Table of Contents
Thank you for purchasing the complete TradewithOptions program. We hope you learn to trade
options profitably and achieve your financial dreams. You are on your way to securing your own
financial freedom. Below is the table of contents for each course with links that will take you
directly to the course sections.
Hedging Your Risk
1. Identifying Risk
2. Risk Reduction Techniques
3. Strategy – Collar Trades
a. Example 1 – USG
b. Example 2 – USG Modified
c. Example 3 – AAPL
4. Summary
Stock Analysis 101
5. Overview
6. Where to find stocks
7. Analysis Techniques
a. Fundamental
b. Technical
c. Sentimental
8. Summary
Debit Spreads
9. Debit Spreads Overview
10. Bull Call Spreads
a. Example 1 - SHLD
b. Example 2 - USG
11. Bear Put Spreads
a. Example 3 - RIMM
12. Summary
Credit Spreads
13. Credit Spreads Overview
14. Bull Put Spreads
a. Example 1 - HDI
b. Example 2 - SUN
15. Bear Call Spreads
a. Example 3 - HAR
16. Summary
Business Plan Essentials
17. Overview
18. Various Security Taxation
19. Trader Tax Status vs. Individual Investor
20. Entity Benefits
21. Example – Tax Savings
22. Summary
Calendar Spreads
23. Calendar Spreads Overview
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Table of Contents
24. Trade Examples
a. Example 1 - PAYX - Calls
b. Example 2 - MON - Calls
c. Example 3 - PEP - Puts
25. Summary
Advanced Neutral Strategies
26. Advanced Neutral Strategies Overview
27. Long Straddle
a. Example 1 - AAPL
28. Long Strangle
a. Example 2 - AAPL
29. Short Straddle
a. Example 3 - RIMM
30. Summary
Advanced Combination Strategies
31. Advanced Combination Strategies Overview
32. Butterfly
a. Example 1 - RIMM
33. Dual Credit Spreads
a. Example 2 - RIMM
34. Summary
Systematic Writing Strategy
35. Systematic Writing Strategy Overview
36. In Theory
37. In Practice
38. Summary
Options to Repair Losing Stocks
39. Options to Repair Losing Stocks Overview
40. Small losses over short term
41. Larger losses over longer term
42. Any size loss over any time frame
43. Summary
Advanced Ratio Spreads
44. Advanced Ratio Spreads Overview
45. Example 1
46. Modified Ratio Spread
47. Example 2
48. Summary
Dividend Income Strategy
49. Dividend Income Strategy Overview
50. Ex-Dividend Dates
51. Stock Splits
52. Dividend Income Strategy
53. Summary
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Hedging Your Risk
Hedging Your Risk
1. Identifying Risk
In theory, any investment carries some risk of loss. Your investment in your home and
cars, for example, could be destroyed in fires or accidents. If your home burned down to
the ground, your investment in your house would be worth very little. To offset the risk
of loss on your assets, you purchase insurance where you pay a premium to obtain
coverage for a period of time. Your premium may be more or less expensive depending
on the size of your deductible. The larger the deductible, the less expensive your
premiums will be. That is because you are assuming more risk with a larger out of
pocket deductible.
Your portfolio also carries risk of loss. All assets in a well diversified portfolio of stocks,
bonds, and mutual funds carries risk of loss and could theoretically go to zero. The odds
of that happening are slim, but there is a risk that you would lose all your assets in your
portfolio. Options can be used as risk management tools to prevent loss in entire
portfolios. We will review techniques to reduce risk to your acceptable levels. Since
options essentially serve as insurance on your portfolio, you will have similar choices
involved with other insurances. You must decide how much coverage you need, how
long you need it, and how much of a deductible you want. The first step is identifying
risk points. The risk in going long securities is that the value goes to zero and you lose
your entire investment.
Many option trading strategies you will learn introduce the idea of being short an option
contract. Shorting options introduces another type of risk since you are essentially giving
someone else the right to choose to exercise the option contract. If they choose to
exercise the option contract they hold, you will be obligated to fulfill the contract terms.
Therefore, it is very important to understand the Option Term Matrix below. By buying
options, you have the right to exercise the contract or not. In contrast, if you sell an
option contract, you are giving someone else that right.
If you are short a Call contract and the contract holder exercises the contract, you will be
obligated to sell the stock at the contract strike price. If you do not own the stock in your
portfolio currently, you can borrow it from your broker and you will be short the stock in
your account.
If you are short a Put contract and the contract holder exercises the contract, you will be
obligated to buy the stock at the contract strike price. This transaction will work the
same as if you were buying the stock in the open market. If you have a margin account at
your broker, you will only need 50% of the capital to buy stock to fulfill your short Put
obligation.
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Hedging Your Risk
Understand Contract Terms
Calls
Puts
Long (Buyer)
Right to buy stock at strike
price before expiration
Right to sell stock at strike
price before expiration
Short (Writer/Seller)
Legal obligation to sell
stock at strike price before
expiration
Legal obligation to buy
stock at strike price before
expiration
2. Risk Reduction Techniques
We will review two techniques to reduce risk in your portfolio. The most common
method presented in the marketplace is Diversification. A better alternative for an
advanced investor is utilizing options to hedge your risk.
For decades, money managers have been preaching the benefits of diversifying your
portfolio. Thousands of books are available on the topic where you will find many ways
to diversify your portfolio. Diversification, as a risk management technique, is based on
the foundation of utilizing various trading instruments such as stocks, bonds, and mutual
funds in your portfolio. The objective is to be exposed to different parts of the market at
the same time. In down markets, diversification will not prevent losses. It is meant to
slow the bleeding in your portfolio by partially offsetting losses in stocks with income
generated by bonds. This slows the bleeding because different trading instruments
respond to changes in the market at different rates.
There are two huge problems with diversification. First, you can not limit your risk to
your personal risk tolerance level in your portfolio. You will not find in any of the
thousands of books out there any method to calculate your maximum risk in your
portfolio using diversification as your primary risk reduction technique. Your maximum
risk can not be calculated because the relationship between the various trading
instruments is not defined or fixed. The second problem with diversification is that the
same logic used to slow the bleeding in your portfolio also applies to the growth in your
portfolio. By using different trading instruments that respond to changes in the market at
different rates, you are stagnating growth because securities that perform well will be
offset by losses in other securities.
A better alternative is to use Put options as insurance on your portfolio. Review the
example of an investor trading Enron from the Options Basic course. You will note the
stock trader lost his entire investment, while the smarter options trader had purchased
Puts as insurance on his Enron investment and exercised his right to sell Enron at $87.50
even though Enron stock was trading in the open market below $60. Below is the
detailed example.
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Hedging Your Risk
Example – Married Put, from Options Basics Course
A Put contract gives the owner the right, but not the obligation, to sell stock at a specific
price (Strike Price) on before the expiration date. Think of Puts as an insurance contract
similar to insurance on your home or car. You pay a premium to buy an insurance policy
that will pay you if your home burns down or if you wreck your car. Puts are insurance
contracts for your portfolio. Let's look at an example comparing a stock trader with an
options trader using puts. Assume a stock trader owns 1000 shares of Enron back in 2000
when it was trading at its split-adjusted high of about $87 per share. Our option trader
also owned 1000 shares of Enron, but also owned 10 Put contracts giving him the right to
sell his 1000 shares of Enron stock anytime in the next 120 days for a guaranteed price of
$87.50 per share. The put contracts cost $3,000 so his cost basis in his trade is $90,000.
As you know, Enron disclosed significant accounting irregularities and the stock
plummeted straight down. Our stock trader realized substantial losses, while the options
trader was protected from downside moves and exercised his option to sell his stock at
$87.50. If you own stocks and do not own Puts protecting your portfolio, you are at risk.
This information is presented in the table below.
Cost of 1000 shares of
Enron @ $87.
Stock Trader
Options Trader
$87,000
$87,000
Cost of 10 PUT contracts
expiring in 120 days at a
strike price of $87.50
$3,000
Cost Basis of Trade
$87,000
$90,000
Maximum Risk
$87,000
$2,500
($20,000)
($2,500)
($87,000)
($2,500)
Results
Enron traded for less than
$60 in 2001 – assume stock
sold at $60
Enron traded for less than
$1 in 2002 – assume stock
trader held stock hoping for
a bounce back.
You can see that using Puts as insurance on your investment provides absolute risk
reduction by limiting your risk of loss to a quantifiable amount. Being able to calculate
your maximum risk in your portfolio is a better risk reduction technique that is available
to options traders. Using Puts as insurance gives you absolute protection on the
downside and still allows unlimited upside growth.
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Hedging Your Risk
Although buying Puts on individual stocks provides great insurance, it can consume
significant amounts of time and capital. To get similar insurance protection quickly and
easily without tying up a lot of capital, you can buy Puts that are based on market
indexes. Let’s review a sample portfolio and examine various ways to hedge your
downside risk using Puts.
Let’s use the following ten stocks in our sample portfolio: IBM, YHOO, DELL, AAPL,
CAT, WMT, BBY, DAL, PIXR, GS. The first step is to analyze your portfolio to
determine classifications and percentages. We can break down our sample portfolio a
couple ways, by industry and index components.
Industries
40% High Tech, 20% Retail, 10% Banking/Finance, 10% Industrial,
10% Entertainment, 10% Transportation
Index Components
80% in S&P 500
If you invest in mutual funds, they will provide percentages and classifications for you in
their prospectus.
To hedge our risk of loss in our sample portfolio, we can buy Puts on industry segment
indexes or on market indexes. If we wanted insurance protection on the portion of our
portfolio related to Transportation specifically, we could buy a Put on the Dow Jones
Transportation average ($DTX). To obtain broader coverage on the sample portfolio, we
could buy Puts on the S&P 500 market index ($SPX) since 80% of our portfolio is
included in the S&P 500 Index. To buy Puts covering a percentage of your portfolio, you
can perform a quick calculation to determine the number of Puts needed to provide
coverage. Assume the 8 stocks in our sample portfolio that are included in the S&P 500
are worth $100,000 and the S&P 500 index is trading at $1,190. Simply divide the index
amount into the value of the portfolio represented by the S&P 500 components.
$100,000/$1,190 = 84 SPX’s. Since each Put contract represents 100 shares, we can buy
1 SPX Put to get coverage on the 80% of our portfolio related to the S&P 500. This will
save us significant amounts of capital and time.
If the stocks in our portfolio related to the S&P 500 decreases, the gain in SPX Put will
offset losses in the stock, but not a 1for1 direct relationship. If the stocks dropped by
$5,000, our Put may only increase in value by $4,000. Therefore, the SPX Put is not a
perfect hedge, although it does absorb a significant amount of the loss. Options are
available on most indices to utilize as a hedge in your portfolio. In addition, you can use
them on your retirement accounts and any mutual funds you may have.
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Hedging Your Risk
3. Strategy- Collar Trades
The collar trade is a natural extension of the covered call strategy defined in the Options
Basics course. Although the covered call strategy can be used to generate large annual
returns, its drawback was that it left large amounts of money at risk in the trade. To
alleviate this situation from the initial trade setup, the collar trade is used to reduce your
maximum risk.
Strategy Objectives
Use multiple contracts and trading instruments to provide reward
potential, while providing an active hedge as insurance.
GOAL = Provide insurance for our investment at little to no cost
Strategy Benefits
Protecting your investment
Low Maintenance, Low Risk
High Annual Return Rates
Steps
1. Find a stock you would like to own or already own.
2. Perform analysis (including Technical, Fundamental, and Sentimental) to determine
anticipated price movement.
– Note – If you are unfamiliar with standard analysis, I have a course
available to bring you up to speed called Stock Analysis 101.
3. Evaluate Option chain focusing on Intrinsic/Extrinsic value of Contracts.
4. Evaluate your choices of Insurance points.
Trade Structure
– Combines Stock and Options.
– Buy 1000 shares of stock and simultaneously sell 10 CALL Contracts
representing 1000 shares of stock and use proceeds from sale of CALL
Contracts to purchase Puts for insurance.
Review Short Call Obligations from Matrix – By selling a CALL
contract, you are giving someone else the right to buy your stock at
a fixed price.
– Is basically the combination of a Covered Call strategy from Options
Basics lesson with Long Put
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Hedging Your Risk
Example 1 – USG Corp
Since the strategy is a natural extension of the covered call strategy reviewed previously,
we will use the same trade examples in this strategy to compare and contrast the two
strategies. For our first trade, we’ll use USG as our stock we would like to own. We can
pull up a chart on www.bigcharts.com to see the past year price chart that confirms USG
is in a bullish trend up. Therefore, we will continue to anticipate the stock going up from
here. Earnings have recently been released so we do not expect any short term news to
come out that would impact the stock price. See the chart below.
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Hedging Your Risk
Next, we will review an option chain for USG available at www.optionsxpress.com. For
this trading strategy, we want to look at Call contracts that are at least two strike prices InThe-Money to capture Intrinsic Value and build in our margin of error. We are also buying
a Put as insurance on our investment in the trade. Review the Option Chain for USG Corp
below.
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Hedging Your Risk
You can see that the $37.50 Strike Call contract is the second contract listed that is
In-The-Money (starting from the Out-Of-The-Money Call Contracts shown in white).
The intrinsic value of the $37.50 strike Call contract can be calculated by subtracting
the strike price from the current market price ($41.51-$37.50 = $4.01). Since the
Intrinsic value is $4.01 and the market price for the contract is $6.20, there is $2.19
($6.20 - $4.01) of Extrinsic value in this option.
The objective of this strategy is to buy intrinsic value in the stock and sell extrinsic
value in the Call options while building in a margin of error into your trades. That is
very important to understand. Your trades will build in a buffer in case the stock
moves against your initial expectation. Remember we selected this stock in
anticipation that it would go up from here. The short call option will provide our
margin of error in case the stock moves down. In addition, we are adding an
insurance point in case the stock drops by more than our margin of error.
To establish the Deep In-The-Money Collar Trade, you will buy the stock and
simultaneously sell the Call contract. We will also add a Put contract as our
insurance point. In our example, we will use a standard 1000 shares of stock and 10
Call and Put contracts representing 1000 shares of stock.
Cost of Trade
Buy 1000 shares of USG at $41.51
– This will consume $41,510 or if you have a margin account, only half of
the stock position will be required, which is $20,755.
Sell 10 June $37.50 Calls at ($6.20)
Buy 10 June $32.50 Puts at $1.05
Net Cost/Share = $36.36 (calculated as $41.51 - $6.20 + 1.05)
By selling the Call contracts, we are giving someone else the right
to buy the stock from us at $37.50. That’s okay though since our
cost is $36.36.
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Hedging Your Risk
Review Trade Metrics/Calculations
The notations made following these calculations compare the results to the
metrics calculated in the Covered Call Strategy. You should compare
them with those listed in the Options Basics course.
Max Gain = Short Call Strike Price less net cost of trade
$37.50 - $36.36 = $1.14 per share, or $1,140 total
Our max gain amount has decreased by the cost of the Put contracts.
Break even = Stock price less credit from selling Call plus cost of Put
$41.51 – $6.20 + $1.05 = $36.36. Stock must be at or above this amount to
breakeven or make a profit. Current stock price = $41.51
Gives you a 12.4% margin of error.
By building in a margin of error, you are increasing
your probability of winning! Your profitability does not
depend on your prediction that the stock will go up.
The stock can also decrease and you will still win.
Our break even point increased by the cost of the Put contract. Our
margin of error decreased slightly from 15% to 12.4%.
Max Risk = Net cost of trade less Put Strike ($36.36 - $32.50) = $3.86/share, $3,860
We essentially forfeited some of the profits in exchange for significantly
less risk in the trade. In the Covered Call strategy, this trade’s max risk
was $35,310. In the Collar trade, it is only $3,860. We cut our risk to
1/10th the amount at risk previously. By owning the Put contract, we have
the right to sell our stock at $32.50 if it falls to zero. The Put is our
insurance for our investment in the trade.
Reward/Risk Ratio
– Equals max gain divided by max risk
$1.14 / $3.86 = 30%
Our reward/risk ratio increased dramatically because we eliminated so
much of the dollar amount at risk. A better metric to use now is the
reward/capital ratio.
Reward/Capital Ratio
– Equals max gain divided by Capital consumed
$1.14 / $36.36 = 3.1%
3.1% in 30 days equates to an Annual Rate
of Return of 44%!!!
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Hedging Your Risk
Below is the Profit and Loss Diagram for the combined position of long stock, long Put
and a short Call Option known as the Collar trade. You can see on the Profit and Loss
Diagram the current stock price is already well above our Maximum gain point. By using
the short Call Option contract, we have built in a Margin of Error on this trade. We can
be completely wrong on our analysis of expected stock movement up and still win our
maximum profit! As long as the stock is trading above $37.50 by the expiration date in
30 days, we will win our $1,140!
D
E
F
$2,000
G
H
I
J
35
37.5
K
L
M
N
Margin of
Error = 12.4%
$1,000
$profit / loss
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
25
27.5
30
32.5
40
42.5
45
47.5
50
$(1,000)
Current Stock
Price
$(2,000)
$(3,000)
$(4,000)
Break-Even
$(5,000)
stock price
Trade Results: At expiration, the stock was trading even higher at $46.81. We allowed
our short call to be assigned which means we were obligated to sell our stock at $37.50.
Our cost basis in the trade was only $36.36 so we achieved our maximum profit of
$1,140 in only 30 days. We are on our way to achieving our annual rate of return of over
44%!
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Hedging Your Risk
Example 2 – USG Corp - Modified
Let’s review a variation of the previous trade to illustrate the differences in trade metrics
and performance if we choose different option contracts for both the Calls and Puts.
Review the option chain for USG presented below. In this example, we will sell the
$42.50 strike Call at $3.60 and buy a $37.50 strike Put at $2.45 as our insurance point.
Note that the Call contract we are selling is at-the-money and not deep in-the-money.
That will play directly into our margin of error. This is the same trade structured with
different option contracts which directly affects the trade metrics calculated. Using
different option contracts ultimately will affect our profitability so be sure to run through
several different combinations on any potential trade. See the recalculated trade metrics
below.
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Hedging Your Risk
Cost of Trade
Buy 1000 shares of USG at $41.51
– This will consume $41,510 or if you have a margin account, only half of
the stock position will be required, which is $20,755.
Sell 10 June $42.50 Calls at ($3.60)
Buy 10 June $32.50 Puts at $2.45
Net Cost/Share = $40.36 (calculated as $41.51 - $3.60 + 2.45)
By selling the Call contracts, we are giving someone else the right
to buy the stock from us at $42.50. That’s okay though since our
cost is $40.36.
Review Trade Metrics/Calculations
The notations made following these calculations compare the results to the
metrics calculated in the previous Collar trade.
Max Gain = Short Call Strike Price less net cost of trade
$42.50 - $40.36 = $2.14 per share, or $2,140 total
Our max gain amount has increased by $1,000 compared to the previous
trade setup.
Break even = Stock price less credit from selling Call plus cost of Put
$41.51 – $3.60 + $2.45 = $40.36. Stock must be at or above this amount to
breakeven or make a profit. Current stock price = $41.51
Gives you a 2.8% margin of error.
Notice the dramatic decrease in your margin of error.
You will win fewer trades by sacrificing your margin of
error.
Max Risk = Net cost of trade less Put Strike ($40.36 - $37.50) = $2.86/share, $2,860
We essentially forfeited some of the margin of error in exchange for
slightly less dollars at risk and increased profit potential in the trade.
Compare these metrics to those in trade example 1.
Reward/Risk Ratio
– Equals max gain divided by max risk
$2.14 / $2.86 = 75%
Our reward/risk ratio increased dramatically because we eliminated
some of the dollar amount at risk and also increased our max gain. A
better metric to use now is the reward/capital ratio.
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Hedging Your Risk
Reward/Capital Ratio
– Equals max gain divided by Capital consumed
$2.14 / $40.36 = 5.3%
5.3% in 30 days equates to an Annual Rate
of Return of 86%!!!
This variation of the collar trade is much more aggressive than the trade setup
presented in example 1. To achieve a higher profit potential with slightly less dollars
at risk, you must sacrifice your margin of error. You can see the Reward/Risk metric
jumped to 75%. Remember, your probability of winning has an INVERSE
relationship with the Reward/Risk ratio. As your Reward/Risk ratio jumped, your
margin of error in the trade approaches zero. This means you must be correct in your
analysis of the stock movement to make money. Review the Profit and Loss Diagram
for this variation of the collar trade and note that the price of the stock must increase
from the current stock price to achieve your maximum gain. You are essentially
playing the same game as a stock trader by basing your profitability on the direction
of a stock move.
D
E
F
G
H
I
J
K
L
M
N
Margin of
Error = 2.8%
$3,000
$2,000
Break-Even
$1,000
profit / loss
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
$25
27.5
30
32.5
35
37.5
40
42.5
45
47.5
50
$(1,000)
Current Stock
Price
$(2,000)
$(3,000)
$(4,000)
stock price
Trade Summary
Although this variation of the trade has increased our potential profit and decreased
our dollars at risk, it has pushed us into a trade where profitability is dependent on the
stock price moving up past $42.50.
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Hedging Your Risk
Do not be seduced by the better Reward/Risk ratio, increased potential profitability,
and less dollars at risk in your trades. You should focus on probabilities of winning
in your trades and always build in a sufficient margin of error. By focusing on
establishing larger margins of error in your trades, you will achieve a much higher
win/loss ratio.
Therefore, I would recommend you apply the trade setup presented in example 1 and
be excited about achieving a 44% annual rate of return. That will beat 99% of the
professional money managers in the market!
Example 3 – AAPL – Apple Computer
For this trade, we’ll use AAPL as our stock we would like to own. We can pull
up a chart on www.bigcharts.com to see the past year price chart that confirms
AAPL is in a bullish trend up. Therefore, we will continue to anticipate the stock
going up from here. Earnings have recently been released so we do not expect
any short term news to come out that would impact the stock price. See the chart
below.
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Hedging Your Risk
Next, we will review an option chain for AAPL available at www.optionsxpress.com. The
standard option chain will list Call contracts on the left and Put contracts on the right with a
column of strike prices down the center. The In-The-Money Calls and Puts are shaded in
light yellow. For this trading strategy, we want to look at Call contracts that are at least
two strike prices In-The-Money to capture Intrinsic Value and build in our margin of error.
We are also buying a Put as insurance on our investment in the trade. Review the Option
Chain for AAPL below.
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Hedging Your Risk
You can see that the $37.50 Strike Call contract is the second contract listed that is
In-The-Money (starting from the Out-Of-The-Money Call Contracts shown in white).
The intrinsic value of the $37.50 strike Call contract can be calculated by subtracting
the strike price from the current market price ($41.19-$37.50 = $3.69). Since the
Intrinsic value is $3.69 and the market price for the contract is $4.90, there is $1.21
($4.90 - $3.69) of Extrinsic value in this option.
The objective of this strategy is to buy intrinsic value in the stock and sell extrinsic
value in the Call options while building in a margin of error into your trades. That is
very important to understand. Your trades will build in a buffer in case the stock
moves against your initial expectation. Remember we selected this stock in
anticipation that it would go up from here. The option will provide our margin of
error in case the stock moves down.
To establish the Deep In-The-Money Collar Trade, you will buy the stock and
simultaneously sell the Call contract. We will also add a Put contract as our
insurance point. In our example, we will use a standard 1000 shares of stock and 10
Call and Put contracts representing 1000 shares of stock.
Cost of Trade
Buy 1000 shares of AAPL at $41.19
This will consume $41,190 or if you have a margin account, only half of the stock
position will be required, which is $20,595. A single stock futures (SSF) account
would only require $8,240! You should substitute SSF’s for stock wherever
possible.
Sell 10 April $37.50 Calls at ($4.90)
Buy 10 April $35. Puts at $.60
Net Cost/Share $36.89 calculated as ($41.19 - $4.90 + $.60)
By selling the Call contracts, we are giving someone else the right
to buy the stock from us at $37.50. That’s okay though since our
cost is $36.89.
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Hedging Your Risk
Review Trade Metrics/Calculations
Max Gain = Short Strike Price less net cost of trade
$37.50 - $36.89 = $.61 per share, or $610 total
Our max gain amount decreased by the cost of the Put contracts.
Break even = Net cost of trade
$41.19 – $4.9 +$.60= $36.89. Stock must be at or above this amount
to breakeven or make a profit. Current stock price = 41.19
Gives you a 10.4% margin of error.
By building in a margin of error, you are increasing
your probability of winning! Your profitability
does not depend on your prediction that the stock
will go up. The stock can also decrease and you
will still win.
Our break even point increased by the cost of the Put contracts. Our
margin of error decreased slightly from 12% to 10.4%
Max Risk = Net cost of trade less Put Strike ($36.89 - $35.00) = $1.89/share, $1,890
We essentially forfeited some of the profits in exchange for significantly
less risk in the trade. In the Covered Call strategy, this trade’s max risk
was $36,290. In the Collar trade, it is only $1,890. We cut our risk to
1/20th the amount at risk previously.
Reward/Risk Ratio
– Equals max gain divided by max risk
$.61 / $1.89 = 32%
Our reward/risk ratio increased dramatically because we eliminated so
much of the dollar amount at risk. A better metric to use now is the
reward/capital ratio.
Reward/Capital Ratio
– Equals max gain divided by Capital consumed
$.61 / $8.24 = 7.4%
7.4% in 30 days equates to an Annual Rate
of Return of 136%!!!
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19
Hedging Your Risk
Below is the Profit and Loss Diagram for the combined position of long stock, long Put,
and a Short Call Option known as a Collar Trade. You can see on the Profit and Loss
Diagram the current stock price is already well above our Maximum gain point. By using
the Option contract, we have built in a Margin of Error on this trade. We can be
completely wrong on our analysis of expected stock movement up and still win our
maximum profit! As long as the stock is trading above $37.50 by the expiration date in
30 days, we will win our $610, or 136% on capital!
D
E
F
G
H
I
J
35
37.5
K
L
M
N
Margin of
Error = 10.4%
$1,000
$500
$profit / loss
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
25
27.5
30
32.5
40
42.5
45
47.5
50
$(500)
$(1,000)
Break-Even
Current Stock
Price
$(1,500)
$(2,000)
$(2,500)
stock price
Trade Results:
April 15th AAPL closed at $35.39, down $5.80 or 14% from where we entered the
trade. Our cost basis in the trade was $36.89 so we can either make an adjustment or
take a loss. The loss would only be $1,500 vs. a loss of $5,800 had we only bought
the stock for our initial trade. The short Call option expired worthless so we kept the
entire $4,900 collected from selling the Call contracts. This gave us our cost basis in
the remaining stock we owned of $36.89. At this point we owned the stock and the
Call option expired. Our $35 strike Put also expired worthless since the stock was
trading above $35 at expiration. Just one day before the options expiration date,
AAPL dropped down to the $36 level. This huge amount of volatility factored into
the Put option value increasing its market price. We could have sold the Put contract
for a $1.25 which would lower our cost of the trade down to $35.64 ($36.89 - $1.25).
This would mean our worst case scenario is taking a loss of $.25 per share or $250
total and moving on to the next trade.
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20
Hedging Your Risk
We could decide to enter another Covered Call by selling a $30 Call against our stock
and collect $8/share. That would lower our cost basis in the stock to $27.64 ($35.64 $8) and obligate us to sell the stock at $30 if AAPL trades above $30 at expiration of
the next month. That would leave us with profit potential of $2.36/share, or $2,360
on a stock that went from $41 down to $35. We were completely wrong and could
simply REACT to the downward movement by adjusting our trade and maintaining
profit potential.
AAPL
dropped
right at
expiration
We elected not to enter another Covered Call and just 3 days later, AAPL traded up to
$37.74 giving us the opportunity to sell our stock at $37.70. We sold our stock for
$37.70 and our cost basis was $36.89 so we captured a profit of $.81 or $810 for the
trade.
We made more money than we originally planned because we simply REACTED to
the stocks downward movement and adjusted our trade. That’s the power of options!
We made more money when we were completely wrong about the stock!
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21
Hedging Your Risk
4. Summary
Identifying your risk is the first step to Hedging Your Risk. You can hedge your risk
in your portfolio to match your specific risk tolerance level. You can even hedge
your downside risk in retirement accounts and mutual funds. The benefits of hedging
your risk with options are absolute protection with quantifiable risk levels while also
maintaining all your upside profit potential.
The Collar trade is a natural extension of the Deep In-The-Money Covered Call
Strategy. The Collar trade will dramatically reduce the amount of dollars at risk in
exchange for a small portion of the upside profit potential. Remember to structure
your trades focusing on large margins of error to generate more consistent wins and
profits. By using single stock futures in place of regular stock you can generate huge
annual returns while building in high probability trades! Whenever possible, you
should substitute single stock futures for regular stock to reduce the margin
requirements and increase your reward/capital ratio.
Collar strategies allow you time to simply REACT to stock movements instead of
trying to predict them. You can adjust your trades at any point to maximize your
profitability in options trading. Always know your risk points and how to hedge your
trades. As always, due diligence will make you a better and more successful trader
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22
Stock Analysis 101
Stock Analysis 101
1. Overview
Although the strategies presented in the TradewithOptions.com courses build in margins
of error that greatly increase your probability of winning, an important factor for
increasing your profitability in trading is knowing how to analyze a stock to determine
potential stock moves. By capturing the stock move in your trade, you will increase your
profitability. No one can predict the future and know which way a stock will move;
however, there are analysis techniques available to help you form an opinion on which
way the stock will move. Understanding how to combine these analysis techniques with
your trading strategy will elevate your profitability.
This course will illustrate several of the most common analysis techniques available to
help you increase the profitability of your trading. We will examine Fundamental,
Technical, and Sentimental analysis. Our emphasis will be on Technical analysis which
focuses on shorter term trading time frames that coincide with the strategies discussed
throughout the program.
One should note that all these analysis techniques are valid; however, there is no sure
way to predict the direction of a stock move. In fact, the technical indicators we will
review are only indicators, not rules the stock follows. No indicator can be relied upon
100% of the time since markets are constantly changing. In addition, an indicator that
seems to apply consistently to one security will not apply to other securities. Often it
appears that each security has its own set of indicators that work the majority of the time.
Therefore, your objective is to find which analysis techniques apply to the securities that
you will be trading. Then you can form an objective opinion on the future direction of a
stock move.
As always, even though we will predominantly rely on technical analysis, one should be
aware of any pending news that could affect the direction of a stock move. For example,
you want to know dates for when earnings are being released, FDA product approvals,
mergers/acquisitions, and any other situations that could make the stock move
significantly in the short-term time frame. These types of events can cause the Volatility
value of an Option contract to change suddenly as well as push the stock into a
directional move. Some of the strategies we will review take advantage of pending news
announcements and the resulting short term stock moves; however, for the strategies
reviewed so far in Options Basics, and Hedging Your Risk, you would be better off to
avoid trading stocks with pending news to be released at some point in the trade’s
duration.
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Stock Analysis 101
2. Where to find stocks
The first step for all trades is deciding which securities you are going to trade. What do
you look for in a stock and where do you find stocks fitting your criteria are the most
frequently asked questions. Since there are over 10,000 stocks traded in the exchanges,
finding a specific stock that meets your trading criteria can be a cumbersome task and
consume significant amounts of time. Traders often take two different approaches to this
task. First, a trader can get comfortable with a specific trading strategy and then search
through all the stocks to find a specific stock that would be ideal for his trading strategy.
Alternatively, a trader can be armed with many trading strategies and only follow a few
stocks because he knows that he will have a strategy to fit the stock no matter what he
anticipates happening with the stock. I am most comfortable following only a handful of
stocks and being prepared with many different strategies to apply to those stocks in
various situations. If you are a trader that would prefer to trade one specific strategy and
search through over 10,000 stocks to find one that is ideal for your strategy, there are
tools available to help you screen the market for stocks with your criteria. Refer to the
website links page on the www.TradewithOptions.com website.
For beginner traders, I recommend trading very stable stocks with lots of daily volume
which are typically the “Blue Chip” stocks. You can also start with the top stocks listed
in the Dow Jones Industrial Average, S&P 100, or Nasdaq 100 indices. You may be
more comfortable with the stock of a Company you are very familiar with, such as your
employer, or a Company that produces the goods you use everyday. The point is to start
with only a handful of stocks that you are comfortable with and can easily find
information about. This will reduce the amount of time required to get to know what
drives the performance of the stock you are trading and what can impact the direction of a
stock move.
There are several sources available to start your search for stocks that you would like to
trade. Check the business section of your local newspaper, Wall Street Journal, or
Investors Business Daily for articles on Companies in the news. There are also several
magazines highlighting business activity and investment information such as Money
Magazine’s list of 1,3, and 6 month largest stock move. Of course there are several
outlets online to find information. Please refer to the Links page on the
TradewithOptions.com website.
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Stock Analysis 101
3. Analysis Techniques
As mentioned, we will review three types of analysis techniques: Fundamental,
Technical, and Sentimental. Fundamental analysis is a stock valuation methodology
primarily driven by earnings. Technical analysis involves charting and identifying
consistent patterns that repeat themselves. Sentimental analysis focuses on current
investor expectations of the stock.
Fundamental Analysis
As fundamental analysis is primarily driven by earnings and earnings growth of a
company, there are very few indicators that you can use for our short-term trading time
frame. It is more useful for long-term investing; however, it is useful to perform
fundamental analysis to become comfortable with the stock you will be trading.
You can find information on a Company’s balance sheet, earnings, and earnings growth
at several online sources. Some of my favorites include www.finance.yahoo.com,
www.Zacks.com, and www.quicken.com. A fundamentally sound company will have
little to no debt, positive earnings, and strong revenue and earnings growth. Many
successful investors buy-and-hold fundamentally strong companies. Beginner traders
should focus on trading fundamentally sound companies to get comfortable with the
trading strategies.
These websites provide information on the two fundamental indicators you should follow
for short-term trading: Earnings Growth, and Earnings Momentum. When evaluating
earnings growth, be sure to compare the most recent quarter’s earnings with the earnings
of the same quarter last year. If earnings are growing, it is a good sign that the future
outlook for the stock is strong. If earnings are deteriorating, it may be a sign that the
future outlook for the stock is weak. We can trade the stock whether it goes up or down.
You also want to evaluate earnings momentum which is the rate of change in earnings. If
the momentum is increasing and earnings are growing by larger percentages than
anticipated by analysts, then we can expect short term movement up in the stock. The
larger the percentage of earnings growth over analysts estimates (Earnings Surprise), the
more likely the stock will move up.
Fundamental analysis is more useful for long-term investors because it is very difficult to
anticipate how all the factors affecting the future earnings of a company will directly
affect the stock price in the next couple days to weeks. You’ll see this play out in the
market when earnings are released. Often times, when positive earnings are announced,
the stock price declines and when negative earnings are announced, the stock price rises.
Once you see this occurring, you must consider other analysis techniques for the shortterm time frame, hence technical analysis comes into play.
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25
Stock Analysis 101
Technical Analysis
Technical analysis is the study of price and volume used to forecast price action. It is
based on three assumptions. First, market action is forward looking. Second, price
moves in trends, and third, history repeats itself. The technical analyst believes that
anything affecting a stock’s price has already been factored into the current stock price.
Therefore, a trader would only need to analyze price and volume in an attempt to identify
patterns that repeat themselves.
The indicators we will review in this section are based on mathematical calculations;
however, you will not be required to know how to calculate the indicators in your trading.
You will only need to understand what they mean and how to apply them to your trading.
It is similar to a mechanic driving a car. The mechanic knows how the combustion
engine in a car functions, but you do not need to be a mechanic to drive a car. Nonmechanics can drive once they understand how the accelerator, brakes, and steering
systems work. We will use www.BigCharts.com as our free charting service to illustrate
these indicators in our examples.
The first step is to pull up a chart with a time frame of about six months to a year so you
can see the history of the stock at a quick glance. You will be able to visually identify
whether the stock is in a trend or a trading range. This is key to selecting which
indicators you will use on your remaining technical analysis efforts on this stock.
Trending stocks will use one set of indicators, while stocks moving within a trading range
will use a second set of indicators called oscillators.
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26
Stock Analysis 101
The first group of indicators we will examine are intended for stocks in a trending state.
Let’s identify a stock in a trend and illustrate support and resistance points. An uptrend is
a price pattern with a series of higher highs and higher lows. A downtrend is the opposite
price pattern with a series of lower highs and lower lows. Support is the point where
buying interest overcomes selling pressure. Resistance is the point where selling pressure
overcomes buying interest. Review the chart below to identify these points.
Resistance
Support
Support and Resistance
This stock is in an uptrend with a series of higher highs and higher lows. You can see the
lines of support and resistance where the buying and selling interest reverse while the
stock still moves in the current trend. The green arrows indicate a buy signal where the
stock nears the support levels and the red arrows indicate a sell signal where the stock
nears the resistance level.
A valid trend with related support and resistance lines can be substantiated by drawing a
straight line through three points on the chart. You can see both the support and
resistance lines pass through three points on the price chart to validate the trend. Support
and resistance lines are common indicators to use on trending stocks.
Moving Averages
Moving averages are simple calculations that can be plotted on a graph to illustrate a
trend direction. Moving averages are lagging indicators since they rely on historical price
data in their calculations. In the chart above, there are two moving averages plotted. The
red line is based on a 20 day moving average where each day’s closing price for the last
20 days are added together and divided by 20 to get the moving average. The yellow line
is based on a 50 day moving average. When the faster moving average (20 day) crosses
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27
Stock Analysis 101
over the slower moving average (50 day), it can generate a buy signal. See the blue
arrow in the above chart. When the faster moving average crosses below the slower
moving average, it can generate a sell signal. See the yellow arrow in the above chart.
Price Gaps
Price Gaps are common chart patterns that can be great buy and sell signals. Price gaps
are areas on charts where no trading has occurred. For example, gaps commonly occur as
earnings are released on stocks. Earnings are typically released either before the market
opens or after the market closes. When the stock begins trading after earnings
announcements, it is typically at a price above or below the previous closing price.
Upside gaps are usually a sign of strength in the market, while downside gaps are signs of
weakness. A breakaway gap is the primary signal for trading and can signal the
beginning of a major market move. It must occur with HEAVY Volume. See the chart
below.
You can see on this chart that the first gap occurred downward and also had heavy
volume. This gap is a great sell signal. The second and third gap occurred upward on
heavy volume and was a great buy signal. Price Gaps that occur on heavy volume are
great buy and sell signals.
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Stock Analysis 101
Bollinger Bands
Bollinger bands are statistical calculations based on 2 standard deviations of the moving
average calculation. The bands are designed to capture 95% of the price data of the
stock. The bands expand and contract based on the volatility in the stock. When the
bands are far apart, it indicates higher volatility in the stock. When the bands are close
together it indicates lower volatility and may signal a new directional move for the stock.
When prices move outside the bands, it generates buy and sell signals. Review the chart
below.
On the above chart, you can see that when the price breaks through the bottom Bollinger
Band, it generates a buy signal (green arrow) and the price bounces off the bottom band
and heads higher. When the price breaks through the top Bollinger Band, it generates a
sell signal (red arrow) and the price typically bounces off the top band and heads lower.
Bollinger Bands work best on stocks that are not in a trend, but are in a trading range.
You can see most of our buy and sell signals occur when the stock is fluctuating between
$40 and $45. Near the last buy signal in the end of May, you can see the Bollinger Bands
getting closer together indicating lower volatility. When the bands are contracted, it
indicates a potential price breakout is going to occur, but it doesn’t indicate which
direction.
The following indicators are classified as oscillators and work best on stocks that are in a
trading range. These oscillators will provide upper and lower boundaries to the stocks
price action that will generate buy and sell signals.
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Stock Analysis 101
Relative Strength Index (RSI)
This is a popular oscillator that measures overbought and oversold conditions on a stock
and generates a ratio on a scale of 0-100. When price reaches an extreme higher
boundary, typically over 70, the stock is considered overbought and this generates a sell
signal. When the price reaches an extreme lower boundary, typically under 30, the stock
is considered oversold and this generates a buy signal. Review the chart below.
You can see on the chart that when the RSI reaches an extreme high, it generates a sell
signal and when the RSI reaches an extreme low, it generates a buy signal. The RSI is a
common oscillator that works well for stocks in a trading range such as CAT above that
trades between $100 and $85 regularly.
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Stock Analysis 101
Moving Average Convergence/Divergence (MACD)
The MACD indicator combines the features of an oscillator with a moving average
crossover system. The moving average (MA) is calculated based on a faster MA, such as
the 20 day, and a slower MA, such as the 50 day. The difference between the two
averages is the convergence/divergence level. This is plotted on a scale of positive and
negative numbers. When the convergence/divergence crosses over and under the zero
line, it generates buy and sell signals. Review the following chart.
You can see on the chart that the MACD generated a buy signal (green arrow) when the
convergence/divergence of the two moving averages crossed above the zero line on the
scale. This is also the point where the two moving averages cross over each other.
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Stock Analysis 101
Slow Stochastic
This indicator uses two lines called %K and %D to measure overbought and oversold
conditions. The %D is the slow stochastic and is our primary indicator that provides the
best buy and sell signals before other indicators. The two lines are plotted on a scale
between 0-100. A slow stochastic over 80 indicates a potential market top generating an
initial sell signal. A slow stochastic under 20 indicates a potential market bottom
generating a buy signal. Review the chart below to identify the buy and sell signals
generated from the slow stochastic.
As you can see on the chart, the slow stochastic generated buy signals (green arrow)
when the stochastic broke underneath the 20 line and generated sell signals (red arrow)
when the stochastic broke above the 80 line. These were valid buy and sell signals on
MCD that would provide excellent early trading signals. The slow stochastic will
typically be the first indicator to generate a buy or sell signal.
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Stock Analysis 101
Money Flow
Money Flow is an indicator that attempts to measure the supply and demand of a stock.
When money is flowing into a stock, it increases demand and subsequently the price of
the stock. As money is flowing out of a stock, it decreases demand and the price of the
stock declines. The money flow is plotted on a scale of positive and negative numbers.
When the money flow crosses over the zero line it will generate signals. See the chart
below for the buy and sell signals.
The money flow indicator does not generate a significant amount of signals as it looks at
the bigger picture of where dollars are flowing over time. This is a good signal to gauge
the overall direction of a stock over a larger time frame.
You can find all these indicators using www.BigCharts.com. The link is available on the
www.TradewithOptions.com website. When you use BigCharts, click on the “Interactive
Chart” button to pull up various options for your technical analysis. You can select
indicators from a drop down list. Review the following chart to identify the points in
BigCharts to insert your favorite indicators. You can also store your chart settings for
future use. BigCharts will also include Earnings announcements, Dividend dates, and
stock splits on the charts to easily identify the impact of these announcements on the
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Stock Analysis 101
stock’s price. To find these news announcements, you would have to switch off
Bollinger Bands and select all news events from the drop down list (Red arrow).
Know the difference between trending indicators and oscillators that generate the best
signals during non-trending (sideways) markets. For each security, indicators will
behave differently. You need to identify patterns of signals that are unique to each
security. Due diligence will make you a better trader!!
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Stock Analysis 101
Sentimental Analysis
Sentimental analysis involves gauging the investing public’s current expectations for a
particular security. It often follows that the majority of the investing public are wrong on
their expectations of stock movement; therefore, if you can gauge the current expectation
or sentiment for a particular security, you can place a trade contrary to those expectations
and be on the winning side of the trade. Sentimental analysis is an approach that
requires a trader to think objectively and independently when placing trades. We will
review several indicators used to identify current expectations of the securities.
Put/Call Ratio
This is a ratio of the volume of Puts traded to Calls traded. When the Put/Call ratio is
low, it indicates that the majority of investors are bullish on the stock because there are
more Calls being traded. Investors buy calls in anticipation of stocks increasing.
Therefore, to place trades contrary to public opinion, a trader would structure a trade in
anticipation of the stock decreasing. When the put/call ratio is at extreme levels, as
measured over the past year, it can generate reliable buy and sell signals. You can find
Put/Call ratio’s on the www.OptionsXpress.com stock quote detail page. An example is
presented on the following page. The red arrows point to the average Put/Call ratio and
the current Put/Call ratio. In this example, you can see the current Put/Call ratio of 1.61
is higher than the average ratio of 1. Therefore, more people are buying Puts in the belief
that the future direction of the QQQQ market is downward. To place a contrarian trade, a
trader can buy Calls since the investing public is wrong the majority of the time.
Open Interest
Open Interest can also be helpful in identifying public sentiment. Open Interest is the
measure of cumulative demand for an option, and is the number of outstanding contracts.
In our example, the blue arrow points to our open interest measurement. Open interest
will increase as new contracts are written, or sold, in the marketplace. It will decrease as
a buyer closes out an old short position.
Surveying the sentiment of the investing public can give strong clues as to which way
one should trade the market. The public is most bullish as the market reaches its top and
starts to turn back down and they are most bearish as the market nears its bottom and
starts to turn back up. Knowing that the public is wrong the majority of the time means
one should take a contrarian viewpoint to the public and trade against them.
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Stock Analysis 101
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Stock Analysis 101
4. Summary
This course has illustrated several of the most common analysis techniques available to
help you increase the profitability of your trading. We examined Fundamental,
Technical, and Sentimental analysis.
The key fundamental analysis techniques include knowing the earnings release dates or
other anticipated news release, and monitoring the change in analyst earnings estimates
and/or recommendations. Beginners should trade fundamentally sound companies.
Technical analysis will give you tools to help form an opinion on which way a stock will
move. Remember, they are just indicators and will not be 100% accurate. Always build
in a margin of error into your trades.
Measuring the sentiment of the investing public will give you an edge in your trading.
The public is wrong on their expectation the majority of the time, so you will want to
place trades contrary to public sentiment.
By capturing the stock move in your trade, you will increase your profitability. No one
can predict the future and know which way a stock will move; however, these analysis
techniques are available to help you form an opinion on which way the stock will move.
Understanding how to combine these analysis techniques with your trading strategy will
elevate your profitability.
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37
Debit Spreads
Debit Spreads
1. Debit Spreads Overview
The previous strategies reviewed (Deep ITM Covered Calls and Collars) have included
combinations of stock, or single stock futures, and options in the initial trade. In this
course, we will examine a strategy that combines two different option contracts into one
trade and eliminates the need for using stocks or single stock futures in your initial trade
setup. These strategies are called Debit Spreads in the options world. The strategies are
spreads because the structure of the trade essentially spreads the risk between various
option contracts. It carries the name Debit spread because to initiate the trade, you will
have a debit in your brokerage account which means it will cost you money up front to
put on the trade. Credit spreads, by contrast, put money in your account upfront. In this
course we will examine two types of debit spreads: Bull Call Spread and Bear Put
Spread.
You can structure debit spread trades to profit from stocks that are moving up or down.
To increase your profit potential, your stock analysis techniques will come into play for
debit spreads. You will still build in margins of error into your trades to increase your
probability of winning and you will be able to profit even if your analysis of stock
movement is wrong.
Debit spreads can earn highly leveraged returns since they require much less capital
upfront. This will build on our previous strategies learned and fix some of the drawbacks
of using the Deep ITM Covered Call and Collar trade. The Collar trade reduced the
amount of dollars at risk from the Covered Call strategy, but still required large amounts
of capital to put on the trades. Debit spreads will address that issue by drastically
reducing the amount of capital required to initiate a trade, while still providing risk
management and reward potential.
To structure a debit spread, you are going to buy a Deep In-The-Money (ITM) option and
sell an At-The-Money (ATM) option. You can use both Calls and Puts for a debit spread.
To determine whether to use Calls or Puts, you need to perform your stock analysis and
form an opinion as to which way the stock will move. If you anticipate the stock moving
up, you will use Calls and structure a Bull Call Spread. Alternatively, if you anticipate
the stock moving down, you will use Puts and structure a Bear Put Spread. We will
examine both trade setups in this course.
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Debit Spreads
2. Bull Call Spreads
In a Bull Call Spread strategy, a trader has the opinion that a stock will make a move
upward and buys one strike call and simultaneously sells a higher strike call. When you
are long an option contract, time value and changes in volatility premiums work against
you; however, they work in favor of the option seller. The higher strike call contract sold
in this strategy serves to offset the forces of time value decay and changes in volatility for
your long call contract. This is a major advantage over just buying a call contract by
itself. By neutralizing the affects of extrinsic value in your long contract, you are giving
up some upside profit potential. As you will see, trading off some profit potential in
exchange for neutralizing the components of option valuation that work against you is
well worth it.
Buying one strike call contract gives you the right to buy the underlying stock up to the
expiration date. By selling a higher strike call contract, you are giving someone else the
right to buy your stock from you at a higher price. Since the agreed upon sales price is
fixed, you have capped your profit potential. Traders should use the same number of
long contracts as short contracts and also be sure to have the same expiration date. There
are many ways to structure a Bull Call Spread, but we will examine a more conservative
approach that increases our probability of winning.
Strategy Objectives
• Use multiple contracts to provide reward potential while providing a margin of
error.
• GOAL = Buy Intrinsic Value and Sell Extrinsic Value
Strategy Benefits
• High Reward Potential
• Neutralizes effect of Time Decay and Volatility changes
• Low maintenance, Low Risk
• High Annual Return Rates
Steps
1. Find a stock you would like to Trade.
2. Perform analysis (including Technical, Fundamental, and Sentimental) to
determine anticipated price movement.
3. Review volatility to ensure a debit trade is appropriate.
4. Evaluate Option chain focusing on Intrinsic/Extrinsic value of Contracts.
Note: Bull Call Spreads are used when you anticipate the stock going up.
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Debit Spreads
Trade Structure
– Combines 2 different Option contracts.
– Buy one strike Call and simultaneously sell a higher strike Call – Buy a
Deep I.T.M. Call and sell an A.T.M. call!
Review Short Call Obligations from Matrix – By selling a CALL
contract, you are giving someone else the right to buy your stock at
a fixed price.
– Functions similar to a Deep ITM Covered Call strategy that requires much
less capital to setup.
Example 1 – SHLD
For our first trade, we’ll use SHLD as our stock we would like to trade. We can pull up a
chart on www.bigcharts.com to see the past year price chart that confirms SHLD is in a
bullish trend up. Therefore, we will continue to anticipate the stock going up from here.
Earnings have recently been released so we do not expect any short term news to come
out that would impact the stock price. We can perform our stock analysis and look for
signals that will help form an opinion of future stock movement direction; however,
reviewing stock analysis indicators is outside the scope of this course so we will bypass
this function at this point. Please refer to the Stock Analysis 101 course for more
information on practical stock analysis techniques. See the chart below.
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Debit Spreads
Next, we will review the volatility valuation for SHLD available at www.ivolatility.com.
For this trading strategy, we want to look at stocks with options at low levels of implied
volatility. Review the Implied Volatility chart for SHLD below.
The gold line in the above graph plots the current Implied Volatility of SHLD. The blue
line plots the 30 day historical volatility. You can see the current implied volatility is at
about 35% which is near its lowest levels over the past year. Therefore, it meets our low
volatility requirement for a debit spread.
Next, we will review an option chain for SHLD available at www.optionsxpress.com.
For this trading strategy, we want to look at Call contracts that are deep In-The-Money to
capture Intrinsic Value and sell Call contracts that are closer to being At-The-Money to
capture Extrinsic value and neutralize the affects of extrinsic value in our long contract.
Review the Option Chain for SHLD below.
www.TradewithOptions.com
41
Debit Spreads
Quotes as of 7/11/2005 5:29:22 PM ET. Intraday data delayed at least 15 minutes.
Last
Change
Bid
Ask
Day High
Day Low
Volume
SEARS HLDG CP (SHLD)
155.21
3.12 155.23 - 155.49
156.47
152.60 3,566,382
SHLD Expiration Months: Jul 05 | Aug 05 | Sep 05 | Oct 05 | Dec 05 | Jan 06 | Jan 07
Calls
Symbol Last Chg
Aug 05
Calls
Bid
Puts
Open
Ask Volume
Int
Strike Symbol Last Chg
Bid
Ask Volume
SHLD @ 155.21
(39 days to expiration)
Open
Int
Aug 05 Puts
KTQHY 26.40 +2.90 26.10 26.50
60
552 trade 130.00 KTQTY
0.50 -0.55 0.60 0.65
KTQHX 22.90 +4.60 21.60 22.00
529
302 trade 135.00 KTQTX
0.90 -0.80 1.00 1.15
KTQHW 17.70 +2.20 17.40 17.80
128
142 trade 140.00 KTQTW 1.80 -0.90 1.70 1.85
299
KTQHV 13.60 +2.10 13.60 13.90
182
420 trade 145.00 KTQTV
2.90 -1.30 2.85 3.00
315 1,090 trade
KTQHU 10.30 +1.40 10.20 10.50
256 1,096 trade 150.00 KTQTU
4.70 -1.60 4.50 4.70
735 1,144 trade
KDUHK
7.70 +1.30 7.40 7.70
415 1,561 trade 155.00 KDUTK
6.90 -1.90 6.60 6.90
258
761 trade
KDUHL
5.30 +0.80 5.30 5.50
414 1,911 trade 160.00 KDUTL
9.50 -2.30 9.50 9.70
109
292 trade
12
230 trade
49
880 trade
200 1,022 trade
890 trade
KDUHM 3.60 +0.50 3.60 3.80
164
901 trade 165.00 KDUTM 13.10 -3.80 12.70 13.00
KDUHN
2.65 +0.65 2.35 2.55
221
918 trade 170.00 KDUTN 17.60
0 16.50 16.80
0
87 trade
KDUHO
1.55 +0.15 1.50 1.60
313
592 trade 175.00 KDUTO 26.00
0 20.70 21.00
0
41 trade
KDUHP
1.00 +0.15 0.90 1.05
276
750 trade 180.00 KDUTP 24.80 -4.20 25.10 25.50
30
You can see that the $135 Strike Call contract is deep In-The-Money. The intrinsic value
of the $135 strike Call contract can be calculated by subtracting the strike price from the
current market price ($155.21-$135 = $20.21). Since the Intrinsic value is $20.21 and the
market price for the contract is $22, there is $1.79 ($22 - $20.21) of Extrinsic value in
this option. The $135 strike call has mostly Intrinsic value and will fit our long call
requirement for this strategy.
The objective of this strategy is to buy intrinsic value in the deep ITM option and sell
extrinsic value in an option closer to being At-The-Money. If we sell an option one strike
higher at the$140 strike, we are moving closer to being At-The-Money. We will sell the
$140 strike Call. The Intrinsic value of the $140 strike Call is $15.21 ($155.21 - $140).
Since the market price of the option we are selling at the bid is $17.40, there is $2.19 of
Extrinsic value ($17.40 – $15.21). Since there is more extrinsic value in the $140 option
than in the $135 option, we are selling more extrinsic value than we are buying. This will
work in our favor.
By using two call contracts, we are spreading the risk between the options. Our long
$135 strike Call gives us the right to buy the stock at $135 by expiration. We sold a $140
strike Call which gave someone else the right to buy the stock from us at $140.
Therefore the most profit we can achieve with this trade is the difference between the two
options of $5, ($140-$135). Review the trade metrics below.
www.TradewithOptions.com
42
Debit Spreads
Cost of Trade
Buy 10 $135 strike Calls at $22
Sell 10 $140 strike Calls at ($17.40)
Net Cost/Share = $4.6 (calculated as $22 - $17.40)
By selling the Call contracts, we are giving someone else the right
to buy the stock from us at $140.
Review Trade Metrics/Calculations
Max Gain = (Long Call Strike Price less Short Call Strike Price) less net cost of trade
($140 - $135) - $4.6 = $.40 per share, or $400 total
Break even = Net Cost per share plus long Call strike price
$4.60 + $135 = $139.6. Stock must be at or above this amount to
breakeven or make a profit. Current stock price = $155.21
Gives you a 10% margin of error.
By building in a margin of error, you are increasing
your probability of winning! Your profitability does not
depend on your prediction that the stock will go up.
The stock can also decrease and you will still win.
Max Risk = Net cost/share X number of shares
$4.60 X 1000 shares = $4,600
If this was a Covered Call strategy, this trade’s max risk would be
$137,810. By spreading risk between two option contracts, we have
forfeited some of the upside potential in exchange for reducing our
amount at risk and capital required to put on the trade.
Reward/Risk Ratio
– Equals max gain divided by max risk
$.40 / $4.6 = 8.7%
The Reward/Risk ratio will be the same as our Reward/Capital ratio
since our Capital requirements to put on the trade will equal our
maximum risk.
8.7% in 39 days equates to an Annual Rate
of Return of 116%!!!
www.TradewithOptions.com
43
Debit Spreads
Below is the Profit and Loss Diagram for the combined position of long Call and short
Call known as the Bull Call Spread. You can see on the Profit and Loss Diagram the
current stock price is already well above our Maximum gain point. By using the short
Call Option contract, we have built in a Margin of Error on this trade. We can be
completely wrong on our analysis of expected stock movement up and still win our
maximum profit! As long as the stock is trading above $140 by the expiration date in 39
days, we will win our $400, and be on our way to winning 216% for the year!
D
E
F
G
H
I
J
K
L
M
N
Margin of
Error = 10%
$1,000
$110
115
120
125
130
135
140
145
150
155
160
$(1,000)
profit / loss
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
$(2,000)
Break-Even
Current Stock
Price
$(3,000)
$(4,000)
$(5,000)
stock price
Trade Results: At expiration, the stock was trading down at $135.14. We allowed our
short call to expire worthless and kept the entire premium of $17.40 from the sale. In
addition we adjusted the trade to react to the downward movement and capture additional
profit. For more information on adjustments, sign up for the live interactive sessions
available at www.TradewithOptions.com.
The Deep ITM Bull Call Spread has reduced the amount of capital required to put on the
trade versus the Covered Call and Collar trades, and has provided excellent reward
potential while building in a margin of error into our trading. By using multiple option
contracts, we have structured a trade with high probabilities of winning and consumed
less capital.
www.TradewithOptions.com
44
Debit Spreads
As you compare different combinations of options in this Bull Call Spread trade setup,
you will find trade setups that offer very high Reward/Risk ratio’s where you can win
much more than you have at risk. For example, if you review the option chain in the
above example and you decide to buy the $155 strike call and sell the $160 strike call
your Profit and Loss Diagram will look like the following.
D
E
F
G
H
I
J
K
L
M
N
$4,000
$3,000
Current Stock
Price
$2,000
profit / loss
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
$1,000
$135
140
145
150
155
160
165
170
175
180
185
$(1,000)
Break-Even
$(2,000)
$(3,000)
stock price
As you move the spread closer to being At-The-Money (ATM) or even Out-of-theMoney (OTM), the cost of the spread will become cheaper and your Reward/Risk ratio
will increase. What you don’t see on the graph is your probability of winning! As you
move your spread closer to being ATM, you are sacrificing your margin of error in your
trading and you will lose more trades. To make a profit in the $155-$160 Bull Call
Spread, the stock has to move up. If the stock stayed near its current price of $155, you
would realize your maximum loss. Be sure to maintain your discipline to structure trades
that have high probabilities of winning, by building in your margins of error. You will be
very happy with your 8.7% return that equates to an annual rate of return of 116%!
Example 2 – USG
Let’s review another example of a Bull Call Spread trade. For this example, we will use
USG Corp which we reviewed in both the Deep ITM Covered Call and Collar strategies.
We will show USG structured in a Bull Call Spread to allow you to compare the different
trade setups side by side.
www.TradewithOptions.com
45
Debit Spreads
We can pull up a chart on www.bigcharts.com to see the past year price chart that
confirms USG is in a bullish trend up. Therefore, we will continue to anticipate the stock
going up from here. Earnings have recently been released so we do not expect any short
term news to come out that would impact the stock price. We can perform our stock
analysis and look for signals that will help form an opinion of future stock movement
direction; however, reviewing stock analysis indicators is outside the scope of this course
so we will bypass this function at this point. Please refer to the Stock Analysis 101
course for more information on practical stock analysis techniques. See the chart below.
www.TradewithOptions.com
46
Debit Spreads
Next, we will review the volatility valuation for USG available at www.ivolatility.com.
For this trading strategy, we want to look at stocks with options at low levels of implied
volatility. Review the Implied Volatility chart for USG below.
The gold line in the above graph plots the current Implied Volatility of USG. The blue
line plots the 30 day historical volatility. The blue arrow points to the time this trade was
initiated (Mid May).You can see the implied volatility is at about 50% which is near its
lowest levels over the past year. The volatility has just decreased off the highest points
for the year. Therefore, it meets our low volatility requirement for a debit spread.
Next, we will review an option chain for USG available at www.optionsxpress.com. For
this trading strategy, we want to look at Call contracts that are deep In-The-Money to
capture Intrinsic Value and sell Call contracts that are closer to being At-The-Money to
capture Extrinsic value and neutralize the affects of extrinsic value in our long contract.
Review the Option Chain for USG below.
www.TradewithOptions.com
47
Debit Spreads
You can see that the $35 Strike Call contract is deep In-The-Money. The intrinsic value
of the $35 strike Call contract can be calculated by subtracting the strike price from the
current market price ($41.51-$35 = $6.51). Since the Intrinsic value is $6.51 and the
market price for the contract is $8.30, there is $1.79 ($8.30 - $6.51) of Extrinsic value in
this option. The $35 strike call has mostly Intrinsic value and will fit our long call
requirement for this strategy.
www.TradewithOptions.com
48
Debit Spreads
The objective of this strategy is to buy intrinsic value in the deep ITM option and sell
extrinsic value in an option closer to being At-The-Money. If we sell an option one strike
higher at the$37.50 strike, we are moving closer to being At-The-Money. We will sell the
$37.50 strike Call. The Intrinsic value of the $37.50 strike Call is $4.01 ($41.51 $37.50). Since the market price of the option we are selling at the bid is $6.20, there is
$2.19 of Extrinsic value ($6.20 – $4.01). Since there is more extrinsic value in the $37.50
strike option than in the $35 strike option, we are selling more extrinsic value than we are
buying. This will work in our favor.
By using two call contracts, we are spreading the risk between the options. Our long $35
strike Call gives us the right to buy the stock at $35 by expiration. We sold a $37.50
strike Call which gave someone else the right to buy the stock from us at $37.50.
Therefore the most profit we can achieve with this trade is the difference between the two
options of $2.50, ($37.50-$35). Review the trade metrics below.
Cost of Trade
Buy 10 $35 strike Calls at $8.30
Sell 10 $37.50 strike Calls at ($6.20)
Net Cost/Share = $2.10 (calculated as $8.30 - $6.20)
By selling the Call contracts, we are giving someone else the right
to buy the stock from us at $37.50.
Review Trade Metrics/Calculations
Max Gain = (Long Call Strike Price less Short Call Strike Price) less net cost of trade
($37.50 - $35) - $2.1 = $.40 per share, or $400 total
Break even = Net Cost per share plus long Call strike price
$2.10 + $35 = $37.10. Stock must be at or above this amount to breakeven
or make a profit. Current stock price = $41.51
Gives you a 11% margin of error.
By building in a margin of error, you are increasing
your probability of winning! Your profitability does not
depend on your prediction that the stock will go up.
The stock can also decrease and you will still win.
Max Risk = Net cost/share X number of shares
$2.10 X 1000 shares = $2,100
If this was a Covered Call strategy, this trade’s max risk would be
$35,310. By spreading risk between two option contracts, we have
forfeited some of the upside potential in exchange for reducing our
amount at risk and capital required to put on the trade.
www.TradewithOptions.com
49
Debit Spreads
Reward/Risk Ratio
– Equals max gain divided by max risk
$.40 / $2.1 = 19%
The Reward/Risk ratio will be the same as our Reward/Capital ratio
since our Capital requirements to put on the trade will equal our
maximum risk.
19% in 30 days equates to an Annual Rate
of Return of over 700%!!!
Below is the Profit and Loss Diagram for the combined position of long Call and short
Call known as the Bull Call Spread. You can see on the Profit and Loss Diagram the
current stock price is already well above our Maximum gain point. By using the short
Call Option contract, we have built in a Margin of Error on this trade. We can be
completely wrong on our analysis of expected stock movement up and still win our
maximum profit! As long as the stock is trading above $37.50 by the expiration date in
30 days, we will win our $400, and be on our way to winning over 800% for the year!
D
E
F
G
H
I
J
K
L
M
N
Margin of
Error = 11%
$1,000
$500
$profit / loss
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
22.5
25
27.5
30
32.5
35
37.5
40
42.5
45
47.5
$(500)
$(1,000)
$(1,500)
Break-Even
Current Stock
Price
$(2,000)
$(2,500)
stock price
Trade Results: At expiration, the stock was trading even higher at $46.81. We allowed
our short call to be assigned which means we were obligated to sell our stock at $37.50.
Our long call gave us the right to buy the stock at $35 so we bought the stock at $35 and
turned around and sold it at $37.50. We achieved our maximum profit of $400 in only 30
days. We are on our way to achieving our annual rate of return of over 800%!
www.TradewithOptions.com
50
Debit Spreads
The Deep ITM Bull Call Spread has reduced the amount of capital required to put on the
trade versus the Covered Call and Collar trades, and has provided excellent reward
potential while building in a margin of error into our trading. By using multiple option
contracts, we have structured a trade with high probabilities of winning and consumed
less capital. Review the Bull Call Spread trade structure and compare it to the Deep ITM
Covered Call and Collar trade setups from previous courses.
3. Bear Put Spreads
In a Bear Put Spread strategy, a trader has the opinion that a stock will make a move
downward and buys one strike put and simultaneously sells a lower strike put. When you
are long an option contract, time value and changes in volatility premiums work against
you; however, they work in favor of the option seller. The lower strike put contract sold
in this strategy serves to offset the forces of time value decay and changes in volatility for
your long put contract. This is a major advantage over just buying a put contract by
itself. By neutralizing the affects of extrinsic value in your long contract, you are giving
up some upside profit potential. As you will see, trading off some profit potential in
exchange for neutralizing the components of option valuation that work against you is
well worth it.
Buying one strike put contract gives you the right to sell the underlying stock up to the
expiration date. By selling a lower strike put contract, you are giving someone else the
right to sell their stock to you at a lower price. Since the agreed upon sales price is fixed,
you have capped your profit potential. Traders should use the same number of long
contracts as short contracts and also be sure to have the same expiration date. There are
many ways to structure a Bear Put Spread, but we will examine a more conservative
approach that increases our probability of winning.
Strategy Objectives
• Use multiple contracts to provide reward potential while providing a margin of
error.
• GOAL = Buy Intrinsic Value and Sell Extrinsic Value
Strategy Benefits
• High Reward Potential
• Neutralizes effect of Time Decay and Volatility changes
• Low maintenance, Low Risk
• High Annual Return Rates
Steps
1. Find a stock you would like to Trade.
2. Perform analysis (including Technical, Fundamental, and Sentimental) to
determine anticipated price movement.
3. Review volatility to ensure a debit trade is appropriate.
4. Evaluate Option chain focusing on Intrinsic/Extrinsic value of Contracts.
Note: Bear Put Spreads are used when you anticipate the stock going down.
www.TradewithOptions.com
51
Debit Spreads
Trade Structure
– Combines 2 different Option contracts.
– Buy one strike Put and simultaneously sell a lower strike Put – Buy a
Deep I.T.M. Put and sell an A.T.M. Put!
Review Short Put Obligations from Matrix – By selling a Put
contract, you are giving someone else the right to sell their stock to
you at a fixed price.
Example 3 – RIMM
For our next trade, we’ll use RIMM as our stock we would like to trade. We can pull up
a chart on www.bigcharts.com to see the past year price chart that confirms RIMM is in a
flat to downward trend. Therefore, we will continue to anticipate the stock going down
from here. Earnings have recently been released so we do not expect any short term
news to come out that would impact the stock price. We can perform our stock analysis
and look for signals that will help form an opinion of future stock movement direction;
however, reviewing stock analysis indicators is outside the scope of this course so we
will bypass this function at this point. Please refer to the Stock Analysis 101 course for
more information on practical stock analysis techniques. See the chart below.
www.TradewithOptions.com
52
Debit Spreads
Next, we will review the volatility valuation for RIMM available at www.ivolatility.com.
For this trading strategy, we want to look at stocks with options at low levels of implied
volatility. Review the Implied Volatility chart for RIMM below.
The gold line in the above graph plots the current Implied Volatility of RIMM. The blue
line plots the 30 day historical volatility. You can see the implied volatility is at about
40% which is near its lowest levels over the past year. Therefore, it meets our low
volatility requirement for a debit spread.
Next, we will review an option chain for RIMM available at www.optionsxpress.com.
For this trading strategy, we want to look at Put contracts that are deep In-The-Money to
capture Intrinsic Value and sell Put contracts that are closer to being At-The-Money to
capture Extrinsic value and neutralize the affects of extrinsic value in our long contract.
Review the Option Chain for RIMM below.
www.TradewithOptions.com
53
Debit Spreads
Calls
Symbol Last Chg
Aug 05
Calls
Bid
Puts
Open
Ask Volume
Int
0 23.70 24.00
Bid
Ask Volume
RIMM @ 71.11
(37 days to expiration)
RUPHW 24.00
Strike Symbol Last Chg
Open
Int
Aug 05 Puts
0
35 trade 47.50 RUPTW 0.15
0 0.05 0.10
0
21 trade
RUPHJ 22.90
0 21.30 21.50
0
68 trade 50.00 RUPTJ
0.10
0 0.05 0.15
0
329 trade
RUPHK 18.00
0 16.50 16.60
0
46 trade 55.00 RUPTK
0.25
0 0.15 0.25
0
482 trade
RUPHL 11.70 -1.00 11.80 12.00
1
137 trade 60.00 RUPTL
0.50
0 0.50 0.55
277 2,396 trade
70
RUPHM
7.70 -0.50 7.60 7.80
346 trade 65.00 RUPTM
1.35 +0.10 1.30 1.35
815 2,122 trade
RUPHN
4.60 -0.20 4.30 4.40
272 1,140 trade 70.00 RUPTN
3.00 +0.25 3.00 3.10
270 5,429 trade
RUPHO
2.30 -0.20 2.10 2.20
489 3,175 trade 75.00 RUPTO
5.70 +0.30 5.70 5.90
234 3,586 trade
RUPHP
1.00 -0.10 0.95 1.00
404 3,652 trade 80.00 RUPTP
9.44 +0.34 9.50 9.70
74
503 trade
RUPHQ
0.40 -0.10 0.35 0.45
66 3,603 trade 85.00 RUPTQ 14.00 +0.60 13.90 14.20
6
363 trade
RUPHR
0.15 -0.05 0.15 0.20
RUPHS
0.15
0 0.05 0.10
RUPHE
0.05
0
0 0.10
274 1,553 trade 90.00 RUPTR 17.70
0 18.80 19.00
0
48 trade
0
861 trade 95.00 RUPTS 21.80
0 23.70 24.00
0
30 trade
0
276 trade 100.00 RUPTE 26.70
0 28.70 29.00
0
0 trade
You can see that the $85 Strike Put contract is deep In-The-Money. The intrinsic value
of the $85 strike Put contract can be calculated by subtracting the current market price
from the strike price ($85 - 71.11 = $13.89). Since the Intrinsic value is $13.89 and the
market price for the contract is $14.20, there is $.31 ($14.20 - $13.89) of Extrinsic value
in this option. The $85 strike Put has mostly Intrinsic value and will fit our long Put
requirement for this strategy.
The objective of this strategy is to buy intrinsic value in the deep ITM option and sell
extrinsic value in an option closer to being At-The-Money. If we sell an option one strike
lower at the $80 strike, we are moving closer to being At-The-Money. We will sell the
$80 strike Put. The Intrinsic value of the $80 strike Put is $8.89 ($80 - $71.11). Since
the market price of the option we are selling at the bid is $9.50, there is $.61 of Extrinsic
value ($9.50 - $8.89). Since there is more extrinsic value in the $80 strike option than in
the $85 strike option, we are selling more extrinsic value than we are buying. This will
work in our favor.
By using two Put contracts, we are spreading the risk between the options. Our long $85
strike Put gives us the right to sell the stock at $85 by expiration. We sold an $80 strike
Put which gave someone else the right to sell their stock to us at $80. Therefore the most
profit we can achieve with this trade is the difference between the two options of $5,
($85-$80). Review the trade metrics below.
Cost of Trade
Buy 10 $85 strike Puts at $14.20
Sell 10 $80 strike Puts at ($9.50)
Net Cost/Share = $4.70 (calculated as $14.20 - $9.50)
By selling the Put contracts, we are giving someone else the right
to their stock to us at $80.
www.TradewithOptions.com
54
Debit Spreads
Review Trade Metrics/Calculations
Max Gain = (Long Put Strike Price less Short Put Strike Price) less net cost of trade
($85 - $80) - $4.70 = $.30 per share, or $300 total
Break even = Long Put strike price less Net Cost per share
$85 - $4.70 = $80.30. Stock must be at or below this amount to breakeven
or make a profit. Current stock price = $71.11
Gives you a 13% margin of error.
By building in a margin of error, you are increasing
your probability of winning! Your profitability does not
depend on your prediction that the stock will go down.
The stock can also increase and you will still win.
Max Risk = Net cost/share X number of shares
$4.70 X 1000 shares = $4,700
By spreading risk between two option contracts, we have forfeited some of
the upside potential in exchange for reducing our amount at risk and
capital required to put on the trade.
Reward/Risk Ratio
– Equals max gain divided by max risk
$.30 / $4.70 = 6.4%
The Reward/Risk ratio will be the same as our Reward/Capital ratio
since our Capital requirements to put on the trade will equal our
maximum risk.
6.4% in 37 days equates to an Annual Rate
of Return of over 83%!!!
Below is the Profit and Loss Diagram for the combined position of long Put and short Put
known as the Bear Put Spread. You can see on the Profit and Loss Diagram the current
stock price is already well below our Maximum gain point. By using the short Put
Option contract, we have built in a Margin of Error on this trade. We can be completely
wrong on our analysis of expected stock movement down and still win our maximum
profit! As long as the stock is trading below $80 by the expiration date in 37 days, we
will win our $300, and be on our way to winning over 83% for the year!
www.TradewithOptions.com
55
Debit Spreads
D
E
F
G
H
I
J
K
L
M
N
Margin of
Error = 13%
$1,000
$60
65
70
75
80
85
90
95
100
105
110
$(1,000)
profit / loss
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
$(2,000)
Break-Even
Current Stock
Price
$(3,000)
$(4,000)
$(5,000)
stock price
Trade Results: At expiration, the stock was trading slightly higher at $73.28. We
allowed our short put to be assigned which means we were obligated to buy the stock at
$80. Our long put gave us the right to sell the stock at $85 so we bought the stock at $80
and turned around and sold it at $85. We achieved our maximum profit of $300 in only
37 days. We are on our way to achieving our annual rate of return of over 83%!
The Deep ITM Bear Put Spread has reduced the amount of capital required to put on the
trade and has provided excellent reward potential while building in a margin of error into
our trading. By using multiple option contracts, we have structured a trade with high
probabilities of winning and consumed less capital.
4. Summary
In this course we have examined two types of debit spreads: Bull Call Spread and Bear
Put Spread. Debit spreads can earn highly leveraged returns since they require much less
capital upfront. This course has built on our previous strategies learned and fixed some
of the drawbacks of using the Deep ITM Covered Call and Collar trade. The Collar trade
reduced the amount of dollars at risk from the Covered Call strategy, but still required
large amounts of capital to put on the trades. Debit spreads addressed that issue by
drastically reducing the amount of capital required to initiate a trade, while still providing
risk management and reward potential.
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56
Debit Spreads
You can structure debit spread trades to profit from stocks that are moving up or down.
To increase your profit potential, your stock analysis techniques will come into play for
debit spreads. Be sure to review the stock analysis 101 course for more information. You
will still build in margins of error into your trades to increase your probability of winning
and you will be able to profit even if your analysis of stock movement is wrong.
Since you are both buying and selling options, you will offset the negative affects of time
value decay and changes in volatility in your long contract. By putting on debit spreads
when volatility is low, you are increasing your adjustment potential in case the trade
moves against you and making it easier to exit the trade early with a profit.
Although you can structure debit spreads into a very high Reward/Risk ratio, remember
that the probability of winning has an inverse relationship with the Reward/Risk ratio.
By structuring trades deep ITM, you are increasing your probability of winning. Be
disciplined enough to remain conservative in your trading and you will see huge annual
returns.
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57
Credit Spreads
Credit Spreads
1. Credit Spreads Overview
Credit Spread strategies are similar to Debit Spreads although they are opposite
strategies. Like the Debit Spreads, the Credit Spreads are strategies that essentially
spread the risk between various option contracts. They carry the name Credit spread
because to initiate the trade, you will have a Credit in your brokerage account which
means it will put money in your account up front. In this course we will examine two
types of Credit spreads: Bull Put Spread and Bear Call Spread.
You can structure credit spread trades to profit from stocks that are moving up or down.
To increase your profit potential, your stock analysis techniques will come into play.
You will still build in margins of error into your trades to increase your probability of
winning and you will be able to profit even if your analysis of stock movement is wrong.
Credit spreads can earn highly leveraged returns since they require much less capital
upfront while still providing risk management and reward potential. Although, they are
similar to Debit Spreads, the primary difference between the two is the level of implied
volatility levels. For the debit spreads, you identified potential trades where implied
volatility was at low levels. Since we are spreading risk between two different option
contracts by being long and short at the same time, the time value decay and changes in
volatility values of one contract offset the other. The point of getting into debit spreads
when volatility is low is to increase our adjustment potential of the trade. For credit
spreads, you want to identify potential trades where implied volatility is at high levels.
When volatility is higher, entering a credit spread will have increased adjustment
potential for when our trades move against our expectations.
A major point of distinction between the debit spreads and credit spreads is where your
profits are generated. In a debit spread, your profits come primarily from your long
contract, while in credit spreads your profits come from the short contract. The exit
strategies for credit spreads are much cheaper and simpler than debit spreads. The ideal
exit point for credit spreads is to let all options expire worthless. This way you will not
incur any commissions to exit the trade or fees to exercise the options.
To structure a credit spread, you are going to buy a Deep Out-of-The-Money (OTM)
option and sell an At-The-Money (ATM) option. You can use both Calls and Puts for a
credit spread. To determine whether to use Calls or Puts, you need to perform your stock
analysis and form an opinion as to which way the stock will move. If you anticipate the
stock moving up, you will use Puts and structure a Bull Put Spread. Alternatively, if you
anticipate the stock moving down, you will use Calls and structure a Bear Call Spread.
We will examine both trade setups in this course.
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Credit Spreads
2. Bull Put Spreads
In a Bull Put Spread strategy, a trader has the opinion that a stock will make a move
upward and buys one strike Put and simultaneously sells a higher strike Put. When you
are long an option contract, time value and changes in volatility premiums work against
you; however, they work in favor of the option seller. The higher strike Put contract sold
in this strategy serves to offset the forces of time value decay and changes in volatility for
your long Put contract. This is a major advantage over just buying a Put contract by
itself. By neutralizing the affects of extrinsic value in your long contract, you are giving
up some upside profit potential. As you will see, trading off some profit potential in
exchange for neutralizing the components of option valuation that work against you is
well worth it.
Buying one strike put contract gives you the right to sell the underlying stock up to the
expiration date. By selling a higher strike put contract, you are giving someone else the
right to sell their stock to you at a fixed price. Since the short Put contract is at a higher
strike price and is closer to being At-The-Money, it will be more expensive than the Put
contract you buy. Since you can only collect the money once for selling a contract, you
have capped your profit potential. Traders should use the same number of long contracts
as short contracts and also be sure to have the same expiration date. There are many
ways to structure a Bull Put Spread, but we will examine a more conservative approach
that increases our probability of winning.
Strategy Objectives
• Use multiple contracts to provide reward potential while providing a margin of
error.
• GOAL = Buy Deep OTM Puts and Sell more expensive OTM Puts
Strategy Benefits
• High Reward Potential
• Neutralizes effect of Time Decay and Volatility changes
• Low maintenance, Low Risk
• High Annual Return Rates
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Credit Spreads
Steps
5. Find a stock you would like to Trade.
6. Perform analysis (including Technical, Fundamental, and Sentimental) to
determine anticipated price movement.
7. Review volatility to ensure a credit trade is appropriate.
8. Evaluate Option chain focusing on Intrinsic/Extrinsic value of Contracts.
Note: Bull Put Spreads are used when you anticipate the stock going up.
Trade Structure
– Combines 2 different Option contracts.
– Buy one strike Put and simultaneously sell a higher strike Put – Buy a
Deep O.T.M. Put and sell an A.T.M. Put!
Review Short Put Obligations from Matrix – By selling a Put
contract, you are giving someone else the right to sell their stock
to you at a fixed price.
Example 1 – HDI
For our first trade, we’ll use HDI as our stock we would like to trade. We can pull up a
chart on www.bigcharts.com to see the past year price chart that confirms HDI is in a
recent bullish trend up. They are recovering from a major gap down, but are steadily
increasing in slightly bullish trend. Therefore, we will continue to anticipate the stock
going up from here. Earnings have recently been released so we do not expect any short
term news to come out that would impact the stock price. We can perform our stock
analysis and look for signals that will help form an opinion of future stock movement
direction; however, reviewing stock analysis indicators is outside the scope of this course
so we will bypass this function at this point. Please refer to the Stock Analysis 101
course for more information on practical stock analysis techniques. See the chart below.
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60
Credit Spreads
Next, we will review the volatility valuation for HDI available at www.ivolatility.com.
For this trading strategy, we want to look at stocks with options at high levels of implied
volatility. Review the Implied Volatility chart for HDI below.
The gold line in the above graph plots the current Implied Volatility of HDI. The blue
line plots the 30 day historical volatility. You can see the current implied volatility is at
about 40% which is near its highest levels over the past year. Therefore, it meets our
high volatility requirement for a credit spread.
Next, we will review an option chain for HDI available at www.optionsxpress.com. For
this trading strategy, we want to look at Put contracts that are deep Out-of-The-Money to
capture Extrinsic Value and sell Put contracts that are closer to being At-The-Money to
sell more expensive Extrinsic value and neutralize the affects of extrinsic value in our
long contract. Review the Option Chain for HDI below.
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61
Credit Spreads
Calls
Puts
Symbol Last Chg Bid Ask Volume
Aug 05
Calls
HDIHV
7.20
HDIHI
6.00 +0.30 5.80 6.00
0 8.10 8.30
Strike Symbol Last Chg Bid Ask Volume
HDI @ 50.38
(37 days to expiration)
HDIHH 10.90 -0.10 10.50 10.70
Open
Int
Open
Int
Aug 05 Puts
20
76 trade 40.00 HDITH
0 0.05
124 2,231 trade
0
207 trade 42.50 HDITV
0.10 -0.35 0.10 0.15
206 5,073 trade
20 1,431 trade 45.00 HDITI
0.20 -0.70 0.20 0.25
228 3,557 trade
0.05 -0.25
HDIHW 3.90 -0.10 3.60 3.80
145 4,084 trade 47.50 HDITW 0.55 -0.95 0.55 0.60 1,142 4,934 trade
HDIHJ
1.90 -0.40 1.85 2.00
584 5,753 trade 50.00 HDITJ
HDIHK
0.30 -0.25 0.25 0.35 5,090 6,323 trade 55.00 HDITK
HDIHL
0.05
0
0 0.05
351 2,121 trade 60.00 HDITL 10.70
0 9.50 9.70
0
325 trade
HDIHM
0.05
0
0 0.05
0 3,104 trade 65.00 HDITM 15.60
0 14.40 14.70
0
115 trade
HDIHN
0.05
0
0 0.05
0 1,212 trade 70.00 HDITN 20.60
0 19.40 19.70
0
28 trade
HDIHO
0.20
0
0 0.05
0
450 trade 75.00 HDITO 16.10
0 24.40 24.70
0
0 trade
1.25 -1.25 1.30 1.35 4,894 11,483 trade
4.70 -1.10 4.70 4.80
120 4,795 trade
You can see that the $45 Strike Put contract is deep Out-of-The-Money. Since the option
is Out-of-The-Money, the entire value is derived from Extrinsic factors. The $47.50
strike Put contract is also Out-of-The-Money, but is closer to being At-The-Money
because it is one strike higher.
The objective of this strategy is to sell Extrinsic value in the deep OTM option and buy
an insurance option deeper OTM to hedge our risk. If we sell the $47.50 strike Put, it
would satisfy the strategy requirement of selling deep OTM options. By selling the
$47.50 strike Put, we are giving someone else the right to sell their stock to us at $47.50.
We are essentially providing the insurance to another trader since we would have to buy
their stock at $47.50. We will collect a premium for providing that insurance. The stock
can theoretically go down to zero and we would be obligated to buy the stock at $47.50.
To protect ourselves and provide our own sub-insurance on this trade, we will buy the
$45 strike Put which will give us the right to sell our stock at $45. Because the amount
collected by providing insurance to another trader is more than the amount we are paying
for our own insurance, we will make a profit provided no one has to use the insurance.
By using two Put contracts, we are spreading the risk between the options. Our long $45
strike Put gives us the right to sell the stock at $45 by expiration. We sold a $47.50 strike
Put which gave someone else the right to sell their stock to us at $47.50. Therefore the
most risk we can have with this trade is the difference between the two options of $2.50,
($47.50-$45). Review the trade metrics below.
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Credit Spreads
Cost of Trade
Buy 10 $45 strike Puts at $.25
Sell 10 $47.50 strike Puts at ($.55)
Net Credit/Share = $.30 (calculated as $.55 - $.25)
We have collected more money than we are paying out so we have
a net credit for this transaction.
Review Trade Metrics/Calculations
Max Gain = Net Credit established for trade
($.55) - $.25 = $.30 per share, or $300 total
Break even = Short Put strike price less Net Credit per share
$47.50 - $.30 = $47.20. Stock must be at or above this amount to
breakeven or make a profit. Current stock price = $50.38
Gives you a 6.3% margin of error.
By building in a margin of error, you are increasing
your probability of winning! Your profitability does not
depend on your prediction that the stock will go up.
The stock can also decrease and you will still win.
Max Risk = Difference in strike prices less Net credit/share X number of shares
($47.50 - $45) - $.30 = $2.2/share X 1000 shares = $2,200
By spreading risk between two option contracts, we have forfeited some of
the upside potential in exchange for reducing our amount at risk and
capital required to put on the trade.
Reward/Risk Ratio
– Equals max gain divided by max risk
$.30 / $2.2 = 13.6%
The Reward/Risk ratio will be the same as our Reward/Capital ratio
since our Capital requirements to put on the trade will equal our
maximum risk.
13.6% in 37 days equates to an Annual Rate
of Return of 246%!!!
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Credit Spreads
Below is the Profit and Loss Diagram for the combined position of long Put and short Put
known as the Bull Put Spread. You can see on the Profit and Loss Diagram the current
stock price is already well above our Maximum gain point. By using the short Put
Option contract Out-of-The-Money, we have built in a Margin of Error on this trade. We
can be completely wrong on our analysis of expected stock movement up and still win
our maximum profit! As long as the stock is trading above $47.50 by the expiration date
in 37 days, we will win our $300, and be on our way to winning 246% for the year! The
ideal exit strategy is to simply let the options expire worthless and keep the premium
collected. The options will expire worthless if the stock is trading above $47.50.
D
E
F
G
H
I
J
K
L
M
N
Margin of
Error = 6.3%
$500
$32.5
35
37.5
40
42.5
45
47.5
50
52.5
55
57.5
$(500)
profit / loss
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
$(1,000)
Current Stock
Price
Break-Even
$(1,500)
$(2,000)
$(2,500)
stock price
Trade Results: At expiration, the stock was trading at $51.13. We allowed both put
contracts to expire worthless and we kept the entire credit received of $300. We achieved
our maximum profit of $300 in only 37 days. We are on our way to achieving our annual
rate of return of over 246%!
The goal of the Bull Put Spread is to sell someone the insurance that Puts provide and not
have that insurance used. No trader will exercise his Puts if the market price for the stock
is trading above the Put strike price. You profit by collecting premiums for the insurance
that is never used. This strategy has provided excellent reward potential while building
in a margin of error into our trading. By using multiple option contracts, we have
structured a trade with high probabilities of winning and consumed less capital.
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64
Credit Spreads
As you compare different combinations of options in this Bull Put Spread trade setup,
you will find trade setups that offer very high Reward/Risk ratio’s where you can win
much more than you have at risk. For example, if you review the option chain in the
above example and you decide to buy the $50 strike put and sell the $55 strike put your
Profit and Loss Diagram will look like the following.
D
E
F
G
H
I
J
K
L
M
N
$4,000
$3,000
Current Stock
Price
$2,000
profit / loss
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
Break-Even
$1,000
$25
30
35
40
45
50
55
60
65
70
75
$(1,000)
$(2,000)
stock price
As you move the spread closer to being At-The-Money (ATM) or even In-the-Money
(ITM), the cost of the spread will become cheaper and your Reward/Risk ratio will
increase. What you don’t see on the graph is your probability of winning! As you move
your spread closer to being ATM, you are sacrificing your margin of error in your trading
and you will lose more trades. To make a profit in the $50-$55 Bull Put Spread, the stock
has to move up. If the stock stayed near its current price of $50, you would realize your
maximum loss. Be sure to maintain your discipline to structure trades that have high
probabilities of winning, by building in your margins of error. You will be very happy
with your 13.6% return that equates to an annual rate of return of 246%!
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65
Credit Spreads
Example 2 – SUN
Let’s review another example of a Bull Put Spread trade. For this example, we will use
Sunoco to structure a Bull Put Spread.
We can pull up a chart on www.bigcharts.com to see the past year price chart that
confirms SUN is in a bullish trend up. Therefore, we will continue to anticipate the stock
going up from here. Earnings have recently been released so we do not expect any short
term news to come out that would impact the stock price. We can perform our stock
analysis and look for signals that will help form an opinion of future stock movement
direction; however, reviewing stock analysis indicators is outside the scope of this course
so we will bypass this function at this point. Please refer to the Stock Analysis 101
course for more information on practical stock analysis techniques. See the chart below.
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66
Credit Spreads
Next, we will review the volatility valuation for SUN available at www.ivolatility.com.
For this trading strategy, we want to look at stocks with options at High levels of implied
volatility. Review the Implied Volatility chart for SUN below.
The gold line in the above graph plots the current Implied Volatility of SUN. The blue
line plots the 30 day historical volatility. You can see the implied volatility is at about
32.5% which is near its highest levels over the past year. Therefore, it meets our high
volatility requirement for a credit spread.
Next, we will review an option chain for SUN available at www.optionsxpress.com. For
this trading strategy, we want to look at Put contracts that are deep Out-of-The-Money to
capture Extrinsic Value and sell Put contracts that are closer to being At-The-Money to
sell more expensive Extrinsic value and neutralize the affects of extrinsic value in our
long contract. Review the Option Chain for SUN below.
Calls
Symbol Last Chg Bid
Aug 05
Calls
Ask
Puts
Volume
Open
Int
Strike Symbol Last Chg Bid
Ask
SUN @ 121.22
(37 days to expiration)
Volume
Open
Int
Aug 05 Puts
SUNHT 23.00
0 21.40 21.80
0 1,144 trade
100.00 SUNTT 0.35
0 0.25 0.35
0
751 trade
SUNHA 17.80
0 16.80 17.10
0
652 trade
105.00 SUNTA 0.65
0 0.60 0.70
0
979 trade
SUNHB 12.30
-1.70 12.40 12.80
4
449 trade
110.00 SUNTB 1.35 +0.10 1.25 1.40
56
553 trade
SUNHC 8.90
-0.60 8.60 8.90
83
519 trade
115.00 SUNTC 2.45 +0.15 2.45 2.60
SUNHD 5.80
-0.30 5.50 5.70
322
770 trade
120.00 SUNTD 4.40 +0.40 4.30 4.60
7
410 trade
SUNHE 3.40
-0.50 3.20 3.40
137 1,407 trade
125.00 SUNTE 7.70
0
10 trade
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67
0 7.00 7.20
115 1,254 trade
Credit Spreads
You can see that the $105 Strike Put contract is deep Out-of-The-Money. Since the
option is Out-of-The-Money, the entire value is derived from Extrinsic factors. The $110
strike Put contract is also Out-of-The-Money, but is closer to being At-The-Money
because it is one strike higher.
The objective of this strategy is to sell Extrinsic value in the deep OTM option and buy
an insurance option deeper OTM to hedge our risk. If we sell the $110 strike Put, it
would satisfy the strategy requirement of selling deep OTM options. By selling the $110
strike Put, we are giving someone else the right to sell their stock to us at $110. We are
essentially providing the insurance to another trader since we would have to buy their
stock at $110. We will collect a premium for providing that insurance. The stock can
theoretically go down to zero and we would be obligated to buy the stock at $110. To
protect ourselves and provide our own sub-insurance on this trade, we will buy the $105
strike Put which will give us the right to sell our stock at $105. Because the amount
collected by providing insurance to another trader is more than the amount we are paying
for our own insurance, we will make a profit provided no one has to use the insurance.
By using two Put contracts, we are spreading the risk between the options. Our long
$105 strike Put gives us the right to sell the stock at $105 by expiration. We sold a $110
strike Put which gave someone else the right to sell their stock to us at $110. Therefore
the most risk we can have with this trade is the difference between the two options of $5,
($110-$105). Review the trade metrics below.
Cost of Trade
Buy 10 $105 strike Puts at $.70
Sell 10 $110 strike Puts at ($1.25)
Net Credit/Share = $.55 (calculated as $1.25 - $.70)
We have collected more money than we are paying out so we have
a net credit for this transaction.
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Credit Spreads
Review Trade Metrics/Calculations
Max Gain = Net Credit established for trade
($1.25) - $.70 = $.55 per share, or $550 total
Break even = Short Put strike price less Net Credit per share
$110 - $.55 = $109.45. Stock must be at or above this amount to
breakeven or make a profit. Current stock price = $121.22
Gives you a 10% margin of error.
By building in a margin of error, you are increasing
your probability of winning! Your profitability does not
depend on your prediction that the stock will go up.
The stock can also decrease and you will still win.
Max Risk = Difference in strike prices less Net credit/share X number of shares
($110 - $105) - $.55 = $4.45/share X 1000 shares = $4,450
By spreading risk between two option contracts, we have forfeited some of
the upside potential in exchange for reducing our amount at risk and
capital required to put on the trade.
Reward/Risk Ratio
– Equals max gain divided by max risk
$.55 / $4.45 = 12.4%
The Reward/Risk ratio will be the same as our Reward/Capital ratio
since our Capital requirements to put on the trade will equal our
maximum risk.
12.4 % in 37 days equates to an Annual
Rate of Return of 212%!!!
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69
Credit Spreads
Below is the Profit and Loss Diagram for the combined position of long Put and short Put
known as the Bull Put Spread. You can see on the Profit and Loss Diagram the current
stock price is already well above our Maximum gain point. By using the short Put
Option contract Out-of-The-Money, we have built in a Margin of Error on this trade. We
can be completely wrong on our analysis of expected stock movement up and still win
our maximum profit! As long as the stock is trading above $110 by the expiration date in
37 days, we will win our $550, and be on our way to winning 212% for the year! The
ideal exit strategy is to simply let the options expire worthless and keep the premium
collected. The options will expire worthless if the stock is trading above $110.
D
F
G
H
I
J
115
120
K
L
M
N
Margin of
= 12.4%
$1,000 Error
$95
100
105
110
125
130
135
140
145
$(1,000)
profit / loss
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
E
$(2,000)
Break-Even
Current Stock
Price
$(3,000)
$(4,000)
$(5,000)
stock price
Trade Results: This stock split 2 for 1 in the middle of the trade. Please see the
Dividend Income Strategy course for details on handling stock splits. This trade resulted
in winning the maximum gain of $550 in only 37 days. We are on our way to achieving
an annual rate of return of over 212%!!
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70
Credit Spreads
The Bull Put Spread trade is essentially betting that the stock price will stay above a
certain price level. It is similar to providing a price floor on the stock. Review the price
chart below and note the horizontal red line is at our break-even point. As long as the
stock stays above this price floor, we will make money without making an adjustment to
our trade.
The goal of the Bull Put Spread is to sell someone the insurance that Puts provide and not
have that insurance used. No trader will exercise his Puts if the market price for the stock
is trading above the Put strike price. You profit by collecting premiums for the insurance
that is never used. This strategy has provided excellent reward potential while building
in a margin of error into our trading. By using multiple option contracts, we have
structured a trade with high probabilities of winning and consumed less capital.
www.TradewithOptions.com
71
Credit Spreads
3. Bear Call Spreads
In a Bear Call Spread strategy, a trader has the opinion that a stock will make a move
downward and buys one strike call and simultaneously sells a lower strike call. When
you are long an option contract, time value and changes in volatility premiums work
against you; however, they work in favor of the option seller. The lower strike call
contract sold in this strategy serves to offset the forces of time value decay and changes
in volatility for your long call contract. This is a major advantage over just buying a call
contract by itself. By neutralizing the affects of extrinsic value in your long contract, you
are giving up some upside profit potential. As you will see, trading off some profit
potential in exchange for neutralizing the components of option valuation that work
against you is well worth it.
Buying one strike call contract gives you the right to buy the underlying stock up to the
expiration date. By selling a lower strike call contract, you are giving someone else the
right to buy your stock from you at a fixed price. Since the short Call contract is at a
lower strike price and is closer to being At-The-Money, it will be more expensive than
the Call contract you buy. Since you can only collect the money once for selling a
contract, you have capped your profit potential. Traders should use the same number of
long contracts as short contracts and also be sure to have the same expiration date. There
are many ways to structure a Bear Call Spread, but we will examine a more conservative
approach that increases our probability of winning.
Strategy Objectives
• Use multiple contracts to provide reward potential while providing a margin of
error.
• GOAL = Buy Deep OTM Calls and Sell more expensive OTM Calls
Strategy Benefits
• High Reward Potential
• Neutralizes effect of Time Decay and Volatility changes
• Low maintenance, Low Risk
• High Annual Return Rates
Steps
1. Find a stock you would like to Trade.
2. Perform analysis (including Technical, Fundamental, and Sentimental) to
determine anticipated price movement.
5. Review volatility to ensure a credit trade is appropriate.
6. Evaluate Option chain focusing on Intrinsic/Extrinsic value of Contracts.
Note: Bear Call Spreads are used when you anticipate the stock going down.
www.TradewithOptions.com
72
Credit Spreads
Trade Structure
– Combines 2 different Option contracts.
– Buy one strike Call and simultaneously sell a higher strike Call – Buy a
Deep O.T.M. Call and sell an A.T.M. Call!
Review Short Call Obligations from Matrix – By selling a Call
contract, you are giving someone else the right to buy your stock
from you at a fixed price.
Example 3 – HAR
For our next trade, we’ll use HAR as our stock we would like to trade. We can pull up a
chart on www.bigcharts.com to see the past year price chart that confirms HAR is in a
flat to downward trend. Therefore, we will continue to anticipate the stock going down
from here. Earnings have recently been released so we do not expect any short term
news to come out that would impact the stock price. We can perform our stock analysis
and look for signals that will help form an opinion of future stock movement direction;
however, reviewing stock analysis indicators is outside the scope of this course so we
will bypass this function at this point. Please refer to the Stock Analysis 101 course for
more information on practical stock analysis techniques. See the chart below.
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73
Credit Spreads
Next, we will review the volatility valuation for HAR available at www.ivolatility.com.
For this trading strategy, we want to look at stocks with options at high levels of implied
volatility. Review the Implied Volatility chart for HAR below.
The gold line in the above graph plots the current Implied Volatility of HAR. The blue
line plots the 30 day historical volatility. You can see the implied volatility is at about
35% which is near its highest levels over the past year. Therefore, it meets our high
volatility requirement for a credit spread.
Next, we will review an option chain for HAR available at www.optionsxpress.com. For
this trading strategy, we want to look at Call contracts that are deep Out-of-The-Money to
capture Extrinsic Value and sell Call contracts that are closer to being At-The-Money to
sell more expensive Extrinsic value and neutralize the affects of extrinsic value in our
long contract. Review the Option Chain for HAR below.
Calls
Puts
Open
Symbol Last Chg Bid Ask Volume
Int
Aug 05
Calls
Strike Symbol Last Chg Bid Ask Volume
HAR @ 82.77
(35 days to expiration)
Open
Int
Aug 05 Puts
HARHO
8.70
0 8.90 9.30
0
58 trade 75.00 HARTO
1.05 0
1.00
1.15 0 291 trade
HARHP
5.30
0 5.30 5.60
0 362 trade 80.00 HARTP
2.50 0
2.35
2.55 0 242 trade
HARHQ
2.65
0 2.75 2.90
0 118 trade 85.00 HARTQ
4.60 0
4.70
4.90 0 158 trade
HARHR
1.25 +0.05 1.15 1.30 10 312 trade 90.00 HARTR
8.50 0
8.10
8.40 0
14 trade
HARHS
0.45
12.60 0 12.20 12.60 0
4 trade
0 0.35 0.50
0 274 trade 95.00 HARTS
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Credit Spreads
You can see that the $95 Strike Call contract is deep Out-of-The-Money. Since the
option is Out-of-The-Money, the entire value is derived from Extrinsic factors. The $90
strike Call contract is also Out-of-The-Money, but is closer to being At-The-Money
because it is one strike lower.
The objective of this strategy is to sell Extrinsic value in the deep OTM option and buy
an insurance option deeper OTM to hedge our risk. If we sell the $90 strike Call, it
would satisfy the strategy requirement of selling deep OTM options. By selling the $90
strike Call, we are giving someone else the right to buy our stock from us at $90. We will
collect a premium for providing that right to them. The stock can theoretically go up
infinitely and we would be obligated to sell them stock at $90. To protect ourselves and
provide our own sub-insurance on this trade, we will buy the $95 strike Call which will
give us the right to buy the stock at $95. Because the amount collected by providing the
right to buy our stock to another trader is more than the amount we are paying for our
own sub-insurance, we will make a profit provided no one will exercise their options.
By using two Call contracts, we are spreading the risk between the options. Our long $95
strike call gives us the right to buy the stock at $95 by expiration. We sold a $90 strike
call which gave someone else the right to buy our stock from us at $90. Therefore the
most risk we can have with this trade is the difference between the two options of $5,
($95-$90). Review the trade metrics below.
Cost of Trade
Buy 10 $95 strike Calls at $.50
Sell 10 $90 strike Calls at ($1.15)
Net Credit/Share = $.65 (calculated as $1.15 - $.50)
We have collected more money than we are paying out so we have
a net credit for this transaction.
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Credit Spreads
Review Trade Metrics/Calculations
Max Gain = Net Credit established for trade
($1.15) - $.50 = $.65 per share, or $650 total
Break even = Short Call strike price plus Net Credit per share
$90 + $.65 = $90.65. Stock must be at or below this amount to breakeven
or make a profit. Current stock price = $82.77
Gives you a 10% margin of error.
By building in a margin of error, you are increasing
your probability of winning! Your profitability does not
depend on your prediction that the stock will go up.
The stock can also decrease and you will still win.
Max Risk = Difference in strike prices less Net credit/share X number of shares
($95 - $90) - $.65 = $4.35/share X 1000 shares = $4,350
By spreading risk between two option contracts, we have forfeited some of
the upside potential in exchange for reducing our amount at risk and
capital required to put on the trade.
Reward/Risk Ratio
– Equals max gain divided by max risk
$.65 / $4.35 = 15%
The Reward/Risk ratio will be the same as our Reward/Capital ratio
since our Capital requirements to put on the trade will equal our
maximum risk.
15 % in 35 days equates to an Annual Rate
of Return of 321%!!!
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Credit Spreads
Below is the Profit and Loss Diagram for the combined position of long Call and short
Call known as the Bear Call Spread. You can see on the Profit and Loss Diagram the
current stock price is already well below our Maximum gain point. By using the short
Call Option contract Out-of-The-Money, we have built in a Margin of Error on this trade.
We can be completely wrong on our analysis of expected stock movement up and still
win our maximum profit! As long as the stock is trading below $90 by the expiration
date in 35 days, we will win our $650, and be on our way to winning 321% for the year!
The ideal exit strategy is to simply let the options expire worthless and keep the premium
collected. The options will expire worthless if the stock is trading below $90.
D
E
F
G
H
I
J
K
L
M
N
Margin of
Error = 10%
$1,000
$60
profit / loss
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
65
70
75
80
85
90
95
100
105
110
$(1,000)
$(2,000)
$(3,000)
Current Stock
Price
Break-Even
$(4,000)
$(5,000)
stock price
Trade Results: At expiration, the stock was trading even higher at $106.23. We adjusted
the trade to react to the upward movement and capture additional profit. For more
information on adjustments, sign up for the live interactive sessions available at
www.TradewithOptions.com.
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Credit Spreads
The Bear Call Spread trade is essentially betting that the stock price will not exceed a
certain price level. It is similar to providing a price ceiling on the stock. Review the
price chart below and note the horizontal red line is at our break-even point. As long as
the stock stays below this price ceiling, we will make money without making an
adjustment to our trade.
The Deep OTM Bear Call Spread has reduced the amount of capital required to put on
the trade and has provided excellent reward potential while building in a margin of error
into our trading. By using multiple option contracts, we have structured a trade with high
probabilities of winning and consumed less capital.
4. Summary
In this course we have examined two types of Credit spreads: Bull Put Spread and Bear
Call Spread. Credit spreads can earn highly leveraged returns since they require much
less capital upfront. This course has built on our previous strategies learned and
structures potential trades based on your expectation of stocks moving up or down.
Credit Spreads put money in your account upfront and drastically reduces the amount of
capital required to initiate a trade, while still providing risk management and reward
potential. The ideal exit strategy is to simply let your options expire worthless and pay
no commission or exercise fees to exit the trade.
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Credit Spreads
You can structure credit spread trades to profit from stocks that are moving up or down.
To increase your profit potential, your stock analysis techniques will come into play. Be
sure to review the stock analysis 101 course for more information. You will still build in
margins of error into your trades to increase your probability of winning and you will be
able to profit even if your analysis of stock movement is wrong.
Since you are both buying and selling options, you will offset the negative affects of time
value decay and changes in volatility in your long contract. By putting on credit spreads
when volatility is high, you are increasing your adjustment potential in case the trade
moves against you and making it easier to exit the trade early with a profit.
Although you can structure credit spreads into a very high Reward/Risk ratio, remember
that the probability of winning has an inverse relationship with the Reward/Risk ratio.
By structuring trades deep OTM, you are increasing your probability of winning. Be
disciplined enough to remain conservative in your trading and you will see huge annual
returns.
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Business Plan Essentials
Business Plan Essentials
1. Overview
The TradewithOptions.com courses will teach you to trade as a business. A trading
business is similar to other businesses in that you need to generate consistent cash flow in
order to predict and plan for growth; however, it is unique in that it offers a wonderful
business model including limited overhead costs, zero product liability, zero inventory,
and no sales or customer service. It also offers the most favorable tax structure of any
other business since there are no self-employment taxes, only capital gains. You can
start your trading business with as little as $10,000 to start generating $500 - $2,500 per
month of trading profits safely.
There are two ways to get more cash out of your small business: Either you grow your
revenue stream or you reduce your cost structure. This course will examine many
strategies to reduce your cost structure by focusing on your largest expense: tax! This
course will have a large impact on the amount of profits you will keep in your trading
account.
There are many nuances within the US tax code that provide many benefits specifically
for traders and trading businesses. This course will highlight many ideas to let you keep
more of the trading profits you earn. Many differences between individual taxation and
business taxation exist for you to explore. This course will review Securities taxation,
Trader Tax Status, and reasons to setup new legal entities for your trading business.
2. Various Security Taxation
The first step for all trades is deciding which securities you are going to trade. Different
securities have different tax effects. Just knowing which securities to trade can
significantly reduce your taxes. Securities such as stock, regular options and single stock
futures are taxed at ordinary capital gains rates. For our short-term trading strategies,
these capital gains rates are the same as your ordinary tax rate which can equal 35%. If
you select broad-based index securities, options on broad-based indexes, or Section 1256
contracts that include commodities and Forex, you will receive much more favorable tax
treatment. These securities have their profits and losses split into 60% long-term and
40% short-term even if you buy and sell them on the same day. The maximum tax rate
on the long-term portion is only 15%.
Broad-based index securities are those that have 10 or more individual securities included
in the index. The most common are the S&P 500 ($SPX), S&P 100 ($OEX), and
NASDAQ 100 (QQQQ). Options traded on these securities will also receive the
favorable tax treatment. Section 1256 contracts include futures contracts such as
commodities and options on those commodities.
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Business Plan Essentials
Any profits realized on trading these types of securities will be taxed at 34% less than
other securities. Assume you made a $1000 profit by trading options on the $OEX. That
$1,000 profit would be split and taxed as 60% Long-Term ($600) and 40% Short-Term
($400). Assume you are in the 35% tax bracket. The tax on your $1,000 trading profit
would be only $230 = ($600*15%) + ($400*35%). Compare that to $1,000 profit on
ordinary options that are taxed at your highest tax rate where you would pay $350 =
($1,000*35%) in taxes. You would save $120, or 34%, in taxes by trading the broad
based index options. This can have a substantial effect on the profits you keep in your
trading account. For every $100,000 of trading profits on broad based index securities,
you will save $12,000 in taxes.
There are several types of securities available to trade. Knowing the tax effects of the
various trading instruments can help you choose which securities to trade. Once you are
comfortable and profitable with a trading strategy, you should look for trading
opportunities in securities that offer tax benefits. This will leave more money in your
trading account. Please refer to the Links page on the TradewithOptions.com website to
find more information on securities taxation from our preferred tax resource, Traders
Accounting.
3. Trader Tax Status vs. Individual Investor
The Internal Revenue Service has two tax classifications for individuals who buy and sell
securities, mutual funds, options, futures, commodities and other derivatives: trader and
investor. Obtaining Trader tax status under the IRS definition is very advantageous
because you are allowed more deductions than an Investor. In addition, you have the
opportunity as a Trader to elect Mark-to-market accounting.
Mark-to-market is the accounting method of choice for most active traders because it
converts your capital gains/losses into ordinary gains/losses. By electing Mark-to-market
accounting you will eliminate the hassle of recording wash sales and provide a sort of
loss insurance for your trading. Since your income/losses are treated as ordinary and not
capital gains/losses, you are not bound by the $3,000 capital loss limitation. This means
you can deduct all losses in the year they occur, providing tax relief when you need it
most.
If you file taxes as a regular investor that itemizes deductions on Schedule A, you are
limited to a handful of deductible investment expenses, including legal and accounting
fees, investment advice and newsletters. These must be listed as miscellaneous itemized
deductions and can only be deductible to the extent they exceed 2% of adjusted gross
income.
As a trader, you can deduct all of your business-related expenses, including your data
feed, dues and subscriptions, equipment, utilities, seminars, transportation, travel and
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81
Business Plan Essentials
entertainment, and the home office deduction if you work from home. These extra
expense deductions allowed for a trader will provide large tax savings.
Here’s how the additional expense deductions would benefit a Trader compared to an
Investor if both had identical trading gains and business expenses. Note that the Investor
is subject to the 2% threshold for the few deductible expenses he is qualified to claim:
Total household income: $100,000
Trading profits: $40,000
Trading expenses: $24,230
Trader’s tax savings: $7,269
Investor’s tax savings: $1,644
Benefit of trader tax status: $5,625
When it comes to covering losses, traders fare even better: the IRS allows traders who
elected mark-to-market to write off their entire loss in one year. You can even apply the
loss to taxable income from past years and generate a tax refund!
Investors, meanwhile, have a maximum allowable net capital loss of $3,000 in any tax
year. That means if you lost more than $3,000, your only recourse is to carry over the
remaining balance until it’s used up, but again, only to a maximum of $3,000 a year.
Here’s how a $40,000 loss would impact a Trader and an Investor. Note that the Trader
was able to offset her regular $100,000 income with her $40,000 loss, while the Investor
was limited to the $3,000 capital loss deduction:
Total household income: $100,000
Trading loss: <$40,000>
Trading expenses: $24,230
Trader’s tax savings: $19,269
Investor’s tax savings: $984
Benefit of trader tax status: $18,285
It is difficult to establish Trader status in the eyes of the IRS. They have many conditions
that must be met that make it very difficult for an active trader to obtain and successfully
defend Trader tax status. One of the best ways to secure and protect your trader tax status
is to trade as a business entity. The IRS treats business filers in a far more consistent and
advantageous way than it does individual traders. In the next section, we will examine the
benefits of establishing a legal entity for your trading business.
4. Entity Benefits
There are five primary legal entity structures: sole proprietorship, limited
partnership, limited liability company (LLC), S-Corporation and C-Corporation. For
tax purposes, a legal entity is an organization recognized by the IRS by its
corresponding Employer Identification Number, whether it has employees or not.
Sole proprietors often use their Social Security number as their Employer
Identification Number.
The chief reason to form a legal entity is to stabilize your business activities and
expense deductions. Without a business entity, your trader tax status could turn on
the ruling of the next tax court judge. In contrast, the tax status of legal entities is
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Business Plan Essentials
well defined by the IRS. In addition, a legal entity can provide many tax-free fringe
benefits to its employee’s that include you.
For example, a C-Corporation can provide fringe benefits that are tax free to the
employee receiving the benefit. Most large C-Corporations offer Tuition
Reimbursement programs, 401(k) and profit sharing plans, and vehicles to their
executives. Within your own C-Corporation where you are the executive CEO, you
can implement the same benefit programs. This will generate a tax deduction for
the Company and it is not taxable to the employee. See www.SmartTaxMoves.com
for more info on entity tax benefits.
While the benefits of trading as a legal entity are numerous, there is no one legal
entity or structure that is right for everyone. It is a decision that should be made
with your tax accountant. Our preferred tax accountants specializing in all areas
related to traders taxation is Traders Accounting. You can find a link to their website
on the TradewithOptions.com Links page.
5. Example – Provided by Traders Accounting
This example will detail the impact of electing to trade within a legal entity to secure
Trader tax status versus filing taxes as a regular Investor. You will see that whether you
win or lose at trading, you will save money on your taxes by electing to trade within an
entity.
Assumptions:
Both the Trader and Investor have the same amount of expenses detailed in the
following list:
o Telephone
$480
o Data feed
$1,200
o Seminars
$3,500*
o Travel
$650*
o Cable
$360
o DSL
$240
o Margin Interest
$6,000
o Home Office
$1,800*
o Office Equipment
$10,000*
Total
$24,230
• Both the Trader and Investor have $100,000 of salary earned from another fulltime job.
Out of the total $24,230 of trading expenses incurred, our Investor can only claim $8,280
in expenses because the expenses marked with an asterisk are not allowable deductions
for an Investor.
Scenario 1 – $40,000 trading profits realized by both Investor and Trader
Our Investor has adjusted gross income (AGI) of $140,000 from $100,000 salary and
$40,000 trading profits. His allowable expense deductions are subject to the 2% of AGI
limitation so the first $2,800 of his $8,280 of expenses is not allowed. This leaves him
with $5,400 of tax deductions, which at his 30% tax rate equals $1,644 of tax savings.
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Business Plan Essentials
Our Trader has setup a legal entity to trade within that provides the benefit of Trader
status. Our Trader will be able to deduct all $24,230 in expenses incurred, which at the
30% tax rate equals $7,269 in tax savings. This is a benefit of $5,625 over the Investor.
Scenario 2 – $40,000 trading loss realized by both Investor and Trader
Our Investor is limited to the amount of deductions he is allowed from Scenario 1, but
now he can not deduct the margin interest expense. Margin interest is only deductible
against profits. This reduces his deductible expenses to $2,280. Since he lost money
trading, his AGI is only made up of his $100,000 wages. His deductions are reduced by
the same 2% of AGI threshold as before which equals $2,000. Now he is only able to
deduct $280 of expenses plus $3,000 of capital loss for a total of $3,280. At the 30% tax
rate, this equals a tax savings of $984 and he will carry forward $37,000 of capital losses
to future years.
Our Trader is still able to deduct all the expenses of $24,230. In addition, she is able to
use the $40,000 loss to offset her regular wage income of $100,000 because she uses the
Mark-to-Market method of accounting. This brings her AGI down to $60,000 so she
saves an additional $12,000 to the $7,269 in scenario 1. Her total tax savings equals
$19,269 for a benefit of $18,285 over our Investor.
6. Summary
This course has briefly reviewed several ideas to help reduce your largest business
expense: tax. Knowing which types of securities to trade will help reduce your taxes
immediately while you are trading under Investor status. Obtaining Trader tax status is
very advantageous, but can be difficult to prove to the IRS. A safer way to achieve the
benefits that Trader tax status provides is to form some sort of legal entity to trade within.
You can establish many tax-free fringe benefit programs in your C-Corporation where
you will be CEO. You can find more information on Trader taxation at Traders
Accounting. You can also find a great E-Book on Corporate fringe benefit programs at
www.SmartTaxMoves.com.
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84
Calendar Spreads
Calendar Spreads
1. Calendar Spreads Overview
Calendar spreads are a new strategy that takes advantage of option valuation components
not related to the stock price. This makes it very easy to adjust the trade in any direction
a stock moves. You will simply react to where the stock moves and adjust your calendar
spread accordingly. Like the Debit and Credit Spreads, the Calendar Spreads are
strategies that essentially spread the risk between various option contracts. They carry
the name Calendar spread because you are spreading risk between option contracts in
different months on the calendar. In this course we will examine a conservative approach
to using Calendar spreads that will lower your margin requirements to bare minimums
and that provide excellent reward potential.
Calendar spreads can earn highly leveraged returns since they require much less capital
upfront while still providing risk management and reward potential. You can structure
calendar spread trades to profit from stocks that are moving up or down. To increase your
profit potential, you will simply react to stock movements and adjust your trade. In a
calendar spread, you will buy and sell option contracts of the same strike price with
different expiration months. The idea behind this trade structure is to take advantage of
the characteristics of time value decay. As you know from the Options Basics course,
time value decays at an exponential rate in the last 30 days of an options life. We will
capture that increased rate of time value decay for our profits.
The ideal time to place a calendar spread is when a stock is trading sideways within a
regular trading range. To structure a calendar spread, you will sell a near term Out-ofThe-Money option and buy a longer term option of the same strike price to hedge your
risk. You can use both calls and puts depending on which one offers the most favorable
reward/risk ratio. This trade does not build in margins of error, and your profitability is
dependent on you reacting to stock movement.
Using Calls:
Buying one strike call contract gives you the right to buy the underlying stock up to the
expiration date. By selling the same strike call contract in the near term month, you are
giving someone else the right to buy your stock from you at a fixed price. Since the short
call contract is in the closest expiration month, it will be less expensive than the call
contract you buy in a further out month. You are trying to sell someone the right to buy
the stock from you that never gets exercised. Therefore, you want to use Out-of-TheMoney calls and puts to increase the probability of winning. Traders should use the same
number of long contracts as short contracts and also be sure to have the same strike price.
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Calendar Spreads
There are many ways to structure a Calendar Spread, but we will examine a more
conservative approach that increases our probability of winning.
Strategy Objectives
• Use multiple contracts to provide reward potential and easily adjust to the
direction of the stock movement
• GOAL = Buy OTM calls/puts in a far out month and Sell OTM calls/puts in the
near month
Strategy Benefits
• High Reward Potential
• Captures the effect of Time Decay and Volatility changes as profits
• Medium maintenance, Low Risk
• High Annual Return Rates
• Lowest possible margin requirements
Steps
9. Find a stock you would like to Trade.
10. Perform analysis (including Technical, Fundamental, and Sentimental) to
determine anticipated price movement.
11. Evaluate Option chain focusing on Extrinsic value of OTM call/put contracts.
12. Initiate neutral Calendar Spread trade.
13. At expiration of near term option, adjust trade into Bull/Bear spread
Note: Calendar Spreads are used when you anticipate the stock trading within a range.
Trade Structure
– Combines 2 different Option contracts.
– Buy one strike call/put in a far out month and simultaneously sell the same
strike call/put in the near month – Use OTM calls and puts
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Calendar Spreads
2. Trade Examples
Example 1 – PAYX
For our first trade, we’ll use PAYX as our stock we would like to trade. We can pull up a
chart on www.bigcharts.com to see the past year price chart that confirms PAYX is in a
relatively flat trading range. It has been trading between $29 and $34 for the past year.
At this point, it is at the top end of the range and we will continue to anticipate the stock
trading relatively flat from here. Earnings have recently been released so we do not
expect any short term news to come out that would impact the stock price. We can
perform our stock analysis and look for signals that will help form an opinion of future
stock movement direction; however, reviewing stock analysis indicators is outside the
scope of this course so we will bypass this function at this point. Please refer to the Stock
Analysis 101 course for more information on practical stock analysis techniques. See
the chart below.
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Calendar Spreads
Next, we will review an option chain for PAYX available at www.optionsxpress.com.
For this trading strategy, we want to look at call contracts that are Out-of-The-Money for
both near term and longer term expiration periods. Review the Option Chain for PAYX
below.
Calls
Puts
Symbol Last Chg Bid Ask Volume
Aug 05
Calls
0
Strike Symbol Last Chg Bid Ask Volume
PAYX @ 34.63
(37 days to expiration)
PQXHD
Open
Int
0 14.50 14.80
Open
Int
Aug 05 Puts
0
0 trade 20.00 PQXTD
0
0
0 0.05 0
0 trade
0
0
0 0.05 0
0 trade
0
0
0 0.05 0
0 trade
PQXHX
10.60
0 12.00 12.30
0
30 trade 22.50 PQXTX
PQXHE
0
0 9.50 9.80
0
0 trade 25.00 PQXTE
PQXHY
3.10
0 7.00 7.30
0
20 trade 27.50 PQXTY 0.30
0
0 0.05 0 20 trade
PQXHF
4.60 +0.10 4.50 4.80 10
407 trade 30.00 PQXTF 0.10
0
0 0.10 0 254 trade
PQXHZ
2.15 -0.15 2.20 2.35 31
716 trade 32.50 PQXTZ 0.20 +0.05 0.10 0.25 60 642 trade
PQXHG
0.50 -0.15 0.50 0.60 44 3,740 trade 35.00 PQXTG 1.00
0 0.90 1.05 0 184 trade
PQXHU
0.05
0
0 0.10
0
4 trade 37.50 PQXTU 7.80
0 2.95 3.10 0 10 trade
PQXHH
0
0
0 0.05
0
0 trade 40.00 PQXTH 7.00
0 5.30 5.60 0 20 trade
Dec 05
Calls
(156 days to
expiration)
PAYX @ 34.63
Dec 05 Puts
PQXLX 8.20
0 12.10 12.40
0
11 trade 22.50 PQXXX
0.15
0
0 0.05
0
50 trade
PQXLE 9.80
0 9.70 9.90
0
51 trade 25.00 PQXXE
0.10
0
0 0.10
0
176 trade
PQXLY 5.90
0 7.30 7.50
0
202 trade 27.50 PQXXY
0.25
0 0.10 0.20
0
425 trade
PQXLF 5.10
0 5.00 5.30
0
467 trade 30.00 PQXXF
0.50
0 0.25 0.35
0
467 trade
PQXLZ 3.20
0 3.00 3.20
0 1,602 trade 32.50 PQXXZ
0.80
0 0.70 0.80
0
777 trade
PQXLG 1.50 -0.10 1.45 1.55
1 3,047 trade 35.00 PQXXG
1.80 +0.05 1.60 1.75 50
435 trade
PQXLU 0.55
0 0.50 0.60
1 3,475 trade 37.50 PQXXU
3.50
0 3.20 3.40
0
21 trade
PQXLH 0.15
0 0.10 0.20
0
111 trade 40.00 PQXXH 10.50
0 5.30 5.60
0
0 trade
PQXLV
0
0
0 7.80 8.10
0
0 trade
0
0 0.10
0 trade 42.50 PQXXV
9.00
You can see that the $35 Strike call contract is Out-of-The-Money. The objective of this
strategy is to sell Extrinsic value in the near month OTM option and buy an insurance
option in a further out month to hedge our risk. If we sell the August $35 strike call, it
would satisfy the strategy requirement of selling a near month OTM option. By selling a
call contract, our risk is if the stock increases in value above $35 because we will be
obligated to sell our stock at $35. To hedge our risk, we will buy a $35 strike call
contract in a further out month such as December. This gives us the right to buy the
stock at $35 by December’s expiration. Be sure to buy a contract with at least 75-90 days
left before expiration so that time decay does not affect your long option.
By using two call contracts, we are spreading the risk between the options and reducing
our margin requirements to a minimum. Our long December $35 strike call gives us the
right to buy the stock at $35 by expiration. We sold an August $35 strike call which gave
someone else the right to buy our stock from us at $35. Since we can sell the stock at $35
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Calendar Spreads
and we can buy the stock at $35, the most risk we can have with this trade is the net cost
of the trade. Review the trade metrics below.
Cost of Trade
Buy 10 December $35 strike Calls at $1.55
Sell 10 August $35 strike Calls at ($.50)
Net Cost/Share =
$1.05 (calculated as $1.55 - $.50)
Review Trade Metrics/Calculations
Max Gain = Can not be calculated
The max gain is difficult to calculate because it depends on the remaining
value of your long option after your short option expires. Adjustments are
not factored into max gain calculation.
Break even = Can not be calculated
The break even point is difficult to calculate because it depends on the
relationship between the intrinsic and extrinsic values of your long and
short option positions.
Max Risk = Net cost/share X number of shares
$1.05/share X 1000 shares = $1,050
By spreading risk between two option contracts, we have significantly
reduced our amount at risk and capital required to put on the trade.
Reward/Risk Ratio = Can not be calculated
The Reward/Risk Ratio is difficult to calculate because the max gain can
not be calculated. Your max risk is very little and your profit potential
depends on your adjustments and how you REACT to stock price
movements. Any return generated on the very low risk levels will have
very high Reward/Risk Ratio’s.
The goal of the Calendar Spread is to enter a trade with very little risk. Your profitability
will depend on how you react to stock movement. There are only three possible ways the
stock will move. The stock can increase above $35, decrease below $35, or stay flat at
$35. We can make a profit by adjusting our trade to any of these scenario’s.
If the stock price increases, you can buy back your short August $35 strike Call contract
at a loss. That loss will be offset by gains in your long December $35 strike Call. Since
the stock has increased, you can then react with a bullish position and anticipate the stock
continuing upward. Since you own a December $35 strike Call, you can simply sell a
December $37.50 strike Call to structure a Bull Call Spread. You have adjusted your
calendar spread into a Bull Call Spread and should recalculate your new trade metrics.
Refer to the Debit Spread course for Bull Call Spread details and trade metrics.
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If the stock price decreases, you can let your short August $35 strike Call contract expire
worthless. This will leave you with a long December $35 strike Call with a cost basis of
$1.05. Since the stock has decreased, you can react with a bearish position and anticipate
the stock continuing downward. Since you own a December $35 strike Call, you can sell
a December $32.50 strike Call which would leave you with a Bear Call Credit Spread.
You have adjusted your Calendar spread into a Bear Call spread and should recalculate
your new trade metrics. Refer to the Credit Spread course for Bear Call Spread details
and trade metrics.
The ideal way to exit a Calendar spread is if the stock stays flat and continues to trade
just below the $35 level at August expiration. This will allow the August $35 strike Call
to expire worthless while your long December $35 strike Call will be worth something
since it has time value remaining. As long as you could sell your December $35 strike
Call above $1.05, you will make money. The Calendar Spread makes money by
capturing the increased rate of time value decay in the near term option. The August
option was originally sold at $.50 and expired worthless, losing 100% of its value.
Meanwhile, the December option was originally bought at $1.55 and will be trading at
least at $.80, so it will only lose 50% of its value. Assume you were able to sell your
long December $35 strike Call at $1.45 after August expiration. You entered the
Calendar spread for a debit of $1.05 and would exit with a credit of $1.45. You would
make $.40/share on a trade with $1.05/share risk. This would give you a 38% (.40/1.05)
return in a month! Suppose you held onto your December $35 strike Call and the stock
subsequently increased to $37 making your $35 strike Call In-The-Money. The Call
value would go to at least $2. You could sell the Call and make an additional profit of
$.95 ($2 - $1.05) or a whopping additional 90% on your initial risk capital of $1.05!
There are many ways to adjust your Calendar Spread. If the stock moves in a certain
direction, you can simply react by adjusting the trade. It the stock moves up, you can
adjust the trade into either a Bull Call Spread (Debit Spread) or a Bull Put Spread (Credit
Spread). If the stock moves down, you can adjust the trade into either a Bear Call Spread
(Credit Spread) or a Bear Put Spread (Debit Spread). Ideally, the stock will trade flat and
you can exit profitably without adjusting your trade.
Trade Results
At the August expiration, PAYX was trading at $34.41, just below our $35 strike price.
This allowed the August $35 strike Call option to expire worthless and we kept the entire
premium. In addition, the December $35 strike Call was trading at $1.45 and we were
able to exit that contract near our purchase price. We captured the entire $.50 premium
from the sale of the August $35 strike call and sold back our December $35 strike Call
for $.10 less than we bought it so we were able to capture a profit of $.40, or $400 total.
On our little risk amount of $1,050, this equates to a return of over 38% in only one
month!!!
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Calendar Spreads
Example 2 – MON
For our next trade, we’ll use MON as our stock we would like to trade. We can pull up a
chart on www.bigcharts.com to see the past year price chart that confirms MON is in a
relatively flat trading range. In the past four months, it has been regularly trading between
$55 and $65. At this point, we will continue to anticipate the stock trading relatively flat
from here. Earnings have recently been released so we do not expect any short term
news to come out that would impact the stock price. We can perform our stock analysis
and look for signals that will help form an opinion of future stock movement direction;
however, reviewing stock analysis indicators is outside the scope of this course so we
will bypass this function at this point. Please refer to the Stock Analysis 101 course for
more information on practical stock analysis techniques. See the chart below.
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Calendar Spreads
Next, we will review an option chain for MON available at www.optionsxpress.com. For
this trading strategy, we want to look at call contracts that are Out-of-The-Money for
both near term and longer term expiration periods. Review the Option Chain for MON
below.
Calls
Puts
Open
Symbol Last Chg Bid Ask Volume
Int
Aug 05
Calls
Strike Symbol Last Chg Bid Ask Volume
MON @ 63.67
(37 days to expiration)
Open
Int
Aug 05 Puts
MONHK
6.40
0 8.90 9.20 0
50 trade 55.00 MONTK
0.45
0 0.05 0.20 0 290 trade
MONHL
4.60 -0.60 4.50 4.80 47
225 trade 60.00 MONTL
0.80
0 0.70 0.85 10 345 trade
MONHM
1.65 -0.15 1.60 1.80 61
477 trade 65.00 MONTM
2.90 +0.15 2.70 2.90 10 558 trade
MONHN
0.40 -0.05 0.35 0.40 10
847 trade 70.00 MONTN
6.50 +0.20 6.40 6.70 10 29 trade
MONHO
0.15
MONHP
0
Oct 05
Calls
0 0.05 0.15 0
0
0 0.15 0
(100 days to
expiration)
79 trade 75.00 MONTO 12.80
0 trade 80.00 MONTP
0
MON @ 63.67
0 11.20 11.50 0
0 trade
0 16.20 16.50 0
0 trade
Oct 05 Puts
MONJI 21.50
0 19.00 19.30 0
122 trade 45.00 MONVI
0.20
0 0.05 0.20 0 327 trade
MONJJ 12.30
0 14.20 14.50 0
71 trade 50.00 MONVJ
0.50
0 0.25 0.35 0 447 trade
MONJK
9.40
0 9.80 10.10 0
183 trade 55.00 MONVK
0.85
0 0.80 0.95 0 687 trade
MONJL
5.90 -0.50 6.00 6.30 10 2,111 trade 60.00 MONVL
2.00
0 2.00 2.15 0 808 trade
MONJM
3.30 -0.20 3.20 3.40 26 1,086 trade 65.00 MONVM 4.10
0 4.10 4.30 0 272 trade
MONJN
1.70
0 1.50 1.65 0
762 trade 70.00 MONVN
9.40
0 7.30 7.60 0 112 trade
MONJO
0.70
0 0.60 0.75 0
392 trade 75.00 MONVO 11.60
0 11.50 11.80 0 99 trade
MONJP
0
0 0.20 0.30 0
0 trade 80.00 MONVP 16.90
0 16.20 16.50 0
1 trade
You can see that the $65 Strike call contract is Out-of-The-Money. The objective of this
strategy is to sell Extrinsic value in the near month OTM option and buy an insurance
option in a further out month to hedge our risk. If we sell the August $65 strike call, it
would satisfy the strategy requirement of selling a near month OTM option. By selling a
call contract, our risk is if the stock increases in value above $65 because we will be
obligated to sell our stock at $65. To hedge our risk, we will buy a $65 strike call
contract in a further out month such as October. This gives us the right to buy the stock
at $65 by October’s expiration. Be sure to buy a contract with at least 75-90 days left
before expiration so that time decay does not affect your long option.
By using two call contracts, we are spreading the risk between the options and reducing
our margin requirements to a minimum. Our long October $65 strike call gives us the
right to buy the stock at $65 by expiration. We sold an August $65 strike call which gave
someone else the right to buy our stock from us at $65. Since we can sell the stock at $65
and we can buy the stock at $65, the most risk we can have with this trade is the net cost
of the trade. Review the trade metrics below.
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Calendar Spreads
Cost of Trade
Buy 10 October $65 strike Calls at $3.40
Sell 10 August $65 strike Calls at ($1.60)
Net Cost/Share =
$1.80 (calculated as $3.40 - $1.60)
Review Trade Metrics/Calculations
Max Gain = Can not be calculated
The max gain is difficult to calculate because it depends on the remaining
value of your long option after your short option expires. Adjustments are
not factored into max gain calculation.
Break even = Can not be calculated
The break even point is difficult to calculate because it depends on the
relationship between the intrinsic and extrinsic values of your long and
short option positions.
Max Risk = Net cost/share X number of shares
$1.80/share X 1000 shares = $1,800
By spreading risk between two option contracts, we have significantly
reduced our amount at risk and capital required to put on the trade.
Reward/Risk Ratio = Can not be calculated
The Reward/Risk Ratio is difficult to calculate because the max gain can
not be calculated. Your max risk is very little and your profit potential
depends on your adjustments and how you REACT to stock price
movements. Any return generated on the very low risk levels will have
very high Reward/Risk Ratio’s.
The goal of the Calendar Spread is to enter a trade with very little risk. Your profitability
will depend on how you react to stock movement. There are only three possible ways the
stock will move. The stock can increase above $65, decrease below $65, or stay flat at
$65. We can make a profit by adjusting our trade to any of these scenario’s.
If the stock price increases, you can buy back your short August $65 strike Call contract
at a loss. That loss will be offset by gains in your long October $65 strike Call. Since the
stock has increased, you can then react with a bullish position and anticipate the stock
continuing upward. Since you own an October $65 strike Call, you can simply sell an
October $70 strike Call to structure a Bull Call Spread. You have adjusted your calendar
spread into a Bull Call Spread and should recalculate your new trade metrics. Refer to
the Debit Spread course for Bull Call Spread details and trade metrics.
If the stock price decreases, you can let your short August $65 strike Call contract expire
worthless. This will leave you with a long October $65 strike Call with a cost basis of
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Calendar Spreads
$1.80. Since the stock has decreased, you can react with a bearish position and anticipate
the stock continuing downward. Since you own an October $65 strike Call, you can sell
an October $60 strike Call which would leave you with a Bear Call Credit Spread. You
have adjusted your Calendar spread into a Bear Call spread and should recalculate your
new trade metrics. Refer to the Credit Spread course for Bear Call Spread details and
trade metrics.
The ideal way to exit a Calendar spread is if the stock stays flat and continues to trade
just below the $65 level at August expiration. This will allow the August $65 strike Call
to expire worthless while your long October $65 strike Call will be worth something
since it has time value remaining. As long as you could sell your October $65 strike Call
above $1.80, you will make money. The Calendar Spread makes money by capturing the
increased rate of time value decay in the near term option. The August option was
originally sold at $1.60 and will expire worthless, losing 100% of its value. Meanwhile,
the October option was originally bought at $3.40 and will be trading at least at $1.60, so
it will only lose 50% of its value. Assume you were able to sell your long October $65
strike Call at $2.00 after August expiration. You entered the Calendar spread for a debit
of $1.80 and would exit with a credit of $2.00. You would make $.20/share on a trade
with $1.80/share risk. This would give you a 11% (.20/1.80) return in a month! Suppose
you then held onto your October $65 strike Call and the stock subsequently increased to
$68 making your $65 strike Call In-The-Money. The Call value would go to at least $3.
You could sell the Call and make an additional profit of $1.20 ($3 - $1.80) or a whopping
additional 67% on your initial risk capital of $1.80!
There are many ways to adjust your Calendar Spread. If the stock moves in a certain
direction, you can simply react by adjusting the trade. It the stock moves up, you can
adjust the trade into either a Bull Call Spread (Debit Spread) or a Bull Put Spread (Credit
Spread). If the stock moves down, you can adjust the trade into either a Bear Call Spread
(Credit Spread) or a Bear Put Spread (Debit Spread). Ideally, the stock will trade flat and
you can exit profitably without adjusting your trade.
Trade Results
At the August expiration, MON was trading at $64.97, just below our $65 strike price.
This allowed the August $65 strike Call option to expire worthless and we kept the entire
premium. In addition, the October $65 strike Call was trading at $3.20 and we were able
to exit that contract near our purchase price. We captured the entire $1.60 premium from
the sale of the August $65 strike call and sold back our October $65 strike Call for $.20
less than we bought it so we were able to capture a profit of $1.40, or $1,400 total. On
our little risk amount of $1,800, this equates to a return of over 78% in only one month!!!
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Calendar Spreads
Example 3 – PEP
For our next trade, we’ll use PEP as our stock we would like to trade. We can pull up a
chart on www.bigcharts.com to see the past year price chart that confirms PEP is in a
relatively flat trading range. It has been trading between $52 and $56 for the past six
months. At this point, we will continue to anticipate the stock trading relatively flat from
here. Earnings have recently been released so we do not expect any short term news to
come out that would impact the stock price. We can perform our stock analysis and look
for signals that will help form an opinion of future stock movement direction; however,
reviewing stock analysis indicators is outside the scope of this course so we will bypass
this function at this point. Please refer to the Stock Analysis 101 course for more
information on practical stock analysis techniques. See the chart below.
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Calendar Spreads
Next, we will review an option chain for PEP available at www.optionsxpress.com. For
this trading strategy, we want to look at Put contracts that are Out-of-The-Money for both
near term and longer term expiration periods. Review the Option Chain for PEP below.
Calls
Puts
Symbol Last Chg Bid Ask Volume
Aug 05
Calls
Open
Int
Strike Symbol Last Chg Bid Ask Volume
PEP @ 54.87
(37 days to expiration)
PEPHH 15.10
0 14.90 15.10
0
42 trade 40.00 PEPTH
PEPHV 12.60
0 12.40 12.60
0
PEPHI 10.10
0 9.90 10.10
0
PEPHW 7.50 -0.10 7.40 7.70
Open
Int
Aug 05 Puts
0
0
0 0.05
0
0 trade
50 trade 42.50 PEPTV
0
0
0 0.05
0
0 trade
50 trade 45.00 PEPTI
0.10
0
0 0.05
0
5 trade
2
56 trade 47.50 PEPTW
0.10
0
0 0.05
0
107 trade
12
531 trade 50.00 PEPTJ
0.05
0
0 0.10
8 4,628 trade
PEPHJ
4.90 -0.20 5.00 5.20
PEPHK
0.95
0 0.90 0.95 3,257 13,459 trade 55.00 PEPTK
PEPHL
0.10
0
0 0.10
1 1,175 trade 60.00 PEPTL
5.00
0 5.00 5.20 10
0 trade
PEPHM
0
0
0 0.05
0
0 trade 65.00 PEPTM
0
0 10.00 10.20
0
0 trade
0.85 -0.15 0.85 0.95 257 1,523 trade
PEPHN
0
0
0 0.05
0
0 trade 70.00 PEPTN
0
0 15.00 15.20
0
0 trade
PEPHO
0
0
0 0.05
0
0 trade 75.00 PEPTO
0
0 20.00 20.20
0
0 trade
PEPHP
0
0
0 0.05
0
0 trade 80.00 PEPTP
0
0 25.00 25.20
0
0 trade
Oct 05
Calls
(100 days to expiration)
PEP @ 54.87
Oct 05 Puts
PEPJH 14.20
0 15.00 15.20
0
38 trade 40.00 PEPVH
0.05
0
0 0.10
0
24 trade
PEPJV 12.70
0 12.50 12.70
0
21 trade 42.50 PEPVV
0.25
0
0 0.10
0
53 trade
PEPJI 11.10
0 10.00 10.30
0
191 trade 45.00 PEPVI
PEPJW
7.80 -0.10 7.60 7.80
183
0.10 -0.05 0.10 0.15 66 5,164 trade
67 trade 47.50 PEPVW 0.15 -0.10 0.10 0.20 122 1,172 trade
PEPJJ
5.40 +0.10 5.30 5.50
6 1,346 trade 50.00 PEPVJ
PEPJK
1.70 +0.20 1.60 1.70
175 13,944 trade 55.00 PEPVK
1.55
0 1.50 1.60 144 5,758 trade
45 7,079 trade 60.00 PEPVL
5.50
0 5.10 5.30
0
634 trade
185 trade 65.00 PEPVM
9.20
0 10.00 10.20
0
0 trade
0 trade
PEPJL
0.25 +0.05 0.20 0.25
PEPJM
0.15
0
0 0.10
0
0.35 +0.05 0.25 0.35
5 5,998 trade
PEPJN
0
0
0 0.05
0
0 trade 70.00 PEPVN 15.10
0 15.00 15.20
0
PEPJO
0
0
0 0.05
0
0 trade 75.00 PEPVO
0
0 20.00 20.20
0
0 trade
PEPJP
0
0
0 0.05
0
0 trade 80.00 PEPVP 26.50
0 25.00 25.20
0
10 trade
You can see that the $55 Strike put contract is At-The-Money. The objective of this
strategy is to sell Extrinsic value in the near month OTM or ATM option and buy an
insurance option in a further out month to hedge our risk. If we sell the August $55 strike
put, it would satisfy the strategy requirement of selling a near month OTM or ATM
option. By selling a put contract, our risk is if the stock decreases in value below $55
because we will be obligated to buy someone else’s stock at $55. To hedge our risk, we
will buy a $55 strike put contract in a further out month such as October. This gives us
the right to sell the stock at $55 by October’s expiration. Be sure to buy a contract with
at least 75-90 days left before expiration so that time decay does not affect your long
option.
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Calendar Spreads
By using two put contracts, we are spreading the risk between the options and reducing
our margin requirements to a minimum. Our long October $55 strike put gives us the
right to sell the stock at $55 by expiration. We sold an August $55 strike put which gave
someone else the right to sell their stock to us at $55. Since we can sell the stock at $55
and we can buy the stock at $55, the most risk we can have with this trade is the net cost
of the trade. Review the trade metrics below.
Cost of Trade
Buy 10 October $55 strike Puts at $1.60
Sell 10 August $55 strike Puts at ($.85)
Net Cost/Share =
$.75 (calculated as $1.60 - $.85)
Review Trade Metrics/Calculations
Max Gain = Can not be calculated
The max gain is difficult to calculate because it depends on the remaining
value of your long option after your short option expires. Adjustments are
not factored into max gain calculation.
Break even = Can not be calculated
The break even point is difficult to calculate because it depends on the
relationship between the intrinsic and extrinsic values of your long and
short option positions.
Max Risk = Net cost/share X number of shares
$.75/share X 1000 shares = $750
By spreading risk between two option contracts, we have significantly
reduced our amount at risk and capital required to put on the trade.
Reward/Risk Ratio = Can not be calculated
The Reward/Risk Ratio is difficult to calculate because the max gain can
not be calculated. Your max risk is very little and your profit potential
depends on your adjustments and how you REACT to stock price
movements. Any return generated on the very low risk levels will have
very high Reward/Risk Ratio’s.
The goal of the Calendar Spread is to enter a trade with very little risk. Your profitability
will depend on how you react to stock movement. There are only three possible ways the
stock will move. The stock can increase above $55, decrease below $55, or stay flat at
$55. We can make a profit by adjusting our trade to any of these scenario’s.
If the stock price increases, you can let your short August $55 strike Put contract expire
worthless. This will leave you with a long October $55 strike Put with a cost basis of
$.75. Since the stock has increased, you can react with a bullish position and anticipate
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Calendar Spreads
the stock continuing upward. Since you own an October $55 strike Put, you can sell an
October $60 strike Put which would leave you with a Bull Put Credit Spread. You have
adjusted your Calendar spread into a Bull Put spread and should recalculate your new
trade metrics. Refer to the Credit Spread course for Bull Put Spread details and trade
metrics.
If the stock price decreases, you can buy back your short August $55 strike Put contract
at a loss. That loss will be offset by gains in your long October $55 strike Put. Since the
stock has decreased, you can then react with a bearish position and anticipate the stock
continuing downward. Since you own an October $55 strike Put, you can simply sell an
October $50 strike Put to structure a Bear Put Debit Spread. You have adjusted your
calendar spread into a Bear Put Spread and should recalculate your new trade metrics.
Refer to the Debit Spread course for Bear Put Spread details and trade metrics.
The ideal way to exit a Calendar spread is if the stock stays flat and continues to trade
just above the $55 level at August expiration. This will allow the August $55 strike Put
to expire worthless while your long October $55 strike Put will be worth something since
it has time value remaining. As long as you could sell your October $55 strike Put above
$.75, you will make money. The Calendar Spread makes money by capturing the
increased rate of time value decay in the near term option. The August option was
originally sold at $.85 and will expire worthless, losing 100% of its value. Meanwhile,
the October option was originally bought at $1.60 and will be trading at least at $.80, so it
will only lose 50% of its value. Assume you were able to sell your long October $55
strike Put at $1.00 after August expiration. You entered the Calendar spread for a debit
of $.75 and would exit with a credit of $1.00. You would make $.25/share on a trade with
$.75/share risk. This would give you a 34% (.25/.75) return in a month! Suppose you
then held onto your October $55 strike Put and the stock subsequently decreased to $52
making your $55 strike Put In-The-Money. The Put value would go to at least $3. You
could sell the Put and make an additional profit of $2.25 ($3 - $.75) or a whopping
additional 300% on your initial risk capital of $.75!
There are many ways to adjust your Calendar Spread. If the stock moves in a certain
direction, you can simply react by adjusting the trade. It the stock moves up, you can
adjust the trade into either a Bull Call Spread (Debit Spread) or a Bull Put Spread (Credit
Spread). If the stock moves down, you can adjust the trade into either a Bear Call Spread
(Credit Spread) or a Bear Put Spread (Debit Spread). Ideally, the stock will trade flat and
you can exit profitably without adjusting your trade.
Trade Results
At the August expiration, PEP was trading at $54.94, just below our $55 strike price.
This allowed the August $55 strike Put option to expire with only $.06 of value and we
kept the remaining $.79 premium. In addition, the October $55 strike Put was trading at
$1.40 and we were able to exit that contract near our purchase price. We captured $.79 of
premium from the sale of the August $55 strike put and sold back our October $55 strike
Put for $.20 less than we bought it so we were able to capture a profit of $.59, or $590
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Calendar Spreads
total. On our little risk amount of $750, this equates to a return of over 79% in only one
month!!!
3. Summary
In this course we have examined Calendar Spreads and how to easily adjust them into
Bullish or Bearish Spreads. Calendar spreads can earn highly leveraged returns since they
require the least amount of capital to initiate. Your profitability is dependent on you
reacting to the movement in stocks.
You can initiate Calendar Spread trades and adjust them to profit from stocks that are
moving up or down. There are many ways to adjust your Calendar Spread. If the stock
moves in a certain direction, you can simply react by adjusting the trade. It the stock
moves up, you can adjust the trade into either a Bull Call Spread (Debit Spread) or a Bull
Put Spread (Credit Spread). If the stock moves down, you can adjust the trade into either
a Bear Call Spread (Credit Spread) or a Bear Put Spread (Debit Spread). Ideally, the
stock will trade flat and you can exit profitably without adjusting your trade.
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Advanced Neutral Strategies
Advanced Neutral Strategies
1. Advanced Neutral Strategies Overview
In this course we will review several strategies that are neutral in their bias of anticipated
stock movement. This means the stock can go up or down and you will be able to profit
in either direction. Contrary to previous spread strategies, the advanced neutral strategies
will combine calls and puts into one trade. As always, we will present a unique approach
to implementing these strategies that will increase the probabilities of winning.
Trades combining calls and puts are different from spreads where a trade involves buying
and selling contracts. In these combination trades, two different options (calls and puts)
are purchased simultaneously. Because we are long both calls and puts, the time value
will decay twice as fast. Implied volatility will also be very important in these trades.
The ideal time to enter these trades is when implied volatility is at low levels. When
implied volatility levels are low, option premiums are less expensive and we can put on
the trade with less capital. We will need to react to stock price movement and adjust our
trades timely to lock in profits.
Two combination strategies we will review include the long straddle and long strangle.
These strategies can be profitable because the risk is fixed at the price paid to enter the
trade while the reward potential is unlimited. In addition, we will cover a related short
straddle trade. Of course, the TradewithOptions.com strategies will be applied in a unique
way to capture more winning trades. We will also describe adjustments available to
increase profitability.
2. Long Straddle
A long straddle trade is structured by buying a call and a put at the same strike price and
expiration. A straddle will profit on the call contract when the stock increases and will
profit on the put contract when the stock decreases. Therefore, if the stock goes up or
down you can profit. Since you are guaranteed a win on either the call or the put, the
way to increase profitability is to react to the stock move and neutralize the loss on the
contract that loses value. For example, if the stock price increases, the call contract will
increase in value. Your adjustments will focus on neutralizing the loss on the put
contract. The best time to enter the long straddle is shortly before earnings
announcements that can drive the stock price in any direction.
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Advanced Neutral Strategies
Strategy Objectives
•
•
•
Use multiple contracts to provide reward potential if the stock increases or
decreases
Adjust to the direction of the stock movement and neutralize the losing side
GOAL = Buy At-the-Money (ATM) calls and puts
Strategy Benefits
•
•
•
•
High Reward Potential
Profits from stock movement in any direction
Medium maintenance, Medium Risk
High Annual Return Rates
Steps
14. Find a stock you would like to Trade.
15. Perform analysis (including Technical, Fundamental, and Sentimental) to
determine anticipated price movement.
16. Review Implied Volatility levels to ensure Long Straddle is appropriate
17. Evaluate Option chain focusing on ATM call/put contracts.
18. Initiate neutral long Straddle trade.
19. Adjust losing side of trade into Bull/Bear spread
20. Adjust winning side of trade into Free Trade
Trade Structure
– Combines 2 different Option contracts.
– Buy calls and puts at the same strike price and same expiration period.
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Advanced Neutral Strategies
Example 1 – AAPL
For our first trade, we’ll use AAPL as our stock we would like to trade. We can pull up a
chart on www.bigcharts.com to see the past year price chart that confirms AAPL is in a
trend up. In addition, we know earnings are about to be released on AAPL. We can
expect that the earnings announcement will significantly affect the stock price and drive
it up or down, but we don’t know which direction. Therefore, a long straddle would be an
appropriate strategy to play. We can perform our stock analysis and look for signals that
will help form an opinion of future stock movement direction; however, reviewing stock
analysis indicators is outside the scope of this course so we will bypass this function at
this point. Please refer to the Stock Analysis 101 course for more information on
practical stock analysis techniques. See the chart below.
Note that this chart was printed shortly after the earnings release to show the subsequent
price movement. The long straddle trade was initiated shortly prior to the earnings
release.
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Next, we will review the volatility valuation for AAPL available at www.ivolatility.com.
For this trading strategy, we want to look at stocks with options at low levels of implied
volatility. Review the Implied Volatility chart for AAPL below.
The gold line in the above graph plots the current Implied Volatility of AAPL. The blue
line plots the 30 day historical volatility. You can see the current implied volatility is at
about 40% which is near its lowest levels over the past year. Therefore, it meets our low
volatility requirement for a Long Straddle.
Next, we will review an option chain for AAPL available at www.optionsxpress.com.
For this trading strategy, we want to look at call and put contracts that are at the same
strike price and expiration. Since earnings are about to be released, we can use a short
term contract such as August with 37 days remaining until expiration. Review the Option
Chain for AAPL below.
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Calls
Puts
Symbol Last Chg Bid Ask Volume
Aug 05
Calls
Open
Int
Strike Symbol Last Chg Bid Ask Volume
AAPL @ 38.35
(37 days to expiration)
Open
Int
Aug 05 Puts
AAQHD 18.30 -0.30 18.20 18.70
6
96 trade 20.00 AAQTD
0
0
0 0.10
0
AAQHT 15.90 +0.60 15.70 16.20
10
121 trade 22.50 AAQTT
0
0
0 0.10
0
0 trade
0 13.30 13.60
0
10 trade 25.00 AAQTE
0.05
0
0 0.10
0
14 trade
AAQHY 10.70 +0.80 10.80 11.30
20
65 trade 27.50 AAQTY
0.10
0
0 0.10
0
330 trade
AAQHF
8.60 +0.30 8.40 8.80
88
234 trade 30.00 AAQTF
0.10
0 0.05 0.15
378
820 trade
AAQHZ
6.30 +0.20 6.20 6.40
92 1,224 trade 32.50 AAQTZ
0.25 -0.05 0.20 0.30 9,902 2,289 trade
AAQHG
4.20
0 4.10 4.30 1,031 4,744 trade 35.00 AAQTG
0.75 -0.05 0.70 0.75 9,997 7,122 trade
AAQHU
2.60 +0.10 2.55 2.65 3,384 10,203 trade 37.50 AAQTU
1.60 -0.05 1.50 1.60 10,156 9,107 trade
AAQHH
1.35 +0.05 1.35 1.40 25,858 17,767 trade 40.00 AAQTH
2.95 -0.15 2.85 3.00 6,327 1,992 trade
QAAHV
0.65 -0.10 0.65 0.75 25,627 8,436 trade 42.50 QAATV
4.70 -0.30 4.60 4.80
100
407 trade
QAAHI
0.34 +0.04 0.25 0.35 2,608 3,100 trade 45.00 QAATI
7.20
0 6.70 7.00
0
59 trade
QAAHW 0.15 -0.02 0.10 0.20 1,838 1,058 trade 47.50 QAATW 10.50
0 9.00 9.40
0
60 trade
478 trade 50.00 QAATJ 11.70 -0.60 11.40 11.80
10
15 trade
0
0 trade
AAQHE 11.90
QAAHJ
0.10
0 0.05 0.15
QAAHK
0.10
0
0 0.10
17
0
80 trade 55.00 QAATK 17.00
0 16.40 16.80
0 trade
You can see that the $37.50 strike call and put contracts are At-The-Money. The
objective of this strategy is to buy both a call and a put at the same strike price to benefit
from stock movement in any direction. Since earnings are about to be released, we can
anticipate the stock moving quickly up or down. Since we own two types of contracts,
our risk is that the time value will decay twice as fast if the stock does not move.
Our objective is to initiate a neutral long straddle just prior to news that could drive the
stock price up or down. Then we simply adjust our trade to react to the stock price move.
We will adjust our losing trade into a Bull/Bear spread to neutralize the loss. We will
also adjust our winning trade into a “Free” trade where we can increase our profit
potential with little to no risk. Review the trade metrics below.
Cost of Trade
Buy 10 August $37.50 strike Calls at $2.65
Buy 10 August $37.50 strike Puts at $1.60
Net Cost/Share =
$4.25 (calculated as $2.65 + $1.60)
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Review Trade Metrics/Calculations
Max Gain = Unlimited
The max gain is difficult to calculate because the call contracts have
unlimited profit potential since a stock has no price ceiling. The put
contracts can profit if the stock price drops, but it can not drop below zero.
Adjustments are not factored into max gain calculation.
Break even = Net cost of trade plus/minus strike price
$4.25 + $37.50 = $41.75
$4.25 - $37.50 = $33.25
You will have two breakeven points since you can win whether the stock
goes up or down. The stock must be at or above $41.75 to breakeven or
make a profit. The stock can also be at or below $33.25 to breakeven or
make a profit. Current stock price = 38.35, therefore, the stock must make
a move up or down just to breakeven.
Max Risk = Net cost/share X number of shares
$4.25/share X 1000 shares = $4,250
Reward/Risk Ratio = Can not be calculated
The Reward/Risk Ratio is difficult to calculate because the max gain is
unlimited. In addition, your profit potential depends on your adjustments
and how you REACT to stock price movements.
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Below is the Profit and Loss Diagram for the combined position of a long put and a long
call known as a Long Straddle Trade. You can see on the Profit and Loss Diagram the
two breakeven points. With the stock price currently at $38.35, the trade will be in a
losing position. As the stock price moves up or down, the trade will become profitable.
D
E
F
G
H
I
J
K
L
M
N
$10,000
$8,000
$6,000
profit / loss
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
Break-Even
$4,000
$2,000
$25
27.5
30
32.5
35
37.5
40
42.5
45
47.5
50
$(2,000)
$(4,000)
Current Stock
Price
$(6,000)
stock price
The goal of the long straddle is to enter the trade just prior to an event that will drive the
stock price up or down. Your profitability will depend on how you react to stock
movement. There are only three possible ways the stock will move. The stock can
increase above $37.50, decrease below $37.50, or stay flat. We can make a profit by
adjusting our trade to any of these scenario’s.
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Advanced Neutral Strategies
As shown in the stock price chart at the beginning of the example, AAPL released
favorable earnings and subsequently gapped up. Below is the option chain for AAPL just
a few days after the earnings release. We are going to use this information to illustrate
how to adjust your initial long straddle trade into a more profitable trade. Review the
option chain below.
Calls
Symbol Last Chg
Aug 05
Calls
Bid
Puts
Open
Ask Volume
Int
Strike Symbol Last Chg
Bid
Ask Volume
AAPL @ 44.00
(26 days to expiration)
Open
Int
Aug 05 Puts
AAQHD 21.50
0 23.90 24.20
0
102 trade 20.00 AAQTD
0
0
0 0.05
0
AAQHT 18.80
0 21.40 21.70
0
131 trade 22.50 AAQTT
0
0
0 0.05
0
0 trade
AAQHE 16.50
0 18.90 19.20
0
26 trade 25.00 AAQTE
0.05
0
0 0.05
0
14 trade
AAQHY 14.50
0 16.40 16.70
0
75 trade 27.50 AAQTY
0.10
0
0 0.05
0
330 trade
AAQHF 12.90
0 13.90 14.20
0
297 trade 30.00 AAQTF
0.05
0
0 0.05
0 1,103 trade
AAQHZ 11.40
0 12,356 trade
0 trade
0 11.40 11.70
0 1,217 trade 32.50 AAQTZ
0.05
0
0 0.05
AAQHG
9.00 +0.70 8.90 9.20
168 5,796 trade 35.00 AAQTG
0.05
0
0 0.05
0 14,536 trade
AAQHU
6.60 +0.60 6.50 6.70
150 11,877 trade 37.50 AAQTU
0.10
0 0.05 0.10
1,518 17,798 trade
AAQHH
4.30 +0.60 4.20 4.40
817 37,010 trade 40.00 AAQTH
0.30 -0.04 0.25 0.30
1,119 19,109 trade
QAAHV
2.40 +0.45 2.35 2.40
3,269 39,896 trade 42.50 QAATV
0.80 -0.30 0.75 0.80
2,424 8,873 trade
QAAHI
1.05 +0.20 1.05 1.10
6,109 26,257 trade 45.00 QAATI
2.00 -0.45 1.95 2.00
853 1,892 trade
QAAHW 0.40 +0.10 0.40 0.45
351 5,277 trade 47.50 QAATW 3.90 -0.11 3.80 3.90
QAAHJ
146 2,131 trade 50.00 QAATJ
QAAHK
0.15 +0.05 0.10 0.20
0.05
0
0 0.05
0
23
125 trade
8.50
0 6.00 6.20
0
35 trade
242 trade 55.00 QAATK 17.00
0 10.90 11.20
0
0 trade
You can see that the long straddle at the $37.50 strike price is now worth $6.55 ($6.50 +
$.05). You paid $4.25 to put on the trade and you could exit now at $6.55 for a profit of
$2.30. That’s a wonderful return of 54% in only a few days! Alternatively, you can
adjust your trade to capture more profit.
Adjustments
Since the stock has increased and gapped up on strong volume, we will anticipate the
stock continuing up from here. To enter a “Free” trade, we are going to focus on our
contract that is showing a profit. In this example, it will be the call that we originally
purchased for $2.65 and is now worth $6.50. In reviewing the call option chain, you can
see the $42.50 call contract can be sold at $2.35 which is about what we paid for the
$37.50 strike call essentially making the adjustment free. By selling a higher strike call
contract, we have structured a Bull Call debit spread. We can structure the spread for a
net debit of $.30 ($2.65 originally paid for $37.50 strike less $2.35 collected for selling
the $42.50 strike call). You have adjusted your winning call contract into a Bull Call
debit spread. Be sure to calculate your new trade metrics. On the call side, your max risk
is $.30 and you could win $4.70 if AAPL stays above $42.50. That would increase your
profits from $2.30 to $4.70!
In addition, you can adjust the contract in your long straddle showing a loss. In this
example, the $37.50 put contract originally purchased for $1.60 is now only worth $.05.
To neutralize the loss and recover the investment in the put contract, you can adjust the
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Advanced Neutral Strategies
put side of the long straddle into a Bull Put credit spread. In reviewing the put option
chain, you can see the $42.50 strike put contract can be sold at $.75. By selling a higher
strike put contract, we have structured a Bull Put credit spread. You will collect $.75 by
selling the $42.50 strike put and use those proceeds to offset the loss in the $37.50 strike
put. You have adjusted your losing put contract into a Bull Put credit spread and should
calculate your new trade metrics. If AAPL stays above $42.50 by expiration, you will
increase your profits by an additional $.75 on the put side. Your total profits would then
be $5.45 ($4.70 from adjusted Bull Call debit spread plus $.75 from adjusted Bull Put
credit spread). By adjusting your trade and reacting to the stock price movement, you
have increased your profits from the current $2.30 up to $5.45!! For our example using
10 contracts representing 1000 shares, the profits amount to $5,450!
There are many ways to adjust your initial long straddle. If the stock moves in a certain
direction, you can simply react by adjusting both sides of the long straddle trade. If the
stock moves up, you can adjust the long straddle trade into a Bull Call Spread (Debit
Spread) and a Bull Put Spread (Credit Spread). If the stock moves down, you can adjust
the long straddle trade into a Bear Call Spread (Credit Spread) and a Bear Put Spread
(Debit Spread). These adjustments represent only the second level of adjustments. You
can continually adjust your trades to simply react to stock price movement. For more
information on adjustments, sign up for the live interactive sessions available at
www.TradewithOptions.com.
3. Long Strangle
A long strangle trade is very similar to a long straddle. The only difference is that long
strangle trades are structured by buying a call and a put at different strike prices. By
using different strike prices, you will modify the profit and loss diagram of the straddle
and have different breakeven points. The TradewithOptions.com unique approach to
long strangles requires you to structure the trade with In-The-Money calls and puts. This
will guarantee some value in the trade at expiration and significantly reduce your risk.
The tradeoff is that it takes more capital to put on the long strangle trade.
To structure an ITM long strangle, one would buy a call and a put that are at different
strike prices. A strangle will profit on the call contract when the stock increases and will
profit on the put contract when the stock decreases. Therefore, if the stock goes up or
down you can profit. Since you are guaranteed a win on either the call or the put, the
way to increase profitability is to react to the stock move and neutralize the loss on the
contract that loses value. For example, if the stock price increases, the call contract will
increase in value. Your adjustments will focus on neutralizing the loss on the put
contract. The best time to enter the long strangle is shortly before earnings
announcements that can drive the stock price in any direction. The goal of the long
strangle is take advantage of the rate of change in value between the winning and losing
contracts. The winning contract will gain value at a faster rate than the other contract
loses value.
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Advanced Neutral Strategies
Strategy Objectives
• Use multiple contracts to provide reward potential if the stock increases or
decreases
• Adjust to the direction of the stock movement and neutralize the losing side
• GOAL = Buy In-the-Money (ITM) calls and puts
Strategy Benefits
• High Reward Potential
• Profits from stock movement in any direction
• Medium maintenance, Medium Risk
• High Annual Return Rates
Steps
1. Find a stock you would like to Trade.
2. Perform analysis (including Technical, Fundamental, and Sentimental) to
determine anticipated price movement.
3. Review Implied Volatility levels to ensure Long Strangle is appropriate
4. Evaluate Option chain focusing on ITM call/put contracts.
5. Initiate neutral long Strangle trade.
6. Adjust losing side of trade into Bull/Bear spread
7. Adjust winning side of trade into Free Trade
Trade Structure
– Combines 2 different Option contracts.
– Buy calls and puts at different strike prices and same expiration period.
Example 2 – AAPL
Since the long strangle is very similar to the long straddle, we’ll use AAPL in both trade
examples to make it easy to compare the two strategies.
To illustrate the long strangle trade, we’ll use AAPL as our stock we would like to trade.
We can pull up a chart on www.bigcharts.com to see the past year price chart that
confirms AAPL is in a trend up. In addition, we know earnings are about to be released
on AAPL. We can expect that the earnings announcement will significantly affect the
stock price and drive it up or down, but we don’t know which direction. Therefore, a long
strangle would be an appropriate strategy to play. We can perform our stock analysis and
look for signals that will help form an opinion of future stock movement direction;
however, reviewing stock analysis indicators is outside the scope of this course so we
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Advanced Neutral Strategies
will bypass this function at this point. Please refer to the Stock Analysis 101 course for
more information on practical stock analysis techniques. See the chart below.
Note that this chart was printed shortly after the earnings release to show the subsequent
price movement. The long strangle trade was initiated shortly prior to the earnings
release.
Next, we will review the volatility valuation for AAPL available at www.ivolatility.com.
For this trading strategy, we want to look at stocks with options at low levels of implied
volatility. Review the Implied Volatility chart for AAPL below.
The gold line in the above graph plots the current Implied Volatility of AAPL. The blue
line plots the 30 day historical volatility. You can see the current implied volatility is at
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Advanced Neutral Strategies
about 40% which is near its lowest levels over the past year. Therefore, it meets our low
volatility requirement for a Long Strangle.
Next, we will review an option chain for AAPL available at www.optionsxpress.com.
For this trading strategy, we want to look at calls and put contracts that are both In-theMoney (ITM). Since earnings are about to be released, we can use a short term contract
such as August with 37 days remaining until expiration. Review the Option Chain for
AAPL below.
Calls
Puts
Symbol Last Chg Bid Ask Volume
Aug 05
Calls
Open
Int
Strike Symbol Last Chg Bid Ask Volume
AAPL @ 38.35
(37 days to expiration)
Open
Int
Aug 05 Puts
AAQHD 18.30 -0.30 18.20 18.70
6
96 trade 20.00 AAQTD
0
0
0 0.10
0
AAQHT 15.90 +0.60 15.70 16.20
10
121 trade 22.50 AAQTT
0
0
0 0.10
0
0 trade
0 13.30 13.60
0
10 trade 25.00 AAQTE
0.05
0
0 0.10
0
14 trade
AAQHY 10.70 +0.80 10.80 11.30
20
65 trade 27.50 AAQTY
0.10
0
0 0.10
0
330 trade
AAQHF
8.60 +0.30 8.40 8.80
88
234 trade 30.00 AAQTF
0.10
0 0.05 0.15
378
820 trade
92 1,224 trade 32.50 AAQTZ
0.25 -0.05 0.20 0.30 9,902 2,289 trade
AAQHE 11.90
0 trade
AAQHZ
6.30 +0.20 6.20 6.40
AAQHG
4.20
0 4.10 4.30 1,031 4,744 trade 35.00 AAQTG
0.75 -0.05 0.70 0.75 9,997 7,122 trade
AAQHU
2.60 +0.10 2.55 2.65 3,384 10,203 trade 37.50 AAQTU
1.60 -0.05 1.50 1.60 10,156 9,107 trade
AAQHH
1.35 +0.05 1.35 1.40 25,858 17,767 trade 40.00 AAQTH
2.95 -0.15 2.85 3.00 6,327 1,992 trade
QAAHV
0.65 -0.10 0.65 0.75 25,627 8,436 trade 42.50 QAATV
4.70 -0.30 4.60 4.80
QAAHI
0.34 +0.04 0.25 0.35 2,608 3,100 trade 45.00 QAATI
7.20
0 6.70 7.00
QAAHW 0.15 -0.02 0.10 0.20 1,838 1,058 trade 47.50 QAATW 10.50
QAAHJ
0.10
0 0.05 0.15
QAAHK
0.10
0
0 0.10
17
0
100
407 trade
0
59 trade
0 9.00 9.40
0
60 trade
478 trade 50.00 QAATJ 11.70 -0.60 11.40 11.80
10
15 trade
0
0 trade
80 trade 55.00 QAATK 17.00
0 16.40 16.80
You can see that the $37.50 strike call and $40 strike put contracts are In-The-Money.
The objective of this strategy is to buy both a call and a put that are ITM to benefit from
stock movement in any direction. Since earnings are about to be released, we can
anticipate the stock moving quickly up or down. Since we own two types of contracts,
our risk is that the time value will decay twice as fast if the stock does not move.
Our objective is to initiate a neutral long strangle just prior to news that could drive the
stock price up or down. Then we simply adjust our trade to react to the stock price move.
We will adjust our losing trade into a Bull/Bear spread to neutralize the loss. We will
also adjust our winning trade into a “Free” trade where we can increase our profit
potential with little to no risk. Review the trade metrics below.
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Advanced Neutral Strategies
Cost of Trade
Buy 10 August $37.50 strike Calls at $2.65
Buy 10 August $40 strike Puts at $3.00
Net Cost/Share =
$5.65 (calculated as $2.65 + $3.00)
Review Trade Metrics/Calculations
Max Gain = Unlimited
The max gain is difficult to calculate because it the call contracts have
unlimited profit potential since a stock has no price ceiling. The put
contracts can profit if the stock price drops, but it can not drop below zero.
Adjustments are not factored into max gain calculation.
Break even = Net cost of trade plus/minus strike price
$5.65 + $37.50 = $43.15
$5.65 - $40 = $34.35
You will have two breakeven points since you can win whether the stock
goes up or down. The stock must be at or above $43.15 to breakeven or
make a profit. The stock can also be at or below $34.35 to breakeven or
make a profit. Current stock price = 38.35, therefore, the stock must make
a move up or down just to breakeven.
Max Risk = Net cost/share X number of shares less spread in strike prices
$5.65/share - ($40 - $37.50) = $3.15, or $3,150 total
There is less risk in a long strangle than a long straddle because you are
guaranteed some value at the end.
Reward/Risk Ratio = Can not be calculated
The Reward/Risk Ratio is difficult to calculate because the max gain is
unlimited. In addition, your profit potential depends on your adjustments
and how you REACT to stock price movements.
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Advanced Neutral Strategies
Below is the Profit and Loss Diagram for the combined position of a long put and a long
call known as a Long Strangle Trade. You can see on the Profit and Loss Diagram the
two breakeven points. With the stock price currently at $38.35, the trade will be in a
losing position. As the stock price moves up or down, the trade will become profitable.
D
E
F
G
H
I
J
K
L
M
N
$10,000
$8,000
$6,000
profit / loss
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
Break-Even
$4,000
$2,000
$25
27.5
30
32.5
35
37.5
40
42.5
45
47.5
50
$(2,000)
$(4,000)
stock price
Current Stock
Price
The goal of the long strangle is to enter the trade just prior to an event that will drive the
stock price up or down. Your profitability will depend on how you react to stock
movement. There are only three possible ways the stock will move. The stock can
increase above $37.50, decrease below $40, or stay in between $37.50 and $40. We can
make a profit by adjusting our trade to any of these scenario’s.
As shown in the stock price chart at the beginning of the example, AAPL released
favorable earnings and subsequently gapped up. Below is the option chain for AAPL just
a few days after the earnings release. We are going to use this information to illustrate
how to adjust your initial long strangle trade into a more profitable trade. Review the
option chain below.
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Advanced Neutral Strategies
Calls
Symbol Last Chg
Aug 05
Calls
Bid
Puts
Open
Ask Volume
Int
Strike Symbol Last Chg
Bid
Ask Volume
AAPL @ 44.00
(26 days to expiration)
Open
Int
Aug 05 Puts
AAQHD 21.50
0 23.90 24.20
0
102 trade 20.00 AAQTD
0
0
0 0.05
0
AAQHT 18.80
0 21.40 21.70
0
131 trade 22.50 AAQTT
0
0
0 0.05
0
0 trade
AAQHE 16.50
0 18.90 19.20
0
26 trade 25.00 AAQTE
0.05
0
0 0.05
0
14 trade
AAQHY 14.50
0 16.40 16.70
0
75 trade 27.50 AAQTY
0.10
0
0 0.05
0
330 trade
AAQHF 12.90
0 13.90 14.20
0
297 trade 30.00 AAQTF
0.05
0
0 0.05
0 1,103 trade
AAQHZ 11.40
0 12,356 trade
0 trade
0 11.40 11.70
0 1,217 trade 32.50 AAQTZ
0.05
0
0 0.05
AAQHG
9.00 +0.70 8.90 9.20
168 5,796 trade 35.00 AAQTG
0.05
0
0 0.05
0 14,536 trade
AAQHU
6.60 +0.60 6.50 6.70
150 11,877 trade 37.50 AAQTU
0.10
0 0.05 0.10
1,518 17,798 trade
AAQHH
4.30 +0.60 4.20 4.40
817 37,010 trade 40.00 AAQTH
0.30 -0.04 0.25 0.30
1,119 19,109 trade
QAAHV
2.40 +0.45 2.35 2.40
3,269 39,896 trade 42.50 QAATV
0.80 -0.30 0.75 0.80
2,424 8,873 trade
QAAHI
1.05 +0.20 1.05 1.10
6,109 26,257 trade 45.00 QAATI
2.00 -0.45 1.95 2.00
853 1,892 trade
QAAHW 0.40 +0.10 0.40 0.45
351 5,277 trade 47.50 QAATW 3.90 -0.11 3.80 3.90
QAAHJ
0.15 +0.05 0.10 0.20
146 2,131 trade 50.00 QAATJ
QAAHK
0.05
0
0 0.05
0
23
125 trade
8.50
0 6.00 6.20
0
35 trade
242 trade 55.00 QAATK 17.00
0 10.90 11.20
0
0 trade
You can see that the long strangle with the $37.50 strike call and $40 strike put is now
worth $6.75 ($6.50 + $.25). You paid $5.65 to put on the trade and you could exit now
at $6.75 for a profit of $1.10. That’s a wonderful return of 19% in only a few days!
Alternatively, you can adjust your trade to capture more profit.
Adjustments
Since the stock has increased and gapped up on strong volume, we will anticipate the
stock continuing up from here. To enter a “Free” trade, we are going to focus on our
contract that is showing a profit. In this example, it will be the call that we originally
purchased for $2.65 and is now worth $6.50. In reviewing the call option chain, you can
see the $42.50 call contract can be sold at $2.35 which is about what we paid for the
$37.50 strike call essentially making the adjustment free. By selling a higher strike call
contract, we have structured a Bull Call debit spread. We can structure the spread for a
net debit of $.30 ($2.65 originally paid for $37.50 strike less $2.35 collected for selling
the $42.50 strike call). You have adjusted your winning call contract into a Bull Call
debit spread. Be sure to calculate your new trade metrics. On the call side, your max risk
is $.30 and you could win $4.70 if AAPL stays above $42.50. That would increase your
profits from $1.10 to $4.70!
In addition, you can adjust the contract in your long strangle showing a loss. In this
example, the $40 strike put contract originally purchased for $3.00 is now only worth
$.25. To neutralize the loss and recover the investment in the put contract, you can adjust
the put side of the long strangle into a Bull Put credit spread. In reviewing the put option
chain, you can see the $42.50 strike put contract can be sold at $.75. By selling a higher
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Advanced Neutral Strategies
strike put contract, we have structured a Bull Put credit spread. You will collect $.75 by
selling the $42.50 strike put and use those proceeds to offset the loss in the $40 strike put.
You have adjusted your losing put contract into a Bull Put credit spread and should
calculate your new trade metrics. If AAPL stays above $42.50 by expiration, you will
increase your profits by an additional $.75 on the put side. Your total profits would then
be $5.45 ($4.70 from adjusted Bull Call debit spread plus $.75 from adjusted Bull Put
credit spread). By adjusting your trade and reacting to the stock price movement, you
have increased your profits from the current $1.10 up to $5.45!! For our example using
10 contracts representing 1000 shares, the profits amount to $5,450!
There are many ways to adjust your initial long strangle. If the stock moves in a certain
direction, you can simply react by adjusting both sides of the long strangle trade. If the
stock moves up, you can adjust the long strangle trade into a Bull Call Spread (Debit
Spread) and a Bull Put Spread (Credit Spread). If the stock moves down, you can adjust
the long strangle trade into a Bear Call Spread (Credit Spread) and a Bear Put Spread
(Debit Spread). These adjustments represent only the second level of adjustments. You
can continually adjust your trades to simply react to stock price movement. For more
information on adjustments, sign up for the live interactive sessions available at
www.TradewithOptions.com.
4. Short Straddle
The short straddle is a strategy to be used only on stock that you anticipate trading flat
over a period of time. It is the opposite of the long straddle and will win the majority of
the trades; however, to gain an edge in winning, you must accept a larger amount of risk.
The short straddle will take advantage of time decay in both calls and puts. Make sure to
only put this trade on when there is no pending news to be released that could impact the
stock price.
A short straddle trade is structured by selling both a call and a put at the same strike price
and expiration. Be sure to use the nearest month expiration with less than 45 days
remaining to capture the exponential time value decay. A short straddle will profit on the
put contract when the stock increases and will profit on the call contract when the stock
decreases. Therefore, if the stock goes up or down you can profit. The ideal scenario is
for the stock to trade flat and you will profit in both the call and the put due to time value
decay.
Strategy Objectives
• Use multiple contracts to provide reward potential if the stock increases or
decreases
• GOAL = Sell At-the-Money (ATM) calls and puts
Strategy Benefits
• High Reward Potential
• Profits from time value decay in both options
• Low maintenance, High Risk
• High Annual Return Rates
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Advanced Neutral Strategies
Steps
1. Find a stock you would like to Trade.
2. Perform analysis (including Technical, Fundamental, and Sentimental) to
determine anticipated price movement.
3. Evaluate Option chain focusing on ATM call/put contracts.
4. Initiate neutral Short Straddle trade.
5. Enter Stop Loss Orders for risk management
Trade Structure
– Combines 2 different Option contracts.
– Sell calls and puts at the same strike price and same expiration period.
Example 3 – RIMM
To illustrate the short straddle, we’ll use RIMM as our stock we would like to trade. We
can pull up a chart on www.bigcharts.com to see the past year price chart that confirms
RIMM is trading within a range. In addition, we know earnings have already been
released and we do not expect any other news announcement that will significantly affect
the stock price and drive it up or down. Therefore, a short straddle would be an
appropriate strategy to play. We can perform our stock analysis and look for signals that
will help form an opinion of future stock movement direction; however, reviewing stock
analysis indicators is outside the scope of this course so we will bypass this function at
this point. Please refer to the Stock Analysis 101 course for more information on
practical stock analysis techniques. See the chart below.
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Next, we will review an option chain for RIMM available at www.optionsxpress.com.
For this trading strategy, we want to look at calls and put contracts that are at the same
strike price and expiration. We want to use a short term contract such as August to
capture the increased rate of time value decay. Review the Option Chain below.
Aug 05
Calls
RIMM @ 70.10
(37 days to expiration)
Aug 05 Puts
RUPHI 29.70
0 25.10 25.50
0
92 trade 45.00 RUPTI
0.05
0
0 0.10
8
64 trade
RUPHW 24.00
0 22.60 23.00
0
35 trade 47.50 RUPTW 0.15
0
0 0.10
0
21 trade
RUPHJ 22.90
0 20.20 20.50
0
68 trade 50.00 RUPTJ
0.10
0 0.10 0.15
1
329 trade
RUPHK 15.80 -2.20 15.40 15.70
11
46 trade 55.00 RUPTK
0.24 -0.01 0.20 0.25
5
482 trade
RUPHL 11.20 -1.50 10.80 11.10
72
137 trade 60.00 RUPTL
0.65 +0.15 0.60 0.65
346 trade 65.00 RUPTM
1.55 +0.30 1.55 1.60 1,619 2,122 trade
RUPHM
6.90 -1.30 6.70 6.90
116
487 2,396 trade
RUPHN
3.90 -0.90 3.70 3.90
761 1,140 trade 70.00 RUPTN
3.50 +0.75 3.40 3.50
651 5,429 trade
RUPHO
1.90 -0.60 1.85 1.90 1,117 3,175 trade 75.00 RUPTO
6.50 +1.10 6.50 6.70
530 3,586 trade
RUPHP
0.80 -0.30 0.75 0.85
554 3,652 trade 80.00 RUPTP 10.40 +1.30 10.40 10.70
156
503 trade
RUPHQ
0.35 -0.15 0.30 0.40
95 3,603 trade 85.00 RUPTQ 14.60 +1.20 14.90 15.20
26
363 trade
RUPHR
0.15 -0.05 0.10 0.15
RUPHS
0.15
0 0.05 0.10
334 1,553 trade 90.00 RUPTR 17.70
0 19.80 20.10
0
48 trade
861 trade 95.00 RUPTS 21.80
0 24.70 25.10
0
30 trade
0
You can see that the $70 strike call and put contracts are At-The-Money. The objective
of this strategy is to sell both a call and a put at the same strike price to benefit from stock
movement in any direction and capture time value decay. Since we have sold two types
of contracts, our risk is that the stock price moves significantly in any direction.
Our objective is to initiate a neutral short straddle when there is no news that could drive
the stock price up or down. Ideally, the stock will be flat and we will profit as time value
erodes from the option premiums. Our exit strategy is to buy back our short option
contracts cheaper than we sold them. Since we are selling calls and puts, we will collect
the option premiums and have a credit in our account. Review the trade metrics below.
Cost of Trade
Sell 10 August $70 strike Calls at $3.70
Sell 10 August $70 strike Puts at $3.40
Net Credit/Share =
$7.10 (calculated as $3.40 + $3.70)
Review Trade Metrics/Calculations
Max Gain = Net Credit collected
$7.10/share, or $7,100 total
Since we can only sell the contracts once, our max gain is the total amount
of proceeds collected from the sale.
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Break even = Net credit of trade plus/minus strike price
$7.10 + $70 = $77.10
$7.10 - $70 = $62.90
You will have two breakeven points since you are selling calls and puts.
The stock must be at or below $77.10 to breakeven or make a profit. The
stock can also be at or above $62.90 to breakeven or make a profit.
Current stock price = 70.10, therefore, the stock is at it’s maximum profit
point.
Max Risk = Unlimited
If the stock trades above $77.10 or below $62.90 you will incur losses.
You can hedge yourself by placing stop loss orders at these break-even
points; however, if the stock gaps outside of this range, you will incur
large losses.
Reward/Risk Ratio = Can not be calculated
The Reward/Risk Ratio is difficult to calculate because the max risk is
unlimited.
Below is the Profit and Loss Diagram for the combined position of a short put and a short
call known as a Short Straddle Trade. You can see on the Profit and Loss Diagram the
two breakeven points. With the stock price currently at $70.10, the trade will be in a
profitable position. All you need to do to become profitable is wait for time to go by and
you can buy back the short options at a profit.
D
E
F
G
H
I
J
K
$10,000
L
M
N
Current Stock
Price
$5,000
$profit / loss
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
45
50
55
60
65
70
75
80
$(5,000)
$(10,000)
Break-Even
$(15,000)
$(20,000)
stock price
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85
90
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Advanced Neutral Strategies
The goal of the short straddle is to enter the trade when there are no expected events that
will drive the stock price up or down. Your profitability will depend on the stock trading
flat shortly after entering the trade.
Below is the option chain for RIMM only 11 days after entering the short straddle trade.
You can see that the stock is trading relatively flat and is currently at $69.17. You can
see that the short straddle at the $70 strike price is now worth $5.30 ($2.40 + $2.90).
You originally sold it for $7.10 and you could exit now by buying back your short
options at $5.30 for a profit of $1.80. That’s a wonderful return of 25% in only 11
days! Review the option chain below.
Calls
Puts
Open
Symbol Last Chg Bid Ask Volume
Int
Aug 05
Calls
Strike Symbol Last Chg
Bid
Ask Volume
RIMM @ 69.17
(25 days to expiration)
Open
Int
Aug 05 Puts
0 9.70 9.90
0
324 trade 60.00 RUPTL 0.25 +0.05 0.25 0.30
10 4,272 trade
RUPHM 6.00 -0.70 5.30 5.60
50
775 trade 65.00 RUPTM 0.85 +0.20 0.95 1.00
204 6,250 trade
2.50 -1.00 2.30 2.40
692 4,810 trade 70.00 RUPTN 2.80 +0.75 2.80 2.90
900 8,787 trade
RUPHO 0.90 -0.40 0.80 0.85
1,086 9,057 trade 75.00 RUPTO 6.10 +1.40 6.30 6.40
182 5,246 trade
RUPHL 10.60
RUPHN
RUPHP
0.30 -0.10 0.25 0.30
185 5,662 trade 80.00 RUPTP 9.00
0 10.80 10.90
0
960 trade
You can see that by initiating a Short Straddle, you put the time value decay in your favor
and can profit when the stock does not move at all. The only drawback of this strategy is
the unlimited risk involved. Even though you can create a trade with a wide range of
profitability levels, the risk is theoretically unlimited. In the next course, Advanced
Combination Strategies, you will learn how to cap your risk so you can use the Short
Straddle more in your trading.
5. Summary
In this course we have reviewed several strategies that are neutral in their bias of
anticipated stock movement. Trades combining calls and puts can profit from stock
moves in any direction. Since we are long options in the Long Straddle and Long
Strangle strategies, the time value will decay twice as fast. Therefore, you will need to
react to stock price movement and adjust your trades timely to lock in profits. In
addition, we reviewed a Short Straddle strategy that profits from stocks trading flat.
The TradewithOptions.com strategies have been applied in a unique way to capture more
winning trades.
You can also increase your profitability with the adjustments described in the Long
Straddle and Long Strangle strategies. If the stock moves in a certain direction, you can
simply react by adjusting the trade. If the stock moves up, you can adjust the trade into
either a Bull Call Spread (Debit Spread) or a Bull Put Spread (Credit Spread). If the
stock moves down, you can adjust the trade into either a Bear Call Spread (Credit Spread)
or a Bear Put Spread (Debit Spread). Ideally, the stock will trade flat and you can exit
profitably without adjusting your trade.
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Advanced Combination Strategies
1. Advanced Combination Strategies Overview
In this course we will review several strategies that profit from stocks that are trading
within a range. The advanced combination strategies are simple variations of strategies
presented in earlier courses with dynamic hedges in place for risk management. As
always, we will present a unique approach to implementing these strategies that will
increase the probabilities of winning.
Part of the benefits of using these Advanced Combination Strategies is that they do not
require any more capital to initiate a trade than a one sided spread trade. You are playing
both sides of a stock therefore you are guaranteed a win on one side. Your broker will
take that into consideration and only require the margin for one side. You can potentially
win on both sides of the trade if the stock stays flat.
In these combination trades, we are establishing a price ceiling and a price floor for the
stock. Since we are playing both sides of a stock, we will profit from the time value
decay and be able to adjust to a directional stock move. Ideally, the stock will trade flat
and we will profit on both sides of a trade.
Two combination strategies we will review include the butterfly and dual credit spread
strategy. These strategies can be profitable because the risk is fixed and we are
guaranteed a win on at least one side of the trade. Of course, the TradewithOptions.com
strategies will be applied in a unique way to capture more winning trades. We will also
describe adjustments available to increase profitability.
2. Butterfly
The butterfly strategy is a combination of a debit and credit spread that involves options
at three different strike prices. It can be structured using calls or puts depending on which
one provides the best reward potential. A butterfly trade involves selling two calls/puts at
the same strike price and expiration and purchasing a lower and higher strike call/put.
Since the butterfly strategy combines three different option contracts into one trade,
commission costs should be factored in prior to trade entry to ensure reasonable profits
can be achieved. A butterfly trade will realize maximum profit from stagnant stocks that
are trading within a range. It can be adjusted to profit from stocks that increase or
decrease by reacting to the stock move and neutralizing the loss on the contract that loses
value while capturing the profit in the winning contracts.
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Advanced Combination Strategies
Strategy Objectives
• Use multiple contracts to provide reward potential from stagnant stocks while
limiting risk
• Adjust to the direction of the stock movement and neutralize the losing side
• GOAL = Sell At-the-Money (ATM) calls or puts and buy Out-of-The-Money
(OTM) and In-the-Money (ITM) calls or puts as insurance.
Strategy Benefits
• High Reward Potential
• Requires margin of only one side of trade
• Profits from stagnant stock
• Medium maintenance, Low Risk
• High Annual Return Rates
Steps
21. Find a stock you would like to Trade.
22. Perform analysis (including Technical, Fundamental, and Sentimental) to
determine anticipated price movement.
23. Evaluate Option chain focusing on ATM call/put contracts.
24. Initiate neutral Butterfly trade.
25. Adjust losing side of trade with dynamic hedge
26. Take profits from winning side of trade
Trade Structure
– Combines 3 different Option contracts.
– Sell calls or puts at the same strike price and same expiration period and
buy OTM and ITM insurance contracts.
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Advanced Combination Strategies
Example 1 –RIMM
Since the butterfly is very similar to the dual credit strategy, we’ll use RIMM in both
trade examples to make it easy to compare the two strategies.
To illustrate the butterfly, we’ll use RIMM as our stock we would like to trade. We can
pull up a chart on www.bigcharts.com to see the past year price chart that confirms
RIMM is trading within a range. In addition, we know earnings have already been
released and we do not expect any other news announcement that will significantly affect
the stock price and drive it up or down. Therefore, a butterfly would be an appropriate
strategy to play. We can perform our stock analysis and look for signals that will help
form an opinion of future stock movement direction; however, reviewing stock analysis
indicators is outside the scope of this course so we will bypass this function at this point.
Please refer to the Stock Analysis 101 course for more information on practical stock
analysis techniques. See the chart below.
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Advanced Combination Strategies
Next, we will review an option chain for RIMM available at www.optionsxpress.com.
For this trading strategy, we want to look at call or put contracts that are at the same
expiration. In this example, we will illustrate a butterfly using put contracts. We want to
use a short term contract such as August to capture the increased rate of time value decay.
Review the Option Chain below.
Calls
Puts
Open
Symbol Last Chg Bid Ask Volume
Int
Aug 05
Calls
Strike Symbol Last Chg Bid Ask Volume
RIMM @ 70.10
(37 days to expiration)
Open
Int
Aug 05 Puts
RUPHI 29.70
0 25.10 25.50
0
92 trade 45.00 RUPTI
0.05
0
0 0.10
8
RUPHW 24.00
0 22.60 23.00
0
35 trade 47.50 RUPTW 0.15
0
0 0.10
0
21 trade
RUPHJ 22.90
0 20.20 20.50
0
68 trade 50.00 RUPTJ
0.10
0 0.10 0.15
1
329 trade
RUPHK 15.80 -2.20 15.40 15.70
11
46 trade 55.00 RUPTK
0.24 -0.01 0.20 0.25
5
482 trade
RUPHL 11.20 -1.50 10.80 11.10
72
137 trade 60.00 RUPTL
0.65 +0.15 0.60 0.65
346 trade 65.00 RUPTM
1.55 +0.30 1.55 1.60 1,619 2,122 trade
64 trade
487 2,396 trade
RUPHM
6.90 -1.30 6.70 6.90
116
RUPHN
3.90 -0.90 3.70 3.90
761 1,140 trade 70.00 RUPTN
3.50 +0.75 3.40 3.50
651 5,429 trade
RUPHO
1.90 -0.60 1.85 1.90 1,117 3,175 trade 75.00 RUPTO
6.50 +1.10 6.50 6.70
530 3,586 trade
RUPHP
0.80 -0.30 0.75 0.85
RUPHQ
0.35 -0.15 0.30 0.40
RUPHR
0.15 -0.05 0.10 0.15
RUPHS
0.15
0 0.05 0.10
554 3,652 trade 80.00 RUPTP 10.40 +1.30 10.40 10.70
156
503 trade
95 3,603 trade 85.00 RUPTQ 14.60 +1.20 14.90 15.20
26
363 trade
334 1,553 trade 90.00 RUPTR 17.70
0 19.80 20.10
0
48 trade
861 trade 95.00 RUPTS 21.80
0 24.70 25.10
0
30 trade
0
You can see that the $70 strike put contracts are At-The-Money. The objective of this
strategy is to sell two puts at the same strike price and buy a deep OTM and deep ITM
put as our insurance. The butterfly is a combination of a Bull Put credit spread and Bear
Put debit spread. We will structure the butterfly as a $60 - $70 Bull Put spread and a $70
- $80 Bear Put spread.
Our objective is to initiate a neutral butterfly when there is no news that could drive the
stock price up or down. Ideally, the stock will be flat and we will profit as time value
erodes from the option premiums. Our exit strategy is to buy back our short option
contracts cheaper than we sold them. The ATM puts are rich in Extrinsic value. The
deep ITM put is rich in Intrinsic value. The deep OTM put is all extrinsic value;
however, it is cheap since it is so far OTM. Since we are selling two ATM puts and
buying a deep ITM and deep OTM put, we will have a net cash outflow and have a debit
in our account. Review the trade metrics below.
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Advanced Combination Strategies
Cost of Trade
Buy 10 August $60 strike Puts at $.65
Sell 20 August $70 strike Puts at ($3.40)
Buy 10 August $80 strike Puts at $10.70
Net Cost/Share =
$4.55 (calculated as $.65 - (2 x $3.40) + $10.70)
Review Trade Metrics/Calculations
Max Gain = (Difference in strike prices of one side of trade) less net cost of trade
($70-$60) – $4.55 = $5.45/share, or $5,450
Our maximum profit point is right at our short option strike price $70.
With the stock at $70 at expiration, the short $70 strike puts would expire
worthless while we maintained the Intrinsic value in our long $80 strike
put.
Break even = Net cost of trade plus/minus long contract strike prices
$4.55 + $60 = $64.55
$4.55 - $80 = $75.45
You will have two breakeven points. The stock must be at or below
$75.45 to breakeven or make a profit. The stock must also be at or above
$64.55 to breakeven or make a profit. Current stock price = 70.10,
therefore, the stock is at the maximum profit point.
Max Risk = Net cost of trade
$4.55 x 1000 shares = $4,550
Since we bought insurance contracts deep ITM and OTM and structured
Bull Put credit spreads and Bear Put debit spreads, our risk is capped.
Reward/Risk Ratio = Max Gain / Max Risk
$5.45 / $4.55 = 123%
Although you have a very high Reward/Risk Ratio, it is very difficult to
achieve because the stock must close exactly at $70 at expiration to reach
your max gain point. This is very unlikely.
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Below is the Profit and Loss Diagram for the combined position of Bull Put credit spread
and Bear Put debit spread known as a Butterfly Trade. You can see on the Profit and
Loss Diagram the two breakeven points. With the stock price currently at $70.10, the
trade will be in a profitable position. All you need to do to realize your profit is wait for
time to go by and you can buy back the short options at a profit.
D
E
F
G
H
I
J
K
L
M
N
$6,000
Current Stock
Price
$4,000
$2,000
profit / loss
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
$45
50
55
60
65
70
75
80
85
90
95
$(2,000)
Break-Even
$(4,000)
$(6,000)
stock price
The goal of the butterfly is to enter the trade when there are no expected events that will
drive the stock price up or down. Your profitability will depend on the stock trading flat
shortly after entering the trade.
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Advanced Combination Strategies
Below is the option chain for RIMM only 11 days after entering the butterfly trade. You
can see that the stock is trading relatively flat and is currently at $69.17. You can see that
the butterfly trade is now worth $5.25 = $10.80 + $.25 - ($2.90 x 2). You originally
bought the butterfly for a net debit of $4.55 and you could exit now by buying back your
short options at $2.90 and selling your long puts at $10.80 and $.25 for a profit of $.70.
That’s a wonderful return of 15% in only 11 days! Review the option chain below.
Calls
Puts
Open
Symbol Last Chg Bid Ask Volume
Int
Aug 05
Calls
Strike Symbol Last Chg
Bid
Ask Volume
RIMM @ 69.17
(25 days to expiration)
Open
Int
Aug 05 Puts
0 9.70 9.90
0
324 trade 60.00 RUPTL 0.25 +0.05 0.25 0.30
10 4,272 trade
RUPHM 6.00 -0.70 5.30 5.60
50
775 trade 65.00 RUPTM 0.85 +0.20 0.95 1.00
204 6,250 trade
2.50 -1.00 2.30 2.40
692 4,810 trade 70.00 RUPTN 2.80 +0.75 2.80 2.90
900 8,787 trade
RUPHO 0.90 -0.40 0.80 0.85
1,086 9,057 trade 75.00 RUPTO 6.10 +1.40 6.30 6.40
182 5,246 trade
RUPHL 10.60
RUPHN
RUPHP
0.30 -0.10 0.25 0.30
185 5,662 trade 80.00 RUPTP 9.00
0 10.80 10.90
0
960 trade
Adjustments
The adjustment potential of the butterfly includes using single stock futures on a stop
order at both of your break even points. If the stock increases, your short puts will show
a profit and your long $80 strike put will sustain the losses. To offset the losses in your
long $80 strike put, you want to place a buy stop order on the RIMM single stock futures
at your upper breakeven point of $75.45. This way, you will buy the futures if the stock
price trades at $75.45 or higher. The two breakeven points are approximately 8% away
from the current stock price giving you plenty of room for the stock to move before
hitting your stop orders. If the stock decreases, your short puts will show a loss and your
long $80 strike and $60 strike puts will show a profit. To offset the losses in your short
puts, you want to place a sell stop order on the RIMM single stock futures at your lower
breakeven point of $64.55. This way, you will sell the futures if the stock price trades at
$64.55 or lower. Using single stock futures as your dynamic hedge will require $15,000
of margin at the $75.45 level or $26,000 of margin at the $64.55 level. Be sure to plan to
have margin available if your hedge is needed in the butterfly trade. For more
information on adjustments, sign up for the live interactive sessions available at
www.TradewithOptions.com.
3. Dual Credit Spreads
The dual credit spread strategy is a combination of two credit spreads that are deep Outof-The-Money and combines calls and puts. This strategy employs both Bear Call credit
spreads and Bull Put credit spreads and is ideal for stocks trading within a range. You do
not place a trade in anticipation of the stock moving up or down, you simply create a
range for the stock to trade within. A Bear Call spread essentially creates a price ceiling
and a Bull Put essentially creates a price floor. The dual credit spread strategy is
guaranteed to win on at least one side of the trades because the stock will either move up
or down. Dual credit spreads involve four different option contracts in one trade;
therefore, commission costs should be factored in prior to trade entry to ensure
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reasonable profits can be achieved. A dual credit spread trade will realize maximum
profit from stagnant stocks that are trading within a range. It can be adjusted to profit
from stocks that increase or decrease by reacting to the stock move and neutralizing the
loss on the contract that loses value while capturing the profit in the winning contracts.
Strategy Objectives
•
•
•
Use multiple contracts to provide reward potential from stagnant stocks while
limiting risk
Adjust to the direction of the stock movement and neutralize the losing side
GOAL = Initiate two credit spreads deep Out-of-The-Money to increase
probabilities of winning.
Strategy Benefits
•
•
•
•
•
High Reward Potential
Requires margin of only one side of trade
Profits from stagnant stock
Medium maintenance, Low Risk
High Annual Return Rates
Steps
1. Find a stock you would like to Trade.
2. Perform analysis (including Technical, Fundamental, and Sentimental) to
determine anticipated price movement.
3. Evaluate Option chain focusing on OTM call and put contracts.
4. Initiate dual credit spread trade.
5. Adjust losing side of trade with dynamic hedge using SSF’s
6. Take profits from winning side of trade
Trade Structure
–
–
Combines 4 different Option contracts.
Initiate Bull Put spreads and Bear Call spreads deep Out-of-The-Money.
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Example 2 –RIMM
Since the dual credit spread strategy is very similar to the butterfly strategy, we’ll use
RIMM in both trade examples to make it easy to compare the two strategies. To illustrate
the dual credit spread strategy, we’ll use RIMM as our stock we would like to trade. We
can pull up a chart on www.bigcharts.com to see the past year price chart that confirms
RIMM is trading within a range. In addition, we know earnings have already been
released and we do not expect any other news announcement that will significantly affect
the stock price and drive it up or down. Therefore, a dual credit spread strategy would be
an appropriate strategy to play. We can perform our stock analysis and look for signals
that will help form an opinion of future stock movement direction; however, reviewing
stock analysis indicators is outside the scope of this course so we will bypass this
function at this point. Please refer to the Stock Analysis 101 course for more information
on practical stock analysis techniques. See the chart below.
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Next, we will review an option chain for RIMM available at www.optionsxpress.com.
For this trading strategy, we want to look at call or put contracts that are OTM and at the
same expiration. We want to use a short term contract such as August to capture the
increased rate of time value decay. Review the Option Chain below.
Calls
Puts
Symbol Last Chg Bid Ask Volume
Aug 05
Calls
Open
Int
Strike Symbol Last Chg Bid Ask Volume
RIMM @ 70.10
(37 days to expiration)
Open
Int
Aug 05 Puts
RUPHI 29.70
0 25.10 25.50
0
92 trade 45.00 RUPTI
0.05
0
0 0.10
8
RUPHW 24.00
0 22.60 23.00
0
35 trade 47.50 RUPTW 0.15
0
0 0.10
0
21 trade
RUPHJ 22.90
0 20.20 20.50
0
68 trade 50.00 RUPTJ
0.10
0 0.10 0.15
1
329 trade
RUPHK 15.80 -2.20 15.40 15.70
11
46 trade 55.00 RUPTK
0.24 -0.01 0.20 0.25
5
482 trade
RUPHL 11.20 -1.50 10.80 11.10
72
137 trade 60.00 RUPTL
0.65 +0.15 0.60 0.65
346 trade 65.00 RUPTM
1.55 +0.30 1.55 1.60 1,619 2,122 trade
64 trade
487 2,396 trade
RUPHM
6.90 -1.30 6.70 6.90
116
RUPHN
3.90 -0.90 3.70 3.90
761 1,140 trade 70.00 RUPTN
3.50 +0.75 3.40 3.50
651 5,429 trade
RUPHO
1.90 -0.60 1.85 1.90 1,117 3,175 trade 75.00 RUPTO
6.50 +1.10 6.50 6.70
530 3,586 trade
RUPHP
0.80 -0.30 0.75 0.85
554 3,652 trade 80.00 RUPTP 10.40 +1.30 10.40 10.70
156
503 trade
RUPHQ
0.35 -0.15 0.30 0.40
95 3,603 trade 85.00 RUPTQ 14.60 +1.20 14.90 15.20
26
363 trade
RUPHR
0.15 -0.05 0.10 0.15
RUPHS
0.15
0 0.05 0.10
334 1,553 trade 90.00 RUPTR 17.70
0 19.80 20.10
0
48 trade
861 trade 95.00 RUPTS 21.80
0 24.70 25.10
0
30 trade
0
With the stock trading at $70.10, we can structure a deep Out-of-The-Money $85-$80
Bear Call credit spread and a $55-$60 Bull Put credit spread. The objective of this
strategy is to sell OTM credit spreads to profit from time value decay and guarantee a win
on at least one side of this trade.
Our objective is to initiate two credit spreads when there is no news that could drive the
stock price up or down. Ideally, the stock will be flat and we will profit on both sides of
the trade as time value erodes from the option premiums. Our primary exit strategy is to
let all the options expire worthless paying no commissions to exit the trade while we keep
the premiums collected from selling the options. Since we are selling two credit spreads
and establishing a price ceiling and price floor that will win on at least one side, the
broker will only require the margin for one side of the trade. Review the trade metrics
below.
Cost of Trade
Buy 10 August $55 strike Puts at $.25
Sell 10 August $60 strike Puts at ($.60)
Sell 10 August $80 strike Calls at ($.75)
Buy 10 August $85 strike Calls at $.40
Net Credit/Share =
$.70 (calculated as $.25 - $.60 + $.40 - $.75)
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Review Trade Metrics/Calculations
Max Gain = Net credit/share collected
$.70/share, or $700
Our maximum profit point can be realized with the stock trading anywhere
between $60 and $80. Compared to the Butterfly trade, you are sacrificing
some profit potential in exchange for a much wider spread between break
even points and increased probabilities of winning
Break even = Net credit of trade plus/minus short contract strike prices
$.70 + $80 = $80.70
$.70 - $60 = $59.30
You will have two breakeven points. The stock must be at or below
$80.70 to breakeven or make a profit. The stock can also be at or above
$59.30 to breakeven or make a profit. Current stock price = 70.10,
therefore, the stock is at the maximum profit point and can move 15%
in any direction before crossing a breakeven point. This significantly
increases your probability of winning
Max Risk = Difference in strike prices of one side of trade less Net credit of trade
($85-$80) - $.70 = $4.30/share, or $4,300 total
Since we structured both a Bull Put and Bear Call credit spread, our risk is
capped.
Reward/Risk Ratio = Max Gain / Max Risk
$.70 / $4.30 = 16%
You can realize a 16% return with the stock trading anywhere between
$60 and $80 at expiration.
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Below is the Profit and Loss Diagram for the combined position of Bull Put credit spread
and Bear Call credit spread known as the dual credit spread strategy. You can see on the
Profit and Loss Diagram the two breakeven points. With the stock price currently at
$70.10, the trade will be in a profitable position. All you need to do to realize your profit
is wait for time to go by and you can buy back the short options at a profit or let them
expire worthless and keep all the premiums.
D
E
F
G
H
I
J
K
L
M
N
Current
Stock Price
$1,000
$45
$(1,000)
profit / loss
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
50
55
60
65
70
75
80
85
90
95
Break-Even
$(2,000)
$(3,000)
$(4,000)
$(5,000)
stock price
The goal of the dual credit spread strategy is to enter the trade when there are no expected
events that will drive the stock price up or down. Your profitability will depend on the
stock trading flat shortly after entering the trade.
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Below is the option chain for RIMM only 14 days after entering the dual credit spread
trade. You can see that the stock is trading relatively flat and is currently at $69.25. You
can see that the dual credit spread trade is now worth $.55 = $.30 - $.05 + $.35 - $.05.
You originally sold the dual credit spread for a net credit of $.70 and you could exit now
by buying back your short options and selling your long options for a profit of $.15.
That’s a wonderful return of 3.5% in only 14 days! Alternatively, you can continue to
hold the trade and profit from further time value decay. Review the option chain below.
Calls
Symbol Last Chg
Aug 05
Calls
Bid
Puts
Open
Ask Volume
Int
Strike Symbol Last Chg
Bid
Ask Volume
RIMM @ 69.25
(23 days to expiration)
Open
Int
Aug 05 Puts
RUPHI 27.30
0 24.50 24.80
0
92 trade 45.00 RUPTI
0.05
0
0 0.05
0
64 trade
RUPHW 23.90
0 22.00 22.20
0
36 trade 47.50 RUPTW 0.05
0
0 0.05
0
147 trade
0 0.10
0
450 trade
RUPHJ 18.20
0 19.50 19.80
0
80 trade 50.00 RUPTJ
0.05
0
RUPHK 14.60
0 14.60 14.80
0
98 trade 55.00 RUPTK
0.10
0 0.05 0.15
RUPHL 10.40
0 9.80 10.00
0
347 trade 60.00 RUPTL
0.25
0 0.25 0.35
0 5,035 trade
1.00 +0.10 0.95 1.05
187 8,607 trade
RUPHM 5.60 -0.60 5.50 5.70
84 1,354 trade 65.00 RUPTM
0 1,064 trade
RUPHN
2.55 -0.30 2.40 2.50
311 6,403 trade 70.00 RUPTN
RUPHO
0.95 -0.10 0.75 0.85
91 10,583 trade 75.00 RUPTO
RUPHP
0.25 -0.10 0.20 0.30
33 5,433 trade 80.00 RUPTP 10.18
0 10.50 10.70
0
963 trade
RUPHQ
0.10
0 0.05 0.10
0 3,823 trade 85.00 RUPTQ 15.60
0 15.40 15.60
0
343 trade
RUPHR
0.05
0
0 0.05
0 1,551 trade 90.00 RUPTR 22.10
0 20.40 20.60
0
34 trade
RUPHS
0.05
0
0 0.05
1
879 trade 95.00 RUPTS 27.10
0 25.40 25.60
0
0 trade
2.60
0 2.75 2.85
51 10,287 trade
6.20 +0.50 6.00 6.30
52 5,671 trade
Adjustments
The adjustment potential of the dual credit spread includes using single stock futures on a
stop order at both your break even points. If the stock increases, your Bull Put spread
will show a profit and your Bear Call spread will sustain the losses. To offset the losses
in your Bear Call spread, you want to place a buy stop order on the RIMM single stock
futures at your upper breakeven point of $80.70. This way, you will buy the futures if the
stock price trades at $80.70 or higher. The two breakeven points are approximately 15%
away from the current stock price giving you plenty of room for the stock to move before
hitting your stop orders. If the stock decreases, your Bull Put spread will show a loss and
your Bear Call spread will show a profit. To offset the losses in your Bull Put spread,
you want to place a sell stop order on the RIMM single stock futures at your lower
breakeven point of $59.30. This way, you will sell the futures if the stock price trades at
$59.30 or lower. Using single stock futures as your dynamic hedge will require $16,000
of margin at the $80.70 level or $12,000 of margin at the $59.30 level. Be sure to plan to
have margin available if your hedge is needed in the dual credit spread trade.
For more information on adjustments, sign up for the live interactive sessions available at
www.TradewithOptions.com.
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4. Summary
In these advanced combination trades, we are establishing a price ceiling and a price floor
for the stock. Since we are playing both sides of a stock, we will profit from the time
value decay and will still be able to adjust to a directional stock move. Ideally, the stock
will trade flat and we will profit on both sides of a trade.
Part of the benefits of using these Advanced Combination Strategies is that they do not
require any more capital to initiate than a one sided spread trade. You are playing both
sides of a stock therefore you are guaranteed a win on at least one side. Your broker will
take that into consideration and only require the margin for one side.
In this course we have reviewed the butterfly and dual credit spread strategies that will be
valuable tools in your profitable trading plan. Using these strategies, you will not have to
predict the direction of a stock price move. You can simply initiate a neutral strategy that
will profit if the stock stays flat; however, if the stock moves in a certain direction, you
can simply neutralize the losing side of your trade using single stock futures. You will
win on at least one side of your trades and have potential to win on both sides without
requiring any additional margin.
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Systematic Writing
Systematic Writing
1. Systematic Writing Overview
In this course we will review a complete strategy including trade setups, initial
adjustments, and secondary adjustments. Our goal will be to generate cash flow every
month, while planning ahead for our primary and secondary adjustments if our initial
trade moves against us.
In the Systematic Writing strategy, you should trade options only on stocks you would be
comfortable owning long-term. This strategy is to be used by stock traders in place of
buying stocks outright. The key to success is knowing your adjustments and exit
strategies prior to entering your initial trade. The adjustments in this strategy will require
more capital than the initial trade so planning ahead is critical for margin management.
The basic premise of the strategy is that a trader initiates a Bull Put credit spread on a
stock he anticipates increasing. If the stock subsequently increases, the trader wins and
keeps the entire credit received from the first trade. This will provide the monthly cash
flow benefit on low margin requirements. If the stock subsequently decreases, the trader
will have three alternative adjustments available. We will review the three alternative
adjustments in theory and review this strategy in practice using real trade information.
The first step of this strategy is to initiate a Bull Put credit spread. You should be fluent
in structuring Bull Put credit spreads or review the details from the Credit Spread course.
Establishing a Bull Put credit spread essentially creates a price floor for a stock. As long
as the stock trades above a certain price level, you will win and keep the entire premium
collected from the sale of a Put contract. If the price floor is breached and the stock
trades below the price floor level at expiration, you will be assigned on your short put
position. This means you will be obligated to buy the stock at the strike price of the short
put contract. Since the strike price is below the current market price of the stock at the
time the trade is initiated, you are essentially buying the stock at a discount, or on sale.
This will work in our favor.
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2. In Theory
The first trade of the Systematic Writing strategy requires a Bull Put credit spread to be
established in lieu of buying stock outright. Let’s compare the use of a Bull Put credit
spread with buying stock outright to illustrate the benefits of the Bull Put credit spread.
This strategy is to be used on stocks you would be willing to own long-term so let’s
compare a typical stock trader with an advanced options trader using the Bull Put credit
spread.
Assume both the stock trader and options trader have $50,000 in their brokerage account
and are bullish on XYZ stock trading at $50. The stock trader buys 1,000 shares, but the
options trader establishes a $40 - $50 Bull Put credit spread by buying the $40 strike Put
and simultaneously selling the $50 strike Put. Assume this will generate a credit of
$7,000 for 10 contracts representing 1,000 shares and only require $3,000 of margin. The
stock trader now has $50,000 of stock and no cash while the options trader will have
$57,000 of cash ($50,000 original cash in brokerage account + $7,000 credit received
from Bull Put spread) and no stock. Let’s look at both traders’ accounts if the stock is
trading at $30, $45, and $55 at expiration.
With the stock trading lower at $30, the stock trader will be down $20,000 and have stock
valued at $30,000 and no cash. The options trader will realize his entire loss of $3,000
because the stock is below his insurance point at $40. His account will include $47,000
cash and no stock.
With the stock trading slightly lower at $45, the stock trader will be down $5,000 and
have stock valued at $45,000 and no cash. The options trader will have his $40 strike put
contract expire worthless and the $50 strike put contract will be worth $5. The options
trader sold the option for a $7 credit, therefore, he makes $2,000 on the trade even though
the stock decreased. The option trader can elect to buy back his short $50 strike put at $5
or he will be assigned on the short put and be obligated to buy the stock at $50. If he
takes the assignment and buys the stock, he can go to step 2 of the Systematic writing
strategy. For any stock price between $40 and $50, the option trader can either take
assignment of stock or close the Bull Put trade. In this Systematic Writing strategy, we
will assume the option trader will take the assignment of stock and move on to step 2.
With the stock trading higher at $55, the stock trader will be up $5,000 and have stock
valued at $55,000 and no cash. The options trader will have both his $40 and $50 strike
put expire worthless and will keep the entire premium collected from the credit spread of
$7,000. The options trader will have $57,000 in cash and no stock positions. He has
generated monthly income of $7,000 and will structure a Bull Put credit spread in the
next month.
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Below is a comparison between the stock trader and the options trader using Bull Put
credit spreads. For any stock price below $57, the option trader’s portfolio value will be
higher. The option trader will forfeit a higher portfolio value at a stock price above $57
for the benefit of having a higher portfolio value at any stock price below $57. A $7
dollar gain on a stock trading at $50 represents an increase of 14%. The options trader is
forfeiting gains above 14% in exchange for downside protection.
$80,000
$70,000
Portfolio Value
$60,000
$50,000
Stock Trader
$40,000
Options Trader
$30,000
$20,000
$10,000
$30
35
40
45
50
55
60
65
70
Stock Price
The first step of the Systematic Writing strategy is to initiate the Bull Put credit spread.
If the stock increases and you win on your Bull Put credit spread, you will initiate another
Bull Put credit spread in the next month. If the stock decreases below your insurance
point of your long put, you should exit your trade for a small loss and move onto the next
trade. Step 2 of the Systematic Writing strategy comes into play when the stock is
trading in between the two strike prices of your Bull Put credit spread at expiration. It is
at this point that the option trader has the choice of taking assignment of the stock
position.
Assume in our example, the stock is trading slightly lower at $45 at expiration. The
option trader had a Bull Put credit spread and will take assignment of the stock and buy it
at $50. By taking the assignment of stock, the option trader’s portfolio will include stock
valued at $45,000 plus $7,000 cash from the credit of the Bull Put spread for a total
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portfolio value of $52,000. The option trader’s cost basis in the stock he was assigned is
$43 ($50 - $7). With the stock trading at $45, he is showing a profit of $2/share, or
$2,000 total. The stock trader’s portfolio value is at $45,000.
Step 2 of the Systematic Writing strategy is to adjust the trade into one of three
alternative trades. We know that when the stock decreases, option premiums will
generally increase due to an increase in implied volatility. We will own stock from the
assignment of the short put and we want to adjust our trade to capture the increased
volatility and provide more downside protection. The three adjustments we will review
provide profit potential while protecting our downside risk.
Adjustments
The first adjustment we will review is to roll the trade into a Collar Trade. The Collar
trades were reviewed in the course Hedging Your Risk, so it should be familiar. Since
we own stock, we want to provide absolute protection on our investment, therefore, we
will buy a put contract at a strike price slightly Out-of-The-Money. Using OTM put
options will make the put protection less expensive. To offset the cost of the put, we will
sell a call contract slightly Out-of-The-Money. The timing of this adjustment is critical
to maintaining profitability while providing the most risk protection. While you are in
your initial Bull Put Spread, if you see the stock price declining and trading in between
your put strike prices, you should plan to roll into the Collar trade. To start the Collar
trade, buy a slightly OTM put in the next month following your Bull Put expiration
month. This is a pre-emptive move to get into your put contract before you take
assignment of the stock from your Bull Put trade. Then once you are assigned the stock
in your account, you should sell the Call contract in the next month. This will offset the
cost of your put contract. With the stock trading at $45, you should try and buy a $40
strike put contract for as little as possible. You should also try to sell a $45 or $47.50
strike call contract for as much as possible. With the increase in option premiums due to
increased volatility, you may be able to buy the $40 strike put for $1 and sell the $45
strike call for $5 for a net credit of $4. The $4 credit will reduce your cost basis in your
stock from $43 down to $39. You will own a $40 strike put giving you the right to sell
your stock at $40. If the stock continues to decrease, then you will exercise your put
contract and sell your stock at $40 for a $1 profit. This may not seem like much, but you
essentially earned a profit on a stock that proved your analysis to be 100% wrong. The
stock went from $50 down to below $40, down 20%, and you made a profit by adjusting
your trade. If the stock reverses back upwards and is trading above $45, you will be
obligated to sell your stock at $45 through your short call contract for a $6/share profit.
The second adjustment we will review is to roll the trade into a covered short straddle. A
short straddle was reviewed in the Advanced Neutral Strategies course and should be
familiar. The short straddle involves selling a call and a put contract at the same strike
price and expiration. This adjustment is called a covered short straddle, because we were
assigned on the stock and can fulfill the short call contract obligations if the stock
increases indefinitely. Therefore, our maximum risk to the upside is covered. Since the
stock has decreased, the implied volatility in options will be elevated. With the stock
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trading at $45, assume we can sell the At-The-Money call and put contracts at $5 each.
Our cost basis in our assigned stock is $43 and now we will sell the $45 strike call and
put for $5 each and collect $10 premium. By collecting $10, we have lowered our cost
basis in our assigned stock from $43 down to $33. We are short both a put and a call at
the $45 strike price. If the stock decreases below $45, we will be obligated to buy more
stock at $45 through our short $45 strike put that will be assigned. We can then enter
another covered short straddle and reduce our cost basis again. If the stock increases
above $45, we will be obligated to sell our stock at $45 through the short call contract for
a profit of $12 ($45 strike price less $33 cost basis). That is more profit than our original
Bull Put spread generated and will justify adjusting the trade into a covered short straddle
that will consume more capital.
The third adjustment we will review is to place a stop sell order on the Single Stock
Futures (SSF’s) at or near your breakeven point. If we are in our initial Bull Put credit
spread and we see the stock trading below the strike price of our short put contract, you
can put a stop sell order in on the SSF contract or on the stock itself. Place the stop sell
order at your breakeven point of your Bull Put spread. Be sure to calculate and review
the Bull Put credit spread trade metrics from the Credit Spread course. By placing a stop
sell order at your breakeven point, you will short the SSF or stock at your breakeven
point and neutralize the trade. When you are assigned on the short put position, you will
be obligated to buy the stock and this will fill your short stock position. If you use SSF’s
to maximize the use of trading capital, you will be short the SSF and will be long the
stock. This will leave you neutral and will not provide a profit opportunity, although you
will not lose either. To unwind the trade using SSF’s, you will buy back the short SSF
contract and sell back your long stock simultaneously. Using SSF’s or stock at your
breakeven points will provide excellent risk management and neutralize your trade. It
can also be used in conjunction with the previous two adjustments discussed.
The previous three adjustments can be used as the initial adjustment to your Bull Put
credit spread. Deciding between them is up to you and depends on your comfort level
with the stock and what is happening with the stock as well as your brokerage account.
Your secondary adjustments will be a repeat of the initial adjustments. You may switch
them around and use them in any order. The goal of the adjustments is to continuously
lower your cost basis in the stock you were assigned so that you may exit with a profit,
even though you were completely wrong on your analysis that the stock price would
increase. These adjustments will consume different levels of margin and it varies by
broker so be sure to manage your margin efficiently so you have the capacity to make
these adjustments.
To continue our example, let’s assume the option trader elected to use the covered short
straddle adjustment detailed above. The cost basis of his stock is now $33 and he is short
the $45 strike call and put contract. If the stock is trading above $45 at expiration, he will
be obligated to sell his stock at $45 through his short call contract and will have a profit
of $12 ($45 short call strike price less $33 cost basis in stock). Let’s assume the stock
continued to decrease and is trading at $30 at expiration of the following month. Note
this is a $20 decrease, or 40%, from the original $50 trading level only two months prior
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when we initiated the Bull Put credit spread. With the stock trading down to $30, the
options trader with the covered short straddle will be assigned on his short $45 strike put
contract and will be obligated to buy more stock at $45. His cost basis will be $39 (1000
shares at $33, and 1000 shares at $45 from his recently assigned short put contract). The
option trader can choose amongst the three adjustments discussed previously. Assume he
chooses to initiate another covered short straddle. To do this, he will sell the $30 strike
call and put contract. Since the stock continued to decrease, we can expect the implied
volatility in the options to be even higher than it was during the first adjustment. Due to
the increased volatility, the At-The-Money $30 strike call and put contracts may be
selling for $6 each. Therefore, to initiate another covered short straddle, the options
trader will sell 20 call and put contracts at $6 each and collect $12 of premium. This will
lower the cost basis of his stock from $39 down to $27 and he will be short both a call
and put contract at the $30 strike price. If the stock continues to decrease, the option
trader will place his stop sell orders on the stock at $27 to neutralize the trade and move
on to the next trade. If the stock is trading above $30 at expiration, the option trader will
be obligated to fulfill his short $30 call contract and sell his stock at $30 for a $3 profit.
This may not seem like much profit, but remember, on a stock that decreased 40% from
$50 to $30 and proven your analysis completely wrong, you are still able to make a small
profit. That’s the power of options!
On the following page is a brief flowchart of the Systematic Writing Strategy. You will
have to evaluate the unique characteristics of your trade to determine the appropriate
steps to take.
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Systematic Writing
Select stock you
would like to own
Perform Analysis
Initiate ATM Bull
Put Credit Spread
Stock
Increase?
Keep premium
collected. Go to
next trade
Yes
No
Primary
Adjustment
Yes
Collar
Covered Short
Straddle
Stock
Increase?
Stock
Increase?
No
No
Exit through short
call assignment
Yes
Trade
Neutralized.
Exit without
loss or profit.
Exit through short
call assignment
Exit through long
put exercise
Secondary
Adjustment
Stop Sell
SSF’s/Stock
Collar
Secondary
Adjustment
Covered Short
Straddle
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140
Stop Sell
SSF’s/Stock
Systematic Writing
In Practice –SHLD
To illustrate the Systematic Writing strategy, we’ll use SHLD as our stock we would like
to trade. We can pull up a chart on www.bigcharts.com to see the past year price chart
that confirms SHLD has been in a bullish trend up and is currently trading within a range.
In addition, we know earnings have already been released and we do not expect any other
news announcement that will significantly affect the stock price and drive it up or down.
Therefore, we can initiate a Bull Put credit spread as part of the Systematic Writing
strategy. We can perform our stock analysis and look for signals that will help form an
opinion of future stock movement direction; however, reviewing stock analysis indicators
is outside the scope of this course so we will bypass this function at this point. Please
refer to the Stock Analysis 101 course for more information on practical stock analysis
techniques. See the chart below.
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Systematic Writing
Next, we will review an option chain for SHLD available at www.optionsxpress.com.
For this trading strategy, we want to look at put contracts that are slightly Out-of-TheMoney. We want to use a short term contract such as August to capture the increased rate
of time value decay. Review the Option Chain below.
Quotes as of 7/11/2005 5:29:22 PM ET. Intraday data delayed at least 15 minutes.
Last
Change
Bid
Ask
Day High
Day Low
Volume
SEARS HLDG CP (SHLD)
155.21
3.12 155.23 - 155.49
156.47
152.60 3,566,382
SHLD Expiration Months: Jul 05 | Aug 05 | Sep 05 | Oct 05 | Dec 05 | Jan 06 | Jan 07
Calls
Symbol Last Chg
Aug 05
Calls
Bid
Puts
Open
Ask Volume
Int
Strike Symbol Last Chg
Bid
Ask Volume
SHLD @ 155.21
(39 days to expiration)
Open
Int
Aug 05 Puts
KTQHY 26.40 +2.90 26.10 26.50
60
552 trade 130.00 KTQTY
0.50 -0.55 0.60 0.65
KTQHX 22.90 +4.60 21.60 22.00
529
302 trade 135.00 KTQTX
0.90 -0.80 1.00 1.15
KTQHW 17.70 +2.20 17.40 17.80
128
142 trade 140.00 KTQTW 1.80 -0.90 1.70 1.85
299
KTQHV 13.60 +2.10 13.60 13.90
182
420 trade 145.00 KTQTV
2.90 -1.30 2.85 3.00
315 1,090 trade
KTQHU 10.30 +1.40 10.20 10.50
256 1,096 trade 150.00 KTQTU
4.70 -1.60 4.50 4.70
735 1,144 trade
KDUHK
7.70 +1.30 7.40 7.70
415 1,561 trade 155.00 KDUTK
6.90 -1.90 6.60 6.90
258
761 trade
KDUHL
5.30 +0.80 5.30 5.50
414 1,911 trade 160.00 KDUTL
9.50 -2.30 9.50 9.70
109
292 trade
12
230 trade
49
880 trade
200 1,022 trade
890 trade
KDUHM 3.60 +0.50 3.60 3.80
164
901 trade 165.00 KDUTM 13.10 -3.80 12.70 13.00
KDUHN
2.65 +0.65 2.35 2.55
221
918 trade 170.00 KDUTN 17.60
0 16.50 16.80
0
87 trade
KDUHO
1.55 +0.15 1.50 1.60
313
592 trade 175.00 KDUTO 26.00
0 20.70 21.00
0
41 trade
KDUHP
1.00 +0.15 0.90 1.05
276
750 trade 180.00 KDUTP 24.80 -4.20 25.10 25.50
30
You can see that the $140 strike put contracts are Out-of-The-Money. The objective of
the Bull Put strategy is to sell puts at one strike price and buy a deep OTM put as our
insurance. We will structure a Bull Put credit spread with the $140 and $130 strike
August contracts.
Our objective is to initiate a Bull Put credit spread when we expect the stock to increase
and we will profit as time value erodes from the options sold. We are going to use deep
Out-of-The-Money puts typically used in the Bull Put credit spread strategy. We already
know our primary and secondary adjustments we will make if the stock moves against
our expectation. In addition, we are comfortable owning this stock in the long-term.
Review the trade metrics below.
Cost of Trade
Buy 10 August $130 strike Puts at $.65
Sell 10 August $140 strike Puts at ($1.70)
Net Credit/Share =
$1.05 (calculated as $1.70 - $.65)
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Systematic Writing
Review Trade Metrics/Calculations
Max Gain = Net Credit established for trade
$1.05 per share, or $1,050 total
Break even = Short Put strike price less Net Credit per share
$140 - $1.05 = $138.95. Stock must be at or above this amount to
breakeven or make a profit. Current stock price = $155.21
Gives you an 11% margin of error.
By building in a margin of error, you are increasing
your probability of winning! Although the margin of
error is small, our adjustments will provide the
opportunity to make more money.
Max Risk = Difference in strike prices less Net credit/share X number of shares
($140 - $130) - $1.05 = $8.95/share X 1000 shares = $8,950
By spreading risk between two option contracts, we have forfeited some of
the upside potential in exchange for reducing our amount at risk and
capital required to put on the trade.
Reward/Risk Ratio
– Equals max gain divided by max risk
$1.05/ $8.95 = 12%
The Reward/Risk ratio will be the same as our Reward/Capital ratio
since our Capital requirements to put on the trade will equal our
maximum risk.
12% in 35 days equates to an Annual Rate
of Return of 320%!!!
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Systematic Writing
Below is the Profit and Loss Diagram for the combined position of long Put and short Put
known as the Bull Put Spread. You can see on the Profit and Loss Diagram the current
stock price is already above our maximum gain point. By using the short Put Option
contract deep Out-of-The-Money, we have built in a margin of error that increases our
probability of winning on our initial trade. With the stock price currently at $155.21, the
trade will be in a profitable position. All you need to do to realize your profit is allow
time to go by and you can buy back the short options at a profit.
D
E
F
G
H
I
J
Break-Even
$2,000
K
L
M
N
Current Stock Price
$115
120
125
130
135
140
145
150
155
160
165
$(2,000)
profit / loss
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
$(4,000)
$(6,000)
$(8,000)
Margin of
Error = 11%
$(10,000)
stock price
On August 19th, 2005 SHLD closed at $135.10. Since the stock price declined below our
short $140 strike put, we will be obligated to buy the stock at $140. Our cost basis in the
stock will be $138.95 ($140 strike price less $1.05 credit received from Bull Put spread).
We will assume that our options trader is more conservative and has limited capital
available for adjustments. Therefore, the option trader will prefer to roll the Bull Put
credit spread into a Collar trade the following month. Let’s review a variation of the
collar trade.
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Systematic Writing
Below is the option chain for SHLD on August 19th showing the option premiums
available for the following months. We know we will be assigned on the short $140
August put and own the stock. With the stock trading at $135.10, the option trader can
structure a Collar trade by buying a September $135 strike put and selling an October
$140 strike call. This will give the option trader the right to sell the stock at $135
anytime before September’s expiration. If the stock rebounds and is trading above $140
at October’s expiration, the option trader will be obligated to sell his SHLD stock at $140
for a profit of $2.25/share or $2,250 total. This is how to make a profit even when you
are completely wrong on your initial Bull Put analysis.
Calls
Symbol Last Chg
Sep 05
Calls
Bid
Puts
Ask Volume
Open
Int
Strike Symbol Last Chg
Bid
Ask Volume
SHLD @ 135.10
(25 days to expiration)
Open
Int
Sep 05 Puts
KTQIB 28.50
0 25.60 26.00
0
198 trade 110.00 KTQUB
0.55
0 0.45 0.55
150 3,687 trade
KTQIC 26.30
0 21.00 21.40
0
863 trade 115.00 KTQUC
0.90 -0.25 0.85 0.95
174 1,749 trade
KTQID 16.20 -1.60 16.70 17.10
18
963 trade 120.00 KTQUD
1.65 -0.20 1.55 1.65
290 2,603 trade
9 1,178 trade 125.00 KTQUE
2.75 -0.25 2.60 2.75
558 3,122 trade
KTQIE 12.30 -1.60 12.80 13.20
KTQIY
9.00 -1.30 9.50 9.70
734 1,216 trade 130.00 KTQUY
4.30 -0.60 4.20 4.40
762 6,711 trade
KTQIX
6.50 -1.00 6.70 6.90
633 4,530 trade 135.00 KTQUX
6.30 -0.80 6.30 6.60
1,301 5,489 trade
KTQIW
4.20 -1.40 4.50 4.70
956 6,684 trade 140.00 KTQUW 9.60 -0.40 9.10 9.40
315 5,953 trade
KTQIV
2.90 -1.00 2.90 3.00
596 3,719 trade 145.00 KTQUV 13.10 +0.30 12.50 12.80
54 2,899 trade
KTQIU
1.65 -1.00 1.80 1.90
667 16,069 trade 150.00 KTQUU 16.70 -0.60 16.30 16.80
19 1,935 trade
KDUIK
1.10 -0.60 1.05 1.15
491 3,167 trade 155.00 KDUUK 19.30 -2.00 20.70 21.10
10
0.60 -0.40 0.60 0.70
242 4,662 trade 160.00 KDUUL 25.10
KDUIL
Oct 05
Calls
0 25.10 25.60
SHLD @ 135.10
(60 days to expiration)
952 trade
0 1,437 trade
Oct 05 Puts
KTQJB
0
0 27.20 27.50
0
0 trade 110.00 KTQVB
1.55
0 1.55 1.65
248
0 trade
KTQJC
0
0 23.00 23.30
0
0 trade 115.00 KTQVC
2.35
0 2.40 2.50
56
0 trade
KTQJD 20.50
0 19.20 19.50
10
0 trade 120.00 KTQVD
3.30
0 3.50 3.70
58
0 trade
KTQJE 17.00
0 15.70 16.00
10
0 trade 125.00 KTQVE
5.10
0 5.00 5.20
61
0 trade
KTQJY 12.50
0 12.60 12.90
11
0 trade 130.00 KTQVY
7.10
0 6.90 7.10
45
0 trade
KTQJX
9.70
0 10.00 10.20
20
0 trade 135.00 KTQVX
9.50
0 9.20 9.40
40
0 trade
KTQJW
7.60
0 7.80 8.00
55
0 trade 140.00 KTQVW 12.10
0 11.90 12.20
32
0 trade
KTQJV
5.80
0 5.90 6.10
104
0 trade 145.00 KTQVV
0
0 15.10 15.30
0
0 trade
KTQJU
4.70
0 4.50 4.60
25
0 trade 150.00 KTQVU
0
0 18.50 18.90
0
0 trade
KDUJK
3.20
0 3.30 3.40
175
0 trade 155.00 KDUVK
0
0 22.40 22.70
0
0 trade
The cost basis of the stock position is equal to the original Bull Put Spread breakeven
point of $138.95. The trader purchased to September $135 put for $6.60 and sold the
October $140 Call and collected $7.80. The adjusted cost basis of the trade now equals
$137.75 ($138.95 from stock + $6.60 for September $135 Put - $7.80 for October $140
Call). The trader can now react to the stock movement over the next 25 days to
determine the appropriate next step.
If the stock is trading below $135, the trader will exercise the September $135 put and
sell his stock at $135. As the stock price declines the October $140 strike call will lose
value and the trader can buy it back much cheaper than he sold it. The profits on the
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Systematic Writing
short October $140 call will offset the loss in the stock of $2.75 ($137.75 cost basis $135 strike Put).
Alternatively, if the stock has rebounded and is trading above $140 by October’s
expiration, the trader will be obligated to sell his shares at $140 through the assignment
of his short call position. Since his adjusted cost basis in the trade is only $137.75, he
will make a profit of $2.25/share, or $2,250 total, on a trade that has proven him wrong.
For more information on adjustments, sign up for the live interactive sessions available at
www.TradewithOptions.com
4. Summary
In this course we have reviewed a complete strategy including trade setups, initial
adjustments, and secondary adjustments. The primary objective of the Systematic
Writing strategy is to generate cash flow every month, while planning ahead for our
primary and secondary adjustments if our initial trade moves against us.
In the Systematic Writing strategy, you should trade options only on stocks you would be
comfortable owning long-term. This strategy is to be used by stock traders in place of
buying stocks outright. The key to success is knowing your adjustments and exit
strategies prior to entering your initial trade. The adjustments in this strategy will require
more capital than the initial trade so planning ahead is critical for margin management.
The basic premise of the strategy is that a trader initiates a Bull Put credit spread on a
stock he anticipates increasing. If the stock subsequently increases, the trader wins and
keeps the entire credit received from the first trade. This will provide the monthly cash
flow benefit on low margin requirements. If the stock subsequently decreases, the trader
will have three alternative adjustments available. We have reviewed three alternative
adjustments in theory and in practice.
For more information on adjustments, sign up for the live interactive sessions available at
www.TradewithOptions.com
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Options to Repair Losing Stocks
Options to Repair Losing Stocks
1. Options to Repair Losing Stocks Overview
In this course we will review several strategies designed to use options to help recover
losses incurred on stock positions. This course assumes you have been in a stock only
position that moved against you and you have no Puts as insurance on your investment.
These strategies can also be applied to options traders that are holding stock through
assignment on options, such as a Bull Put credit spread where the stock decreased.
Inevitably, stock traders find themselves holding onto stocks that have decreased in
value. The larger the paper loss on the stock, the less likely a stock trader will sell it and
move on to the next trade. Even when stock traders utilize stop loss orders, often they
find themselves holding onto losing stocks and praying that the stock price increases just
enough so that they can exit the stock at breakeven or even at a small loss. We will
examine four variations of option trades designed to recover losses incurred in stock
trades with the assumption that the stock trader wants to exit the trade at breakeven and
not use the trade as a profit opportunity. The stock trader must also have the expectation
that the stock has sustained the majority of the losses and will bounce back up slightly. If
the stock trader anticipates the stock continuing downward, a risk management program
would be better. The goal of these four strategies is to lower the cost basis of your losing
stock while you still own it, which will allow you to sell the stock at a lower price to
breakeven. To help distinguish which of these strategies to use in practice, we will detail
them in terms of losses incurred on the stock. The first two strategies are best used on
stocks that have had small losses in a short time frame. The third strategy is designed for
stocks that have larger losses over a longer time frame, and the fourth strategy is
applicable in any loss situation over any time duration.
2. Small losses over short term
In this section, we will review two strategies to employ when you have been in a stock
trade for a short time and have small paper losses. It assumes that you’re technical
analysis is still intact and you expect a small bounce back in the stock, but you were too
aggressive in your initial trade. Both strategies assume you simply want to exit the trade
near break even and move onto the next trade rather than adjust your initial trade into a
profitable opportunity.
The first strategy we will explore is basically a combination of a Collar trade and a
Covered Call. To structure this adjustment, you will sell two At-The-Money (ATM) calls
and buy one Out-of-The-Money (OTM) put contract for every 100 shares of stock you
own. By selling two call contracts for every 100 shares you own, you will be uncovered
on half of the short call contracts and your risk is that that the stock increases
substantially. To cover your risk on the uncovered short call contracts, you will place a
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Options to Repair Losing Stocks
stop buy order to purchase more stock at the short call strike price. That way, the extra
short call contract will be covered if the stock increases and you will neutralize your extra
short call position. Let’s examine the strategy using an example of a stock trader that
bought 1,000 shares of XYZ at $50 and the stock decreased to $45, down 10%, showing
a $5,000 loss.
Trade Positions
Long 1000 shares XYZ
Short 20 $45 Calls @ ($3)
Long 10 $40 Puts @ $1
Total
Cost Basis
$50,000
($6,000)
$1,000
$45,000
This strategy has reduced the cost basis down of the trade down to $45 per share, or
$45,000 total. With the stock trading at $45, you are at your breakeven point and can exit
the trade. If the stock is at $45 at expiration of the option contracts, all the options will
expire worthless leaving you with the premium collected on their sale which offsets the
loss in the stock. Then you can simply sell your stock to exit the trade.
If the stock continues to decline, your short call options will expire worthless so you will
keep the $6,000 premium collected on their sale and you can exercise your put to sell
your stock at the $40 put strike price. Since your cost basis is $45,000, this will generate
a small $5,000 loss on the total position compared to a potential total $50,000 loss in the
stock position alone. You have essentially cut your losses in half. A $5,000 loss on a
$50,000 investment equals 10%, while the stock has moved from $50 down below $40
where the stock trader would realize a loss of over 20%.
Alternatively, if the stock increases, your short call contracts will be assigned. You are
uncovered on half of the short call contracts because you sold two call contracts for every
100 shares of stock you owned. If the stock increases, your buy stop order will be
triggered and you will buy more stock at $45. You will then be left with a covered call
position and a long put contract. Your cost basis in 2000 shares equals $95,000 (1,000
shares at $50 plus 1,000 shares at $45). You can simply react to the increasing stock price
and adjust your long put contract into a Bull Put credit spread by selling a higher strike
put contract to make your total position a combination of a Covered Call and Bull Put.
At expiration, you will be assigned on your short call contracts and will be obligated to
sell your stock at $45. Your Bull Put spread will expire worthless and you will keep the
premium collected from the sale. The total proceeds from exiting the trade with the stock
trading above $45 equals $90,000 (2,000 shares sold at $45). Since your cost basis in the
trade is $87,000, this will leave you with a small $3,000 profit.
Trade Positions
Long 2000 shares XYZ
Short 20 $45 Calls @ ($3)
Long 10 $40 Puts @ $1
Short 10 $45 Puts @ ($3)
Total
Cost Basis
$95,000
($6,000)
$1,000
($3,000)
$87,000
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Options to Repair Losing Stocks
The second strategy we will explore is basically the combination of a Covered Call and a
Bull Call debit spread. This strategy is ideal for stocks in a small loss position and it does
not require more investment into the trade. We will create a “free” trade without
assuming any new risk. This will provide a leverage effect where we can exit the entire
trade at breakeven with a small bounce back up in stock price. To structure this
adjustment, you will buy one ATM call and sell two higher strike calls. The long stock
and half the short call position is effectively a Covered Call while the long ATM call and
other half of the short call position is effectively a Bull Call debit spread. Since we are
selling two call contracts and only buying one, we want to establish this adjustment for
“free” meaning the premiums collected from the short call contracts should pay for the
long call contract. This strategy limits risk and is covered from the initial adjustment in
contrast to the previous strategy discussed. To illustrate, assume the same facts as in
example 1 where a stock trader purchased 1,000 shares of XYZ at $50 and the stock is
down 10% to $45.
Trade Positions
Long 1000 shares XYZ
Short 20 $50 Calls @ ($1.50)
Long 10 $45 Calls @ $3
Total
Cost Basis
$50,000
($3,000)
$3,000
$50,000
If the stock stays flat and trades at $45 at expiration, all the option contracts will expire
worthless and you will still be down $5,000 in your stock position. You can then utilize
one of the other adjustments in this course to reduce your cost basis and exit the trade.
If the stock continues to decline below $45, you will incur additional losses because you
do not have downside protection. If this occurs, you should consider an alternative
adjustment. This variation is designed for those expecting a slight bounce back up in
stock price.
If the stock price increases, you will be profitable in your Bull Call position and have
capped your losses in your Covered Call position. Review the table below to see overall
profit/loss of each position at various stock prices. You can exit the trade at breakeven
with a slight bounce up to $47.50. You can also generate a $5,000 profit if the stock
rebounds to the point of your initial purchase. This works very well in a stock that is
trading in a range.
Trade Positions
Long 1000 shares XYZ
Short 20 $50 Calls
Long 10 $45 Calls
Total
Profit/Loss with
Stock @ $45
($5,000) loss
$3,000 profit
($3,000) loss
($5,000) loss
Profit/Loss with
Stock @ $47.50
($2,500) loss
$3,000 profit
($500) loss
0 - Breakeven
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Profit/Loss with
Stock @ $50
$0 – Breakeven
$3,000 profit
$2,000 profit
$5,000 profit
Options to Repair Losing Stocks
3. Larger losses over long term
In this section, we will review a strategy to employ when you have been in a stock trade
for a longer time period and have larger unrealized losses. It assumes that you were too
aggressive in your initial trade and did not have a stop loss in place nor any puts as
insurance. As a result, you are holding onto the losing stock position just so you can
avoid taking the large loss. Since you have been in this position for a long time and have
seen larger losses, it will take more time to recover your losses. The goal of this strategy
is to lower your cost basis in the stock while also providing a long term level of
protection.
The basic structure of this strategy is a combination of a Covered Call and Bear Put debit
spread. To make this adjustment, you will buy a long-term put contract to provide
protection and sell near term OTM calls and puts to reduce your cost basis. This is a
strategy that is to be played out over a longer time period where you simply react to the
movement in the stock. The long term put contract will be expensive and add to the cost
basis of your trade therefore, you will need several months of selling OTM calls and puts
to offset the cost of the long term put and begin reducing the cost basis in your stock.
To illustrate this strategy, assume a stock trader purchased 1,000 shares of XYZ stock at
$50 and it is currently trading down at $30 for a loss of $20,000, or 40%. Because of the
significant decline in the company’s stock price, the volatility component of option
valuation should be inflated. This is an ideal time to sell OTM options using both calls
and puts. The first step is to buy a long-term put contract to limit additional losses on the
trade. In our example, assume the trader elects to buy a 1 year $25 strike put contract at
$6. He then sells the current month $35 strike call and $25 strike put contract that are
both OTM and selling for $3. He will collect $6 in premium from the sale of the current
month call and put which pays for the long term 1 year $25 strike put contract so his cost
basis in the trade remains the same.
Month 1
Trade Positions
Long 1000 shares XYZ
Short 10 $35 Calls @ ($3)
Short 10 $25 Puts @ ($3)
Long 10 1 year $25 Put @ $6
Total
Cost Basis
$50,000
($3,000)
($3,000)
$6,000
$50,000
This provides long term insurance on your trade and will set up the opportunity to reduce
the cost basis of your trade over time. Your goal with this adjustment is to have the stock
trading between $25 and $35 at expiration which will have both your short call and put
contracts expire worthless leaving you with the premiums from the sale. Then in the
following month, you will sell another OTM call and put contract which will directly
lower the cost basis in your stock.
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Options to Repair Losing Stocks
To continue with our example, assume the stock is trading at $33 at expiration and both
the near term call and put contract expire worthless. Now we are left with 1,000 shares
of XYZ stock and a 11 month $25 strike put contract with a cost basis of $50. At this
point, the trader will sell another current month call and put contract to collect the
premium. His risk is capped because he is covered on the short call if the stock increases.
In addition, his long term put covers the risk on the current month short put contract.
Assume the trader sells a $37.50 strike call at $2 and a $27.50 strike put at $2. The trader
will reduce his cost basis in the trade by the $4 premium collected. Review the table
below for the second month adjustments.
Month 2
Trade Positions
Long 1000 shares XYZ
Short 10 $37.50 Calls @ ($2)
Short 10 $27.50 Puts @ ($2)
Long 10 1 year $25 Put @ $6
Total
Cost Basis
$50,000
($2,000)
($2,000)
0
$47,000
Our trader will continue to sell OTM calls and puts each month to reduce the cost basis in
his stock until he can exit the trade at breakeven. If he collects the same $2 premium on
both calls and puts each month, he will reduce his cost basis by $4,000 each month. With
the stock trading near $30, it will take approximately 4 months to reduce his cost basis
from $47,000 to $31,000 where he can exit with a small loss. He could also sell one
additional month of calls and puts to reduce his cost basis down to $28,000 where he can
exit with a small profit.
If the stock rebounds and increases above the strike price of the short call, the trader can
buy back the short call position for a loss which will be offset by gains in the stock
position. He will then sell a higher strike call contract. His short put contract will expire
worthless and he will keep the entire premium collected. The next month, the trader will
again sell OTM calls and puts to reduce his cost basis in the stock. Since the stock price
has increased, he will not need to perform this transaction many times to recover the
losses in his stock position.
If the stock decreases below the strike price of the short put contract, the trader can take
assignment of the short put where he will be obligated to buy the stock at the strike price
of the short put. In our example, the short put strike price was $27.50. Therefore, the
trader will be obligated to buy more stock at $27.50 which will serve to reduce our cost
basis by dollar cost averaging into the stock. We only have protection on half of our
stock position, so we will need to buy an additional long term put contract for protection
and restart the process of reducing our cost basis by selling current month OTM calls and
puts.
For our example, assume the stock decreased to $27 and our trader took assignment on
the short put contract and bought 1,000 mores shares of XYZ stock at $27.50. Our cost
basis in the initial 1,000 shares had been reduced to $47,000 as seen in the table above.
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With the purchase of an additional 1,000 shares at $27.50, our new cost basis in the stock
is $74,500 ($47,000 + $27,500). He then sold current month OTM calls and puts to
reduce his cost basis. He chose to sell the current month $32.50 call and $22.50 put for
$3 each. The option premiums should be inflated due to increased volatility therefore, he
can sell the options for more premium than received in the prior month. In addition, he
will need to buy the same long term put contract to cover his additional 1,000 shares of
XYZ stock purchased through assignment on the short put. Review the table below to
see the trade basis.
Month 3
Trade Positions
Long 2000 shares XYZ
Short 20 $32.50 Calls @ ($3)
Short 20 $22.50 Puts @ ($3)
Long 20 1 year $25 Put @ $5
Total
Cost Basis
$74,500
($6,000)
($6,000)
$5,000
$67,500
Our trader has a new cost basis of $67,500, or $33.75 per share. To extend our example,
assume the stock is trading between $22.50 and $32.50 at expiration and both the short
calls and puts expire worthless. Our trader is left with 2,000 shares at $33.75 per share
and 20 long term 1 year $25 strike put contracts as insurance. To reduce his cost basis
further, he will sell the next expiration month calls and puts and collect more premiums.
Since the stock has somewhat stabilized and is trading between $22.50 and $32.50, the
implied volatility in the option premiums may have decreased slightly. Assume the stock
is trading at $30 at expiration and our trader can sell the $25 put and $35 call contracts in
the near month for $2 each. The trader will reduce his cost basis in the trade by the $4 of
premium collected. Review the table below to see the trade basis.
Month 4
Trade Positions
Long 2000 shares XYZ
Short 20 $35 Calls @ ($2)
Short 20 $25 Puts @ ($2)
Long 20 1 year $25 Put @ $5
Total
Cost Basis
$67,500
($4,000)
($4,000)
0
$59,500
Our trader has reduced his cost basis in the trade down to $59,500 or $29.75 per share.
With the stock trading in a range around $30, he can now exit the trade at break even plus
or minus a few dollars. The trader started out buying stock at $50 and saw the stock lose
40% of its value down to $30 before he initiated this strategy to reduce his cost basis. It
took a series of adjustments and combinations of long and short calls and puts over 4
months to reduce his cost basis in his losing trade. He ultimately eliminated the $20,000
loss on his stock position and is now free to exit at breakeven and move on to a profitable
trade.
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3. Any size loss over any time frame
In this section, we will review a strategy to employ when you have any size loss in a
stock position over any time period. It assumes that you were too aggressive in your
initial trade and did not have a stop loss in place or a put contract for insurance. As a
result, you are holding onto the losing stock position until it rebounds and you can exit at
breakeven. It assumes that if you are hanging onto the stock in hopes of a rebound, you
theoretically believe the stock can increase in value from this point. The goal of this
strategy is to free up your trading capital to move into more profitable trades while
keeping your exposure in this stock to recover the losses incurred. This is the simplest
method to handle losses in stocks.
The basic premise of this strategy is to switch trading instruments from stocks to longterm call options by selling the losing stock and buying long term call options. This
simple strategy has three large benefits that we will review. First, options consume much
less capital than stocks thereby giving you the exposure to benefit from stock increases
with unlimited profit potential without tying up a significant amount of trading capital.
Secondly, by selling your losing stock, you will generate a tax loss to use this year to
offset taxable gains. This will reduce your tax bill and free up trading capital to trade in
other profitable opportunities. Thirdly, you can continually reduce the cost basis of your
long-term call contract by selling OTM front month call contracts. This will lower the
amount consumed in the trade while maintaining profit potential.
To illustrate this strategy, assume a similar set of facts as previous examples where a
trader bought 1,000 shares of XYZ at $50 and the stock subsequently decreased down to
$35, or 30%. The stock trader is holding 1,000 shares valued at $35,000 and has a loss of
$15,000. Assume the trader can buy 10 long term 1 year $35 strike call options at $6. If
the trader sells his stock at a $15,000 loss, he will free up $35,000 of trading capital.
With that trading capital, he can buy 10 long term 1 year $35 strike call contracts at $6, or
$6,000 total. This will leave the trader exposed to the upside potential in the stock if it
rebounds back up towards $50. It also allows the trader to take the remaining $29,000
($35,000 less $6,000) of trading capital and use it in other trades that can generate a
profit. The $15,000 loss on the stock sale will shield tax on $15,000 of profits earned in
the year. If the trader is in the 30% tax bracket, this equates to a tax benefit of over
$4,500. By purchasing the long term call contract, the trader has limited further losses to
only the cost of the call contract. In addition, the trader can now start the process of
reducing the cost basis of the long term call contract by selling front month OTM call
contracts. Assume the trader can sell a front month $40 strike call contract for $1. This
would lower the cost basis in the long term $35 strike call contract to $5 ($6 - $1) and
further limit the losses if the stock continues to drop. If the stock increases to $40, the
front month short $40 strike call contract will expire worthless while the long term $35
strike contract will have a profit of at least $5,000. The $5,000 profit in the long $35 call
contract plus the $4,500 tax benefit received from taking the stock loss would leave the
trader with a small $5,500 net loss on a stock that lost more than 30% of its value. The
trader has taken a $15,000 loss and reduced it to only $5,500 using a simple strategy that
switched trading instruments from stock to long term call options. Even this small
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$5,500 net loss could be reduced if the trader generates a profit on the remaining $29,000
of capital he freed up by selling the stock. Sometimes, the simplest strategy is the best
strategy and this simple idea can help stock traders reduce their losses and exit losing
stock trades so they can use their trading capital more efficiently trading options!
4. Summary
In this course we have reviewed several strategies designed to use options to help recover
losses incurred on stock positions. These strategies assume you have been in a stock only
position that moved against you and you have no Puts as insurance on your investment.
Inevitably, all stock traders find themselves holding onto stocks that have decreased in
value and the larger the loss, the less likely a stock trader will sell it and move on to the
next trade. We have examined four variations of option trades designed to recover losses
incurred in stock trades with the assumption that the stock trader wants to exit the trade at
breakeven and not use the trade as a profit opportunity. The stock trader must also have
the expectation that the stock has sustained the majority of the losses and will bounce
back up slightly. If the stock trader anticipates the stock continuing downward, a risk
management program would be better. The goal of these four strategies is to lower the
cost basis of your losing stock while you still own it, which will allow you to sell the
stock at a lower price to breakeven. To help distinguish which of these strategies to use
in practice, we have detailed them in terms of losses incurred on the stock. The first two
strategies are best used on stocks that have had small losses in a short time frame. The
third strategy is designed for stocks that have had larger losses over a longer time frame,
and the fourth strategy is applicable in any loss situation over any time duration.
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Advanced Ratio Spreads
1. Advanced Ratio Spreads Overview
In this course we will review a more advanced strategy that incorporates your technical
analysis skills to build a very high reward trade. It is used by professional option traders
and floor traders alike and can be structured using calls or puts. Ratio spreads are an
advanced spread trade that provides for buying valuable options rich in Intrinsic value by
selling a higher number of worthless options comprised of Extrinsic value. Ratio spreads
essentially sell junk options to generate cash flow needed to buy valuable options. With
this strategy, you can generate very large returns if the stock moves in your expected
direction, while also limiting losses for stocks that move against your expectation. As
always, we will present a unique approach to implementing these strategies that will
increase the probabilities of winning.
The basic premise of a Call Ratio Spread is that you anticipate the stock price moving
upwards by a certain amount within a certain period of time. To structure a ratio spread
using calls you would simply buy an At-The-Money (ATM) call and sell 2 Out-of-TheMoney (OTM) calls at a higher strike price. This would leave you with 1 long call and 2
short calls. This ratio spread is essentially the combination of a Bull Call Debit Spread
and a Naked Short Call. As you will see, the profit and loss diagram for the ratio spread
is very appealing; however, there is a higher level of risk assumed in this trade since you
have a naked short call component. The risk is unlimited for the naked short call
position; however, we will review adjustments to hedge that risk.
A Ratio Spread using puts can be structured by buying 1 ATM put and selling 2 OTM
puts at a lower strike price. It is essentially the combination of a Bear Put Debit Spread
and a Naked Short Put. Although the profit and loss diagram for a Put Ratio Spread is
the inverse of the Call Ratio Spread, the risk is not theoretically unlimited. That is
because a stock can only go down to zero, so your naked short put position has a
maximum amount of potential loss. Of course, we will review adjustments to hedge that
risk as well.
Your technical analysis skills will determine the profitability achieved using ratio
spreads. If you have had steady success and are fairly competent in technical analysis
and regularly predict stock price moves within an acceptable tolerance range, ratio
spreads will significantly magnify your winnings. The key to success with ratio spreads
is to know the stocks you are trading and technical indicators that work consistently with
that particular stock. Be sure to only use this strategy on stocks that do not have any
pending news that could drive the stock price in a particular direction quickly, such as
earnings releases, product announcements, and potential mergers and acquisitions.
We will review the Ratio Spread as well as introduce a lower risk structure of the ratio
spread. In practice, you should start with the modified ratio spread and work your way
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into a standard ratio spread. We will review adjustments to consider for both versions of
the ratio spread to hedge our risk.
2. Example 1
The ratio spread is best illustrated by walking through examples so we will start with a
Call Ratio Spread. As mentioned, we structure a call ratio spread by buying one call and
selling two higher strike calls. This is essentially the combination of a bull call debit
spread and a naked short call. We sell an extra call contract to generate more cash and
reduce our cost basis in the bull call debit spread. That way we will reduce our loss or
even guarantee a small profit if we are wrong on the anticipated stock price movement.
Since we are using calls, we should anticipate the stock moving upwards by option
expiration.
Strategy Objectives
• Use multiple contracts to provide highly leveraged reward potential based on
technical analysis skills
• Adjust to the direction of the stock movement and neutralize the extra short call
contract if stock moves up beyond our expectation
• GOAL = Buy one At-the-Money (ATM) call and sell two Out-of-The-Money
(OTM) calls.
Strategy Benefits
• Highest Reward Potential
• Profits significantly from stock movement in our expected direction
• Possible guaranteed profits if stock moves against expectation
• Medium maintenance, High Risk
• High Annual Return Rates
Steps
27. Find a stock you would like to Trade.
28. Perform analysis (including Technical, Fundamental, and Sentimental) to
determine anticipated price movement.
29. Evaluate Option chain focusing on ATM and OTM call contracts.
30. Initiate Call Ratio Spread trade.
31. Adjust trade with dynamic hedge
32. Take profits from winning side of trade
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Example 1 –RIMM
To illustrate the call ratio spread, we’ll use RIMM as our stock we would like to trade.
We can pull up a chart on www.bigcharts.com to see the past year price chart that
confirms RIMM is trading within a range and we expect it to bounce up slightly or stay
flat at $70. In addition, we know earnings have already been released and we do not
expect any other news announcement that will significantly affect the stock price and
drive it up or down. Therefore, a call ratio spread would be an appropriate strategy to
play. We can perform our stock analysis and look for signals that will help form an
opinion of future stock movement direction; however, reviewing stock analysis indicators
is outside the scope of this course so we will bypass this function at this point. Please
refer to the Stock Analysis 101 course for more information on practical stock analysis
techniques. See the chart below.
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Next, we will review an option chain for RIMM available at www.optionsxpress.com.
For this trading strategy, we want to look at ATM and OTM call contracts that are at the
same expiration. Review the Option Chain below.
Calls
Puts
Symbol Last Chg Bid Ask Volume
Aug 05
Calls
Open
Int
Strike Symbol Last Chg Bid Ask Volume
RIMM @ 70.10
(37 days to expiration)
Open
Int
Aug 05 Puts
RUPHI 29.70
0 25.10 25.50
0
92 trade 45.00 RUPTI
0.05
0
0 0.10
8
RUPHW 24.00
0 22.60 23.00
0
35 trade 47.50 RUPTW 0.15
0
0 0.10
0
21 trade
RUPHJ 22.90
0 20.20 20.50
0
68 trade 50.00 RUPTJ
0.10
0 0.10 0.15
1
329 trade
RUPHK 15.80 -2.20 15.40 15.70
11
46 trade 55.00 RUPTK
0.24 -0.01 0.20 0.25
5
482 trade
RUPHL 11.20 -1.50 10.80 11.10
72
137 trade 60.00 RUPTL
0.65 +0.15 0.60 0.65
346 trade 65.00 RUPTM
1.55 +0.30 1.55 1.60 1,619 2,122 trade
64 trade
487 2,396 trade
RUPHM
6.90 -1.30 6.70 6.90
116
RUPHN
3.90 -0.90 3.70 3.90
761 1,140 trade 70.00 RUPTN
3.50 +0.75 3.40 3.50
651 5,429 trade
RUPHO
1.90 -0.60 1.85 1.90 1,117 3,175 trade 75.00 RUPTO
6.50 +1.10 6.50 6.70
530 3,586 trade
RUPHP
0.80 -0.30 0.75 0.85
554 3,652 trade 80.00 RUPTP 10.40 +1.30 10.40 10.70
RUPHQ
0.35 -0.15 0.30 0.40
95 3,603 trade 85.00 RUPTQ 14.60 +1.20 14.90 15.20
RUPHR
0.15 -0.05 0.10 0.15
RUPHS
0.15
0 0.05 0.10
156
503 trade
26
363 trade
334 1,553 trade 90.00 RUPTR 17.70
0 19.80 20.10
0
48 trade
861 trade 95.00 RUPTS 21.80
0 24.70 25.10
0
30 trade
0
You can see that the $70 strike call contracts are At-The-Money. The objective of this
strategy is to buy one ATM call contract and sell two OTM call contracts. The call ratio
spread is a combination of a Bull Call Debit Spread reviewed in the debit spread course
and a naked short call contract. We will structure the call ratio spread as a $70 - $75 Bull
Call debit spread and a naked short $75 strike call. The risk with a naked short call is if
the stock price rises significantly. From previous courses, we know that if the stock price
rises above our naked short call strike price, we will be obligated to sell someone else the
stock at our short call strike price. Since the stock price can rise indefinitely, there is
theoretically unlimited risk with a naked short call position because you will have to buy
the stock in the open market at a high price and sell it to someone else at your short call
strike price.
Our objective is to initiate a call ratio spread when there is no news that could drive the
stock price up or down. Ideally, the stock will rise to our price target of $75 at expiration
and we will profit as time value erodes from the short option premiums. Our exit strategy
is to buy back our short option contracts cheaper than we sold them. Since we are buying
one ATM call contract and selling two OTM call contracts, we will have a net cash
outflow and have a debit in our account. Sometimes you can structure these trades for a
credit which would guarantee a profit if the stock moves down against our expectation
and analysis. Review the trade metrics below.
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Cost of Trade
Buy 10 August $70 strike Calls at $3.90
Sell 20 August $75 strike Calls at ($1.85)
Total debit
Net Cost/Share =
= $3,900
= ($3,700)
$200
$.20 calculated as $3.90 - (2 x $1.85)
Review Trade Metrics/Calculations
Max Gain = Difference in strike prices less net cost of trade
($75-$70) – $.20 = $4.80/share, or $4,800
Our maximum profit point is right at our short option strike price $75.
With the stock at $75 at expiration, the short $75 strike calls would expire
worthless while we maintained the Intrinsic value in our long $70 strike
call that would be worth $5.
Break even = Net cost of trade plus long contract strike price
$.20 + $70 = $70.20
The stock must be at or above $70.20 at expiration to breakeven or make a
profit. Current stock price = 70.10, therefore, the stock is near the lower
breakeven point. If the stock price decreases, we only have $200 in the
trade to lose.
There is also an upside breakeven point. With a 1-2 ratio spread, the
upper breakeven point is calculated by adding the maximum gain to the
higher strike price. In this example, it will be $79.80 calculated as $4.80
plus $75. If the stock price rises too much, you will start to lose money in
the extra naked short call contract. Therefore, it is of utmost importance
to have your hedge in place to neutralize that extra naked short call
contract.
Max Risk = To the downside, Net cost of trade
$.20 x 1000 shares = $200 If the stock price decreases, our maximum risk
is capped at our initial investment in the trade of only $200.
To the upside, the amount at risk is theoretically unlimited. In practice,
your risk depends on your adjustment.
Reward/Risk Ratio = Max Gain / Max Risk
$4.80 / $.20 = 2,400%
This assumes your risk is to the downside where you will lose your small
initial investment. It also assumes you hedge your risk to the upside and
neutralize the extra naked short call contract. Although you have a very
high Reward/Risk Ratio, it is very difficult to achieve because the stock
must close exactly at $75 at expiration to reach your max gain point.
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Below is the Profit and Loss Diagram for the combined position of Bull Call debit spread
and naked short call known as a Call Ratio Spread. You can see on the Profit and Loss
Diagram the two breakeven points. With the stock price currently at $70.10, the trade
will be near the lower breakeven point. To realize your profit, the stock price must rise
towards the $75 point.
D
E
F
G
H
I
J
K
L
M
N
$10,000
Break-Even
$5,000
Hedge
$profit / loss
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
45
50
55
60
65
70
75
80
85
90
95
$(5,000)
$(10,000)
Current Stock
Price
$(15,000)
$(20,000)
stock price
The goal of the call ratio spread is to enter the trade when there are no expected events
that will drive the stock price up or down erratically. Your profitability will depend on
your technical analysis skills and establishing a price target. If the stock reaches the $75
price target at expiration, you will achieve maximum profitability. That’s because both
the short $75 call contracts will expire worthless and your long $70 call contract will be
worth $5. You essentially sold worthless options to finance the purchase of a valuable
option contract that will have $5 of intrinsic value at expiration.
Adjustments
The adjustment potential of the call ratio spread includes using single stock futures on a
stop buy order at your higher break even point. If the stock price increases, your short
calls will show a loss and your long $70 strike call will hold the profits. To offset the
losses in your short call contracts, you want to place a buy stop order on the RIMM single
stock futures at your higher breakeven point of $79.80. This way, you will buy the
futures if the stock price trades at $79.80 or higher. This will neutralize the extra short
call contract because you will profit in the long single stock futures contract at the same
rate you will generate losses in your extra naked short call contract.
Using single stock futures as your dynamic hedge will require approximately $16,000 of
margin at the $79.80 level. Be sure to plan to have margin available if your hedge is
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needed in the call ratio spread trade. For more information on adjustments, sign up for
the live interactive sessions available at www.TradewithOptions.com.
Alternatively, if the stock price decreases, you are better off to accept that your analysis
is wrong and limit your loss to your initial $200. It is a very small loss and you can
prepare for another trade to generate profits.
Trade Results:
On August 19th, RIMM closed at $73.02. Our breakeven point in the trade was $70.20 so
we generated a profit of $2,820! Since the stock did not rise above $75, we did not have
to execute our hedge with single stock futures. Notice that had we only initiated a $70$75 Bull Call Debit Spread, our breakeven point would be $72.05 generating a profit of
only $970. The ratio spread has increased our profitability by over 190%!
3. Modified Ratio Spread
The modified ratio spread has a slightly higher probability of winning and pushes the
breakeven point further out creating a larger range of stock prices in which you can win.
The trade off is that it will consume slightly more trading margin and provide a slightly
smaller return. It is well worth the tradeoff since you do not have to be exactly right with
your analysis; you just have to be close enough to win with this modified ratio spread. It
is structured similarly to the standard ratio spread; however, instead of selling two
contracts at the same strike price, you will sell one contract Out-of-The-Money and sell
another contract even further Out-of-The-Money. Your objective is to sell deep Out-ofThe-Money options that are rich in Extrinsic value and have very low probabilities of
becoming In-The-Money at expiration. This will reduce your cost basis in your valuable
options and increase your profitability. By selling an additional contract deep OTM, you
are increasing the probabilities of winning.
Your technical analysis skills will determine the profitability achieved using the modified
ratio spreads. If you have had steady success and are fairly competent in technical
analysis and regularly predict stock price moves within an acceptable tolerance range,
modified ratio spreads will significantly magnify your winnings. The key to success with
the modified ratio spreads is to know the stocks you are trading and technical indicators
that work consistently with that particular stock. Be sure to only use this strategy on
stocks that do not have any pending news that could drive the stock price in a particular
direction quickly, such as earnings releases, product announcements, and potential
mergers and acquisitions. The modified ratio spread has more room for error than the
standard ratio spread so you should start out using the modified ratio spread strategy
before moving on to the standard ratio spread discussed above.
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Strategy Objectives
• Use multiple contracts to provide highly leveraged reward potential based on
technical analysis skills
• Adjust to the direction of the stock movement and neutralize the extra short
contract if stock moves beyond our expectation
• GOAL = Buy one At-the-Money (ATM) contract and sell one Out-of-The-Money
(OTM) contract and sell another contract even further OTM.
Strategy Benefits
• Very High Reward Potential
• Profits significantly from stock movement in our expected direction
• Possible guaranteed profits if stock moves against expectation
• Medium maintenance, Medium Risk
• High Annual Return Rates
Steps
1. Find a stock you would like to Trade.
2. Perform analysis (including Technical, Fundamental, and Sentimental) to
determine anticipated price movement.
3. Evaluate Option chain focusing on ATM and OTM contracts.
4. Initiate Modified Ratio Spread trade.
5. Adjust trade with dynamic hedge
6. Take profits from winning side of trade
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Example 2 –NKE
For this example, we will show the modified ratio spread strategy utilizing put contracts
so you can see how to structure ratio spreads on stocks you anticipate decreasing. To
illustrate the modified ratio spread strategy, we’ll use NKE as our stock we would like to
trade. We can pull up a chart on www.bigcharts.com to see the past year price chart that
confirms NKE is trading within a range between $75 and $90. It has just pulled back
from its resistance point around $90 so we can anticipate it continuing downward from
here. In addition, we know earnings have already been released and we do not expect any
other news announcement that will significantly affect the stock price and drive it up or
down. Therefore, a modified ratio spread strategy would be an appropriate strategy to
play. We can perform our stock analysis and look for signals that will help form an
opinion of future stock movement direction; however, reviewing stock analysis indicators
is outside the scope of this course so we will bypass this function at this point. Please
refer to the Stock Analysis 101 course for more information on practical stock analysis
techniques. See the chart below.
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Next, we will review an option chain for NKE available at www.optionsxpress.com. For
this trading strategy, we want to look at put contracts that are ATM and OTM and at the
same expiration. Review the Option Chain below.
Calls
Puts
Symbol Last Chg Bid Ask Volume
Aug 05
Calls
(37 days to expiration)
NKEHM
Open
Int
Strike Symbol Last Chg Bid Ask Volume
NKE @ 87.08
Open
Int
Aug 05 Puts
0
0 22.20 22.40
0
0 trade 65.00 NKETM
0
0
0 0.05
0
0 trade
NKEHN 16.10
0 17.20 17.40
0
21 trade 70.00 NKETN
0
0
0 0.05
0
0 trade
NKEHO 11.50
0 12.30 12.60
0
31 trade 75.00 NKETO 0.15 +0.05 0.05 0.15
NKEHP
0 7.70 7.90
0
95 trade 80.00 NKETP
7.80
2 286 trade
0.45 +0.05 0.45 0.50 15 649 trade
NKEHQ 3.90 +0.10 3.80 4.00 582 2,600 trade 85.00 NKETQ 1.50 +0.05 1.50 1.60 309 646 trade
NKEHR
1.25 +0.05 1.20 1.30 295 1,988 trade 90.00 NKETR
5.30
0 3.80 4.00
0 131 trade
NKEHS
0.20
0 0.20 0.30
1
960 trade 95.00 NKETS
9.40
0 7.90 8.10
0 10 trade
NKEHT
0.05
0
0 0.15
0
440 trade 100.00 NKETT 14.00
0 12.80 13.10
0 10 trade
NKEHA
0.05
0
0 0.05
0
1 trade 105.00 NKETA 18.50
0 17.80 18.10
0 10 trade
NKEHB
0
0
0 0.05
0
0 trade 110.00 NKETB
0
0 22.80 23.10
0
0 trade
NKEHC
0
0
0 0.05
0
0 trade 115.00 NKETC 27.70
0 27.80 28.10
0
0 trade
You can see that the $90 strike put contracts are At-The-Money. The objective of this
strategy is to buy one ATM put contract and sell one OTM put contract and sell another
put contract even further OTM. The modified put ratio spread is a combination of a Bear
Put Debit Spread reviewed in the debit spread course and a naked short put contract. We
will structure the modified put ratio spread as a $90 - $85 Bear Put debit spread and a
naked short $80 strike put. The risk with a naked short put is if the stock price drops
significantly. From previous courses, we know that if the stock price decreases below
our naked short put strike price, we will be obligated to buy someone else’s stock at our
short put strike price. Since the stock price can only drop to zero, there is a maximum risk
with a naked short put position.
Our objective is to initiate a modified put ratio spread when there is no news that could
drive the stock price up or down. Ideally, the stock will decrease to our price target of
$85 at expiration and we will profit as time value erodes from the short option premiums.
Our exit strategy is to buy back our short option contracts cheaper than we sold them.
Since we are buying one ATM put contract and selling two OTM put contracts, we will
have a net cash outflow and have a debit in our account. Sometimes you can structure
these trades for a credit which would guarantee a profit if the stock moves upwards
against our expectation and analysis. Review the trade metrics below.
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Cost of Trade
Buy 10 August $90 strike Puts at $4.00
Sell 10 August $85 strike Puts at ($1.50)
Sell 10 August $80 strike Pus at ($.45)
Total debit
Net Cost/Share =
= $4,000
= ($1,500)
= ($450)
$2,050
$2.05 calculated as $4.00 - $1.50 - $.45
Review Trade Metrics/Calculations
Max Gain = Difference of long put and closest short put strike prices less cost/share
($90-$85) – $2.05 = $2.95share, or $2,950 total
Our maximum profit point is right between our short put strike prices of
$85 and $80. With the stock at $85 at expiration, the short $85 and $80
strike puts would expire worthless while we maintained the Intrinsic value
in our long $90 strike put that would be worth $5.
Break even = Long contract strike price less net cost of trade
$90 - $2.05 = $87.95
The stock must be at or below $87.95 at expiration to breakeven or make a
profit. Current stock price = 87.08, therefore, the stock is in a profitable
position already.
There is also a downside breakeven point. With a 1-2 ratio spread, the
lower breakeven point is calculated by subtracting the maximum gain
from the second short strike price. In this example, it will be $77.05
calculated as $80 less $2.95. If the stock price decreases too much below
$80, you will start to lose money in the extra naked short put contract.
Therefore, it is of utmost importance to have your hedge in place to
neutralize that extra naked short put contract.
Max Risk = To the upside, Net cost of trade
$2.05 x 1000 shares = $2,050 If the stock price rises, our maximum risk is
capped at our initial investment in the trade of only $2,050.
To the downside, the amount at risk depends on your adjustment.
Reward/Risk Ratio = Max Gain / Max Risk
$2.95 / $2.05 = 144%
This assumes your risk is to the upside where you will lose your small
initial investment. It also assumes you hedge your risk to the downside
and neutralize the extra naked short put contract. Although you have a
very high Reward/Risk Ratio, the stock must close between $85 and $80
at expiration to reach your max gain point.
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Below is the Profit and Loss Diagram for the combined position of Bear Put debit spread
and naked short Put known as a Modified Put Ratio Spread. You can see on the Profit
and Loss Diagram the two breakeven points. With the stock price currently at $87.08, the
trade will be in a profitable position. To realize your maximum profit, the stock price
must decrease towards the $85 point.
D
E
F
G
H
$2,000
I
J
K
L
M
N
Break-Even
$4,000
Hedge
$$(2,000)
profit / loss
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
65
70
75
80
85
90
95
100
105
110
115
$(4,000)
$(6,000)
$(8,000)
Current Stock
Price
$(10,000)
$(12,000)
$(14,000)
stock price
The goal of the modified put ratio spread is to enter the trade when there are no expected
events that will drive the stock price up or down erratically. Your profitability will
depend on your technical analysis skills and establishing a price target. If the stock
reaches the $85 price target at expiration, you will achieve maximum profitability.
That’s because both the short $85 and $80 strike put contracts will expire worthless and
your long $90 put contract will be worth $5. You essentially sold worthless options to
finance the purchase of a valuable option contract that will have $5 of intrinsic value at
expiration.
Adjustments
The adjustment potential of the modified put ratio spread includes using either single
stock futures or stocks on a stop sell order at your lower break even point. If the stock
price decreases, your short puts will show a loss and your long $90 strike put will hold
the profits. To offset the losses in your short put contracts, you want to place a sell stop
order on the NKE stock at your lower breakeven point of $77.05. This way, you will sell
the stock short if the stock price trades at $77.05 or lower. This will neutralize the extra
short put contract because you will profit in the short stock at the same rate you will
generate losses in your extra naked short put contract.
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Using stock as your dynamic hedge will require approximately $38,000 of margin at the
$77.05 level. Be sure to plan to have margin available if your hedge is needed in the
modified put ratio spread trade. Single stock futures are not available on every stock;
however, the availability list changes frequently so be sure to use SSF contracts where
available to preserve trading capital. For more information on adjustments, sign up for
the live interactive sessions available at www.TradewithOptions.com.
Alternatively, if the stock price increases, you are better off to accept that your analysis is
wrong and limit your loss to your initial $2,050. It is a very small loss and you can
prepare for another trade to generate profits.
Trade Results:
On August 19th, NKE closed at $80.34. The stock decreased below our expectation of
$85 and we generated a profit of $2,950! Since the stock did not decrease below $77.05,
we did not have to execute our hedge. Notice that had we only initiated a $90-$85 Bear
Put Debit Spread, our breakeven point would be $87.50 generating a profit of only
$2,500. The ratio spread has increased our profitability by over 18%!
4. Summary
In this course we have reviewed a more advanced strategy that incorporates your
technical analysis skills to build a very high reward trade. Ratio spreads are an advanced
spread trade that provides for buying valuable options rich in Intrinsic value by selling a
higher number of worthless options comprised of Extrinsic value. Ratio spreads
essentially sell junk options to generate cash flow needed to buy valuable options and can
be structured using either calls or puts. With this strategy, you can generate very large
returns if the stock moves in your expected direction, while also limiting losses for stocks
that move against your expectation.
Your technical analysis skills will determine the profitability achieved using ratio
spreads. If you have had steady success and are fairly competent in technical analysis
and regularly predict stock price moves within an acceptable tolerance range, ratio
spreads will significantly magnify your winnings. The key to success with ratio spreads
is to know the stocks you are trading and technical indicators that work consistently with
that particular stock. Be sure to only use this strategy on stocks that do not have any
pending news that could drive the stock price in a particular direction quickly, such as
earnings releases, product announcements, and potential mergers and acquisitions.
Always have your buy or sell stop orders in place to hedge your risk on the uncovered
short option contract. In practice, you should start with the modified ratio spread and
work your way into a standard ratio spread.
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Dividend Income Strategy
1. Dividend Income Strategy Overview
In this course we will review a unique low risk trade setup designed to capture dividends
paid by companies. As you know, option holders do not participate in dividends like
typical stock holders do; however, with this strategy, you can design a trading plan to
focus on capturing dividends in stock with very little risk using a combination of stocks
and options. The dividend income strategy can be initiated and closed over a one day
period to capture profits equal to the amount of dividends paid by the company. In order
for this strategy to be effective, you must be fluent in how companies pay out dividends
and know the key dates related to the payment. This course will review the essential
elements involving corporate dividend payments as well as commons stock split
scenarios. We will then move on to the Dividend Income Strategy in detail.
2. Ex-Dividend Dates
If you have been involved with investing or trading for a period of time, you have
probably come across the term ex-dividend date. It is the most important date to know
once a company has declared a dividend as it will determine who will receive the
dividend and who will not. The Dividend Income Strategy will focus on the ex-dividend
date and you must know this date to effectively employ this strategy. Dividends are often
a source of confusion for investors since there are many dates and elements at work to
determine those investors that will receive the payment.
In practice, there are usually three dates announced when a company declares a dividend
including the record date, ex-dividend date, and payable date. The company is most
concerned with the record date because on the record date the company will look up the
list of all investors that own their stock. The company will then prepare to pay the
dividend to all the shareholders as of the record date. If you own the stock on the record
date, you will be receiving the dividend. One problem that arises often with novice
investors is that they buy the stock of the company issuing the dividend on the record
date or even a day before the record date expecting to receive the dividend. What they
must keep in mind is that they must be the shareholder on record as of that date. To be
the shareholder on record, you must buy the stock and have the transaction settled by the
record date. Currently, there is a three day settlement process, so you would need to buy
the stock three days prior to the record date so that the purchase transaction settles and
you become the shareholder on record as of the record date.
The next date involved with the issuance of the dividend is the ex-dividend date. The exdividend date is simply the date when the stock will trade without the dividend benefit.
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This means that any investor purchasing the stock on or after the ex-dividend date will
not receive the dividend. The ex-dividend date is typically calculated by brokerages
which factor in the settlement period of transactions discussed above. For example, if a
company declared a dividend for all shareholders on record as of June 30, the ex-date
would be calculated to be June 27th to factor in the three day settlement process. This
means that an investor purchasing the stock on June 27th or later would not receive the
dividend even though they bought the stock before the record date issued by the
company. This is why the ex-dividend date is the most important date to remember when
considering trades on stocks issuing a dividend.
A dividend is where a company takes cash on hand and distributes it back to
shareholders. It is basically a return of capital and has no net effect on your total
position. There will be no net effect on your position because the stock price will be
decreased by the amount of the dividend on the ex-date. For example, if a stock issuing a
$1 dividend closes at $50 on June 26th, the day before the ex-dividend date. On June 27th,
the stock will open at $49 to reflect the dividend payment. Assume an investor purchased
the stock on June 26th at $50 and it was settled by the record date of June 30th. At the
close of June 26th, the investor has stock valued at $50 and is entitled to the $1 dividend;
however, the stock price will be adjusted to $49 the next morning. This will leave the
investor with stock valued at $49 plus the $1 dividend he will receive for a total position
value of $50. Even though the stock price decreased by $1, the investor is not in a losing
position. Similarly, an investor that purchased the stock on the ex-dividend date would
pay $49 for the stock and not receive the dividend, so his total position value would be
$49 and he would not be in a losing position. Therefore, it is immaterial to an investor
whether they receive the dividend or not, although tax benefits must be considered.
The dividend payable date is the date the company actually issues payment to the
shareholders on record as of the record date. Interestingly, if you happen to short a stock
in which a dividend has been declared, you will be obligated to pay the dividend to an
individual on the other side of your short stock position. This is called payment in lieu of
the dividend and will be a debit in your account. You will have no net effect in the value
of your position since the stock price will decline by the amount of the dividend and your
short stock position will show a gain that offsets the payment in lieu.
Although your total position in a trade will be unchanged whether you are long or short
the stock issuing the dividend, there are many tax and margin management issues to
consider when trading stocks issuing dividends. The positions will be unchanged in
value before regular trading occurs and the forces of supply and demand play out. Once
regular trading resumes, the price of the stock will fluctuate.
3. Stock Splits
Stock splits occur periodically in the marketplace and can also be a source of confusion
for investors so we will review the fundamentals of stock splits here. Stocks can split in a
variety of ratio’s, such as 2 to 1, or 3 to 1. There is no limit to the ratio of splitting
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stocks. The stock split is basically the same event as a dividend, except the shareholder is
receiving additional shares of stock instead of cash as in a dividend. Since a stock split
functions similarly to a dividend, you will have the same issues with key dates to focus
on. With a stock split, you will want to focus on the same ex-date as followed in the
dividend. Transactions past the ex-date will be settled on the split adjusted basis.
The stock split will not affect your current position value. For example, assume a stock
trading at $100 announced a 2 for 1 stock split with an ex-date of July 1st. An investor
buying 200 shares on June 30th will have stock valued at $2,000 ($100 x 200 shares). On
July 1st the stock would open trading at $50, but the investor would own 400 shares
leaving his total position value at $2,000. The 2 for 1 stock split will double the number
of shares he owns, but cut the value per share in half. In the end, he will have the same
position value. Therefore, it is immaterial to an investor whether they buy the stock
before the ex-date and receive the stock split or not.
Option traders will also see the stock split factored into the strike prices of the options as
well as the premiums of those options. To continue our example, assume a trader owned
a $100 strike call contract on June 30th. On July 1st, the trader would see two $50 call
contracts in his position. This would not affect the value of his position because the
number of call contracts doubled and the premium per call was cut in half.
Options are typically structured at regular intervals of $2.50 or $5.00 between contracts.
Once a stock splits, you may see contracts offered at irregular strike prices. For example,
if a stock trading at $100 split in a ratio of 3 to 1 and an option trader owned a $100 call
contract just prior to the split, he would end up with 3 call contracts at a strike price of
$33.33 after the split. There may also be call contracts offered at $32.50 and $35.00 to
account for the regular intervals between contracts, but due to the stock split, the previous
contracts were adjusted to reflect an irregular strike price.
4. Dividend Income Strategy
This is a unique strategy to employ anytime you know the stocks ex-dividend date. It is
designed to only hold a position over one night. The ideal time to enter the trade is near
the market close of the trading day before the ex-dividend date. Your exit strategy is to
close the position at the opening of the next trading day. It is a low risk trade because
you are basically playing against the trader on the opposite side of your trade. The worst
case scenario is that you will breakeven and the best case scenario is that you will capture
the value of the dividend as profit.
The basic premise of the Dividend Income Strategy is to buy the stock and sell a deep InThe-Money (ITM) call option just before the market close on the day prior to the exdividend date. It is basically a deep ITM covered call as described in the Options Basics
course, but it factors in conditions unique to options and dividends. Since option holders
do not receive the benefit of the stock dividend, the call contract owner must decide if
they want to exercise their call contract to buy stock and become a shareholder that does
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receive the dividend. You know from previous sections above that the shareholder’s
position value will not change due to the dividend. The stock price will open on the exdividend date at a price lowered by the amount of the dividend. To capture the dividend
value, you will sell a call contract deep ITM and try to buy it back at the market open at a
price lower by the amount of the dividend.
It is best illustrated using an example. Assume a stock is trading at $50 and is about to
pay a $1 dividend. Also assume a deep ITM $30 call is trading at $20 (all intrinsic
value). A trader employing the Dividend Income Strategy can buy the stock at $50 and
sell the $30 call and collect $20 of premium for a net debit of $30. On ex-date, the stock
will open at the price of $49 (down $1 due to the dividend payment). This will impact
the value of the deep ITM $30 strike call contract. Since the call contract was comprised
entirely of intrinsic value, the premium will drop proportionately with the decrease in
stock price. Since the stock price decreased by $1, the $30 strike call contract will
decrease by $1 and only be worth $19. You can then buy it back at $19 and profit by the
$1 dividend amount. If the trader you sold the call to decides to exercise the call option,
then you will breakeven. Review the transactions below.
The initial trade setup involves buying the stock and selling the deep ITM $30 call.
Long Stock @ $50
= $50
Short $30 strike Call @ $20 = ($20)
Net Debit
= $30
You can close out the trade in one of two ways. Either you will profit by the amount of
the dividend or the call holder will exercise the call and you will be assigned obligating
you to sell your stock at breakeven.
Ex-date
Long stock @ $49
= ($49)
Short $30 Call @ $19 = $19
Dividend received
=$1
Net Credit
= ($29)
If assigned
Long stock sold @ $30
= ($20) loss
Short $30 call exercised = $30
Short Call sale proceeds = $20
Net Credit = ($30)
Profit of $1, the amount of the dividend
Breakeven
You can also enter the trade using a Bull Call Debit Spread. This would require you to
purchase the $25 strike call and sell the $30 strike call as in the previous example. At the
market close the day before ex-dividend date, you will exercise the $25 strike call
contract to adjust your position into a long stock and short call position as in the previous
example. This variation will not consume as much capital since Bull Call debit spreads
require much less margin and you plan to exit upon the market open on ex-date. To enter
this deep ITM Bull Call debit spread, you want to enter the spread for a debit of $5, the
exact difference in strike prices. Ideally, you will not have your short call contract
assigned and the next morning you can buy it back $1 cheaper than you sold it the day
before.
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Alternatively, you can also structure this trade using a Bear Call Credit Spread. This
would require you to purchase the $35 strike call and sell the $30 strike call as in the
primary example. You will exercise the long call at the market close on the day before
ex-dividend dated. Ideally, you will be able to buy back your short call contract at the
market open on the ex-dividend date at a cheaper price than you sold it.
Both the debit and credit spread variations requires you to enter the spread for the $5
difference in strike prices. You must then exercise your long call position and plan to
buy back the short call at the market open on the ex-dividend date. This will leave you
with a profit equal to the dividend amount while staying in the market for the least
amount of time possible.
For more information on adjustments, sign up for the live interactive sessions available at
www.TradewithOptions.com.
5. Summary
In this course we have reviewed a unique low risk trade setup designed to capture
dividends paid by companies. As you know, option holders do not participate in
dividends like typical stock holders do; however, with this strategy, you can design a
trading plan to focus on capturing dividends in stock with very little risk using a
combination of stocks and options. The dividend income strategy can be initiated and
closed over a one day period to capture profits equal to the amount of dividends paid by
the company. In order for this strategy to be effective, you must be fluent in how
companies pay out dividends and know the key dates related to the payment. This course
has reviewed the essential elements involving corporate dividend payments as well as
commons stock split scenarios. You should now be able to structure low risk trades
targeting dividend payments.
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Next Steps
Next Steps
Be sure to check out the interactive live sessions where you can ask questions, learn new
adjustments, and even review current trades in the marketplace. To sign up for the live
sessions, go to www.TradewithOptions.com and click on the course link. The live
session schedule is posted on the website.
Additional courses will be published periodically to review new strategies and
adjustments. These additional courses will be offered at a discounted price to existing
members. Just sign up for the early distribution list and you will be notified as soon as
the courses become available.
To compliment your trading knowledge and help guide you through the learning curve in
real-time, a monthly trading newsletter will be published highlighting strategy keys to
success, current real-time trades available in the marketplace, and Q&A forums. You can
write to TradewithOptions.com and ask questions that may be published in future
newsletters.
Thank you for your interest in TradewithOptions.com. We hope you received significant
value in this trading program. Send us your testimonials on your future successful
trading and you can win free gifts. Email your testimonials to
[email protected].
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