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The Motley FoolOptions EdgeHandbook 2011
BY JEFF F ISCHER
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welCome .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
wh y op Tion s? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
B uyin g Calls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
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s e l l i n g C o v e r e d C a l l s . . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . . 5
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8 T i p s f o r w r i T i n g ( o r s e l l i n g ) p u T s . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . 7
syn Th eT iC lon gs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
w r i T i n g s T r a d d l e s . . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . 1 1
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o p T i o n s g l o s s a r y . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . 1 6
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wc
Dear Fellow Investor,
The market gyrations of the past few years created a unique investing landscape. One tha
has many investors looking beyond traditional buy and hold for the kinds of opportuni
ties that can make you substantial amounts of money in shorter periods of time...
Options Edge 2011 is a perfect primer for the moments of crisis and
opportunity ahead!
This handy guide (we designed it so that you can print it out and keep it) will give you
the tools to make money in shorter periods of time, generate income, leverage returns
and squeeze out some of your portfolio risk. In short, this handbook could be your first
step to building wealth faster and more assuredly than at any point in recent history!
And its part of a bigger opportunity were extremely excited to tell you about. Youll
discover all the details in a very special invitation that will be put into your hands on
Monday, December 13.
Keep your eyes on your inbox!
Kindest regards,
Jeff Fischer
Advisor, Motley Fool Options
Hee o Oo Ee Hboo 2011!
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WHy OptiOns?
Options are ideal for generating income, protecting profits, and most importantly, earning
outsized gains! They can generate returns in flat markets, cushion the blow of down
markets, and be outstanding performers in decent markets. So basically, whatever your
investment goals, options can be a powerful addition to your portfolio.
And its important for you to know that I advocate trading options as an investor, not as
a speculator. In other words, every option trade we make should be based on thorough
analysis of the underlying stock and its value. That way, the option is simply a way tol
everage what we know about a stock.
WHat arE OptiOns?
Stock options formally debuted on the Chicago Board Options Exchange in 1973,
although option contracts (the right to buy or sell something in the future) have been
around for thousands of years.
Applied to stocks, an option gives the owner the right, but not the obligation, to buy or
sell an underlying stock at a set price (the strike price) by a set date (the expiration date)The option contract allows you to profit if a stock moves in your favor before the contract
expires. Not all stocks have options -- only those with enough interest and volume.
There are only two types of options: calls and puts. A call appreciates when the underly-
ing stock rises, so you buy a call if you are bullish on that company. A put appreciates
when a stock declines. You buy a put if you believe a stock will fall or to hedge a stock
that you already own. One way to remember this is: call up and put down...
By the way, theres an options glossary in the back of the handbook for you to use at any
point!
Next, lets walk through the most common options trades: buying calls, buying puts
selling covered calls, and selling puts.
sTraTegy why
B CWhen you believe a stock will rise significantly over time and
you want to leverage your returns or minimize capital at risk
B ptTo short a position, or to hedge or protect a current long
holding
s C C
(sell to open)
To earn income on shares you already own while waiting for
your desired sell price
s pt
(sell to open)
To get paid while waiting for a lower share price (your desired
buy price) on a stock you would be happy to buy
Buying Calls
Investors often buy call options rather than buying a stock outright to obtain leverage
and potentially increase returns several-fold. Call options work as controlled lever-
age, enhancing your possible returns while limiting your potential losses to only what
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Aside from betting against a position with puts, you can also buy
puts to protect an important position in our portfolio, one that you
dont want to sell yet for any number of reasons. When a stock
being protected -- or hedged -- in this way declines for a while, the
puts will increase in value, smoothing out returns.
I tend to buy puts on stocks that I believe are due to decline over
the coming months or even years. You may also use puts to hedge
long positions that you own, or to short sectors and indexes in a
small portion of your portfolio. I often buy puts rather than short
something outright to limit my risk.
sElling COvErEd Calls
Now our overview moves from the act of buying options to
instead, selling them to others. Selling -- or writing -- options is
what we do most, because it can be consistently lucrative and the
odds are stacked in our favor.
Any qualified investor can sell to open an option contract. Whenyou do so, you dont pay the premium; instead, as the contrac
writer,you get paid. All cash generated from your option selling
is paid immediately to you.
Covered simply means that we own the underlying stock at the
same time. Writing covered calls is one of the most conservative
options strategies available. In fact, most retirement accounts
allow you to write covered calls. Theyre generally used to gener-
ate income on stock positions while waiting for a higher share
price at which to sell the stock.
Heres an example of a covered call. Suppose you own 1,000
shares of a stable, blue-chip stock. Its trading at $56, but youthink it is fairly valued around $60 and you would be happy to sel
at that price. So you write $60 call options on the stock expiring a
few months ahead, and you get paid up front to do so.
If the stock does notexceed $60 by your options expiration, you
keep your shares andyouve made money on the call options. You
could then write more calls if you wanted to for more income. If
the stock is above $60 by expiration and you havent closed out
your call option contract, youd sell your stock at $60 via the
options. Your actual proceeds on the sale would include the option
premium you were paid. So you sold your shares at the pric
you wanted to andreceived extra cash for doing so. This income
really adds up as you write covered calls again and again.So, writecovered calls when:
You would sell a stock that you own at a higher price, and
youre not worried about it declining too much in the mean-
time. Write calls at your desired sell price, collect the dough
and then kick back and wait. Rinse and repeat, month after
month, when you can.
You believe a stock you own is going to stagnate for a while
you invest (which is usually a much smaller amount than a stock
purchase would be). Because each option contract represents 100
shares of stock, an investor can control -- and benefit from -- many
shares of stock without putting a lot of capital at risk. When you
make the right call, youll enjoy higher returns than you would
have if you had used that money to buy the actual shares.
Lets look at an example. Imagine that a stock that you know well
has been hit hard and now trades at $27 per share. You believe
the shares will rebound in the coming months or year. The market
offers $30 call options on the stock that expire in 18 months for
$1.50 per share. Therefore, 10 contracts, representing 1,000 shares
of the stock, will cost you $1,500 plus commissions. This option
contract gives you, its owner, the right to buy 1,000 shares of the
stock at $30 any time before expiration.
If your stock starts to rise again, your options will increase in
value, too. Suppose the stock recovers all the way to $32 after a
few months. Your options value would likely at least double to $3
or higher per contract. Youve made 100% in a few months. If youhad simply bought the stock, youd only be up 18.5%.
Of course, there is a flip side. Suppose your stock continues its
decline to the abyss. Even 18 months later, its below $20, so your
options expire worthless -- though hopefully you sold them at
some point along the way to recoup part of your investment. The
good news is: youve saved a lot of money compared to if you had
bought the stock instead.
I like to buy longer-term call options on well-valued stocks that I
believe will pay off handsomely over the coming months or years.
Its a way to take more meaningful positions in stocks I believe
in -- without risking mounds of capital. This is useful if yourelacking capital or just dont feel like risking it all in a stock.
As with any investment, you should only invest what you can
afford to lose, since a stock can easily work against you over a set
amount of time and make your call worthless. Where real oppor-
tunity can be lost is when your timing is wrong. Your options
might expire before the stock rebounds, causing you to lose your
option money and miss the stocks eventual rebound. Thus, we
aim to buy longer-term calls in positions in which we have high
confidence and that have near-term catalysts.
Buying putsNext up, the antithesis to call options: puts.
Buy put options when you believe that the underlying stock will
decline in value. Buying puts is an excellent tool for betting
against highly priced or troubled stocks, or even entire sectors.
With put buying, your risk is again limited to the amount that you
invest in stark comparison to traditional short selling, where your
potential losses are unlimited.
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but you dont want to sell it right now. Write calls to make the stagnation more
profitable.
You want to cushion a stock that is in decline, but that youre not ready to sell yet.
Tread carefully here so you dont get sold out at too low a price.
When you write covered calls,you must be prepared to give up your shares at the strike
price. Approximately 80% to 90% of options are not exercised until expiration, but they
can be exercised early, so the call writer has to be prepared to deliver the shares.
That means that if the $56 stock in the example above suddenly soars to $70, youd
still have to sell at $60. This is the biggest downside to covered calls -- lost potential if
a stock price rises. The other risk is that a stock may fall sharply after hovering around
your desired sell price for a while, forcing you to wait longer for your sell price. But in
this case, at least youve earned option income.
Even though covered calls are low risk, you should use them only on stocks you know
well. You could even set up some covered call-only positions -- buying a stock just to
write calls on it.
sElling puts
Note: to sell (or write) puts, you must have a margin account. You wont actually need
to use margin -- which entails high risk-- but you must be margin-approved, have ample
buying power (cash, in our margin-free strategy).
Selling puts -- also referred to as selling naked puts or writing puts -- is a favorite strategy
of mine to seed a portfolio. There may be plenty of stocks that Id like to buy at the start,
but Id prefer to snag them at lower prices. Put options are an excellent way to potentially
buy a stock at your desired, lower share price and get paid an option premium while
waiting for that price, whether it arrives or not.
Lets turn to an example: A top-rated stock we found on Motley Fool CAPS and
researched thoroughly is trading at $39, but our analysis suggests that we shouldnt buyit above $35. The $35 put options expiring four months out are paying $3 per share. We
sell to open the put contracts and get paid $3 per share to make the trade, giving us a
potential net purchase price of $32 before commissions. A few things could happen here.
Scenario 1: The stock could stay above our $35 strike price; the options we
sold would expire. We didnt get to buy the stock at the price we wanted, but at
least we made money on the options we sold.
Scenario 2: The stock could fall below $35 by expiration. In this situation,
our broker would automatically buy the stock for our account, giving us a start
price of $32 before commissions because we still keep the option income --thats -- even lower than our $35 desired buy price!
Scenario 3: The stock may tank to $29 soon after we sell the puts, but then
climb back above $35 by expiration. In this case, we most likely would not
have had the shares sold to us during this brief decline because about 80% of
options are exercised only at expiration, not before. So we wont own the shares,
and well have missed our buy price and the stocks rebound -- but we did get
paid the premium, at least, and can try again.
when To wriTe Covered Calls
You would sell a stock that you own at
a higher price, and youre not worried
about it declining too much in the
meantime. Write calls at your desired
sell price, collect the dough, and thenkick back and wait. Rinse and repeat,
month after month, when you can.
You believe a stock you own is going to
stagnate for a while, but you dont want
to sell it right now. Write calls to make
the stagnation more profitable.
You want to cushion a stock that is in
decline, but that youre not ready to sell
yet. Tread carefully here so you dont
get sold out at too low a price.
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Scenario 4: The companys CEO flees to Bermuda
and the stock is only at $16 by our options expiration.
We didnt have the heart to close our losing option posi-
tion, and we still have hope, so we wait and the shares are
put to our account at $35 (minus our option premium)
upon expiration. This is the worst-case scenario -- were
down 50% to start. But we own the stock now and canhope it rebounds. Of course, assuming that we would
have bought the stock outright when it hit our $35 buy
price, as we had considered, we would be down even
more than we would be with this strategy.
You should most often sell puts when a stock you follow closely
and want to own is, alas, above your desired buy price. You should
sell puts on it at lower strike prices, prices that you believe are great
levels at which to buy. Either you eventually get to buy the stock at
your desired price via the puts, or you keep writing puts if the situ-
ation merits it, earning more income each time while you wait. You
may also sell puts when a stock you already hold a partial positionin is above the price where youd like to buy more. You can write
puts as you wait to average in at lower prices. This is a great tool for
allocation and averaging into a position.
Writing puts on stocks you know well and want to own at lower
prices can be an excellent tool for income and for securing lower
buy prices, butyou must be prepared to buy the stockshould it fall
below your strike price. At all times, you must maintain the cash
or margin (for us its always cash and we recommend you follow
that rule, too) to buy shares if they are put to you.
Its important that you only write puts on stocks that you under-
stand well and will be happy and ready to buy at the prices youre
targeting. The risks of writing puts include the fact that the stock
could soar away without you. In many cases, its better to just buy
a great stock once youve found it. The other risk, of course, is
that a stock falls sharply and youre stuck owning it. The biggest
risk with selling puts, as with all options, is when investors rely
on margin instead of cash.
Lets review...
Call opTion puT opTion
ot b
The right, but not obli-gation, to b a stockat a set price (the strikeprice); calls appreci-ate as the stock rises(remember: call up)
The right, but not obliga-tion, to a stock at a setprice (the strike price); putsappreciate as the stock falls(remember: put down)
ot t(or seller)
The obligation to sell astock at the strike price;must hold the stockin the account. Thisis called a coveredposition.
The obligation to buy astock at the strike price;must have the buyingpower at the ready (pref-erably in cash) in case thestock declines
ot bBelieves the underly-ing stock will rise
Believes the underlyingstock will fall
ot t(or seller)
If the stock rises, isready to sell sharesat the strike price,keeping the premiumpaid for writing theoption
If the stock falls, isready to buy it at thestrike price, keeping thepremium received forwriting the option
8 tips fOr Writing (Or sElling) puts
Always choose a strike price at which youd be happy to
buy the stock.
Focus on strong businesses that youd be excited to own
for the long term.
Write out-of-the-money puts, meaning your strike
price is below the stocks current share price.
Verify that the option premium payment makes the trade
worthwhile.
Remember, you often wont get to buy the stock; youll
just get option income. Thats why we sometimes write
puts on stocks in which we already own partial positions.
Put writers do not collect dividends paid by the underly-
ing stock.
Never overextend yourself by writing too many puts.
Brokers allow put writing on margin, but we write puts
when we have the cash to buy the stock.
Vary the expiration dates among your individual option
holdings so they dont all fall in the same month -- this
staggers your risk.
You may write in-the-money puts with strike prices
above the current share price when youre especially
bullish on a stock and want to capture more upsidepotential with its options. This strategy also increases the
odds that you get to buy the stock. When you write in-
the-money puts, the guidelines in our table dont apply.
Put writing is a bullish, or at least neutral, strategy. When you
write a put, youre saying you believe the underlying stock
will eventually increase in price (hopefully after youve bough
shares), or at least hold steady -- meaning youll earn income on
your puts when they expire.
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Lets use an example: Assume youre bullish on the health-care company, Kinetic
Concepts (NYSE: KCI). The stock increased lately, so youre not as anxious to buy it.
If the shares fell to $35 or so, however, youd be happy to buy. Rather than just sit and
wait, you can write (remember, thats sell to open) the $35 strike price put options
Youll get paid while you wait, and youll potentially get that lower buy price.
Before placing this trade, make sure you have the cash (or, for experienced investors,
ample buying power) in your account to buy a minimum of 100 shares of Kinetic. You
can then write $35 puts that expire in a few months. Lets say the puts pay you $2 per
share, and you write two contracts representing 200 shares of Kinetic. Youre paid $400
(minus commissions) up front. And now you wait (cue theJeopardy theme).
If Kinetic Concepts ends this time period above $35, your options simply expire, and
you keep the $400. You can then write new puts if youd like. If Kinetic dips below $35
at the options expiration, the puts you wrote will be exercised, and youre on the hook
to buy 200 shares of Kinetic at a strike price of $35. Including the option premium you
received, your start price is actually $33. Nice! Now you own shares at an attractive start
price and can wait for appreciation.
So, you write puts when:
Youre ready and willing to buy a stock at a lower price and
You dont believe the stock will soar away from you in the meantime (otherwise
youd just buy the stock), or
You just want to make income writing puts. You dont believe a stock will drop
to your buy price, but if it does, youd still be happy to buy it.
WHat Can gO WrOng?
Sounds perfect, doesnt it? Youre paid to potentially buy a stock you wanted to buy
anyway -- and at a price you like. Thats beautiful.
But every investing strategy has some risk. In this case, assume Kinetic Concepts doesnt
fall below $35 by the time your option expires, but instead jumps to $45 over the next
few months. You miss out on a several dollar stock gain for only a $2 gain in the put
options, and you still dont own shares. Now what do you do? It might be a tough call.
Kinetic could also drop to $30 soon after you write your puts, but then climb back to $38
just as your puts hit their expiration date. Because almost all options are exercised only at
expiration, you wont get the shares, and you will have missed your buy price. Of course,
you keep the $2 option premium and can write new puts.
Theres also the scenario that the stock drops and doesnt come back up for a long time.
If Kinetic fell to $25, your options would be far underwater. In this case, you must be
ready to just buy the stock at your net price of $33 and wait for a rebound. At least youre
getting a much lower start price than if you had simply bought the stock outright on dayone.
So, Fools, whenever you write puts, be confident that you want to own the stock for the
long haul.
when To wriTe puTs
Youre ready and willing to buy a stock
at a lower price and
You dont believe the stock will soar
away from you in the meantime
(otherwise youd just buy the stock), or
You just want to make income writing
puts. You dont believe a stock will drop
to your buy price, but if it does, youd
still be happy to buy it.
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Are you confident about a stock, but reluctant to pony up the cash to buy it today? A
synthetic long may be just the ticket.
This option strategy works nearly the same as owning the underlying stock outright
except you dont need to pay up front. Usually, youll set up a synthetic long on a stock
if you foresee a strong catalyst for appreciation in the next 18 months or so. As the stock
price goes up, your options gain value along with it, sometimes to a much greater degree
Earlier, you discovered that when you buy options as opposed to selling (or writing)
them you aim to profit from the option itself, rather than getting the underlying equity
involved (unless its to your benefit). The synthetic long allows for the best of both
worlds: On the options you buy in this strategy, your upside potential is unlimited; on the
options you sell, the worst-case scenario is that you end up buying the underlying stock
at a price of your choosing. This makes the synthetic long an especially attractive trade
for bullish investors.
Buy Calls, sEll putsTo initiate a synthetic long, you buy a call option and concurrentlysella put option on
the same underlying stock or exchange-traded fund. For a true synthetic long, the calls
and puts will have the same expiration date and strike price, although there are attractive
variations that youll discover below.
When you buy a call, you believe that the underlying stock is going to appreciate consid
erably over the life of your option. If it does, the call usually gains value dramatically. If
the stock does notappreciate, however, your calls will move toward expiration with less
and less value, finally ending with little or no value.
That is always the risk of buying options. You need to be correct by the expiration date or
the option wont maintain value, and you could lose your whole investment. This poten-tial loss is much easier to stomach, though, if you use income from a put sale to buy your
calls. This is exactly what you do to set up a synthetic long position. Lets see an example
BullisH On autOdEsk? gO syntHEtiC lOng!
Suppose you have a bullish long-term stance on 3-D software leaderAutodesk(Nasdaq
ADSK). You believe the business will be on the upswing again within 18 months, so
youd like to set up a synthetic long position to benefit.
With the shares trading around $12.50 (as of March 13), you would buy the January
2011 $12.50 call options on Autodesk for $3.80 per contract, and concurrently sell (or
write) the January 2011 $12.50 put options for $3.50. Your net cash outlay is just $0.30
per share. Once you make these trades, if Autodesk begins to appreciate, both your callsand puts will start to show gains in your portfolio, in effect mirroring the stock or even
outperforming it. If Autodesk appreciates to, say, $20 by sometime in 2010, your calls
will gain 100% to 200%, and your puts will be well on their way to becoming a 100%
cash gain, too.
On the flipside, lets suppose Autodesk continues to suffer from soft sales, and shares drif
lower to $10 or $11 for the next year or longer. In that case, your call options will slowly
lose value, and your put options put you on the hook to buy shares at $12.50. Given tha
you paid a net $0.30 to set up your synthetic long, your net start price on Autodesk will
synTheTiC longs aT a glanCe
Synthetic longs are best when youre bull-
ish on a strong business, at least somewhatbullish on the market overall, and expect a
catalyst over the next 18 months or so.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Typically, you should use the longest-dated
LEAPs (Long-Term Equity Anticipation
Securities) you can find so youll have the
largest window of time to be proven correct;
refrain from initiating short-term synthetic
longs that expire in nine months or less.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
You must be ready to buy the underlying
stock if it falls below your put options strike
price.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Remember the three possible outcomes
with a synthetic long: (1) the stock increases
and both your options make money; (2)
the stock decreases enough that youre
obligated to buy it via your put options; or
(3) the stock stagnates, in which case both
your options may simply expire, and youre
back where you started.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
A true synthetic long uses the same strike
price and expiration date for both calls and
puts; you can split the strikes, however, to set
up a more defensive or aggressive synthetic
long, depending on your preference.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Once your thesis has largely played out and
youve earned money on your calls, con-
sider taking your profit on the calls; use the
underlying stocks valuation and your options
approaching expiration date as guides.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Using a synthetic long option strategy on a
dividend-paying stock does not entitle you
to the dividend payment.
sttc l
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Tip of The Trade
Target healthy businesses with attractively
valued stocks, and your put writing
strategy should leave you happy, whether it
generates income or you end up buying the
stock. Write puts on stocks youd like to ownat cheaper prices, or on stocks that wont
likely decline (but youd happily own if they
did) to generate income. If you really want
to own a stock, though, buy at least some
shares outright.
be about $12.80 per share. This is the only number youll ultimately care about if your
trade is underwater. Youre ready to buy Autodesk at a net $12.80, and you can then hold
the shares and hope for a recovery. Your synthetic long didnt make you any money, but
ideally it bought you shares of a good company.
splitting tHE strikEs
Setting up a synthetic long with identical put and call strike prices near a stocks current
share price is the norm (because youre looking to approximate a stock purchase today),
but it may not be the most comfortable choice for you. For more downside protection,
you may consider splitting the strikes as you set up a synthetic long. In this case, you
still use calls and puts that expire during the same month, but you use different strike
prices.
Using Autodesk as the example, lets say you decide to write the January 2011 $10 put
options instead of the $12.50 puts. The $10 puts pay you $2.50 per share. With that
income, you can then buy the January 2011 $15 call options (instead of the $12.50 calls
from the first example) for about $2.80 per share. The net cost is the same just $0.30
per share but you have more downside protection when you split the strike this way.
If Autodesk declines, you dont need to buy it until it is $10 or lower, and your net start
price will be $10.30.
What do you sacrifice? You now need Autodesk to appreciate by a greater degree (com-
pared to buying the $12.50 calls) by January 2011 for your call options to appreciate
meaningfully or at all.
WHEn tO ClOsE a syntHEtiC lOng
If all goes well, the underlying shares will appreciate for you well before your options
near expiration, at which point based on the valuation of the stock and the amount
of time left in your options you should start to consider taking your profit in your
call options (unless you prefer to exercise them in order to own the stock at your callsstrike price). At the same time, your put options are on the path to expire for the full cash
payment.
Usually, youll use synthetic longs to profit from the options themselves over the course
of your investing thesis typically, around 18 months. Only rarely will you exercise the
calls and turn them into a stock position if the options are successful. On the flip side,
when the position works against you and you need more time for your thesis to material-
ize, youll be ready to buy the shares and hold them.
BOttOm linE On syntHEtiC lOngs
When youre bullish on a stock and want to invest without spending capital today, setting
up a synthetic long position is a sensible alternative. The strategy can reward you withhandsome profits on two options at once, with unlimited upside on the call options or
it nets you shares of a stock that you should be happy to buy at a lower price.
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Sometimes a stock or the market as a whole just takes a nap, and buying or even
shorting isnt likely to land you a profit. But by writing (sell to open) straddles, you can
generate income from a steady stock, or simply from decreasing volatility, as the marke
calms down or catches up on some Zs.
sEtting up tHE tradE
A straddle involves an identical number of calls and puts with the same strike price and
expiration date on the same underlying stock or index. As you know, you buy the calls and
puts to profit in either direction from high volatility. Inversely, writingthe calls and puts is
a way to profit from low or declining volatility. How? Simply by collecting option premium
payments on either side of a potentially sleepy position. There are risks, however.
unCOvErEd straddlE Writing
When writing an uncovered straddle, you usually dont intend to get the underlying stockinvolved. Youre just looking to profit on the value erosion of the options you write, and
youll plan to buy to close them (or let them expire) once youve earned your targeted
profit. (Note: You need a margin account to write an uncovered straddle.)
As an example, suppose a recently volatile stock just announced earnings, and you expect
its volatility will now all but cease. The options still pay well, though, so youd like to
capture the option premium as income. The stock is trading at $25, so you write $25 calls
and $25 puts and get paid $2 for each contract thats $4 total in option premiums per
straddle. This means as long as the stock ends the expiration period between $21 and $29
($4 above or below $25), youll at least break even before commissions and in most
cases, earn a profit on the trade. (call this the profit range.)
For example, if the stock ends the period at $27, the puts you wrote expire
(giving you the full $2 value), and the calls break even, so the trade pays
you $2 per share overall.
If the stock ends lower in your profit range, lets say $23, the calls expire
and the puts break even, so you profit $2 per share overall here, too.
However, outside your profit range, its another story. You face unlimited potential losses
as the stock rises above $29 per share, and you facing growing losses (along with an
obligation to buy the stock and wait for a recovery) the further it falls below $21.
As the table on the next page shows, the maximum profit from an uncovered straddle
occurs when the stock ends exactly at the strike price; you keep the entire $4 per share
you were paid in this example. Your total profit declines as the stock moves away from
the strike price in either direction which is why you want minimal volatility wheneveyou write straddles.
Take a minute to study the table and grasp how this works. As the stock rises, the naked
(or uncovered) calls you wrote increase in value, working against you. As the stock
declines, the puts you wrote work against you, but youll still profit anywhere between
$22 and $28, and break even at $21 or $29. Remember, you were paid $2 for each cal
and put, or $4 total. But since you wrote the options, your desired outcome is that their
value goes to $0, or as low as possible:
why wriTe a sTraddle?
You believe a stock or index is going to hold
steady.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
You believe a stock that was recently vola-
tile will calm down considerably.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
You believe the markets overall volatility is
going to decrease.
wriTing sTraddles: The BasiCs
Write (sell to open) an equal number of
puts and calls on the same stock or index.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Use the same strike price and the samemonth of expiration on both options.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The strike price with a straddle is at-the-
money: as close to the current underlying
stock price as possible.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
When you write an uncoveredstraddle, you
dont own the underlying stock, so your risk
is high (more on this in a minute).
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
When you write a coveredstraddle, you
own the stock, lowering your risk. Here the
straddle works like a covered call strategy
but your returns are potentially goosed with
additional put-writing income.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The most you can earn writing straddles is
what the options pay you initially.
wt st
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To help achieve a successful uncovered straddle, you want the
widest possible profit range (in other words, you want to capturegenerous option premiums). In this example, the range is signifi-
cant $4 in either direction assuming the underlying stock
isnt exceptionally volatile and your options expire in two to
five months (rather than longer). But remember, the trade creates
unlimited potential losses outside the profit range.
One way to greatly mitigate that risk: When you write your
straddle, use some of your option proceeds to simultaneously buy
far out-of-the-money calls and/or puts, too with strike prices
at the two ends of your profit range (for this example, you might
buy $30 calls and $20 puts; or just buy calls to protect you on that
side and be ready to buy the stock via your written puts if it falls).
Doing so, youve hedged and covered your written straddle,and because buying these options generally costs little, youll
still begin with a net credit from your option writing and keep
that profit if the stock stays in a now slightly tighter range. For
example, if you paid $0.80 total for the protective calls and puts,
your profit range decreases by that amount on either side of the
strike price. If you dontbuy protective options initially, be ready
to do so if the trade starts to work strongly against you.
Given that a steady stock can suddenly make a big move for any
number of reasons, its risky to write uncovered straddles withou
this added protection. However, another route is to simply own the
underlying stock outright. Lets take a look.
COvErEd straddlE Writing
Owning the underlying stock takes away all of the naked calloption risk when writing a straddle. In fact, a covered straddle
writing strategy is basically a covered call strategy, but it generally
offers more profit potential because youre also writing puts on the
stock. The key difference with a straddle is that both options are
at-the-money, so youre more likely to see your options exercised
As with a covered call, its important that youre ready to sell your
stock if it rises. And as with writing puts, you need to be ready
to buy more stock if it declines (or close the options early). The
benefits of writing a covered straddle are two-fold:
Your profit can be higher and your profit range wider than
with a mere covered call.
You have more ways to close your options profitably
and still keep your stock if you like.
Continuing the earlier example, lets assume you want to write
a straddle on a steady $25 stock but in this case, you own the
underlying shares. You write $25 calls and puts, getting paid $2
each, with the same expiration date. Since you own the stock, no
matter how high it climbs, youre covered on that side of your
trade. Lets consider some potential outcomes:
You end up selling your stock via the covered calls, but
you keep the $4 option premium you were paid on the puts
and calls, netting a sell price of $29 (compared with just$27 if youd only done a covered call and not a straddle)
The stock declines below $25. You end up buying more
shares, but at a net $21 given the option premiums you
were paid. Youve added to your existing stock holding.
The stocks holds steady, around $24 to $26. You can buy to
close both the calls and puts by expiration and capture much
of the profit while keeping your existing shares. Nice!
Finally, as an example of the added flexibility here
Assume the stock increases to $28 by expiration, and you
decide you want to keep your shares. Since you were paid
$4 per share in option income, you could close your calls
for $3, still have a $1 per share profit on your straddle, and
keep your stock. If you had only written covered calls and
not a straddle, youd need to book a loss if you wanted to
keep your stock.
taking fOllOW-up aCtiOn
Writing uncoveredstraddles requires keeping a close tab on your
sToCk priCeaT expiraTion
endingCallvalue
ending puTvalue
your ToTalprofiT pershare
$20 and lower $0$5 and higheras the stock
falls
($1) and wors-ening as the
stock falls
$21 $0 $4 Break-even
$22 $0 $3 $1
$23 $0 $2 $2
$24 $0 $1 $3
$25(the strike price)
$0 $0 $4
$26 $1 $0 $3
$27 $2 $0 $2
$28 $3 $0 $1
$29 $4 $0 Break-even
$30 and up
$5 andhigher asthe stockrises
$0($1) and wors-ening as thestock rises
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trade. If the stock is moving sharply against you in either direction,
you may want take action to limit your losses. One way to do so
is to close the losing side of your straddle when the stock reaches
your break-even price. In this example, if the stock rises to $29,
you might close your call options for a loss and let your puts go,
presumably to expiration, keeping your overall losses marginal.
If the stock falls, just be ready to buy it via your puts. Uncoveredstraddles dont usually lend themselves to rolling forward (to a
later expiration date), rolling up (to higher strike prices), or rolling
down (to lower strike prices), so you cant depend on these defen-
sive follow-up moves being available to you. As mentioned above,
if you buy out-of-the money protective calls (and puts, if you like)
when you set up your straddle, your potential profit on the straddle
is lower, but you wont need to consider follow-up action.
Writing covered straddles is much less risky and requires less
upkeep, but you still want to keep a watchful eye on your strategy,
since only your calls are truly covered. You need to be ready to
accept more shares if the stock falls below your puts strike price.
For this reason, some investors will use a lower strike price onthe puts they write, providing more leeway but once you start
to stagger strike prices on your calls and puts, youre not using a
straddle anymore, youre using astrangle.
BOttOm linE On Writing straddlEs
Youre not likely to write uncovered straddles without using some
protective options as well. Writing covered straddles, however, is a
sensible way to increase option profits on a covered call strategy as
long as youre also willing to buy more shares if need be. With this
strategy, you have another tool to profit no matter what the market
throws your way in this case, even if the market goes nowhere.
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You write (sell to open) a covered strangle to profit when a stock stays within a wide
price range -- or, if it doesnt, to get a better buy price on new shares or a higher sell price
on existing shares. Its a great strategy.
rECap: straddlE vs. stranglE
Straddle: Use puts and calls, on the same stock, with the same expiration date and strike
price (one at-the-money).
Strangle: Use puts and calls, on the same stock, usually with the same expiration date bu
with differing strike prices (both out-of-the money).
A strangle is similar to a straddle: Youre using call and put options on the same underly
ing stock or index, typically with the same expiration date. As with a straddle, you buy
a strangle to profit on high volatility. Inversely, you write a strangle to profit when a
stock stays within a predetermined price range or is relatively stable. The bonus: Writing
a strangle offers more flexibility than writing a straddle because you split the strikes-- set it up with a different strike price on your calls than on your puts -- and you use
strike prices that are out-of-the-money, or well above or below the stocks current price
giving you more room to profit. Lets take a look.
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sEtting up tHE tradE
To write a covered strangle, sell to open puts and calls, both options out-of-the moneyand usually with the same expiration date. However, the number of puts you write i
dependent on how many additional 100 share blocks youd like to potentially buy, and the
number of calls you write will depend on how many 100 share blocks you already own
and would be willing to sell at your higher price.
Usually, you write both sides of your strangle at the same time, but sometimes you can
increase your option payments by legging into the strategy -- setting up one side of you
trade at a different time than the other; for example, writing calls on your targeted stock
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when its near the high of your expected range and then writing
puts when its nearer the low end.
Writing a COvErEd stranglE
Writing a covered strangle (also called a short strangle) is a way to
profit on a stock you own and would be willing to either buy moreof or sell at the right price. Writing strangles can be superior to
writing straddles because splitting the strike prices provides more
flexibility and room for profit.. The options wont pay as much as
a straddle, but the stock has more room to roam.
For example, say you own shares of a retail stock and youre
willing to buy more if the shares decline meaningfully (potentially
doubling your position, well suppose); or, youre willing to sell
your existing shares higher. With the retailer recently near $14,
you could write the $13 puts expiring in six months for $1, and
write $15 covered calls expiring at the same time for $1 as well,
collecting $2 in total option premiums (or 14% of the current share
price).
Consider the possible outcomes:
The stock ends the expiration period between $13 and
$15: You keep the whole $2 per share the options paid
you -- great income -- and keep your shares, and can
consider your next move.
The stock increases above $15 by expiration: Youre on
the hook to sell your existing shares for a net $17, includ-
ing the $2 the options paid you.
Shares fall below $13: Youre obligated to buy new shares
at a net $11, again including the $2 the options paid you.Youve now doubled your ownership, and lowered your
cost basis. (It might be time to write covered calls!)
Of course, in most cases you could also buy to close your
options early or upon expiration, and still have a profit on the
combined option trades assuming the stock hasnt moved too dra-
matically (in this case, as long as its between $11.10 to $16.90).
As you can see, a covered strangle can give you a wide profit
range, and its more powerful and flexible than a covered call
strategy alone -- as long as youre ready and willing to buy more
shares if it comes to that. As with any time you write puts, you
need to be confident in the stock or ETF youre exposing yourselfto and ready to buy it. With a covered strangle, you also must
be ready to sell your existing shares if they increase in price.
However, given how much the two combined options pay you,
you also have more flexibility -- or possibility -- to close your
options early if you wish, keep your shares, and still have a profit.
Writing unCOvErEd stranglEs
Some daring investors write uncovered strangles when they
strongly believe a stock wont break above or below a certain
(generally wide) price range, aiming to profit via option premi-
ums on both ends. Were unlikely to partake in this risky strategy
without buying calls to protect ourselves -- otherwise, the losses
can be unlimited.
BOttOm linE On Writing stranglEsWriting a covered strangle is a way to generate option profits on a
position if you already own at least 100 shares, would be happy to
add at least 100 more shares at a lower price, or sell your existing
shares at a higher price. More flexible than just writing covered
calls, strangle-writing can provide a wide window of profit using
options on a stock that you believe will stay in a stable range.
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Call option: A call option is the right to buy the underlying stock
at a set price (the strike price) at or before the options expira-
tion date. A call rises in value as a stock rises and declines in value
when the stock falls.
Delta: The amount that an options price will change with any
change in the underlying share price.
Gamma: A measure of risk in an option based on the amount
that the delta will change with a $1 change in the stock (we dont
concern ourselves much with delta or gamma, since were much
more concerned about the underlying value of the equity were
targeting, but theyre still good things to know).
In the money: This term is used when an option has intrinsic
value. Call options are in the money when the underlying stock is
above the calls strike price. Put options are in the money when
the underlying stock is below the options strike price (a stock is
at $22 and the put option has a strike price of $30, allowing the
holder to sell the stock at $30).
Intrinsic value: This is the value of an option if it were to expire
immediately. Its an options value in direct proportion to the
underlying stocks current price. If a call option gives the owner
the right to buy a stock at $10, and the stock is trading at $12, the
options intrinsic value is the difference: $2. The option may actu-
ally be priced at $3, with $1 of time value (see below) because it
doesnt expire for a few months, and much could change by then.
LEAPS (Long-Term Equity Anticipation Securities): These
are simply stock options that, when first offered, expire at least
two years in the future. We like LEAPS because they give you a
relatively long time for an investment thesis to play out.
Option contract: Each option contract represents 100 shares of the
underlying stock. A contract is quoted at the price for just one share,
so you need to multiply it by 100 to get the full value. So, if you buy
two option contracts for $1.50 each, it actually represents 200 (2 x
100) shares of stock, and would cost you $300 ($1.50 x 200).
Out of the money: This is the opposite condition as in the
money. Here, an option has no intrinsic value, only time value.
This occurs when, for example, a stock is trading at $8 and a call
option has a strike price of $10.
Premium: Not unlike an insurance premium, the value paid for an
option contract is called the premium. The more volatile a stock
is, generally the higher the premium on its options. Also, all else
equal, the longer until an option expires, the higher the premium
it commands, accounting for more unknowns.
Put option: A put option is the right to sella stock at a set price
at or before the options expiration date. A puts value increases
as a stock falls.
Strike price, expiration, and exercise: Every option has a strike price and expiration date (which is always the third Friday o
a month, after the market closes). The strike price is the value
at which the underlying stock can be bought or sold. When an
option is converted into a stock transaction, the option has been
exercised.
Time-value premium: This is the price of an option above its
intrinsic value. Its the value placed on an option purely to accoun
for unknowns and expected volatility between now and expiration
Time value declines as expiration draws closer.
Writing a contract: Selling a new option contract (opening a posi
tion) is usually called writing a contract; the brokerage command
to do so is usually sell to open, just as when you short a stock
The new option seller is called the option writer; to close the
position, the trade command is called buy to close.
ot g