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 |
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| 2 | Exercise price |
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| 3 | Risk-free rates |
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| 4 | Volatility |
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| 5 | Time to expiration |
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| 6 | Dividends |
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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!
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:
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;-------No Value ------![[Right Arrow]](http://www.21stcenturyinvestoreducation.com/courses/course-201/005/image004r.gif){kind=small}
-------- 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: $60 put = $12 |
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: 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? |
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? For the $80 strike call: |
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 Stock price *(risk factor1) - (present value of the exercise price) *(risk factor2) |
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 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.
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 $50 call trading for $5 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: |
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!
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.
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
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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:
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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
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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:
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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.
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:
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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:
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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:
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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.
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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:
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The strip, because it has two puts instead of one will look like this:
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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:
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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!
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 later in the course 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.
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![[Profit and Loss Diagram]](http://www.21stcenturyinvestoreducation.com/courses/course-201/006/image12.gif)
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.
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:
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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:
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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.
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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:
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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.)
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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.
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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 higherdoes not need the stock to move; it just cannot move down. as the trader must make up for the debit. The credit spread; however,
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 losegain $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. $2-5/8 while the put trader will
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:
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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:
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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:
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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:
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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!
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:
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![[Profit and Loss]](http://www.21stcenturyinvestoreducation.com/courses/course-201/008/image008.gif)
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)
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![[Chart]](http://www.21stcenturyinvestoreducation.com/courses/course-201/008/image004.jpg)
Headline: Apple computer falls more than 52% on 4th-quarter earnings estimates (9/28/00)
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![[Chart]](http://www.21stcenturyinvestoreducation.com/courses/course-201/008/image006.jpg)
Headline: Priceline.com down 42% on 3rd-quarter estimates (9/27/00)
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![[Chart]](http://www.21stcenturyinvestoreducation.com/courses/course-201/008/image008.jpg)
Headline: Xerox down 26% as sales decline and 3rd-quarter loss expected (10/03/00)
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![[Chart]](http://www.21stcenturyinvestoreducation.com/courses/course-201/008/image010.jpg)
Headline: Eastman Kodak falls 25% on profit warning (9/26/00)
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![[Chart]](http://www.21stcenturyinvestoreducation.com/courses/course-201/008/image012.jpg)
Headline: Intel falls 22% on 3rd quarter revenue warning (9/22/00)
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![[Chart]](http://www.21stcenturyinvestoreducation.com/courses/course-201/008/image014.jpg)
Headline: Lucent shares fall 23% on 4th quarter earnings (10/10/00)
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![[Chart]](http://www.21stcenturyinvestoreducation.com/courses/course-201/008/image016.jpg)
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.
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:
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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:
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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:
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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:
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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 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.
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 On ex-date, the account values are as follows: Stock = +$99 (stock price reduced by amount of dividend) 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 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 Trader exercises the $65 call and is now: Exercise $65 call = -$65 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) 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 |
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.
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: |
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.")
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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 revenues will be (S - $40 -3/4) because we will have intrinsic value of this amount on the long position. Our expenses will be 2* (S - $50). 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. Now put the two equations equal to each other and solve:
S - $40 .75 = 2 * (S - $50)
S - $40.75 = 2S - $100
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:
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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:
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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.
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 course), 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 section 1 on "Early Exercise"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. 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
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!
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:
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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:
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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:
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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:
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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:
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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:
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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:
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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:
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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:
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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:
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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:
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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.
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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:
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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.
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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.
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