Options Education

How to interpret the put call ratio

What is an embedded option?

Options: Pros and Cons

The right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific amount of a given stock, commodity, currency, index, or debt, at a specified price (the strike price) during a specified period of time. For stock options, the amount is usually 100 shares. Each option contract has a buyer, called the holder, and a seller, known as the writer. If the option contract is exercised, the writer is responsible for fulfilling the terms of the contract by delivering the shares to the appropriate party. In the case of a security that cannot be delivered such as an index, the contract is settled in cash. For the holder, the potential loss is limited to the price paid to acquire the option. When an option is not exercised, it expires. No shares change hands and the money spent to purchase the option is lost. For the buyer, the upside is unlimited. Option contracts, like stocks, are therefore said to have an asymmetrical payoff pattern. For the writer, the potential loss is unlimited unless the contract is covered, meaning that the writer already owns the security underlying the option. Option contracts are most frequently as either leverage or protection. As leverage, options allow the holder to control equity in a limited capacity for a fraction of what the shares would cost. The difference can be invested elsewhere until the option is exercised. As protection, options can guard against price fluctuations in the near term because they provide the right acquire the underlying stock at a fixed price for a limited time. risk is limited to the option premium (except when writing options for a security that is not already owned). However, the costs of trading options (including both commissions and the bid/ask spread) is higher on a percentage basis than trading the underlying stock. In addition, options are very complex and require a great deal of observation and maintenance.

OPTION STRATEGIES

Writing options for high probability investing

Naked Puts

A “naked put” is simply selling or writing a put option instead of buying it.
Here, you would be selling a 50 put for $3. You would give someone else the
right to sell you the stock for $50 on or before expiration for a $3 credit.

stk price

20

30

40

50

60

70

80

p/l at exp

-2700

-1700

-700

300

300

300

300

p/l% at exp

-900%

-567%

-233%

100%

100%

100%

100%

Here your loss would be almost unlimited and your profit would be limited to $300.
The probability would be high that the stock would stay the same or go up giving you the $300 profit.

Covered Calls

A “covered call” has the same exact profit and loss table as a naked put.
Here you would buy 100 shares of a $50 stock and sell (write) a 50 call for $3.
Basically, selling the 50 call would give someone the the right to buy the stock
from you for $50 on or before expiration. In return for granting this, you will
receive $3. Should the stock close above $50 at expiration, you would end up
selling your stock to that person for $50 and profiting $300. If the stock is
below $50, you would still own it and keep the $300.

Buying a put as insurance for an existing stock position

If you own an existing stock and are worried that there may be huge correction
in the short term, you can buy a put to insure the stock against such a catastrophe.
For example, you own 100 shares of a stock with a current price of $50.
You buy a 40 put for $1 which expires in one month. Should the stock drop toward $40 on or before expiration, your profits from the put could offset the losses on the stock.

stk price

20

30

40

50

60

70

80

stock pl

-3000

-2000

-1000

0

1000

2000

3000

put option pl

2900

1900

900

-100

-100

-100

-100

NET pl

-100

-100

-100

-100

900

1900

2900

The put will limit your total losses to only $100 (cost of the put) reduce your gains by the same amount.

Bull Spread – a conservative option play

A more conservative approach to just buying a call would be the bull spread.
This involves buying one call and selling another call further out.
For example, a stock is trading at $50 and you buy the 50 call for $3 and sell the 60 call for $1.
This would result in a spread position where you max loss and profit are limited. The max profit would be $800 and the max loss would be $200 (net cost).

The PL at expiration table would look as follows:

stk price

20

30

40

50

60

70

80

buy 50 call@3

-300

-300

-300

-300

700

1700

2700

sell 60 call@1

100

100

100

100

100

-900

-1900

net pl

-200

-200

-200

-200

800

800

800

This position in comparision to just buying the call, would give you a lower maximum risk and limit the max profit to $800.

Straddle – Making money up or down

A straddle option spread allows you to make money whether the stock moves up OR down. It is simply combining a buy put and buy call option. The Straddle will only lose if the stock stays the same.

The PL at expiration table for a STRADDLE would look as follows:

stk price

20

30

40

50

60

70

80

buy 50 call@3

-300

-300

-300

-300

700

1700

2700

buy 50 put@3

2700

1700

700

-300

-300

-300

-300

net pl

2400

1400

400

-600

400

1400

2400

Short Straddle – Making money if the Stock stays the same

A Short Straddle is the opposite of the straddle. It is combining a SELL call and SELL put option.

The PL at expiration table for a SHORT STRADDLE would look as follows:

stk price

20

30

40

50

60

70

80

sell 50 call@3

300

300

300

300

-700

-1700

-2700

sell 50 put@3

-2700

-1700

-700

300

300

300

300

net pl

-2400

-1400

-400

600

-400

-1400

-2400

Advantages & Disadvantages of Trading Stock Options

Advantages

· Leverage: With options you can achieve a greater amount of leverage than when purchasing the underlying stock. In an example with Microsoft ‘Call’ options (that you’ll soon read) the leverage achieved was 8 to 1. Leverage affects gains and losses equally so it’s important to understand how much risk you can take on a trade and how to protect yourself against losses. The trading strategies (‘PSTS’) taught in this Course are going to be simple purchase of Calls and Puts. But please also realize that there are other more complex option strategies that will allow you to construct different risk profiles.

· Limited risk: A strategy with limited risk can be easily constructed. In one of our examples (in a coupe pages) with Buying Microsoft Call options when the price increased we were able to make an 86% percent return while the risk was fixed at $315. Even if the price of Microsoft collapsed and went to $10 we could of only lost the $315 we paid for the option contract.

· Going Short: There are no restrictions or large margin requirements when purchasing a Put option (discussed shortly).

· 2 out of 3: When a purchase of a stock is made there are three possible outcomes: The stock can either, (1) go UP, (2) go DOWN or (3) stay the same. An option trade can be constructed so the outcome is profitable in two of those three conditions. This is accomplished with more complex strategies like a calendar spread.

· Hedge: Options can also be used as a hedge in your portfolio. A hedge is the purchase or sale of a futures contract or other derivative as a temporary substitute for a cash market transaction to be made at a later date. The hedge position is designed to protect the investor from temporary price movements in an instrument that the investor already owns or plans to own. Usually it involves opposite positions in the cash market and futures market at the same time.

Disadvantages

· Time Decay: Options are a decaying asset. The time component of the price gradually diminishes as the option approaches expiration, at which time it becomes zero. The seller of the option wants more money for his time while the buyer wants more time for his money.

· Commission: Commission as a percent can be more significant than trading the underlying stock itself. This is something you need to watch closely as it can quickly erode profits.

· Knowing When: Just being right about the direction (of a stock) is not enough to make money when trading the options. The movement of the stock (in your desired trade direction) must happen within the specified contract period and it must also happen fast enough to offset the time decay that the asset (stock option) is experiencing

Myths about options

Myth 1:

“Options are very risky. They are gambling”

While this can be certainly true for just buying options, option writing (or selling)

gives the investor many very conservative and high probability options strategies.

Options can even be used as insurance against existing stock positions.

Myth 2:

“Options are too complicated”

Understanding the basic option concept can be difficult at first. Read the intro

section for a very easy way to understand options.

Myth 3:

“Options are for rich people”

Buying options requires very little investment capital (under $1,000). Writing options account requirements

have dropped down to under $10,000 for many brokerages.

Myth 4:

“Options are rare and not easy to trade”

Options trading has exploded over the past 5 years. Now, options are available on over 2700 stocks.

All major online brokers now offer options trades as low as $1 a contract.

Myth 5:

“Most options expire worthless”

This can be true if there are more “out of the money” options than “in the money” and you are always the BUYER of the option. If you become the SELLER of the options than you can take advantage of this.

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