In the previous blog we have covered the option basics. Here are a few investing strategies using options.
We discussed buying and selling options (both puts and calls) which can we worded as buying the right (but not an obligation) to buy or sell (calls or puts respectively). Similarly an investor can also initiate an options contract by writing it (called writing as the investor initiated the contract). So this investor will be selling the right to buy or sell the underlying shares to the investor buying such a right. If the investor buying such a right decides to exercise it the investor who has written the contract has to oblige. So broker of an investor writing an option generally will not let them right the option unless this investor shows the ability to meet the obligation. When the investor writing an option demonstrates the ability to cover/ meet that obligation the option he/she sells are called covered option.
Investor writing a covered call (person buying this call may decide to exercise the right and buy the underlying shares at strike price) should demonstrate the availability of these shares till the call option they wrote expires.
Investor writing a covered put (person buying this put may decide to exercise the right and sell the underlying shares at strike price) should demonstrate the availability of cash to buy these underlying shares till the put option they wrote. This availability of cash can be done by having cash, generating cash by short selling (cannot close the position till option expires)
Investors writing call or put options cannot use stop losses but have to wait till the option expires or gets exercised.
Spreads
There are ways to reduce risks associated with writing these covered options. Easy way to offset this risk is to buy and sell (write) the same type of option at a different strike price and/ or different expiry. Here is a current example. Price of BAC on 7th June 2009 is $11.86
Sell Jan 2010 Call of BAC for $0.53/ share at strike price of $20 (Profitable below 20)
Buy Jan 2010 Call of BAC for $1.42/ share at a strike price of $15 (Profitable above 15)
So investor gains $0.53 per share of liquidity by selling such a call of 100 shares and pays out $ 1.42 to buy the call. The investor here believes that the stock price will be between 15 and 20 by the option expiry date.
Lets look at selling these calls with and without using spreads. An investor is hoping that that his sell or writing an option makes money.
Case 1: Stock price above $20 (say $25)
i.e. this investor sold the right to other investor to buy BAC at $20. This call got exercised so the selling investor will now exercise the $15 call option and sell the shares to the other investor at $20.
Selling Investor’s balance sheet/ share
With Spread
+0.53 (sale of call)-1.42 (buy of call)-15 (exercise call)+ $20 (proceeds from the option which got exercised)= profit of $4.11/ share
Without spread:
+0.53(sale of call)-25 (buy at market price)+ 20 (proceeds from the option which got exercised)= loss of -4.47/ share
Case 2: Stock price below $20 (say $13)
So the sold call won’t get exercised and the investor won’t exercise the call they bought either and let his bought call expired.
With Spread
+0.53 (sale of call)-1.42 (buy of call)= loss of $0.89/ share
We discussed buying and selling options (both puts and calls) which can we worded as buying the right (but not an obligation) to buy or sell (calls or puts respectively). Similarly an investor can also initiate an options contract by writing it (called writing as the investor initiated the contract). So this investor will be selling the right to buy or sell the underlying shares to the investor buying such a right. If the investor buying such a right decides to exercise it the investor who has written the contract has to oblige. So broker of an investor writing an option generally will not let them right the option unless this investor shows the ability to meet the obligation. When the investor writing an option demonstrates the ability to cover/ meet that obligation the option he/she sells are called covered option.
Investor writing a covered call (person buying this call may decide to exercise the right and buy the underlying shares at strike price) should demonstrate the availability of these shares till the call option they wrote expires.
Investor writing a covered put (person buying this put may decide to exercise the right and sell the underlying shares at strike price) should demonstrate the availability of cash to buy these underlying shares till the put option they wrote. This availability of cash can be done by having cash, generating cash by short selling (cannot close the position till option expires)
Investors writing call or put options cannot use stop losses but have to wait till the option expires or gets exercised.
Spreads
There are ways to reduce risks associated with writing these covered options. Easy way to offset this risk is to buy and sell (write) the same type of option at a different strike price and/ or different expiry. Here is a current example. Price of BAC on 7th June 2009 is $11.86
Sell Jan 2010 Call of BAC for $0.53/ share at strike price of $20 (Profitable below 20)
Buy Jan 2010 Call of BAC for $1.42/ share at a strike price of $15 (Profitable above 15)
So investor gains $0.53 per share of liquidity by selling such a call of 100 shares and pays out $ 1.42 to buy the call. The investor here believes that the stock price will be between 15 and 20 by the option expiry date.
Lets look at selling these calls with and without using spreads. An investor is hoping that that his sell or writing an option makes money.
Case 1: Stock price above $20 (say $25)
i.e. this investor sold the right to other investor to buy BAC at $20. This call got exercised so the selling investor will now exercise the $15 call option and sell the shares to the other investor at $20.
Selling Investor’s balance sheet/ share
With Spread
+0.53 (sale of call)-1.42 (buy of call)-15 (exercise call)+ $20 (proceeds from the option which got exercised)= profit of $4.11/ share
Without spread:
+0.53(sale of call)-25 (buy at market price)+ 20 (proceeds from the option which got exercised)= loss of -4.47/ share
Case 2: Stock price below $20 (say $13)
So the sold call won’t get exercised and the investor won’t exercise the call they bought either and let his bought call expired.
With Spread
+0.53 (sale of call)-1.42 (buy of call)= loss of $0.89/ share
Without spread
+0.53 (sale of call)= profit of $0.53/ share
Case 3: Stock Price between $20 and $15 (say $ 18)
So the sold call won’t get exercised and the investor will be able to exercise the call they purchased
With Spread
+0.53 (sale of call)-1.42 (buy of call)-$15 (exercise call)+$18 (sell at market)=
Profit of $ 2.11/ share.
Without Spread
+0.53(sale of call)= Profit of $0.53/share
Straddle:
For a stock in news with high expected fluctuations, an investor can buy both a call and a put on the same underlying security at same strike price. So the investor makes large profit in one direction and small loss in the other direction. Generally Straddle will have a strike price close to the market price of the stock when the straddles are bought.
Example
Here is a current example. Price of BAC on 7th June 2009 is $11.86. Now we are talking about a certain event which may occur in the near future so lets consider options expiring in June 2009. We will consider buying call and put close to current market value of $11.86
Buy Jun 2009 Call of BAC for $0.55/ share at strike price of $12 (Profitable above $12)
Buy Jun 2009 Put of BAC for $0.62/ share at a strike price of $12 (Profitable below $12)
Positive news
So say there is positive news for BAC and stock jumps 15% to 13.63 (so call is in the money). We assume that this investor will sell these options after the news is released. Also we assume that the value of option not in the money will reduce by three times as much%.(ie.45% reduction that original value)
Investors balance sheet will look like
-.55(price paid for call)-0.62 (price paid for put)+1.63 (intrinsic value of call)+0.341(reduced value of put)=0.801/ share profit
Negative news
So say there is negative news for BAC and stock slides 15% to 10.08 (so put is in the money)
-.55(price paid for call)-0.62 (price paid for put)+1.92 (intrinsic value of put)+0.302 (reduced value of call)= 1.052/ share profit
So a Straddle will produce a profit in case of big price fluctuations.
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