one very important point that needs to be made here. When we speak of profit and loss diagrams, we are talking about the profit and losses at expiration of the option. Prior to expiration, it is very difficult to say what the profit/loss diagrams will look like because of the many factors that affect an option's price.

So what exactly is a profit and loss diagram? Let's start with the simplest one -- a long stock position.

If you are long stock (meaning you own it), you will make one point of profit for every point increase in the stock above your cost basis. Likewise, for every point drop below your cost, you will lose exactly one point. This is easy to show on a spreadsheet. Assume we buy 1 share of stock at a price of $50:

If the stock price is: Your profit/loss will be $45 -$5 $46 -$4 $47 -$3 $48 -$2 $49 -$1 $50 $0 (the break-even point) $51 +$1 $52 +$2 $53 +$3 $54 +$4 $55 +$5

Assuming you paid $50 for the stock, this table shows that you will have a loss of $5 if the stock is trading at $45. If the stock is trading for say, $53, you will have a profit of $3 per share. If the stock is trading for $50, you will have no profit and no loss -- you are just breaking even.

You must admit, even though this is a relatively simple position, it's not readily apparent as to the behavior. So let's take the above numbers and put them in a picture -- a profit and loss diagram. All we have to do is plot the stock prices from the table above on the horizontal axis (the x-axis) and the profit/loss numbers on the vertical axis (the y-axis). Once we do, we get the following picture:

How do you read the chart? Using the chart below, look at any stock price along the horizontal axis such as $53, for example. Now trace a line to the profit/loss line (blue) and see where that point lines up with the vertical axis to the left. It lines up with $3 profit, which is exactly what we calculated in the spreadsheet previously. At a stock price of $46, we see the profit/loss line shows a $4 loss.

It should be evident that it is much easier to look at the picture rather than the spreadsheet to see how a long stock position, at $50, will behave. We know immediately that the break-even point is at $50 -- the point where the profit/loss line crosses zero on the horizontal axis. We can also immediately see that there is unlimited loss (at least all the way down to a stock price of zero since you can never lose more than what you paid) and an unlimited upside potential as the line continues up to the right without bounds.

What if you are short the stock? Shorting stock involves borrowing the shares and selling them with the intent of buying them later at a cheaper price. You are, in essence, doing the reverse of the traditional "buy low - sell high" strategy. You are trying to "sell high - buy low." The profit and loss diagram for short stock looks like this:

A short position will always behave the opposite of the corresponding long position. In this case, we see that profit is made as the stock falls and unlimited losses occur as the stock rises. The unlimited loss part is what makes the short stock position so dangerous!

Got the hang of it? Ok, let's try something a little more complicated and see what a long call position looks like.

Long call position

A long $50 call gives the owner the right, but not the obligation to buy stock at a price of $50 over a specified amount of time. The trader, in this case, paid $3 per share for that right and, consequently, that is all that can be lost. So, no matter how low the stock falls, this trader's maximum loss is just the premium of $3.

Looking at the chart below, we see the call option trader has, in effect, limited the downside risk below $50, as compared to the long stock position, but still retained all of the upside potential. Of course, this does not come for free. If you notice, the break-even has been moved upward by $3, the price of the call option, to $53. This is the most powerful benefit of options; they allow you to custom-tailor the profit/loss profiles to exactly suit your needs.

Short Call

Let's see what a short call looks like. Remember, we said at the beginning that a short position would be exactly the opposite of the corresponding long position.

The profit/loss diagram for the short call (red line) is telling us that the maximum profit is $3, the amount of the premium. This will be made for any stock price (at expiration) below $50. Because

the $50 call will be worthless to the owner (the long position) at expiration, the short position will profit by the entire premium of $3.

Notice how this short call is the mirror image of the long call position (blue line). For the long call, $3 is the maximum loss; this is the amount of the short call's maximum gain. The short call's break-even point is at $53, because at this point at expiration, the option will be trading for $3, (remember, this is the profit for the long position). The short's position will be worth -$3 and this is the amount for which the call was sold for a net profit/loss of zero. If the stock moves above $53, unlimited losses will occur for the short call beyond this point. Because of the high leveraged nature of options, the short call (also called a naked or uncovered call) position is the riskiest of all! Why? Because you can only make a limited gain on the position, but are assuming an unlimited risk to do so.

An interesting point should be made here. Look again at the above chart with the long call and short call positions. Because they are mirror images of each other, this shows that no net flow of cash is created from the options markets. In other words, any option trader's gain is exactly somebody else's loss; the money merely changes hands. The financial press is often known for making the statement that the options markets should not exist for this very reason. This is a big misconception. The options markets were created as a way to hedge risk; it is a way for hedgers to meet speculators. So the next time you hear about a devastating loss due to derivatives, remember, the trader/traders on the other side of the trade made exactly that amount of a gain.

Okay, let's work one backwards. I'll show you the profit/loss chart and see if you can identify it:

Look at the chart and try to read it: The trader in the diagram can only lose $5, no matter how high the stock goes. But, an unlimited amount (down to a zero stock price) can be made if the stock falls below $50. Which option position has these characteristics?

If you said a long $50 strike put, you're right! A long put is a bearish position; you make money if the stock falls (assuming it falls far enough to offset the premium). A short stock position, as we saw earlier, is bearish too. But, the long put position is not exposed to the unlimited upside risk as the stock moves higher. Again, this does not come for free. The long put position, in this example, must have the stock fall below $45 before money is made. The short stock position will make money for any fall in the stock below $50.

Okay, just to make sure you have it, let's look at a short put, which remember, should be the mirror image of the long put above.

And we see that it is. It is easy to see from the profit and loss diagram that a short put is bullish, as maximum profit is made when the stock is above $50. The trader is exposed to unlimited losses (down to a stock price of zero). This short put position will break-even at a stock price of $45, since the put will be worth -$5 at expiration, which is exactly the amount of the premium collected.

Combination Strategies

The above strategies are relatively simple, but are intended to teach you the basics in reading a profit and loss diagram. Now we will get a little more complicated and really see their value when we look at combination strategies. These are strategies that combine two or more positions to really custom tailor those risk-reward profiles you may be seeking but were unable to do with stock alone.

For starters, let's view the profit/loss diagram for a covered call position, which is one of the most popular strategies in options. The covered call is a strategy in which the investor buys the stock and sells (or writes) the call against that stock. The investor will take in some money for doing so, which in effect, provides a small downside hedge -- it lowers the break-even point. However, the investor also gives up some of the upside potential in the stock.

Let's piece the two positions together. Remember that the profit/loss for long stock looks like this (assuming that $50 is paid per share):

Now let's add the covered call. Say the investor sells a $60 call against the stock for a premium of $5. This means the investor will receive $5 per share but may have to sell the stock at $60. On the surface, it doesn't seem like a bad deal as you are getting paid to sell your stock at a profit. As we will soon see, with the help of our profit/loss diagram, there is a price to pay.

By selling the $60 call, the investor "gives up" any appreciation in the stock above $60; he has sold those rights to somebody else -- the person who bought the call. But the investor also reduces the downside risk, slightly, in exchange. The total covered call position now looks like the red line below:

The red line is our profit and loss diagram for the covered call position. We see that the break-even has now been reduced to $45 because of the $5 premium received from the call. However, for any stock price above $60, there is no more appreciation in the position as there is for the long stock position. The maximum that can be made, in this example, is $15. How? If the stock is $60, we make $10 on our stock because we paid $50, but also made $5 from the call for a total of

$15. If the stock is higher than $60, it does not matter; we are under contract to sell it for $60, so our profit is still $15.

Now here is the price you pay for entering into a covered call position. YOU are holding ALL of the downside risk! You cannot sell your stock until expiration of the call unless you are willing to buy the call back, which could be a loss. Otherwise, you must wait for expiration in order to fully profit by the $5 premium.

The Myth Of Covered Calls

There is a lot of bad information floating around out there about covered calls. If you ask most people, brokers included, you will hear that the "risk" of a covered call position is that you may have to sell your stock for a price below market. In other words, the stock may be trading at $100 but you have to sell it for $60. Look at all of the points on the above chart at $60 or above -- the points where you will likely be assigned on the option and must sell your stock. Is this the "risky" area of the chart? NO! It is our maximum profit zone, exactly the points where you want to be. There are a lot of professionals and academic journals that surprisingly make this mistake. It is a huge myth in the marketplace. The risk of any position is not missing out on some reward.

If you are really sharp, you may have noticed that the covered call profit/loss diagram is exactly the same shape as that for the short put shown earlier. These are called "synthetic equivalents" (and will be discussed in detail at a later time). Covered calls are often considered among the "safest" strategies while naked puts are considered to be one of the riskiest. Covered calls and naked puts are, incorrectly, considered by many to be polar opposites in terms of risk. Even option approval levels with your broker will usually require the lowest level for covered calls and the highest level for naked puts. Yet, from a profit and loss standpoint, they are exactly the same strategies.

Now you should understand the beauty of profit/loss diagrams. They can help uncover the myths.

The risk with the covered call is the same as with the naked put. The risk is that the stock goes down.

So who should enter into a covered call position? If you write calls against stock you would hold regardless, then writing calls can be a great strategy because you were willing to assume the risk with or without the covered call.

But if you are buying the stock because of the premium, then you should strongly reconsider your strategy. People who do this are known as premium-seekers, as they seek out the very high premiums on the options, then buy the stock just to gain the premium. I have witnessed, on more than one occasion, million dollar accounts becoming virtually worthless doing nothing but covered calls using this method.

Long straddles

The long straddle is a position where the trader buys a call and a put with same strikes and expiration. The idea behind the strategy is that a large move is expected but the trader is unsure about which direction. Usually, this strategy is used prior to an earnings report, FDA approval for

a drug company or some other big announcement. If the report is favorable, the stock may run wild to the upside; if not, it may tank. So the strategy plays both sides.

We will be discussing straddles in detail at a later time, but we do want to make the point that playing straddles solely for news announcements is usually not a good strategy, as the price of the calls and puts will already factor in the expected rise or fall of the stock. This means that it will usually be difficult to get out of the straddle for a profit. A bigger reason to play straddles is if you think the market has underestimated the volatility.

Say a trader buys a $50 call for $5 and a $50 put for $3 for a total of $8. What does its profit/loss diagram look like:

It is easy to see now where your profit zones are. This trader will need to see the stock go above $58 (the strike plus both premiums) or below $42 (the strike minus both premiums). If the stock stays between these two points, at expiration, the trader will lose a maximum of $8.

Be aware of seminars or books that announce, "We'll show you how to make money regardless of where the stock moves" as they are usually talking about straddles.

The downside to the straddle is that you are basically buying a very expensive call and a very expensive put. In effect, you are buying the call for the price of a call and a put. You are also buying a put for the price of a call and a put. This is because you must buy both options to complete the straddle yet only one will be in-the-money at expiration (unless the stock closes exactly at $50 or under a rare partial tender offer where both options can expire in-the-money). This makes the straddle very tough to profit from unless you get a tremendous move in the stock. So, while you may "make money" on either leg of the spread, that's not necessarily the same as being profitable.

Okay, ready for one more?

Ratio spread

Let's look at a more complicated position -- the ratio spread. I am only showing this to demonstrate the power of the profit and loss diagrams and why you should learn to use them. I

will not even discuss the strategy (although it will be available in another section), but instead, I want to see if you can identify the critical points.

First of all, let's say a trader buys 10 $50 strike calls for $5 and sells 35 $65 strike calls for $1-3/4. That's a ratio spread, or ratio-write with calls.

Now, think about this for a minute. Just by looking at the above ratio spread, can you tell what the trader wants the stock to do? Where the maximum profit and loss is? Where the danger zones are?

It's pretty tough, isn't it?

Now let's use the profit and loss diagram for the ratio spread described and see if we can answer the questions a little easier:

Much easier, isn't it? We can now see that the trader will make money if the stock either collapses below $50 or rises up to $65, which is the point of maximum profit. After $65, the trader starts to lose some profits and will reach a break-even point around $73. Beyond $73, unlimited losses will occur.

Would you have been able to analyze the trade in this way just knowing that the trader bought 10 $50 calls at $5 and sold 35 $65 strikes at $1-3/4? Don't feel bad, most people can't. But that's what profit and loss diagrams are for.

Learn to use them, as they will greatly help your understanding of option strategies!

Are Options Good For The Market? Many times I am asked if options are good for the market. After all, there is no new equity created as when new shares of stock are issued. What seems to be happening is that we are allowing a legalized gambling arena. At least, this is what the popular financial press would have us believe.

Further, we saw Baring's Bank, a 233-year old institution that helped finance the Napoleonic Wars, brought down single-handedly by an options trader. Certainly options cannot be good for anybody, right?

Before you take that view, let me show you why options were created and why they are actually good for the market. Options were created out of economic necessity, and are a logical extension of a well-developed financial market.

To help you understand, assume that there are no options and only stocks. Say you want to buy shares of ABC stock, trading for $100, and you're a long-term investor -- none of this short-term speculative stuff for you! When you decide to purchase shares for your long-term hold, what's better for you, one seller or two? Obviously, two sellers are better, as they will compete for your business and help to lower your purchase price. Likewise, when you sell your stock, would you prefer one buyer or two? Again, you should prefer two, as they will compete for your business and help to raise your selling price.

In other words, the more market participants you have, the better off you are whether buying or selling. Another way to say this is that the bid-ask spreads will be narrowed, causing more stock to transact -- and more wealth to be created. The spreads will narrow because the buyers will compete by raising the bid price (giving incentive for sellers to enter the market), and the sellers will compete by lowering the asking price (giving incentive for buyers to enter the market). The financial markets always benefit from narrow spreads.

Notice in the following diagram how the bid-ask spreads (red-dotted line) cause less shares to be sold (122,000 instead of 128,000) when compared to no spread (solid blue line).

Now, back to the buying of your stock. At this time there is only one seller, who also is a long-term player and has held this stock for ten years. Notice the nice, neat, clean market we have here with no speculators. However, with only one seller, this is certainly not a good situation for you.

Now let's meet Sam Speculator. Sam likes to speculate on market direction. He's willing to take big risks and gamble for big profits. Long-term investing for him is measured in hours. He just happens to think ABC stock will fall a few points. He would short the shares (which would be good for you since you'd have another seller), but he's very afraid to because of the recent volatility in ABC. He doesn't want to take the risk of the stock moving higher. So he sits on the sideline, leaving you with just the one seller.

Now let's enter the options market. Call options give market participants a way to purchase stock, while put options provide a way to sell stock for a fraction of the cost of the stock. In addition, the owner of a call or put option has risk that is limited to the amount paid for the option. This idea gets Sam's attention. He puts in a bid to buy 10 of the $100 strike puts for a price of $5 1/2.

The market maker sees this order and wants to fill it, as this is how he makes money. He will create a synthetic put by selling stock and buying a call. In other words, the market maker must "manufacture" the long put option that Sam wants. But where will the market maker be able to buy the call? He doesn't know either, so he puts in a bid to buy one for, say, $5-1/4.

Another investor, Conservative Connie, also hates the idea of speculation in the markets. However, she will gladly sell someone a call option against stock in her IRA account, as it will give her income without the need for selling her shares. She happens to own ABC stock, so she sells the market maker the call and pockets the $5-1/4 per share. She's willing to assume the downside risk on ABC (if she wasn't, she wouldn't own it). Connie doesn't think the stock will fall; Sam thinks it will. Together, they bring more stock to the market.

Notice what's happened. The market maker shorts stock, which is really what Sam wanted to do but was afraid of the risk. The market maker then protected himself with the purchase of a call and sold that package (a synthetic put) as a long put to Sam.

You wanted to buy shares of ABC but now have two sellers instead of one. The market maker, in essence, has partitioned his risk between two other players. Together, Sam and Connie hold the synthetic short position (Sam is long the put and Connie is short the call). Because those two participants were willing to accept the associated risks, the market maker was able to short the stock, thus lowering the asking price of the stock you're interested in buying!

Options, in this example, gave us an arena in which to meet speculators. It doesn't matter where they live or what they want to use the option for. In this example, Connie was willing to assume the downside risk of the stock if she could get paid for it. Sam was willing to pay for that. Unfortunately, Sam doesn't know Connie. But, through the options market, Sam and Connie are matched.

Ultimately, the options markets bring in more participants, making the spreads narrower for all. So speculators are actually a necessary part of financial markets, and although it's sometimes difficult to see, they make the markets better and more efficient.

If you're still not convinced, think about the bond market. Bonds are almost always associated with conservative investing. If you buy a bond, you may see yourself as a responsible, conservative investor. In fact, you may even hate the idea of borrowing! No credit cards or debts of any kind for you. Now for the hidden truth. Who do you think is on the other side of that bond trade? A borrower -- a speculator -- hoping to make a profit by earning more with the borrowed funds than they will owe in interest. If you love the idea of loaning money, be glad there are speculators in the world. No speculators, no bond market.

Speculators are an essential part of any well-functioning market. While it is a tragedy that Nick Leeson single-handedly brought down Barings Bank with options, that is the fault of the user and not of the options market.

Keep in mind there were also investors on the other side of those trades, and for every option trade there is a winner for every loser, as shown in the following chart:

Notice how the profit and loss diagrams are mirror images for the long and short positions. Money merely changes hands from one person to the other. In this way, options can

be viewed as a "bet" between two people, but that should not trick you into believing that's why they were created.

Somewhere in the world, a conservative mutual fund manager may have desired puts as a hedge for his mutual fund, and bought the puts that Nick was selling. Options are about transferring risk. Nick Leeson was selling straddles on a Japanese index speculating on a quiet market; he was accepting the risk the mutual fund manager wanted to hedge.

Because of this, that mutual fund may have had a great year and provided for a new home for someone or protected their IRA account. The fund may have sent someone to college who, otherwise, never would have had a chance. But we will never know the name of this person as we know Nick Leeson's. We will never know, because that is not horrific news, so it just vanishes into the background. It's easy to overlook what you cannot see. But they are there every time another loses on an option trade.

Options are good for the market. They create narrower spreads and provide excellent hedges for conservative investors. They are also excellent speculating tools for those who use them responsibly.

Option Exam 2 - Week 2

Use charts above to answer questions (1-4).

1) Which profit and loss diagram represents a long straddle?

a), b), c), d),

2) Which represents a long call?

a), b), c), d),

3) Which exposes the investor to the largest loss?

a), b), c), d),

4) Which represents a long put?

a), b), c), d),

5) A particular option contract has 1,500 open interest, which your friend says is a fairly high number, so it appears to be liquid. However, you disagree because you notice that it is trading for 1/16, which means the total dollars invested in the contract are:

a) $93.75

b) $9,375.00

c) $937.50

d) $9.37

6) What does open interest represent?

a) It is the total number of long positions plus the total of all short positions

b) It is the total number of long positions

c) It is the number of people interested in the contract and have placed limit orders to purchase

d) It is the number of people who have submitted exercise instructions

7) On Monday, open interest for a particular option is 1,000. You place an order to buy to open 10 contracts and are the only volume for the day. The next day open interest is still 1,000. What happened?

a) The exchange made a mistake and didn't count your order

b) The exchanges only count trades of 100 contracts or more

c) The person selling the contracts was selling to close

d) The person selling the contracts was selling to open

8) Who determines the spreads between the bid and ask?

a) Market makers

b) The market participants -- all of the investors in that security

c) The exchanges

d) NASD (National Association of Securities Dealers)

9) What can you infer if you see a large bid-ask spread?

a) The market makers are trying to cheat you

b) The security is fairly illiquid

c) There is added risk in the security

d) Both b and c

10) If the underlying stock increases 20%, a particular option contract may increase 300%. This magnification in profits (and losses!) is called:

a) Gambling

b) Leverage

c) Profits

d) Elasticity

PART 2 : Gearing Up For Trading

Buy or Sell

Better to buy or sell options?

There are a number of investors who adamantly believe you are better off selling options as opposed to buying. They reason that since most buyers lose money, it must be better to be a seller. While this may make sense on the surface, it completely neglects other factors of option trading. With a little effort, we will show you that neither the buyer nor the seller has a long-term advantage.

This is not to say that, under certain conditions, a buyer or seller cannot have a theoretical edge on the trade. That happens all the time. We are talking about making an unconditional statement that one side has an advantage over the other.

Equilibrium -- the efficient markets theory

Is it better to own a Porsche Boxster or a Ford Taurus?

Many people are tempted to answer that the Porsche is clearly the better choice.

What if the Ford Taurus and Porsche Boxster are both priced the same? With both cars priced the same, most would agree that you are better off with the Porsche. If so, people will buy the Porsche over the Taurus. This will put buying pressure on the Porsche and raise its price relative to the Taurus. Say the Porsche is now bid up to a price $3,000 above the Taurus. Most would agree that it is still a better deal and continue to buy it. This action will continue until the markets are not so sure that an additional $1 is worth jumping from the Taurus to the Boxster. If it were worth it, they would do it.

While it may seem counterintuitive, as long as there is no net bidding up or down of prices between the two cars, you are equally well off with either one. While the Porsche may be faster and have higher quality and resale value (not to mention it just looks cooler), it also comes with higher repair bills, insurance rates, and theft occurrences. The car market will reflect all pros and cons in the prices of the two cars.

Similarly, the financial markets will price all assets to reflect their risks. Quality assets are bid up and riskier assets are sold off. This is why a government T-bill yielding 5% is equal to a more risky bond priced to yield 10%. The government bond is higher quality but also has a lower yield. The markets realize that, all else constant, you are better off with the T-bill so it will continue to bid that price up until there is no net difference between the two bonds. If there were an advantage, the markets would continue taking action and reflect it in the price.

In more technical terms, the market's action in the above examples is a form of the efficient market theory (called the semi-strong form), which states that all publicly available information is priced into the asset. The markets will price all assets so that the risk-reward ratios are equal across the board.

So is it better to be a seller of options as opposed to a buyer? Now you should know that, on average, there is no difference between the two choices. The markets will reflect the risk in the prices. If it were always true that, say, sellers of call options were better off, the market would continue to sell calls and drive down their price. The price will stop falling when buyers purchase all that is for sale and there is no net selling. At that point, equilibrium is reached and the assets are priced fairly.

Do not be lured into strategies that claim you are always better off as a buyer of this or a seller of that. If you do, you may encounter a very expensive understanding of efficient markets.

Types Of Orders Even if you have the winning stock and matching option strategy, you still need to get the order in correctly to carry out your intentions. There is a whole list of terms, restrictions, and general market lingo you will need to know in order to maximize your use of options. Whether you are new or experienced with options, this section will greatly help with your trading.

This is especially important with Web trading. Most firms offer great incentives to place your orders over the Web. However, you are now at risk by checking off the wrong box or entering the wrong amount. You will be given many choices when placing trades over the Web, so you need to be aware of what these terms mean.

Opening and closing transactions

The first thing you need to understand regarding an option order is that you must specify whether you are opening or closing the position. For example, if you want to be long a call option, you will need to place the order as "buy calls to open." This is very different from a stock trade where you just designate the order as either buy or sell. The reason the options markets need to know if you are opening or closing the position is so the OCC (Options Clearing Corporation) can account for the open interest. For example, you may be buying the call to open and the person on the other side of the trade is selling to close their position. In this case, there is no net change on open interest, as one party is opening and the other is closing (please see our section "Open Interest" for more information). The OCC must track open interest, as there is no limit to the number of contracts that can be traded on any individual stock or index as with stocks. With stocks, you can only buy or sell up to the available number of shares outstanding.

Basically, if you are initiating a position for the first time, you are opening. If you are getting out of a position, you are closing.

There is a common mistake new traders make when selling covered calls: They often feel they must designate the order as some type of buy. This mistake usually stems from the fact that most other financial instruments (stocks, bonds, mutual funds, etc.) are initiated with a buy. Remember, you are selling the call and opening the position, so your first transaction would be "sell calls to open," then you would "buy calls to close" if you want to undo the position.

Always check with a broker if you are unsure. There is nothing worse than being on the wrong side of the market because of a mistake on the order. I have seen this result in very costly mistakes!

Market versus limit orders

The next thing your broker will want to know is whether you are buying at market or at a limit.

A market order guarantees the execution but not the price.

In fact, a market order is the only way to make certain you will get the trade (the only exception is with a "short sale" on stock which must be executed on an uptick). However, in order to do that, you must be willing to accept the best available price at the time your order hits the floor. So, while you may see an option quoting $5 - $5-1/2, placing a buy order at market does not guarantee you the asking price of $5-1/2 as many people think. It's entirely possibly for the stock to be in a fast market (which means the quotes are not accurate due to delays in processing orders), and you find yourself being filled at something like $7. In most cases, this is unlikely, but just be aware that with a market order, you are saying that you are willing to pay any price. You will have no recourse with your broker by placing a market order and being filled at a higher price with a buy order, or a lower price with a sell order.

With a limit order, you tell your broker that you are willing to buy or sell, but only at a certain price called the limit price. If you say, "buy calls to open" at a limit of $6, this means your order will only be filled if it can be filled for $6 or less. Of course, your risk is that your order will never get filled. If you are selling at a limit of $6, your order can be filled only at $6 or higher.

Limit orders guarantee the price but not the execution.

Also, a limit order may be filled in part unlike a market order. For example, if you place an order to buy 30 contracts at a limit of $6, it's possible that you get filled on 20 contracts or some other number less than 30. What you are really telling your broker is that you are willing to buy up to 30 contracts. If you only want all 30 or nothing at all, you will need to use an "all-or-none" restriction discussed later.

When placing an order, you need to figure out which is more important -- making sure it is filled (market orders), or making sure you get a certain price (limit orders). There is no way to guarantee the execution and price -- you get one or the other.

By the way, if you are placing a limit order on options, you need to be aware of the following rule: Options quoted at $3 or less may be entered in 1/16ths and options quoted above $3 must be entered in minimums of 1/8ths. So, if you see an option quoting $3-1/2 to $3-3/4, do not send in a limit order at $3-9/16; the floor will return your order to be re-entered in 1/8ths. Under decimalization, the new MPV's (Minimum Price Variations) are as follows: options under $3 may be entered in .05 increments while options over $3 must be entered in .10 increments.

Or-better orders

There is a type of limit order which sort of blends a market and limit order, called an "or better" condition.

With an or-better order, you place buy orders above the current asking price, and sell orders below the current bid price.

Say an option is $5 on the ask. You can tell your broker to buy at a limit of $5-1/2 or better, for example. Now, when your order hits the floor, you will be filled as long as it doesn't exceed $5-1/2. Some people think this is a recipe for ruin as the floor will probably fill you at the higher $5-1/2 price. This is not true, as the traders are bound by time-and-sales, which reflect the current prices at the time your order was received. With or-better orders, your order is still not guaranteed to fill, but the odds are much higher compared to a straight limit order. I would almost always use "or better" orders if the underlying stock is moving quickly.

Day, good-until-cancelled, immediate-or-cancel, fill-or-kill

If you use a limit order or an or-better order, you must also specify a time period that the order is to remain open. Technically there are four different time designations: day, good-until-cancelled, immediate-or-cancel, and fill-or-kill. By far, most trades are entered as either day or good-until-cancelled, but we will go over each so you understand them all.

Remember: a limit order is not guaranteed to fill, so your broker will need to know if you want the order cancelled at the end of the day (day order), or cancelled after a much longer period (up to six months) with a good-'til-cancelled order, also called GTC. The New York Stock Exchange allows firms to keep the orders on the books for up to six months. However, individual firms are free to make the requirements stricter. They may, for example, only hold a GTC order for two months. Check with your broker as to their firm's policy on GTC orders.

Be careful with GTC orders, though -- especially when buying! There have been many cases where people place GTC buy orders and then forget about them. Weeks later they see an option position in the account trading for a huge loss and wonder how it got there. It's probably not a good idea to use GTC buy orders on options for this very reason unless you actively monitor your account.

However, using GTC sell orders can be a very good portfolio management tool. For example, say you buy an option at $5 and are willing to sell it for $8. By placing a GTC order to sell it at $8, you now never have to worry about not being at your computer to place the order if it trades that high -- the computer will take care of it for you. Further, you will not be tempted to hang on hoping for more if you see it trade at $8, as the computer will automatically sell it. Using GTC sell orders can be a great tool for disciplined trading.

Instead of day or GTC, you can elect your timeframe to be immediate-or-cancel or fill-or-kill also known as IOC and FOK orders respectively. Both orders are asking for an immediate execution or cancellation of the order. The difference is that immediate-or-cancel orders allow for partial fills while fill-or-kill orders must be filled in entirety.

For example, if you enter an order to sell 50 contracts at $7 immediate-or-cancel, the market maker may fill a portion of that order at $7 or higher; they are not required to fill the entire 50 lot order. A fill-or-kill order would require that they fill the entire 50 contracts immediately, or none at all. These orders are often used to pressure the market makers into making a decision, and consequently, are usually cancelled! It is recommended that you do not use these orders. Any trader who gets filled by using them probably would have been filled with a day or good-til-cancelled order as well. There is not a big advantage to the immediate-or-cancel or fill-or-kill orders, and there's a great chance it may hurt the execution.

Why don't you use day, GTC, IOC, or FOK time frames with market orders? Remember, market orders are guaranteed to execute, so they will default to a day order and normally be filled within seconds.

All-or-none

If you place a limit order, for example, to buy 30 contracts at a limit of $5, it is possible to get filled on only a portion, say 20 contracts. With a limit order, you are telling your broker to buy up to the amount designated (30 contracts in this example). If, however, you want to insure that you get all 30 contracts or nothing at all, you need to use an "all-or-none" restriction, also designated AON. If you use this restriction, you are telling the floor to fill the entire order, or nothing at all.

There is a big danger in using all-or-none orders! Any order marked all-or-none goes to the back of the line (for listed stocks), or is held in the back pocket of a trader for options. This means that it is possible you'll never get an execution, even though many traded at your price or better, and you cannot hold the exchange to time and sales! The trader can always come back and say that all contracts could never be filled at once and you will have no recourse against your broker or the exchange.

Also, all option quotes are good for at least 20 contracts. So, if you are placing option orders for 20 contracts or less, you will be doing yourself a huge disservice by placing all-or-none restrictions on these orders.

Minimums and minimum lots

If you don't like the idea of all-or-none restrictions, you can opt for a minimum. For example, say you are selling 50 contracts but want at least 30 or nothing at all. You can place the order to sell 50 with a minimum of 30.

Further, if you only want your trade filled in minimums of 5 contracts thereafter, you can tell your broker "minimum lots" of 5. So the order would look like "sell 50 contracts, minimum 30, and minimum lots 5." Now the order must be filled with at least 30 initially, and in 5 lot increments thereafter, such as 35, 40, etc. up to 50.

Minimums and minimum lots are a nice alternative to all-or-none orders.

Market on close

There is a really nice tool that's not widely used by most traders. It's called a market-on-close order or MOC. With an MOC order, you try to buy or sell your contracts at a limit price during the trading day. If it is not filled, it converts to a market order within the last five or so minutes of the trading day. For example, say you bought 10 contracts at $2 and they are now selling for $10. The market looks really strong and there is a possibility it could trade much higher. However, you don't want to lose your profit.

You could place an order to sell your 10 contracts at a limit of $12 MOC. Now, if the option trades at $12 or higher, you will be filled. But, if it doesn't trade that high, you will be sold very close to the closing price of the day. Keep in mind this could be much less than you anticipated! But MOC orders can be a great tool, as they allow you to try for better prices during the day, but get you executed by the end of the day regardless.

Net credits and net debits

Net credits and net debits are types of limit orders, but are used for multiple option orders. For example, you may enter a buy-write, which allows you to simultaneously buy stock and sell a call against it (please see our section on "Buy-Writes" for more information). If the stock is trading for

$50 and the call is trading for $3, you can enter the buy-write for a net debit of $47. This tells your broker that you are willing to buy the stock and sell the call as long as the net charge to you does not exceed $47. The floor could fill the stock purchase price at $50-1/2 but would have to fill the call for $3-1/2 or any other combination that nets a $47 debit. Often, traders will try to "negotiate" a better deal, and may enter the above order for a net debit of $46-1/2 for example.

Net credit orders are just the reverse of net debits. Say you bought the above buy-write for $46-1/2 debit and it is now trading for $48-1/2. You could enter the reverse of this trade, called an "unwind," which sells the stock and buys the call for a net credit of $48-1/2. Now the order cannot be filled unless the net proceeds to you are $48-1/2 or higher.

Stop orders

Stop orders can be a great risk-management tool. They can also cause great losses is you're not sure how they work.

If you are planning to use stop orders on your option trades, make sure you understand this section.

How do stop orders work?

There are two basic types of stop orders: stop orders and stop limit orders. There are very important difference between the two, so we'll look at them individually.

First, the basics of stop orders are the same for stocks and options. There is one major difference with options though, and we'll look at that at the end. For now, we'll just concentrate on how basic stop and stop limits work with stocks.

Stop order

A stop order is a conditional order to buy or sell at market. You specify a price at which point the trade is "triggered" and becomes a market order to either buy or sell.

For example, say you paid $30 for a stock and it is now $50. You feel it could climb much higher so would like to keep holding it, but at the same time, you do not want to see it fall back to $30. You could place an order to sell your shares at a stop price of $45, for example. When you specify a stop price, that is the "trigger price," and is not necessarily the price you will get for your shares. So if the stock trades at $45, your order is triggered and becomes a market order, which will be filled at the next best available price.

It is very important to note that the stock needs to trade at or through your price in order to become triggered. Here is where a lot of traders get themselves in trouble. Using the above example, say the trader places a stop at $45 and the stock closes that day at $45-1/2. The order is not triggered, so the trader at this point still has his shares. However, the first trade the following morning is $38 on bad news. Because the last trade is through the stop price of $45, this trader will be filled at market -- around $38, which is very different from the stop price of $45.

Remember, the stop price is only a trigger point -- the point where the order is activated. It is not the price you will necessarily receive!

Stop orders used to be called "stop loss" orders until the Securities and Exchange Commission ruled to change the name because it was misleading. It sounds like the order will prevent a loss, which is definitely not true.

Trading Case

One of the worst cases I can remember was with a trader who had 3,000 shares of one of the "dot com" stocks back when they were hot. This person paid around $100 per share, so he had a decent profit with the stock trading around $120. He placed an order to sell the shares at a stop price of $110. The stock started to fall radically with every couple of trades decreasing the stock by a point or so. The stock traded at $110 and continued to fall. The customer was impatiently calling to find out where he finally sold his stock. After all, a price of $110 was still a nice profit for him.

The confirmation came back with all shares being sold at $87. This fill was deemed good by time and sales; that was the fair price when his order hit the market maker.

Stop orders do not prevent losses!

Stop limit orders

The trader in our first example was hoping to get around $45 per share if the stock fell. Under normal circumstances, if the stock falls slowly, stop orders work great. It's only when you see the large gaps down where the prices can be very different.

What if the above trader would rather hold the stock instead of selling it at $38? Is there a way to prevent the sale? Yes, and that is done with a stop limit order.

With a stop limit order, you specify two prices. One is the trigger point and the other is the sell limit price. The above trader could have placed a stop limit order by telling his broker to sell at a stop price of $45 and a stop limit of $45. If the stock trades at $45 or below (the stop price) the order will be activated as with a regular stop order. However, instead of becoming a market order, a stop limit order becomes a limit order to sell. This order is saying to activate it at $45 (the stop price), but do not sell for anything less than $45 (the limit price). The limit price can be equal to or less than the stop price.

In the above example, when the stock opened at $38, the trader with the stop limit order would also have their order activated. However, they will still hold the shares because they could not be sold for $45 or higher. If the stock does rise to that price during the day (or later if a good-til-cancelled order), the stock will be sold. If you do not want this to happen, you need to cancel the order.

Notice again that the stop limit order did not prevent a loss either. This trader still has the shares!

Buy stops

Buy stops work the same as sell stops but just in the other direction. Usually they are used by short sellers -- those who borrow shares to sell hoping to buy them back cheaper at a later time. In order to prevent the stock from getting away from them to the upside, these traders often place buy stops.

For example, say a trader shorts shares at $100. The risk to this trader is if the stock moves higher. In order to make sure the stock doesn't get away from him, he may place a buy stop at

$110. This is saying to buy the shares at market if the stock trades at $110 or higher. Again, this is not necessarily the price he will pay.

If the trader does not want to pay more than a certain price, he can elect to place a buy stop limit. As an example, he could say buy the shares at a stop price of $110 with a stop limit of $111. If the stock trades at $110, the order will be activated, but will only fill if the shares can be purchased for $111 or lower.

Traders also use buy stops to buy stocks on momentum. For example, say a stock has been sitting flat for a very long time at $30. The rumor is that a new product is expected to be released that could send it into the hundreds of dollars per share. Rather than buy it now and possibly wait a long time for that day to come, traders may put in a buy stop order at $35, for example. Now, the only time the trader will be filled is if the stock is trading at $35 or higher. In effect, the trader is buying the stock only if it appears the market is starting to rally the stock.

Incidentally, it is possible to be filled at a higher price on a stop or stop limit order. This is fairly uncommon, but if the stock bounces at the time your order is triggered, it may be trading at a higher price when the market maker fills it.

Stop orders on options

Stop orders on options work about the same as for stocks with one big exception. With stocks, the last trade will trigger a stop order. With options, the asking price will trigger the order and you will be sold at the bid.

A sell stop will be triggered on the ask and sold at the bid; a buy stop will be triggered on the bid and purchased on the ask.

This is very important for option traders due to the leverage in options. Gains can quickly become losses if you are not careful.

For example, say a stock is trading at $100, and a $100 call is bid $7 and offered at $7-1/2. A trader bought 10 contracts earlier for $5 and now places a stop order at $6. To the novice option trader, this trade seems nearly risk-free as the trader paid $5 and will get out at $6 (less some commissions) if the stock should fall. The stock starts to fall but there are no trades on the option; however, the quotes on the option will change as the stock falls. Eventually, the option quote is bid $5-1/2 and offered at $6. Now the stop order is triggered because the offering price is $6, but the trader is sold at the bid price of $5-1/2. That little 1/2 point spread cost the trader an additional $500 on top of the commissions.

Time stops

Another stop order many option traders use is that of "time stops." A time stop is more of a mental stop order that the trader keeps in his head; it is not one that can be placed with your broker.

Say a trader buys a 6-month option for $10 and is hoping to sell for $15 before expiration. The trader may set a time stop and sell the option if it has not hit $15 by a certain day. The reason traders do this is to prevent holding the option too close to expiration day and seeing the entire premium fall to zero from time decay.

Stop orders can be great tools when used under the right circumstances. Be sure you thoroughly understand the mechanics before using them, as the results can be upsetting if your expectations are not realistic.

There are many other types of orders and restrictions but these will be the majority of the terms you will come in contact with. Always check with your broker with specific questions, as individual firms can have different policies. Keep in mind that these orders were developed for various reasons, each with its own set of benefits and drawbacks. If you learn the different types of orders, you will become more flexible in your option strategies.

Time Value & Intrinsic Value An option's premium, the amount you pay, can be broken down into two component parts: time value and intrinsic value. It is important to know how to break an option's price into these two components as well as understand the interpretation if you want to become better at trading options.

In-the-money versus out-of-the-money

Before you can break an option's premium into time and intrinsic values, you need to understand the terms in-the-money and out-of-the-money, also called the moneyness of an option.

An option is in-the-money if the stock price is higher than the strike for calls and lower than the strike for puts. If a stock is trading for $100, a $90 call is in-the-money and a $90 put is out-of-the-money. The following chart may help:

Calls Puts Stock price ABOVE strike In-the-money Out-of-the-money Stock price BELOW strike Out-of-the-money In-the-money

An option that is exactly at the strike price is said to be at-the-money. Now, it's rare to find a stock trading exactly at the strike price, so it is customary to call the nearest strike (whether in or out-of-the-money) the at-the-money strike. For example, if a stock were trading at $99-1/2, most traders would consider the $100 strike at-the-money even though the strike is slightly out-of-the-money. Likewise, if the stock were slightly higher, say $100-1/4, most would call the $100 strike at-the-money even though it is slightly in-the-money.

Intrinsic value

If an option is in-the-money, it is said to have intrinsic value. This is the value of the option if you were to immediately exercise -- the difference between the stock price and the strike. For

example, if the stock is trading for $101 and you hold the $100 call, you could realize a $1 point gain by exercising the call option; you would receive stock worth $101, but pay only $100*.

*Generally a trader should never exercise a call option early. Please see our section on "Early Exercise" for more information. The value you could gain by exercising early is purely a definition of intrinsic value.

Another way to view intrinsic value is to calculate the value of the option if it were to expire immediately. Using the above example, if the $100 call option expired, it would be worth $1, the same value as if you exercised early. Why will it be worth $1? If it is trading for less than that, say $1/2, arbitrageurs will correct for it by buying the option for $1/2 and selling the stock for $101, for a net credit of $100-1/2. By immediately exercising, they can cover the short position by paying only $100, the strike, for an arbitrage profit of $1/2. This would continue until the option is priced at a minimum of $1 (please see our section under "Basic Option Pricing" in week five).

For puts, the idea of intrinsic value is the same but in the other direction. If the stock were trading for $99, the $100 put would have an intrinsic value of $1. The holder of the put could exercise and sell stock worth $99 but receive $100 -- a $1 gain.

Also, if the put option expired immediately, it would be worth $1. If it is worth less than this, say $1/2, arbitrageurs will buy the put for $1/2 and buy the stock for $99, for a total purchase price of $99-1/2. Then they would immediately exercise it, sell the stock for $100, and capture a $1/2 arbitrage profit. This would continue until the option is priced at a minimum of $1.

Probably the easiest way to understand intrinsic value is to think of it as the number of points the stock is in your favor in relation to the strike price. For example, if you are long a call, you are bullish and want the stock to go up. If you have the $100 strike call with the stock at $103, then your option is 3 points in-the-money; the stock is trading $3 points to the bullish side (above) of your option. If you are long the $105 put, you are bearish and want the stock to fall. With the stock at $103, the stock is two points to the bearish side (below) of your strike.

Time value

Time value (or time premium) is easy to calculate. It's what is left over after accounting for intrinsic value. Assume a $100 call is trading for a premium of $3. If the stock is trading for $101 then the $100 call has intrinsic value of $1; the remaining $2 is called time premium. The following formula may help:

Premium - intrinsic value = time value

What if the stock were trading at $100? Now, the $100 call is at-the-money and has no intrinsic value. With the option trading for $3, the entire premium is all time premium. This would be true for any stock price at or below $100; the option would be comprised entirely of time premium.

For puts, let's assume the stock is $98 and you are holding the $100 put, which is trading for $5. The option has $2 intrinsic value and therefore has $3 time value.

Examples:

Call option premium Stock Intrinsic Value Time value $50 call = $3 $52 $2 $1

$100 call = $7 $105 $5 $2

$80 call = $5 1/2 $79 $0 $5 1/2 $75 call = $4 3/4 $77 $2 $2 3/4

Put option premium $100 put = $5 $97 $3 $2

$75 put = $2 3/4 $77 $0 $2 3/4 $40 put = $3 $38 1/2 $1 1/2 $1 1/2 $85 put = $6 1/2 $79 $6 $1/2

Notice in the above examples that the intrinsic value plus the time value equals the total price (premium) of the option.

How much time premium do options have?

Generally there will always be some time premium on an option, even if only a small amount. With all else constant, the longer the maturity of the option or the more volatile the option, the more you will pay in time premium. Why? With all else constant, investors will prefer to buy longer-term options, as they will have more time for it to gain intrinsic value. Likewise, investors will prefer more volatile options, as they have a greater chance of making bigger moves, thereby giving the option more intrinsic value.

Also, the deeper-in-the-money you go, the more time premium will decrease. So if the stock is $100, the $80 call will have less time premium than the $85 call, and the $85 will have less than the $90, etc. If the option is deep enough in the money, the time premium will equal the risk-free rate. Why? If the stock is at $100 and the $80 call is sufficiently in-the-money, investors can buy the stock and sell the $80 call (covered call position) thereby "guaranteeing" them $80 at expiration. As with any guaranteed trade, the interest rate will be the risk-free rate. Now, it should be mentioned that a covered call is never truly guaranteed, as it is always possible for the stock to fall below the strike price of the short call. However, if it is sufficiently deep-in-the-money where the markets perceive it to be guaranteed, then the market will only reward you the risk-free rate for that trade. The important point to understand is that as you move to lower and lower strikes for calls (higher strikes for puts), they become more and more likely to have intrinsic value. Because of this, they will have correspondingly lower amounts of time premium.

Parity

If there is no time premium on an option, it is said to be trading at parity. For example, with the stock at $103, a $100 call trading for $3 would be trading at parity; there is no time premium on this option. Usually, the only time you will see an option trading at parity is at expiration with options that are fairly deep-in-the-money.

How do i use this information to trade?

We said earlier that it is important to understand time value and intrinsic value in order to understand what you're getting into with a particular option. Any option that has high time premium is risky (in trading terms, it will have a high gamma value). The reason it is risky is because the underlying stock must move, in the proper direction, enough to make up for the time premium. If it does not, you will end up with a losing trade.

For example, if you buy a $100 call option for $10 with the stock at $100, the stock must get to $110 (stock price plus time premium) in order to break even. If the stock moves to $108 at expiration, the $100 call will be worth $8, yet you paid $10 for a $2 loss.

Now compare this to the trader who may have purchased the $80 call, which may have been trading for $21 ($20 intrinsic + $1 time premium). With the stock at $110 at expiration, the $80 call will be worth $30. This trader bought for $21 and sold for $30 -- a profit of $9, which is certainly different from the $2 loss taken with the $100 call (for more on this, please see "Deltas and Gammas" during week 5).

If you are looking for very quick moves in the underlying, you can afford to buy options with higher time premium. However, if you are only interested in speculating on the direction of the underlying stock, you should consider deeper-in-the-money options to avoid the high risk associated with high time premium options.

But avoiding the speed game is not for free. If you buy a deep-in-the-money option, you will pay more in total dollars (more intrinsic value and less time value). By doing so, you now have more money at risk if the stock should move against you. In addition, if the stock should fall, the deep-in-the-money option will fall nearly point-for-point through a certain range of stock prices before slowing. It is a delicate balancing act to find the appropriate option that suits your needs.

Option trading mistakes

One of the biggest mistakes new option traders make is to buy an option just because it is "cheap." The inexperienced trader will usually look to out-of-the-money options because they can buy more contracts for a fixed dollar investment, or similarly, pay less money for a given number of contracts. For example, if a stock is trading at $50, a new trader who is bullish on the stock will usually look at a $55 strike or higher. They often wonder why one should buy an in-the-money option as the stock has already exceeded the strike price. They feel they are "wasting" money by paying for the intrinsic value.

Usually cheap options are composed entirely of time premium and can also be far-out-of-the-money. Make sure you know where your break-even points are and that it matches your sentiment with the underlying. For example, if the stock is $100 and you want to buy the $115 option for $2, that stock will have to move to $117 by expiration in order to break even on the trade. If you do not think this is likely, you should probably consider another option. A deeper-in-the-money option will be more costly but have less time premium; it will not need to move as far to break even.

Many strategies rely on the behavior of time premium. If you plan to increase your trading knowledge of options, you need to have a solid understanding of time and intrinsic values.

Fair Value FAIR VALUE Futures Markets

You may have heard financial sources, such as CNBC, talk about the futures quotes prior to the market open. Advanced market participants will watch the futures trading to get an idea of where the market will open. However, even advanced traders get confused as to exactly what this means. Often they associate the change in futures prices as the indication. For example, if the futures are trading up 20, many mistakenly believe this mean a positive indication for the open. Likewise, they feel if the futures are trading down 10, that the markets will open negatively.

While it may appear to make sense, this interpretation can get you into trouble especially if you are trading in pre-market based on the indication. In order to understand how to interpret the quote, you need to understand a concept called "fair value."

Before we can talk about fair value, we need to understand some basic mechanics of the futures markets. When you buy a futures contract, you are entering into an agreement to buy and take delivery of a commodity (or financial future) at a future date. This sometimes confuses people who are new to futures but you've probably entered into similar agreements although not specifically futures contracts. For example, if you have a contractor build a house or a car dealer order a car. You agree to take delivery at a future date and exchange cash at that time. The important thing to keep in mind is that, with futures contracts, the buys and sells are locked in! This is very different from the options market where the buyer has the right, but not the obligation to purchase. If you buy a futures contract, you must purchase the goods. If you sell a futures contract, you must deliver the goods. Of course, if you do want to get out of your obligation, you can execute a reversing contract just like in the options market.

Futures markets are used as hedging tools for both buyers and sellers. For example, a farmer would probably be a seller of wheat futures. He can grow the crops today and know in advance what his price will be at harvest. Likewise, Kellogg would probably be a buyer of wheat futures to lock in their purchase price of wheat for use in cereal.

The financial futures (SPX and NDX among others) are used for similar purposes. They allow fund managers to hedge portfolios. There are four contract months, each is the last month of the quarter. So, the contracts are March (represented by the letter "H"), June (M), September (U) and December (Z). Whenever you hear CNBC quoting fair value, they are always talking about the near-term contract.

Fair Value Review

Fair value is the relationship between the index (also called the "spot") and the corresponding futures contract. It has nothing to do with the fundamental value of the companies representing the index. Fair value tells us what the value of a futures contract "should be." But, because futures trade on separate markets from the spot market, they are subjected to their own sets of supply and demand so may wander off in different directions from the stock market. In fact, the futures trade all night long on GLOBEX, from 4:45pm until 9:15 am EST. But, if the futures get too far out of line, the arbitrageurs will correct for that prior to the opening bell.

Definition: Fair value is nothing more than the cost to carry the index to delivery to the future. What do we mean by cost of carry? It is the interest that could be earned on money in a risk-free asset such as a money market or T-bill. So, if you have an asset that costs $100 and must carry it for one year, your cost would be $10 if interest rates were 10%; this is the amount of money forgone by not having the money in the risk-free asset.

To simplify things, let's look at a simple commodity such as gold and assume the following:

Gold price: $200 Interest rate: 10% 1-year futures contract: $250

If you buy this futures contract, you are saying you will buy gold for $250 per ounce in one year. The person who sells this contract is saying they will sell gold for $250 per ounce in one year. Of course, as things change (i.e., supply and demand for gold, time remaining on contract etc.) so will the price of this contract.

Fair value to carry the gold is $200 * (1.10) = $220.

If you borrowed $200 to buy the gold, it would cost you $20 in interest; if you bought it with your own money, you would miss out on $20 in interest. So, either way you look at it, there is a $20 cost to buy the gold and hold for one year.

Because the 1-year futures contract is above the fair value, arbitrage is possible.

Note: In order for a transaction to qualify as arbitrage, two conditions must be met: (1) The transactions must guarantee a profit (2) there can be no initial cash outlay. The second condition is necessary otherwise the straight purchase of a government bond would qualify as arbitrage since profit is guaranteed.

With the fair value above the spot price, arbitrageurs will take the following strategy:

Today Borrow $200: +$200 Buy gold in spot market: -$200 Sell the futures contract: $0 Net cash outlay: $0

1 year later Deliver the gold against futures contract and receive: +$250 Pay the interest from loan ($200 + 10%) -$220 for an arbitrage profit of $30. $30

This is an arbitrage profit because there was no initial cash outlay to acquire the asset but we guaranteed our selling price by selling the futures contract.

Traders will buy the spot and carry it to the future thus creating their own futures contract. This is called "cash and carry" arbitrage. These actions will put buying pressure on the spot price and selling pressure on the futures contract, which will eventually eliminate the arbitrage opportunity.

In a perfect market, any futures price above $220 will result in cash and carry arbitrage.

What if the futures price is too low? Assume the following prices:

Spot price: $230 Interest rate: 10% 1-year futures contract: $250

Fair value = $230 * (1.10) = $253

In this case, the futures contract is below fair value. It "should be" priced at $253 but is only $250 so arbitrageurs will do the following strategy:

Today Sell short gold: +$230 Lend proceeds at 10%: -$230 Buy the futures: $0

1 year later Take delivery of the spot through futures contract and cover short position: -$250 Collect proceeds from loan: +$253 For arbitrage profit of $3

Notice that this is arbitrage because there was no cash outlay at beginning. We guaranteed the profit with the purchase of the futures contract. These actions should put buying pressure on the futures contract and selling pressure on the spot market, which will eventually eliminate the arbitrage opportunity.

In a perfect market, any futures price below fair value will result in this "reverse cash and carry arbitrage."

Remember, if the futures price is above fair value, arbitrageurs will buy the spot. If the futures price is below fair value, they will sell the spot.

We have seen how traders can arbitrage when futures are too high or too low. The only time they cannot arbitrage is when the futures contract is priced at the cost of carry -- the fair value!

Market Imperfections

We just showed that arbitrage is theoretically possible if the futures contract is either above or below fair value. However, in the real world, there are many imperfections that make arbitrage impossible even though the futures contract may be higher or lower than fair value. Some of these imperfections are:

1) Transaction Costs 2) Bid/Ask spreads 3) Restrictions on short sales 4) Different borrowing/lending rates 5) Execution risk 6) Lack of storability (for non-financial commodities)

Because of these imperfections, arbitrage may disappear even though the futures are not priced at their fair value.

For example, assume the following but with a 3% transaction cost: Gold price: $200 Interest rate: 10% 1-year futures contract: $225 Transaction costs: 3%

We know that fair value is $200 * (1.10) = $220 and the futures price is $225 so it appears that arbitrage is possible. Let's see if it is:

Today Borrow $206 +$206 Buy gold in spot market ($200 + 3%) -$206 Sell the futures contract: $0 Net cash outlay: $0

1 year later Deliver the gold to make delivery of futures contract: +$225.00 Pay the interest from loan ($206 + 10%) -$226.60 For net loss -$1.60

Now, because of transaction costs, the arbitrage situation is eliminated. In this example, the futures would have to be priced at $226.60 or higher to execute a "cash and carry" arbitrage.

Using the above example but with futures priced too low, what happens with a 3% transaction cost?

Gold price: $200 Interest rate: 10% 1-year futures contract: $215 Transaction costs: 3%

We know that fair value is $200 * (1.10) = $220 so it appears the futures contract is priced too low at $215. Arbitrageurs will attempt to arbitrage by executing a reverse cash and carry.

Today Sell short gold: +$194 (sell at $200 less a 3% transaction cost) Lend at 10%: -$194 Buy the $215 futures: $0 Net cash outlay $0

1 year later Take delivery of the spot through futures contract and cover short position: -$215.00 Collect proceeds from loan: +$213.40 For net loss: -$1.60

With the spot at $200, the futures contract would have to trade below $200*(0.97)*(1.1) = $213.40 before arbitrage could be implemented. So, with 3% transaction costs, the futures must trade in the range of $213.40 and $226.60 before arbitrage can be successful.

Any futures price inside this range results in NO arbitrage.

An easier way to state this is that if the spread (the difference between the futures and spot) is above $26.60 or below $13.40 then arbitrage will occur.

For instance, using the above example with the spot at $200 and the futures at $215, the spread would be $215 - $200 = $15. Because $15 lies between the "no arbitrage" bounds of $13.40 and $26.60, then no arbitrage can occur.

Often you will hear sources refer to "buy and sell program" values. This is exactly what the buy and sell programs tell us. If an index has buy programs at $26.60 and sell programs at $13.40, then if the spread (the difference between the futures and spot) rises above $26.60 the arbitrageurs will buy the index and sell the futures for a guaranteed profit. This creates buying pressure on the index, which is why it is labeled as "buy." If the spread falls below $13.40, then arbitrageurs will short the index and buy the futures for a guaranteed profit. This causes selling pressure on the index and is therefore labeled "sell."

So, the futures are allowed to wander within an "invisible fence" around the fair value as shown in the chart below. The fence is created by the transaction costs and other market imperfections listed above. Again, any spread within this fence results in no arbitrage.

Also notice that the number of points above and below fair value is the same. In the above example, fair value is $220 with buy programs at $26.60 and sell at $13.40. This is 6.6 points above and below the $20 fair value. Assuming equal transaction costs on the buy and sell programs, the number of points above and below fair value will always be equal.

It is important to keep in mind that it is the spread (the difference between the futures and spot) that counts.

In the above example, the spread must expand to $26.60 or higher before the sell programs start. The spread can increase by several cases such as: (1) the futures can increase while the spot stays the same (2) the spot can decrease while futures stays same (3) futures rise and spot falls (4) futures and spot rise but futures rise at a faster rate.

This shows that program trading (arbitrage) does not necessarily guarantee a correction toward fair value. If the futures and spot are both rising, but the futures is rising at a faster rate then the index may stay in sell territory for extended periods of time, possibly the entire day. As long as the spread remains outside the upper arbitrage bounds, sell programs will continue. In a similar but opposite way, buy programs can exist for extended times. If the spread shrinks (i.e., the spot market is falling faster than the futures), then buy programs will continue.

How Is Fair Value Calculated?

Now that you understand that fair value is nothing more than the cost of carry of the underlying asset, there is just one adjustment you need to make to fully understand how fair value is calculated for the S&P 500 (SPX) or Nasdaq (NDX) futures.

If you buy all the stocks in the index on margin and carry them to the future (cash and carry arbitrage) you will receive some dividends, which offsets your cost of carry. So, if the risk-free rate is 5% and you receive 3% in dividends, effectively your cost of carry is (5%-3%) = 2%.

Futures contract * (1+ (interest - dividends) ) ^ days/360

And that is the formula for Fair Value!

Example: Say the NDX index closed last night at 3465. The futures closed at 3490. However, the futures traded throughout the night and are now trading at 3550. Also assume that fair value calculations put fair value at 3550. What does this imply for the opening of the Nasdaq market?

The futures are currently 3550 but closed at 3490 so the futures will be indicating UP 60 points (3550 - 3490). But, the fair value formula says the futures "should be" trading at 3550 so they are, in essence, priced fairly. This is actually a neutral or flat indication for the opening even though the futures are up. The futures may be up from their closing price the day before, but they are currently trading for fair value.

Most Important Concept!

Here is where most people get tripped up when looking at futures quotes. Say we use the same example above but now, instead, the futures are trading for 3495. Here, the futures closed at 3490 but are now trading for 3495 so the quote will show the futures up 5.

KEY POINT: If you get nothing else from all this, please understand that just because the futures are UP that this, in itself, does not tell you the indication for the opening of the market. You need to know where fair value is.

Likewise, just because the futures quote is down does not mean that it is a negative indication for the market.

In this second example, the futures are trading for 3495 but "should be," based on the fair value calculation, trading for 3500. In essence, they are still cheap even though their price increased overnight. Arbitrageurs will buy the futures and sell the spot. So, even though the futures are up, in this case, it is actually a negative indication for the market!

The concept of fair value is of little use for retail investors other than to satisfy their curiosity as to the direction of the market at the opening bell. Where many investors get in trouble is to either buy or sell in the pre-market (such as selectnet) based on the futures quote. Before you base your decisions on the futures quote, make sure you know where it is in relation to fair value. It is only then that you will truly know the expectation of the market on the opening bell.

Option Exam 3 - Week 3

1) A stock is currently $50 and the $45 call is trading for $6. How much time premium is there?

a) $6

b) $1

c) $5

d) $0

2) A stock is trading for $100 and the $105 put is trading for $7. How much time premium is there?

a) $2

b) $7

c) $0

d) $5

3) Assuming a call option has intrinsic value, which of the following defines intrinsic value?

a) Stock price minus the exercise price

b) Exercise price minus the stock price

c) Stock price plus the exercise price

d) Exercise price plus time premium

4) Which of the following types of option orders must be filled?

a) Market order

b) Limit order

c) "Or better" order

d) Day order

5) Which of the following orders guarantees the price but not the execution?

a) Limit order

b) Market order

c) "Or better" order

d) Both a and c

6) Which order guarantees the execution but not the price?

a) Market order

b) Limit order

c) "Or better" order

d) Immediate or cancel

7) Stop orders prevent losses:

a) True

b) False

8) A stock is trading for $100 and a trader places an order to sell at a stop price of $97. If the stock falls below $97, the trader's shares will be sold at $97.

a) True

b) False

9) If you place a limit order to buy 50 contracts, is it possible to get filled on less than 50?

a) No, all 50 must be filled

b) Yes, partial fills may occur unless and "all-or-none" restriction is used

10) You want to buy an option that is trading for $5 and sell an option trading for $2. If you place a limit order, it must be for a(n):

a) Net debit

b) Could be either net debit or credit

c) Net credit

d) You cannot specify net credits or debits for options

11) You are always better off being the seller of options, because the majority of option contracts expire worthless.

a) True

b) False

12) The S&P futures are trading down 5 points this morning. This implies there would be a negative opening if the markets were to open right now.

a) True

b) False

13) You purchased a $50 call for $2 and it is now trading for $7. You can guarantee a profit by placing an order to sell at a stop price of $6.

a) True

b) False

14) Stop orders for options work the same way as for stocks.

a) True

b) False

Put-Call Ratio

Technical analysis is quickly becoming widespread as an active trader tool. Used only by professionals just a few years ago, this same information is available to nearly everybody through the World Wide Web.

Technical indicators try to predict market turns; that is, at what point a stock or index will rise or fall. If we knew these points, the gains could be unimaginable so the incentive is certainly there for investors to try to figure out where these points are.

Of all technical indicators, the put-call ratio is probably the most recognized that uses options as its focal point.

From a mathematical standpoint, the calculation of the put-call ratio is very easy. It is the total volume for all put contracts divided by the total volume of call contracts traded on the Chicago Board Options Exchange (CBOE).

Put-call ratio = Total CBOE put volume / Total CBOE call volume

The indicator suggests that a market downturn is threatening when the put-call ratio hits a low level and vice versa. The rationale is quite simple: most speculators of options are unsophisticated and typically will be lured to buy calls when the market is at a top, and buy puts when the market is at a bottom.

If speculators start to buy a high number of call options relative to puts, the indicator decreases (because you are dividing by a larger number) and it is read as a negative indicator. Likewise, if

speculators are loading up on puts, the ratio increases and it becomes a bullish reading. Because the put-call indicator works in a backward fashion (bullish indicator when markets bearish and vice versa), it is called a contrarian indicator.

Where these "high" and "low" points are is a matter of debate. There are many interpretations and many traders and technical analysis firms that make small modifications to the formula to meet their specific needs. But as a general rule, a level of 80 is bullish and 45 is bearish.

Keep in mind that no technical indicator is perfect by any means! So do not speculate just because the indicator is giving a particular reading. Use it in conjunction with other information and your own opinions.

There are two important points to remember when using the put-call ratio. First, remember it is a contrarian indicator. There are many novice traders who have been burned by buying puts just because the indicator was high; they should have been buying calls.

Second, put-call ratio is much harder to interpret now with sophisticated traders and the use of synthetics. If a trader buys a put, it will get calculated as a bearish position by the put-call ratio. But what if the trader is buying a put as protection for a long stock position? Now he is certainly bullish and should be counted as so. Likewise, someone selling puts would be counted towards the bullish side (selling puts by themselves is bullish). But if this investor were selling puts against short stock, they should be counted as bearish because they are now synthetic short calls. So in theory, the indicator may be of significance. The reality is, unless you know how the investor is using the put or call, the indicator is highly uncertain.

Percent To Double Investors are constantly coming up with tools to find the ideal option trade. In essence, they are looking for ways to beat the market. Of course, many businesses are willing to sell those products to them, and one of the most pointless is the analytic tool called "percent to double" (there is a similar indicator called price-to-double which is the same information, just expressed in prices and not percentages).

I'll show you the basic idea of percent to double and you will immediately see why it's of no value. Be wary of brokers who tell you they add value to your option trades because they have access to percent-to-double values.

Here is the idea behind percent-to-double. Say a stock is trading for $100 and a $100 call option is trading for $5. Percent-to-double is supposed to tell you what percent the underlying stock needs to move in order for the option price to double. For example, a broker may tell you an option has a percent-to-double of 20%. This means that if the stock moves up 20%, the call price will double from its current price.

On the surface, it sounds like it may be of value since a lot of option traders will close positions when they double their money. So it would be nice to know just how much the stock needs to move in order to reach that point.

Here's why it does not work. Say the above $100 call is priced at $5 with delta of 1/2. In order for the option to double, it would have to be trading for $10. Now, how many points does the stock need to move to create a 5-point move in the option? With a delta of 1/2, it may seem that the stock would have to move 10 points. However, delta is accurate for sudden, small changes in the stock price. If this stock were to move 10 points, you can be assured the delta will no longer

be 1/2; it will be something much higher. So dividing the number of point movement required in the stock by delta will not work.

Further, we need to know how long it will take the stock to move. If you are told your option has a percent-to-double of 20%, we really need to know over what time period. Does that mean the stock must move 20% immediately, sometime today, next week or next month? Every single moment in time will produce a different percent-to-double figure. To complicate that even more, you have implied volatilities that are constantly changing, too. If the stock does move that high but implied volatility drops, your option will not double.

Another problem is that as the stock moves higher and the option becomes more in-the-money, the bid-ask spreads become very wide. So even if percent-to-double forecasted correctly, it would be in reference to the asking price and not the bid price, which is what you will receive for selling the option.

If you are still not convinced, use percent-to-double for your next hundred or so option trades -- you will not see one time that it forecasts correctly. There are just too many variables that affect the option's price.

The only time percent-to-double will work is at expiration. With the above $100 call trading at $5, we do know that the call will double in price if the stock closes at $110. With the stock at $110, the $100 call will be trading for $10 (the intrinsic amount) -- exactly double the price. But notice that in order for it to work, we had to wait until expiration -- and then it is too late.

Even if percent-to-double did work, there is just no value to the information. The markets already have that information priced into the option. It may seem that a percent-to-double of 1% is much better than 20%. However, think about this example: Say there are two stocks, A and B. Stock A is $100 and hardly moves, and the $100 call is $1/2. Stock B is a high-flying tech stock capable of moving several points in a day. It is priced at $50 with the $50 call at $5. Stock A has an at-expiration percent-to-double of 1%, and B has one of 20%. It should now be apparent why there is a difference. Stock B is much more likely to move, so the markets will bid it's option price up; that's why its price is $5 while A's is only $1/2. You have no added value by knowing the percent-to-double.

Unless you are familiar with option pricing, be careful with software that tries to pick out the "best" trades for you. Remember, the markets will always price in the proper risk-reward ratios. Using some of these tools can lead to a false sense of security and disappointing trades.

Hedging Did you hold your tech stocks last month hoping for an upside bounce? YES! Are you now wishing you had sold instead? YES! Well, now you can reap the benefits of both.

Here's how...

Portfolio insurance is nothing new to professional traders yet unknown to most retail investors. Before you say, "I don't need any insurance," think about this: Many investors' homes and cars are insured, yet valued less than their stock portfolio. In addition, we have recently seen some of the bluest of blue-chips such as Proctor and Gamble, Home Depot, Eli Lilly and Hewlett-Packard lose over twenty-five percent of their value in a single day. Don't think it can't happen to the tech stocks you hold. If you are not familiar with portfolio insurance, read on and find out how the professionals take the emotions out of investing.

It is often said that knowing when to sell is the most difficult part of investing. This is because of the two most significant factors that drive the markets: greed and fear. When stocks are flying, we hang on hoping for more. When they fall, we sell the shares out of fear, often forgetting about the long-term reasons we bought them in the first place. We are afraid to take profits yet quick to take losses, which is not a very good formula for making money in the markets!

Now, we are not advocating short-term trading. After all, the stock market has a very long history of an upward bias, and statistically speaking, you are better off buying and holding. But the emotional side of the investor rarely allows this strategy to work. The roller coaster starts, your profits become losses, and there you are selling at a loss again. Is there a better way to trade?

In certain circumstances, you may want to consider portfolio insurance. Basically, portfolio insurance can be defined as an added asset to your portfolio that will increase in value as a particular stock or index falls in value. Financial professionals call this a hedge, and we will look at many ways to place a hedge in your portfolio, some without any out-of-pocket expense!

To understand hedging, you need to understand some basics of the options markets, as this is one of the primary tools used for hedging. Options were created as a way for investors to buy and sell risk, and while this may seem unusual, it actually occurs in many ways in our everyday lives. For example, driving a car involves the risk of wrecks, injury, and theft. You do not want this risk, but for a fee, your auto insurance company does. You have, in fact, transferred the risk to them. When you buy a one-year magazine subscription, you are transferring risk. The magazine company is at risk if the price of its magazines goes way up. Of course, you are at risk if the price stays the same or falls. But for the up-front fee, you both consider the risks mutually beneficial. Out of economic necessity, the options markets were created in 1973 as a standardized way for the financial markets to transfer risk.

In most cases, options can be purchased through most brokerage firms with just as much ease as a stock. Usually, you will need to fill out an options application and wait a few days to get approval. Do not worry if you do not get approved or are not comfortable with options, as we have another way for you to hedge yourself that will be discussed later.

More about options

What exactly is an option? Options are assets that give owners the right, but not the obligation, to buy or sell certain securities (or indexes) at a fixed price over a given amount of time. Since the owner has the "right, but not the obligation," this means that the owner of an option chooses whether or not to buy or sell -- it is their option to do so, hence the name.

There are two basic types of options; calls and puts. Call options give the owner the right to buy the stock (or "call" it away from the owner), while put options give the owner the right to sell the stock (or "put" it back to the seller). This is a contractual obligation, controlled through a clearing firm (called the Options Clearing Corp. or OCC), so there is no need to worry about a defaulting party on the other side of the transaction. Because they are contractual obligations, options are traded in units called contracts, just as stock is traded in shares, with one contract usually representing 100 shares of stock.

Options are standardized meaning there are only certain prices at which you can agree to buy/sell stock as well as specific time frames. The prices are set by the exchange at fixed

intervals and are known as strikes, because that is the price where the contract is struck. As for the time frames, you will always find at least four different months being traded for stock options. There will always be the current month, the following month, and at least two additional months. Also, there may be longer-term options that can go as long as three years. Options do have a specified expiration date which, for trading purposes, is the third Friday of the month.

That's a lot of information, so an example should make things clear. Let's say it is October and you are bullish on XYZ stock trading at $50. You could purchase a January $50 call option that gives you the right, but not the obligation, to purchase XYZ for a price of $50 through expiration in January. Now, of course, there is a fee for this, called the premium, and let's say it is $5. This means that you are paying $5 per share, but remember, each contract controls 100 shares so the total purchase price for one contract would be $500 plus commissions. Now, you have the right to buy the stock at $50 per share at any time through expiration. If XYZ is trading for $70 when the option expires, the call option must be worth $20 (the difference between the stock price and strike). However, if XYZ is trading at $70 before expiration, then the option will be worth at least $20 as there will still be time remaining on the option and investors are willing to pay for time. How much they pay is up to the market and determined solely by supply and demand for the option. Of course, if the stock closes below $50, the option expires worthless so the most you can lose is the amount paid, in this case, $500.

You may be thinking, "Hey, wait a minute, how do I know the market makers won't try to rip me off and only offer me $15 for the call when I decide to sell?"

If XYZ is trading at $70 and the market makers are bidding $15 for the $50 call, then the arbitrageurs will step in and come to your rescue! These are people who watch for price discrepancies in the market and are able to make riskless transactions for guaranteed profits. These transactions happen at lightning speeds and do not last for long. Arbitrageurs will buy the call for $15, sell short the stock, and receive $70 for a net credit of $55. They will then exercise the option (use it to buy stock) for $50 and keep the $5 profit -- exactly the amount the market maker, in this example, was trying to steal! This process will continue until it disappears, at which point, the option will be trading for $20. So have no fear, the market makers cannot steal the intrinsic value (the difference between the stock and strike) of your option!

What if you were bearish on XYZ? Well, you could instead buy a January $50 put. Now you have the right, but not the obligation, to sell your stock for $50 per share through expiration in January. If XYZ is trading for $40 at option expiration, the put must be worth $10 (the difference between the strike and the stock price). If XYZ is trading at $40 before expiration, the put must be worth at least $10, as there will still be time remaining. If a market maker decided to only bid $8 for the put, arbitrageurs will buy the put for $8, buy the stock for $40 (far a net debit of $48), exercise the put and sell the stock for $50 for a guaranteed profit of $2. Again, this process (which would be measured in seconds) will continue until the put is priced fairly at $10.

So far, we have only considered the owners or buyers of calls and puts. What about the person who sold them? Well, the seller of any option has an obligation to perform. If you sell a call, you must sell your stock if and when the owner of the call chooses to buy it. If you sell a put, you must buy the stock if and when the owner of the put chooses to sell it. It is only the owner (the long position) who has the right; the seller (short position) has an obligation.

Hedging your portfolio

Now that you have the basics of options, let's look at ways to hedge and see if hedging sounds like a good idea to you!

Assume we are back in late May and you bought Intel (INTC) at $55. Later, in mid July it's trading above $70 and you decide to hedge by buying a January $70 put trading for $10.

By placing this trade, you have guaranteed yourself a profit of at least $5 per share through expiration in January. This is because you can always sell your shares for $70 but it cost you $10 for a net of $60. Because you paid $55 for the stock, the put guarantees you $5 per share profit.

Now consider the advantages of this trade. If the stock continues to move higher, we still participate in the upside (less our $10 premium). But if the stock starts to fall, as it did in mid-July when we bought our put (see chart above), we now have removed the emotional side out from our trading! The put allows us to focus on fundamental values in the company, and not the short-term downtrend. We can hold the stock, hoping for an upturn, yet never regret it as we have locked in a profit. There's also no fear of a maintenance call (for those who trade on margin). Best of all, it's easy to sleep at night knowing you never have to look back thinking "I should have sold that back when it was $70" because now you have the option to do so! It's not a bad deal if you think about it -- guaranteed profit of at least $5, with no limit to the upside, and we have all the way until January reap our rewards.

Some people think the "downside" to this trade is if the stock continues to run higher and you "wasted" your $10 on the put. However, is your home insurance a waste just because it never caught fire? Of course not, and you shouldn't feel that way about the put either. In fact, because you still participate in all of the upside movement of the stock, the best thing to happen is for the stock to climb higher, leaving your put worthless.

Let's look at our profit and loss profile (at option expiration) on the trade above with and without the put.

Stock Price Profit/Loss for long stock @ $55

Profit/Loss for long stock @ $55 + long $70

put @ $10 100 + $45 + $35

90 + $35 + $25 80 + $25 + $15 70 + $15 + $5 60 + $5 + $5 50 - $5 + $5 40 - $15 + $5 30 - $25 + $5

It is easy to see the value of the protection here. Look at the profit/loss for the two positions in the table above. If the stock closes at $100, the long stock position will have a gain of $45 points ($100 minus the $55 cost), while the long stock/long put position will have a gain of $35 (this is due to the $10 spent on the put). There will always be a $10 difference between the two positions for all stock prices at $70 or above. So the investor that hedged the portfolio will only be off by $10 in terms of profit and loss to the upside, but look at the difference to the downside!

For any stock price below $60, the hedged portfolio dominates. For example, say the stock closes at $40. The investor who bought the shares at $55 is down $15 points. The investor who hedged is also down $15 on the stock but the $70 put must be worth at least $30 points (the difference between the strike and the stock price). This gives a profit of $15; however, we must subtract out the $10 cost of the put, which gives us a total profit of $5. This $5 profit will hold for all stock prices below the $70 strike of the put. This is exactly what happens in a fully hedged position. The loss on the stock is exactly offset by the gain in the option.

Options can be very versatile and there is no need to necessarily have hedged our imaginary position above at $70. If you are willing to take a $5 point "deductible," you could have elected to purchase a $65 put which would be cheaper than the $70 for exactly the same reason your auto insurance is cheaper when you assume some of the risk through a deductible. The options market will always give less value to a put with a lower strike with all other factors being the same. So the choice is yours...do you want more protection or cheaper cost?

Hedging with no out-of-pocket expense

There is another hedging technique that may be interesting to you. This one allows you to hedge all the downside risk, as above, but without paying for it! Of course, nothing is free in the financial markets, so what's the catch? The catch is that you must be willing to give up some or all of your upside potential in the stock. We do this by selling call options against the stock and then using that money to buy the puts. Remember that when we sell an option we have an obligation. So if the person who buys the call from us elects to buy our shares, we must sell. This hedging strategy is sometimes called a collar.

Let's run through an example with the same INTC trade above. Again, we bought shares at $55 and the stock is now $70. The $70 put is trading for $10. We could sell the $75 call option and buy the $70 put. Depending on where they are trading, this trade may result in only a slight debit instead of the $10 we paid before. Or we could buy the $65 put and sell the $75 call for a credit of about one. That's right, depending on which options we choose, we can actually get paid to put on the hedge. But be careful, the only way to get a credit is to allow for a bigger downside loss. It doesn't mean that it's necessarily a bad trade, it's just that the credit doesn't come for free.

For example, say we sell the $75 call and buy the $65 put for a net credit of $1. This means we actually get paid $100 per contract. Now, what does the profit and loss look like at option expiration?

Stock Price Profit/Loss for long stock @ $55

Profit/Loss for long stock @ $55 + long $65 put + short $75 call for

credit of $1 100 + $45 + $21 90 + $35 + $21 80 + $25 + $21 70 + $15 + $16 60 + $5 + $11 50 - $5 + $11 40 - $15 + $11 30 - $25 + $11

Now compare this profit/loss (at expiration) table to the previous one. We can easily see that we have sacrificed upside potential, as our max gain with the collar is only $21 regardless of how high the stock goes. However, because we didn't pay $10 for the put, our downside is much higher with a credit of $11 instead of $5.

To recap, hedging is a method of maintaining upside potential, whether limited or unlimited, and reducing our downside loss. Hopefully, it is now apparent that hedging can be beneficial!

Hedging without options

There is a really nice way to hedge your portfolio without the use of options. Through the use of "bear" mutual funds, mutual funds that go up in price as the market falls, one can easily hedge a portfolio. However, some funds are better than others for hedging. One that we like to utilize from time to time is the ProFunds UltraShort OTC Fund (USPIX). This fund is unique in that it produces double the inverse of the Nasdaq 100 (NDX), the most volatile of all indices. So if the NDX is down 5%, this fund will be up 10%. Of course, the reverse is true too; if the NDX is up 5%, the fund will be down 10%. Further benefits are that you are not on margin, as would normally be the case to produce a 2:1 performance ratio. Also, you do not need options approval and there is no expiration as with options. You are also not exposed to "time decay" which is the portion of the option premium that erodes with the passage of time. On the downside, mutual funds only trade at one time -- in the evening after the close -- so you cannot trade them intra-day. But if you have a heavily laden tech portfolio and are looking for a relatively cheap way to hedge, USPIX is tough to beat!

These are just the basics of options and hedging, and are intended to show the benefits of hedging, which can be very important at certain times in the market.

We will be recommending various hedges for winning positions and we want you to be aware of the idea and philosophy behind them. Please understand that these are just the basics; there are numerous factors to consider before placing a hedge. Some of the factors are the deltas and gammas (options sensitivity measures) as well as implied and historical volatilities. Sometimes we will utilize roll-up or roll-down strategies as well as dollar-cost or constant-dollar methods. But that's what we are here for. As a subscriber, you can be assured that we look at all relevant factors, combine them with a lot of research and expertise, and relay the information to you as quickly as possible to insure winning trades.

Remember, in a bear market, the money returns to its rightful owner. Hedging can keep you from giving it back!

LEAPS are long-term options that usually trade in January for a maximum of three years out, although there are exceptions. If a stock trades LEAPS, then new LEAPS will be issued in May, June, or July, depending on the cycle. When January month is "hit" in the normal rotation (other than by default as the current or near-term contract), a new LEAP will be added. The January option will become a normal option and the root symbol will change.

Again, this is difficult to explain without the use of examples so let's look at INTC options.

It is currently November and INTC has the following months trading:

Month Root Symbol November INQ December INQ

April INQ January '01 INQ January '02 WNL January '03 VNL

From what we learned earlier, we know there must be a November and December contract and we see that there is. You can never tell which cycle a particular stock is on just by looking at the first two months; remember, all options will have these months being traded.

We see that January '01 is the next contract traded. Normally, this would tell us that this stock is on a January cycle. However, INTC has LEAPS, too which means there will always be a January option traded so we still cannot be sure which cycle it is on just because we see January next in line. Looking out to the next month, we see April is trading. Because April is part of the January cycle, we can now be certain that INTC trades on a January cycle.

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Based on what we know, the four months highlighted above should be trading for INTC, and we see they are when compared to the above table. When November expires, December and January become the current and near-term months respectively, and July will be added.

In this case, no LEAPS will be added because the LEAPS are currently out three years to '03.

However, when May expiration comes around, June, July, October will be trading and January will be added. At this point, the '02 LEAPS will have their root symbol changed to INQ and the '04 LEAPS will be added.

So depending on which cycle your stock is on, look for new LEAPS to be added sometime in late May, June, or July. Otherwise, the basic option expiration cycle applies.

Let's go back to the questions asked at the very beginning and see if we can find out the answers:

It is now October and MRVC has April options but SCMR does not.

1) Why is that?

2) When will April options become available for SCMR?

Looking at the options for MRVC there are:

November, December, January, April

For SCMR:

November, December, March, June

It is evident there are no LEAPS as there are only four contract months trading. We know there will be November and December for each. For MRVC, the next month is January so it is on a January cycle and SCMR is on a March cycle.

When will April options become available for SCMR?

Because April is not part of the March cycle, the only time April options will become available will be when February expires. At that time, March will be the current month and April will be the near-term contract.

Option expiration cycles can be a little confusing if you are new to them. With a little work, they will become second nature. They are important to know because many strategies require some type of position management during the holding period, yet the proper contracts may not exist. Understanding these cycles can give you an added edge in option trading!

Additional questions:

1) It is now August and your stock trades on a March cycle. Which months should you expect to see trading?

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

We will see the current and near-term months trading, which will be August and September. In addition, we will see two contracts from the original March cycle, which will be December and March.

2) When will the May contracts start trading?

Because May is not part of the March cycle, the only time they could trade is when March contracts expire. At that time, April will be the current month and May will be the near-term.

3) When will the June contracts begin trading?

Since June is part of the March cycle, it could start trading months in advance, so we need to be careful here. Run through them step-by-step.

When August expires, we will have September, October, December and March for a total of four contracts so no June contracts, will trade at this point.

When September expires, we will see October, November, December and March, so June still will not trade.

When October expires, we will have November, December and March for a total of three. At this time, June contracts will be rolled out.

Option Exam 4 - Week 4

1) The put-call ratio is calculated as:

a) The total CBOE put volume / the total CBOE call volume

b) The total CBOE call volume / the total CBOE put volume

c) The S&P 500 put volume / the S&P 500 call volume

d) The S&P 500 call volume / the S&P 500 put volume

2) The put-call ratio is a contrarian indicator.

a) True

b) False

3) A relatively high put-call ratio is bearish.

a) True

b) False

4) "Percent to double" is the best indicator to detect options that are undervalued.

a) True

b) False

5) Which are the three option expiration cycles?

a) March, April, May

b) January, February, March

c) March, June, September

d) None of the above

6) It is now January and you are looking at option quotes in the newspaper. You see contracts trading in January, February, April and July. This particular stock is on a(n):

a) February cycle

b) January cycle

c) March cycle

d) Not enough information

7) For any stock, there will always be contracts trading in at least _____ different months.

a) 5

b) 4

c) 3

d) 2

8) It is now January and a stock has options trading on a March cycle. Which four months are trading?

a) January, February, March, April

b) January, February, May, August

c) January, February, March, June

d) January, February, April, July

9) It is now January and a stock has options trading on a March cycle. When will the October options start trading?

a) When January expires

b) When February expires

c) When August expires

d) March cycles will never have an October option

10) It is now January and a stock has options trading on a March cycle. When will the November options start trading?

a) When January expires

b) When March expires

c) When September expires

d) March cycles will never have a November option

Basic Options Pricing In 1973, Fisher Black and Myron Scholes introduced their landmark publication with a formula for calculating the "fair price" of an option. It is arguably the most significant publication in finance or economics over the past fifty years or more. Myron Scholes received the Nobel Prize in 1997 for his contribution.

The reason it is so significant is because, prior to, there was no way to fairly determine the price of an option. In this case, buyers bid very low and sellers offer very high. There becomes very little liquidity and the market never gets off the ground.

This financial breakthrough led to the creation of the Chicago Board Options Exchange (CBOE) because prior to, there was no way to fairly determine the price of an option. Options were traded through the over-the-counter market (OTC) on an unregulated basis and did not have to adhere to the principle of "fair and orderly markets." Today, largely due to Black and Scholes, the CBOE trades tens of millions of contracts per month.

Black and Scholes basically developed an "options calculator," known as the Black-Scholes Model, that will tell you what a call should be worth if you know five main factors (six if you include dividends):

1) Stock price 2) Exercise or strike price 3) Risk-free rate of interest 4) Volatility of the underlying stock 5) Time to expiration

The calculator is similar to a loan calculator that will tell you what your payment should be if you know the loan amount, time, interest rate and compounding periods. Similarly, if you know the five factors in the Black-Scholes Model, you can determine what the call option should be worth.

Trading without theoretical values

The Black-Scholes Model is an invaluable tool for floor traders and retail investors alike. However, there are certain principle relationships that must remain within the options markets, with or without the Black-Scholes Model, otherwise arbitrage opportunities will be available. This is where we will be focusing as, if you know these relationships, it will greatly improve your trading skills and knowledge of option pricing and strategies.

Option pricing relationships

Pricing Relationship #1:

The Lower the strike, the higher the price of a call option.

If you have two call options, one that is a $50 and $55 strike with all other factors alike (i.e. same underlying stock and time), the $50 will always be more expensive than the $55. Why?

There are a number of ways to show this, and whichever way is easiest to remember is fine -- just as long as you understand it.

First, we can look at it from a probability standpoint:

;-------No Value ------ -------- Value ---------

$0 ------------------------------- $50 ------------------------$100

Looking at the diagram above, say a stock can only trade between $0 and $100 and you have the $50 strike call. You have, in effect, a 50-50 chance of having intrinsic value at expiration. If the stock is above $50, your option will have some value; if it is below $50, it will be worth nothing. So, how do we increase our chances of having intrinsic value at expiration? Simple -- we buy a call with a lower strike price.

No Value ---------------- Value ------------------

$0 --------------$25 ----------------------------------------------$100

For example, buying the $25 strike gives us far more room to the right (intrinsic value) as compared to the $50 strike. Thus, our chances are better of having some value at expiration. The markets figure this out and will accordingly bid the $25 strike higher than the $50.

The second method to show this relationship is simply from a financial cash flow standpoint. Remember, the option gives you the right to purchase the stock. Using the example above, at expiration, assuming you did want to buy the stock, would you rather pay $25 for it or $50? Again, the markets realize this and will bid the lower strikes above the higher strikes with all other factors constant.

Okay, this may sound good in theory, but how do we know that it will actually happen in the real world? Say we quote two options one day and see the following prices:

$50 call priced at $5 $55 call priced at $6

What will happen? We found out above that the markets should bid the $50 strike higher, but for some reason, it is lower. If this were to happen in the real world, traders known as arbitrageurs, will do the following trades simultaneously:

Buy the $50 call: -$5 Sell the $55 call: +$6 Net Credit +$1

They will receive a credit of $1 into their account. If the stock collapses, both options expire worthless and the arbitrageur will keep the $1. If the stock is trading higher, say $70, then the $50 call will be worth $20 and the $55 will be worth -$15 (remember, this call was sold. It will be worth $15 to the person who bought it) for a net credit of $6 ($5 for the difference in calls plus the $1 credit from the initial trade).

This credit of $6 will be the result for any stock price at $55 or higher. What if the stock is between $50 and $55? If the stock closes at $52, the $50 call is worth $2, and the $55 expires worthless, leaving the trader a credit of $3. So the worst that can happen is the arbitrageur makes $1, and the best is that he makes $6. Because there is a guaranteed profit with no cash outlay, it is an arbitrage. Do not worry -- arbitrageurs will guarantee that the lower strike calls will always be worth more than the higher strikes!

Insights into option pricing: Why can't I enter a buy-write for a net credit?

This leads to some interesting insights about option pricing. Theoretically, the optimal strike to own would be a $0 strike price (these don't exist, but just say they do). What should it be worth? Well, the price of a call can never exceed the price of the stock, otherwise -- you guessed it -- arbitrage is possible. Say a $0 strike is trading for $51 with the stock at $50. Arbitrageurs will buy the stock for $50 and sell the $0 strike for $51 thus guaranteeing them a $1 profit.

This is why buy-writes (orders where you simultaneously buy the stock and write, or sell, the call) can never be done at a credit. Now you know why! The call option can never be worth more than the stock.

For puts, the opposite relationship will hold for exactly the opposite reasons listed above. Put options will always be worth more with higher strikes with all other factors the same.

As a practice, you may want to pull up option quotes on your favorite stock and see if lower strike calls are always worth more than the higher strikes and the opposite for puts.

Check: Why is there an arbitrage opportunity in the following quotes? How would you perform the arbitrage? (Answers at the end.)

$60 put = $12 $70 put = $10

Pricing Relationship #2:

At expiration, a call must be worth either zero or the difference between the stock price and the strike price.

All this says is that a call must be worth intrinsic value (the difference between the stock price and strike) at expiration. If there is no intrinsic value, it's price will be zero at expiration.

If the stock is trading at $57 at expiration, the $50 call must be worth exactly $7 (actually, in the real world, bid/ask spreads will make it worth slightly less). Why must an option always be worth intrinsic?

If it is not, an arbitrage opportunity is available. Say the following quotes exist:

Stock trading at $57 $50 call trading at $5

The arbitrageurs will realize the call is mispriced and do the following trades simultaneously:

Short the stock: +57 Buy the call: -5 Net credit +52

The arbitrageur will short the stock and buy the call as above. Now all he has to do is cover the short. How will he do this? Simple, he will use the option, which gives him the right to buy at $50, and exercise it immediately. Upon doing this, he will have received +$57 then spent $55 for a net of $2; exactly the amount the call was mispriced. Because this is a guaranteed transaction with no cash outlay, it is an arbitrage.

Check: Stock is trading for $100 $110 put is trading for $9

Is there an arbitrage opportunity? How would you do it? (Answers at the end.)

Pricing Relationship #3:

Prior to expiration, a call option must be worth at least the difference between the stock price and the present value of the exercise price.

This one is a little complicated, but still important for many strategies. What this says is that for any call option, the minimum price it must trade for is the cost of carry.

Why? Think about this. Say a stock is trading for $100 and your best friend came to you and said, "I'm getting a huge bonus in one year but really want to buy 1,000 shares of this stock now. Would you be willing to buy it for me and I will pay you the $100,000 in one year?"

If you see your friend as risk-free, you should, at a minimum, charge him $5,000 for your forgone interest. That's all this relationship is stating. Of course, if there is an element of risk, you should charge more than $5 per contract. This leads to another important insight of call options -- they are a form of borrowing money!

Let's look at this closely. If your friend owes you $5 in one year, how much is it worth today? To answer that, we need to know the present value of $5 owed in one year at 5% interest.

What does present value mean? The present value of money is simply the value of a future cash flow today -- the value at the present. It's really very easy. Say you have $100 in a bank at 5% interest. In one year, you would have $105, right? That's called the future value of money -- it is a sum of money today ($100) valued in the future ($105). Now, present value just works backwards. If you are owed $105 in one year, how much is it worth today? Simple, just undo the above calculation -- $105/1.05 = $100. We would say the present value of $105 due in one year is $100 today if interest rates are 5% and the investment is risk-free. In other words, an investor should be indifferent between $100 today or $105 due in one year.

Because your friend is borrowing $5 for one year, that amount is worth $5/1.05 = $4.76 today. Because your principal, the $100, is being returned in one year, the only thing you will be missing in one year is the $5 interest. So the call option, in this case, should sell for at least $4.76. Why would it trade higher? If the markets see the stock as risky, investors would rather buy the option versus the stock to reduce their downside risk. They will bid the option higher. So volatility makes options -- both calls and puts -- more expensive.

Assume now that your friend wants to buy the stock from you in a year but only wants to pay $80 even though it's currently trading for $100. Now at the end of the year, you will be out $5 in interest plus $20 in principal for a total of $25 loss in one year. How much is that worth today? Take the present value: $25/1.05 = $23.81, and that's how much the $80 call must at least trade for! Any price lower than this leads to arbitrage.

Mathematically, the formula for this relationship can also be written as:

Minimum call price = Stock price - Present value of the strike price.

Examples:

Let's use the above formula to calculate the minimum price of a call instead of the intuitive method used earlier. If the stock is trading at $100 and interest rates are 5%, how much should the 1-year, $100 strike call trade for? Stock price - present value of the strike price =

$100 - ($100/1.05) = $4.76

For the $80 strike call: $100 - ($80/1.05) = $23.81

Why does this formula work? Remember, we said the call should trade for at least the cost of carry. If the stock is trading for $100 today, we can rewrite this relationship as:

$100 stock price today = $100 exercise price/1.05 + $5 interest/1.05

In order to isolate the interest amount or cost of carry (shown in bold), we can rewrite the formula as $100 stock price - $100 exercise price/1.05 = cost of carry, which is exactly the formula above.

If the call option does not trade for this minimum amount, what will happen? This one is tricky to see, but an arbitrage opportunity does exist. Here's how the arbitrageurs will do it.

Say we see the following quotes:

Stock: $100 $100 call: $3 Time: 1-year option Interest rates: 5%

We have already determined that this call option should be worth $4.76 yet we see it trading for $3.

Arbitrageurs will do the following trades simultaneously:

Short 1000 shares of stock: +$100,000 Buy the call: -$3,000 Net credit $97,000

Now, the arbitrageurs will owe 1,000 share of stock from the short sale. By purchasing the call, they will always be able to buy back the stock for $100 if the stock is trading higher. They will leave the $97,000 in the money-market (or T-bills) and receive $101,850 ($97,000 credit * 1.05).

The arbitrageur now has two choices depending on where the stock is trading at the end of the year. If the stock is above $100, they will just use the call option, pay $100, and keep the $1,850 (difference between the $101,850 received in interest and the $100,000 that must be paid to cover the short position). However, if the stock is trading below the strike price, traders will just let the option expire worthless and buy the stock in the open market, thus increasing the profits further.

Insights into the Black-Scholes Option Pricing Model The Black-Scholes Option Pricing Model, in a simplified form, can be written as:

Stock price *(risk factor1) - (present value of the exercise price) *(risk factor2)

Without the "risk factors," you will see the Black-Scholes formula is exactly the same as our formula above. Black and Scholes are simply saying that a call must be worth at least the cost of carry plus an additional amount if risk is present. It is the calculations of these risk factors that won the Nobel Prize!

Pricing Relationship #4:

The more time to expiration, the greater the price of calls and puts.

This relationship should be fairly obvious. The longer the life of the option, the more you will pay for it. The more time you have, the better your chances for the option going in-the-money. The markets, knowing this, will bid the longer-term options higher. This it true for calls and puts.

Can we be assured this will happen in the real world?

Say we see the following quotes one day:

3-month $50 strike call = $5 6-month $50 strike call = $4 (with all other factors being the same)

What will happen?

Arbitrageurs will buy the 6-month and sell the 3 month for a net credit of $1. If the stock falls below $50, the arbitrageur will keep the $1. What if the stock is higher than $50 when the 3-month expires?

If the stock is trading at, say, $70 after 3-months, the person who owns the 3 month call will exercise it and buy the stock from us for $50. That's okay because we'll just exercise our call and buy the stock for $50. The reason we can exercise our call option early is because equity options are American-style, which means they can be exercised at any time*. We still keep our $1 and have not lost a thing.

*It is important to note that, under normal circumstances, it is never optimal to exercise a call option early except to capture a dividend. However, to complete the arbitrage, we must exercise early.

Here's a tricky question: What if these are European style calls? European-style options can only be exercised at expiration, not before as with American-style calls.

If this is the case, and we are assigned on the 3-month call, we would have to buy stock in the open market at $70 and sell it for $50. That's a loss of $20 to us although we still have our original $1 credit from the original transaction. It may appear as though we are faced with a $19 loss since we cannot exercise our call option.

So what happens now? Are we stuck? No, and here's why:

All we have to do is sell our call to close in the open market. Remember, under Pricing Relationship #2, the call must be worth at least the difference between the stock price and exercise price; therefore our call will be trading for at least $20 ($20 intrinsic value + time premium). So selling our call in the open market, we can complete the arbitrage!

Pricing Relationship #5

For any two options, the difference in price cannot exceed the difference in strikes.

This relationship says that for any two call options, the difference in their prices cannot be greater than the difference in their strikes. An example will make this easier. Say we see the following quotes one day:

$50 Call = $10 $55 Call = $4 (with all other factor constant)

We know from Pricing Relationship #1 that the $50 call should be worth more than the $55, and we see that it is. However, Relationship #5 says that there cannot be this much of a difference because the difference in strikes is $5, yet the difference in price is $6. So the difference in prices has exceeded the difference in strikes.

How will the markets correct for this? You should know by now that arbitrage is the answer!

Arbitrageurs will buy the $55 call and sell the $50 for a net credit of $6.

Buy $55 -$4 Sell $50 +$10 Net credit +$6

If the stock collapses, the arbitrageur will keep $6. This will be true for any stock price below $50. If the stock close between $50 and $55, say $52, the trader will lose $2 on the short $50 call, but still keep the initial $6 for a net gain of $4.

The worst that can happen is for the stock to close above $55, for the trader will be assigned on the $50 strike. We must then buy the stock at market and sell for $50. Of course, we can always exercise our $55 call to buy the stock, so no matter how high the stock moves, the worst we can be hurt is by the amount of the spread, in this case, $5. Because we made $6 initially, we will end up with a credit of $1.

So the arbitrageur will make a minimum of $1 and a maximum of $6.

An easier way to understand Pricing Relationship #5 is to view the two contracts as if they were money. Imagine you are bidding on a foreign currency and can buy any denomination of bills. If you bid for 100 Yen, for example, you would never bid more than double that amount for 200 Yen.

Likewise, options must obey the same principle. If you think about it, there really is no difference in owning a $50 call vs. a $55 call in terms of financial liability. The person with the $50 strike can pay $50 for the stock; the person with the $55 strike can pay $55. So the market will never give you more than the difference in strikes.

The same will hold for put options too.

Insights into option prices

Look at the call option quotes for your favorite stock. Look very deep in-the-money. What is the difference in asking prices? If you look deep enough, it will be exactly the difference in strikes and no more. If you look for the at-the-money quotes, you will see they will be less than the difference in strikes, usually about half. The markets will not give you the full value of the difference in strikes, because at-the-money options involve more risk so the markets will bid these spreads downward. Finally, look for the far out-of-the-money quotes. There will be virtually no differences in the asking prices; their spreads have collapsed to zero.

Now you should have a basic understanding of why this relationship is true for any option quotes!

How to easily figure your maximum gain on spreads

Now that you understand some basics in option pricing, you should be able to easily figure out the max gain and loss for spreads! Say you buy a $50 call for $3 and sell a $55 call for $1. Think about it this way: the maximum this spread could ever be worth is $5, right? However, you paid $2 for it (paid $3 and sold for $1 for a net of $2). So the maximum gain is $3 on this spread. The maximum loss is the amount you paid, $2. See, it's really not that hard once you understand why the prices must hold.

These are just some of the most basic yet most important relationships to understand about options. It should be evident now, too, that market makers cannot just "throw any quote on the board they please" as many people will have you think. There is a very intricate web of pricing relationships that cannot be broken otherwise arbitrage opportunities will arise.

Understanding option pricing is a key element to success in trading!

As a subscriber to 21st Century Options, you will have access to our selected trades that are based on, among other factors, differences in theoretical prices. If you are having poor results with your trades, let us help you by giving you access to a team of professionals that will put the odds on your side.

Answers:

Why is there an arbitrage opportunity in the following quotes? How would you perform the arbitrage?

$60 put = $12 $70 put = $10

There is an arbitrage opportunity because, all else constant, a higher strike put will always be worth more than a lower strike put. Because a put represents a cash flow in to your account upon exercise, it is more desirable to have a higher strike so it should trade for a higher price.

To arbitrage: Buy $70 put -$10 Sell $60 put +$12 Net cash +$2

If the stock collapses, you will make $10 from the spread plus $2 from the original transaction for a total of $12. If the stock flies to the upside, above $70, both contracts become worthless and

you keep the $2. If the stock closes between $60 and $70, you will make money on the $70 but the $60 will expire worthless. So you will make at least $2 and possibly $12 from this arbitrage.

Question #2

Stock is trading for $100 $110 put is trading for $9

Is there an arbitrage opportunity? How would you do it?

Yes, an arbitrage opportunity exists because any option, call or put, must trade for at least the intrinsic amount. In this case, the put option is trading for $9 but should be at least $10.

To arbitrage: Buy stock -$100 Buy $110 put -$9 Net outlay -$109

Exercise the option and receive $110 for a net credit of $1. This is the exact amount by which the option is mispriced.

Black-Scholes The black-scholes factors

According to the Black-Scholes formula for option pricing, there are five main factors that affect an options price. Technically, dividends are a sixth factor but aren't of much concern, as they are generally factored into the price of the option, since all market participants know the amount of the dividend and when it will be paid. However, if it is a surprise dividend or dividend increase or cut, then it becomes a much more relevant factor.

According to the Black-Scholes model, the factors are: 1) Stock price 2) Exercise or strike price

3) Interest rates (risk-free rate) 4) Volatility of the underlying stock 5) Time to expiration 6) Dividends

We will look at each of these in turn and see exactly the effects they have on calls and puts. Some will be fairly intuitive and others not but all are important if you really want to understand options.

Stock price

The stock price is probably the most obvious of all the factors that affect an option's price. This is simply due to the fact that the option's price is derived from the underlying stock -- hence the name derivative instrument.

As the stock price increases, the price of a call will increase and the price of the put will decrease with all other factors constant.

This is a theoretical statement, so do not be alarmed if your call option is not up with the underlying stock trading higher. In fact, anybody who has traded options for any length of time has experienced this. There are sound reasons why this happens, so let's see if we can make sense of it.

First of all, there are many strikes for any given option. In fact, new strikes will be added if the stock is moving, either up or down, significantly. If a stock is trading at $120 up $2, a $100 strike will likely be up a significant portion of that $2 -- maybe up $1-1/2 or so -- depending on the volatility and time remaining on the option.

What about a $150 strike? Here, it is difficult to say. We know it is worth more theoretically, but it is up to the market to determine just how much. As an analogy, say you are betting on a runner to complete a twenty-six mile marathon and the runner has just taken the first step across the start line. Do you adjust your bet upward? Probably not, even though, theoretically, the runner is closer to the finish line than he was one step earlier. From a theoretical viewpoint, you should be a little more confident on your bet that he will complete it. It does not mean you will adjust your bet.

This holds for the options, too. An option can be thought of as a bet that the stock will cross the finish line -- the strike -- by expiration. As the stock moves higher, all calls become worth more theoretically. Whether or not the market reflects added value remains to be seen.

This same reasoning holds for puts, but in the opposite direction. Because a put option confers the right to sell stock, it should be worth more as the stock moves lower. As the stock falls, all puts become worth more theoretically.

Exercise (or strike) price

The exercise price is closely related to the stock price. In fact, they are really just two ways of looking at the same thing. When we were considering the stock price above, we assumed the strike price remained constant (as well as all other factors). Now, if we hold the stock price constant but lower the strike, effectively we are doing the same thing; that is, in either case we are putting the call option more in-the-money or at least in that direction.

As the exercise price (strike price) is decreased, calls become worth more and puts less with all other factors constant.

By the same reasoning, as the exercise price is raised, puts become worth more and calls will be worth less.

Another way to understand this is by thinking of what a call does. It gives you the right to purchase stock. Now, would you rather buy stock for $100 per share or $120 per share? Of course, you'd rather pay $100 and so would everybody else in the market, so market participants correspondingly bid the $100 strike higher, which is just a reflection of the higher demand.

Similarly, a put option gives you the right to sell your stock. Because everybody would rather get $120 per share, investors bid the $120 put higher than the $100 strike.

Interest rates

How interest rates affect calls and puts are a little more difficult to understand. It may be helpful to think about the following analogy. Calls are a form of borrowing money. Although you pay for the call option, in effect you are borrowing funds. Here's why: Say you buy a one-year $100 strike. You control all stock prices above $100 for the next year but are not obligated to pay him until one year from now. So effectively you are borrowing money from the call writer. Because interest rates affect the cost of carry to the seller:

An increase in interest rates will increase the price of a call option and decrease the price of a put option with all other factors constant.

Although this is fairly easy to show mathematically, it is easier to remember if you understand it conceptually. So let's look at another line of reasoning.

Say interest rates are very high -- 20%. You have $100,000 in the money-market that you would like to invest in stocks. You can either buy the stocks today, or for a fee, buy a call option which gives you control of the stock but allows you to defer payment. The choice should be clear: buy the call option so you can hang on to your money and continue to earn interest. The markets follow this same line of reasoning and bid the calls higher.

What about the puts? Puts give you the right to sell your stock, which represents a cash flow into the account, which is nice to have if interest rates are really high. So do you elect to buy puts to defer the sale? No, in fact, you may even sell the puts to generate cash into the account so it can earn the high rate of interest. Because few of the market participants are willing to buy puts relative to those wanting to sell them, the price of puts will fall.

There is one thing to be careful with here. All of these factors we are discussing assume the other factors remain constant. In the real world, this is rarely the case. So if interest rates rise suddenly, do not be surprised if your call options decrease in price and don't increase as we have said so far. This is usually due to the fact that stock prices will fall with increases in interest rates. We know that falling stock prices correspond with falling call prices. But it should be evident that all factors did not stay the same in this case -- we assumed interest rates rose and stock prices fell.

Volatility

Without a doubt, volatility is the single-most important factor of the Black-Scholes model. In fact, it is the only true unknown in the equation. For example, if you asked 10 different people what

the stock price is, they would all give you exactly the same answer. Likewise, they would quote the same strike price, risk-free rates of interest, and time remaining on the option. However, what should they tell you is the correct volatility measure for the stock? The 10-day average? The 20-day? The 50-day? Or should they quote the projected expected future volatility? It should be easy to see why this is the most important factor in the model -- it is the only one that nobody knows for sure.

If volatility increases, both call and put prices will increase with all other factors the same.

Now, you may be thinking if volatility increases, the stock becomes riskier. Why would somebody pay more for a risky asset? After all, junk bonds trade for lower prices than government bonds because of the risk.

The reason for the apparent contradiction is that options have a limited downside; the owner can only lose what they put into it.

Look at the following diagram. Assume one investor buys stock at $50 and another purchases a $50 call for $5:

30 35 40 45 50 55 60 65 70 75 Gain on stock purchased at

$50 -20 -15 -10 -5 0 5 10 15 20 25

Intrinsic gain on $50 call

purchased at $5

-5 -5 -5 -5 -5 5 10 15 20 25

If you purchased stock at $50 and the stock closes at $30, you are down $20. However, the call owner is only down $5. In fact, that's the most the call owner can lose; however, they can match the stock purchaser on profit for all stock prices above $50. So more volatility just means a higher expected return for the option buyer -- whether calls or puts. So investors will bid up the prices of options that are tied to risky stocks.

Time to expiration

This factor is fairly straightforward. We said earlier that an option could be viewed as a bet that the stock will be above the strike price (for calls) or below the strike price (for puts) by expiration. In other words, you are in effect betting that the option will have intrinsic value. Because of this, the more time available, the more likely the stock will have intrinsic value.

The more time to expiration, the more valuable are calls and puts.

From a trading standpoint, the more time you buy, the better. This is because calls and puts become increasingly cheaper (on a per month basis) the more time you buy. For example, if a one-month option is trading for $5, you would have to look at a four-month option to double the price to $10. Many people think that a two-month option would double the price but it doesn't -- it takes four times the amount of time to double the price. So the implication is that it becomes a better and better deal for the option buyer to buy time. Likewise, it becomes a worse and worse deal for the options seller to sell longer-term options.

Please don't confuse this to mean that it is wrong to sell longer-term options or that it's wrong to buy little time because that's not necessarily true. It depends on many factors with the particular strategy at hand. All that is being said is that, everything else constant, option buyers should buy lots of time and option sellers should sell short amounts of time.

Special note: There is one small point that should be made here. It is possible for a deep-in-the-money European put option to become more valuable with the passage of time. This is due to the fact that the European option holder must wait to receive the cash from the put. So a deep-in-the-money European put will be worth the present value of the future cash flow and will increase in price with the passage of time. However, options on the equity market (stocks) are always American style so this caveat doesn't hold for most of our discussions on equity trading strategies. Just be aware that there is one exception to this rule.

Dividends

Last, we will consider the effect of dividends on calls and puts. This one is also fairly straightforward.

If a stock pays a dividend, the price of the stock is reduced by the amount of the dividend (rounded to the nearest 1/8th of a point) the next trading session. The reason the price is reduced is because the company has paid out cash -- one of its assets -- so is now worth less than before it paid the dividend. For example, say a $100 stock will pay a $1 dividend tomorrow. On the opening, the stock will be trading for $99 unchanged (this is considered to be unchanged since the fall is not due to supply and demand factors).

Think about it for a moment. If the stock price is down and all other factors stay the same, what will happen to the call? You've got it, the call price will fall.

Dividend increases cause call prices to fall and put prices to rise with all other factors the same.

Why will put prices rise? Because the put owner can force the seller to buy the stock, which is now worth even less after the dividend is paid, so the put options become more valuable.

The following table will help as a recap. The table shows the effect on call and put prices with the six factors being up. Of course, the reverse will be true if the factors are down.

If this factor is up: Call price Put price

1 Stock price 2 Exercise price 3 Risk-free rates 4 Volatility 5 Time to expiration 6 Dividends

Most strategies are some form of a play on the five main factors that affect option prices. If you understanding these factors, you are on your way to becoming a better options trader!

Implied Volatility As you learn more about options, you will eventually run into the term "implied volatility." It is an essential concept in option trading; in fact, many strategies rely on "volatility" as opposed to directional plays with the underlying stock. For example, short straddles and calendar spreads are volatility plays, as the long position does not want the stock to move (or at least move very far).

Understanding implied volatility allows you to find the best options to use, even if just a long or short position. It will also allow you to understand why, sometimes, the stock moves up but your long call moves down which seems contradictory -- until you understand implied volatility.

We'll take it slow, but you will understand implied volatility when we're through.

A little statistical background

We will be using the term standard deviation throughout, so we need to have a basic understanding of what this means. Standard deviation is a statistical measure telling you how likely it is that something deviates from the average. We will not be doing the exact calculations, but it is necessary to understand the concept.

For example, the average adult male is about 5'9" tall. How often will we see one taller than 6'5"? In order to answer this, we need to know how the numbers are distributed. One of the most popular distributions is called a normal distribution or bell curve. If we assume that the heights of adult males are normally distributed and we have calculated the standard deviation, then all we need to do is find where 6'5" falls on the bell curve. With a little math, we can figure out how likely it is that we will see someone 6'5" or taller.

With the standard bell curve, about 68% of the area lies within one standard deviation, and about 95% lies within two standard deviations. Essentially all information lies within three standard deviations under a bell curve.

Volatility

Before we attempt to explain implied volatility, we should clarify what is meant by the term volatility. Although we hear generic phrases like "that stock is volatile," it is actually a statistical concept with a very precise meaning. Volatility is the annualized standard deviation of stock price movements.

We'll show you what this means with an example:

Say there is a stock trading at $100 with a volatility of 20%.

If we assume that stock prices are random, then about 68% of the time (or two out of three chances), the stock will be between $80 and $120 after one year. This is found by adding and subtracting 20% the volatility to the $100 starting stock price.

Remember, this is one standard deviation from the starting point of $100, so that, means that plus and minus 20% will occur 68% of the time.

To continue, we would expect 95% of the time to see the stock in one year trading between $60 and $140 (or 19 out of 20 chances). This was found by adding 2 * 20%, or two standard deviations from our initial price of $100. Because 95% of the bell curve area lies within two standard deviations, we expect to see the stock within two standard deviations (between $60 and $140) 95% of the time.

Now, it may seem a little odd to make a statement like "95% of the time, the stock will be between $60 and $140." After all, doesn't it make sense that it either will be or won't be between these prices? What we mean by this statement is that if the exact conditions were to occur over and over many times, 95% of the closing prices after one year would be between $60 and $140. While it is true that after one year, the stock either will or will not be between these prices, we do not know that beforehand so we say "95% of the time it will be between these prices."

It should be intuitive that the higher the volatility number, the wider the range of closing prices we would expect to see after one year. For example, one would expect a wider distribution of closing price possibilities for a stock with 40% volatility versus 20%.

The black-scholes option pricing model

Now that we have a grasp as to what volatility means, let's find out what implied volatility is all about. In order to do that, we need to return to the Black-Scholes Option Pricing Model (please see our section under this title if you need more information).

The Black-Scholes Option Pricing Model is basically an options calculator. It is similar to a car-payment calculator where you may input the amount you are financing, the interest rate, the term of the loan, etc., and the result is your payment. Similarly, with the Black-Scholes Model, you put in the five key factors that affect an options price: stock price, exercise price, risk-free rate of interest, volatility, and time to expiration and out pops the price of the call option. This is the price we would expect to see the option trading for.

Let's look at this closely:

Stock price + exercise price + risk-free rate + volatility + time = call option price

Say we want to find out the price of a 3-month, $100 call option. If we ask hundreds of investors for the stock price, we should get the same answer. All they have to do is look at the quote. The exercise price is given and so is the time so we'll get exactly the same answers there. While everybody may not return the exact answer as to the risk-free interest rate, they should all be very close. Further, interest rates do not greatly affect option prices especially over a three-month period. So 4 out of the 5 factors (all in blue) are basically givens; that is, if we asked hundreds of people for these four pieces of information (stock price, exercise price, risk-free rate, time to expiration), we should get exactly the same answers (allowing for a slight variation in the risk-free interest rate).

Now for volatility. What should these hundreds of investors tell us is the correct volatility to use? Some may say the historic volatility is 20%, so let's use that figure. Others may say the historic is 20%, but the stock has been at 30% volatility over the past month, so let's use that. Still, others may say it has been 30% recently, but they feel it will be higher so we should use 35%.

The point is that the only true unknown factor of the Black-Scholes Model is volatility, and that's why it is so important to understand. It is the one variable that determines option prices!

Let's run through an example with actual numbers.

$100 $100 5.5% 20% 90 days $4.61

Stock price + exercise price + risk-free rate + volatility + time = call option price

If we actually run the above numbers through a Black-Scholes Option Pricing Model we find the $100 call option should be trading for $4.61.

BUT, let's say we look at the option quote and it is actually quoting $5 1/2. In this case, the call option price becomes a given; our hypothetical hundred traders would all return this same value as well.

Implied volatility

Something must be out of balance as 20% volatility returns a call price of $4.61, yet we see it quoting $5-1/2. The only term we can adjust on the left hand side of the equation is volatility (red) as all the other factors (blue) are givens.

Now the question becomes, what volatility will produce an option price of $5-1/2 with all the other factors the same? If we go back to the Black-Scholes Model, we can try different volatilities until we come up with a price of $5-1/2. If we do, we see the volatility that makes the equation true (that is, the call option price $5-1/2) is 24.6%.

We would say the implied volatility of the option is 24.6%. This means the market is telling us it feels the forward volatility or future volatility of this stock over the next 90 days is about 25% and not the historical 20% we had observed earlier. In fact, this is one of the main benefits of an options market; it allows a window in which to monitor the opinion of the market.

Trading volatility

One of the main tactics of option traders is trading volatility. In order to understand why, we need one more statistical concept known as mean reversion. While this sounds intimidating, it's really very simple; it suggests that many types of data revert back to the mean.

For example, if you flip a coin many times, you would expect to have "heads" land 50% of the time. Now, it shouldn't shock anybody if, after the first ten flips to see 7 heads and 3 tails -- a 70% hit rate. But if you keep flipping, that will eventually revert closer to a mean of 50%. In other words, on average, the averages win!

The same holds true for options and has been proven in many studies. For example, if a stock has an historic volatility of 20% but the markets are trading it with a volatility of 30% (implied volatility), then on average, we should expect to see the volatility revert to the mean of 20%. What happens to calls or puts when the volatility falls? The price comes down as well. The reverse is true, too. If implied volatility rises, so will the prices of calls and puts.

So as a whole, traders tend to buy options with low implied volatility hoping that the volatility reverts to the higher average and increases in price. Likewise, they tend to sell options with high implied volatility hoping the premiums deflate as they fall to the historic means.

Volatility trap

Now we may be able to shed some light as to why sometimes the call you hold falls in price even though the stock rises. This happens to puts as well. You may see the stock fall, yet have your put decline in value.

Say you are interested in a stock trading at $50 that has an historic volatility of 25% and is about to announce earnings. You feel they will have a record quarter and great comments from the analysts, so you decide to buy 10 $50 calls.

Now think about this. You are probably not the only investor who had the same thought. You very likely deduced this from current information and recent comments from the company or analysts. So the entire market is probably doing the same thing. By acting on this information, the price of the calls keeps getting bid higher and higher. Let's say it is bid up to an implied volatility of 40% instead of the historic 25%.

You buy your call option with very high implied volatility (remember, options with high implied volatilities are the ones professional traders look to sell). The stock releases great numbers and comments from the analysts and is now up 2 points. But your option is now being priced with a volatility of closer to 25%. Why, there are no new buyers speculating for a good earnings release; it's now old information. According to the Black-Scholes Model, you will get a two-point increase in the stock price but a 15% decrease in volatility, which can leave you holding an option that is down in price even though the stock is up. This phenomenon is called a volatility trap.

Be careful when buying or selling options. Check with your broker to see what the implied volatilities are relative to the historic levels. If they cannot get this for you, you should consider finding one that can, as the information can be crucial for winning option trades.

Learn to use the tactics professionals use to put the odds on their side. If you are selling calls, perhaps even a covered call, you should check the implied volatilities. If the implied volatility is high, this is one more piece of information suggesting the odds are on your side. If you want to buy an option, check to see if the implied volatilities are low and if it will tilt the odds in your favor, assuming your assumptions about the underlying stock are correct.

Please note that buying an option with high implied volatilities or selling one with low implied volatilities is not necessarily wrong. It's just that you have now added another dimension stacked against you.

How volatile is the market?

One way to monitor the overall volatility of the market is with the Chicago Board Options Exchange (CBOE) indicator called the VIX (volatility index) and can be quoted under that same symbol. The VIX was created in 1993 and calculated by taking a weighted average of the implied volatilities of eight S&P 100 (OEX) calls and puts. The options have an average time to maturity of 30 days, so the VIX is intended to indicate the implied volatility of 30-day index options.

Learn to interpret and use implied volatilities in your trading. It will open your eyes to a new way of trading options and add a new list of strategies to implement.

Delta Gamma The single most important concept in option trading is that of delta and gamma. Investors not aware of these terms or concepts are setting themselves up for a disappointing trade. Understanding these advanced option terms will improve your investment results immediately!

Let's start with a simple trading question:

You are bullish on XYZ stock and want to invest in options. Which of the following do you do?

A) Buy calls B) Buy puts C) Sell calls D) Sell puts

If you answered A, as most people do, you just set yourself up for a potentially losing trade. And no, you didn't misread the question; you just fell into the most common error in option investing.

To really emphasize why so many people lose with options, think about this: We never even got to the point of which option to buy, yet have already made a critical mistake. There was no discussion as to whether we should buy a 1-month, 3-month, 6-month, or even LEAPS option. There was no discussion as to which strike. We just invested a lot of money and sent a wounded horse to the starting gate.

Let's find out what the mistake is and how to correct it.

Options have two components to their value

Stocks, compared to options, are much easier to trade. All you have to do is decide whether the stock is going up or down. You only need to determine the direction. Of course, anyone who has ever invested in stocks knows that this, in itself, can be incredibly difficult.

With options, there are two components to their value -- direction and speed. It is this second component, speed, that makes options such tricky investments. Delta measures direction, and gamma measures speed. Although there are specific numerical measures of delta and gamma, we are only going to consider them in a much simpler, conceptual format.

Delta, as mentioned, measures direction. A long call position has positive delta; in other words, the value of the call will go up (positive) as the price of the underlying stock rises. Put options have negative delta; their value will go down (negative) as the price of the stock rises. Of course, the opposite is also true. If the underlying stock goes down, calls will lose and puts will gain in value.

What if we are short a call? Then our position will have a negative delta meaning our position will lose value as the stock rises. Similarly, if we are short a put, then we have positive delta; our position will gain in value as the stock rises.

It should be easy to see now that there are two ways to obtain positive deltas; long calls and short puts.

KEY CONCEPT: If you are bullish on a stock, you want positive delta for your option position. If bearish, you want negative delta.

What about gamma? Gamma measures the speed component of an option. In a conceptual sense, gamma can be measured, as can any object with speed, with time. So time premium is a way to determine gamma. The higher the time premium of an option, the higher the gamma. Because the time premium is the portion of the option's price that erodes with the passage of time, it is this portion that is exposed to slow or no movement in the underlying stock.

Example:

XYZ stock is trading for $50

XYZ $50 call trading for $5 XYZ $30 call trading for $21

Here, the $50 call is all time premium. Therefore it will have a higher gamma component. The $30 call has only $1 time premium, so compared to the $50 call, its gamma component will be much lower. Gamma can also be thought of as a risk measure. We can say the $50 call is riskier, in terms of speed, than the $30 call, because if the stock sits still, the $30 call can only lose $1 (3.23% of value), while the $50 call can lose the entire $5 (100% of value).

Another way to look at the risk factor is in terms of break-even points. The $30 call will need to have the stock trading at $51 by expiration in order to break even. Why? If the stock is $51, the call will be worth exactly $21, the price paid for the option. However, the $50 call must have the stock trading at $55 to break even. So again, the $30 call, with respect to speed, is less risky. In other words, the $30 call does not need as much movement in the stock to break even as compared to the $50 call.

Although it may seem counterintuitive, long calls and long puts both have positive gamma. This is because you need speed in the underlying stock if you have a long position; you need to make up for the time premium you paid.

KEY CONCEPT: If you are looking for quick speed of movement in the underlying stock, your option position should have positive gamma. If you expect the stock to move slowly or sit flat, your option position should have zero gamma or even negative gamma.

Putting it all together

Example

We are bullish on XYZ trading at $100

1-month $105 call is trading at $7

1-month $95 put is trading at $5

We determined at the beginning of this lesson, that most investors would be inclined to buy calls because we are bullish. So let's buy a call and see what happens!

We are long the $105 call at $7. At expiration, the stock is trading at $110. The question now is, are we correct in our bullish assumption? There is no question that we are. The stock is up a whopping 10% in a month (that may not seem like a lot, but that's an annualized rate of over 200% -- at that rate, you would more than triple your money in a year). So just how much of a killing did we make on our call?

The $105 call will be trading for $5, exactly the intrinsic amount. We paid $7 and sold for $5, yet we were correct in our bullish assumption. That's a 28% loss on the investment for being correct! Sound familiar?

Now that we know about deltas and gammas, let's see if we can correct the mistake. This trader just made the classic mistake of trading options only on delta -- the direction of the stock. Let's polish up the trade a bit.

We know that the trader is bullish so we should have positive delta -- either long calls or short puts. But now let's say that we ask the trader, "How quickly do you think the stock will move?" Let's say he says, "I think it will move up but slowly."

Now we are in position to set up a winning trade -- assuming the trader's assumptions are correct.

We now know he wants positive delta (because he's bullish) but also needs negative gamma (because he believes it will move slowly). The following chart should help us determine what we should do:

Delta Gamma Long Calls + + Long Puts - +

So how can we get positive delta and negative gamma? We can short the puts, which will give us the opposite signs as listed in the table above. Long puts have negative delta and positive gamma, so a short position will have positive delta and negative gamma -- exactly what the trader needs!

Now, if he shorts the $95 puts, he will receive $5 and keep the entire $5 instead of losing $2 as he did with the calls. What if the trader doesn't want to be short or doesn't have the option approval level to be short? We could do a credit spread that would lessen the risk. Or, we know he desires negative gamma but a gamma close to zero would also work. Remember, time premium is synonymous with gamma, so to get a gamma of zero (or close to it), we could also look at deep-in-the-money calls.

With XYZ at $100, the $80 call may be trading in the neighborhood of $20-1/2 ($20 intrinsic + a small amount of time premium). If he buys the $80 call he will spend $20-1/2 and with the stock closing at $110. He will be able to sell the option for $30 for a profit of $9-1/2 (46% gain), which is certainly better than the 28% loss taken when he traded only on direction alone.

Now you should be in a position to fully answer the question asked at the beginning. The correct way to answer is this: We should have clarified the gamma component with the investor; in other words, is the investor bullish quickly or slowly. Once we determine that, we can then recommend

either long calls or short puts, or a host of other strategies that would properly align the deltas and gammas with his directional opinion of the stock.

It should now be evident that there are TWO components you need to determine when dealing in options -- direction and speed. In order to make a profitable trade, a position with positive gamma must move up; a position with negative gamma does not have to move up, it just cannot

move down. These are two very different situations. If you don't consider both, you will almost certainly set yourself up for a losing trade.

More Delta Gamma The concept of delta and gamma are of utmost importance for the option trader. In our section "Deltas and Gammas" we learned that delta measures direction and gamma measures speed of the option. But it was presented in a format to understand the concepts without the use of numbers.

In this section, we will broaden the concept of delta and zero-in on an exact definition you can use and understand.

The importance of delta cannot be emphasized enough; understanding it will most likely change the way you pick your option trades.

The concept of delta

Delta is a mathematical relationship between the option and the underlying stock. It expresses the dollar amount the option will increase for a very small move in the underlying stock. How much is a small move? Technically we mean very small (as in infinitesimal) but it will probably be easier to understand if you think of a $1 move in the underlying stock.

For example, say an option is trading for $50 and has a delta of 1/2. If the stock were to move up $1 to $51 rather quickly, we would expect the price of the option to move up $1/2 from $5 to $5-1/2. In other words, the stock gained 1 point but the option only gained 1/2 point. If that same option, instead, had a delta of 1/4, then the price of the option would have moved to $5-1/4 -- only 1/4 the move of the stock.

Delta will always be a number between 0 and 1 for calls (0 and -1 for puts). There are some exceptions to this but they are usually minor and not too important for trading purposes. Delta constantly changes primarily from moves in stock price, time or volatility.

We now want to find out why the option does not move point-for-point with the stock. This may sound trivial, but it will change the way you see and understand options!

It will take some basic math but we will make it as easy as possible. We will start first with a simple analogy to get the idea of why deltas exist.

Why does delta exist?

This often confuses the new options trader. Often they will purchase an out-of-the-money call option that sits relatively flat in price -- even though the underlying stock is moving up. They wonder how that can be since call options are supposed to go up in value as the stock moves up. If you understand the following analogy, you will understand why the market will not price your option point-for-point with the underlying stock unless the option is very deep-in-the-money or in-the-money with little time remaining.

Analogy: Promotional cell phone coupon

Assume you are holding a promotional coupon that allows you to purchase a particular cell phone for $100. The phone actually sells for $120. Also assume that this coupon is marketable; that is, it can be bought and sold freely and there are a large number of buyers and sellers.

Notice that this is similar to a call option; it gives the buyer the right to buy the asset for a fixed price.

If these assumptions are true, the coupon should be trading for $20. This is because someone could buy the coupon for $20 and use it to buy the phone for $100. The total purchase price would be $120, which is the market price of the phone. In this case, there is no net advantage to owning the coupon. The markets will always make sure there is not net advantage to owning one asset over another, otherwise arbitrageurs will correct for it.

Let's look at two different scenarios and see how the coupon will react:

Scenario I

It is announced to the market that the price of the phone will increase to $130. What will happen to the price of the coupon? For the same reasons as above, it will immediately move to $30. A consumer could buy the coupon for $30 and use it to pay $100 for the phone thus paying $130 -- the market price.

Notice that the phone jumped by $10 (from $120 to $130) and so did the coupon (from $20 to $30). We could say the delta of the coupon is one. In other words, the coupon appreciates dollar-for-dollar with moves in the underlying asset, in this case, the phone. This will be true for any price appreciation or depreciation in the phone (assuming the phone price does not drop below $100 because the coupon cannot have negative value).

Scenario II

Let's say the phone company executives are meeting tonight and will decide if the phone price should be raised from $120 to $130. These executives are in a deadlock and have decided to break the tie by flipping a coin: heads they raise the price, tails they do not. It is announced to the market that the price of the phone may increase to $130 with a 50%-50% chance; otherwise the price will stay the same.

Now comes the tricky part. What happens to the price of the coupon?

Think about this, the price of the coupon will either move to $130 or stay at $120 with a 50%-50% chance. If the market does not bid up the price of the coupon, there is an inherent advantage for a speculator; they will bid up the price hoping the decision is to raise the price of the phone. The reason is this: If faced with this same situation multiple times, half of the time investors would make $10 (when phone is raised to $130 and coupon jumps from $20 to $30) and half the time they will not make anything (when phone price stays the same and coupon stays priced at $20). So on average, if given this opportunity multiple times, investors will make $5; they make $10 half the time and make nothing half the time.

Mathematically, this can be shown as follows:

(1/2) * (+$10) = $5 (1/2) * ( $0 ) = $0 Net gain +$5

Mathematically, this is called the expected value and is key to understanding delta. The expected value is nothing more than the sum of the probabilities multiplied by the outcomes.

So what should speculators do? They should bid up the price of the coupon to where there is no net advantage -- they bid it to $25. If not, the market will continue to compete for the difference. For example, if the market only bids the price to $24, now speculators have a $1 net advantage.

The expected value is:

(1/2) * (+$6) = +$3 (1/2) * (-$4) = -$2 Net gain +$1

With the coupon priced at $24, speculators are putting $4 at risk in order to make $10. Half the time they will win for a net gain of $6, and half the time they lose for a net loss of $4. If they were allowed to do this many times, they would expect to win, on average, $1 per time. So they continue to bid the price of the coupon to $25 so there is not net advantage.

When priced at $25, the expected value of the coupon is:

(1/2) * (+$5) = +$2.5 (1/2) * (-$5) = -$2.5 Net gain $0 When the prices rises to $25, the buying pressure stops.

What happens if the markets immediately price the coupon to $30 as they did in scenario I? For similar reasons, if the market prices the coupon at $30, again there is an inherent advantage for the speculator; they will sell it because it is theoretically overpriced.

The expected value will be:

(1/2) * (+$10) = +$5 (1/2) * ($0) = $0 Net gain +$5

Half the time speculators will make $10 by selling the coupon at $30 and buying it back for $20 when the phone price is not raised; otherwise, they make nothing (sell coupon for $30 and buy it back for $30). Again, there is a net advantage to being short so speculators will compete for this money. For the same reasons as above, they will continue selling the coupon until the price is $25.

When the price falls to $25, the selling pressure stops.

Understanding delta

Let me give you a simple definition of delta and hopefully you will understand why the markets will not give you dollar-for-dollar moves on your option.

Definition: Delta is the probability that the option will have intrinsic value at expiration.

Now that you know exactly what delta is, you should immediately understand why it exists. If an option has a delta of-1/2, then the markets will only compensate you for-1/2 of the move in the underlying -- otherwise there will be a net advantage for speculators to buy or sell! This is exactly what happened with the cell phone example in scenario II.

Once the option is deep-in-the-money or in-the-money with little time remaining, the market will increase the price of your option dollar-for-dollar with moves in the underlying. This is because the market is effectively saying that the option will expire with intrinsic value. This is exactly what

happened in scenario I with the cell phone coupon. It was announced that the price will be increased; in other words, it is 100% guaranteed to happen. When the market heard this news, they priced the coupon dollar-for-dollar.

New Uses For Delta

You may hear that delta is of little concern for the average investor and only used as a theoretical hedging value for floor traders. While it is true that it can be used in this sense, there are also a great deal of insights that are practical, if not necessary, for retail investors.

First, because we know delta is the probability that the option will have intrinsic value at expiration, it will shed some light on your option picks. Often, new traders are attracted to the short-term, out-of-the-money option because it is cheap. If it has a long way to get to the strike and little time to do it, what kind of probability do you think the markets are assigning to it? If you said very low, you're right. The delta on short-term, out-of-the-moneys are usually in the neighborhood of 0 to 20%. Now you know why they don't appreciate dollar-for-dollar with moves in the underlying. Usually, these options are lucky to see a few cents appreciation in them, but are often eaten away by bid-ask spreads.

If you're not having a lot of success with your option trades despite getting the direction of the stock right, try using ones with higher deltas!

What are the chances I will have my stock called away?

Here is another use and one we get a lot of questions on. Many times investors will be in a covered call position (long stock and short call) and ask, "What do you think the chances are that I will have my stock called away?" Most brokers will tell you there is no way to know but this is completely false. The answer is the delta. If you are long stock and short a call with a delta of 0.70, at this time, the markets are telling you there is a 70% chance you will lose your stock.

Keep in mind that we said "at this time" there is a 70% chance. Obviously as information changes, so will the delta.

Why Deltas Change

The main factors that affect delta are stock price movement, time and volatility in the underlying stock. Let's find out how these factors affect delta and why.

Again, we could use a lot of math, but a simple analogy will probably work better.

Let's assume you are an odds maker for an upcoming basketball game. It's the Miami Heat vs. the Orlando Magic. You do your analysis and decide that the Heat have a 60% chance of winning.

There are now 10 minutes remaining in the game and the score is Miami: 70 Orlando: 72. As the odds maker, should you change your odds at this point? Probably not, as the score is too close and there is too much time remaining to be sure.

Example 1:

Let's say that, instead, the score is Miami: 80, Orlando:70 with 5 minutes remaining. Now, because your team is a good bit ahead, although not unbeatable, you will probably decide to increase your odds, right? You may now, for example, think Miami has a 70% chance of winning.

Your job as the odds maker is to decide which team will win. Well, that's exactly what the market does with options. The market tries to determine which options will win -- which ones will have intrinsic value at expiration. So as your option goes deeper-in-the-money, the odds of it expiring with intrinsic value will increase; that is, the deltas will increase.

As the stock rises, call deltas increase and put deltas decrease.

Now back to the basketball game.

Example 2:

Let's now assume that the score is Miami: 86, Orlando: 80. If we still had 5 minutes on the clock, this would be a close one to call. Instead, let's drop the time to only 30 seconds remaining. Now you would almost certainly boost your odds to nearly 100%; it's almost a sure thing the Heat will win.

Notice the difference with the above examples. In the first example, a ten-point difference in scores boosted the odds from 60% to 70%. However, in the second example, a 5-point difference with little time boosted us to nearly 100%. Remember, you are trying to determine which team will win. In this case, you as the odds maker see no way for the Magic to win at this point, so you boost the odds for the Heat to nearly 100%.

As time decreases, options with intrinsic value will have delta increase. Out-of-the-money options will have deltas decrease.

In other words, the options that are "winners" (have intrinsic value) are becoming more likely to stay that way as time decreases.

Example 3:

Still assume that the score is Miami: 86, Orlando: 80 with 30 seconds on the clock as in the second example. But this time, some key players for the Heat suddenly get removed from the game. Because of this, the Heat's scoring ability has now been reduced. As the odds maker, instead of increasing the Heat from 70% to 100%, you would either not increase them as much or possibly decrease them.

A losing team is helped by adding key players to the game (or having key players removed from the winning team).

This is what happens when volatility is increased in the underlying stock. A losing option (out-of-the-money) is helped by increased volatility; it now has a chance to become a winning option and the deltas will increase. Similarly, an in-the-money option is hurt by volatility; it may now end up out-of-the-money.

As volatility increases, out-of-the-money options will increase deltas and in-the-money options will lose deltas.

An easy way to remember time and volatility concepts is that they are synonymous.

As time or volatility increase all options become more at-the-money!

To be a good trader, it is not necessary to know the actual number for delta as much as it is to know the relationships between delta, stock price, time, and volatility.

Let's run through some examples to be sure you've got it.

1) The stock is at $50. Which option has a higher delta, a one-month $60 call or a 6-month $60 call? Why?

Remember, the market is trying to assign odds as to which option will be a winner or in-the-money. Because both are out-of-the-money, you would have to assign a higher probability to the 6-month call. It is much more likely to be a winner relative to the one-month call. The 6-month call will have the higher delta. If the underlying stock move up $1, the 6-month call will appreciate more relative to the 1-month.

2) The stock is $100. Which has a higher delta, a one-month $90 call or a 3-month $90 call? Why?

Both of these options are currently winners because they are in-the-money. But the 3-month option is more likely to become a loser relative to the 1-month so the 1-month, will have a higher delta. If the underlying stock moves up $1, the 1-month option will appreciate more relative to the 3-month.

Remember, once you are winning, you want the time clock to go to zero!

3) The stock is $50 and a 3-month $55 call has a delta of 0.45. Suddenly, there is increased volatility in the stock. Does delta increase or decrease?

The option is currently "losing" because it is out-of-the-money. But with the added volatility, it is much more likely to become a winner. Delta will increase.

4) A stock is trading at $75. What is the delta of a $75 strike call?

Because this option is at-the-money, it is riding the fence of being in or out-of-the-money. The delta will be very close to-1/2. Technically, the delta will be a little higher because of the continuous compounding assumption in the Black-Scholes Option Pricing Model. But for most trading purposes, an at-the-money option has a delta of-1/2.

5) You want to use a call option as a substitute for stock. Would you look at short or long term? In-the-money or out-of-the-money?

If you really want the option to behave virtually like stock, you should look at short-term, deep-in-the-money calls. Because, these are in-the-money with little time, there is close to a 100% chance they will expire with intrinsic value, so the market will have to increase the option dollar-for-dollar with moves in the underlying stock.

If you continue to work with the concept of delta, it will greatly help you with your option trades whether beginning or advanced. It will shed new light on the risks involved with short-term out-of-the-money options. It will show why longer-term options are more desirable than shorter term if you are looking at out-of-the-money options. You will start to understand strategies in new ways and more closely match your positions to your opinion on the market. You will become a more informed and accomplished options trader, and that can only mean better trades!

Option Exam 5 - Week 5

1) What happens to the price of call options if interest rates increase? (Assume all other factors remain constant.)

a) Call prices increase

b) Call prices decrease

c) Call prices remain unchanged

2) What happens to the price of calls, all else constant, if the exercise price is decreased?

a) Call prices increase

b) Call prices decrease

c) Call prices remain unchanged

3) What happens to put option prices as the stock price rises (assuming all else is constant)?

a) Put prices rise

b) Put prices fall

c) Put prices remain unchanged

4) What happens to the prices of both calls and puts, all else constant, if time remaining to expiration is increased?

a) Both calls and puts increase in price

b) Calls increase and puts decrease in price

c) Both calls and puts decrease in price

d) Puts increase and calls decrease in price

5) If the stock price rises by one dollar, the price of the call option will rise by how much?

a) One dollar

b) It depends on the delta

c) More than one dollar, to reflect the added risk of options

d) Sometimes more, sometimes less than one dollar

6) If the delta of a call option is 0.70, what will be the delta of the corresponding put option?

a) 0.70

b) 1.70

c) -0.30

d) -0.70

7) The delta of a call is 0.80 and the implied volatility just increased. Assuming all other factors the same, what happens to the delta?

a) It will increase

b) It will decrease

c) It will stay the same

d) Cannot be determined

8) What do delta and gamma measure?

a) Delta measure direction, gamma measure speed

b) Delta measure speed, gamma measure direction

c) Delta and gamma measure speed at different times

d) Delta measure direction for calls and gamma measures direction for puts

9) Which is true regarding delta?

a) Calls and puts have positive delta

b) Calls have negative delta, puts have positive delta

c) Calls and puts have negative delta

d) Calls have positive delta, puts have negative delta

10) Which is true regarding gamma?

a) Calls and puts have positive gamma

b) Calls have negative gamma, puts have positive gamma

c) Calls and puts have negative gamma

d)Calls have positive gamma, puts have negative gamma

11) If an option is trading for $7 but "should be" trading for $6 according to the Black-Scholes Option Pricing Model, how would you account for the discrepancy?

a) Market makers are cheating

b) Implied volatility is high

c) Implied volatility is low

d) Bid-ask spreads must be wide

Week 6 : Basic Strategies

Long Call Long and short calls

A long call option gives the buyer the right, but not the obligation, to purchase stock for a fixed price over a given amount of time. It is the call buyer that has the right to purchase stock; the short call seller has the obligation to sell stock if the long position exercises their option. There should be no concern for default by the short side as the Options Clearing Corporation (OCC) guarantees the performance of the contract.

The long call strategy is therefore bullish, as the value of the call rises with increases in the underlying stock. Please understand that when we say call prices rise as the stock rises, this is assuming that all other factors stay the same. It is quite possible for calls to fall in value as the stock rises due to time or volatility decreasing.

Investors are typically attracted to the long call strategy for two main reasons:

1) Leverage

2) Protection (hedge)

Long call options provide leverage, that is, they cost far less to control shares of stock as compared to an outright purchase; therefore, their performances will be magnified (up or down) relative to the stock. They also provide protection by limiting your downside risk.

Example:

You are bullish on MRVC trading for $39-1/2.

If you want to buy 1,000 shares, it will cost you $39,500. You could, instead, buy 10 January $40 calls which are trading for $9-1/2. This would cost you $9,500.

If the stock is trading at $60 by expiration, the long stock position would be worth $60,000 while the call would be worth $20.

Leverage

Your return on the long stock is 52% (not annualized) while the return on the option is 110% (not annualized). This is what they mean by leverage. The investor who bought the call options, in this example, more than doubled the returns as compared to the long stock position.

Protection

What if the stock falls substantially? The long stock position has $39,500 at risk, which, theoretically, could end up at zero. The long call only has $9,500 at risk. This is what is meant when you hear that long call options provide protection -- they limit your downside risk. The long call position is controlling the same number of shares (1,000) for $30,000 less at risk ($9,500 vs. $39,500).

It should be noted that the long stock position, in this example, while beaten in return on investment (50% vs. 110%) would never lose in terms of total dollars. For example, the long stock position earned $60,000 - $39,500 = $20,500, while the long call earned $20,000 - $9,500 = $10,500. The long stock position earned nearly twice the amount of dollars, which is why its return is roughly half the return for the long call. So be careful in your understanding when you hear that options beat stock in terms of returns. Assuming two investors are controlling the same number of shares, the option will outperform stock in terms of return on investment and not total dollars.

What if our long call position puts the same dollars at risk as the long stock position? Long stock would have cost $39,500 so, for that money, the call option buyer could purchase 41 contracts (controlling 4,100 shares) at $9-1/2. Now, the call position will be worth 4100 * $20 = $82,000 at expiration. The return on investment is back to the 110% as in the example above. However, this option investor is controlling 4,100 shares and not 1,000. This is another way to view leverage; for the same dollar investment, one can control more shares through the options market.

So regardless of how you cut it, options do provide leverage!

Profit and loss diagram

We can see the effect of the protection by the profit and loss diagram above (if you are not sure how to read this chart, please see our section under "Profit and Loss Diagrams"). Again, the most the option investor can lose, in our original example, is the $9,500 paid for the 10 contracts. Yet, they participate in all of the upside returns above the $40 strike price.

This added downside protection does not come for free. We can also see that the break-even point is raised from $39-1/2 to $49 for the call buyer.

Strategies using long calls

One very useful strategy that many investors use is that of diversification through call options. For example, say you have $50,000 to invest and would like 500 shares each of ten great companies. The good news is you will probably make money over the long term; the bad news is this may cost you $300,000. Well, with long calls you can invest in all of them for $50,000 or less. Now you have a lot of diversification without the need for a lot of money to achieve it.

Deep-in-the-money-calls

Probably one of the most underutilized strategies in options is that of long deep-in-the-money calls as a substitute for long stock. Using our previous example, MRVC is trading at $39-1/2. We were looking at the $40 strike for $9-1/2. However, this is all time-premium as the stock is still below the strike price. So there is substantial risk if the stock does not move quickly enough (please see our section on deltas and gammas). This is why we saw the break-even point pushed to $49 in the profit and loss diagram.

Let's say we have two traders with $40,000 to invest. The first trader buys 1,000 shares MRVC at $40 for a total outlay of $40,000. The second trader buys a deep-in-the-money call such as the Jan $20 trading for $21-3/8 for a total price of $21,375, and leaves the remaining $18,625 in the money-market.

The second investor who buys this option will be participating nearly point-for-point to the upside just like the long stock position that paid $40,000. But let's say the stock falls substantially -- down to nearly $20. Now the long stock position is down $20 points, while the long call position is down less than this. Why? Because now the option is more at-the-money and the time premium is increasing; it provides a crutch for the option holder. So long deep-in-the-money option holders enjoy the benefit of point-for-point upside movement and less than point-for-point downside. In the worst-case scenario, the first investor is bankrupt while the second investor still has $18,625 sitting safely in the money-market.

Think about how powerful this strategy can be especially for those volatile tech stocks you may be trading. You participate in all of the gains to the upside but not to the downside. It's a tough strategy to beat.

Short calls

The strategy behind the naked (or uncovered) short call is neutral to bearish. The investor is betting that the stock will either fall or sit still.

Important note! This is very different from the short call against long stock position (covered call strategy), which is neutral to bullish. All too often investors make the big mistake of hearing "short call" and immediately associate the covered call as a bearish position. Things change when you start pairing options with other positions! So please keep in mind that we are talking about naked, or uncovered, calls in this section.

When selling naked (uncovered) calls, the investor takes in the premium, and in exchange is willing to assume the upside risk of the stock. Let's take a look at the profit and loss diagram assuming the MRVC investor above shorts 10 Jan $40 calls at $9-1/2:

We see the maximum this investor can make is the $ 9-1/2 points, or $9,500 for 10 contracts. The investor is also exposed to unlimited upside exposure if the stock continues to climb above $49 1/2. Why? The investor starts to lose profits for any stock price above $40 -- the strike -- at expiration. However, because of the $9-1/2 points we received as an initial credit, the investor can afford to have the stock rise to $40 + $9-1/2 = $49-1/2 before losses will be incurred. It should be evident that this is among the most dangerous of all option positions!

Long call options are among the most basic of strategies, yet are very powerful due to the leverage. They are relatively easy to understand, so they're usually the first option trade for most investors. However, be sure to see our sections on "Deltas and Gammas" and "Implied Volatility" before entering into a long or short call position.

Long Put Long and short puts

A put option gives the buyer the right, but not the obligation, to sell stock for a fixed price over a given amount of time. It is the put buyer, also called the long position, who has the right to sell stock. The short put seller, on the other side of the trade, has the obligation to purchase stock if the long position exercises their option. There should be no concern for default by the short side as the Options Clearing Corporation (OCC) guarantees the performance of the contract.

The long put strategy is therefore bearish, as the value of the put rises with decreases in the underlying stock. Please understand when we say that the put will rise if the underlying falls, that is assuming all other factors remain the same. It is entirely possible for the put to fall in value even though the underlying is falling, but this is usually due to changes in other factors such as time or volatility.

Investors are typically attracted to the long put strategy for two main reasons:

1) Leverage 2) Protection (hedge)

Long put options provide more leverage than short stock for speculators who are bearish. In other words, for a given dollar investment, the return on investment for the owner of a put option is much higher as compared to the investor who shorts stock. However, this leverage works both ways. The long put owner may lose 100% of their investment with just a small adverse move, whereas the short seller will lose only a small fraction.

Example:

You are bearish on Intel (INTC) currently trading for $31-3/4. Let's compare a short seller with a long put buyer.

With short sales, there is usually more leverage than with the purchase of stock. The reason is that most speculators will only post the required Reg T amount of 50%.

If a speculator wants to short 1,000 INTC, they would need to post a minimum of 50%, so the total credit would be $31-3/4 * 1.5 * 1,000 = $47,625. Remember, when you short stock, you receive a credit; you will purchase the stock later for a debit.

The accounting looks like this:

Credit = $47,625 MVS = $31,750 Equity $15,875

Notice that your equity is $15,875 and when divided by the market value short of $31,750 gives you 50% equity, which is the Reg T amount.

Let's assume the stock falls to $25 per share. Now the account looks like this:

Credit = $47,625 MVS = $25,000 Equity $22,625

Notice that the credit balance does not change; it is simply cash sitting in the account. The market value short (MVS) will change which will change your equity. If the MVS falls, your equity will rise and vice versa.

The stock fell, in this example, about 21% from $31 3/4 to $25 giving the investor a 42% increase in equity from $15,875 to $22,625. The reason the investor doubled the move of the stock is because they only posted 50% of the requirement which doubles the leverage.

Let's look at the puts now. A March $30 put is $1 1/4 and an investor could instead elect to purchase 10 contracts to control 1,000 shares and pay only $1 1/4 * 10 * 100 = $1,250. Later, with the stock at $25, the $30 put will be worth at least $5 (more if there is some time remaining on the option). Here the investor paid $1 1/4 but sells for $5 (and maybe more) for a minimum 300% increase.

Leverage

Your return on the short stock is 42% (not annualized) while the return on the option is 300% (not annualized). This is what they mean by leverage. The investor who bought the put options, in this example, has a return on investment that is over 7 times higher as compared to the short stock trader.

Protection

What if the stock rises substantially? The short stock position has an unlimited amount of risk as a stock can keep rising without bounds. The long put holder, however, is only at risk for the $1 1/4 points regardless of how high the stock moves. Therefore, the long put holder also gets a "peace of mind" by holding the option; they know the maximum loss up front.

As with call options, one must be careful in interpreting return on investment. In the above example, the option trader had a much higher return on investment (300% vs. 42%). However, the short stock position has more dollars. The short stock seller gained $6,750 while the option trader gained $3,875. This will always be the case, as the put buyer must pay some sort of premium. The smaller the premium, the more the total dollars will match that with the stock trader.

Profit and loss diagram

We can see the effect of the protection by the profit and loss diagram above (if you are not sure how to read this chart, please see our section under "Profit and Loss Diagrams"). Again, the most the option investor can lose is the $1,250 paid for the 10 put contracts. Yet, they participate in all of the downside moves below the $30 strike price.

This added upside protection does not come for free. We can also see that the break-even point is lowered from $30 to $28-3/4 for the put buyer.

Long puts can also be used as an "insurance policy" against long stock. Say you own 1,000 shares of Intel so your total position is worth $31,750, but you fear it may fall in the short term. You can purchase 10 of the $30 strike puts for $1-1/4 (which raises the cost basis of your long shares by the same amount), and be hedged for all prices below $30. For example, assume the stock falls to $25. Your stock is now worth $25,000, which is down $6,750. But your long $30 put is worth at least $5,000. At expiration, you can elect to do one of two things:(1) hang on to your stock and sell the put for $5,000; this will help to offset the $6,250 loss, or (2) Exercise your put and sell your shares for $30.

Notice that the put, at expiration, is worth $5,000 yet the long stock position was down $6,750 for a difference of $1,250. This is the cost of the put, and it will never be recouped.

Long puts can be especially useful if you trade stocks on margin and are close to a maintenance call. Sometimes it is worth a little bit of money to insure yourself from a forced sale of your stock.

If you didn't want to spend $1-1/4 for the put option, you may decide to buy a lower strike put such as the $25 strike. The $25 will be cheaper than the $30 because you are, in effect, assuming a $5 point deductible as compared to the $30 strike. In other words, protection with the $25 strike will not start until the stock is trading below $25. As with any insurance policy, the higher the deductible, the lower the premium.

Short puts

The strategy behind the naked (or uncovered) put is neutral to bullish. The investor is betting that the stock will either rise or sit still. Another strategy for short put sellers is to use short puts as a way to purchase stock. In other words, it changes the scope of the investment if you are selling puts on stock you want to purchase anyway. Selling puts against stock that you don't mind owning is similar to getting paid to place buy limit orders below the current market.

For example, using the above INTC prices, say you want to purchase shares of Intel, but you think it may fall to $28 in the short term. Many investors would place a buy order with a limit of $28 and just hope it hits. If it doesn't, they have completely missed any profitable opportunity. Compare this to the short put seller. The short put seller may want to purchase the stock, but is afraid it may fall to $28. This investor sells the $30 put for $1-1/4. Now, if the stock rises, at least this investor receives $1-1/4. If the stock falls to $28 at expiration, the short put seller will be forced to buy a $28 stock for $30; however, they received $1-1/4 for it, which makes their cost basis $28-3/4. Granted, their cost basis is a little higher than the investor who used the limit order. But the limit order will have zero profit if the stock rises; they miss out on all opportunities.

Using short puts as a way to purchase stock you want to own can be a tough strategy to beat!

From a profit and loss standpoint, the short put looks like this:

We see the maximum this investor can make is the $1-1/4 points from the sale. But if the stock falls, the investor starts heading into losses. Keep in mind that if you are willing to purchase the stock regardless, then it's difficult to say these are truly losses, at least when compared to a speculator who sells puts with the intention of never buying the stock. The short put seller who intends to purchase the stock is, in fact, potentially deferring the purchase but getting paid if it rises. If the stock falls, he may be forced to buy stock, but he was going to purchase it anyway. Now, the big tradeoff with the short put selling for stock you want to buy is this: the stock may take off to the upside, and you're left with only the premium from the put.

An alternative hedging strategy is to do the following: Buy half the amount of shares you are willing to purchase and sell puts on half the shares. Using the above Intel example, if you are willing to purchase 1,000 INTC today, maybe just buy 500 shares and sell $5 for the $30 puts. Now, if the stock moves higher, you will profit on the 500 shares plus the premium from the puts. If it moves down, you were willing to assume this risk anyway, but now you've lowered your cost basis by $1-1/4 on the additional 500 shares.

Put options are great tools for hedging. However, be careful in using puts as an ongoing form of insurance. The reason is due to the relatively high costs of puts. It's not uncommon to see put option premiums reach 20% (or more) of the underlying stock price on an annualized basis. Historically, stocks have returned about 12% per year so if you use puts as a continuous form of insurance, you'll be losing at an annual rate of about 8%. Instead, use puts for specific points in time that concern you such as upcoming earnings reports or other announcements that may affect your stock. If you want to speculate on stock prices, using puts may be a better bet than shorting stock once you understand all the risks.

Covered Calls For many investors, the covered call is their first encounter with options. It is a popular strategy because it generates cash into the account and is relatively simple to understand. Unfortunately, there are a lot of misconceptions about this strategy and some can lead to devastating losses. This may be the single-most important piece of information you will read on options, as there are many professionals and academic journals that fall prey to one of the most critical mistakes with covered calls. I will point out the mistake later.

What is a covered call?

A covered call (also called a covered write) is a strategy where the investor buys stock and then sells a call against it. By selling the call, you are giving somebody else the right to buy your stock at a fixed price.

The reason this strategy is called "covered" is because you are not at risk if the stock moves higher. This is different from the trader who sells calls "uncovered" or "naked," as that position will continually lose money -- theoretically an unlimited amount -- as the stock moves higher. Because of this risk, naked call writing is among the most dangerous of all option strategies. But, with covered writing, this upside risk is removed; you will always be able to deliver the shares no matter how high the stock is trading. The short call is "covered" by the long stock.

For example, you may buy 1,000 shares of JDSU at $102 and sell a one-month $115 strike call currently trading for $4-1/2. Now, for the next month, you may have to sell your shares at a price of $115. This is regardless of where the stock is trading. If the stock is trading at $200 at option expiration, you will most likely be forced to sell your shares for $115. Of course, for this right, the person buying the call paid you $4,500. So on the surface, it doesn't seem to be a bad deal. It's like getting paid to place a sell limit order at $115.

However, there is significant risk to the downside. With our JDSU trade above, we paid $102 for the stock and received $4-1/2 for the option. The stock could fall $4-1/2 points to $97- 1/2, and we'd still be okay -- that's our break-even point. That's another small benefit of covered-calls; they provide a little downside hedge. In other words, they reduce the cost basis of our long stock position. But if the stock continues downward from there, we get more and more into a losing situation. In fact, the maximum we could lose, theoretically, is the $102 we paid for the stock, less the $4-1/2 we got for the option -- a total of $97-1/2 points. In other words, we are at risk for everything below the break-even point.

Many professionals and even academic journals will tell you that the risk of a covered-call position is that you may lose the stock! Nothing could be further from the truth. Risk, for most people, is not defined as missing out on some reward. It is defined as loss of principle. So if you get nothing else from this page, please understand that the risk of a covered call is that the stock goes down, not up. This is the mistake referred to at the beginning.

If a professional tells you the risk of a covered call is losing the stock through assignment of the short call, ask him why it's called a covered position? He will likely tell you, "That's because you're not at risk if the stock moves higher -- you will always be able to deliver the shares." Think about it...on one hand the broker tells you the risk is that the stock moves higher and on the other they tell you you're not at risk if it moves higher. Which is correct?

Are you still not convinced that's the risk? Well, think about this. Say you were thinking of buying a stock trading at $100 and asked your broker what the risk of the investment is. He claims,

"Well, the risk is that you buy it for $100 and then sell it later at $120, only to watch it trade higher at a later date." If that were really the "risk," the optimal strategy would be to bet the farm and buy all the stock you can. Buying at $100 and selling at $120 certainly doesn't sound like a lot of risk, does it? The same holds for the covered call -- you are the one holding the stock. The risk is that the stock goes down.

Two types of covered call writers

This brings us to another critical point of covered call writing. There are two basic categories of call writers; those who use it as an income producing strategy against stock they like, and those called "premium seekers."

If you write calls against stock you like, then the covered call strategy can be argued to be one of the most powerful strategies for most investors. After all, you are getting a little downside hedge and getting paid to sell the stock at a price you see as favorable. If it is a stock you like, then you obviously are willing to assume all of the downside risk. You would hold the stock whether options were available or not.

However, there are those who do not understand the downside risk side of covered calls. These are sometimes called the "premium seekers." These people look through the option quotes, find one that pays a high premium relative to the stock price, and then enter into a covered call. Usually they follow up this trade with a comment like, "By the way, what exactly does this company do?"

If you trade covered calls this way, stop! I have seen million-dollar accounts fall below $10,000 doing nothing but covered-calls using this method.

Trading Example: I remember one investor who bought 7,000 shares of a stock trading at $55 (to make matters worse, it was on margin or borrowed funds). He thought he was laughing all the way to the bank when he discovered that a three-week option was bidding $8 for a $55 stock. "Wow, that's over 15-fold on your money," he exclaimed. "At that rate, it would take less than two and a half years to turn $1,000 into $1,000,000."

The trader bought the shares and wrote the calls waiting patiently for his windfall to arrive. At option expiration, the stock was trading at $4. Yes, he did get to keep the entire $8 premium for the calls. I'll let you decide if it was worth it.

There was a reason the markets were bidding up the options so high. They wanted someone else to hold the risky stock. The risk is that the stock falls.

A word of caution

Many times you will hear people say that the risk of the stock going down in a covered call position should not be of great concern. They reason that you can always write another call after the first call expires and eventually "write your way out of the stock." There is a big danger in believing this. Covered calls realistically only give you one chance over the short term to write the calls. This is not to say that you will never be able to write a second call against your stock. It's just that you may have to wait a long time to do it.

For example, say a stock is trading at $100 and you write a $105 call for $5. At expiration, the stock is now $75. At this point, you decide to write another call. You'll be lucky if the $105 call is trading for $1/16 which, after commissions, will net you zero. How about the $80 call? Yes, you will definitely get some money here and let's assume another $5. If you write this call and the stock goes up to $80 or higher at expiration, you just locked yourself into a loss! How? Your cost basis is $90 ($100 originally paid for the stock less two calls written for $5 each) and you just gave someone the right to buy your stock for $80, which locks in a $10 loss.

Sometimes you will hear people tell you to "roll down" or "roll up" if the stock is moving significantly. However, there are drawbacks with those strategies as well, so let's take a look at each. Please just understand that covered calls do have a sizeable amount of risk and that you may not be able to realistically keep writing calls month after month.

Rolldown

We just saw a situation where an investor bought stock for $100 and wrote the $105 call for $5, but got locked into a loss because they wrote the $80 call at expiration. Many investors incorrectly think you can beat the market to the punch by rolling down your strike as the stock falls.

A rolldown, for covered calls, is simply a strategy where the investor buys the short call to close and simultaneously sells a lower strike call to open. The new position is a covered call but at a lower strike; the investor has thus "rolled down" their strike price.

For example, say the stock is now trading at $100. The above investor could buy the $105 call to close and simultaneously sell the $100 call to open. However, they will receive a credit less than the difference in strikes (you'll find out why during week 5 when we talk about basic option pricing). So the investor has given someone the right to purchase their stock for $5 less than originally anticipated, yet received less than $5 to do so -- a net loss.

Let's say they roll down for a net credit of $3 and see what happens. Remember, the original trade was buying stock at $100 and selling the $105 call for $3, which gives a cost basis of $97. Once the rolldown is executed, we're assuming the investor receives an additional $3, which gives a new cost basis of $94 for a $6 gain if the stock is called at $100. Keep in mind the original trade had a profit of $8 if called at $105. The reason the investor has reduced their profit margin by $2 is because that's the net loss on the rolldown. Credits can be deceiving with options. A net loss develops because the investor gave somebody the right to purchase his or her stock for $5 less, yet only received $3 for it.

If you roll down long enough, you will eventually lock in a loss. Be very careful when rolling down and keep track of your effective cost basis.

Rollup

The opposite of the rolldown is the rollup. To enter a rollup with covered calls, you buy the call to close and simultaneously sell a higher strike call to open.

Let's assume our investor is, instead, faced with the stock trading up to $110 now. If they rollup, they may, for example, buy the $105 call to close and simultaneously sell the $110 call to open. Again, we'll assume they pay less than the difference in strikes, which will always be true prior to expiration. If the investor rolls up to the $110 strike for a net debit of $3, they have paid $3 to gain $5.

On the surface, this doesn't appear to be a bad deal. However, keep in mind that with the original position, the investor is more likely to receive $105 from the exercise of the $105 call. Now they are short the $110 call, which is the same price of the stock, which means there is inherently more risk with the rollup. This does not mean that investors should never rollup a covered call, but rather use it sparingly in situations where you are very confident that the stocks price won't fall too dramatically.

Another way to view the additional risk is that, with each rollup, you are raising the cost basis of your long stock position. If you chase a fast rising stock with rollups long enough, you will eventually end up holding a long stock position with a relatively high cost basis on a stock that may come crashing down.

Most people try to roll up to get themselves out of a "losing" situation. For example, the above investor wrote the $105 call. If the stock is suddenly trading for $120, most investors try to undo the "damage" by rolling up. However, you should always remember your reason for writing the call. If you purchase the stock for $100 and are willing to sell it at $105 for a $5 fee (the option premium), you should probably let the stock go. If you never intended to sell your stock, then you must question why you wrote the original call in the first place. Remember, a short call is an agreement to give someone else the right to purchase your stock. If that's not what you wanted to do, then writing calls is the wrong strategy.

Getting out of a covered call

Many times investors write calls and regret it later when they see the stock trading for a much higher price. If you have a renewed confidence in the stock, you may want to consider closing out the short call.

Many investors, however, have trouble with this as they feel they are taking a huge loss. This is absolutely false. Let's take a look at an example and see why. Say an investor has $40,000 cash in the account with no other positions. If he buys 100 shares of stock for $100, he now has $10,000 worth of stock and $30,000 cash. Now assume he writes a $100 call for $3, which gives him $30,300 in cash for a total account value of $40,300.

Now assume the stock is $130 at expiration, which makes the $100 call worth $30. If the investor buys the call to close in order to not lose the stock, they must pay $30. Because they received $3 initially, they feel they have incurred a loss of $27. But they often fail to realize that the stock position is now worth more, too. If they buy the call to close, they will pay $3,000 but now their stock is worth $13,000! That's because they are no longer obligated to sell the stock for $100 once they buy the $100 call to close. The stock is worth $13,000 and the cash is reduced to $27,300 for a total account value of $40,300 -- exactly the same as before the closing of the call.

If you exit a covered call position by buying the call to close, you're really swapping cash for an unrealized capital gain in the stock. In the above example, the investor lost $3,000 for sure in cash, in exchange for an unrealized gain of $3,000 in the stock.

So if you have new information on the stock and decide you want to keep it, buying the call to close is not the worst thing to happen. You really don't lose anything at the moment you buy back the call -- but you may if the stock falls afterward. Buying covered calls to close doesn't really destroy account value; it just changes the values of the assets in the account.

If you decide to get out of a covered call position by buying back the call, be sure you are comfortable holding the stock at the current valuations.

Profit and loss diagram

In the profit and loss diagram, we are assuming an investor buys stock at $50 and writes a $60 call for $5. You can see the break-even point has been reduced to $45 because they paid $50 for the stock but received $5 for the call, giving them an effective cost basis of $45. Also, we see that for any stock price above $60 -- the strike -- the profit is capped at $15, which is the maximum. Again, you must wonder why many professionals tell you this is the risk zone. It should be evident from the chart that the downside risk is that the stock falls.

Covered calls are a very useful strategy if used properly. If you use this strategy, make sure you are writing calls against stock you would hold regardless. Otherwise, treat the position as highly speculative and invest accordingly.

Straddles and Strangles A long straddle is a strategy where the investor buys a call and buys a put with the same strike and time to expiration.

The most common use of the strategy is when the trader expects a large move but is unsure about which direction. This strategy is often suggested, even by professionals, to be used prior to a big announcement such as an earnings report or FDA approval for a drug company. If the report is favorable, the stock may run wild to the upside; if not, it may come crashing down. However, please bear in mind that other participants in the market are thinking the same thing, so the put and call will be bid up to much higher prices making it difficult to recoup your costs!

Probably a better use of the straddle is to buy them if you expect increases in volatility. Increased volatility will increase the price of both calls and puts. So, if you are faced with a big announcement or news, you should buy the straddle only if you think the market has underestimated the volatility.

Nonetheless, the strategy attempts to play both sides of the market hoping that the move in the underlying stock, whether up or down, is sufficient to cover the cost of the losing option.

Example:

A trader buys a March $50 call for $5, and a March $50 put for $3 for a total of $8.

The profit and loss diagram looks like this:

Because the trader buys both the call and put, the break-even points will be raised significantly. In this case, the stock must rise above $58 (the strike price plus both premiums) or fall below $42 (the strike price minus both premiums). Because only one of the options -- either the call or put -- can expire in-the-money[1], the downside to this strategy is that you are effectively buying a very expensive call and a very expensive put. Why? Again, only one of the options can have value at expiration not both. However, both premiums must be recovered before a profit can be made. It's like buying a call for the price of a call and a put and buying a put for the price of a call and a put. If you think making money with calls or puts is tough, the straddle will magnify this difficulty.

[1] Actually, this is true the majority of the time; either the call or put finish with intrinsic value. However, if there is a partial tender offer for the underlying stock, both the call and put may go in-the-money! This happens because the target stock will be trading higher and so will the calls. But after the purchase, the target stock will normally fall back to the original price. Traders will start pricing the puts with this intrinsic value causing both the calls and puts to be in-the-money.

Be very careful if you hear of seminars or books that profess to show you how to "make money in any market" as this is the strategy they are often alluding to. If the stock moves up or down, technically you are making money on one of the legs -- either the call or put -- but being profitable is another story.

This is not to say that the straddle is a bad strategy. Just don't get lured into thinking it's a sure bet. The two premiums will almost always make the straddle a sure loser (in trader's jargon, the high gamma and negative theta components usually won't allow it to be profitable). Use the straddle when you are, in fact, expecting a really BIG move in one direction or another and you feel the market has underpriced it.

The short straddle

If the long straddle is almost a sure loser, then the short straddle must be the ultimate option strategy, right? Not so fast. Yes, it's true that over time the short straddle will win far more than it will lose; however, when straddles go against you, they can bite hard! You need to be prepared to accept a large loss before entering into the short straddle.

From a profit and loss standpoint:

Here, the short trader will receive $8 in our hypothetical example and have break-even points of $42 and $58. Beyond these points, large losses can quickly develop!

Alternative strategy - the covered straddle

There is a nice alternative for the short straddle called a covered straddle. Here, the investor is long the stock and then sells the straddle. Assuming the number of call options does not exceed the equivalent number of long shares, the investor is fully covered to the upside. The risk is that the stock falls. But if the investor is willing to buy more shares, this can be a powerful strategy!!

Example:

An investor is long 500 shares of stock purchased at $50. He then sells 5 contracts of the above straddle for $8. The investor will receive 500 * $8 = $4,000. If the stock is above $50 at expiration, the investor will be assigned on the short call and sell his shares -- effectively for $58. But if the stock is below $50, the trader will be assigned on the short puts and be forced to buy stock at $50, which is effectively $42 when you consider the $8 premium from the straddle. You can see the benefits of this strategy! If you are willing to buy more, and are not afraid to sell your shares, the covered straddle is a tough one to beat. It is called a covered straddle because the long shares cover the most serious risk in that the stock moves higher.

Strangles

A related strategy to straddles is one called a strangle and sometimes called a combination[2] or "combo" for short.

[2] The term combo varies between markets. In the equity markets, a combo is usually long calls and long puts with different strikes. In the futures markets, however, a combo is usually a synthetic stock position -- long calls and short puts with the same strikes.

The idea behind straddles and strangles is the same in that the investor is looking for a large move in one direction or another. The strangle differs in that the strike prices are different. The expiration months are the same.

Earlier, we assumed a trader with the stock at $50 bought the $50 call and $50 put for a total of $8. Now let's say that same trader buys a strangle instead. He may buy the $55 call and the $45 put for a total of only $5. But the tradeoff is big; this trader's break-even points are now $40 and $60 instead of $42 and $58 with the straddle trader.

This is sometimes called a $45/$55 strangle.

This does not mean that strangles are a poor strategy. It just means you should be careful in choosing it. Use it when you really expect monstrous moves in the underlying, and not because it's cheaper than the straddle.

From a profit and loss standpoint:

It is easy to see that the stock must make a really large move in order to be profitable! Also, there is no reason the trader must limit themselves to a 5-point difference in strikes. One could also enter a $40/$50 strangle or any other combination as long as they cover the same expiration months. Keep in mind though, as you make the difference in strikes wider, your break-even points become wider as well.

The short strangle

The short strangle is similar to the short straddle but, from a risk/reward standpoint, it may be a better deal for most investors simply for the fact that the break-even points are stretched so wide.

In-the-money and out-of-the-money strangles

One small point should be clarified here. In the above example, we assumed the stock was at $50 and the trader bought a $45 put and $55 call to complete the strangle.

This is specifically known as an out-of-the-money strangle because both the call and put are out of the money. There is another alternative position -- sometimes called a guts by floor traders where the trader will buy, say, the $45 call and the $55 put.

Be careful when discussing strangles with your broker, as this is a very common mistake! Say the $45 call is trading for $8, and the $55 put is trading at $6 for a total purchase price of $14. It is very easy to think that the maximum loss is $14. However, this position has a built-in box position because one of the options must always be in-the-money. This particular strangle must be worth $10 at expiration (of course, the bid/ask spreads will make it worth slightly less). Why? Work through some numbers and you will see that it is impossible to have both the call and put expire worthless. In the original example, the call and put would expire worthless for any stock price between $45 and $55.

The maximum loss for this in-the-money-strangle is only $4. In addition, you get the benefits of in-the-money calls and puts working for you so your time decay is diminished significantly.

Just be aware that there is a difference. An out-of-the-money strangle has the put with the lower strike and the call with the higher strike. In this case, the maximum loss is the total cost of the two positions.

The in-the-money strangle has the call with the lower strike and the put with the higher strike -- exactly the opposite of the out-of-the-money strangle. Here, the maximum that can be lost is the premium minus the difference in strikes. In our example, $14 -$10 = $4.

Straddles and strangles are popular strategies, especially in a lot of beginning courses because they are combination positions yet easy to understand. From a practical trading standpoint, the long straddle/strangle is not too practical because of the wide break-even points. Typically, the

stock will bounce around between these two points and you will just watch you position erode from the time decay (high negative theta of the position).

From a traders viewpoint, the short positions are much more desirable, but just be sure you are, in fact, willing to assume risks if it should go against you.

In fact, you can even combine these strategies. If you short a straddle and buy a strangle, you effectively put protective wings on the upside and downside risks of the short straddle. The combination of these two positions -- short straddle and long strangle -- is also called a butterfly spread! (Please see our section on Butterfly Spreads for more information.)

Strips and Straps Options are very versatile and one of the most powerful tools you can learn as a trader is how to combine them to create unique profit and loss profiles that exactly meet your needs.

Although the terms are not used much anymore, strips and straps are two very basic combinations that demonstrate this ability.

Strips

A strip is a strategy where the trader buys one call and two puts with the same strike and expiration dates.

If you read the section on straddles, you will see these strategies are similar. With a strip, though, the investor is unsure about the direction, but is putting a little more emphasis on the downside move.

First, let's look at the straddle which is one long one call and one long put with the same strikes and expiration dates. Assuming this investor paid $8 for the two positions, the profit and loss will look like this:

The strip, because it has two puts instead of one will look like this:

It is evident from the profit and loss diagram that the investor will profit more from a fall in the stock as compared to a rise. This strategy exactly matches the investor's sentiment of the stock. The tradeoff is that the strip costs more than the straddle simply for the fact that you are buying an additional put for the strip. Because of this additional cost, a bigger rise in the stock will be necessary before break-even is achieved to the upside with the strip as compared to the straddle. Conversely, the strip will show a profit quicker as compared to the straddle if the stock should fall. Both strategies hit maximum loss at the strike price, as all options will expire worthless here.

Strap

A strap is basically the opposite of the strip: the investor buys two calls but only one put. In this case, the investor is betting that there is a higher chance the stock will rise but is still uncertain so wants to play the downside as well. Looking at the profit and loss diagrams for the straddle and

strap:

Again we see the traders biases built into the strategy. If the stock rises, as he believes, he will profit at a much greater pace. However, if the stock falls, he will still profit but will have a much lower break-even point as compared to the straddle.

These simple strategies should suggest just how powerful options can be. Not only can you build your profit and loss lines in the direction you want, you can adjust the rates of profit and losses.

In addition, there is no reason to stop here! An investor could easily buy three puts for every one call, or three calls for every put. Hopefully you get the idea. Options are very versatile!

Option Exam 6 - Week 6

1) If you are extremely bullish on a stock and want to use options, you should:

a) Buy calls

b) Buy puts

c) Sell calls

d) Buy straddles

2) A _____ can be used as an "insurance policy" to protect your long stock position.

a) Long call option

b) Long put option

c) Short put option

d) Short call option

3) If you are bearish on a stock, you would:

a) Sell calls

b) Sell puts

c) Buy puts

d) Either buy puts or sell calls

4) The most you can lose on a long call or long put is:

a) The amount you paid

b) The exercise price

c) The stock price minus the exercise price

d) Theoretically unlimited amount

5) The most you can lose on a short call is:

a) The amount you received

b) The exercise price

c) Exercise price minus the stock price

d) Theoretically unlimited amount

6) If you expect a large swing in the stock price but are unsure about direction, you may decide to use:

a) Long calls

b) Short calls

c) Short straddles

d) Long straddles

7) The most you can lose on a long straddle is:

a) The call premium plus the put premium

b) The call premium minus the put premium

c) Only the call premium

d) Only the put premium

8) A strip is a strategy similar to a straddle except it biases the position in favor of what kind of move in stock price?

a) Downward

b) Upward

c) Sideways

9) A strap is a strategy similar to a straddle except it biases the position in favor of what kind of move in stock price?

a) Downward

b) Upward

c) Sideways

10) If you expect the stock to sit relatively still, you may decide to use which strategy?

a) Short straddle

b) Long put

c) Long call

d) Long straddle

Week 7 : Intermediate Strategies

Equity Collar

The equity collar or sometimes just collar is a popular strategy among institutional and floor traders. It can also a great strategy for retail investors, although most are unfamiliar with it.

Equity collars involves long stock paired with a long put and short call to provide limited upside profits in exchange for limited downside losses.

Equity collar example:

Assume an investor is long 1,000 shares of stock at $100. He is willing to sell the stock at $105, but is also worried about the downside risk. He could sell the $105 calls, and use those proceeds to finance the long $95 puts. These three positions, long stock, short call, and long put make up an equity collar.

There is no reason this investor must sell the $105 call and buy the $95 put. Instead, he could sell the $100 call and buy the $100 put, or sell the $110 call and buy the $100 put. There are many ways to position the collar including out-of-the-money, at-the-money and in-the-money options. Each has a unique set of risks and rewards and we will look at many variations.

First, notice a couple of things about the collar. The above investor was long stock and then sold the $105 calls -- a covered call position. However, the risk of a covered call is to the downside (please see our section on "Covered Calls" and "Synthetics" if you are not sure why). So to reduce the downside risk, the investor used the proceeds from the sale of the calls to buy the puts.

If the stock rises above $105, he will be forced to sell his stock for $105 per share regardless of how high it goes. But if the stock falls, he can always elect to sell the shares for $95 per share.

From a profit and loss standpoint, the collar looks like this:

We are assuming this investor paid $100 per share for the stock, sold the calls, and bought the puts for a credit of $1. If the stock falls below $95, he will exercise the put and receive $95 for a total profit of $96 after taking into account the $1 credit. Bear in mind that the investor paid $100 for the stock, so this is still a $4 loss overall.

If the stock rises above $105, he will be assigned on the short calls and be forced to sell the stock for $105. With the $1 credit, this yields a profit of $106 for any stock price above $105. Because the investor paid $100 for the stock, a $6 profit is made for any stock price above $105.

Sometimes it is easier to view the profit and loss diagram to take into account the cost of the stock. We can view the above chart by subtracting out the $100 cost for the stock and see the true profits and losses for all stock prices:

If you read our section on "Basic Spreads" and "Synthetics," you may have noticed the above profit and loss diagram looks very much like a bull spread. In fact, the collar strategy is a synthetic bull spread. Also, you may remember the three-sided position used by market makers called a conversion. Because the strike prices are unequal in this example, this strategy is sometimes called a split-price conversion.

If you're still not sure why it is the same as a bull spread, the following may help. Keep in mind that a bull spread with the above positions would be long $95 call and short $105 call.

Collar = Long stock + long $95 put + short $105 call

Synthetically, the long $95 put = short stock + long $95 call

So replace the long $95 put with short stock and long $95 call as follows:

Collar = Long stock + (short stock + long $95 call) + short $105 call

The long and short stock cancel out and you're left with a long $95 call + short $105 call -- a bull spread.

Collars for credits or debits?

There are many investors who believe the best strategy with collars is to execute them for credits. After all, why not get paid to have the long put and short call position?

Investors who believe this are not understanding profit and losses with the total position. If you execute a collar for a credit versus a debit with all else the same, you will open the doors to a larger loss. Once you understand synthetics, you will see you are paying for the credit synthetically by allowing a larger loss potential. This is not to say that it is not a good strategy to execute for credits. Just be sure that you understand the total picture, and that it is in line with your expectations on the stock. In other words, do not execute for credits if your bigger concern is the downside risk of the stock.

Let's run through several examples to make sure you understand it.

Corning (GLW) is currently trading for $59-3/4 with the following option quotes for January (approximately 2 months to expiration):

Calls Puts Bid Ask Bid Ask Jan $50 13 5/8 14 3/8 4 4 3/8 Jan $55 11 11 3/4 5 7/8 6 3/8 Jan $60 8 1/2 8 3/4 8 1/4 8 3/4 Jan $65 6 1/4 6 3/4 10 7/8 11 5/8 Jan $70 4 3/4 5 1/8 14 1/8 14 7/8

Same strike collars (Conversions)

Say an investor buys 1,000 shares and sells 10 $60 calls and buys 10 $60 puts -- a collar with both strike prices the same. If you read our section on synthetic options, you will recognize this strategy as a conversion.

The investor will pay $59-3/4 for the stock, receive $8-1/2 for the call (the bid) and pay $8-3/4 (the ask) for the put. The options (not counting commissions) cost 1/4 point. The most this investor will gain on the stock is 1/4 of a point if the stock rises above $60 at expiration. But because it cost 1/4 to establish the collar, there is no net gain from the position; it is effectively locked at $60.

This investor is guaranteed to receive $60 at expiration in two months. If the stock is above $60, he will be assigned on the short calls and receive $60; if it closes below $60, he will exercise the puts and receive $60.

Notice that the investor's cost basis is also raised by 1/4 point. He paid $59-3/4 and paid 1/4 point for the options for a total of $60.

What does this cost? If interest rates are roughly 5%, then $60 * 5% * 2 months (2/12 year)= 1/2 point. So, strictly from a monetary standpoint, this collar is not a good strategy, as it will cost you 1/2 point in lost interest. Basically, this investor is buying stock today for $60, and guaranteeing the sale in two months at $60 for no money, as he will be losing out on interest he could be earning if he just sold the stock today.

Now, this may be a good strategy for someone who is deferring a sale of stock. In the past, this was done with a box position where the investor would short 1,000 shares against their long 1,000 effectively locking in the current price, as did our collar trader above. Recent tax law changes have effectively eliminated the box position as a tax advantaged trade. But we can still execute it synthetically. Notice that the trader is long shares at an effective price of $60. The short $60 call and long $60 put constitute a synthetic short position. So the investor truly is long

and short the same stock -- a box position. This is exactly why our trader will not profit -- or lose -- anything from the above collar.

Collars for credits

Say our same investor, instead, chose to sell the $60 call for $8-1/2 but buy the $55 put for $6-3/8. Now, he has a credit of $2-1/8 effectively, reducing the cost basis on the stock by this amount to $57-5/8 ($59-3/4 - $2-1/8 = $57-5/8). Notice, though, that his "insurance" from the put doesn't start until $55, so he can still lose $2-5/8 points (he pays $57-5/8 and sells for $55) if he exercises these puts. This is what we were referring to when we said traders who execute collars for credits wind up paying for it by additional downside risk.

The trader who executed the collar for a net zero had no downside risk, but when executed for a credit, now has a $2-5/8 risk. This is exactly why the market will "pay" you credits for this type of collar. Effectively this credit trader is assuming a "deductible" of $2-5/8. Notice too that the market only paid him $2-1/8 for it. Again, the credit collars do not come for free.

This is a great strategy if the trader is very fearful of downside risk below $55 yet willing to sell his stock for $60. He will profit by the $2-1/8 credit if the stock sits flat through expiration.

Collars for debits

Now let's assume the trader sells the $70 call for $4-3/4 and buys the $60 put for $8 3/4 for a net debit of $4. Now the cost basis on the stock is raised from $59-3/4 to $63-3/4. In exchange, he can sell his stock for $60 for a $3-3/4 loss, but may be forced to sell the stock for $70 realizing a $6-1/4 profit.

This time, the trader is allowing a larger loss -- $3-3/4 instead of $2-5/8. Why did this happen when he paid a debit to begin with? This is due to the fact that the $70 out-of-the-money call was sold. The trader wants more profit if the stock rises, because all else being equal, all investors would rather have more profit than not. The markets will effectively charge you for that privilege.

Notice that no collar combination will prevent a loss! This is due to the fact that the markets will not assume the risk for free. If you buy the stock at $59-3/4, no matter which combination of short calls and long puts you choose, you must accept some downside risk after accounting for the debits or credits from the collar. If you buy the $60 put for $8-3/4, you just bumped your cost basis to $68-1/2. True, you are guaranteed to be able to sell your stock at $60 but this leaves a loss of $8- 1/2 points. By selling calls against the long put position, it will lessen the expense of the put, but never to the point of no loss. Even with the zero debit at-the-money collar we looked at earlier, the trader still lost on foregone interest and retained no upside potential in the stock.

The only time a collar can lock in a profit is if the trader had purchased the stock previously at a lower price, say, $50. With the above prices, he can now execute a number of collars to guarantee a profit and still leave upside potential. But this still doesn't come for free either, as the trader was holding the stock for some time and assuming all off the downside risk. Now that the stock has moved in his favor, he may be able to lock in gains with a collar.

This is when collars are especially attractive. Consider using them when you have significant profits especially if there is a big announcement such as earnings that may cause the stock to plummet. The collar can still yield healthy upside potential while greatly reducing downside risk.

Collar comparisons

The following chart shows four of many possible combinations of collars that could be constructed from the above option quotes. There are two important things to notice: (1) None of the collars prevent a loss, and (2) The higher the debit, the lower the loss and the higher the reward. This confirms what we said earlier when it was noted that a trader who places collars for credits is allowing for more downside risk. Notice in the chart how the trader receiving the $6-5/8 credit has the lowest profit and highest loss. Again, this does not mean that it is not a good strategy to execute for credits. Just be sure you understand that it does not come for free.

Reverse equity collars

We mentioned earlier that equity collars are actually bull spreads. This allows the investor, in most cases, to participate in additional upside in the stock as well as reduce the downside exposure. What if the investor's main concern is the downside? Is there a way to hedge that portion in exchange for the upside gains? Yes, and that is called a reverse equity collar.

In order to execute a reverse equity collar, one needs only to buy the higher strike put and sell the lower strike call -- an in-the-money collar. Notice how, up until now, we have always purchased the put with a lower strike, and sold a call with a higher strike. This will always net a synthetic bull spread. If we execute the reverse, we end up with a synthetic bear spread.

Using the option quotes in the above box, let's assume a trader buys stock at $59-3/4, buys the $65 put for $11-5/8, and sells the $55 call for $11 for a net debit of $5/8. The following chart shows the profit and loss diagram for a reverse equity collar:

Notice how the chart favors the downside; that is, it becomees more profitable as the stock falls, which is not the case with a regular collar.

Once again, this shows just how versatile options can be, and why all investors should take the time to understand them.

Collars are fairly complex in that they require three positions. Most brokerage firms will require level 1 option approval level to place a collar and they can be used in an Individual Retirement Account (IRA). They are fairly simple to understand once you become familiar with them, and a powerful hedging tool to add to your list of tactics.

Spreads Bull and bear spreads

Spreads are strategies where the investor buys one option and sells another. There are many different types of spreads, and we will look at most of the major strategies. Spreads get their name because you are, in fact, spreading the risk when you enter into one of these transactions. One of the positions, either the long or the short, acts as a hedge and either makes the position cheaper or acts as protection from a runaway stock. We will look at this in a lot of detail later. But for now, just understand that you are spreading the risk and this, among other factors, is what makes spreads so popular and powerful.

In most situations, the trader is buying and selling an option in the same underlying stock or index. For example, long MRVC $35 call and short MRVC $40 call. These are collectively known as intra-market spreads because they are spreading within the same market. If you are long MRVC $35 and short INTC $45, this is an inter-market spread. The intra-market spreads are by far the most common and will be our only focus. Just be aware that you do not have to be long and short the same underlying for it to be considered a spread.

Important note: A lot of references will be made regarding pricing relationships about options. If you are not familiar with basic option pricing, you may want to read that section first before continuing.

The four basic spreads

The most basic spreads are the bull spread and bear spread. Each can be accomplished by using calls or puts for a total of four basic spreads. If you understand these four spreads, you will add an invaluable tool to your arsenal of option strategies!

Bull spreads

As the name implies, bull spreads need an upward movement in the stock to be profitable. The term bullish actually gets its name from the way a bull attacks; it lowers its horns and then raises its head -- from low to high. Bull spreads can be placed with either calls or puts.

Bull spreads using calls The bull spread using calls is one of the most common spreads. This strategy involves the purchase of a lower strike call and the sale (equal number of contracts) of a higher strike call with all other factors the same (i.e., same underlying stock or index and time to expiration).

For example, a trader may buy 10 MRVC Jan $35 calls and sell 10 MRVC Jan $40 calls. This is sometimes referred to as a $35/$40 call bull spread.

Because the lower strike call will always be more expensive than the higher strike [1], this trade will result in a net debit. In order to make up for this debit, the trader will need the stock to move higher, hence the name bull spread. This spread is also known as a debit spread, price spread or vertical spread. We'll show you how to remember these names later.

[1] Remember, calls give you the right to purchase stock. With all else constant, investors will prefer to pay less for a stock, so they'll bid up the price of lower strike calls relative to the higher strikes. Again, please refer to our section on "Basic Option Pricing" for more information.

In this case, the trader is said to be long the $35/$40 bull spread. Why? As with any position, if you buy it, you are long; if you sell it, you are short. Because this trade resulted in a net debit (the trader paid for it), the trader is long the spread.

In a call debit spread such as this one, the short call (the $55 strike) acts as a way to bring in cash -- it reduces the cost basis of the long $50 strike. This is a great tool for option trading as it can allow you to buy lots of time without having to pay a lot of money.

Example:

Say it is November, you are bullish on SCMR, trading around $64, and want to buy 10 June $60 calls which are currently trading for $20-1/2. That trade will cost you $20,500 and could expire worthless. Because of the high price, many people avoid buying time in options and instead look at, say, a November $60 currently trading for $8. That call will cost you $8,000 for 10 contracts. Now, granted you can lose less money with the November contract; however, you have a much higher probability of doing so. Is there a better way? Yes, and the bull spread answers this problem for a lot of traders. Let's do a bull spread with SCMR and see the difference:

Buy 10 SCMR Jun $60 = $20 1/2 Sell 10 SCMR Jun $65 = $18 1/4 Net cost $ 2 1/4

Now, for only $2,250 expense, you will own 10 contracts but have all the way until June (8 months) to profit from it. Your tradeoff is that you will not profit above $65, but, that's not so bad. If the stock does get above $65 at expiration, this trade will be worth $5 for $2-1/4 down, or a profit of 122% or roughly 231% on an annualized basis. By using the spread tactic, you reduce the time-decay of the position and put the odds on your side that you will, in fact, get a very healthy profit.

Because options are so versatile, spreads can be versatile too. If you want more upside potential, maybe sell the June $70 call instead:

Buy 10 SCMR Jun $60 = $20 1/2 Sell 10 SCMR Jun $70 = $16 7/8 Net cost $3 5/8

Here you will pay $3,625 for 10 contracts. Yes, you now have more money at risk, but you also get more reward in that you profit all the way to $70 instead of $65. The financial adage "more risk, more reward" cannot be escaped, even in the options market. You can custom-tailor the spreads to exactly meet your needs. If the stock reaches $70 or higher at expiration, this trader will make $10 points for $3-5/8 initial investment for a profit of 175%, or 358% annualized.

What does the position look like from a profit and loss standpoint? (Please see our section on "Profit and Loss Diagrams" if you are not familiar with these diagrams.)

We can see that the most the trader can lose is the $3-5/8 -- the amount paid. The most the spread can be worth is $10 points, so the max gain must be the difference or $6- 3/8. Where is the break-even point? The trader needs to make back the $3-5/8 initially paid. If the stock is trading for $63-5/8 at expiration, the long call will be worth exactly $3-5/8 and the short call will be worthless; the break-even is therefore $63-5/8.

This trader will profit if the spread widens. In other words, he wants the spread to increase in value so that it can be sold for a profit.

No matter how high the stock goes above $70, the most this trader will make is $6 3/8. The bull spread has a limited downside as well as upside; the trader is trying to capture the 10-point move between $60 and $70.

Bull spreads using puts A bull spread with puts is a strategy where the trader buys a low strike put and sells a higher strike put in equal quantities. Because a higher strike put will always be worth more (all else constant)[2], this trade will result in a credit to the account.

[2] Put options give the owners the right to sell stock. With all else constant, investors prefer to sell for higher prices so they will bid up the prices of higher strike puts relative to lower strike puts. Again, please refer to our section on "Basic Option Pricing" for more information.

For example, a trader may buy 10 MRVC $40 puts and sell 10 MRVC $50 puts. This is also called a $40/$50 put bull spread.

This spread is also known as a credit spread, vertical spread, or price spread.

This trader is said to be short the $40/$50 bull spread because of the resulting credit to the account. This trader is hoping for the spread to "shrink" (as is any short seller) so that it may be purchased back later at a profit. How will a bull spread using puts shrink? Only if the stock moves up (actually, this spread can also profit by sitting still too; it just cannot move down) hence the name bull spread.

Example:

Say you are bullish on MRVC trading at $39 1/2. You elect to do the following bull spread with puts:

Buy 10 Apr $40 puts = $12 1/2 Sell 10 Apr $50 puts = $16 1/4 Net credit $3 3/4

You will receive a credit of $3,750 to your account and will profit by this amount if the stock closes above $50. If the stock is $50 or higher at expiration, both puts expire worthless and the spread shrinks to zero -- exactly what you want it to do!

Let's look at the profit and loss diagram for the short $40/$50 bull (credit) spread.

It is easy to see, by looking at the chart, you will make $3- 3/4 maximum; that's assuming the stock closes at $50 or higher on expiration. However, this $3-3/4 credit does not come for free. In exchange, you must be willing to assume a downside risk of $6-1/4. Why? Remember, the higher strike put is more valuable, and that is the one you sold. If the stock falls, the higher strike put becomes more valuable to the owner and equally less valuable to you! But, if the stock continues to fall below $40, then your long $40 put starts to become valuable to you. So the spread can only be worth $10 at a maximum to the owner or negative $10 to you, the seller. Because you brought in $3-3/4 for the initial trade, the most you can lose is $10 - $3-3/4 = $6-1/4. Where is the break-even point? You took in $3-3/4 initially, right? So the $50 put can go against you by this amount at expiration. So if the stock is trading at $50 - $3-3/4 = $46-1/4 at expiration, then your short $50 put will be worth negative $3-3/4 to you, and your long put will be worthless; you will just break even.

Notice also, that the above two profit and loss charts have exactly the same shape. This is another way to identify a bull spread, as they will always have this similar shape.

Which is better -- the credit or debit spread?

There are a lot of people and books that claim there is no difference between the two types of spreads. This is totally false. There is a big difference in the underlying assumptions, depending on what they are, the call or put spread will be better suited.

We saw that, for the debit spread, the trader must have the stock move higher as the trader must make up for the debit. The credit spread; however, does not need the stock to move; it just cannot move down.

Example:

PWAV is currently $44-1/2. Let's compare the debit and credit spreads:

Debit Spread Buy Dec $45 Call = $6 7/8 Sell Dec $50 Call = $4 1/4 Net debit $2 5/8

Credit Spread Buy Jun $40 Put = $4 3/4 Sell Jun $45 Put = $6 3/4 Net credit $2

The trader using calls (debit spread) will pay $2-5/8 while one using the puts (credit spread) will receive $2. If the stock sits still, the call trader will lose $2-5/8 while the put trader will gain $1-1/2. How? If the stock is still $44- 1/2 at expiration, both calls will be worthless; the long bull spread will lose the entire premium.

For the credit spread, if the stock is $44-1/2 at expiration, the short put will be worth -$1/2 and the long put worthless. The credit spreader will take a loss of $1/2 from the short position, but keep the $2 from the initial trade for a gain of $1- 1/2.

So is the credit spread the best? After all, in this example, it seems like you get the best of both worlds. You get paid for the position, and you don't need the stock to move in order to profit. Here's the catch, if you are wrong in your assumption about the direction of the stock and it falls, the debit spread can only lose the amount of the debit or $2-5/8 while the credit spread can lose $3.

The differences in the two types of spreads, either debit or credit, have to do with your assumptions on how quickly the underlying stock will move (please see our section on deltas and gammas for further details).

Cheap or chicken

You may have noticed something about the two spreads we have been discussing. The debit trader is really only interested in purchasing the more valuable call. By entering the spread, the trader can reduce the premium paid for this long position.

For the credit spreader, their goal is to short the more valuable strike and receive a premium; however, the trader is now exposed to potentially unlimited losses. So by entering the spread, they hedge themselves in case the stock moves the other way.

There is a somewhat comical, although valuable way of understanding the philosophies between credit or debit spreads. We can say the debit spreader is "cheap" since they do not want to pay a lot for the long call position by itself. Selling the higher strike reduces the price.

For the credit spreader, they are "chicken," as their goal is to short the more valuable strike. But they are fearful of the unlimited downside risk, so buying another position gives them a hedge.

So remember "cheap" or "chicken" to help identify the underlying philosophies!

Bear spreads

A bear spread, as the name implies, desires the stock or index to fall. The term bearish gets its name from the way a bear attacks; it raises its paws and strikes down -- from high to low. As with the bull spreads, bear spreads can be executed through calls or puts.

Bear spread using puts

This strategy involves the purchase of a high strike put and the sale of a lower strike put with all other factors the same.

Because you are buying the higher strike put, it will always be worth more and result in a debit. In order for the trade to make money, the stock must fall -- hence the name bear spread.

Let's say you are bearish on INTC; you think the price will fall. You could enter the following spread:

Buy Apr $45 put = $6 1/2 Sell Apr $35 put = $2 1/4 Net debit $4 1/4

This trader would be long the $45/40 bear spread. As before, this trader is long because a premium is paid.

Let's run through the idea of the spread again. This trader is really interested in owning the $45 strike because it is the most valuable of the two puts. However, he does not want to pay $6-1/2. By entering the spread, he can own it for only $4-1/4. Using our "cheap or chicken" method, this trader is "cheap." The tradeoff is that he can only profit to a fall of $35.

At expiration, if INTC is $45 or higher, this trader loses the entire premium of $4-1/4. If the stock is $35 or below, the trader will make the full spread of $10 less the amount paid of $4-1/4 for a total profit of $5-3/4. In order to break even, the trader must be able to sell the long position for $4-1/4, which means the stock will have to be this amount in-the-money or $40-3/4. As with any debit spread, this trader wants the spread to widen so that it may be sold for a profit.

Let's take a look at these numbers on the profit and loss diagram:

The chart confirms what we figured out intuitively. Also notice that the bear spread profit and loss diagram is opposite that of the bull diagrams above. The bear spread profits from a downward move in the stock.

Bear spread using calls

This trader is really only interested in shorting (selling) the $45 call. However, because of the unlimited risk to the upside, he buys a $55 call for protection. This follows the "chicken" philosophy. Now it should be evident why the trader would spend the money to buy the $55 call.

For example, a trader could buy a $50 call and sell a $45. Because the lower strike will always be more valuable, this trade will result in a credit.

Let's use INTC again but with calls instead.

Sell Apr $45 call = $8 1/8 Buy Apr $55 call= $4 5/8 Net credit $3 1/2

At expiration, if INTC is below $45, both puts expire worthless and the trader will profit by the $3-1/2 credit. If the stock is above $55, the trader will lose $10 on the spread, but will offset this loss by the initial premium for a net loss of $6-1/2. In order to break even, the trader can afford to have the lower strike call move $3-1/2 points against him for a closing stock price of $48-1/2 at expiration. At this point, he will owe $3-1/2 for the short position, which exactly offsets the original premium so he breaks even.

The following profit and loss diagram should confirm this:

Again, as expected, this bear spread has the same shape as the bear spread above. We see that the maximum profit is in fact $3-1/2 and the maximum loss is $6-1/2.

Because this trader received a credit from the initial transaction, he wants the spread to narrow so that it can be purchased back cheaper or expire worthless. Either way will result in a profit.

A word of caution

One of the biggest mistakes investors make using spreads is to fail to understand the risk-reward concept. This usually leads to unsuitable trades based on the investor's risk-reward profile or outlook on the stock. Let's look at an example:

INTC is now trading for $44-7/8 with the following quotes for December available:

$35/$40 spread =; $4 1/4 $40/$45 spread =; $3 3/8 $45/$50 spread = $2 1/2 $55/$60 spread = $11/16

Novice investors will look at quotes such as these and think the $55/$60 spread is the best because they pay only $11/16 and can make a maximum of $5 on the spread for a $4-5/16 profit. It certainly sounds better than paying $4-1/4 for the $35/$40 spread and only making $3/4 profit.

The reason the $55/$60 spread is relatively cheap is because it is an out-of-the-money spread; remember, the stock is trading at $44-7/8 so neither option is in-the-money. It is a higher risk strategy, relative to the other spreads listed, so it should be trading for a cheaper price and have a higher reward.

The $35/$40 spread is an in-the-money spread as both options have intrinsic value. This spread will grow to a maximum of $5 without the stock moving -- just as long as the stock does not fall below $40 by expiration. It is much less risky than the other two spreads so should be trading for a higher price and have a lower reward.

When looking at profit and loss diagrams on spreads, you can immediately see the relative risk in strategies. Take a look at the profit and loss diagrams for the four spreads listed above:

You can see the $35/$40 spread in the upper left (red) has a large loss area and a low reward area. As the spreads move more out-of-the-money, the profit and loss line shifts upward to reflect a lower loss and higher reward. For example, look at the $55/$60 spread in the lower right (orange). It has only an $11/16 loss but a $4-5/16 reward, which certainly sounds appealing.

This is where the mistake is made. Again, most novice investors immediately jump to the $55/$60, in this example, because of the amount of profit that can be made relative to the amount invested. Remember, you cannot get around the risk-reward relationship! With the $35/$40 spread, you will probably keep the $1/4 profit; with the $55/60 spread, you will probably lose the $11/16.

It doesn't mean that either spread is right or wrong. Just be careful that you are picking the correct one that matches your opinion of the move in the underlying stock.

One final note of caution: in the above example, we looked at a $35/$40 spread that cost $4-3/4 and could yield 1/4 profit. Even though you will probably keep the 1/4 point, be sure to factor in commissions before entering into low yielding spreads such as this. The commissions will, in many cases, lock you into a loss. Low profit spreads are common with floor traders as they may only pay a couple of bucks in commissions and they are really stacking the odds on their side that they will make a profit. For retail investors, you need to be sure the commissions are not too high.

Spreads that lock you into a loss are entertainingly called alligator spreads -- as you will never get out alive!

Bull and bear spreads -- how can I keep all these names straight?

It can be confusing to remember which strategies are bullish and which are bearish, especially if you are new to spreads. Fortunately, there is a really neat device that will help you remember!

Whenever you BUY a LOW strike and SELL a HIGH strike, remember BLSH, which looks like "Bullish" and you'll get the right answer. Of course, the reverse is true too. If you buy the high strike and sell the low strike, it is a bearish strategy.

This method works for calls or puts so it can be very helpful.

Examples:

Buy $40 call and sell a $45 call. You are buying the low strike and selling the high strike, so it is a bull spread.

Buy $120 put and sell $100 put. You are buying the high strike and selling the low, so it is a bear spread.

Buy $40 put and sell $45 put. You are buying the low strike and selling the high, so it is bullish.

Buy $50 call and sell the $40 call. You are buying the high strike and selling the low for a bearish position.

Be careful with this method though. A lot of people remember the "BLSH" mnemonic but often forget that it is in relation to the strike prices. It is very easy to look at the price of the option and this is incorrect; in fact, it will get you the exact opposite answer!

Example:

Earlier we looked at the following trade:

Buy 10 SCMR Jun $60 = $20-1/2 Sell 10 SCMR Jun $65 = $18-1/4

It is easy for people to look at the prices of the options instead of the strikes. In this case, they may think we are buying high ($20-1/2) and selling low ($18-1/4) and think it is a bearish strategy -- exactly the opposite!

Just be careful and remember that the BLSH method works great -- for calls or puts -- if you use it in relation to the strike prices.

How to remember the different kinds of spreads

There are many names for spreads, and some are used interchangeably. If you understand where these names come from, it will help you to identify the type of trade. For example, you may hear the following names for different spreads: price, time, vertical, horizontal, calendar, time and diagonal just to name a few. So how do you remember them?

If you look at option quotes in your local paper, you will most likely see a similar grid with the months across the top and the strikes down the side:

Now, look at the Jan $50 and Jan $60 highlighted in red. Depending on which one you buy and sell, it could be either a bull or bear spread. Because it's also spread on the vertical axis, it can be called a vertical spread or price spread , because it is the prices that are being spread.

So all the bull and bear spreads that we've talked about are also vertical spreads or price spreads.

If you spread horizontally such as the Mar $55 and Feb $55 in blue, then this is known as a horizontal spread, calendar spread, or time spread because we are actually spreading time, not price.

Lastly, if we spread time and price such as the Mar $65 and Feb $70 in green, what do you think it's called? You've got it, that's a diagonal spread!

As always, if any of these spreads results in a net debit, the trader is said to be long the spread and short if it results in a credit.

These are just the basics of spreads. There are many more strategies involving spreads listed on our Web Site. We hope you take the time to learn more about them.

Deep-in-the-Money (DIM) Covered Calls Many investors are aware of the covered call strategy; in fact, it is the first option strategy most encounter. The strategy involves buying stock and then selling a call against it. This position is considered covered, because no matter how high the stock moves, the trader will always be able to deliver the stock in the event of an assignment from the short call. If the stock rises, you may be forced to sell your stock, and if not, you keep the premium from the option sale.

It can certainly be a great strategy for an investor who would hold the stock whether options traded on it or not. In other words, as long as the investor is willing to assume the downside risk of the stock, covered calls can provide income and provide small downside hedges.

Most traders entering covered call positions buy the stock and then sell a strike above the current stock price. For example, they may buy stock at $50 and then sell a $55 or higher strike call. Because these calls are out-of-the-money, they do not carry much time premium, so they don't provide much of a downside hedge if the stock falls. Falling stock prices, not rising as some think, are the risk of a covered call. Covered calls constructed with out-of-the-money calls are more of a revenue generating strategy than a risk reducing strategy.

Deep-in-the-money covered calls

We would like to introduce you to a variation of the covered call strategy, one that utilizes deep-in-the-money calls. For example, a trader buys stock at $50 but sells a $40 strike call. Now, I know some of you are thinking, "Wait a minute, why would I want to buy stock at $50 and give someone else the right to buy it for $40? That's a guaranteed loss!"

It is exactly this thinking that keeps most beginning option traders from using deep-in-the-money calls against stock. The piece of the puzzle they are missing is the time premium of the call option. The $40 call in the above example may be selling for, say, $11. So even though it appears you may be taking a 10-point loss at expiration, the call buyer is paying for that up front. This $40 call has $10 intrinsic value and $1 point of time premium. It is the $1 time premium that the deep-in-the-money call writer is trying to capture. Deep-in-the-money call writers intend to have the stock called.

If the option is trading at parity (all intrinsic value and no time premium), then deep-in-the-money calls certainly would not be a good strategy. For example, if the $40 call is trading for exactly $10 (trading at parity), by entering the covered call position, you are buying the stock for effectively $40 (buying stock at $50 and selling the call for $10), then selling your stock at a later date for $40. Effectively, you are giving up the interest on $40 through option expiration and paying two commissions to do so! Clearly, options trading at parity are not a winning strategy for covered calls.

But as long as there is time premium on the deep-in-the-money call, the strategy changes. Now the deep-in-the-money call writer is putting the odds on their side that they will get assigned and be forced to sell the stock in exchange for the time premium.

What makes this strategy appealing is that you are, in most cases, receiving a high rate of return and getting a huge downside hedge. You are getting the best of both worlds.

Now, don't get me wrong and think you will be overcompensated for the strategy. The markets will price them according to the relative risks involved. But if you are using this strategy on stock you like regardless, you will probably find this strategy to be one of the most appealing, especially when you see the balance between returns and downside protection.

Example:

Extreme Networks (EXTR) is currently trading for $53 5/8. The December options with 16 days to expiration are quoted as follows:

Strike Bid Ask Time Premium

42 1/2 12 3/4 14 1 5/8

45 10 5/8 11 7/8 2

47 1/2 9 1/8 10 1/8 3

50 8 1/8 9 1/8 4 1/2

52 1/2 6 1/2 7 1/2 5 3/8

55 5 3/8 6 3/8 5 3/8

57 1/2 4 5/8 5 3/8 4 5/8

60 3 3/4 4 1/2 3 3/4

Say you buy the stock at $53-5/8 and sell a deep-in-the-money call such as the $45 strike. The net cost to you is:

Buy stock = -$53 5/8 Sell $45 call = $10 5/8 Net cost $43

Effectively you are buying stock at $43 and putting the odds heavily on your side that you will sell it for $45. In fact, because the delta is currently 0.70, the markets are saying there is now a 70% chance the sale will occur. If that happens, you earned 2 points (time premium) as interest on a $43 investment for only 16 days of time. That's a simple return of 4.65%, an annualized return of over 106%, and an effective compounded return of over 178%.

So far so good. Now let's look at the downside hedge. Because you received $10-5/8 for the call, the stock can fall by this amount and you'd just be at break-even. With the stock trading at $53-5/8, it could fall to $43 for nearly a 20% downside hedge!

If the stock is above $45 at expiration, you make an annualized rate of 178%; if it's down to $45, you're at break-even. It's tough to beat, especially if it's a stock you don't mind holding, and you're willing to assume the downside risk.

There are, of course, many ways to use the strategy. Maybe you're not so concerned with the downside risk and want more upside return. You may elect to sell the $47-1/2 or $50 strikes instead. If you're more concerned with downside risk, you may go for sale of the $42-1/2 strike with $1-5/8 time premium.

You should now see the benefits of using deep-in-the-money calls compared to the usual out-of-the-money calls used by most traders. Using the above quotes, many would be inclined to sell the $60 calls. While that will yield a whopping 20.3% simple return and 6,397% compounded return if the stock is above $60 at expiration, it only gives $3-3/4 points or 6.8% downside

hedge. Further, those returns are realized if the stock is above $60 -- there is a huge chance that it will not be. The out-of-the-money call strategies are, for most investors, disproportionately stacked with upside returns in relation to their downside hedge.

Why does this strategy work?

If you are still not clear as to why this strategy works, think about the following analogy:

Say you have a used car for sale for $20,000. A buyer comes to you with the following offer: he will give you $15,000 now and the balance in 3 months. If you take the offer, you are effectively loaning $5,000 to the buyer. Therefore, the only way you should accept the offer is to take additional money (interest) above the $5,000 payment that he will owe you in 3-months.

Notice the similarity with the deep-in-the-money covered call strategy above. The buyer (long call position) is offering to buy your stock for $53-5/8. Instead of giving you the full amount up front, he will pay you $10-5/8 now and the balance in 16 days effectively borrowing $43.

You are not taking a loss by purchasing stock at $53-5/8 and selling it for $45 any more than you are taking a loss by giving someone the right to buy your $20,000 car for $5,000. In both cases, the buyer is paying part of that future obligation now and paying you interest (time premium on the option) to float the balance. If the interest rate is appealing to you, you will take the offer.

Buy-writes

You can add a little edge to deep-in-the-money covered calls by entering the trade as a buy-write where both orders, the long stock and short call, are executed simultaneously. Because market makers love combinations of stock, calls, and puts to get them into locked positions, they will usually give you a break on the natural quote. For example, notice the spread on the $45 calls above: $10-5/8 to $11-7/8 for a $1-1/4 spread. It is very feasible to enter an order to buy the stock and sell the $45 call for a net debit of, say, $42-1/2. While this is only $1/2 point better than the natural $43 debit we assumed earlier, look what it does to the returns! Now you are buying stock at $42-1/2 and potentially selling it for $45. That's a 5.88% simple return (compared to 4.65% earlier) and 261% effective annualized compounded rate (compared to 178%). What a difference a half point can make.

You do not need to necessarily look at volatile stocks for this strategy to work either. For example, take General Electric (GE), which is considered to be one of the bluest of blue-chips. The stock is trading for $48-7/8 and the January $43-3/8 strike is trading for $7 to $7- 1/4. If you sell the call for $7, that's $1-1/2 points of time premium for 51 days to expiration. Chances are you will be assigned on the short call; if so, you effectively paid $41-7/8 (paid $48-7/8 for stock and sold call for $7) and sold for $43-3/8 in 51 days. That's a simple return of 3.58% or effective annualized compounded rate of 28.2%. Granted, not as impressive as the returns we saw earlier but not as risky either. Your break-even point would be $41-7/8 for a 14% downside hedge.

Two warnings

If you trade in small lots (say 100 to 300 shares), make sure the commissions do not eat away your profits before entering the buy-write. To check, calculate the total net debit including commission to enter the position and the total credit to sell it (called unwinding the position). If you are trading in small lots (or being charged very high commissions), it will not be uncommon to see the difference between your net credit from the sale and net debit from the purchase be close to the same. If that's the case, it's definitely not worth doing. Make sure there are significant dollars left over and that you feel that amount is worth the risk.

The second warning is to make sure you are not being compensated at only the risk-free rate. The time premium on an option will approach the risk-free rate as you look deeper-in-the-money. For example, in the GE example above, we assumed the trader buys stock at $41-7/8. So the trader is missing out on interest on $41-7/8 by entering the covered call. If we assume a risk-free rate of roughly 6%, the cost of carry for this position is $41-7/8 * 6% * 51/360 = 0.355 or about 36 cents. Because the time premium of $1-1/2 is higher than 36 cents, this strategy will make financial sense as long as the commissions do not eat away the profits. If enough strikes were available, you could keep looking further in-the-money and eventually find one that is trading for exactly the cost of carry (if you are familiar with delta, it will be where delta equals one). This will be true for all strikes below this strike too.

To enter a deep-in-the-money covered call with options that exactly pay the risk-free rate of interest is to pay two commissions to enter the position yet earn the exact amount had you just left the money in the risk-free money market. Why will the markets only reward you the risk-free rate if you look deep enough into the calls? Because the deeper in-the-money you go, the less risky the strategy becomes. At a certain strike and below, the markets will view the deep-in-the-money covered position as nearly risk-free, and will only reward you the risk-free rate.

As a reminder, covered calls should really be attempted with stocks you would own regardless. Remember, the downside risk is that the stock falls.

Covered calls can be a very rewarding strategy, especially when you get the risk-reward ratios in proportion to your taste. If you feel the out-of-the-money covered positions you've tried did not feel quite right, try deep-in-the-money calls for a revitalizing change.

Selling Options On Expiration Day If you are an avid options trader, you may have noticed that in-the-money calls and puts will often trade for less than the intrinsic amount (the difference between the stock price and the strike) on, or near, expiration day. This is especially true for deep-in-the-money options. For example, today is February 16th (option expiration day), and Juniper Networks (JNPR) is trading for $83-5/8. You would think the Feb $70 call would be trading at parity -- exactly intrinsic -- and be quoted at $13-5/8.

However, it is currently quoted at $12-3/8 on the bid. Many investors accept this as normal functioning of the market and will sell their options to close below intrinsic value. For example, say you hold 10 of the above JNPR Feb $70 calls and want to sell them. You could sell at the bid and receive $12-3/8 * 10 * 100 = $12,375.

Is there a better way? Yes!

If you read our section on "Basic Option Pricing," you may recall that, in theory, an option cannot trade for less than intrinsic. The theory says that if an option does trade below intrinsic, arbitrageurs will sell the stock and buy the call for a guaranteed profit. This buying and selling pressure will continue until intrinsic value is restored.

So how do you trade your in-the-money option that is trading below parity? The same way the arbitrageurs would.

Instead of selling your call at the bid, simply place an order to sell the stock, then immediately exercise the call option.

The stock is currently $83-11/16 on the bid. So you place an order to sell 1,000 shares at $83-11/6. Now it doesn't matter if you have the stock or not. Why? Once the sell order is executed, you simply submit exercise instructions to your broker and buy 1,000 shares at $70. You received $83-11/16, but paid $70 to deliver the shares. Your proceeds are $13-11/16 * 10 * 100 = $13,687, for a difference of $1,312! Now, your broker will charge you an extra commission to sell the stock, but I think you can see it can be well worth it.

There is one important note to make here. There are people, brokers included, who will tell you to "short" the stock, instead of a regular sell order, and then exercise the call. However, shorting the stock subjects you to unnecessary risk and can be more costly. How? If you short the stock you must have an uptick, and there is never a guarantee of this. So it is possible you may never get the stock sold! In addition, if you short the stock, you will be subjected to a 50% Reg T charge and may not earn interest on that amount while waiting for settlement of the exercise (3 business days).

The regulations always allow you to sell shares (without it being a "short sale") that are not held in your account. Many investors keep shares in safe deposit boxes and deliver the shares within the three-day settlement period. This is perfectly acceptable. Now, it's possible your firm does not allow shares to be sold that are not in the account. Sometimes the deep-discount brokers have restrictions like this because they spend too much time chasing down people to deliver the shares they promised to deliver, and do not generate the revenues to make it worth their while. Further, it costs the firm money to file extensions in the event the shares are not delivered. However, even if your firm requires the shares to be in the account in order to be sold, let your broker know that your are immediately submitting exercise instructions to purchase the

shares. There is no reason they shouldn't allow it; the Options Clearing Corporation (OCC) guarantees delivery of the shares at settlement.

Once you sell the stock, immediately submit exercise instructions. It is very important to submit your exercise instructions on the same day, otherwise the sale of stock and purchase from the option exercise will not have matching settlement dates. While this is not a major problem (it's not going to cause you to lose the sale or anything), it's something your broker does not want you to make a habit of. I won't go into the details, but as long as you submit your exercise instructions on the same day you sell the stock, you will be fine.

What about put options? Assume the JNPR Feb $100 puts are trading for $15-7/8 on the bid. If you sell 10 contracts, you'll receive $15,875. But with the stock trading at $83-3/4 on the ask, we see they are below intrinsic and "should be" priced for $100 - $83-3/4 = $16-1/4.

If your put options are trading below intrinsic value, simply buy the stock, then exercise your put.

So you would pay $83-3/4 to buy the stock and receive $100 from the exercise of the put, leaving you with the intrinsic amount of $16-1/4 or $16,250 -- a difference of $375 when compared to the trader who just sold the puts at the bid price of $15-7/8. Again, the extra commission will be well worth it.

In fact, years ago, there used to be an order called "exercise and cover" meaning that the broker would sell the stock and cover the sale by exercising the call (or buy the stock and exercise the put). With the increased liquidity in the options markets, this order has disappeared although there are certainly times it could still be used.

Why will options trade below intrinsic? There are a number of reasons, but the overall reason is that the market makers are having a difficult time spreading off the risk with the current liquidity.

For example, as discussed earlier, the Feb $70 calls are trading for $12-3/8 but "should be" trading for $13-5/8. This is strictly a result from having more seller than buyers. Everybody wants to sell their calls and nobody wants to buy; the new equilibrium price is $12-3/8, which is below the theoretical value.

You may be wondering why nobody is buying the calls and selling the stock to restore the equilibrium. The answer is, they are. Market makers are buying at $12-3/8, then selling the stock. However, there's just not enough volume or interest to bring it to equilibrium. In the meantime, the stock continues to fall, so by the time they short the stock, they may be in for a loss (even though market makers are immune to the "uptick" rule). With a bid at $12-3/8, they feel that is worth the risk while awaiting executions.

What about retail investors? Why don't they join in and buy the call and sell the stock? They can. However, they must purchase the call on the ask at $13-5/8 and sell the stock at the bid of $83-5/8, leaving zero room for error! If you sell stock at $83-5/8 and buy the $70 call, you will have a net credit of $13-5/8, which is exactly what it will cost you to buy the call.

Now, you may think to compete with the market makers and try to notch up the bid price a bit. In other words, if you bid $12-5/8, you will now be the highest bidder and the quote will move to $12-5/8 on the bid and $13-5/8 on the ask. If you purchase the call for $12-5/8, you could certainly sell the stock and make money. But here's the catch: if you bid at $12-5/8, the market makers will bid $12-3/4, giving them a call option for 1/8th! How? Market makers would love to buy the

call option below the "fair value" and hold an asset that will behave just like the underlying stock. But if the stock falls, the market maker will sell it back to you at $12-5/8 and be out 1/8ths of a point. In other words, they will use your buy order as a guaranteed stop order. If they buy it for $12-3/4 and it doesn't work out, they know they have a buyer at $12-5/8 -- you! This is called "leaning on the book" and is a common practice among market makers.

Just because the market is offering you a price below the fair value, this doesn't mean you must accept it. Learn to correct for it and improve your option trading results!

Option Exam 7 - Week 7

1) Which best describes an equity collar?

a) Unlimited losses regardless of direction

b) Limited downside losses, limited upside returns

c) Limited upside returns, unlimited downside losses

d) Unlimited upside returns, limited downside losses

2) An equity collar is similar to a(n):

a) Bear spread

b) Bull spread

c) Ratio write

d) Condor spread

3) A reverse equity collar is similar to a(n):

a) Bear spread

b) Bull spread

c) Ratio write

d) Condor spread

4) Covered call strategies typically provide a very little downside hedge in the even the stock falls. If this is a concern, you could use:

a) Deep-in-the-money covered calls

b) Out-of-the-money covered calls

c) At-the-money covered calls

5) An investor buys a stock trading for $100 and wants to write the $80 call for $21 1/4 with three months of time. Assuming interest rates are 5%, the investor should write the call.

a) True

b) False

6) An investor has written a call against stock (covered call) and wants to get out of the position by selling the stock and buying the call to close. However, he does not want to be exposed to market movement. He can enter:

a) A buy-write

b) An unwind

c) A sell-write

d) A straddle

7) An investor buys a low strike call and sells a high strike call. This is a(n):

a) Bear spread

b) Bull spread

c) Ratio write

d) Condor spread

8) An investor buys a $50 call for $5 and sells the $60 call for $2. This is a(n):

a) Debit spread

b) Credit spread

c) Unwind

d) Sell-write

9) Using the same information in #8, what is the maximum the investor can lose per spread?

a) $2

b) $3

c) $4

d) $10

10) An investor buys a $55 call and sells a $50 call for a net credit of $3. The most this investor can lose per spread is:

a) $2

b) $3

c) $4

d) $5

11) An investor buys a $100 put and sells the $95 put. This is an example of a(n):

a) Bull spread

b) Bear spread

c) Condor spread

d) Ratio spread

12) An investor is considering two different bull spreads. With one he can pay $2 and possibly make $10. The other he can pay $8 and possibly make $10. With the $2 spread is the better deal because it allows for more profit.

a) True

b) False

Week 8

Ex-Dividend Dates As you invest in stocks, you will encounter the words "ex-dividend date." This is a term that is important to understand -- what it is and how it works. Ex-dividend dates govern who gets

dividends, split shares, spin-off shares, or any other form of payment or distribution from the company.

Many option strategies depend on the payment of a dividend on the underlying stock and, if you miss the payment, the strategy could be shot. Even if you are not using options, it helps to understand ex-dividend dates if you wish to collect a dividend on a stock.

Many stocks pay dividends, which are simply distributions of cash given to shareholders. If a stock pays a 10-cent dividend and you own 100 shares, you will receive 100 shares * 0.10 = $10 from the company.

In fact, stock splits are really just dividends paid in the form of stock. If you have 100 shares and they split 2:1, your account statement will show a 1-share dividend paid on your statement. That just means that you received 1 share for each share owned. In this example, you'd receive 100 shares * 1 share dividend = 100 shares, which when added to your original 100 shares equals 200 shares and is what you'd expect after a 2:1 split on 100 shares.

There's no question as to who gets the dividends (or split shares) if you've been the one holding the stock all along. But what if you purchased the stock close to the time the dividend is paid? Will you get it or will it be the person who sold the stock?

To answer that question, we need to know the ex-dividend date.

What Is the Ex-Dividend Date?

The ex-dividend date, also called the ex-date, is the date the stock trades without the dividend. Just remember that "ex" means without, and you will not be prone to one of the most common mistakes made by investors (and brokers too).

Let's say a stock is about to pay a dividend, and the ex-date is June 10. If you buy the stock on June 10 or later, you will not get that upcoming dividend. Remember, ex means without. If you buy the stock on the ex-date (or later), you are buying the stock without that dividend.

If you buy the stock before June 10, you will get the upcoming dividend when it is paid.

If you just focus on the ex-date and nothing else, it is very easy to determine who gets the dividend and who does not.

More Examples:

1) ABC stock will pay a 5-cent dividend and the ex-date is August 18. You sell your shares on August 18. Will you get the dividend?

Answer: Yes. The buyer of your shares purchased them on the ex-date. They purchased the shares without the dividend, which means you are entitled to it.

2) Using the above example, what if you sold your shares on August 17 or before?

Answer: You will not get the dividend. The buyer of your shares is purchasing them before the ex-date, which means they are entitled to it.

If you want to receive the upcoming dividend, you must purchase the shares before that ex-date. Likewise, if you are selling your shares but want to receive the upcoming dividend, you must sell those shares on or after the ex-date.

Hopefully you can see how straightforward dividends can be if you just concentrate on the ex-date.

Why Is There So Much Confusion in Practice?

The reason for all the confusion is that when a dividend is announced, there are usually three dates associated with it:

• Record date • Ex-date • Payable date

Usually, companies only publish the record date and payable date in the newspaper. In many cases, the companies will not even be able to tell you what the ex-date is, even if you call investor relations, and we'll show you why shortly.

The only date that matters to the company is the record date. Before the company pays the dividend, they look up a list of names of all investors who are owners of their stock as of the record date and pay the dividends to those names. For example, XYZ may announce they will pay a dividend to all shareholders of record as of March 15. If you own the stock as of this date or before, you will get the upcoming dividend.

Here's where the confusion sets in for most investors...

In order to be the owner of record, the stock transaction must be settled by the record date. Keep in mind there is currently a three-business day settlement period! If you want to be a record holder as of March 15, you need to purchase it as of March 12 (assuming those are business days with no holidays). If you purchase the stock on March 12, the stock transaction will settle on March 15, and you will be owner of record as of March 15. Now you can see where all the confusion comes from. It all has to do with the timing of the settlement period.

Back to the Ex-Date

Fortunately, the ex-date was created by brokerage firms to mathematically figure out the purchase date that makes you owner by the record date. In the previous example, March 13 would be the ex-date. If you purchase on or before March 12, you will be owner of record by March 15.

Corporations are not stockbrokers and they are not, in many cases, even aware of the three-business day settlement period. They only publish the record date. This is why most firms will not even be able to tell you what the ex-date is.

Many investors believe if they purchase shares on or before the record date, they will get the dividend. This is false! In the previous example we said March 13 was the ex-date. If you purchase your shares on March 13, it will settle three business days later on March 16 -- one day too late. The stock will not settle by March 15, and you will not get the dividend.

Hopefully you see how much easier it is if you just focus on the ex-date, which you may have to call your broker to get. If you wish to focus on the record date, that's okay too, but just be sure you are purchasing the stock far enough in advance to make settlement by the record date.

Stock Splits

As mentioned, stock splits are really nothing more than dividends. If a stock is about to split 2:1 and you want to get the split shares, you can call your broker and ask for the ex-date, which we'll assume is May 10 for this example. If you buy 100 shares before May 10, you will end up with 200 shares. If you buy 100 shares on May 10 (or later), you will buy the shares at the cheaper price but will not get the additional shares.

Does It Matter If I Get the Dividend?

In most cases, it doesn't even matter if you get the dividend or not. Many new to investing find this hard to believe. After all, it certainly seems like you'd be better off buying the stock and getting the dividend rather than not getting the dividend, right?

The reason there is not a difference is that the stock price is reduced by the amount of the dividend (rounded up to the nearest 1/8) on the ex-date! For instance, say a stock closes at $100 on March 19 and is scheduled to pay a $2 dividend with an ex-date of March 20. On March 20, the stock will open at $98 unchanged to reflect the $2 dividend that was paid. The reason the stock will show unchanged is because the drop in price from $100 to $98 was due to the dividend and not changes in supply and demand for the stock.

Let's compare two investors: one who buys the stock before ex-date and another who buys it on the ex-date. You will be convinced there is no difference.

The investor who buys before the ex-date will pay $100 for the stock and receive a $2 dividend. The stock, however, will trade for $98 on the ex-date, and the total value of the position will still be $100 ($98 in stock and $2 in cash). This investor is down $2 in the value of the stock, which is offset by the $2 dividend.

A second investor who buys the stock on the ex-date will only pay $98 for the position and not receive the dividend. While they are not down $2 on the value of the stock, they did not receive the dividend either. Both investors are holding stock worth $98, and neither investor is down overall.

So it doesn't really matter mathematically whether you get the dividend or not (although there could be tax benefits to one choice over the other).

Rules Violation: Selling Dividends

Many brokers take advantage of investors by touting an immediate return on your money by purchasing stock just before the ex-date. Using the above example, a broker may call and say, "If you buy this stock for $100, you will get an immediate 2% return on your money the very next day." By now you should understand why this is not true.

If you buy the stock for $100, it will be worth $98 the next day, and you will have $2 in cash for a total position value of $100, which is neither a gain nor a loss. If this were really an immediate return of 2%, the position would be worth $102 the following day.

Further, buying the stock just to get the dividend is a bad idea for tax reasons. If you buy one share of stock for $100, you are paying with after-tax dollars; you do not owe taxes on the $100. However, if you buy the stock, the very next day your position is still worth $100, yet you owe taxes on $2. Basically, the dividend represents an immediate taxable return of capital (where previously there was none) and not a return on your money.

For these reasons, the NASD prohibits brokers from selling you stock solely for the reason of getting the dividend. Obviously, if the broker thinks the stock is going to be much higher in the next day or two and recommends buying it for that reason, that's okay. They just cannot sell you the stock based solely on the immediate return of the dividend. If they do, they are guilty of "selling dividends" and in violation of NASD rule 2830, which states:

NASD Rule 2830 (e): No member shall, in recommending the purchase of investment company securities, state or imply that the purchase of such securities shortly before an ex-dividend date is advantageous to the purchaser, unless there are specific, clearly described tax or other advantages to the purchaser, and no member shall represent that distributions of long-term capital gains by an investment company are or should be viewed as part of the income yield from an investment in such company's securities.

While some option strategies rely on payments of dividends (please see "Dividend Play" in this week's courses), keep in mind that you will never receive dividends from holding options. If you own a call option and wish to receive a dividend, you must exercise the call option and take delivery of the underlying stock before the record date.

A Real Life Example

The following is an excerpt from a Business Wire news article:

FAIRFIELD, Conn. -- (BUSINESS WIRE) -- Dec. 14, 2001 -- The Board of Directors of GE today raised the Company's quarterly dividend 13% to $0.18 per outstanding share of its common stock and increased its share repurchase program to $30 billion from $22 billion.

"GE has paid a dividend every year since 1899," said GE Chairman and CEO Jeff Immelt. "Today's increases, in both our dividend and our share repurchase program, signal our confidence in our ability to extend this track record of returning value to shareowners."

The dividend increase, from $0.16 per share, marks the 26th consecutive year in which GE has increased its dividend. The dividend is payable January 25, 2002, to shareowners of record on December 31, 2001. The ex-dividend date is Thursday, December 27.

Questions:

1) If you buy 100 shares of GE on December 27, will you get the dividend?

2) What is the last day you could purchase the stock and get the dividend? If you buy 100 shares, how much money will you receive? When will you receive it?

3) Why do you suppose there are four days between the ex-date and the record date?

Answers:

1) No. December 27 is the ex-date, and you will not get the dividend if you buy on or after this date.

2) The last date you could purchase shares to get the dividend is December 26. If you have 100 shares, you will receive 100 * 0.18 = $18.

3) Notice that the ex-date is Thursday. This means that the last day to buy the stock and get the dividend is Wednesday. If you buy on Wednesday, the stock will settle three business days later on Monday, December 31, which the article shows as the record date.

Using Options to Take Delivery

If you wish to take delivery of the stock in order to get the dividend, you should wait as long as possible (please see our course in week 1 on "Early Exercise" for reasons why you should wait as long as possible) and exercise the call option the day before the ex-date. You must exercise the option the day before the ex-date because options take one day to settle, which will be on the ex-date. At that time, the stock will be delivered in three business days with your name as owner of record. As always, if there are any questions, you should contact your broker before entering the trade.

In cases where you are trying to capture a dividend (or avoid one), focus on the ex-date, and there will be no unwanted surprises!

Dividend Play One of the more interesting strategies is known as a dividend play. It is ironic that it is nearly risk-free yet entails a lot of uncertainty. It is uncertain because you are betting on the move of the trader on the opposite side of your position.

The dividend play strategy is executed by purchasing stock and selling deep-in-the-money calls prior to ex-date (the day the stock trades without the dividend). Doing so creates a position where the trader will break even as a worst-case scenario, but may capture the dividend if the long call position fails to exercise.

For example, say a stock is trading for $100 and is about to pay a $1 dividend. Also assume that a $70 call is trading for $30 (trading at parity). A trader can buy the stock and sell the call for a net debit of $70. On ex-date, the stock will fall by the amount of the dividend to $99 causing the deep-in-the-money call to fall to $29. The trader will lose $1 on the price of the stock, but gain it back from the dividend. But the short call can be purchased back for $1 less. Overall, the trader profits by the amount of the dividend.

However, if the trader is assigned, he will receive $70 (the strike), which is the amount paid originally, and break even. If not, he keeps the dividend.

The transactions are as follows:

Long Stock = -$100 Short $70 call = +$30 Net debit $70

On ex-date, the account values are as follows:

Stock = +$99 (stock price reduced by amount of dividend) Short $70 call = -$29 (call price falls $1 due to stock price reduced by dividend) Dividend = +$1 Net credit $71

The trader can now sell the stock for $99 and buy back the short position for a total credit of $70, which exactly offsets the original debit. In addition, he will keep the $1 dividend.

Look back to the original position and now assume the trader is, instead, assigned before ex-date:

Original position:

Long Stock = +$100 Short $70 call = -$30 Net debit $70

He will lose the stock from the assignment but also lose the $30 obligation because the call has

been assigned. In exchange, he will receive the $70 exercise price, which is exactly what was paid originally.

Because of the low transaction costs, traders see it as a low risk, but potentially profitable trade.

Variations with vertical spreads

There is a variation of the dividend play that uses vertical spreads. For example, say the stock is $100 and the $65/$70 vertical spread (long $65 call and short $70 call) is trading for $5 -- exactly the intrinsic amount.

It is possible for a market maker to attempt to purchase this spread at $5 even though there appears to be no justification -- in most cases, you will pay $5 for the spread and sell it for $5, but pay two commissions to do so.

So why would a market maker want to pay $5 for the spread? They may exercise the $65 call and hope they are not assigned on the $70 call. By exercising the day before ex-date, they will capture the dividend of the underlying. Of course, if assigned on the short $70 strike, they will lose the gains and break even.

The transactions are as follows:

Long $65 call = -$35 Short $70 call = +$30 Net debit $5

Trader exercises the $65 call and is now:

Exercise $65 call = -$65 Long stock = +$100 Short $70 call = -$30 Net credit $5

Effectively, the trader has legged into a covered call position (long stock plus a short call). Notice that the long $65 call was originally priced at $35. By using it to buy stock, he is now long stock worth $100, but paid $65 for it -- a net value of $35. The market maker is simply changing the form of the position and not the value.

On ex-date:

Long stock = +$34(remember, the trader paid $65 for stock now worth $99) Short $70 call = -$29 Dividend = +$1 Net credit +$6

The trader gains by the amount of the $1 dividend. But assume he is assigned instead:

Now he will lose the stock and receive $70 for it. In addition, he will lose the short call obligation due to the assignment.

Receive $70 strike = +$70 Paid $65 for the stock = -$65 Net credit $5

Because the calls are both so deep-in-the-money, it is possible to execute the same strategy with a short vertical as well (sell the $65 call and buy the $70 call). In a similar fashion, the market maker will exercise the $70 in an attempt to capture the dividend and hope he is not assigned on the $65. If he is assigned, he breaks even.

The market maker can take advantage of the strategy with any deep-in-the-money call spread; he will exercise whichever call is long and hope he is not assigned on the other.

This strategy also explains why it is possible to see quotes such as bid $5 and ask $5 for deep-in-the-money call spreads. The market makers, in these cases, are often trying to buy or sell the spread for $5 in an attempt at a dividend play.

Remember, this strategy is only useful if you are paying very low commissions. We mention it because it is useful for understanding why you may see your stock called the day before ex-dividend date.

Option Repair If you have been buying stocks for any length of time, you have probably been in the situation every investor dreads -- seeing your stock down twenty or more percent from your purchase price.

Some of you may be thinking that will not happen to you because you use stop orders to prevent such losses. Well, even if you use stop orders, large losses can occur between trading days (known as gap downs). For example, a stock can close at $75 one night and open the next day at $60. If you have a stop order in at $75, you will be filled at $60. If you have a stop limit at $75, you will not be filled at all. In either case, the stop did not work as expected and you're down!

Fortunately, with the use of options, we can sometimes get out of these precarious positions with ease. To do so, you need to understand the option repair strategy.

Option repair strategy

This strategy is a very clever, yet simple strategy. Many investors would not think to do it, which is what makes it a powerful tool to add to your list of strategies.

The repair strategy does have a couple of assumptions. First, you must be at least moderately bullish on the stock over the short term. If you think the stock is heading south, you are probably best selling at a loss or buying protective puts as a full or partial hedge. Second, you are assumed to be trying to get out of the position by just breaking even (or close to it). In other words, this strategy is not used as a high profit one; it is designed to get you out of a bad situation for nearly break-even. So if you're in a losing stock situation and thinking, "Just get me my money back and I'll walk away," then this may be the strategy for you.

With the above assumptions, we can accomplish a break even with the repair strategy.

Here's how the strategy works:

Say you buy 1,000 shares of stock at $50 and it is now trading for $40 -- down 20%.

You think the stock will rise to $45 but not much past that; you must be somewhat bullish in order for the strategy to work. The way to design a repair strategy under these assumptions is to look for a ratio call spread you can write for free (if you are not familiar with these, please see our section on "Ratio Spreads"). How do we do that? In our example, we may buy 10 $40 calls for $5 and write 20 $45 calls for $2-1/2.

Here are the transactions: Buy 10 $40 calls for $5 = -$5,000

Sell 20 $45 calls for $2-1/2 = $5,000 Net cost $0

Notice that we bought 10 and sold 20 -- a ratio call spread. Normally, a ratio writer is subjected to unlimited upside risk. However, because you already own shares, you can cover 10 of the short $45 calls with your stock and the remaining 10 contracts with the $40 call. Effectively you are writing 10 $45 contracts as a covered call plus entering 10 $40/$45 bull spreads. Because we can write a twice as many calls as we need to purchase, the long $40 calls cost us nothing!

In most cases, you will be limited to no more than a five-point difference in strikes. In other words, this strategy will usually not work by buying the $40 and selling the $50 calls, because that is a ten-point difference in strikes.

Now, if the stock does move to $45 at expiration, the long shares will be worth only $45 (the short $45 calls will expire worthless). The $40/$45 bull spread will be worth $5 points for a total of $50 points.

Here are the transactions in detail:

Transaction Account Value Buy the stock at $50 $50,000

Stock falls to $40 $40,000 Buy 10 $40 calls, Sell 20 $45 calls for $0 $40,000

Stock rises from $40 to $45 Long stock now worth $45,000 Long $35/$40 spread worth $5,000 Total account value = $50,000

In effect, we have leveraged the account for an upside move for no money down or additional risk. Our trade-off is that we cap our upside returns. But if you are not long-term bullish, then capping the upside in exchange for break-even may make perfect sense for a particular situation.

In the example above, does the stock need to close at exactly $45 in order for the strategy to work? No, it will work as long as the underlying stock rises to $45 or higher. Say the stock rallies all the way back to $50 at expiration. Now your long stock is worth +$45 (remember, you have a $45 covered call against the shares), and your long $40/$45 calls spread is worth +$5 for a total of $50.

Any stock price above $45 at expiration will result in the total position being worth $50.

It is also helpful to look at the various option strikes and months, known as option chains, to help make your decision as to which options to buy and sell. You can get these through most brokerage firms or from the Chicago Board Options Exchange at http:/www.cboe.com.

The option repair strategy is yet another demonstration as to the versatility of options. We have taken these "risky" assets and used them in a way to leverage our returns for no money down. If you take the time to learn and understand these assets, you will greatly improve your portfolio performance.

Naked Put Alternatives

Spreads as an alternative to naked puts

This section probably belongs under "Basic Spreads," but it is so powerful we feel it qualifies as its own strategy. It is one that is highly overlooked, even by the most seasoned investor.

If you ever use the strategy of naked puts, you will want to reconsider once you see the difference a spread can make!

Naked put strategy

As a review, recall that the strategy of selling naked puts is actually neutral to bullish. If the stock sits still or rises, the trader will profit by the amount of the initial credit. However, many traders add a twist to this strategy and use it as a way to purchase stock. They sell puts on stocks they do not mind owning if the put is assigned. Because of this, they feel it is a win-win strategy. If the stock rises, they keep the premium; if it falls, they got paid to buy a stock they wanted to buy anyway.

It is these investors we want to target in this section. We'll show you an alternative strategy for selling naked puts.

In fact, this strategy is especially useful for investors who wish to sell naked puts (which requires level 3 option approval) but only have approval to enter spreads (level 2). This strategy allows you to effectively sell naked puts in a level 2 account!

Using far-out-of-the-money spreads

Assume you are willing to buy 1,000 shares of Intel (INTC) currently trading around $42-1/2. Instead, you elect to sell a naked put, and the Jan $40 put is trading for $3. If you sell 10 contracts at $3, you bring in a credit of $3,000 and keep this amount regardless of what happens to the stock. If the stock should fall below $40, the strike, you may be required to purchase it at $40 if the long position decides to exercise. From a profit and loss standpoint your max gains and losses are as follows:

Maximum gain: $3,000 Maximum loss: $37,000

The most you can make is $3,000, but the risk is that you may be forced to buy stock at $40, which theoretically, could be worthless. You offset this $40 loss with the initial credit for a max loss of $37,000.

Now I know some of you are saying that Intel will never go to zero, so the argument is invalid. Well, it's probably true that it won't go to zero, at least anytime soon, so that may not be a probable risk. It is, nonetheless, the worst that can happen from a naked put, and that's how we have to base our decisions. Besides, there are many newer companies that can go very close to zero even though they were high-fliers at one time, so the risk is very real. Microstrategy (MSTR) rose from $7 to over $300 within a year -- only to return to $3 for the longest time. Currently, it is trading around $16- 1/2. If you sold the $300 puts, believe me, it felt like worthless stock no matter how much you received for the put. Iomega (IOM) went from $3 to over $100 in a short time and back to $3 even quicker. Egghead.com (EGGS) fell from $55 to the current price of $1-1/2. There are numerous examples, so please do not discount the maximum loss zone.

Back to the example. Let's now compare a trader who enters a spread order. He will sell the $40 put for $3 but simultaneously buy a far-out-of-the-money put, say a Jan $25, trading for $1/4. Because these are simultaneous orders, it's very likely to get a better fill between the two prices, but we will ignore that for now.

From a profit and loss standpoint:

Maximum gain: $2,750 Maximum loss: $12,250

This trader will take in a credit of $2,750 instead of the $3,000 the naked put trader received. This is because the spread trader will use $1/4 ($250) of his proceeds to buy the $25 strike put. In doing so, he now eliminates 25 points of risk to the downside. His maximum loss is only $12,250 versus $37,000 for the naked put.

The result is this: The naked put trader increased his returns by only 1/4 point in return for accepting an additional $24,750 potential loss ($37,000 versus $12,250). That is a very expensive 1/4 point.

Naked puts are a great strategy, especially if you are selling against stocks you would like to buy regardless. However, when things go bad, they can really go bad. This is the real risk of naked put writing. Using spreads can eliminate this risk cheaply.

Comparing the two profit and loss diagrams:

We see the two traders are virtually identical for all stock prices down to $25. In fact, they are only separated by 1/4 point, which was the difference in initial proceeds. However, if things go bad and INTC falls below $25, the spread trader will be very happy to have the long $25 put as insurance.

Which profit and loss diagram looks more appealing to you? Would you pay 1/4 point for it?

In addition, most brokerage firms will charge you the lesser of the full spread requirement (difference in strikes less the credit) or the naked requirement. So you will never be worse off, from a margin standpoint, with the spread order. Granted, it will cost you an extra commission, but in most cases, this will be well worth it.

Using far-out-of-the-money spreads as an alternative to naked puts is a form of catastrophe insurance. The trader in the above example is "insured" for all prices below $25. Again, it is unlikely for Intel to fall below this point, which is why the markets are pricing the $25 put at $1/4. However, when using any form of insurance, it is wise to buy insurance on high-severity and low-probability events, and that's exactly what a far-out-of-the-money put spread does for you; it insures against low-probability catastrophes.

Take a look at the following charts to see just how big and fast a catastrophe can happen!

Headline: Lilly shares fall more than 31% as ruling speeds generic prozac (8/09/00)

Headline: Apple computer falls more than 52% on 4th-quarter earnings estimates (9/28/00)

Headline: Priceline.com down 42% on 3rd-quarter estimates (9/27/00)

Headline: Xerox down 26% as sales decline and 3rd-quarter loss expected (10/03/00)

Headline: Eastman Kodak falls 25% on profit warning (9/26/00)

Headline: Intel falls 22% on 3rd quarter revenue warning (9/22/00)

Headline: Lucent shares fall 23% on 4th quarter earnings (10/10/00)

Hopefully you will see far-out-of-the-money put spreads as an enhanced alternative to naked put selling. Many investors have gone broke selling naked puts on "good" companies. However, good companies do not always report good news as the above charts demonstrate. It is during these times the value of the far-out-of-the-money spread strategy will be realized.

Ratio Spreads Ratio spreads are a very powerful strategy and can be done with calls or puts. In theory, they are probably the perfect trade as they provide for buying the valuable options and selling off higher amounts of the "worthless" options to finance the long position. But they do come with great risks to the tune of unlimited losses at an accelerated rate if the stock moves above the strike of the short position.

The mirror image of the ratio spread is the backspread. If you place a ratio spread, the trader on the other side has a backspread.

Call ratio spreads

A call ratio spread consists of buying a lower strike call and then selling a higher number of contracts of a higher strike price.

Example:

A trader is bullish on MRVC currently trading $37-3/4. The trader thinks the stock will go above $40 by December but not above $50. A ratio spread, under these circumstances, may be a perfect strategy:

Buy 10 Dec $40 calls = $5 1/4 Sell 20 Dec $50 calls = $2 1/4 Net debit $3/4

We have arbitrarily chosen the ratio of 10 and 20 (buying 10 and selling 20). The trader could have bought 10 and sold 11, or bought 50 and sold 150, or any other ratio among the infinite combinations. We will see shortly why a trader will choose one ratio over another.

First, we need to understand how we arrived at a net debit of $3/4 in the above trade.

There are two fairly easy ways to figure this out, and whichever one works for you is fine. The first and probably best way to understand the ratio spread is to break the trade up into the smallest component parts. To do this, we need to find the highest number that is common to the 10 calls we're buying and the 20 we're selling (in math terms, the greatest common factor).

The highest number, in this case, is 10; there is no number higher than 10 that can go into both 10 and 20 evenly. If we divide the buy 10 and sell 20 calls by our greatest common factor, we arrive with buy 1 call and sell 2, a basic unit. The trader in the above example is just executing this basic spread 10 times.

In other words, he could call his broker and say, "Buy 1 and sell 2, Buy 1 and sell 2, Buy 1 and sell 2..." The trader could repeat this order 10 times and, in the end, would have purchased 10 and sold 20.

In trader's jargon, this person executed 10 1 by 2 spreads which is usually written as 10 (1 x -2) spreads.

Examples:

If a trader: buys 7 and sells 21: This is 7 (1 x -3) spreads buys 3 and sells 7: This is 1 (3 x -7) spread buys 16 and sells 24: This is 8 (2 x -3) spreads

Now that we know the basic unit is 1 by 2, let's look at the above trade again. Effectively the trader has done this:

Buy 1 Dec $40 calls = $5 1/4 Sell 2 Dec $50 calls = $2 1/4

The trader purchases 1 for $5-1/4 and sells 2 for a total of 2 * $2 1/4 = $4-1/2. They paid $5-1/4 and received $4-1/2 for a net debit of $3/4.

The second method may be a little easier:

Buy 10 $40 calls for $5 1/4 = -$5,250 Sell 20 $50 calls for $2 1/4 = +$4,500 Net debit $750

The trader buys 10 calls for a total of $5,250 and sells 20 for a total of $4,500. The net difference is $750. Because he is trading 10 spreads (yes, you still have to be able to break it down into component parts!), we need to divide $750 by 1,000 (because 10 contracts represent 1,000 shares) for a net debit of $3/4 per spread.

Important note: It is very important to understand how to calculate these figures if you are executing a ratio spread, because it is a complex strategy and will require level 3 option approval. If your broker calculates this incorrectly, they may hold you either partially or fully liable for the trade. Why? Because on the options application you will have to check the box designating "excellent" knowledge to get level 3, and they may hold you to this.

Now we know the trader is trying to execute 10 (1 x -2) spreads for a net debit of $3/4. The total debit from his account will be 1,000 * $3/4 = $750.

Can the market maker fill only part of the trade?

Yes, but not just arbitrarily. Because the minimum spread, in this example, is 1 by 2, the floor trader could give your broker a confirmation of buy 1 sell 2, buy 2 sell 4, buy 3 sell 6, and so on up to the total of buy 10 and sell 20. They could not, for example, return a confirm of buy 2 sell 20. It will always have to be a multiple of the basic unit, which is 1 by 2 for this trade.

An "all-or-none" restriction will prevent partial fills but are generally inadvisable, as option quotes are good for a minimum of 20 contracts. If you put an "all-or-none" restriction on the order, it is possible to get no execution, and you cannot hold the floor to time and sales. So use "all-or-

none" orders sparingly and it's probably best to never use all-or-none's for orders of 20 contracts or less.

Let's assume our trader gets filled on all 10 (1 x -2) spreads and spends $750 to do so. What does the position look like from a profit and loss standpoint? (If you are unsure how to read these charts, please see our section under "Profit and Loss Diagrams.")

We see that the trader will lose the entire $3/4 per spread, or $750, if the stock is below $40 at expiration. The trader will maximize profits at $50, the strike price of the short position. What will be the max profit? The maximum this spread can be worth is $10, the difference in strikes; however, the trader paid $3/4, so the max profit will be $10 - $3/4 = $9 1/4.

It is easy to see where the danger is with the ratio spread; there is unlimited upside risk. The trader will start to lose profit with the stock above $50 at expiration, and will break-even at $40-3/4 and $59-1/4. The downside break-even is simple to figure; the trader paid $3/4 for the position, so he must make this up. If the stock is at $40-3/4 at expiration, the long call position will be worth $3/4 and the short position will expire worthless, so the trader will break even.

It can be a little tough to figure the break-even on the upside, so we'll spend some time here. For all the math people, one easy way to figure it is to understand that the slope will be negative one due to the 1:2 ratio of the spread. With a slope of negative one, the stock must move 9-1/4 points (the max profit) to the right of $50 (the stock price at max profit), which puts you at a stock price of $59-1/4. This method does require a solid understanding of graphs and slopes so do not use it if this does not make sense to you. I only mention for those who do understand mathematical slopes, as it is easy to calculate in your head if you do. As an example, if the trader entered a $40/$50 1 by 3 ratio spread for a net debit of $3/4, the break-even point to the upside would occur at twice the rate; a slope of negative 2. Now, instead of moving 9-1/4 points to the right, the stock will only have to move half this distance or $4-5/8 for a break-even price of $54-5/8.

To be on the safe side, especially if you are new to ratio spreads, the following method will be the best, but does require basic skills in algebra. Start by understanding that the definition of break-even is where revenues equal expenses, so:

If we let S represent the stock price at expiration,

Our profits will be (S - $40), because we will have intrinsic value of this amount on the long position. Our expenses will be 2* (S - $50) - $3/4. This is because we sold two contracts for every one purchased and they will have S - $50 for value which is a liability to us. In addition, we spent $3/4 for the trade, which is also an expense. Now put the two equations equal to each other and solve:

S - $40 = 2 * (S - $50) - $3/4 S - $40 = 2S - $100 - $3/4

After collecting all like terms to one side, we see S = $59-1/4.

If you understand nothing about the break-even point to the upside, at least understand this: there is unlimited risk to the upside in a call ratio spread! The larger the ratio, the more accelerated the losses become.

Why enter a call ratio spread?

This is a popular tool among floor traders and there are good reasons it is well liked. The basic reason is this: it allows the trader to buy the "good" option cheaply by financing it with the "junk" option -- the one he feels will never have intrinsic value. By doing so, the return on investment is radically magnified.

Example:

Assume our trader above was bullish and just bought 10 calls of the $40 strike with two months to expiration. He would have paid $5-1/4 per contract or $5,250. Let's also assume the stock closes at $50 -- our trader's expectation -- at expiration. This position would be worth 10 points on 10 contracts for a total of $10,000; however, the trader will net $4,750 after costs. The return on investment is roughly 90-1/2% or 4,675% annualized!

Now let's look at our trader who entered the ratio spread. Effectively, he is buying the 10 $40 strike contracts for only $3/4 of a point instead of the $5-1/4 of the long call trader. Of course, this does not come for free, as the ratio trader is faced with unlimited risks to the upside; the long trader would simply make more money as the stock moves higher. Assuming the trader's assumption that the stock will not rise (or at least significantly) above $50, let's see how the ratio spread fares:

Buy 10 Dec $40 calls = $5 1/4 Sell 20 Dec $50 calls = $2 1/4 Net debit $3/4

Again, assuming the stock closes at $50, this trader will also make $10 points on the spread, as the short $50 calls will expire worthless. The return on investment here is 1,233% or 561,865,400%

You can certainly see where the incentive is to trade ratios! Be careful, the market does not allow for these returns for nothing. The ratio spreader took a proportionately higher risk to capture that kind of profit.

Why would a trader enter a different ratio?

We have demonstrated the advantage of the ratio spread,which is magnified gains if you are correct in your assumptions. If the trader feels really sure about his assumptions and is willing to take the risk, he may decide to enter into a larger ratio. Let's run through the above example again, but this time, assume the trader enters a 1:3 ratio spread.

Buy 10 Dec $40 calls = $5 1/4 Sell 30 Dec $50 calls = $2 1/4 Net Credit $1 1/2

This trader actually gets a credit from the net transactions, effectively getting paid to take the 10 long $40 strike calls. Again, do not be fooled into thinking it comes for free!

How did we figure the credit? The trader bought 1 for - $5-1/4 and sold 3 for a total of + $6- 3/4 for a net of $1-1/2 credit per spread.

We know he bought 10 (1 x -3) spreads for a total credit of $1,500. By the way, this is still considered a buy even though a credit is received. This is because the trader wants the spread to widen.

The profit and loss diagram looks like this:

It is now easy to see the differences. As the number of sells increases relative to the buys, the profit and loss diagram will shift upward as in the 1:3 ratio (red) compared to the 1:2 (blue). That's the good part; the long position gradually becomes cheaper to own, and the trader will receive a credit if enough of the short calls are sold. Now for the downside, as more are sold, the downside break-even point approaches much more rapidly, which means you head into losses at a faster rate.

For the 1:3 spread, the trader received a credit of $1-1/2 so there is no downside breakeven. The trader will have a $1-1/2 profit even if the stock collapses. The maximum gain is the 10 points on the spread plus the $1-1/2 received, for a total of $11-1/2.

As for the upside break-even point, (for the math people again) we know the slope is negative 2, so the $11-1/2 maximum gain will fall at twice the rate or $5-3/4. So if the stock price is $55 3/4 at expiration, this trader will be at break even.

Algebraically, our revenues at expiration are: S-$40 + $1-1/2

And the expenses are: 3 * (S-$50)

Putting these two equal to each other: S - $40 + $1-1/2 = 3 * (S-$50) S - $40 + $1-1/2 = 3S - $150 2S = $111.50 S = $55-3/4

If you want to check it, assume the stock is at $55 3/4 at expiration. The long calls will be worth +$15 3/4 (intrinsic value) and the short calls with be worth 3 * $5-3/4 = $17-1/4 which is a liability because it is a short position. So, the trader has +$15- 3/4 and - $17-1/4 for a net loss of $1-1/2 which exactly offsets the $1-1/2 credit received at the onset of the position.

The real risk to the trader is if the call ratio trader is if the stock makes a large move to the upside, especially between trading sessions. For example, the trader in the above trade could be holding the position with the stock now at $48. The next trading day, the stock opens at $60 and continues trading higher. In this instance, the trader never has a chance to get out of the position until large losses have occurred. Floor traders will generally close them out long before the risk gets too great, and if the stock collapses, often end up with a credit from the trade.

Ratio spreads with puts

Ratio spreads can be established with puts as well. A put ratio spread allows the investor to play the downside for much less money then either a long position or regular spread position.

To establish a ratio spread with puts, the trader will buy one strike price and sell a higher number of contracts of a lower strike price.

Assume a trader is bearish and we have the following quotes on MRVC:

Buy 10 Dec $40 puts = $7 1/2 Sell 20 Dec $30 puts = $2 3/8 Net debit $2 3/4

The trader effectively buys 10 $40 strike puts for $2-3/4 instead of $7-1/2.

The profit and loss diagram looks like this:

We see, as expected, that the put ratio spread is exactly opposite the of the call ratio spread. Here, that maximum gain is at the strike price of the short $30 put. At this point, the spread will be worth $10 to the trader for a net of $7-1/4 after the $2-3/4 cost is subtracted. Below $30, the trader starts to lose profits and hits break-even at $22-3/4. If the stock should fly to the upside, the maximum the trader can lose is the original $2-3/4.

Ratio spreads are a wonderful tool for trading. The spreads can all be custom-tailored to suit your specific needs and sentiment of the underlying stock. They can, depending on how they're used, have substantial risks and will require the use of naked options approval (usually level 3 for most firms) from your broker.

Practice doing "paper trades" if you're new to ratio spreads, as they will greatly improve your understanding of options, strategies, and position management techniques.

Christmas Tree A Christmas tree strategy is similar to a ratio spread. For calls, it involves the buying of one strike and the sale of two higher strikes (for example, buy $50 call, sell a $55 call, sell a $60 call); for puts, a trader will purchase one strike and sell two lower strikes (for example, buy $50 put, sell a $45 put, sell a $40 put). If you read our section on condor spreads, you may recognize the strategy as a long condor spread without the upper protective wing (for calls) or the lower protective wing (for puts).

The idea behind this strategy is that the trader lowers the cost basis of the long position by selling two options against it, thereby accelerating the rate of return on investment. However, unlike the ratio spread where multiple calls of a single higher strike are sold against the long position, the trader instead sells multiple strikes. It is a lower risk, lower reward strategy relative to the ratio spread.

Example:

A trader is bullish on a stock trading at $100 and wants to go long a Christmas tree. He will buy the $100 call, sell the $105 call, and sell the $110 call for a net credit of $1. The profit and loss diagram looks like this:

The trade is usually placed at a small credit and reaches maximum profit at the strike of either short position. If the stock moves above the highest short call, $110 in this example, the trader will start to lose profits and eventually end up with losses if the stock rises far enough.

The trader is effectively taking a little more conservative stance (although there is still the risk of unlimited losses) relative to the ratio spreader.

Examples:

Corning (GLW) is currently trading for $59-3/4 with the following option quotes. Let's compare a ratio spread with a Christmas tree and see how they differ. Investor A buys the $60 call and sells two $65 calls.

Calls Puts Bid Ask Bid Ask Jan $50 13 5/8 14 3/8 4 4 3/8 Jan $55 11 11 3/4 5 7/8 6 3/8 Jan $60 8 1/2 8 3/4 8 1/4 8 3/4 Jan $65 6 1/4 6 3/4 10 7/8 11 5/8 Jan $70 4 3/4 5 1/8 14 1/8 14 7/8

This produces a credit of $3-3/4 as follows:

Buy $60 = -$8 3/4 Sell 2 $65 = +$12 1/2 Net credit $3 3/4

Investor B enters a Christmas tree and buys the $60, sells the $65 and sells the $70 for a net credit of $2-1/4 as follows:

Buy $60 = - $8 3/4 Sell $65 = +$6 1/4 Sell $70 = +$4 3/4 Net credit +$2 1/4

Notice the higher reward, $3-3/4 credit versus $2-1/4, with the ratio spread indicating the higher risk.

From a profit and loss standpoint:

It is now easy to see the differences in the two strategies. The ratio spread has a higher reward if the stock should fall or hit $65, the point of maximum profit for both strategies. If the stock collapses, the ratio spread will keep the initial $3-3/4 credit while the Christmas tree will keep $2-1/4. If the stock hits $65, the ratio spread makes an additional $5, the difference in strikes, for a total profit of $8-3/4. Similarly, the Christmas tree will make $5 at a stock price of $65 for a total of $7-1/4.

However, the ratio spread starts to lose profits for any stock price above $65, while the Christmas tree does not start to lose them until $70 -- one strike higher.

At a stock price of $66-1/2, the two strategies are even; this is the point where the red line crosses the blue line. Beyond $66-1/2, the Christmas tree strategy dominates the ratio spread. This can be seen by the fact that the blue line (Christmas tree) is above the red line (ratio spread) for all stock prices above $66-1/2. Likewise, the ratio spread wins for all stock prices below $66- 1/2 and we can see that its profit and loss line is above the Christmas tree's for all stock prices below this level.

The ratio spread will start heading into losses after the break-even $73-3/4, while the Christmas tree will not start taking losses until the stock exceeds $77-1/4.

Christmas tree using puts

The Christmas tree with puts is used for the opposite reasons as above. Here, the trader is bearish and wants to buy puts but sell two additional lower strikes to offset the cost.

Assume a trader is bearish on a stock trading at $100 and wants to go long a Christmas tree using puts. He will buy the $100 put, sell the $95 put, and sell the $90 put for a net credit of $1. The profit and loss diagram looks like this:

The trader will start to profit if the stock falls below $100. At a stock price of $95, he will reach the maximum profit of $6 ($5 difference in strikes + $1 credit) and remain at this maximum amount to

a stock price of $90. Below $90, the trader starts to lose profits and will head into losses below the break-even point of $84.

Examples:

Let's use the above option quotes again and compare a ratio spread with a Christmas tree. Investor A again will enter a ratio spread and buy the $60 put and sell two $55 puts to finance the purchase. His net credit is $3 as follows:

Buy $60 put = -$8 3/4 Sell 2 $55 = +$11 3/4 Net credit $3

Investor B enters a Christmas tree and buys the $60 put, and sells the $55 and $50 puts for a credit of $1 1/8:

Buy $60 put = -$8 3/4 Sell $55 put = +$5 7/8 Sell $50 put = +$4 Net credit $1 1/8

The profit and loss diagrams for the two strategies look like this:

Again, we see the ratio spread and Christmas tree make money if the stock falls below $100. This should be the case, as both traders own the $100 put. However, Investor A with the ratio spread will dominate as a higher credit was received from the initial trade ($3 versus $1-1/8). This can be seen by the fact the red line is above the blue line through this range.

If the stock falls to $90, the ratio spread will reach maximum profit of $8 ($5 difference in strike plus the initial $3 credit).

If the stock falls below $90, the ratio spread starts to lose profits; the Christmas tree will not start to lose them until the stock falls below $85. The two trades are strategies that will be equal at a stock price of $88.

Below $88, the Christmas tree dominates and we can see its profit and loss diagram is above the ratio spreads throughout this range. The ratio spread will incur losses below the break-even point of $82, while the Christmas tree's losses will occur below the break-even point of $79.

The Christmas tree is a nice strategy for those wanting to utilize short positions to offset the cost of long positions. They are a nice alternative for ratio spreads but still have unlimited loss potential, so will require level 3 option approval from your broker. Christmas trees are a lower risk, lower reward strategy relative to the ratio-spread counterpart.

If you like to enter ratio spreads, run through some numbers with the Christmas trees as well. You may find you like the risk-reward structure much better.

Option Exam 8 - Week 8

1) A Christmas tree strategy is similar to a:

a) Straddle

b) Ratio spread

c) Buy-write

d) Sell-write

2) Which of the following is a Christmas tree?

a) Buy $100 call, sell 2 $105 calls

b) Buy $100 call, sell a $105 call, sell a $110 call

c) Buy $100 call, sell 2 $105 calls, buy a $110 call

d) Buy $100 call, sell a $105 call, buy a $110 put

3) A $50 call is quoting $8, the $55 call is $6, and the $60 call is $3. What is the net debit/credit for a long Christmas tree?

a) Net debit $1

b) Net credit $1

c) Net debit $11

d) Net credit $11

4) A long Christmas tree has:

a) Unlimited upside risk

b) Limited upside risk

c) Unlimited downside risk

d) Limited downside and limited upside risk

5) Christmas trees are usually initiated for a(n):

a) Credit

b) Debit

c) Net zero

6) Compared to ratio spreads, Christmas trees are usually:

a) A higher risk, lower reward strategy

b) A higher risk, higher reward strategy

c) A lower risk, higher reward strategy

d) A lower risk, lower reward strategy

7) You wish to write a naked put. However, your broker is only able to get you approved for spreads and not naked positions. You should:

a) Transfer the account

b) Consider far out-of-the-money credit spreads

c) Just stick to stocks

8) In order to execute an "option repair" strategy, you must be _____ on the underlying stock.

a) Bearish

b) At least mildly bullish

c) Neutral

9) An "option repair" strategy has:

a) Limited risk

b) Unlimited risk

10) When might you see the bid and ask for a spread the same price?

a) After ex-date

b) Prior to ex-date

Week 9 : Advanced Strategies and Topics

Calendar Spread

A calendar spread is any spread where the trader buys a particular month, and then sells the same strike of a different month. For example, a trader may buy a March $50 strike and sell a January $50. Notice that the trader is spreading months, hence the name calendar spread. Also, because months represent time, these are equally known as time spreads or horizontal spreads.

If the trade results in a net debit, the trader is said to be long the calendar spread; if it results in a net credit, then he is short the spread.

With a calendar spread, the trader is expecting the stock to sit flat -- this trade is actually a play on time-decay and volatility as opposed to direction.

Many traders have trouble understanding why you want the stock to sit still, so let's go through the reasoning. Say a trader buys the above trade -- long March $50 for $10 and short Jan $7 for a net debit of $3. Because the trader is long the spread, he will want the spread to widen so that he may close it for a profit.

Now, if the stock sits still, as we approach January expiration, what will happen to the spread? Both options will lose money as time goes by, but the short January option will lose far more than the long March option. The January will be nearly worthless, while the March will still have significant time remaining. For instance, the January option may be trading for $1/2 while the March, with over two months remaining, may be worth $7. The trader paid $3 and can close it for a net credit of $6-1/2 for a $3- 1/2 gain.

Let's say the stock nosedives and is trading for $20. Now, both options will be virtually nothing. You may see the January for $1/16 and the March for $1/8, but the point is: the trader will close out the spread for next to nothing for a loss of about $3. If the stock collapses, the spread will also collapse toward zero.

What if the stock rallies and is trading way up? If the options are very deep-in-the-money, regardless of the time remaining, they will converge on intrinsic value. You will see a small difference in the March $50 calls just to reflect an additional two months cost-of-carry, but the difference will be negligible.

We may see the Jan $50 trading for $30-1/2 and the Mar $50 for $31 but, again, the spread has narrowed to 1/2 point so the trader will incur a $2-1/2 loss.

From a profit and loss standpoint, the long calendar spread looks like this:

It should be evident that a long calendar spread wants the stock to sit still. Conversely, a short calendar spread will want the stock to move, either up or down by a large amount as shown by the profit and loss diagram below:

Many traders make the big mistake of entering into a calendar spread when bullish on the stock. If they are lucky enough to get the direction correct, they are greatly disappointed to see the spread collapse.

If you are bullish or bearish on a particular stock and entering into a calendar spread, you want to be short the spread -- you want the spread to narrow. In other words, if you short the spread, you will receive a credit. If the stock moves way up or way down, the spread will narrow and you can purchase it back for a profit.

If you are expecting the stock to sit still, you want to be long the spread. You will spend money to do so but the spread will widen if you are correct and the stock is relatively quiet.

Calendar spreads add a whole new dimension for most traders; that is, a limited risk way to profit from a stock doing nothing. Granted, short calls, short puts and covered calls can make money from a neutral outlook on the stock as well. However, their risk with an adverse move in the underlying is often too big for many investors. Calendar spreads can be a great way to profit from a neutral outlook while greatly limiting your risk.

Butterfly As you become more involved in trading options, you will no doubt hear about a strategy known as the "butterfly spread."

The butterfly spread is one of many strategies that belong to a family collectively known as "wing spreads"; they get this name, as you will soon see, from the shape of their profit and loss diagrams.

The butterfly spread is avidly written about in many options books, so it tends to attract traders who want to venture into new strategies. But because the strategy involves three or four separate commissions (and sometimes more depending on how the spread is constructed) to open and the same number to close, it is very costly and typically not a good strategy for the retail investor.

The butterfly spread is really designed for floor-traders to take advantage of pricing discrepancies between spreads. While it is not an arbitrage play, it stacks the odds in their favor, largely due to the fact they are not paying retail commissions.

The long butterfly spread

A basic butterfly spread involves three strike prices, which we shall generically call low, medium, and high. For the long butterfly, the trader will buy 1 low strike, sell 2 medium strikes, and buy 1 high strike all with the same expiration dates. The butterfly can be executed with either calls or puts (or a combination). The high and low strikes must be the same distance from the medium option.

Example:

A stock is trading at $100, and a trader wants to place a butterfly spread. The trader may buy 1 $95 call, sell 2 $100, calls and buy 1 $105 call. Notice how the high and low strikes are the same distance, in this example $5, from the medium strike. This would be called a $95/$100/$105 butterfly. Sometimes traders will just refer to the "body" of the butterfly and call it simply a $100 butterfly.

The long butterfly spread is always executed in a 1-2-1 pattern -- buy 1, sell 2, buy 1. Of course, you could elect to do multiple spreads in which case your pattern would be 2-4-2 or 3-6-3 or any other combination as long as the middle strike is always double the number of contracts as either the high or low.

If you execute a 2-4-2 pattern, this is considered 2 butterfly spreads; a 3-6-3 is considered to be 3 spreads.

Understanding the butterfly

There are many ways to view a butterfly spread. In fact, there are probably an infinite number of ways to construct one although most investors who are faintly familiar with them will tell you there are only two ways (either with calls or puts) and always three strikes. A trader can use calls, puts, combinations of the two, and synthetic versions of each piece of the butterfly to create the

same profit and loss diagrams. All ways are equally correct as long as the profit and loss diagrams look the same.

One of the easiest ways to view the long butterfly is as a combination of a long bull spread and a long bear spread. For example, the trader in the above example went long 1 $95 call, short 2 $100 calls, and long 1 $105 call. We can look at that trade in another way as follows:

Long $95 call This is the bull spread Short $100 call

Short $100 call This is the bear spread Long $105 call

We see the long bull and long bear spreads consist of exactly the same pieces as the butterfly spread: long 1 $95, short 2 $100, long 1 $105.

If you understand the butterfly spread in this way, it will help to understand why it is so useful to the floor traders.

Why floor traders love butterflies

Let's assume a stock is trading for $101 and we see the following quotes on some call options:

Option Quote $95 call $10

$100 call $8 $105 call $6

We know from basic option pricing that the $95 call should be more than the $100 and the $100 more than the $105, and we see that they are. In addition, the differences in price do not exceed the strikes, so no problems there (if you are unsure about these principles, please see our section under "Basic Option Pricing").

However, after checking these basic relationships, market makers will additionally check spreads and straddles for other possible mispricings.

Here is what they will look for: the $95/$100 bull spread becomes more valuable as the stock rises. In fact, the maximum profit is achieved if the stock price is above $100 at expiration. With the stock at $101, the bull spread, at this point, would be at maximum profit if the options were to expire instantaneously.

Now let's look at the bear spread. The bear spread consists of the short $100 call and the long $105 call. This spread will become more valuable as the stock falls; in fact, the maximum profit here will occur if the stock is below $100 at expiration. The bear spread, unlike the bull spread at this point, will be below maximum profit if the options expire instantaneously.

So if you had to pick a spread to be the winner, which would it be? Obviously, it should be the bull spread because it is theoretically worth more. But look at the quotes again -- we see both spreads are prices at $2.

How? The bull spread consists of the long $95 and short $100 for a net debit of $2. The bear spread consists of the short $100 and long $105 for a net credit of $2.

With the stock at $101, the market maker knows the bull spread should be more valuable relative to the bear spread, so he'll buy the bull spread and sell the bear spread -- a butterfly spread.

Notice that this does not guarantee a profit -- the stock could fall below $95 or rise above $105 -- so is not an arbitrage play. It does, however, allow the market maker to take an unfair advantage of a mispricing and put the odds on his side that the trade will, in fact, be profitable. This is one of many trading situations known as a pseudo-arbitrage because it does not guarantee a profit, but is traded solely from a theoretical mispricing viewpoint; it is an arbitrage on theoretical odds.

What does a butterfly spread look like?

The profit and loss diagram for the above butterfly looks like this:

Notice how there is no loss area; the lowest this spread can go, in this example, is zero. This is because it was constructed with the bull and bear spread priced the same, so there was no cash outlay -- the market maker paid $2 for the bull spread and received $2 for the bear spread. Realistically, there may be a slight debit, especially after commissions, so it may actually look like this:

The point is that with a butterfly (assuming a very low debit or low commissions), you have very little loss area but a high profit area albeit over a small range of stock prices. In a lot of ways, it's like playing the lottery. The market makers are thinking they have little to lose but much to gain. The maximum profit will be achieved at the strike price of the short, in this case, $100.

If you use your imagination, the profit and loss diagram looks like the wings of a butterfly (I told you to use your imagination!) -- hence the name butterfly spread.

Iron butterfly

Another way to view the spread is that it's the combination of a short straddle and long strangle (please see our section on "Straddles and Strangles" for more information on these strategies). If a trader executes a short straddle and long strangle, it is a special variation of the butterfly known as an iron butterfly. The trader of an iron butterfly wants the stock to fall, so the above profit and loss diagram is actually a short iron butterfly or long butterfly. The short straddle is easy to see; it is the part that forms the upside down "V" in the diagram. The long strangle just provides protection from further losses if the stock falls below $95 or rises above $105. It is the long strangle that forms the protective "wings" to the left and right of the diagram. If a butterfly spread is constructed in this manner, there will be four commissions to open and four to close.

If you can ever execute a butterfly for a very low debit, you may want to consider it. If you can ever execute it for a credit, do not pass it up, as this would be an arbitrage situation -- you cannot lose!

Let's look at some real numbers and see why retail investors should think twice before entering a butterfly spread.

Example:

MSFT is currently trading for $68-3/4 with the following option quotes available:

Dec $65 call = $6-1/2 ask Dec $70 call = $3-3/8 bid Dec $75 call = $1-3/4 ask

Let's trade the $65/$70/$75 butterfly and see what happens:

Long 1 $65 = -$6-1/2 Short 2 $70 = +$6-3/4 Long 1 $75 = -$1-3/4 Net debit $1-1/2

Now, to make it more realistic, let's say you pay a commission of $100 for the three contracts, which may be a conservative number. Now you must add $100 to the cost. Remember that we are dealing with three different strikes, so there will be three separate commissions -- and that's just to buy it.

Now our net debit is $2-1/2 and the maximum we can make is $5. Here's our profit and loss diagram so far:

It already looks much different from the market maker's above. Notice just how much more "loss" area there is in this diagram.

Now, our break-even points are $67-1/2 and $72-1/2. If the stock closes below $67-1/2 or above $72-1/2, the trade will incur losses, and we haven't even considered the commissions to get out.

Already it's a pretty narrow range in order to be profitable -- a five-point range between break-even points. Let's assume the stock closes at exactly $70, which is the point of maximum gain. We make $250 but have to pay another $100 in commissions for a total of $150.

Now, it still may not seem like such a bad deal, after all, $150 bucks is $150 bucks. But this was assuming the stock closed at exactly $70. Just how much room do we have to work?

Taking the sell commissions into account, here's how the trade looks now:

The stock must close above $68-1/2 or below $71-1/2 in order to get anything. In order to get the full $150, we need the stock at exactly $70. If you can call the stock closing prices within this close of a range, you're probably better off selling naked calls, puts, or straddles.

The butterfly spread is an interesting combination strategy, which you will no doubt hear about as you continue with your options trading. Over the past seven years, I have seen many retail investors attempt butterfly spreads and did not see one -- not a single one -- make a dime.

If you decide to try one, you may want to check with your broker regarding commissions and break-even points.

My guess is that you will decide against it.

Condor Condor, albatross, pterodactyl spreads

Once again, the traders have given some creative names to another class of wingspreads -- strategies with profit and loss diagrams resembling wings. The condor, albatross and pterodactyl spreads are all similar to the butterfly spread (please see "Butterfly Spreads" for more information) except each of these strategies sells multiple strikes.

It should be noted that, like the butterfly, these spreads are really meant to be used as floor trader tools for hedging and taking advantage of small pricing discrepancies that periodically appear in the market. Because of the large number of strikes involved, the commissions usually make these losing strategies for retail investors.

This does not mean that you should not take the time to understand them. They will increase your knowledge of options and give insights into the versatility of options by showing how strategies can be stacked on one another.

Condor spread

The condor spread is a strategy involving four strikes and can be made up of calls, puts or a combination of both. The basic condor spreads are usually constructed with either calls or puts.

To execute a basic condor spread, a trader needs four strikes, which we will call S1, S2, S3 and S4 with each strike being successively higher and having the same expiration. The trader will be long S1, short S2, short S3, and long S4. For example, the trader may be long the $100 call, short the $105 call, short the $110 call and long the $115 call. Notice how each strike is successively higher. It is not necessary to have them separated by five points, though. You could construct one with a long $100 call, short $110 call, short $120 call and long $130 call -- as long as the strikes are evenly spaced. From a profit and loss standpoint, the condor spread looks like this:

The trader will maximize profit between the two short strikes, $105 and $110 in this example. For stock prices below $105 or above $110, the trader will start to lose profits and eventually end up negative if the stock falls below $101 (low break-even point) or rises above $114 (the high break-even point). Any stock price below $100 or above $115 produces the maximum loss of $1 -- the cost of the spread.

Notice how the condor is similar to a butterfly where the trader buys a low strike, sells two medium strikes, and buys one high strike. The condor is the same basic pattern except the trader is splitting the two medium strikes of the butterfly into two separate strikes. This action creates a wider profit area relative to the butterfly. The trader is hoping for a relatively stable stock price. The following chart shows a comparison between the condor and butterfly:

Notice how the butterfly (blue) has a higher profit but, in return, gets into loss territory quicker. The condor (red) has a lower, but wider, profit area and takes longer to head into losses. The markets realize the condor is therefore more desirable and will bid its price up.

Again, market makers are probably the biggest users of condors as they pay very little in commissions and can make it worth their while to pay four commissions to enter the condor and four to exit.

Why do market makers use them?

To understand them, we need a refresher on butterflies. If you read our section on butterfly spreads, you will recall that market makers are actually spreading spreads -- they buy the bull spread and sell the bear spread. For example a basic call butterfly has this pattern:

Strike 100 105 110 115 120 125 Call butterfly +1 -2 +1

In other words, the long butterfly trader is long the $100 call, short 2 $105 calls and long the $110 call. If the stock is at $105-1/2, the $100/$105 bull spread (long $100, short $105) should be more valuable than the $105/$110 bear spread (short $105 and long $110). If, for some reason, the markets are pricing them equally, market makers will buy the bull spread and sell the bear spread making them long the butterfly. For the same reasons traders buy spreads (buy one call and sell another), traders will spread spreads, which is a butterfly.

With condors, market makers are actually laddering butterfly spreads; that is, they buy one set of butterflies and buy a successively higher set of butterflies.

Strike 100 105 110 115 120 125 Call butterfly #1 +1 -2 +1 Call butterfly #2 +1 -2 +1 Net position +1 -1 -1 +1 = condor spread

A trader may see a theoretical discrepancy between the $100/$105 bull and $105/$110 bear spread and want to buy butterfly #1 above. In addition, there may be another discrepancy between the $105/$110 bull and $110/$115 bear, so they may desire to purchase that one as well. With one condor, all pricing discrepancies between the two butterflies are captured!

A short condor will be the mirror image of the long position and, consequently, have opposing profits and losses. Using the same example above, to execute a short condor, the trader will be short $100 call, long $105 call, long the $110 call, and short the $115 call. The short condor looks like this:

With the short condor, the trader will make maximum profit if the stock makes a large move in either direction. In this example, if the stock is below $109 or above $114, the break-even points, the trader will keep the initial $1 credit. If the stock is between $100 and $115, the position will start to lose profits, and eventually end up at a maximum loss of $4 if the stock is between $105 and $110 -- the strikes of the two long positions.

Albatross spread

The basic long albatross is a strategy utilizing four strikes just as the condor. However, the trader skips a strike in the middle. Using the earlier notation, a long condor trader will be long S1, short S2, short S3, long S4, but skip a strike between S2 and S3. For example, a trader who is long the $100 call, short $105, short $115, long $120 is long an albatross spread.

From a profit and loss standpoint, the long albatross looks like this:

It has a wider but lower profit zone relative to the condor. This reflects the relative risks of the two strategies. All else equal, traders would prefer to have wider ranges of profit so will bid this strategy higher relative to the condor. This can be seen if we overlay the two profit and loss diagrams:

The trader will profit for any stock price above $102 and below $118, the break-even points. Maximum profit will be realized for stock prices between $105 and $115. Similar to the condor trader, a long albatross position is betting on a fairly stable stock price; however, the albatross trader has more room for error.

As with the condor, the albatross is a continuation of the laddering of butterfly spreads. For example, the following chart shows the trader who is long an albatross spread is effectively long the $105, $110 and $115 butterflies.

Strike 100 105 110 115 120 125 Call butterfly #1 +1 -2 +1 Call butterfly #2 +1 -2 +1 Call butterfly #3 +1 -2 +1 Net position +1 -1 0 -1 +1 = albatross spread

The short albatross, of course, will be the opposite of the long position. Here, the trader is betting on a very large move, either up or down, in the underlying.

Pterodactyl spread

As you probably guessed, the pterodactyl spread is just a continuation of the albatross. It still involves four strike prices but, this time, two strikes are skipped in the middle. A trader who is long $100 call, short $105 call, short $120 call, and long $125 call is long a pterodactyl. The profit and loss diagram looks like this:

The albatross trader has an even lower, but wider, range of profits compared to the albatross. The trader, in this example, will be profitable for any stock price above $102 3/4 or below $117-1/4, the break-even points. Maximum profit will be realized for stock prices between $105 and $120.

As shown in the following chart, the pterodactyl spread is a laddering of four butterfly spreads:

Strike 100 105 110 115 120 125 Call butterfly #1 +1 -2 +1 Call butterfly #2 +1 -2 +1 Call butterfly #3 +1 -2 +1 Call butterfly #4 +1 -2 +1 Net position +1 -1 0 0 -1 +1 = pterodactyl spread

Notice in the following chart how each spread -- the condor, albatross, and pterodactyl -- reflects the relative risks of each position. The strategy with the highest profit potential will be the cheapest one to purchase. Sometimes new traders find this confusing and think the highest profit strategies should be the most expensive, as those are the ones everybody wants and will bid the price higher. This is incorrect, as the highest profit strategies are also the riskiest. In order to make them worth the risk, the market must reduce the price.

Think of it this way: if all spreads were priced equally, which would you prefer? Obviously, the pterodactyl as it has the widest area for profit. So traders will bid up the price of the pterodactyl relative to the others. The same process will occur for the albatross and the condor. No matter how sophisticated you become with option trading, you will never be able to avoid the risk-reward relationships.

Spreads are great trading tools and you should take the time to become familiar with these advanced combinations. In most cases, these are better suited for market makers but that doesn't mean they cannot be used at the retail level. If you plan to use one, be sure to evaluate your break-even points and maximum gains and losses taking commissions into account.

Option Exam 9 - Week 9

1) Assume you are looking at $50, $55 and $60 strike call options. How would you construct a butterfly spread?

a) Buy a $50, sell a $55, buy a $60

b) Buy a $50, buy 2 $55, sell a $60

c) Sell a $50, sell a $55, buy a $60

d) Buy a $50, sell 2 $55, buy a $60

2) The butterfly can be viewed as the combination of a(n):

a) Bull spread and condor spread

b) Bull spread and bear spread

c) Bear spread and condor spread

d) None of the above

3) The owner of an at-the-money butterfly spread (middle strike equal to the stock price) wants the underlying stock to:

a) Move sharply upward

b) Move slowly upward

c) Fall sharply

d) Sit still

4) A trader enters a $50/$55/$60 butterfly. The maximum value this spread can ever be worth is:

a) $5

b) $10

c) $60

d) None of the above

5) If you can ever enter a butterfly spread for a net credit you should:

a) Never do it as it is a sure loser

b) Always do it as you can never lose

c) Not enough information as butterfly spreads are always executed for credits

6) The butterfly spread is generally a great strategy for retail customers.

a) True

b) False

7) Compared to the butterfly spread, the condor is a higher risk, higher reward spread.

a) True

b) False

8) The owner of a calendar spread wants the spread to:

a) Narrow

b) Widen

c) Stay the same

9) The owner of a calendar spread wants the underlying stock to:

a) Stay the same

b) Rise

c) Fall

10) Which of the following is a calendar spread?

a) Buy the March $50 and sell the January $40

b) Buy the March $50 and sell the January $50

c) Buy the March $50 and sell the April $55

d) Buy the March $50 and buy the April $50

Week 10 : Advanced Strategies & Topics

Backspread

The backspread is similar to a ratio spread, except that it has unlimited profit instead of unlimited loss on the profit and loss diagram. It is the mirror image of the ratio spread. In fact, the backspread is often called a long ratio spread.

Call backspread

A call backspread involves the sale of a low strike price call and the purchase of a higher number of contracts at a higher price. For example, a trader may sell 10 $50 calls and buy 20 $60 calls, also known as a $50/$60 backspread.

The profit and loss diagram for a call backspread looks like this:

Assume the trader sells 10 $50 calls for $10 and buys 20 $60 calls for $3. This trade can be broken down to 10 (-1/2) spreads (please see our section on "Ratio Spreads" for more information). In other words, the trader sold one call and bought two calls, but did this ten times. For every call sold at $10, two were purchased at $3 for a total of $6. Therefore, the above trade was executed for a net credit of $4 (received $10 but paid $6). Depending upon prices and ratios used, backspreads may be entered for either debits or credits.

For any stock price below $50, the trader will keep the net credit of $4, as both calls will expire worthless. If the stock moves above $50, the trader will head into loss territory because he is short these calls. However, if the stock continues upward, the $60 calls will come to the rescue and stop the losses. The maximum loss will occur at $60 where the trader will lose ten points (the difference in strikes) less the credit of $4, for a maximum loss of $6. Because there are two $60 calls for every short $50, the trader will start to make gains above $60. In order to make up for the $6 loss, the stock must rise to $66 to reach break-even. The downside break-even can be found in two ways: One, the trader must make up the $6 loss from the low point of $60; Or, he can sustain a loss of $4 (the initial credit) above $50. Either way you choose, you will see the downside break-even is $54.

Notice that if the trader had purchased the 10 $50 calls and sold 20 $60 calls, he would have a ratio spread. Ratio spreads and backspreads are opposites. The following is a profit and loss diagram comparing the two spreads:

Why enter a call backspread?

If a trader is bullish on a stock yet fears a market turndown, then both sides of the market can be played with a backspread. The trader will capture all upside profits yet have a credit (or less of a loss if entered as a debit) if the stock should fall. Typically, novice traders will enter long straddles to play the upside and downside. However, with long straddles, the break-even points become very wide due to the fact that premiums are paid for both the call and put and must be made up. With the backspread, a trader can custom-tailor his bias in the stock and create better risk-reward ratios. The trader using a call backspread is more bullish, but fears a downturn. He will not profit as much as a long straddle trader, but does not have as much at risk either.

Backspreads are another great example of just how versatile options can be.

Put backspread

Backspreads can be used with put options too. To enter a put backspread, the trader will sell a high strike put and buy a higher number of a lower strike put. For example, a trader may sell 10 $60 puts and buy 20 $50 puts.

The profit and loss diagram for a put backspread looks like this:

Assume the trader sells the $60 puts for $10 and buys the $50 puts for $3. As above, this spread can be broken down into 10 (-1/2) spreads. This means that for every one put that was sold, two were purchased. The trader receives $10 from the sale of the $60, but pays $6 for the two $50 puts for a net credit of $4. If the stock should rise, the trader is left with a credit, as both puts will expire worthless. If the stock falls below $60, the trader heads into loss territory, as he is short these puts. If the stock continues to fall to $50, the losses stop and gains will start, as he is long two of the $50 puts for every one of the $60 puts that are short.

So for any stock price below $50, the trader starts to gain. At $50, the trader is down $10 (the difference in strikes), but received $4 from the initial trade for a net loss of $6. Because this $6 must be made up, the break-even will be $6 points below the $50 strike or $44. If the stock falls below $44, the trader will start to show profits. Where is the upside break-even? The trader will need to make up the $6 from the max loss point at $50 to the upside; equally, he can sustain a $4 loss (the initial credit) below $60. Either way of looking at it will yield an upside break-even of $56.

With puts, traders are betting more on the downside, but they fear the upside risk. A put backspread allows them to capture both possibilities while favoring the position to the downside.

Intel backspread example

Let's run through an actual example using Intel (INTC), which is currently trading around $41. The option quotes are as follows:

Dec $40 Call = Bid:$3-1/2 Ask: $3-3/4 Dec $45 Call = Bid:$1-3/8 Ask: $1-3/4

Assume a trader wants to place a $40/$45 backspread and sells the $40 call for $3-1/2 and buys 2 $45 calls for $1-3/4 each or $3-1/2 for a net debit of zero shown by:

Short 1 $40 call = -$3 1/2 long 2 $45 calls at $1 3/4 each = +$3 1/2 Net debit $0

Here is what the profit and loss diagram will look like for the above trade:

The trader will make nothing if the stock falls, and lose $5 if the stock closes at $45. If the stock is above $45, the trader will start to recover losses and eventually break even at $50. Any stock price above $50 will yield a profit. Note the break-even points of $40 and $50. If the stock closes between these two points, the trader ends up with a loss.

Remember we said the trade opposite the backspread is the ratio spread? Well, the floor trader who executes the above backspread will have the ratio spread (assuming the trades are not

matched with other orders or positions). The floor trader's profit and loss diagram looks like this:

Backspreads are great tools; especially for active traders. They generally require level 2 option approval (ratio spreads require level 3). Many traders shy away from ratio and backspreads because of the initial complexity in understanding them. However, with a little work, you can quickly find the maximum gain and loss points as well as the break-evens. They are a wonderful tool for option traders, so you should take the time to understand them if you want advance to a higher level of trading!

Box Spread There are many tools that market-makers use to hedge risks, either partially or fully. One of the most powerful tools is called a box spread. While this particular strategy is not widely used by retail investors, it is very useful in determining if your vertical spread is priced fairly.

Another important use of the box spread is for investors who place spread orders (please see our section on spreads if you are not familiar with these.) They often ask, "Do you think I can get filled at such-and-such a price?" If you understand the box spread, you will be able to immediately determine if there is any room for the market makers to work with your order.

If you are a user of spread orders, understanding box spreads will be a very helpful tool!

The box spread

A box spread is a relatively simple strategy. To enter into a long box position, all you need to do is buy the bull spread and buy the bear spread with the same strikes and all other factors the same (if you are unsure about bull and bear spreads, please see our section on "Basic Spreads.")

For example, say a stock is trading at $50. A trader could buy the Jan $50 call and sell the Jan $55 call (bull spread), and also buy the Jan $55 put and sell the Jan $50 put (bear spread.)

This trade will result in a debit for both spreads. What is interesting about this position is that it is now guaranteed to be worth $5 (the difference in strikes) at expiration (keep in mind this is a theoretical price, and in the real world of trading, the bid-ask spreads will probably make the value slightly less than $5 at expiration).

How? Think about this: No matter where the stock closes, either the $50 call or the $55 put will be in-the-money. Because these are the two long positions of the box spread, the trader who buys the box spread is guaranteed to have a position worth $5 at expiration.

Let's run through some examples if you are still not sure:

If the stock closes at $53, the long $50 call will be worth $3 and the long $55 put will be worth $2 for a total of $5. The short $55 call and short $50 put will expire worthless (if you are not sure why these prices must hold, please see our section under "Basic Option Pricing").

If the stock closes at $51, the $50 call will be worth $1, and the $55 put will be worth $4 for a total of $5. Again, the two short positions expire worthless.

What if the stock closes outside the ranges of $50 and $55?

If the stock closes at, say, $30, the $55 put will be worth $25 and both calls will expire worthless. However, the short $50 put now has value. In fact, it will be worth $20, which is an obligation because the trader is short. So the total value of the position is +$25 - $20 = $5.

You can't get around it. No matter where the stock closes, the position will be worth the difference in strikes, in this case, $5.

Question: Okay, here's one for you to try. What will be the value of the above box spread is the stock is trading for $100 at expiration? How would you show it? (Answers at the end.)

Pricing a box spread

Now that we know the mechanics of the box spread, how can we use it to help with our trading?

It is now October 31 and say you are interested in SCMR, which is currently $58-3/8, with the following quotes available for options:

BID ASK Dec $55 Call $12-7/8 $13-7/8 Dec $65 Call $8-7/8 $9-5/8

Dec $55 Put $8-3/4 $9-1/2 Dec $65 Put $14-3/4 $15-3/4

Let's say you are bullish on SCMR and want to place a $55/$65 bull spread:

Buy Dec $55 Calls = $13-7/8 Sell Dec $65 Calls = $ 8-7/8 Net debit $ 5

Is this being priced fairly? Is it likely we will get filled if we put a net debit of $4-3/4?

In order to answer these questions, let's look at the other side of the box spread:

Buy Dec $65 Puts = $15-3/4 Sell Dec $55 Puts = $ 8-3/4 Net debit $ 7

Now, you will pay $5 for the bull spread and $7 for the bear spread for a total debit of $12, which is guaranteed to fall to a value of $10 at expiration! So with the current bid/ask spreads, this box is not being priced fairly. In fact, this is most often the case and the primary reason the box spread is not a popular tool for retail investors.

Let's see what the market makers are trying to do. Remember, the bid represents what they are willing to pay, and the ask what they are willing to sell. So, from the market-makers perspective, here is how the box spread looks:

Buy Dec $55 Calls = $12-7/8 Sell Dec $65 Calls = $ 9-5/8 Net debit $ 3-1/4

Buy Dec $65 Puts = $14-3/4 Sell Dec $55 Puts = $ 9-1/2 Net debit $ 5-1/4

The market makers want to complete the box spread for a total of $8 1/2 points, which is guaranteed to grow to a value of $10.

On the surface, it appears to be a pretty good deal. Let's see just how good it is.

Remember, it is October 31 and we are looking at December options, which will expire in 45 days. That actually works out to be 17.6% simple interest, or a whopping 267% annualized rate of return -- which certainly beats the guaranteed rates on T-bills.

So to answer the second question: yes there is certainly a lot of room to work with on the bull spread.

Let's go a step further. Just how much room is there? One useful method is to start with what the spread "should" cost. If the spread is guaranteed, it should earn the risk-free rate (roughly 6%). So the value of $10 guaranteed in 45 days is about $9.93, which is roughly $1.17 above the $8-3/4 price the market makers are trying to pay.

In a case like this, it is very feasible to get 1/2 point or maybe more off of this spread.

Please remember, any limit order, no matter how close to the market, is not guaranteed to fill, so, if you really need to get into or out of a trade, use caution in applying this method. This pricing method is a great tool for analyzing the potential for all traders who like to use limit orders.

Uses of the box spread

Why would a market maker enter into a box spread? The box spread is effectively a way for market makers to borrow or lend money. If a market maker sells a box spread, they are effectively borrowing money. They receive a credit and must pay back the value of the box at expiration. Similarly, if they buy a box spread, they are loaning money. They will pay money but receive a guaranteed return at expiration.

Of course, the market makers will price the boxes in their favor and either buy it below or sell it above the theoretical fair value.

For example, say a $90/$100 box is priced at $9. If the $90/$100 put spread is priced at $4, the $90/$100 call spread should be worth $5. However, the market maker may bid $4-3/4 and ask $5-1/4 for the call spread. This way, regardless of whether he buys or sells the call spread, he is either borrowing at less than (or loaning for a higher rate of) current risk-free rates by completing the box. For instance, if he buys the call spread for $4-3/4, he will buy the put spread for $4 and thus pay only $8-3/4 for a box position worth $9, and effectively loan money for higher than the risk-free rate. Likewise, if he sells the bull spread for $5-1/4, he will sell the bear spread for $4 thereby completing the box for $9-1/4. Now the market maker has sold a box worth $9 for $9-1/4 and effectively borrowed money for less than the risk-free rate.

Other views of the box spread

We said earlier that a long box spread could be viewed as a long bull spread matched with a long bear spread. There are two other ways to view boxes, and depending on your situation, one or the other may be more helpful.

One way to see it as a conversion at one strike and a reversal at another. For example, if a trader is short stock at $50, long $50 calls and short the $50 puts, he has a reversal at $50. If he subsequently buys stock at $60 with long $60 puts and short $60 calls, he has a $60 conversion.

Notice that the long and short stock positions cancel out, leaving the trader with long $50 calls and short $50 puts (synthetic long position) with long $60 puts and short $60 calls (synthetic short position).

$50 reversal $60 conversion Short 1,000 shares at $50 Long 1,000 shares at $60 Long 10 $50 calls Long 10 $60 puts Short 10 $50 puts Short 10 $60 calls

The long and short stock positions cancel each other out (shown in red). The remaining positions are a synthetic long position (blue) at $50 and a synthetic short position (black) at $60. Notice the embedded bull and bear spreads (long $50 call and short $60 call, long $60 put and short $50 put).

Of course, a long position matched with a short position cancels each other. This holds true whether it's actual stock or synthetic versions. The trader who is synthetic long at $50 and synthetic short at $60 has effectively purchased stock at $50 and sold at $60. Bear in mind this is not as good as it seems, as the trader was also short stock at $50 and long at $60. The profits or losses come for the total reversal and conversion prices.

If you trade spreads, take the time to really understand box positions, as it will make all the difference in the world in your understanding of spread pricing. Once you have a handle on that, you will be able to make more knowledgeable decisions as to which limits to use with your orders.

Answers: What will be the value of the above box spread if the stock is trading for $100 at expiration? How would you show it?

The question was referring to the $50/$55 box spread. The value of the box spread must be worth $5 -- the difference in strikes -- at expiration. To prove it, if the stock is trading at $100, the long $50 call will be worth $50 and the short $55 call (which is an obligation) will be worth $45. Both puts, the $50 and $55, will expire worthless because they are out-of-the-money. So the total value to the trader will be +$50 - $45 = $5

Option Exam 10 - Week 10

1) Call backspreads exhibit unlimited profit potential for the holder.

a) True

b) False

2) Call backspreads have unlimited downside risk if the stock falls.

a) True

b) False

3) Which of the following is a call backspread?

a) Sell $50 call, buy 2 $55 calls

b) Sell $50 call, sell $55 call

c) Buy $50 call, sell 2 $55 calls

d) Buy $50 call, sell $55 call

4) Put backspreads have unlimited risk if the stock rises.

a) True

b) False

5) A call ratio spread has unlimited risk if the stock rises.

a) True

b) False

6) A put ratio spread has unlimited risk if the stock rises.

a) True

b) False

7) Consider these two ratio spreads: (1) Buy $50 call and sell 2 $55 calls (2) Buy $50 call, sell 3 $55 calls

a) The first ratio spread is riskier than the second

b) The second ratio spread is riskier than the first

c) Both are equally risky

d) Neither have any risk

8) A trader places a ratio-spread order to buy 10 $50 calls and sell 20 $55 calls as a limit order. Can the market maker fill the order as buy 8 $50 calls and sell 14 $55 calls?

a) Yes

b) No

9) Box spreads are a way for market makers to borrow and lend money.

a) True

b) False

10) Box spreads can be used by retail investors to see if vertical spreads are priced fairly.

a) True

b) False

Week 11 : Advanced Strategies & Topics

Synthetic Options The name sure sounds intimidating, but synthetic options are fairly easy to understand and are truly a fascinating and useful part of options trading. Understanding synthetic positions will allow you to effectively do things many traders will tell you cannot be done, such as shorting stock on a downtick (or even when no stock is available), buying calls or selling naked puts in an IRA, buying stock for virtually no money, and a host of other imaginative strategies. Further, understanding synthetics will give you great insights into option pricing. You will understand how options are created, and why the market makers are quoting the puts and calls the way they are.

In order to understand these mysterious sounding options, you need to understand one of the most fundamental concepts of option pricing known as put-call parity.

Put-call parity

Put-call parity is a relationship showing that call and put prices are very dependent on one another, and not just arbitrarily chosen. In order to understand the put-call parity equation better, it's best to show how orders are filled on the floor of the exchange. Here's an example of how it works:

Say you want to buy 10 calls to open of the ABC $50 strike (with 1 year to expiration) at market. ABC stock is also trading at $50.

When this buy order is received on the floor, the market maker must become the seller so that the transaction can be completed. This means the market maker must be willing to be short a call. Now, while you may be totally comfortable in speculating by buying 10 calls, the market maker may not be so eager to be on the short side. The reason is this: Market makers are in the business to take 1/8th's or 1/4th's of a point on a large number of trades; they are not really too interested in holding open speculative positions over long periods of time -- especially short calls that have unlimited upside risk!

How does the market maker create a short call?

If the market maker is to be short a one-year call, his risk will be that the stock goes higher. So, in order to protect himself from this risk, he will purchase 1,000 shares. No matter how high the stock moves, he will always be able to deliver 1,000 shares of stock (represented by the 10 calls) at expiration.

However, now there is a new risk; the stock may fall. So to protect himself from this, he will buy a $50 put with one year to expiration.

Now our market maker is now long 1,000 shares of stock, long 10 $50 put options and short 10 $50 call options. Because he is short 10 calls, he can now fill your order to be long 10 calls. But what price should he charge?

Here is what's interesting about this position: The market maker is now fully hedged (protected) against any stock price movement at expiration. This means he cannot lose on the position! How? Well, the stock price can do one of three things between now and expiration of the call:It can stay the same, go up or go down. If the stock stays exactly at $50, the call and put expire worthless and the market maker's position is worth exactly $50,000, which is the amount he originally paid for the stock. If the stock closes above $50, the long put will expire worthless and the market maker will get assigned on the short call and lose the stock; however, he will be

paid the $50 strike and receive exactly $50,000. Likewise, if the stock closes below $50 at expiration, the short call will expire worthless and the market maker will exercise his put and receive $50,000.

With the long stock at $50, long $50 put and short $50 call, the market maker is now guaranteed to receive $50,000 in one year. It is kind of ironic by using these speculative derivatives of puts and calls we can actually create a risk-free portfolio!

Now, if any financial asset is guaranteed to be worth a certain amount in the future, then its value today must be worth the present value discounted at the risk-free rate of interest.

PRESENT VALUE/FUTURE VALUE are "time value of money" concepts used throughout the financial industry to describe the value of assets at different points in time. The concept of time value says that a dollar today is worth more than a dollar tomorrow because the dollar today can be invested and earn interest. For example, if you deposit $100 into an account that pays 5% interest, you will have $100 (1+5%) = $105 in the future. So the future value of $100 today is $105 if interest rates are 5%.

Similarly, if someone owes you $105 one year from now and interest rates are 5%, then you should be willing to accept $105/(1+5%) = $100 today. In other words, it should make no difference to you by waiting one year and receiving $105 or collecting $100 today. The reason is that you can take the $100 today, invest it at 5% for one year, and still have your $105 a year from now. So the present value of $105 one year from now is $100 (if rates are 5%). To calculate the present value, we simply take the future value of the asset and divide it by 1 + risk-free interest rate.

The market maker is guaranteed to receive $50,000 in one year regardless of the stock price. So the present value of $50,000 in one year is $50,000 / (1.05) = $47,619 today. The market maker should pay $47,619 today for these three assets -- the stock, long put and short call positions. Why? If he pays $47,619 and receives $50,000 in one year, his return on investment will be 5%, which is exactly the interest rate he should receive for a risk-free investment.

The market maker will spend $50,000 for the 1,000 shares of stock trading at $50. Let's also assume he pays $5 for the put. Now he will spend an additional $5,000 for the put for a total cash outlay of $55,000. We already figured that the fair price for this package of three assets should be worth $47,619 yet he's paying $55,000 for it.

The market maker has overpaid by $55,000 - $47,619 = $7,381, so he will need to bring in a credit for this amount. How can the market maker receive a credit of $7,381? Easy -- he will fill your order on the 10 $50 calls for roughly $7-3/8. Doing so, he will receive the necessary credit to make his -$55,000 cash outlay equal to -$47,619. Of course, the market maker will try to make an 1/8 or 1/4 point profit, so the order would probably be filled around $7-1/2.

To summarize, the market maker's initial position looks like this:

Buy 1000 shares at $50 = -$50,000 Buy 10 $50 puts at $5 = -$5,000 Sells 10 $50 calls at $7 3/8 = +$7,375 Equals -$47,625 cash outlay by market maker.

This is guaranteed to grow to a value of $50,000 in one year ($47,625 * 1.05 = $50,000) because of the full hedge provided by the 3-sided position.

This three-sided position (long stock + long put + short call) established by the market maker is called a conversion. If he does the reverse (i.e. short stock + short puts + long calls) then it is called a reversal or reverse conversion.

The put-call parity equation

We have shown that the market maker's three-sided position (conversion) is guaranteed to be worth the present value of the exercise price. Remember, he was short $50 calls and long $50 puts; the stock must either be above or below this price at expiration, resulting in a cash inflow of $50 -- the exercise price. Because he's guaranteed this strike price, the long stock + long put + short call position must be worth the present value of the exercise price. We can rewrite this using S for stock price, P for put price, C for call price, and E for exercise price as follows:

S + P - C = Present Value E

And therein lies the magic of synthetic options!

Notice the notation with the plus and minus signs. The long put position is denoted by a "+" sign and the short call is denoted by "-". This will be important to remember later.

To make things a little easier to understand, we know the present value of E (the right side of the equation) is guaranteed to grow to E so it behaves like a risk-free investment -- a T-bill (or Treasury bill, treasury note or treasury bond). We can therefore rewrite the above equation as:

S + P - C = T-bill

With some very basic algebra, we can create many interesting positions. We will take it slow with lots of examples, so hang in there!

This equation is known as put-call parity. If you know the value of a call option, you can immediately figure out the value of the put.

One small adjustment

Before we can continue with some examples, there is one note we need to make with an example. Let's say we are interested in seeing what a long stock + long put position are equal to. Using the equation, S + P - C = T-bill, how can we get the S + P (the pieces we are interested in) by themselves? Algebraically, we need to get the C to the other side of the equal sign; we need to add C to both sides. Now we have S + P = C + T-bill.

What does this mean? It means that someone holding long stock and a long put in a portfolio (the left side of the equation) will have exactly the same portfolio balance at option expiration as another person holding a call plus a T-bill (the right side of the equation).

Let's see if it holds true:

Assume we are interested in 1-year options and interest rates are 5%:

Investor A holds stock at $50 and a $50 put (left side of the equation)

Investor B holds a $50 call and a T-bill (right side of equation)

Investor B will pay $50,000/(1.05) = $47,619 for the T-bill.

At expiration:

Portfolio A Portfolio B

Stock price Stock $50 put Total

Value At Expiration

T-bill $50 Call Total

Value At Expiration

35 35 15 50 50 0 50 40 40 10 50 50 0 50 45 45 5 50 50 0 50 50 50 0 50 50 0 50 55 55 0 55 50 5 55 60 60 0 60 50 10 60 65 65 0 65 50 15 65 70 70 0 70 50 20 70 75 75 0 75 50 25 75 80 80 0 80 50 30 80 85 85 0 85 50 35 85

Regardless of where the stock closes, investor A will be worth exactly the same as investor B; there are no differences in the two portfolios. Why does this happen? Portfolio A can never fall below $50 -- the strike of the put. However, if the stock rises, investor A will participate fully. Portfolio B must grow to a value of $50 because that is the T-bill portion and is guaranteed. Portfolio B, like A, can never have a value below $50. If the stock rises, investor B's call will start to increase in value by the same amount as the increase in stock in A's portfolio so both A and B receive all of the upside potential in the stock.

Portfolio B is said to be the synthetic equivalent of portfolio A. Also A can be said to be the synthetic equivalent of B.

So, a synthetic equivalent -- or synthetic -- is any position that has exactly the same profit and loss, at expiration, as another position using different instruments.

Now here's the one small adjustment I was referring to at the beginning of this section. By definition, synthetic positions only track the changes in portfolios and not the total value. For example, in the above example with investor A and B, the total value of B's portfolio is the same as A's. To have the synthetic equivalent, we only need to look at the changes. If B just held the $50 call option and not the T-bill, he would exactly reflect the changes in A's portfolio.

For example, if A buys the stock for $50 and it falls to $40, A can exercise the put and receive $50 -- so A starts with a value of $50 and ends with $50 and therefore has no change. Portfolio B would also reflect no change as well. The $50 call will expire with a value of zero. If the stock is trading at $60 at expiration, portfolio A will be worth $60, from $50, reflecting a change of $10. Portfolio B will also change by $10, as the $50 call will now be worth $10.

The whole point of all this is that, with the original equation S + P - C = T-bill, we can ignore the T-bill on the right hand side; it accounts for total value and not the changes in portfolio value.

Now our equation is even easier! All you need to know is:

S + P - C = ?

And you can figure out any synthetic position!

Synthetic positions

Now that you have the necessary equation, let's work through lots of examples to get the hang of synthetic options.

For starters, remember that we said the above is equal to a T-bill? Well, if you are long stock + long put + short call you are said to be holding a synthetic T-bill; the positions will behave exactly the same at expiration.

Synthetic long call Using the equation, S + P - C = ?, we are in a position to find out. We are trying to find out the synthetic value of a long call, so we need to get a +C (remember, we are using "+" to denote a long position) on one side of the equation. If we add C to both sides and we get: S + P = C, and there's the answer; long stock and long put (left side of the equation) will behave just like a long call (right side). Therefore, if you hold long stock and a long put, you have a synthetic call position.

Let's check the profit and loss diagrams to see if we're correct:

We can easily see there is no difference between long stock + long $50 put purchased at $5 (left chart) and long $50 call purchased at $5. The person holding the long stock and long put raised the cost basis of their stock from $50 to $55, that's why their break-even point is now $55. However, they still participate in all of the upside movement of the stock. What if the stock falls? The investor is protected for all prices below $50, which is the strike of the put. The worst that can happen is for the stock to fall to zero. This investor will exercise the put and receive $50 effectively only losing on the $5 they paid for the put; therefore the maximum loss is $5.

For the call holder (right chart), they paid $5 so their maximum loss is also $5 but they too participate in all of the upside of the stock. The stock will have to be $55 at expiration in order for the call holder to break even.

It should now be apparent that call owners get downside protection as well as a put holders; the call keeps you from losing value in the stock because you are not holding the stock!

So how do you own calls in an IRA? Now you should know. Use the synthetic equivalent and buy the stock and put. Your return on investment will be much lower than the person who buys the call because of the difference in capital required to purchase the stock, but the two positions will behave the same way at expiration.

Synthetic long stock Without looking ahead, see if you can use the equation S + P - C = ? and solve it for long stock.

Because we have +S on the left side already, let's move the C and P to the other side. To do this we need to add C and subtract P from both sides. If you did it correctly you should find that S = C - P. Now you know that a trader holding a long call and short put (right side of equation) are actually holding synthetic stock (left side).

Looking at the profit and loss diagrams for each:

We see there is no difference in the two positions. The long stock purchased at $50 (left chart) will gain and lose point-for-point to the upside as well as the downside. The same holds true for the long $50 call and short $50 put (right chart). The $50 call will gain point-for-point at expiration while the short put will become a liability (loss) point-for-point if the stock should fall.

So synthetic stock is long call plus a short put. What would synthetic short stock be? Just the opposite, long put and short calls. This is great to know for all traders involved in short selling. Now you know how it is possible to short stock without an uptick or when stock is not even available for shorting -- use synthetics and buy the put and sell the call.

How much will it cost to short synthetic stock? Theoretically you should receive a credit. This can be shown by the original equation S + P - C = Present value of E. If we rearrange so that C - P = S - Present value E we see that, if S and E are equal (in other words, at-the-money), then S - Present value E must be a positive number. In order for C - P to be positive, C must be more expensive than P. Because you are buying puts and shorting calls, you should get a slight credit. Realistically though, because of bid-ask spreads and commissions, it will probably cost you a slight debit.

Synthetic covered call Hopefully you are getting the hang of this, but we'll do one more to be sure. What is a synthetic covered call? We know a covered call is long stock plus a short call, so it would be represented

by S - C in our equation. Looking at the equation S + P - C = ?, we need to get S and -C on one side. In order to do that, we can just subtract P from both sides and get S - C = -P. A covered call position is synthetically equivalent to a short put.

As expected, the profit and loss diagrams are the same. For the covered call position (left chart), the investor buys stock at $50 and sells a $50 call for $5, effectively giving the stock a cost basis of $45, which is the break-even point. If the stock rallies, the investor will be forced to sell it for $50 regardless of how high the stock moves. The short put (right chart) is at risk for all stock prices below $50, which is offset by the $5 premium received, which gives a break-even point of $45.

How can an investor sell puts in an IRA? Using synthetics, one can buy stock and sell calls, which is exactly the same thing from a profit and loss standpoint.

It is a little ironic that most brokerage firms require level 3 option approval to short puts yet require only level 0 to enter covered call positions. Synthetically, they are exactly the same thing. If you wouldn't short a put on a particular stock, you shouldn't enter into the covered call either.

Incidentally, if you do enter a into a covered call position, you should see the benefit of entering the order as a buy-write (please see our section under "Buy-writes" for more information). Doing so gives the market maker two of the three sides necessary to complete a reversal. This gives

the market maker a guaranteed trade so they are very eager to get them filled. Most of the time, you will receive a better fill than the natural at the time the trade is placed.

Practicing with synthetics

It is a good idea to practice with the synthetic relationships of any trade you are thinking of entering. Doing so will help you understand synthetics as well as give you additional insights into the way the trade will behave at expiration.

As a guide, remember that there are three pieces to the puzzle: Stock, calls and puts. The synthetic of any one of the pieces will always be some combination, either long or short, of the remaining two. For example, a synthetic call will be some combination of stock and puts. Synthetic stock will be a combination of calls and puts.

Once you become proficient with synthetics, you will certainly become a better options trader!

Synthetic Short If you read the section on synthetics, you should have a handle on how they work. Now we'll show you how powerful they can be.

Shorting stock

Before we talk about synthetic short stock, let's go through the basic short sale.

A popular strategy among bearish investors is shorting stock. When you short stock, you are selling it first and then buying it back later at hopefully a lower price. Short sellers are attempting to sell high and buy low -- just in the reverse order of bullish investors.

In order to sell stock you don't own, you must borrow it from another investor. While this may sound complicated, it is a seamless transaction and usually takes a matter of seconds to execute.

Notice how the short stock position is exactly opposite the long position:

This means the investor who is short stock has unlimited upside liability. As the stock moves higher, the short position increases its losses.

Uptick

There is one catch with selling stock short; the sale must be done on an uptick or a zero-plus tick. What is an uptick? Say a stock is quoted bid $25 and offered at $25-1/2 with the last trade at $25. If the next trade is higher than the last trade of $25, that new trade is an uptick. If the trade is lower, it is a downtick.

When you look at the last trade of a stock, you will usually see a "+" or "-" sign to the side (or on some systems, an up or down arrow). The "+" indicates and uptick and the "-" a downtick. Using the above example, if the next trade is $25-1/4, you will see the last trade reported as +$25-1/4. If the following trade is back to $25, you will see -$25.

If the next trade is $25-1/4, again, you will see +$25. What if the following trade is also $25- 1/4? That is called a zero-plus tick indicating that the last change was an uptick but the recent prices are unchanged.

The uptick rule was created to prevent investors from selling into a sharp downtrend, thereby nearly guaranteeing a profit. The rule is of little significance to the investor other than it must be met. There is nothing the trader needs to do other than place the order -- either it will fill or it won't.

Because of the uptick rule, it is possible for a short sale to not execute even if it is a market order!

We've seen there are two main obstacles to overcome when shorting stock: shares must be located to be borrowed and the sale must occur on an uptick.

Locating shares

Although it is fairly uncommon, it is possible for shares to not be available for shorting. Around April of 1999, there was a four-month period where Amazon.com (AMZN) was starting to fall after being on a record climb to the upside (shown in red circle below). Prior to that, investors saw it fall from nearly $100 to just above $40 (blue circle). So once it started falling again in late April, investors were eager to sell it short hoping it would fall back to $40.

But many investors were unable to capitalize on the situation, as there was a two-week period or so where no shares were available to short!

Most investors would let the situation pass as an unfortunate market technicality, and miss out on a potentially terrific trading opportunity.

But if these same investors understood synthetic options, they would have participated fully on the short side. Better yet, they would avoid the uptick rule.

Synthetic short stock

If you read our section on synthetics, you will recall the equation for synthetic options is Stock + Put - Call = ? Because we want to find out the synthetic equivalent of short stock, we need to get short stock (minus stock) by itself in the equation. If we subtract stock from both sides, we get Put - Call = - Stock and there's the answer: Long put + short call = short stock.

Basically what investors are doing with synthetic short sales is buying puts, and that gives them the right to sell the stock so, will appreciate as the stock falls -- just like a short stock position. However, puts can be very expensive especially under the conditions in the chart above. So in order to pay for the puts, investors will sell calls and use the proceeds to buy the puts. If the stock is trading for $100, the trader should theoretically receive a credit from the trade. But due to bid-ask spread and commissions, the synthetic short sale will usually result in a slight debit.

From a profit and loss standpoint, the synthetic short position looks like this:

We can see that is looks exactly like our short stock position shown earlier; at expiration, the investor gains point-for-point if the stock falls, and loses point-for-point if it rises. The synthetic position, at expiration, is behaving exactly like short stock.

It is important to remember that options do not behave like stock until expiration unless they are very deep-in-the-money. So if a trader executes a synthetic short at a strike of $100, the profit and loss diagram will not have the above shape until expiration. If a trader wishes to have the options behave more like stock, he should consider buying an in-the-money put and selling and in-the-money call.

What's great about the synthetic short is that it does not need an uptick to execute. You simply place your order to buy the put and sell the call. Of course, it is usually suggested these two trades be placed simultaneously to prevent execution or risk -- the risk of an unfavorable market move while you are executing two separate orders.

Bear in mind that the short call position is naked. This means you will generally need level-3 option approval and, in addition, will have an option requirement in order to hold the naked call position. Be sure to check with your broker if you are unsure as to how that works. The requirement is not a huge offset for the synthetic position compared to short stock; the short stock position will be charged with a 50% Reg T requirement, which is not applicable to the synthetic.

Bullet strategy

There is an interesting strategy known as a "bullet" where investors can actually intensify the fall of a stock and increase the odds that they will make money. Here's how it works, Say a stock is in a rapid decline. You'd like to short it, but you're concerned there may not be an uptick. However, if you buy a put, the market maker will be forced to short the stock and buy a call to create the long put position for you. Market makers are not subject to the uptick rule; they can just hit the bid and execute a short sale.

One strategy is to buy deep-in-the-money puts, which force market makers to hedge nearly dollar-for-dollar and short an equal number of shares. For example, say a stock is trading for $100 and falling sharply. If you buy a deep-in-the-money put such as a $130 (or wherever delta is near 1), the market maker will sell nearly 100 shares for each put, thereby putting more downward pressure on the underlying. Because you hold a deep-in-the-money put, it will appreciate nearly dollar-for-dollar with each point fall in the underlying.

To exacerbate the fall further, you can enter the deep-in-the-money synthetic short position by selling the calls, too. Now the market maker will be forced to short the stock again nearly point-for-point. So if you buy 10 puts and sell 10 calls (both deep-in-the-money), the market maker will be forced to short nearly 2,000 shares without an uptick.

Semifutures

There is a related strategy that has a little less risk called a semifuture. The strategy can be used as a long or short position. If you want a synthetic short position with a little less risk, you can split the strike prices, such as buy the $50 put and sell the $55 call. The more distance you put between the strikes the less upside risk there is. From a profit and loss standpoint, the short semifuture position looks like this:

You can see that the flat area between $50 and $55 creates less risk to the upside. In other words, with synthetic stock at $50, the trader is exposed to losses for any stock price above $50. With the semifuture, the trader is not exposed to losses until the stock is above $55.

The semifuture strategy can be split further. For example, the trader may buy the $45 put and sell the $55 call. Now there will be less risk to the upside, but also less profit to the downside as shown in the following chart:

Market downturns can be fast and furious, which is what attracts speculators to short sales. Many investors recognize potential situations, but are unable to capitalize on them due to market restrictions. If you understand synthetics, you can overcome many restrictions and profit from your outlook on the market.

Systematic Writing The strategy called "systematic put writing" or sometimes just "systematic writing" is a hedged variation of naked, or uncovered, put writing. This strategy will be appealing to investors ranging from conservative to speculative. If you like writing naked puts, this strategy will be of great interest to you. If you think you would never attempt it, you may change your mind!

Before we start, we should clarify some misconceptions about naked put writing. When you sell a put, you are effectively acting as an insurance company by entering into an agreement to potentially buy stock at a fixed price over a given amount of time. For this protection, the buyer will pay you a premium. It's a mutually beneficial relationship; you are willing to insure their stock and they are willing to pay for the peace of mind.

Many investors shy away from naked puts because of the large downside risk, to a stock price of zero, if the stock should fall. But these same investors are usually willing to buy stock and hold it. Let's see what the real risk is.

Example:

Say we have two investors, A and B. A only buys stock and B only sells naked puts. In the eyes of many investors, A is conservative, and B is a loose cannon that speculates with options.

A and B each have $50,000 in their accounts.

XYZ stock is selling for $50 per share. A buys 1,000 shares but B sells 10 $50 puts, with 3 months of time, for $8. Investor A now has $50,000 worth of stock and no cash while B has $58,000 cash ($50,000 cash + $8,000 from sale of put) and no stock. What happens at expiration?

If the stock is down, say $30, A's account will be worth $30,000 but B's will be worth $38,000. Why? Because B started with $58,000 but is forced to buy stock 3 months later for $50,000 due to the option assignment. He will pay $50,000 but receive stock worth $30,000. His transactions are:

Portfolio value at start: +$58,000 Pays for option assignment: -$50,000 Receives stock: +$30,000 Net account value: +$38,000

In fact, B's total account value will always dominate A's for all stock prices at $58 ($50 strike price plus $8 premium for the put) or below. Any stock price above $58 at expiration, B's account will be worth $58,000 and no more. From a profit and loss standpoint, the two accounts look like this at expiration:

Investor B's account dominates A's for all prices below $58. His tradeoff for this privilege is that he does not participate in any upside potential of the stock if it moves above $50. Investor B is giving up upside potential in exchange for a downside hedge. In addition, B has deferred his payment for buying the stock by three months in exchange for the premium. So, B actually appears conservative compared to A, the long stock position!

If you read our sections on "Profit and Loss Diagrams" and "Synthetic Options," you will understand that a naked put is really nothing more than a covered call in disguise. They are synthetic equivalents.

So, the point of all this is to understand that naked put writing really isn't as speculative or dangerous as some would think. This is assuming you are writing puts on stock you would buy regardless, not because the premiums are high!

Hopefully you are now not as reluctant to write naked puts. If so, continue reading about how systematic writing may benefit you.

The systematic writing strategy

This strategy is appealing in a number of ways. It allows investors to sell naked puts but adds a couple of new dimensions. First, it allows the investor to dollar cost average into the stock. Second, it allows for the sale of a covered straddle thereby giving the investor one more additional option premium to further reduce the downside risk.

The systematic writing recipe:

Step 1:Start by writing puts on half the amount of shares in which you are willing to buy (for example, if you are willing to buy 1,000 shares, write 5 puts).

Note: Repeat step 1 until you are assigned. Again, it is very important to use this strategy only for stocks you would be willing to buy at the strike price regardless.

Step 2:Once you are assigned in step 1, write covered straddles (sell a call and sell a put). In this example, the investor will write 5 calls and 5 puts. The position is considered covered, because the investor can always deliver the shares if assigned on the short calls.

Step 3:If the investor gets assigned from the calls in step 2, start with step 1 again. If assigned on the puts again, write covered calls against the entire position.

Example:

Let's use our two investors above, A and B, and see how they would fare using naked puts versus systematic writing.

Investor A is now convinced that naked put writing may not be so bad. He likes the stock and would be willing to buy 1,000 shares so he sells 10 $50 puts for $8. The time to expiration is a matter of preference, but all else equal, investors are usually better selling shorter-term options.

Step 1 for systematic writing

Investor B uses the systematic strategy. He will write puts on one-half of the position, to represent the 500 shares he's willing to purchase. So he writes only 5 of the contracts for $8.

At expiration, the stock is trading for $35. While A is at least hedged by the amount of the original premium, he's not willing to buy any more stock because he is now long 1,000 shares -- his original limit -- from the assignment. His cost basis is $42 per share ($50 for the stock less $8 for put premium). He must sit and be patient for the stock to rally. While it is possible for A to write calls at this point, if the stock is down far enough, this strategy may not be sufficient, as there may be no premium in a $45 strike that would be necessary to bring him to a profit if called away.

Step 2 for systematic writing

Because B is using the systematic principle, he bought only 500 shares from the put assignment. Now he enters the second step of the strategy: writing covered straddles. Investor B will now write 5 $35 puts (assume they are $5) and 5 $35 calls (assume they are $6).

Investor B will bring in an additional $2,500 for the puts and $3,000 for the calls.

At this point, two only two things can happen for the stock: It will either be above or below $35 at expiration. If the stock is above $35 (the strike price) at expiration, B will have his shares called away due to the short call option. But that's okay, as we will see shortly that his average cost is only $33, and he will make 2 points profit. But, let's assume the stock is down again to $30. Investor B will buy his second lot of 500 shares at a price of $35, the strike of the short put.

Investor A's cost basis is $50 for the stock, less $8 for the put, for a total of $42. Investor B's cost basis is effectively $42-1/2 for the purchase of stock alone (500 shares at $50 and 500 shares at $35). But in addition, B took in $4,000 for the original put sale, and $5,500 for the covered straddle (500 * $5 for the puts and 500 * $6 for the calls). The total proceeds from the options is $9,500, for a total cost basis of $33,000 or $33 per share for investor B.

Now, investor A has a cost basis of $42, and B has one of $33 with the stock trading at $30.

Notice the large difference in cost basis between the two investors. The majority of the difference in costs is due to B being able to average into the stock. He bought 500 shares at $50 and 500 at $35 with 3 option premiums along the way to boot.

Step 3 for systematic writing

The third step for the systematic writing would require B to write 10 calls (covered call position) against his 1,000 shares. The market is at $30 and his average cost is $33. Say he can sell 10 $30 calls trading at $5 to bring his cost basis to $28 per share. If he gets assigned, he will sell 1,000 shares at $30. If not, he will continue to write calls against the entire position until called out. At that point, he will look to start with step 1 again in the strategy.

Notice too that, although a two-point profit may not seem like such a big deal, the stock has fallen 34% from $50 to $33. There is not much an investor who paid $50 for the stock can do at this point. But our systematic writer is able to potentially capture a two-point profit despite the fall.

Using the strategy

This is an outstanding strategy for naked put writers; especially for stocks you expect to be volatile. The average cost basis on your stock will be greatly reduced if you are assigned on the short put written at the time of the covered straddle.

The strategy is very versatile. Investor B, in the above example, could have written calls and puts with different strike prices (called a strangle or combo) for step 2 instead of the covered straddle. Investors can select different time frames or strikes to meet their needs. You can even mix and match some of the steps. For example, if you are very bullish on the stock, you may elect to enter step 2 initially. This way you own half the shares you are willing to purchase and have a short put to provide a small hedge. Now, if the stock runs to the upside, at least you have some shares to fully participate in the rally unlike the investor who starts with step 1 and only writes puts on half the position.

Again, it should be emphasized that naked put writing can actually be viewed as a conservative strategy if you are writing puts on stock you would be willing to buy at the strike price regardless. If, however, you are writing puts on stocks solely for a high premium that is present and would rather not own the stock, be aware that this is an extremely speculative position and you should invest accordingly.

Hopefully this strategy adds some interesting insights as to how valuable options can be for conservative and speculative investors alike.

Jelly Rolls Breakfast menu? No, it's an actual options strategy. There doesn't appear to be any particular reason for the name, although rumor has it that market makers on the floor of the Chicago Board Options Exchange (CBOE) created it.

Jelly rolls are primarily used by market makers, but are a great tool for retail investors to evaluate the fair price between calendar spreads in the same way that box spreads can be used to evaluate vertical spreads.

While you may never enter a jelly roll, they are crucial to understand if you are placing calendar spreads -- spreads where you buy and sell calls or puts of the same strike, but at different expiration months.

Jelly rolls

There are many ways to view and understand the jelly roll strategy, but it is probably easiest to view from the market makers perspective. If you read our section on synthetics, you will recall that market makers like to enter conversions and reversals -- three sided positions -- involving stock, calls and puts.

Conversions (long stock, long puts and short calls) and reversals (short stock, short puts and long calls) are ways for market makers to lock in profits, so they are always looking for orders that allow them to create these positions.

Say a market maker has the following reversal for January expiration:

Short 1,000 shares at $50 Long 10 $50 calls Short 10 $50 puts

And also has the following conversion for March expiration:

Long 1,000 shares at $50 Long 10 $50 puts Short 10 $50 calls

This is a jelly roll -- a conversion in one month and a reversal in another.

Notice the market maker is short 1,000 shares in the reversal and long 1,000 shares in the conversion -- a net zero position. This leaves him with long calls and short puts (synthetic long position) in January, and long puts and short calls (synthetic short position) in March as follows:

January reversal March conversion Short 1,000 shares at $50 Long 1,000 shares at $50

Long 10 $50 calls Long 10 $50 puts Short 10 $50 puts Short 10 $50 calls

The long and short stock positions cancel each other (shown in red). The remaining positions are a synthetic long position (blue) in January and a synthetic short position (black) in March.

One way to interpret the January synthetic is that the market maker will buy stock for $50 at expiration. How? If the stock is above $50, he can exercise the call and pay $50; if it's below $50, he will be assigned on the puts and be forced to buy stock at $50. Similarly in March he must sell stock for $50. If the stock is above $50, he will be assigned on the short calls and be forced to sell stock at $50; if the stock is below $50, will exercise the $50 puts and receive that amount for the sale.

The market maker is therefore left with a position that forces him to buy stock for $50 in January and sell it for $50 in March. What is the cost? It should be evident that the market maker is not losing any principal as he's buying and selling at $50; however, he is missing out on the interest he could have earned during the three months had he not been forced to purchase the stock in January. Assuming the risk-free rate of interest is 6% and exactly three months to expiration, the cost is $50 * 3/12 months * 6% = $3/4.

Therefore, the difference in cost between the synthetic long position in January and synthetic short position in March should be about $3/4. If the January synthetic costs $10, the March synthetic should cost $10-3/4.

If the stock pays a dividend, this must be subtracted from the position as well, because it represents a cash inflow. If the above stock pays a 1/4-point dividend in March, the spread value would be reduced by 1/4 point from $10-3/4 to $10-1/2.

Calendar spreads

We can also view the synthetic long and short positions as calendar spreads:

January March Short 10 $50 puts + Long 10 $50 puts = Long calendar spread Long 10 $50 call + Short 10 $50 calls = Short calendar spread = Long synthetic stock =Short synthetic stock

If we view the positions vertically, we see the market maker has a long synthetic stock position in January and short synthetic stock position in March. This is the way we were viewing the positions earlier. However, we can also view them horizontally and say he is long a put calendar spread (long Mar $50 puts and short Jan $50 puts) and short a call calendar spread (short Mar $50 calls and long Jan $50 calls).

An equally valid way, then, to view the jelly roll is the difference between two calendar spreads (also called time or horizontal spreads).

If you trade calendar spreads, here's where the jelly roll can help!

Example:

Intel (INTC) is currently trading for $36-7/8 with the following quotes:

Calls Puts Month/Strike Bid Ask Bid Ask

Jan $35 5-3/8 5-3/4 3-1/8 3-1/4 Apr $35 7-1/4 7-5/8 4-1/4 4-5/8

Say you are interested in the following long calendar spread: Long April $35 calls and short January $35 calls. The natural quote is currently $2-1/4 debit:

Buy Apr $35 calls = $7-5/8 Sell Jan $35 calls = $5-3/8 Net debit $2-1/4

Because there is a net payment (debit), this is a long calendar spread.

Traders often ask if this is a fair price. Is there room to negotiate? If so, how much?

To answer these questions, let's look at the value of the synthetic long and short stock positions from the retail investor's side. An investor buying a synthetic long position will pay the asking price and sell at the bid price. As a guide, these numbers are highlighted below: red is a debit and blue is a credit.

Calls Puts Month/Strike Bid Ask Bid Ask

Jan $35 5-3/8 5-3/4 3-1/8 3-1/4 Apr $35 7-1/4 7-5/8 4-1/4 4-5/8

The retail investor can create the January synthetic long and April synthetic short for: +7 1/4 - $5 3/4 + $3 1/8 - $4 5/8 = $0. So a retail investor will receive zero credit for the trade. How much should it be worth theoretically? There are approximately 135 days to expiration, so the cost of carry is roughly $35 * 135/360 * 6% = 0.79 cents.

In addition, any dividends received must be subtracted. Intel is currently paying 2 cents per share. The dividend is expected during the life of the jelly roll, so the cost is reduced from 79 cents to about 77 cents[*]. Most of the time dividends are not a big concern, especially for tech companies. But in cases where the dividends are sizeable, be sure to factor it into the cost.

[*]Technically, the credit will be reduced by the present value of the dividend. This is because the investor must wait to receive the dividend. However, since most dividends are small as well as the time between buying and selling the stock, most traders will just subtract off the full amount of the dividend as a very close estimate.

The trade should be worth a credit of 77 cents, but the retail investor receives zero. The spread is clearly not priced fairly at the bid and ask prices for the retail investor.

How about from the market makers' perspective? Using the same color coded notation as before, the market maker can create the synthetic January $35 long position by buying the Jan $35 call at the bid and selling the Jan $35 put at the ask. He can also create the synthetic short April position by purchasing the Apr $35 put on the bid and selling the Apr $35 call at the ask as shown in the chart below:

Calls Puts Month/Strike Bid Ask Bid Ask

Jan $35 5-3/8 5-3/4 3-1/8 3-1/4

Apr $35 7-1/4 7-5/8 4-1/4 4-5/8

The synthetic positions will create a net credit of: -$5-3/8 + $7-5/8 - $4-1/4 + $3-1/4 = + $1-1/4.

We said earlier the fair price of the package should be about 77 cents; however, the retail investor receives nothing, and the market maker wants $1-1/4.

Notice a key point here. The market maker is able to construct the synthetic long and short positions with the color coded trades above. If you recall from the beginning, we were assuming you were interested in the calendar spread consisting of long April $35 calls, and short January $35 calls. You would pay the asking price on the April $35 calls and sell for the bid price on the January $35 calls -- exactly two of the pieces the market maker needs to construct his synthetic positions!

The market maker can offset your trade by buying an April $35 put at $4-1/4 and selling the January $35 put at $3-1/4 (remember, market makers buy at the bid and sell at the ask). In other words, because you want to be long the calendar spread, the market maker must be short the same spread in order to fill the order. To offset the short call calendar spread, he will execute a long put calendar spread.

Because neither party -- neither you nor the market maker -- wants to execute the trade for less than 77 cents, it appears you have about 48 cents with which to work. The market maker wants $1-1/4, but theoretically should only receive 77 cents for a difference of 48 cents. You probably won't be able to shave the full 48 cents off the price, but 1/4 point certainly looks reasonable. So the calendar spread we described earlier:

Buy Apr $35 calls = $7-5/8 Sell Jan $35 calls = $5-3/8

could probably be filled for a net debit of $2 instead of the $2-1/4 natural.

Now, 1/4 point may not seem like much, but on a relative basis, it's about 11% better than the $2-1/4 debit most traders would be tempted to place.

This is the essence of great options trading -- becoming a little bit better on each trade. It's the little changes that make big differences on profits.

STRATEGIES Wrangles

The wrangle is a complex position usually used by market makers for reasons we will see later. It consists of a long ratio spread with calls and a long ratio spread with puts. Long ratio spreads are also known as backspreads. A long call ratio spread is established by selling a lower strike call and purchasing two (or more) higher strike calls. Likewise, a long put ratio spread entails selling a higher strike put and then purchasing two (or more) lower strike puts.

Let's look at the individual pieces and then put them together. The profit and loss diagram for a long call ratio spread looks like this:

The profit and loss for the long put ratio spread looks like this:

If we put these two profit and loss diagrams together we get the wrangle:

If you read our section on the strategy of "strangles," you may recognize the above profit and loss diagram as identical. However, the wrangle, unlike the strangle, will not be exposed to the same time decay if the stock stands still. It's my guess that the wrangle gets its name from the fact that it is a ratioed strangle (which sounds like wrangle).

It may be difficult to see why the above profit and loss diagram results from two long ratio spreads but let's break down the two component positions using $50 and $55 strikes and see if we can make sense of it.

The basic long call ratio spread is:

Sell 1 $50 call Buy 2 $60 calls

The basic long put ratio spread is:

Sell 1 $60 put Buy 2 $50 puts

There are many ways to dissect this position but probably the easiest is to look at just the short positions: sell 1 $50 call and sell 1 $60 put. These two options, by themselves, are a short in-the-money strangle also called a "guts." The reason it is an in-the-money strangle is because the put has a higher strike thereby guaranteeing this position to be down at least $10 (the difference in strikes) at expiration. Don't let the guaranteed value bother you because we haven't even talked about price yet; the markets will have to pay you more than $10 for it. We will use the proceeds from this short strangle to purchase two $50 puts and two $60 calls, which is a long out-of-the-money strangle. Because we are long more contracts than short, this position must become profitable as the market moves either up or down. In other words, we are net long calls and puts so must make money if the market explodes to either the upside or downside.

Another way to look at this net long contract position is to look at just the calls. If we are long two $60 calls and short 1 $50 call, the effectively we are net long one $60 call. The sale of the one $50 call reduced our purchase price a bit and lessens the risk if the stock should fall. That's why the chart goes up on the right "wing" (showing profit) if the stock should move beyond $60; we are net long 1 $60 call.

A similar argument can be made for the puts.

Is this position better than a strangle? It depends on your outlook on the stock and tolerances for risk. Remember, there are no superior strategies as they all come with their own unique sets of risks and rewards (Please see course "Best Strategy" under week 1). The wrangle has less risk if the stock stands still but will also take longer to become profitable if the stock does move. That's because the short positions are competing with the deltas of the long positions -- something known as gamma risk.

The benefit of the short strangle is offset by its sluggish responsiveness to moves in the underlying stock. Which is better depends on you and the circumstances at the time of the trade.

While wrangles are generally used by market makers (after all, there are four commissions just to establish the long position!), this doesn't mean it's not useful for retail investors to understand. One scenario is that you enter into a backspread (long ratio spread) at one time and hedge at a later time by legging into a wrangle.

But probably more important is the wrangle shows, once again, the versatility that options provide and why they are so necessary to understand if you want to compete in today's markets. By finding different combinations of calls and puts, you can completely change the risk-reward characteristics to match your needs and that is something that cannot be done with stocks alone.

Option Exam 11 - Week 11

1) A position of long stock plus long put is synthetically the same as a:

a) Long put

b) Long call

c) Short call

d) Short put

2) Synthetic equivalents have the same ____ as the asset being replicated:

a) Profit and loss shape

b) Cost

c) Profit

d) Return on investment

3) Short stock plus a long call is synthetically the same as:

a) Short put

b) Short call

c) Long put

d) Long call

4) A trader wants to execute a short sale in a rapidly falling market. There have been no upticks so he cannot get the trade executed. However, he can get it executed by entering a synthetic short by:

a) Buying a call and selling a put

b) Buying a put and selling a call

c) Buying a call and buying a put

d) Selling a call and selling a put

5) A jelly roll is a(n):

a) Synthetic long in one month and a synthetic short in another

b) Synthetic short and synthetic long in the same month

c) Synthetic short in one month and a long position in another

d) Synthetic short in one month and a short position in another

6) Synthetic short stock positions have:

a) Limited upside risk

b) Unlimited downside risk

c) Unlimited upside and downside risk

d) Unlimited upside risk

7) Jelly rolls can be used to determine if _____ are being priced fairly.

a) Box spreads

b) Vertical spreads

c) Calendar spreads

d) Synthetic calls

8) Systematic writing is a three-step method of writing naked puts over time. Once you are assigned on puts written in the first step, the next step is to sell:

a) Covered straddles

b) Naked straddles

c) Spreads

d) Box spreads

9) If you are interested in purchasing 400 shares of a stock and want to use a systematic writing strategy, what is the first step?

a) Sell 4 straddles

b) Sell 4 puts

c) Sell 2 puts

d) Buy 200 shares

10) What is the last step in a systematic writing strategy?

a) Selling puts

b) Selling calls

c) Buying puts

d) Selling straddles

Final Exam

Options Final Exam

1) A stock is trading for $100 and the $95 call is trading for $8. The $8 premium is composed of:

a) only intrinsic value

b) only time value

c) only extrinsic value

d) time value and intrinsic value

2) A stock is trading for $50 and the $55 call is trading for $3. The option premium is:

a) only time value

b) $3 intrinsic value and no time premium

c) $5 intrinsic value and no time premium

d) $3 time value and $3 intrinsic value

3) An option's time value plus intrinsic value will equal its price.

a) True

b) False

4) An option's price must have intrinsic value.

a) True

b) False

5) A stock is trading for $75 and the $80 put is trading for $6. How much intrinsic value is there?

a) $3

b) $5

c) $0

d) Put options will never have intrinsic value

6) A stock is trading for $100 and the $90 put is trading for $7. Which of the following correctly identifies the time and intrinsic values?

a) There is $7 intrinsic value and $10 time value

b) There is $10 intrinsic value and $7 time value

c) There is $7 intrinsic value and no time value

d) There is no intrinsic value and $7 time value

7) a trader wishes to buy an option and must get it filled. The trader should enter a:

a) market order

b) limit order

c) all or none order (AON)

d) good until cancelled (GTC) order

8) a trader sees an option trading for $6 but doesn't want to pay more than $5 1/2 for it. He should enter a:

a) market order

b) all or none order (AON)

c) limit order

d) Day order

9) A trader has purchased a stock at $100. It is now trading for $125. He thinks it will continue higher, but also does not want to lose all of his unrealized profits. If he enters an order to sell his shares at a stop price of $122, which of the following are true?

a) The order will be filled for $122 if the stock falls below that price

b) The order will become a limit order to sell at $122 if the stock trades for that price

c) The order will become a market order if the stock trades at $122 or lower

d) You cannot place sell stops on stocks

10) A trader is entering an order to buy 50 contracts. However, he does not want to be filled unless all 50 contracts can be purchased. Which of the following types of orders should he use?

a) All-or-none (AON)

b) Immediate or cancel

c) Good until cancelled (GTC)

d) Or-better

11) A trader is trying to buy option contracts at a limit price. However, every time he enters the order, the price immediately jumps above his limit because it is in a fast market. He is afraid to use a market order. Which of the following orders would help him best?

a) All-or-none (AON)

b) Or-better

c) Immediate or cancel

d) Day order

12) A trader is trying to purchase stock in a fast market, which is currently trading for $100. He wishes to use an "or-better" order to avoid the risk with a market order. Which of the following would be an "or-better" order?

a) Buy 100 shares at a limit of $100

b) Buy 100 shares at a limit of $102

c) Buy 100 shares at a limit of $100, good-until-cancelled

d) Buy 100 shares at a $99-3/4

13) An option trader wants to purchase call options to initiate a new position. Her order would be:

a) buy calls to close

b) buy calls to open

c) sell calls to open

d) sell calls to close

14) A trader has 300 shares of stock and 3 short calls against it (covered call position). He now wants to back out of the call options. He would:

a) sell calls to open

b) sell calls to close

c) buy calls to open

d) buy calls to close

15) A trader owns 700 shares of stock and wishes to write 3 call options against it. She would:

a) buy calls to open

b) buy calls to close

c) sell calls to close

d) sell calls to open

16) A trader owns 10 put options and wishes to sell them. He would:

a) sell puts to close

b) sell puts to open

c) buy puts to open

d) buy puts to close

17) Put-call ratio is:

a) the total CBOE put volume / the total CBOE call volume

b) the total CBOE call volume / the total CBOE put volume

c) the S&P 500 put volume / the S&P 500 call volume

d) the S&P 500 call volume / the S&P 500 put volume

18) If the put-call ratio gets sufficiently high, then this is viewed as a:

a) bullish signal

b) bearish signal

c) neutral signal

19) How many option expiration cycles are there?

a) 3

b) 4

c) 6

d) 12

20) It is now February and a certain stock has options traded on a March cycle. Which months will be available for options trading?

a) Feb, Mar, Jun, Sep

b) Feb, Mar, May, Aug

c) Feb, Mar, Apr, Oct

d) Jan, Feb, Jun, Sep

21) There are always at least ____ option expiration months for equity options.

a) 2

b) 3

c) 4

d) 6

22) It is now March and a certain stock has options traded on a February cycle. When will the November options start trading?

a) When April options expire

b) When May options expire

c) When October options expire

d) When March options expire

23) Not counting dividends, how many factors are in the Black-Scholes Option Pricing Model?

a) 3

b) 4

c) 5

d) 6

24) According to the Black-Scholes Option Pricing Model, if the risk-free interest rate rises, put prices will ______ (assuming all other factors stay the same).

a) stay the same

b) rise

c) fall

25) According to the Black-Scholes Option Pricing Model, if the strike price is reduced, call prices will ______ (assuming all other factors stay the same).

a) fall

b) stay the same

c) rise

26) According to the Black-Scholes Option Pricing Model, if volatility is increased, call prices will _____ and put prices will _____ (assuming all other factors stay the same).

a) fall, fall

b) fall, rise

c) rise, rise

d) rise, fall

27) With the Black-Scholes Option Pricing Model, if you enter the factors, the pricing model will give you the theoretical value of a:

a) put option

b) call and put option

c) call option

d) synthetic long position

28) The single most important factor in the Black-Scholes Model is:

a) risk-free interest rate

b) exercise price

c) volatility of the underlying

d) stock price

29) The price of a call option can never exceed:

a) the price of a put

b) its own strike price

c) the delta

d) the price of the underlying stock

30) For any two call options, the difference in their prices cannot exceed the difference in their strikes.

a) True

b) False

31) What two conditions must be met in order for an arbitrage to occur?

a) Guaranteed profit without waiting

b) Guaranteed profit for no cash outlay

c) Guaranteed profit with limited risk

d) Limited risk with large profit potential

32) At expiration, a call option must be worth either:

a) zero or the stock price plus the risk-free rate

b) zero or the exercise price

c) zero or the stock price minus the exercise price

d) zero or the stock price

33) A stock is trading for $100 and the $90 call is trading for $9. Is arbitrage possible in this situation?

a) Yes

b) No

34) A buy-write can be executed for a net credit.

a) True

b) False

35) A stock is trading for $75 and the $70 put is trading for $3. Is arbitrage possible in this situation?

a) Yes

b) No

36) Basically speaking, the delta of an option is:

a) the price of the option

b) the price change of the option for a $1 change in the stock

c) the price change of the put for a $1 change in the call

d) the change in the stock price for a $1 change in the call

37) If a May $50 call has a delta of 0.60, what will be the delta of the May $50 put?

a) -0.60

b) -0.40

c) 0.60

d) No way to determine

38) A stock is trading for $100 and the $90 call has a delta of 0.70. If the stock moves to $101 immediately, the price of the call should increase by approximately (assuming all else stays the same):

a) 30 cents

b) 70 cents

c) $1

d) $1.70

39) One way to define delta (ignoring the negative sign for put deltas) is that it is:

a) the probability of a profit

b) the probability of the option having intrinsic value

c) the probability of a loss

d) the probability of an automatic exercise

40) Gamma can be thought of as the:

a) time decay

b) risk-free rate

c) delta of the delta

d) increase in an option's price for a $1 move in the stock price

41) Long calls have _____ delta and long puts have _____ delta.

a) negative, negative

b) positive, positive

c) negative, positive

d) positive, negative

42) Long calls have _____ gamma and long puts have _____ gamma.

a) negative, negative

b) positive, positive

c) negative, positive

d) positive, negative

43) An option is trading for $5. However, according to the Black-Scholes Model, it "should be" trading for $4. How do you account for the difference?

a) There is a decrease in the implied volatility

b) The implied volatility is the same as the historic volatility

c) There is an increase in the implied volatility

d) The option could never trade for more than the theoretical value

44) You purchased a call option yesterday for $7. Today the stock is trading up $1, but the call option is trading for $6-1/2. How do you account for this?

a) There is an increase in the implied volatility

b) The delta is 1/2

c) The gamma is 1/2

d) There is a decrease in the implied volatility

45) You purchased a $50 call for $3. What is your breakeven point at expiration?

a) $53

b) $50

c) $47

d) There is no way to tell

46) A long call gives the owner:

a) the right, but not the obligation to buy stock

b) the obligation to buy stock

c) the right, but not the obligation to sell stock

d) the possible obligation to sell stock

47) You have been watching a stock move sharply upward from $30 to $100 over the past couple of weeks. You think the stock will continue upward but are afraid to purchase it at these levels. In order to profit from further increases but greatly limit your losses you could:

a) buy puts

b) sell puts

c) sell calls

d) buy calls

48) You purchased a $100 put for $6. What is your breakeven point at expiration?

a) $100

b) $106

c) $94

d) No way to determine

49) You have sold 10 $50 put options. You have:

a) the right to purchase 1,000 shares for $50

b) the possible obligation to buy 1,000 shares for $50

c) the right to buy 100 shares for $50

d) the possible obligation to buy 100 shares for $50

50) You have purchased a June $50 call and a June $50 put on the same underlying stock or index. This position is called a:

a) straddle

b) strangle

c) combo

d) horseshoe

51) You bought a $70 put for $5 and a $75 call for $6. Your breakeven points at expiration are:

a) $59, $86

b) $75, $81

c) $5, $6

d) $70, $75

52) You own 500 shares of stock at $100 and would like to buy some puts to protect the shares from a downward fall. However the puts are expensive, so you elect to sell the $105 call for $8 and use those proceeds to purchase the $95 puts. This position is called:

a) reversal

b) strangle

c) butterfly spread

d) equity collar

53) Equity collars expose the investor to:

a) unlimited losses, unlimited gains

b) limited losses, unlimited gains

c) limited losses, limited gains

d) unlimited losses, limited gains

54) You have purchased a $50 call and sold a $55 call for a net debit of $3. Which of the following are true?

I. This is a bear spread II. This is a bull spread III. Maximum profit is $2 IV. Maximum loss is $5

a) I only

b) I, III

c) II, III

d) II, III, IV

55) You place a spread order to buy 5 $100 calls and sell 5 $105 calls for a net credit of $2. This order will be:

a) filled only for $2 or lower

b) filled only for $2 or higher

c) rejected

d) filled regardless of price

56) An investor buys a $100 put and sells a $90 put. This is a:

a) horizontal spread

b) vertical spread

c) diagonal spread

d) condor spread

57) An investor buys a March $50 call and sells a January $60 call. This is a:

a) diagonal spread

b) horizontal spread

c) vertical spread

d) box spread

58) You sell a $100 call for $7 and buy a $105 call for $5. Your maximum profit is _____ and your maximum loss is _____.

a) $2, $5

b) $7, $5

c) $5, $2

d) $2, $3

59) A trader enters a Christmas tree by buying one $50 call, selling one $55 call and selling one $60 call. The investor is exposed to which of the following risks?

a) Unlimited downside risk

b) Limited upside risk

c) Unlimited upside risk

d) Unlimited upside and downside risk

60) A Christmas tree is most similar to which strategy?

a) Condor spread

b) Ratio spread

c) Box spread

d) Vertical spread

61) Which of the following is a butterfly spread?

a) Buy 1 $50 call, sell 1 $55 call, buy 1 $60 call

b) Buy 1 $50 call, sell 2 $55 calls, buy 1 $60 call

c) Buy 1 $50 call, sell 2 $55 calls, buy 2 $60 calls

d) Buy 2 $50 calls, sell 1 $55 calls, buy 1 $60 call

62) The owner of a butterfly spread wants the stock to close:

a) at the highest strike

b) at the lowest strike

c) above the highest strike

d) at the middle strike

63) You have an opportunity to establish a butterfly spread for a net credit after commissions. You should:

a) not enter it, because you are exposed to unlimited risk if the stock sits still

b) enter as many spreads as you can, because you cannot lose

c) not enter it, because you are exposed to unlimited risk if the stock rises

d) not enter it, because you are exposed to unlimited risk if the stock falls

64) Butterfly spreads are generally a great trading strategy for retail investors.

a) True

b) False

65) The condor spread is most similar to the:

a) butterfly spread

b) vertical spread

c) ratio spread

d) time spread

66) An investor owns a $50 call and a $65 call on the same underlying stock. She wishes to hedge by creating a condor spread. She should:

a) sell the $55 call and sell the $60 call

b) buy the $55 call and sell the $60 call

c) buy the $55 call and buy the $60 call

d) sell the $55 call and buy the $60 call

67) You purchased a $100 call for $7, and the stock is now trading for $120 with three weeks remaining until expiration. You are afraid the stock will start to fall, so you should:

a) exercise the call early

b) buy the call and short the stock

c) sell the call to close in the open market

d) sell the put

68) The risk of a covered call is:

a) the stock rises, and you are forced to sell your shares below market

b) the stock closes at the strike price of the short call

c) the stock falls

d) the covered call is a riskless transaction

69) An option is quoting bid $7 and asking $7-1/2. You place an order to sell 1 contract at a limit of $7-1/4. If the exchange does not fill your order, what will be the new quote?

a) Bid $7, asking $7-1/4

b) Bid $7-1/4, asking $7

c) The quote will remain unchanged

d) Bid $7-1/4, asking $7-1/2

70) An option is quoting bid $10 and asking $10-1/4. You place an order to buy 1 contract at a limit of $9-3/4. Your order is not filled, but you also notice that the quote did not change. Did the exchange make a mistake?

a) Yes. the exchange should have made the new bid $9-3/4

b) No. The exchange will only show the lowest bid and highest offer

c) No. The exchange will only show the highest bid and lowest offer

d) Yes. you should contact your broker and they will get the order filled

Answer questions 71 - 73 using this information:

An investor buys 12 $50 calls for $5 and sells 20 $55 calls for $3-1/2.

71) How many spreads is this?

a) 12

b) 20

c) 4

d) 2

72) Is this trade entered as a net debit or credit?

a) Debit

b) Credit

c) Cannot be determined

73) What is the amount of the net debit or credit?

a) $5

b) $3-1/2

c) $1-1/2

d) $2-1/2

74) An investor holds a long calendar spread. They want the stock to:

a) move higher

b) sit still

c) move lower

d) make a large move either higher or lower

Answer questions 75 - 77 using this information:

An investor sells a $50 call for $5 and buys 2 $55 calls for a total of $7 ($3-1/2 each).

75) This investor has placed a:

a) bull spread

b) bear spread

c) backspread

d) condor spread

76) The trade is placed for a net:

a) credit of $2

b) debit of $2

c) credit of $5

d) debit of $7

77) The maximum this investor can make is:

a) theoretically unlimited

b) $2

c) $5

d) $7

Answer questions 78 - 79 using this information:

An investor buys a $50 call and sells a $60 call. Then he buys a $60 put and sells a $50 put.

78) This investor has entered a:

a) condor spread

b) bull spread

c) butterfly spread

d) box spread

79) Assume the investor pays a total of $9 for the four positions. Which of the following best describes the profit at expiration?

a) Possible $1

b) Possible $5

c) Guaranteed $5

d) Guaranteed $1

80) A jelly roll is defined as a:

a) conversion and reversal in the same month

b) conversion in one month and a reversal in another

c) reversal in one month and reversal in another

d) conversion at one strike and a reversal at another strike in the same month

81) Jelly rolls are important for retail investors to understand because they can help determine:

a) fair prices for vertical spreads

b) fair prices for calendar spreads

c) fair prices for box spreads

d) fair prices for bull spreads

Answer questions 82 - 83 using this information:

An investor is holding a position of long stock and a long put.

82) These two positions together are a:

a) synthetic short position

b) synthetic call

c) synthetic put

d) synthetic bull spread

83) The most this investor could make is:

a) theoretically unlimited

b) the strike price of the put

c) the strike price of the put less the premium paid

d) the stock price minus the exercise price of the put

84) Synthetic positions have the same _____ as the position they are synthetically creating.

a) rate of return

b) return on investment

c) profit and loss diagram

d) sets of risks

85) Short stock plus a short put is synthetically the same as:

a) short put

b) long put

c) long call

d) short call

86) You want to short a stock in a rapidly falling market but are unable to get an execution because there are no upticks. You can short the stock synthetically by:

a) buying the call, and shorting the put

b) buying the put, and selling the call

c) buying the put, and buying the call

d) selling the put, and selling the call

87) A position of long stock and short call (covered call) is synthetically the same as:

a) long put

b) short put

c) short stock

d) long call

88) A position of short stock and long call is synthetically the same as:

a) long put

b) short put

c) long call

d) short call

89) You think a stock will rise slowly over the next two months. If you're using options, your position should have:

a) positive delta, positive gamma

b) positive delta, negative gamma

c) negative delta, negative gamma

d) negative delta, positive gamma

90) The owner of a straddle wants the stock to:

a) sit still

b) move slowly either up or down

c) decrease in volatility

d) make a quick, large move in either direction

91) The following profit and loss diagram represents a:

a) Backspread

b) Straddle

c) Ratio spread

d) Condor spread

92) The following profit and loss diagram represents a:

a) covered call

b) naked put

c) naked call

d) either a or b

93) The following profit and loss diagram represents a:

a) short straddle

b) condor spread

c) short call

d) ratio spread

94) A stock is trading for $100. The $95 put is:

a) in-the-money

b) out-of-the-money

c) at-the-money

d) none of the above

95) On expiration day, all options expire worthless.

a) True

b) False

96) Option approvals for IRA accounts generally only allow:

a) naked put writing

b) long straddles

c) spreads

d) covered calls and protective puts

97) Which of the following option positions expose the trader to the greatest risk?

a) Long put

b) Long condor spread

c) Backspread

d) Naked call

98) The strategy of systematic writing involves which steps (in order)?

a) Naked put, covered straddles, covered calls

b) Naked put, condor spreads, naked calls

c) Covered puts, long stock, covered calls

d) Covered puts, covered calls, long stock

99) As an option trader, you are better off being the seller of options since most buyers lose money.

a) True

b) False

100) If the stock or option has moved in your favor, stop orders are a great trading tool, as they prevent losses.

a) True

b) False

c) True for stop limits, but not regular stop orders

d) True for regular stop orders, but not stop limits