Single-Stock Futures Part 11

Options on Futures

We've covered a lot of ground on futures, and hopefully you're starting to see that they're not too difficult to understand. At the very beginning of the course, we mentioned that futures are not options; it's now time to find out what separates the two. This is important information to know so you can use futures options or futures contracts as appropriate for your needs. Sometimes futures options will be your best choice and other times futures will be. If you don't understand the differences, you'll never be able to make an educated decision.

It is expected that options on single-stock futures will begin trading about two years after the introduction of the futures contracts. Although it's unclear at this time as to why there is a two-year waiting period, it is probably due to the regulators wanting to see the single-stock futures market get established and any bugs worked out of the computer systems before trading derivatives on them. After all, options on futures will be a derivative on a derivative! Futures options are currently traded on most commodities.

While this course is not a complete course on options, it will cover the necessary basics you need to know. In addition, the next course provides a detailed look at synthetic options, which will be the foundation for the following course. There we will show you how to exit a futures contract without using the futures market. This is invaluable information if you should find yourself in a commodity contract that is locked limit for the day and you wish to get out. There will be no other way to do it than by using the technique we will present.

What Is an Option Contract?

Options are simply legal contracts between two people giving the buyer of the option the right, but not the obligation, to buy or sell stock for a fixed price over a given time period.

Notice the distinction between this definition and our definition of a futures contract. The futures trader has the obligation to either buy or sell the underlying asset (assuming they do not enter an offsetting position) while the optionstrader has the right to either buy or sell without the obligation. The option owner is not obligated to do anything on or before expiration.

Another difference is that, with options, you can take delivery of the underlying asset before the expiration date, although it is usually never advantageous to do so. With futures however, you must wait until the expiration date if you wish to buy or sell.

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

There are two types of options: callsand puts.

Long Call Options

If you buy a call option, you are the owner, and are long the contract. A long call optiongives the owner the right, but not the obligation, to buy stock ("call" it away from the owner) at a specified price over a given time period. As with single-stock futures, equity options each control 100 shares of the underlying stock.

The specified price at which you can purchase the stock is called the "strike price" (also called the "exercise price"). For example, an IBM May $100 call gives the owner the right, but not the obligation, to buy 100 shares of IBM for $100 per share through the expiration in May. Once again, this expiration date is the same as single-stock futures, so your last trading day will be the third Friday of the expiration month.

Notice that the owner, the long position, has the right, but not the obligation, to buy the underlying stock. They are allowed to purchase the stock for a fixed price, but are not required to do so. In other words, you have the option to buy -- which is where these financial assets get their name. It is up to the owner of the call option to determine if that right should be used. Consequently, the most the call option owner can lose is the amount paid for the option.

Buying a call option is similar to holding a coupon from your local pizza restaurant. You may find, for example, a coupon good for one large pizza or $9.99 good through June. If you think about it, this fits the same description of a call option. You have the right, but not the obligation to buy one pizza for a fixed price through a given time period. If the price of pizzas jumps to $20, you're locked in for a price of $9.99.

Long Put Options

A put option allows the owner to sell their stock ("put" it back to someone else) for the strikepricewithin a given time. As with call options, the put buyer (longposition) has the right, but not the obligation. If you buy an IBM March $100 put, you have the right, but not the obligation, to sell 100 shares of IBM for $100 per share through the third Friday in March. As with call options, it is up to the put owner to determine if that right should be used and, consequently, the most the put option owner can lose is the amount paid for the option.

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

Short Calls and Puts

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

If you wish to actually purchase the underlying asset with a call optionor to sell it by using a put option, you must submit exerciseinstructions to your broker. If you do, you will either pay or receive the strike price. (It should now make sense as to why the strike price is also called the exercise price.) Usually your broker will charge the regular commission whether you buy or sell the underlying asset in the open market or through an option exercise. Remember, it is only the long positions that can submit exercise instructions, as they are the ones who purchased that right. If a long position exercises, the person who sold that call (the short call) is said to be assignedon that option.

Moneyness

Options are classified as at-the-money, in-the-money, or out-of-the-money, which is also called the moneynessof an option. A strikepriceequal to the current market price of the underlyingstock is said to be at-the-money. For example, if a stock is trading at $100, the $100 strike (call or put) is at-the-money.

For call options, if the stock price is below the strike, the option is out-of-the-money. If the stock price is above the strike, it is in-the-money. With the stock at $100, a $105 call (or higher strike) is out-of-the-money and a $95 call (or lower) is in-the-money.

When you are longan in-the-moneycall, you can purchase the stock for less than market price.

The reverse is true for puts. If the stock price is above the strike, the put option is out-of-the-money. If the stock price is below the strike, the put is in-the-money. Any time you are longan in-the-money put, you can sell your stock for more than the market price.

The following chart may help:

If you have trouble remembering the differences between in-the-moneyand out-of-the-moneyoptions, just remember that any time you can buy or sell stock with your option for more favorable prices than the stock currently trading, you have an in-the-money option.

Intrinsic and Time Values

We said earlier that the amount you pay for an option is called the premium. The premium can be broken down into two component parts: the intrinsic valueand the time value.

In order to understand option strategies, it will be important to separate an option's price into intrinsic and time values.

An option that is in-the-moneyhas intrinsic value. This is the value of the option if you were to immediately exercise-- the difference between the stock price and the strike. For example, if the stock is trading for $101 and you hold the $100 call, you could realize a $1 point gain by exercisingthe call option; you would receive stock worth $101 but pay only $100. *

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

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

The value of an out-of-the-moneyoption is composed purely of time premium(also called time value); there is no advantage in exercisingthe option at this time.

Intrinsic value is defined as the difference between the stock price and the exerciseprice(Stock - Exercise) for callsor the difference in the exercise price minus the stock price (Exercise - Stock) for puts. If this number is positive, the option has intrinsic value; if negative, the option has only time value.

For example, say a stock is trading at $105 and you have the $100 call option. Clearly it is better to use the option and pay $100 a share for the underlyingstock than to pay the current market price of $105. So this option has $5 intrinsic valueor, equivalently, is $5 in-the-money. We can confirm this by using the above intrinsic formula for calls: Stock - Exercise = $105 - $100 = $5.

Depending on how much time is remaining on the option, it may trade for more than intrinsic value. If the above option is trading for $7, then $5 of that value is intrinsic value and $2 is time value. Time value is what is left over after accounting for intrinsic value. The following formula may help:

Premium - Intrinsic value = Time value

To run through an example with puts, if the stock is $100 and you have the $105 put, then you could benefit by exercisingthe put and selling your stock for $105 instead of the $100 market price. Therefore, this put has intrinsic value. If this option were trading for $8, then $5 is intrinsic value and $3 is time premium. Using the intrinsic value formula for puts: Exercise - Stock = $105 - $100 = $5 intrinsic value.

Examples:

An option that trades for exactly the intrinsic amount with no time premiumis said to be trading at parity. This usually happens very close to expiration. For example, if the stock is $105 and the $100 call is trading for exactly $5, the option is trading at parity.

Options on Futures

Equity and index optionscurrently being traded are called spot options since they control the current, or spot, asset. For example, if you own an Intelcall optionand exerciseit, you immediately own Intel stock. Options on futures, however, work a little differently. If you are long a futures call option, you have the right, but not the obligation, to buy the futures contract for a fixed price. If you exercise a futures call option, you will be long a futures contract, which means you cannot take delivery of the actual asset until expiration of the futures contract. If you are long a futures put option, you have the right, but not the obligation to sell (short) the futures contract at a fixed price.

Can you think why an investor would rather own an option contract rather than a futures contract?

Why trade optionson futures? After all, it may seem unnecessary since you can already buy options on the actual asset. There are many reasons why someone would prefer an option on a future rather than the spot asset. For example, assume a jewelry manufacturer that makes graduation rings is about to enter the busy season. At this time it does not know how much gold it will need as orders have not yet been taken. If the company waits for the orders, gold prices may rise, which may leave it with far less profit than expected and possibly with a loss. In order to hedgethis risk, the manufacturer could enter into a long gold futures contract. But if the price of gold falls, the manufacturer will incur a nearly a point-for-point loss. Now you may be thinking that we said throughout the text that this loss is offset by the manufacturer's ability to buy gold cheaper in the market. The fact that they "lose" on the futures contract is exactly offset by the lower prices in the spot market. However, that argument assumes that the hedgeractually does, in fact, take delivery of the underlying asset. In this case, we are assuming that the manufacturer is not even certain that delivery will take place. There is a big difference in assumptions and therefore a big difference in the type of hedge that should be in place.

Because the jewelry manufacturer is uncertain of the delivery, a futures option may be the perfect solution. For only a little money down, the manufacturer has locked in his price on the futures contract and limited his risk to the amount paid for the option. The act of guaranteeing a purchase price and limiting the downside risk is something that cannot be done through a straight purchase of a futures contract.

This example shows a conservative hedging use of optionson futures. Of course, options will attract speculatorswho wish to place "bets" that the underlying market will move up or down. So why would a speculatorbuy options on futures rather than on the spot asset? One reason is liquidity. Many times the underlying asset, oddly enough, is not as liquid or as "price transparent" as the futures contract. For instance, if you wish to buy a treasury bond, your broker must make several phone calls to bond traders to obtain the best bid or offer, which is very time consuming. However, if you buy a treasury bond futures contract, you will have immediate price information and many willing buyers and sellers.

Another reason speculatorslike these optionsis because it is easier, if not just for the sake of being cheaper, to take delivery of the futures contract than of the underlying asset. For example, if you are long a call optionand it's near expiration, you may need to take delivery of the underlying asset at that time, assuming that was your intent. Depending on the cost of the underlying asset, that can require a large cash outlay or high borrowing costs if you use marginfor stocks. However, if you are long a futures option, you will only need to take delivery of the futures contract, which only requires the nominal initial marginrequirement.

Options on futures work in about the same way as optionson equities. Most futures options are American-style, just as with equities, which means they can be exercised at any time prior to expiration. The following table recaps the main differences between futures and options on futures:

Asset	Risk	Maximum gain	Margin?	Premium
Long or Short Futures	Unlimited	Unlimited	Yes	No
Long Option	Limited to premium paid	Unlimited	No	Yes
Short Option	Unlimited	Limited to premium received	Yes	No

Risk and Reward Comparisons: Stocks, Futures and Options

Let's compare four traders with four different assets. One buys 100 shares of a $50 stock outright, another buys those same shares on margin, another buys the futures contract at $50, and the last trader buys a futures call option. We will assume the underlying stock is $50 and the option trader buys a $50 strike for a premium of $2, which is a total purchase price of $200 since each contract controls 100 shares. The next table shows comparisons of the initial deposits, market exposure, maximum gain, and maximum loss:

	Stock Trader	Stock Trader on Margin	Futures Trader	Option Trader, $50 Strike
Initial Deposit	$5,000	$2,500	$1,000	$200
Market Exposure	$5,000	$5,000	$5,000	$5,000
Maximum Loss	$5,000	$5,000	$5,000	$200
Maximum Gain	Unlimited	Unlimited	Unlimited	Unlimited

Notice how all four traders have the same exposure to $5,000 worth of stock and all have the potential for unlimited gains as long as the underlying stock keeps rising. The maximum loss, however, is far less for the option trader. He is only exposed to a $200 loss, which is the amount paid for the option. But do not forget

that this limited downside luxury comes at a cost. If the stock is $50 at expiration,

the option trader loses 100% of the investment while the other three do not. The stock trader only misses out on interest that could have been earned had the stock not been purchased. The margin stock trader will pay some margin interest

and the futures trader will lose the cost-of-carry on the futures contract. Regardless, these are negligible losses compared to the option trader who loses everything if the stock is the same price at expiration.

The following table shows a detailed look at the four traders under different stock prices.

Stock Price	Stock Trader	% Gain/Loss	Margin Stock Trader	% Gain/Loss	Futures Trader	% Gain/Loss	Option Trader	% Gain/Loss
30	-2000	-40%	-2000	-80%	-2000	-200%	-200	-100%
35	-1500	-30%	-1500	-60%	-1500	-150%	-200	-100%
40	-1000	-20%	-1000	-40%	-1000	-100%	-200	-100%
45	-500	-10%	-500	-20%	-500	-50%	-200	-100%
50	0	0%	0	0%	0	0%	-200	-100%
55	500	10%	500	20%	500	50%	300	150%
60	1000	20%	1000	40%	1000	100%	800	400%
65	1500	30%	1500	60%	1500	150%	1300	650%
70	2000	40%	2000	80%	2000	200%	1800	900%

Notice that with the stock at $30, the stock trader is down $2,000 for a 40% loss.

The margin trader is also down $2,000 but, on a percentage basis, is down 80% because of the 2:1 leverage created by only placing 50% of the total cost down on the margin trade.

The futures trader only placed $1,000 down initially but would have an account value of -$1,000 if the stock fell to $30 at expiration. He would have to send a check for $1,000 to bring his account to a zero balance and would thus lose the initial deposit plus the second one, or 200%. We also could figure this out by looking at the 40% loss of the stock trader and realize the futures trader has 5:1 leverage because of the 20% initial margin and 5 * 40% = 200%.

The option trader loses 100% for any stock price below $50 at expiration whereas the other three traders do not necessarily. Also notice that if the stock closes at $50 the first three traders lose nothing, but the option trader loses 100%. This clearly shows that all assets listed offer different sets of risks and rewards and should not be thought of as substitutes for one another.

It is important that you have a basic understanding of options in order to continue to the next course. If you're still unclear, you may want to go back and review the basic terminology and mechanics of calls and puts.

Profit and Loss Diagrams

In this section we are focusing on options on futures. One of the reasons we are doing this is to help you understand one of the most important tools a futures trader can know -- how to exit a futures contract through the options market -- which is covered in the last course during this section.

Until then, we will be talking about futures options and presenting their advantages and disadvantages. In order to understand options, it is helpful, if not necessary, to understand profit and loss diagrams

Profit and Loss Diagrams

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

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

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

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

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

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

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

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

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

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

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

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

A short position will always behave the opposite of the corresponding long position. In this case, we see that profit is made as the stock falls and unlimited

losses occur as the stock rises. The unlimited loss part is what makes the short stock position so dangerous!

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

Long Call Position

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

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

Short Call

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

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

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

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

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

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

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

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

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

-$5 at expiration, which is exactly the amount of the premium collected.

Combination Strategies

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

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

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

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

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

The red line is our profit and loss diagram for the covered call position. We see that the breakeven has now been reduced to $45 because of the $5 premium received from the call. However, for any stock price above $60, there is no more appreciation in the position as there is for the long stock position. The maximum that can be made, in this example, is $15 points. How? If the stock is $60, we make $10 on our stock because we paid $50 but also made $5 from the call for a total of $15. If the stock is higher than $60, it does not matter; we are under contract to sell it for $60 so our profit is still $15.

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

The Myth of Covered Calls There is a lot of bad information floating around out there about covered calls. If you ask most people, brokers included, you will hear that the "risk" of a covered call position is that you may have to sell your stock for a price below market. In other words, the stock may be trading at $100 but you have to sell it for $60. Look at all of the points on the above chart at $60 or above -- the points where you will likely be assigned on the option and must sell your stock. Is this the "risky" area of the chart? No, it is our maximum profit zone, exactly the points where you want to be. There are many professionals and academic journalists who surprisingly make this mistake. It is a huge myth in the marketplace. The risk of any position is not that you may miss out on some reward. If you are really sharp, you may have noticed that the covered call profit/loss diagram is exactly the same shape as that for the short put shown earlier. These are called "synthetic equivalents" (which will be discussed in detail in the next course). Covered calls are often considered among the "safest" strategies, while naked puts are considered to be one of the riskiest. Covered calls and naked puts are, incorrectly, considered by many to be polar opposites in terms of risk. Even option approval levels with your broker will usually require the lowest level for covered calls and the highest level for naked puts. Yet, from a profit and loss standpoint, they are exactly the same strategies. Now you should understand the beauty of profit/loss diagrams. They can help uncover the myths. The risk with the covered call is the same as with the naked put. The risk is that the stock goes down.

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

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

Long Straddles

The long straddle is a position where the trader buys a call and a put with same strikes and expiration. The idea behind the strategy is that a large move is expected but the trader is unsure about which direction. Usually, this strategy is used prior to an earnings report or FDA approval for a drug company or some other big announcement. If the report is favorable, the stock may run wild to the upside; if not, it may tank. So the strategy plays both sides.

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

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

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

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

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

Ok, ready for one more?

Ratio Spread

Let's look at a more complicated position -- the ratio spread. I am only showing this to demonstrate the power of the profit and loss diagrams and why you should learn to use them. I will not even discuss the strategy (although it is available on our free options online course). But I do want to see if you can identify the critical points.

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

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

It's pretty tough isn't it?

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

Much easier, isn't it? We can now see that the trader will make money if the stock either collapses below $50 or rises up to $65, which is the point of maximum profit. After $65, the trader starts to lose some profits and will reach a breakeven point around $73 ($71.45 to be exact). Beyond $73, unlimited losses will occur.

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

Learn to use them, as they will greatly help your understanding of option strategies! We will be using them in the courses that follow to make important points about strategies. If you were not comfortable with profit and loss diagrams, it would be a good idea to go back and review. We also offer a bonus workshop, which is listed in the courses if you'd like to work some sample problems.