Tutorial 1: Outline of Basic Strategies

The purpose of this tutorial is to help you distinguish between the most common option strategies. When people say 'options are this, or options are that' it often just displays their ignorance because there are different kinds of options, and they can be used in many different ways. So if you are going to understand them you first have to understand the different kinds. Think of it as learning about cats. If I tell you cats are dangerous, I may be thinking of lions or tigers. But you might be thinking about your gentle pussycat. And if I say that I'm allergic to cats that might not be true of certain breeds that don't shed. So the first thing is for you to get clear in your mind some of the different kinds of cats'I mean options'that there are. Later you will learn about some more complex cases. In order to understand the materials in this tutorial, you might need to know the definitions of some of the specialized terms used, such as 'in-the-money.'

Definitions

Listed below are a few of the definitions that may be helpful. Please remember that the 12 most important definitions are always available to you by clicking on the 'Definitions' button on the web site.

CALL

One stock Call is a right to buy 100 shares of stock at a particular price until a specified time.

If I own one Ford January 35 Call, I have the right to buy 100 shares of Ford Motor stock at $35 per share through the close of the business day of the third Friday of the following January. Alternatively I can sell the Call itself. If I own such a Call, someone sold it to me. That person has committed to sell 100 shares of Ford stock to me if I exercise my option. If I exercise my option, the stock is said to be 'called away' from the seller.

The seller of the call is obligating himself to sell the stock at the strike price. This seller might already own Ford stock and have sold a Call against it, or the seller, if called, may have to go into the open market and buy the stock to 'cover' the position. If the stock has moved up significantly above the strike price, this 'uncovered' seller will lose the spread between $35 and the price he has to pay to acquire the stock and deliver it to the holder of the call.

PUT

One stock Put is a right to sell 100 shares of stock at a particular price until a specified time.

If I own one Ford January 35 PUT, I have a right to sell 100 shares of Ford Motor stock at $35 per share at any time through the expiration date. The person that sold the PUT to me has become obligated to buy the stock. As with the CALL, I can also sell the PUT itself at any time during its life. I may already own the 100 shares, and have bought the PUT to protect its value. Alternatively, if I do not own the stock and if the stock price goes down during the option period, it will pay me to purchase the stock and then 'put it' (sell the stock by implementing the PUT) to the buyer at the higher ($35) price. The result of the transaction will be that I sold high, and then bought low, which never hurts! On the other hand, if I SOLD the put at 35, I guaranteed to buy it at that price. Thus, if the stock goes down during the option period and does not recover, if exercised (and you can bet it will be) I will have to buy the stock at 35 even if the market price is below that figure.

STRIKE PRICE

We have talked about the 'strike price' in the previous examples. The 'strike price' is either the dollar value of the stock, or the number of the index, specified in the option. Thus, in the examples above, when we talked about a Ford 35 CALL, the strike price is $35. When we talked about an index option at 300, the strike price is $300.

TERMINATION DATE

The 'termination date' is the date on which, at the close of business, the option rights expire unless exercised. Most options expire at the end of the third Friday of the designated month. Note that you can exercise an option (or be put or called, if you are the seller) at any time during the life of the option - not only at the end of the period. Also note that you must initiate some action through your broker, or else the option may expire worthless even if it still has value!

AT-THE-MONEY

An option is 'at-the-money' when the actual present dollar value or index number is the same as the strike price specified in the option. The option is 'in-the-money' when the stock or index price goes past the strike price in the direction of profit for the holder; and the option is 'out-of-the-money' when the current price is not yet at the strike price, in the direction of the loss for the holder.

LONG AND SHORT

We speak of a holding as 'long' when we own the position. To own a position means that you have purchased it, whether voluntarily or involuntarily. Accordingly, if you buy a Call you are long that Call. If you sell a Call, you are short that position. If I say 'I am long the Ford 55's and short the Ford 50's,' that means that I bought the Ford Calls at a strike price of 55, and sold the Ford calls with a strike price of $50. I would then have to specify the termination date to fully describe my position. If I also own the Ford stock, I can be described as 'long Ford.' If I own 1,000 shares I might describe it as 'long 1,000 shares of Ford.'

When you sell calls, such as the Ford 50's, we say that you are 'short the Ford 50's.' When you sell an option it is sometimes referred to as 'writing' the option and the seller is referred to as an 'option writer.'

A. Buying a Call (Not recommended by itself)

The most simple option position is just to buy an option. You can buy either a PUT or a CALL. Your risk is limited to the amount that you pay to buy the option.

A.1. the strategy

When you buy a Call, it gives you the right to BUY the underlying stock at the strike price of the call.

For example, if you buy 1 IBM March 85 Call, you have the right to buy 100 shares of IBM stock for $85 per share until the third Friday of March. If you pay $2 for the Call, it means $2 per share, or $200 per option (which represents 100 shares). In this scenario, the stock has to move up to over 87 for you to make a profit. But you would exercise the Call at any price over 85, just before the termination date, to recoup some of your cost.

Obviously the purchase of a Call, by itself, is for someone that wants to be in the position of owning 100 shares of stock for a short period of time, without putting up all the money necessary for such a purchase.

A.2. Risk Analysis

When you buy an option, your only risk is that you will lose the premium that you paid. If you pay very little for it, and you have reasonable grounds to believe that you might make a profit, it could be a reasonable investment, and not very 'risky,' since you haven't put much money at risk. I think some people confuse 'risky' with 'wasteful.' There is a certain element to the puritan ethic which considers it wasteful to buy something impermanent. Thus, it seems to some to be a waste of money to spend on food or entertainment. But buying a sturdy piece of furniture would not be wasteful.

And so it is, to some, with buying an option. If you save up your money and buy a share of stock instead, you have something of permanence. But if you buy the option, it expires.

To me, 'risky' means that you are put in a position where there is a significant likelihood of losing an inappropriate sum of money. Therefore, buying an option, by my definition, is rarely risky. It may be stupid. It may be wasteful. It may be inappropriate. But it's rarely risky, because you know the cost at the outset, and that is what you can lose.

 

A.3. Benefit Analysis

The main reason investors buy an option by itself is for leverage. If you believe that IBM stock will go up from 100 to 110 in the next 30 days, to buy 1000 shares would require that you put up $100,000 (or perhaps half of that if you buy on margin). But you can control 1000 shares, and be in the same position vis-'-vis the right to a gain on the increase, if you buy 10 calls. To buy 10 calls will only require a cash outlay of, perhaps $2,000.

In my opinion, however, buying an option is usually only worthwhile if it is part of a larger strategy, such as using this purchase as a hedge against accepting too much risk. You will see examples of this when we discuss spreads below. To buy an option by itself and make money on it requires a correct judgment about a stock price change in a short period of time. Except where you have special information about a company, I have usually not found this to be successful, especially after transaction costs.

Thus, in the IBM example above, unless IBM stock in fact goes over 87 within the following 30 days, you will lose money. If it should go to 94 during that period of time, you will make a $7,000 profit (less transaction costs). If you can double your money in a 30 day period it certainly is a good result. Personally, however, I have not been able to consistently predict stock prices over a short period of time well enough to benefit from this strategy.

A.4. Summary of the Call Purchase Strategy

You should buy a call only if there is some special reason why you want to be like an owner of the stock for a short period of time, and are willing to lose the premium. Generally option investors only buy a call as part of a more complex strategy, and not just one call by itself.

B. Buying a PUT (not recommended by itself)

Buying a put is another example of a simple option position where the risk is limited to the amount that you pay to buy the option.

B.1. the Strategy

The purchase of a Put gives you the right to SELL 100 shares of the stock at the strike price to the termination date.

For example, if you buy 1 IBM 85 March Put, you have the right to sell 100 shares of IBM at $85 through the third Friday of March. Note that you do not have to own the 100 shares that you might sell. You could always buy the 100 shares at the same time you sell them. On the third Friday of March, if IBM is at $80, you can buy 100 shares for $8,000, and simultaneously sell them (by 'putting' them to the person who sold the Put) for $8,500. Or, at any time during the life of the option, you could just sell the option for its market price. Once IBM stock drops below $85, the market price for the 85 Put options will be considerably higher than it was when the stock was at or over $85 per share.

B.2. Risk Analysis.

The only risk of buying a put is losing the amount you pay for the premium.

B.3. Benefit Analysis

Purchasing a Put can be viewed in several ways. For some investors it is a way to profit from an anticipated drop in stock price. For others it is like buying an insurance policy. If you own 100 shares of IBM stock, and some event is about to happen that might adversely affect the price, or you plan to sell and want to defer the sale while not risking a drop in price, buying a Put can protect you against a decline in value of your holding.

B.4. Summary

As with buying a call, buying a put is usually only worthwhile if it is part of a larger strategy, such as using this purchase as a hedge against accepting too much risk. You will see examples of this when we discuss spreads below. To buy an option by itself and make money on it requires a correct judgment about a stock price change in a short period of time. Except where you have special information about a company, I have usually not found this to be successful, especially after transaction costs.

An example of when it would be appropriate to buy a put is at year end, when you have a large position that you don't want to sell until after the first of the year, for tax purposes. If you do not want to risk a decline in the price until you are ready to sell, you can put a put, like insurance, to protect against a decline in the value. Since you are only holding the put for a short time, the cost may be nominal.

C. Selling an Option

The next simplest group of positions is to sell an option. But this is quite a bit more complicated than buying an option.

C.1. Risk Analysis of selling an option

First of all, when you sell any option there is a big difference between selling an in-the-money option and selling an out-of-the-money option. Selling an in-the-money option subjects you to much higher risk than selling an out-of-the-money option. And selling a long-term option usually brings in a much higher premium than selling a short-term option. But selling any option, by itself, generally subjects you to a very substantial market risk. For this reason, there are very few cases where it would be appropriate for an investor to just sell a Call or (to a lesser extent'see below,) a Put, except where the sale is part of a larger strategy. Absent the ability to absorb the worst case risk, and absent extremely unusual and dependable information, this is the one area of option trading which is most likely to be inappropriate for most investors.

Figure 1: This figure compares the risk of sale of an In-the-Money CALL with an Out-of-the-Money CALL. The index is at 300 on this chart. If you sell a 310 call, the price might be 1 or 2 points, depending on the volatility of the stock ' or less if there is low volatility. The index has to move up 10 points, or approximately 3%, before you start to loose money. This is an out-of-the-money call, and the premium is all based on risk. If you sell a 290 call, it is in-the-money. The price will be over $10 of intrinsic value, because the right to buy something at $290 when the market value is $300 is always worth at least $10. In this case, the risk of profit or loss is much greater than in the out-of-the-money call because the value will change dollar-for-dollar with the stock price. Since most stock prices change at least weekly, there will regularly be changes in the call value.

C.2. Risk Analysis: Selling an in-the-money call versus an out-of-the-money call

Why does the sale of an in-the-money Call put the seller at greater market risk than the sale of an out-of-the-money Call? Take a look at Figure 1. The seller of the out-of-the-money Call has a window of stock price volatility before the risk of loss materializes -i.e., the price increases to the strike price. But the seller of the in-the-money (or at-the-money) Call is subjected to loss point-for-point with a rise in the stock price.

Because the sale of an in-the-money Call can produce a large cash influx into your account (the intrinsic value), one sometimes sees brokers selling them to cover up losses. The cash premium inflates the cash position in the account, although if the option is priced on the statement it reduces the account value. But in-the-money options usually have a lower time value premium component, and are therefore less valuable as a way to collect premium income. And premium income is what you can profit from, not cash from intrinsic value. Cash collected from a sale with intrinsic value is just trading risk for cash on a temporary basis.

As far as I know, there is rarely a valid reason for you yourself, or you on behalf of someone to whom you owe a fiduciary duty, to sell an uncovered call solely in the expectation of making a profit from that single position. That is because there is, in every case that I can think of, a way to hedge the risk for a nominal sum, without interfering with the primary motive of potentially profiting from the sale of the Call option. Since there is always some combination strategy which will work almost as well as the individual option sale, it seems to me generally inappropriate to engage in the simple sale of an option - except in one situation - the uncovered Put.

D. Selling a Put

Under proper circumstances, selling an uncovered Put is a more conservative investment strategy than buying and holding stock.

D.1. the strategy

The sale of a put, by itself, is generally done in an attempt to acquire the stock at a price below the current market price. For example, if you want to buy 100 shares of IBM stock at 80, but the stock is at $90, you could (1) call your broker and place a 'good till cancelled' order to buy the stock at 80; or (2) sell an 80 put. If you elect the second alternative, you will be paid a premium, so it is clearly the better choice.

Suppose, again, that I would be willing (and am financially able) to buy 100 shares of IBM at $80. But the stock is now at $90. At 90 I don't dislike it, but I don't love it. At closer to $80 I love it, and I want it. So I sell the 90 day 85 PUTS at, say, 3 points (or I sell the 90 PUTS at say, 7' points if I really want the stock.) This means I agree to buy the stock at the strike price (85) at any time during the option period, because my net cost, with the premium I receive, is a price I am willing to pay. In the case of the 85 Put with a $3 premium, that price would be $82. If I can get a $7.50 premium for the 90 in-the-money Put, my price will be $82.50.

D.2. Risk Analysis

At expiration, if the stock has remained above my strike price, I keep the earned premium I received, and I may elect to rewrite a new position. I can keep rewriting until either (1) the stock dips to my strike price, and I acquire it, (2) it rises beyond the point where there is any significant premium in the 85 PUT (or maybe I roll up to a higher strike price), or (3) I have made so much premium income writing these Puts that I retire from the market

Sometimes these combinations, which we will study later, can get very complicated, so just glance at this and save it for later; this represents how options can sometimes save you if you buy a stock that goes down.

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Figure 1b: This figure shows the use of in-the-money CALL as a Hedge for an out-of-the-money PUT that went in-the-money. By selling the call, I picked up $3 of Time Value Premium. Added to the $2 received on the original sale of the put, I have received $500 in premium. I own the stock at $95 and the stock is worth $91 ' so I could sell out and approximately break even on the transaction. While the goal was not to break even, that's not a bad result for a stock that fell 10% in 60 days.

Any of these alternatives is not bad. The only negative is that if IBM moves up to $250 and never dips, I will kick myself for having written Puts instead of buying the stock. But my billfold, swollen from profits from Put premiums, will shelter the blow!

D.3. Benefit Analysis

Writing puts in situations where the investor is willing and able to take delivery of the underlying stock is a sound conservative strategy. The main caveat is to be sure that you have enough money on hand to buy the stock if that becomes the result of the position.

D.4. Summary

The purchase of a put is used to act as insurance against a drop in a stock price. Like the purchase of life insurance, you expect to lose the premium, and are glad to lose it (considering the alternative). The sale of a put, by itself, is used to try to acquire stock that you otherwise wish to buy anyway, at a price below the current market price. Viewed in this light, the sale of a 'naked' put could be deemed to be one of the view 'zero risk' investments that can be made. It is 'zero risk' because the risk is no greater than had you just purchased the stock, but you receive a premium just because you are willing to commit to purchase the stock.

E. The Buy-Write Strategy [Strongly recommended]

One of the most common institutional options strategies is the 'buy-write.'

E.1. the strategy

In this trade, the investor buys a stock and writes a Call against the stock (Figure 2).

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Figure 2: This figure demonstrates the Buy-Write strategy. I bought 1000 shares at $100 and sold 10 calls at 100 at $2.

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Figure 3: This figure demonstrates the Buy-Write yield scenarios. The first scenario yields $12,000 plus dividends before the stock was called away because the stock went up; the second scenario yield is $2,000 plus dividends because the stock stayed the same, but the premium was a profit. Naturally if the stock goes down more than the amount received for the premium it will create a loss.

E.2. Examples of Risks and Benefits

Absent some special strategy, the Call is typically 5-10% out-of-the-money. Let's look at an example:

On January 20 I buy 1,000 shares of IBM at $100 a share, investing $100,000. Simultaneously I sell 10 CALLS of the April 110's for two points, taking in $2,000 of premium. Now my net cost per share is only $98. If IBM stock goes over $110 during the following 90 days, absent some action on my part, it will be called away from me (that is, sold to the owner of the Call) at $110. So there are three possibilities:

1.IBM stock goes down. In this case I keep the premium, and I am more than $2,000 better off than had I just bought the stock. Obviously, if I intended to buy IBM stock anyway, selling the Call was a good move.

2.      IBM stock does not fluctuate very much during the 90 day period. Again, I keep the $2,000 premium, and, coupled with the quarterly dividend of just under 1% per annum, I have increased my yield approximately 8% annualized. I get that figure by taking $2,000/100,000 for 1/4th of the year, or 2% times 4.

3.      IBM stock goes over $110 during the 3 month period. If I allow the stock to be called away (without buying other stock to deliver), I will make a $10,000 capital gain, plus the $2,000 premium, plus any dividend declared during this period. My annualized return will be approximately 30%!

Of course, I can't always get 2 points for a call 10% out of the money on a stock like IBM, and it is a stretch to write it exactly four times in one year. But you get the idea.

E.3. Summary

By writing an 'out-of-the-money call what I gave away was the potential for a really large profit in the IBM stock during the 90 day period (life of the call). For this reason, the buy-write strategy is not appropriate for those who want to get rich quickly. It's best for those who want to enhance their returns on stock.

If the stock goes over $110 and I don't want to sell the stock, I can buy back the Calls (at a loss) at any time. Of course, the loss is offset by the unrealized gain in the stock price. Or, I can buy back those Calls and sell other Calls at a higher strike price and in a different time frame. These are 'rolling' strategies which are described in greater detail in a later tutorial.

F. Summary of Simple Positions and Strategies

The simplest position to take in options is to buy an option. But experts in the market will tell you that most people who buy an option lose money on it. Some say that since there are two sides to every trade, there must be an even number that make money and lose money. But with commissions, that's clearly not true: the sellers have the advantage. Certainly in many cases the option buyer hopes to lose money on an option, since the option is purchased as a hedge for some other kind of position, and that position makes a large profit which is only slightly reduced by the cost of the option. Think of it as insurance.

I believe that most sophisticated investors will agree, however, that merely buying a Put or a Call for the purpose of expecting it to go up in value is rarely a good investment. Naturally, there are special circumstances where the investor has a strong basis for believing that there will be a substantial short term movement in a particular stock or in the market as a whole. In these circumstances the purchase of an option makes sense. In such a situation, the purchase of an option with a risk of loss appropriate for the investor should not be considered as a risky investment, because the risk of loss is limited to the cost of the investment, and therefore can be carefully evaluated by the investor at the initiation of the investment.

The other side of that transaction is to sell an option. Selling a Call, by itself, without being hedged or as part of a combination, puts the seller at the risk of a loss which is usually very large compared to the potential profit. Even a non-volatile stock may be subject to a takeover, can have a very substantial increase in a short period of time, and can therefore subject the naked Call seller to great risk.

The seller of a naked Put on any stock, no matter how highly valued for stability, subjects the seller to a substantial risk, since adverse news or information about the company or industry can cause a substantial decline in the value of any stock. Who could have predicted the uncovering of massive fraud either in the Equity Funding Corporation or the Technical Equity Companies; the American Express scandal or the LTV bankruptcy' What about Enron and WorldCom? But to write (sell) a naked stock Put is a very conservative move as a method of capturing ownership of a stock during a decline, at a price reduced by the premium.

The buy-write is a widely used method of increasing the current income from stock holdings, while giving up only some portion of the upside potential. This technique is a low risk option technique, provided that the investor has already decided to accept the risk of holding the stock. A large capital investment is required to participate in a buy-write, and that is its main drawback. For this reason, this strategy is often favored by institutional investors that have the capital available for wide diversification. There are also potential tax drawbacks which are discussed below under 'tax considerations.'

The basic option strategies that I consider often inappropriate for the conservative investor are the following:

1. Selling an uncovered stock Call.

2. Selling more uncovered stock puts than you are prepared to convert to long term stock holdings if the stock is put to you.

3. Selling any uncovered index option that is not part of a hedged strategy.

The following basic strategies stand out as those used regularly by professionals to make money in the options market:

1. Acquiring stock at a discount, or during a price dip, by selling puts.

2. Selling out-of-the-money Calls against stocks owned, to generate premium income. When the stock is purchased at the same time the Calls are written, this is called a 'buy-write.'

In Tutorial 2 we will look at the buy-write more carefully, with current examples of such trades. If you want to get ready for this, you can enter the sample trades in 'Merv's letter' that will come to you with this tutorial, and follow them every few days on your computer to see how changes in the stock price affect your unrealized profit or loss on these positions.

DISCLAIMER: This is an educational site. The trades suggested on this site are examples to help the readers understand the principals of option trading. They are not intended as "tips" for actual trading and are suggested so that the reader can enter and follow hypothetical trades in the portfolio manager.

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