fool.com_ options trading

Motley Fool options wiz, Jeff Fischer -- an

extraordinary trader with a documented 93%

success rate -- leads two exclusive groups

committed to achieving bigger returns in up,

down, and sideways-moving markets:

Motley Fool Options, ourdedicated options service, hasbeen piling up profits anddazzling members...

Motley Fool Pro, our slightlymore sophisticated tradingservice, employs options, ETFs,and other advanced hedgingstrategies to help membersachieve their financial dreams...

And because we're committed to maximizingthe profit potential and experience for ourpremium members -- Motley Fool

Options and Motley Fool Pro are by

invitation only...

So if you're interested in learning moreabout Motley Fool Options, or slightlymore advanced Motley Fool Pro, simply

click the button below. We will notify youthe moment either service beginsaccepting new members.

Click HereIt's Free!

The Motley Fool "Options Edge" Handbook

By Jeff FischerFrom Motley Fool President,Scott Schedler

Dear Fellow Investor,

You're in a very fortunate position...

The market of the last year or two is creating some unique opportunities. That's why I've arranged for Jeff Fischer (the expert

behind our two premium trading services, Motley Fool Options and Motley Fool Pro) to reveal to you some of his most powerful,

and widely useful, options trading strategies in this special "Options Edge" handbook.

Jeff Fischer is a long-time Fool who co-managed the original Rule Breaker

portfolio from 1994 to 2003 with Motley Fool co-Founder David Gardner.

Together they helped investors earn more than 20% per year. More

recently, Jeff began focusing on options to take advantage of moments of

unprecedented volatility. And of his last 42 trades -- 39 have generated

serious profits. That's a staggering 93% rate of success.

And what's truly exciting are the profits that are still to come!

With access to all of The Motley Fool's resources -- all the research and

coverage from our newsletter team, and all the community intelligence of

CAPS -- Jeff is prepared to zero in on short-term price moves and

leverage his considerable trading expertise.

And this special "Options Edge" handbook is a perfect primer if you, too,

are interested in building wealth in up, down, and even flat markets. Inside

you'll discover the tools to profit more substantially, and more assuredly,

than at any point in recent history!

It's all part of The Motley Fool's ongoing commitment to empowering you,

the individual investor.

Kindest regards,

Scott Schedler

President, The Motley Fool

Fool.com: A Motley Fool Special Report http://www.fool.com/newsletters/50/sfr/01/PrintAll.htm?v...

1 of 23 2009/12/13 12:06






Motley Fool Options, our

dedicated options service, has

been piling up profits and

dazzling members...

"84% gain in 3 weeks..." I closed myNVDA covered call option at a 84% gain in3 weeks!!! I would never ever thoughtabout using options in my years ofinvesting if it wasn't for Jeff and Jim.Thanks guys. -- S.S. Melrose Park, IL

"Add to my education and wealthbuilding...." "I've been able to add optionsto my toolbox. I have seen the potentialoptions can add to your portfolio and knowthis service will add to my education andwealth building. -- D. Heredia, Keller, TX

Motley Fool Pro, our slightly

more sophisticated trading

service, employs options,

ETFs, and other advanced

hedging strategies to help

members achieve their

financial dreams...

"Incredible" "My average investmentreturn per month is 11%, which will bringmy annual to 132%. Wow! That isincredible! Am I missing something or canthis be true?"-- A. Ward in Brighton, Michigan

"In for the long haul..." "I will be in for thelong haul with this philosophy!!!! I wish Ihad been 'playing the FOOL' since 1995,but just since February 2009 it has beenextra fine. Rock on!" -- G. Seibert, Marietta,Georgia

And because we're committed to maximizingthe profit potential and experience for ourpremium members -- Motley FoolOptions is by invitation only...

Why Options?

Options are ideal for generating income, protecting profits, and most importantly, earning outsized gains! They can generate

returns in flat markets, cushion the blow of down markets, and be outstanding performers in decent markets. So basically,

whatever your investment goals, options can be a powerful addition to your portfolio.

And it's important for you to know that I advocate trading options as an investor, not as a speculator. In other words, every option

trade we make should be based on thorough analysis of the underlying stock and its value. That way, the option is simply a way

to leverage what we know about a stock.

What Are Options?

Stock options formally debuted on the Chicago Board Options Exchange

in 1973, although option contracts (the right to buy or sell something in the

future) have been around for thousands of years.

Applied to stocks, an option gives the holder the right, but not the

obligation, to buy or sell an underlying stock at a set price (the strike

price) by a set date (the expiration date). The option contract allows you

to profit if a stock moves in your favor before the contract expires. Not all

stocks have options -- only those with enough interest and volume.

There are only two types of options: calls and puts. A call appreciates

when the underlying stock rises, so you buy a call if you are bullish on that

company. A put appreciates when a stock declines. You buy a put if you

believe a stock will fall or to hedge a stock that you already own. One way

to remember this is: "call up" and "put down"...

By the way, there's an Options Glossary in the back of this handbook for

you to use at any point!

Next, let's walk through the most common options trades: buying calls,

buying puts, selling covered calls, and selling puts.

Strategy Why

Buy Calls

When you believe a stock will rise significantly

over time and you want to leverage your returns or

minimize capital at risk

Buy PutsTo short a position or to hedge or protect a current

long holding

Sell Covered

Calls

(sell to open)

To earn income on shares you already own while

waiting for your desired sell price

Sell Puts

(sell to open)

To get paid while waiting for a lower share price

(your desired buy price) on a stock you would be

happy to buy

Buying Calls

Investors often buy call options rather than buying a stock outright to


2 of 23 2009/12/13 12:06

So if you're interested in learning more

about Motley Fool Options, or slightlymore advanced Motley Fool Pro, simplyclick the button below. We will notify youthe moment either service beginsaccepting new members.


obtain leverage and potentially increase returns several-fold. Call options

work as "controlled" leverage, enhancing your possible returns while

limiting your potential losses to only what you invest (which is usually a

much smaller amount than a stock purchase would be). Because each

option contract represents 100 shares of stock, an investor can control --

and benefit from -- many shares of stock without putting a lot of capital at

risk. When you make the right call, you'll enjoy higher returns than you

would have if you had used that money to buy the actual shares.

Let's look at an example. Imagine that a stock that you know well has

been hit hard and now trades at $27 per share. You believe the shares

will rebound in the coming months or year. The market offers $30 call

options on the stock that expire in 18 months for $1.50 per share. Therefore, 10 contracts, representing 1,000 shares of the

stock, will cost you $1,500 plus commissions. This option contract gives you, its owner, the right to buy 1,000 shares of the stock

at $30 any time before expiration.

If your stock starts to rise again, your options will increase in value, too. Suppose the stock recovers all the way to $32 after a

few months. Your option's value would likely at least double to $3 or higher per contract. You've made 100% in a few months. If

you had simply bought the stock, you'd only be up 18.5%.

Of course, there is a flip side. Suppose your stock continues its decline to the abyss. Even 18 months later, it's below $20, so

your options expire worthless -- though hopefully you sold them at some point along the way to recoup part of your investment.

I like to buy longer-term call options on well-valued stocks that I believe will pay off handsomely over the coming months or

years. It's a way to take more meaningful positions in stocks I believe in -- without risking mounds of capital. This is useful if you

lack capital or just don't feel like risking it all in a stock.

As with any investment, you should only invest what you can afford to lose, since a stock can easily work against you in a set

amount of time and make your call worthless. Where real opportunity can be lost is when your timing is wrong. Your options

might expire before the stock rebounds, causing you to lose your option money and miss the stock's eventual rebound. Thus, we

aim to buy longer-term calls in positions in which we have high confidence and that have near-term catalysts.

Buying Puts

Next up, the antithesis to call options: puts.

Buy put options when you believe that the underlying stock will decline in value. Buying puts is an excellent tool for betting

against highly priced or troubled stocks, or even entire sectors! With put buying, your risk is again limited to the amount that you

invest in stark comparison to traditional short selling, where your potential losses are unlimited. Ouch!

Aside from betting against a position with puts, you can also buy puts to protect an important position in our portfolio, one that

you don't want to sell yet for any number of reasons. When a stock being protected -- or hedged -- in this way declines for a

while, the puts will increase in value, smoothing out returns.

I tend to buy puts on stocks that I believe are due to decline over the coming months or even years. You may also use puts to

hedge long positions that you own, or to short sectors and indexes in a small portion of your portfolio. I almost always buy puts

rather than short something outright to limit my risk.

Selling Covered Calls

Now our overview moves from the act of buying options to, instead, selling them to others.

Any qualified investor can "sell to open" an option contract. When you do so, you don't pay the premium; instead, as the contract

writer, you get paid. All cash generated from your option selling is paid immediately and is yours to keep.

"Covered" simply means that we own the underlying stock at the same time. Writing covered calls is one of the most

conservative options strategies available. In fact, most retirement accounts allow you to write covered calls. They're generally

used to generate income on stock positions while waiting for a higher share price at which to sell the stock.


3 of 23 2009/12/13 12:06

When to write Covered calls

You would sell a stock that you own at a

higher price, and you're not worried

about it declining too much in the

meantime. Write calls at your desired sell

price, collect the dough, and then kick

back and wait. Rinse and repeat, month

after month, when you can.

You believe a stock you own is going to

stagnate for a while, but you don't want

to sell it right now. Write calls to make

the stagnation more profitable.

You want to cushion a stock that is in

decline, but that you're not ready to sell

yet. Tread carefully here so you don't get

sold out at too low a price.

Here's an example of a covered call. Suppose you own 1,000 shares of a stable, blue-chip stock. It's trading at $56, but you think

it is fairly valued around $60 and you would be happy to sell at that price. So you write $60 call options on the stock expiring a

few months ahead, and you get paid up front to do so.

If the stock does not exceed $60 by your option's expiration, you keep your shares and you've made money on the call options.

You could then write more calls if you wanted to. If the stock is above $60 by expiration and you haven't closed out your call

option contract, you'd sell your stock at $60 via the options. Your actual proceeds on the sale would include the option premium

you were paid. So you sold your shares at the price you wanted to and received some extra cash for doing so. That's pretty

sweet.

So, write covered calls when:

You would sell a stock that you own at a higher price, and

you're not worried about it declining too much in the meantime.

Write calls at your desired sell price, collect the dough, and

then kick back and wait. Rinse and repeat, month after month,

when you can.

You believe a stock you own is going to stagnate for a while,

but you don't want to sell it right now. Write calls to make the

stagnation more profitable.

You want to cushion a stock that is in decline, but that you're

not ready to sell yet. Tread carefully here so you don't get sold

out at too low a price.

When you write covered calls, you must be prepared to give up your

shares at the strike price. Approximately 80% to 90% of options are

not exercised until expiration, but they can be exercised early, so the

call writer has to be prepared to deliver the shares at any moment.

That means that if the $56 stock in the example above suddenly

soars to $70, you'd still have to sell at $60. This is the biggest

downside to covered calls -- lost potential if a stock price rises. The

other risk is that a stock may fall sharply after hovering around your

desired sell price for a while, forcing you to wait longer for your sell price.

Even though covered calls are low risk, you should use them only on stocks you know well. You could even set up some

covered call-only positions -- buying a stock just to write calls on it.


4 of 23 2009/12/13 12:06

Selling Puts

Note: to sell puts, you must have a margin account. You won't actually need to use margin -- which entails high risk -- but you

must be margin-approved, have ample buying power (cash, in our margin-free strategy), and have full options permission from

your broker.

Selling puts -- also referred to as selling naked puts -- is a favorite strategy of mine to seed a portfolio. There may be plenty of

stocks that I'd like to buy at the start, but I'd prefer to snag them at lower prices. Put options are an excellent way to potentially

buy a stock at your desired, lower share price and get paid an option premium while waiting for that price, whether it arrives or

not.

Let's turn to an example: A top-rated stock we found on Motley Fool CAPS and researched thoroughly is trading at $39, but our

analysis suggests that we shouldn't buy it above $35. The $35 put options expiring four months out are paying $3 per share. We

"sell to open" the put contracts and get paid $3 per share to make the trade, giving us a potential net purchase price of $32

before commissions. A few things could happen here.

Scenario 1: The stock could stay above our $35 strike price; the options we sold would expire. We didn't get to buy the

stock at the price we wanted, but at least we made money on the options we sold.

Scenario 2: The stock could fall below $35 by expiration. In this situation, our broker would automatically buy the stock for

our account, giving us a start price of $32 before commissions -- even lower than our $35 desired buy price!

Scenario 3: The stock may tank to $29 soon after we sell the puts, but then climb back above $35 by expiration. In this

case, we most likely would not have had the shares sold to us during this brief decline because about 80% of options are

exercised only at expiration, not before. So we won't own the shares, and we'll have missed our buy price and the stock's

rebound -- but we did get paid the premium, at least, and can try again.

Scenario 4: The company's CEO flees to Bermuda and the stock is only at $16 by our option's expiration. We didn't

have the heart to close our losing option position, and we still have hope, so we wait and the shares are "put" to our account at

$35 (minus our option premium) upon expiration. This is the worst-case scenario -- we're down 50% to start. But we own the

stock now and can hope it rebounds. Of course, assuming that we would have bought the stock outright when it hit our $35 buy

price, as we had considered, we would be down even more than we would be with this strategy.

You should most often sell puts when a stock you follow closely and want to own is, alas, above your desired buy price. You

should sell puts on it at lower strike prices, prices that you believe are great levels at which to buy. Either you eventually get to

buy the stock at your desired price via the puts, or you keep writing puts if the situation merits it. You may also sell puts when a

stock you already hold a partial position in is above the price where you'd like to buy more. You can write puts as you wait to

average in at lower prices. This is a great tool for allocation and averaging into a position.

Writing puts on stocks you know well and want to own at lower prices can be an excellent tool for income and for securing lower

buy prices, but you must be prepared to buy the stock should it fall below your strike price. At all times, you must maintain the

cash or margin (for us it's always cash and we recommend you follow that rule, too) to buy shares if they are put to you.

It's important that you only write puts on stocks that you understand well and will be happy and ready to buy at the prices you're

targeting. The risks of writing puts include the fact that the stock could soar away without you. In many cases, it's better to just

buy a great stock once you've found it. The other risk, of course, is that a stock falls sharply and you're stuck owning it. The

biggest risk with selling puts, as with all options, is when investors rely on margin instead of cash. That can quickly wipe out a

portfolio.

Let's review...

Call Option Put Option

Option buyer

The right, but not obligation, to buy a stock

at a set price (the strike price); calls

appreciate as the stock rises (remember:

"call up")

The right, but not obligation, to sell a stock at a set price

(the strike price); puts appreciate as the stock falls

(remember: "put down")


5 of 23 2009/12/13 12:06

When to write puts

You're ready and willing to buy a stock at

a lower price and

You don't believe the stock will soar

away from you in the meantime

(otherwise you'd just buy the stock), or

You just want to make income writing

puts. You don't believe a stock will drop

to your buy price, but if it does, you'd still

be happy to buy it.

Option writer (or

seller)

The obligation to sell a stock at the strike

price; must hold the stock in the account.

This is called a "covered" position.

The obligation to buy a stock at the strike price; must

have the buying power at the ready (preferably in cash) in

case the stock declines

Option buyer Believes the underlying stock will rise Believes the underlying stock will fall

Option writer (or

seller)

If the stock rises, is ready to sell shares at

the strike price, keeping the premium paid for

writing the option

If the stock falls, is ready to buy it at the strike price,

keeping the premium received for writing the option

8 Tips for Writing (or Selling) Puts

Always choose a strike price at which you'd be happy to buy the stock.

Focus on strong businesses that you'd be excited to own for the long term.

Write "out-of-the-money" puts, meaning your strike price is below the stock's current share price.

Verify that the option premium payment makes the trade worthwhile.

Remember, you often won't get to buy the stock; you'll just get option income. That's why we sometimes write puts on

stocks in which we already own partial positions.

Put writers do not collect dividends paid by the underlying stock.

Never overextend yourself by writing too many puts. Brokers allow put writing on margin, but we write puts when we have

the cash to buy the stock.

Vary the expiration dates among your individual option holdings so they don't all fall in the same month -- this staggers

your risk.

You may write "in-the-money" puts with strike prices above the current share price when you're especially bullish on a

stock and want to capture more upside potential with its options. This strategy also increases the odds that you get to buy

the stock. When you write in-the-money puts, the guidelines in our table don't apply.

Put writing is a bullish, or at least neutral, strategy. When you write a put, you're saying you believe the underlying stock will

eventually increase in price (hopefully after you've bought shares), or at least hold steady -- meaning you'll earn income on your

puts when they expire.

Let's use an example: Assume you're bullish on the health-care company, Kinetic Concepts (NYSE: KCI). The stock increased

from $20 to $25, so you're not as anxious to buy it. If the shares fell to $22 or so, however, you'd be happy to buy. Rather than

just sit and wait, you can write (remember, that's "sell to open") the $22.50 strike price put options. You'll get paid while you wait,

and you'll potentially get that lower buy price.

Before placing this trade, make sure you have the cash (or, for

experienced investors, ample buying power) in your account to buy a

minimum of 100 shares of Kinetic. You can then write $22.50 puts

that expire in a few months. Let's say the puts pay you $1.50 per

share, and you write two contracts representing 200 shares of

Kinetic. You're paid $300 (minus commissions) up front. And now you

wait (cue the Jeopardy theme).

If Kinetic Concepts ends this time period above $22.50, your options

simply expire, and you keep the $300. You can then write new puts if

you'd like. If Kinetic dips below $22.50 at the option's expiration, the

puts you wrote will be exercised, and you're on the hook to buy 200

shares of Kinetic at a strike price of $22.50. Including the option

premium you received, your start price is actually $21. Nice! Now you

own shares at an attractive start price and can wait for appreciation.


6 of 23 2009/12/13 12:06

So, you write puts when:

You're ready and willing to buy a stock at a lower price and

You don't believe the stock will soar away from you in the meantime (otherwise you'd just buy the stock), or

You just want to make income writing puts. You don't believe a stock will drop to your buy price, but if it does, you'd still be

happy to buy it.

What Can Go Wrong?

Sounds perfect, doesn't it? You're paid to potentially buy a stock you wanted to buy anyway -- and at a price you like. That's

beautiful.

But every investing strategy has some risk. In this case, assume Kinetic Concepts doesn't fall below $22.50 by the time your

option expires, but instead jumps to $30 over the next few months. You miss out on a $5 stock gain for only a $1.50 gain in the

put options, and you still don't own shares. Now what do you do? It might be a tough call.

Kinetic could also drop to $22 soon after you write your puts, but then climb back to $25 just as your puts hit their expiration

date. Because almost all options are exercised only at expiration, you won't get the shares, and you will have missed your buy

price. Of course, you keep the $1.50 option premium and can write new puts, but what if you miss your buy price again?

There's also the scenario that the stock drops and doesn't come back up for a long time. If Kinetic fell to $17, your options would

be far underwater. In this case, you must be ready to just buy the stock at your net price of $21 and hope for a rebound. At least

you're getting a much lower start price than if you had simply bought the stock outright at $25 on day one.

But if you no longer wanted to own Kinetic even at $17 -- say there's a fundamental change in the business -- you would need to

buy back your puts ("buy to close") early -- and at a large loss. So, Fools, whenever you write puts, be confident that you want to

own the stock for the long haul.


7 of 23 2009/12/13 12:06









dazzling members...









financial dreams...



And because we're committed to maximizingthe profit potential and experience for our

Make Put Writing Worthwhile

When you like a stock enough to want to own it, be as certain as possible that it's a good strategy to write puts rather than just

buying the shares outright. In general, don't write puts when you believe a stock is greatly undervalued and about to take off --

just buy the stock. Write puts when you believe a stock is a good buy at a certain price yet is unlikely to leave you in the dust if

you don't buy it anytime soon.

Once you've identified a put contender, calculate whether the options are paying you enough to make the risks worthwhile.

Weigh both the risk of waiting to buy the stock instead of buying today (missing potential upside) and the risk if the stock falls

sharply.

You want a large enough cushion on your puts to ensure a much better valuation on the stock you'll potentially buy. At the same

time, you want enough payment from the options to make the trade worth your wait. The table below shows what to generally

seek on options expiring in four months or longer versus those that expire in a few months:

Fact or to

Consider

Options Expiring in 4

Months or More

Options

Expiring in 3

Months or

Less

Strike price

Strike price should be at

least 7% below current

stock price.

Strike price

should be at least

4% below current

stock price.

Trade's break-even

price (your strike price

minus the option

premium paid to you)

At least 14% to 17% below

current stock price.

At least 8% to 9%

below current

stock price.

Option premium

payment

At least 7% to 10% of your

strike price. (This is also

your return on the cash

you'll be keeping aside for

the possible stock buy.)

At least 4% to 5%

of your strike

price.

Target time frame

until option

expiration

No more than 9 months;

ideally, 6 months or less.

For the above

figures, ideally, 3

months or less.

Now let's apply these guidelines to a real-life scenario. On Nov. 11, 2008,

Kinetic Concepts was trading at $24.35 per share -- but let's say you

preferred to buy in the low $20s. The $22.50 January options, which

expire in just two months, we're bidding at $2.20 per share. The strike

price of $22.50 was 7.6% below the stock's current price of $24.35, and

the option premiums paid a solid 9.7% of your potential purchase price

($2.20 on a $22.50 strike price). Your breakeven price if you get the

shares is just $20.30 -- 16.6% below the current share price.

These numbers are great, especially for an inexpensive-looking stock and

options that expire in less than three months. Even if you didn't get the

shares at expiration, you would have earned $2.20 per share in two

months, or nearly 10% on the cash you have set aside for this trade.


8 of 23 2009/12/13 12:06

premium members -- Motley FoolOptions is by invitation only...

So if you're interested in learning moreabout Motley Fool Options, or slightlymore advanced Motley Fool Pro, simplyclick the button below. We will notify you

the moment either service beginsaccepting new members.


Bottom Line

Target healthy businesses with attractively

valued stocks, and your put writing strategy

should leave you happy, whether it generates

income or you end up buying the stock. Write

puts on stocks you'd like to own at cheaper

prices, or on stocks that won't likely decline

(but you'd happily own if they did) to generate

income. If you really want to own a stock,

though, buy at least some shares outright.

Closing Early and Rolling Forward

If you no longer want to potentially buy the underlying stock, or if you've

made most of your potential profit on the options, you can close your puts

early. Just "buy to close" the puts you sold earlier; you'll pay the going

market price, resulting in a gain or loss dependent upon what you were

paid for the puts at the start. In most cases, we won't close a put early at a

loss unless we're certain that we don't want to own the underlying stock

anymore -- which would mean our analysis was mistaken from the

beginning or something drastically changed at the company.

You can also choose to close your put-writing strategy early to write new

puts that expire in a later month, paying you a higher option premium. You

might do this if you've made most of the money you can possibly earn on

the trade (about 85% is our guideline); if you want more time for your strategy to play out; or if you simply want to be paid more

now for keeping the strategy in place, for any reason. This is called "rolling forward." Just make sure you can find attractive new

puts to write before closing your old ones.

Bottom Line

Target healthy businesses with attractively valued stocks, and your put writing strategy should leave you happy, whether it

generates income or you end up buying the stock. Write puts on stocks you'd like to own at cheaper prices, or on stocks that

won't likely decline (but you'd happily own if they did) to generate income. If you really want to own a stock, though, buy at least

some shares outright.

Broker Requirements

Applying for options trading permission with your broker involves filling out a form that they'll give you when you ask. Simply say,

"I'd like to apply for full options trading permission, please." You'll need to answer questions about your investing experience,

your assets, and a bit more. It can take a week or longer to get approved. If you plan to follow along with our options trades,

you'll want to apply for full permission right away.

With most brokers, you can buy options even if you have very little money, say $5,000 or $10,000. The advantage of buying an

option contract or two is that you can "control" many shares of the underlying stock for, typically, just a few hundred dollars. If the

stock rises, you'll earn strong higher returns on your money. However, to make options worthwhile after spreads and

commissions, we suggest have at least $10,000 in your account.

To sell -- or write -- options, you should have a higher account

balance and you'll need a margin account as well. Typically, a

brokerage firm will require about $25,000 before you can sell put

options, less if you wish to sell covered calls (there, you only need to

own the underlying stock). If you're not ready or able to sell puts yet,

that's perfectly fine. It's probably the strategy you should consider

last if you're new to options. We suggest starting with the more

practical (and less expensive) strategies of buying calls, buying puts,

or writing covered calls. As your account grows over time, you can try

out more involved options strategies.

When writing any options, the brokerage terminology used to start

the position is "sell to open." To later close the position, you would

use "buy to close." Writing options -- put-writing, specifically --

requires ample buying power in your account. Be sure to review your

cash and margin buying power before writing a put option.

Meanwhile, buying options is not unlike buying stocks. You can buy

options with cash or partly on margin, but margin is certainly not recommended.


9 of 23 2009/12/13 12:06

Collar Cheat Sheet

Protective collars can be used to shieldagainst downside risk in rocky markets orto safeguard gains when you're not readyto sell -- but would willingly sell at slightlyhigher prices.

Buy puts and sell calls with the sameexpiration date but different strike prices(the most attractive available).

You can "cover" all or some of yourshares.

The position you're protecting usuallyneeds to decline soon -- or sharply -- forputs to pay off handsomely.

Don't sell calls on stocks you're not willingto sell or that you believe are grosslyunderpriced.

Typically seek to use options that expirein six months or more -- or evenLong-Term Equity Anticipation Securities(a.k.a. LEAPS) that expire in 18 months ormore. This allows you to choose moreadvantageous strike prices and be paidmore for the calls.

Protective Collars

As you move deeper into the world of option strategies, you'll begin to find creative ways to protect, leverage, or hedge your

portfolio -- often with little downside risk and at little to no cost to you.

In this guide, you'll learn how to use options to protect an existing investment from downside, often without any out-of-pocket

expenses. This is called a protective collar -- and when it's free to you, it's called a costless collar.

Protective collars are useful in bear markets or when you're uncertain about a stock's valuation risk. They can also be a prudent

way to protect your gains on stocks that have recently leaped in price, nearing your estimate of fair value. Let's explain how

collars work, starting from the beginning.

Insure Your Positions by Buying Puts

As a long-term investor who remains committed to your core holdings, you

may be reluctant to sell even if you see storm clouds on the economy's

horizon. After all, life is full of ups and downs, and you can't simply disengage

when the going gets tough. However, when it comes to equities, you can

protect your portfolio by purchasing put options.

That's right. Purchasing options -- not selling them. When you sell options,

you are obligated to either deliver the shares (in the case of a call) or buy

shares (in the case of a put). But when you buy options, you're not under any

obligation regarding shares of the underlying investment.

So if you buy puts on a stock you own, and the puts gain value, you'll simply

sell those puts later for a profit and still keep your shares of the underlying

stock (assuming you want to). In other words, when you buy them, you're

using options as a strategy on their own, without needing to get the

underlying stock involved unless you want to.

Now let's explain buying puts, specifically. A put option goes up in value when

the underlying equity or exchange-traded fund declines in price. So when you

buy a put, you're basically buying insurance for your investment. A put gives

its owner the right to sell the underlying investment at a minimum set price

(the strike price) by a set date (the option's expiration date) no matter how far

it falls. In times of uncertainty, buying puts to protect your key holdings makes

plenty of sense. However, it can be expensive -- and who wants to shell out

piles of cash for insurance policies that will one day expire?

Enter the costless collar. Using this strategy, you buy your puts -- your

insurance -- with funds you receive from the concurrent sale of call options,

thus saving yourself the cost of the puts.

The Costless Collar: Buy Puts, Sell Calls

Assume you own shares of Vanguard Emerging Markets (NYSE: VWO). You believe emerging markets will reward investors

in the long run. But in the intermediate term, you still see risk to the downside. You want to protect your investment against a

large decline, just in case.

For example, assume Emerging Markets is trading at $21. For a costless collar, you want to buy puts and sell ("write") calls to

pay for them. Let's say (using real-life quotes available as I write this) that the $19 strike price put options expiring in seven

months can be purchased for $2.30 per contract. Also, the $24 strike price call options can be sold for $2.10 per contract. The

puts will protect you from a meaningful decline in the ETF's price, and selling the calls to pay for them means your net cost for

the strategy is only $0.20 per share plus commissions (remember, you're paid $2.10 for selling the calls, and you need to pay out

$2.30 to buy the puts). Nice -- that's cheap insurance.

The real cost of implementing a protective collar is limited upside. If shares of Emerging Markets exceed $24 by your call option's


10 of 23 2009/12/13 12:06

Synthetic Longs at a Glance

Synthetic longs are best when you're bullish on

a strong business, at least somewhat bullish

on the market overall, and expect a catalyst

over the next 18 months or so.

Typically, you should use the longest-dated

LEAPs (Long-Term Equity Anticipation

Securities) you can find so you'll have the

largest window of time to be proven correct;

refrain from initiating short-term synthetic longs

that expire in nine months or less.

You must be ready to buy the underlying stock

if it falls below your put option's strike price.

Remember the three possible outcomes with a

synthetic long: (1) the stock increases and

both your options make money; (2) the stock

decreases enough that you're obligated to buy

it via your put options; or (3) the stock

stagnates, in which case both your options

may simply expire, and you're back where you

started.

A true synthetic long uses the same strike price

and expiration date for both calls and puts; you

expiration, you'll miss any upside above that price and need to sell your shares at $24. But if the ETF's price declines over the

next few months, you'll be glad you set up the collar. The puts will provide a profit, and the calls you sold will expire. Meanwhile,

you can keep holding your shares to await eventual gains.

Insure Your Positions and Keep Upside, Too

There is a way to insure your investment and maintain unlimited upside potential on at least some of your shares. Assume you

own 600 shares of Kinetic Concepts (NYSE: KCI), bought at $21. Looking at the options that expire in 10 months, you can sell

$25 strike price covered calls for $4 per contract. With the proceeds, you can buy the $17.50 strike price puts for only $2 per

contract. This means you can protect all 600 shares by buying six puts, but you only need to sell three calls to pay for it -- and

you still pay nothing out of pocket.

Your full position is protected against a sharp decline, and half of your shares still have unlimited upside potential since you

didn't sell calls on them. This type of strategy combines the best of both worlds: Limited downside and unlimited upside.

The Bottom Line

Collars can smooth returns, help hedge your portfolio, protect a holding, and allow you to ride out a rough market with more

confidence. They're not for everyday use, but they're useful in situations that merit protection.

Synthetic Longs

Are you confident about a stock, but reluctant to pony up the cash to buy it today? A synthetic long may be just the ticket.

This option strategy works nearly the same as owning the underlying stock outright -- except you don't need to pay up front.

Usually, you'll set up a synthetic long on a stock if you foresee a strong catalyst for appreciation in the next 18 months or so. As

the stock price goes up, your options gain value along with it, sometimes to a much greater degree.

Earlier, you discovered that when you buy options -- as opposed to

selling (or writing) them -- you aim to profit from the option itself,

rather than getting the underlying equity involved (unless it's to your

benefit). The synthetic long allows for the best of both worlds: On the

options you buy in this strategy, your upside potential is unlimited;

on the options you sell, the worst-case scenario is that you end up

buying the underlying stock at a price of your choosing. This makes

the synthetic long an especially attractive trade for bullish investors.

Buy Calls, Sell Puts

To initiate a synthetic long, you buy a call option and concurrently

sell a put option on the same underlying stock or exchange-traded

fund. For a true synthetic long, the calls and puts will have the same

expiration date and strike price, although there are attractive

variations that you'll discover below.

When you buy a call, you believe that the underlying stock is going to

appreciate considerably over the life of your option. If it does, the call

usually gains value dramatically. If the stock does not appreciate,

however, your calls will move toward expiration with less and less

value, finally ending with little or no value.

That is always the risk of buying options. You need to be correct by

the expiration date or the option won't maintain value, and you could

lose your whole investment. This potential loss is much easier to

stomach, though, if you use income from a put sale to buy your calls.

This is exactly what you do to set up a synthetic long position. Let's

see an example.


11 of 23 2009/12/13 12:06

can "split the strikes," however, to set up a

more defensive or aggressive synthetic long,

depending on your preference.

Once your thesis has largely played out and

you've earned money on your calls, consider

taking your profit on the calls; use the

underlying stock's valuation and your option's

approaching expiration date as guides.

Using a synthetic long option strategy on a

dividend-paying stock does not entitle you to

the dividend payment.

Bullish on Autodesk? Go Synthetic Long!

Suppose you have a bullish long-term stance on 3-D software leader

Autodesk (Nasdaq: ADSK). You believe the business will be on the

upswing again within 18 months, so you'd like to set up a synthetic

long position to benefit.

With the shares trading around $12.50 (as of March 13, 2009), you

could have bought the January 2011 $12.50 call options on Autodesk

for $3.80 per contract, and concurrently sell (or write) the January

2011 $12.50 put options for $3.50. Your net cash outlay is just $0.30

per share. Once you make these trades, if Autodesk begins to

appreciate, both your calls and puts will start to show gains in your

portfolio, in effect mirroring the stock or even outperforming it. If

Autodesk appreciates to, say, $20 by sometime in 2010, your calls

will gain 100% to 200%, and your puts will be well on their way to becoming a 100% cash gain, too.

On the flipside, let's suppose Autodesk continues to suffer from soft sales, and shares drift lower to $10 or $11 for the next year

or longer. In that case, your call options will slowly lose value, and your put options put you on the hook to buy shares at $12.50.

Given that you paid a net $0.30 to set up your synthetic long, your net start price on Autodesk will be about $12.80 per share.

This is the only number you'll ultimately care about if your trade is underwater. You're ready to buy Autodesk at a net $12.80,

and you can then hold the shares and hope for a recovery. Your synthetic long didn't make you any money, but ideally it bought

you shares of a good company.

Splitting the Strikes

Setting up a synthetic long with identical put and call strike prices near a stock's current share price is the norm (because you're

looking to approximate a stock purchase today), but it may not be the most comfortable choice for you. For more downside

protection, you may consider "splitting the strikes" as you set up a synthetic long. In this case, you still use calls and puts that

expire during the same month, but you use different strike prices.

Using Autodesk as the example, let's say you decide to write the January 2011 $10 put options instead of the $12.50 puts. The

$10 puts pay you $2.50 per share. With that income, you can then buy the January 2011 $15 call options (instead of the $12.50

calls from the first example) for about $2.80 per share. The net cost is the same -- just $0.30 per share -- but you have more

downside protection when you split the strike this way. If Autodesk declines, you don't need to buy it until it is $10 or lower, and

your net start price will be $10.30.

What do you sacrifice? You now need Autodesk to appreciate by a greater degree (compared to buying the $12.50 calls) by

January 2011 for your call options to appreciate meaningfully or at all.

When to Close a Synthetic Long

If all goes well, the underlying shares will appreciate for you well before your options near expiration, at which point -- based on

the valuation of the stock and the amount of time left in your options -- you should start to consider taking your profit in your call

options (unless you prefer to exercise them in order to own the stock at your call's strike price). At the same time, your put

options are on the path to expire for the full cash payment.

Usually, you'll use synthetic longs to profit from the options themselves over the course of your investing thesis -- typically,

around 18 months. Only rarely will you exercise the calls and turn them into a stock position if the options are successful. On the

flip side, when the position works against you and you need more time for your thesis to materialize, you'll be ready to buy the

shares and hold them.

The Bottom Line

When you're bullish on a stock and want to invest without spending capital today, setting up a synthetic long position is a

sensible alternative. The strategy can reward you with handsome profits on two options at once, with unlimited upside on the call

options -- or it nets you shares of a stock that you should be happy to buy at a lower price.


12 of 23 2009/12/13 12:06

Synthetic Shorts Synopsis

To replicate shorting a stock with options, you

sell a naked call and buy a put option

simultaneously.

For a straight synthetic short, you sell a call

and buy a put with the same strike price, the

one that is as close to the current share price

as possible.

Use the same expiration date for both the call

and put.

Be careful -- selling naked calls is risky! The

higher the stock goes, the greater your

potential loss.

Use LEAPs so you have more time to be

proven right.

Once you have your desired profit, close the

options -- shorts usually involve a narrow time

frame.

To take on less risk, "split the strikes" and use

a higher call strike price.

Consider synthetic shorts on indexes (like

SPY) as a portfolio hedge.

For less risk shorting with options, simply buy

puts and forego writing naked calls.

Synthetic Shorts

Feeling bearish? If you're looking to profit when stock prices slip,

there's a way to use options to mimic shorting a stock -- but with

distinct advantages. To set up this "synthetic short" position, you

sell a call option and simultaneously buy a put option, using the

same strike price and expiration date for each. Unlike a covered call

strategy, in this case you do not own the underlying stock, so when

you sell (or write) the call, it's a "naked" call.

That means, just as when you short a stock outright, your potential

losses are unlimited with synthetic shorts -- so this is a risky strategy.

But your potential profits are hefty, and the strategy provides

advantages when compared to traditional shorting.

First, you don't need to borrow shares of a stock to short it when

using options -- often, the stocks you want to short most are the most

difficult to obtain for a traditional short sale. Second, the amount of

money you need to risk up front is typically much smaller with a

synthetic short, given the leverage provided by options. Third, unlike

when you short a stock outright, you don't need to cover any

dividend payments yourself. Finally, both opening and closing a

synthetic short can be done quickly, while the traditional shorting

method sometimes involves a lot of waiting. To get a handle on how

this strategy works, let's run an example.

Sell a Naked Call, Buy a Put

Brave soul that you are, let's say you want to bet against one of

Warren Buffett's recent investments. Volatile Goldman Sachs

(NYSE: GS) has jumped to over $180 per share, and you believe

there's profit to be had by shorting it over the next few months

(remember, shorting usually involves a narrow time frame).

Borrowing shares to short is difficult, and the stock pays nearly a 1%

dividend -- which you don't want to cover yourself -- so a synthetic

short is your best route.

Although your shorting thesis only covers a few months, you want to

use LEAP options so you have more time to be correct if need be.

Choosing options that are as close to Goldman's current share price as possible, you simultaneously sell the January 2011 $180

calls (which will pay you $30 each) and buy the January 2011 $180 puts (which will cost you $28). This results in a $2 per share

credit to you. You're now effectively short Goldman Sachs -- and Buffett (how do you even sleep at night?).

In the ideal situation for you, Goldman declines 20% or more over the next few months and pushes both your calls and puts

toward sizable profits. Your thesis has played out, and you should close your position -- both options -- profitably while you can.

The terrifying outcome (here's that risk you read about) would be if Goldman soared. Your options would show large losses, and

you would either need to take your lumps and close them or wait and hope for Goldman to fall. Because you have naked calls,

by their expiration you'll be required to buy Goldman stock at the going market price if it sits above $180 per share, and then

deliver the shares at $180 per share for an instant loss -- just as if you'd shorted the stock outright.

Another risk with an underwater call option is that it could be exercised early, forcing you to buy the stock and deliver it sooner

than you wanted. It's rare that an option is exercised early, but -- especially when you don't own the underlying shares -- you

need to be aware that it could happen. You also need to maintain enough buying power to cover your naked call obligations, and

those broker requirements will be updated daily if the stock increases against your position.

Splitting the Strikes


13 of 23 2009/12/13 12:06

Who Should Use StockRepair

Someone who is:

Down 15% to 25% on a stock and

willing to forego profits to sell at

breakeven.

Not interested in averaging down or

holding for the long haul.

Using a margin-approved account and

can write call options.

To Set It Up

To set up a stock repair, for every 100

shares of a losing stock you (woefully) own:

Buy one call option at a strike price

below the current share price.

Sell (write) two call options at a strike

price above the current share price.

Use the same expiration date for the

options you buy and sell.

Typically, use options that expire in 90

days or less.

If this example sounds too risky, you can add a little breathing room to your synthetic short by "splitting the strikes" (you

discovered this earlier as well). To do this, you still sell your naked calls and buy your puts with the same expiration date, but

you use different strike prices.

For example, rather than using the $180 strike price, assume you sell the January 2011 $195 calls on Goldman for $24 each and

buy the $165 puts for $24 each. This gives you a sleep-aiding 15% window before your naked call's strike price is hit. The lower

strike on the put does make it more difficult to ultimately profit from the stock's decline, but in the short term, the $165 put will

move nearly as much as the $180 put when Goldman declines. So, it's still attractive, and you're still effectively short Goldman,

but with less risk.

Just Buy the Puts

Remember, you can also invest against a stock by simply buying put

options on it and foregoing selling naked calls to finance your put purchase.

Sure, you need to come up with all the money to buy the puts yourself, and

if you're wrong on the trade, most or all of that money will be lost. But that's

the most you can lose with a put purchase, so your risk is known. You won't

have to worry about the potentially unlimited losses that a naked call

entails.

The Bottom Line

Despite the recent rout, the market's long-term trend remains up, so a

Foolish investor should only "go short" carefully and in special situations.

Business is Darwinian by nature, companies come and go every year, and

synthetic shorts provide a way to invest against the losers. You'll likely

prefer to short companies with high debt, weak or no profits, few growth

prospects, a low Motley Fool CAPS score, and inflated valuations. A

synthetic short is also well-suited for shorting a market index to hedge your

portfolio. Naturally, an index doesn't present as much upside risk as an

individual company. In closing, while synthetic shorts are as risky as selling

short outright and shouldn't be taken lightly, the advantages of the strategy

over straight shorting should earn it a rightful place in your tool box.

Stock Repair

At some point, every investor gets stuck hanging onto a stock that has

declined 20% or so and never seems to recover. This guide will teach you

how to use options to exit laggard positions at breakeven. The "stock

repair" option strategy not only recoups your initial investment, but frees up

your cash for new, stronger buys.

But first, a reality check: Stock repair does not protect you from additional

downside in the shares you already own -- nor does it offer you a profit

above your break-even price. The strategy can, however, lower your cost

basis in your losing stock and allow you to exit the position at breakeven without introducing any additional risk.


14 of 23 2009/12/13 12:06









dazzling members...









financial dreams...




Setting It Up

These option trades result in minimal or no cash outlay for you because the call you buy is paid for by the two calls you sell.

Plus, the strategy does not bring new risk to your stock -- your options are neutral and covered: They largely cancel each other

out, and the first call option you sell (or write) is covered by the 100 shares of stock you already own, while the second call you

sell is covered by the new call you just bought. Got that? Let's turn to an example to show how it works.

Repair That Dog!

Assume you purchased 100 shares of a stock at $40 per share, and it now trades at $30. You're down 25%, lack hope for the

stock's recovery, and don't want to hold your shares any longer. At the same time, you don't believe there's high risk left in the

stock -- otherwise, you'd simply sell. It seems your best move to get to breakeven is to initiate a stock repair strategy.

To start, you purchase a $30 call option for $2.50 that expires in 60 days.

You then sell two $35 call options for $1.25 each. Your option trades have

paid for themselves. Your positions look like this:

Original stock, bought at $40, is now $30

Buy one $30 call option costing $2.50

Sell two $35 call options for $2.50 total income

Here are your possible outcomes:

If the $30

Stock...Then...

Declines or holds

steady at $30

All the options expire, nothing changes (you just

lost on commissions). You can try again.

Ticks up a few

dollars -- say, to

$32.50

You make $2.50 per share on your $30 call option

(because you bought it for $0 net cost) and by

selling the call for the gain, you've effectively

lowered your stock's cost basis to $37.50. The

calls you wrote expire. You can use the strategy

again.

Recovers to $35

-- bingo!

Your $30 call is now worth $5 per share, all profit,

so your cost basis in the stock is now $35. You

can sell or close all positions and break even

(commissions aside).

Soars to $40 No problem. You are breakeven on the stock, and

your options cancel each other out. You can close

everything and move on.

Catapults beyond

$40

All of your positions still cancel each other out, and

you can still sell your stock at breakeven. You've

foregone a profit in the stock, though.

As you can see, the stock repair strategy has three possible results: (1) no

change at all if the stock doesn't move or declines; (2) a lower cost basis if

the stock ticks up; or (3) a break-even sale if the stock cooperates even


15 of 23 2009/12/13 12:06

Options is by invitation only...

So if you're interested in learning moreabout Motley Fool Options, or slightlymore advanced Motley Fool Pro, simplyclick the button below. We will notify youthe moment either service begins

accepting new members.


Why Buy A Straddle?

You believe a stock or index will move

dramatically, but you don't know which way.

You believe volatility will increase in general,

so the value of the options you're buying will

increase.

You want to leverage potential returns when

the underlying investment moves meaningfully

in either direction, but limit your risk.

How The Strategy Works

Now let's "straddle up" and see how the

strategy works. Here are the basics:

You buy ("buy to open") an equal

number of calls and puts on the

underlying stock or index (usually you'll

do this as a stand-alone strategy, so you

halfway.

But what if you set up a stock repair trade only to change your mind and

turn bullish on your stock again? The situation is salvageable. Let's say

your stock returns to $40 on good news, and you wish to keep owning it.

In that case, you can close all of your option trades at or near breakeven

(they'll largely cancel each other out) and continue to hold the stock.

Choosing Your Strike Prices

In general, this strategy works best when you're down about 20% on a

stock. You buy your lower-priced call options at a strike price that is about

20% below your stock's start price (or, at about the current share price),

and you write your two other call options at the midway point between the current share price and your stock's start price,

splitting the two. So, in another example, if you bought 100 shares of a stock at $50 that is now $40, to repair it, you'd buy one

$40 call and write two $45 calls.

The Bottom Line on Stock Repair

When you're down a reasonable amount on a lagging stock and simply want out at breakeven, setting up a stock repair strategy

may help you meet your goal more quickly. The strategy does not increase or decrease your risk in owning the stock, but (unless

you close the options early) it does limit your upside to your break-even price. You must be happy to just breakeven and

confident the stock won't fall sharply while you wait.

Buying Straddles

Have you ever thought a stock was about to make a significant move -- but you didn't know which direction it would go? Maybe a

big earnings announcement is looming, an acquisition is pending, or a stock has recently soared and could keep going -- or turn

at any moment. Most investors would sit on their hands, unsure what to do. But if you buy an option straddle, you can set

yourself up to profit whether the stock goes up or down, while risking only the small cost of a few options. This makes buying a

straddle attractive as a bullish or bearish strategy. In fact, buying a straddle can be superior to shorting a high-flying stock

outright, since you'll profit even if it keeps rising -- but also profit if it finally flames out.

Whether bearish or bullish, this strategy positions you to make

money as long as the underlying stock is especially volatile in one

direction, moving at least (as a general guideline) 10% to 30% in the

coming weeks or few months. The strategy works because you gain

a much larger profit on one side of your straddle than you lose on the

other (more on that later). And, to answer your burning question, it's

called a "straddle" because your calls and puts sit symmetrically on

either side of the same strike price -- while expiring in the same

month, on the same stock.

Pros and Cons

Before you walk you through an example, let's go over what can go

right or wrong. On the plus side, when you buy a straddle, your profit

potential is unlimited -- the more the underlying stock moves in one

direction, the more you can profit on that side of your trade.

However, as with any option you buy (as opposed to writing options),

you can lose your whole investment -- in this case, if the stock stays

tightly range-bound, the options would eventually expire with little or

no value.

The clock also plays a large role, as the biggest drag on a straddle

purchase is the time value erosion of the options. Buying a call and a

put, you've paid two option premiums, and with each passing week


16 of 23 2009/12/13 12:06

won't own the underlying stock).

The strike prices of the calls and puts

should be the closest available to the

current price of the underlying stock or

index (also called "at the money").

The expiration month on the calls and

puts should be the same, and usually

you'll choose an expiration up to four

months ahead if you expect volatility

soon, or six months or more if you want

more time. Having more time for the

strategy to work can be an advantage,

but will cost more up front.

their value erodes unless the stock's volatility increases. If the

underlying stock doesn't make a significant move in either direction,

your options will steadily lose value. Plus, the underlying stock needs

to move enough so that one side of your straddle (either the calls or

puts) gains enough value to offset the losses on the other side.

A Straddle in Action

Let's use a real world example. Autodesk (Nasdaq: ADSK) has been

volatile as investors try to determine when business will improve.

Suppose you believe the stock will move aggressively, in one

direction or another, depending on the company's outlook in its next

quarterly report. With shares at $17.50 in July, 2009, you could have

set up a straddle that expires in three months, buying the October

$17.50 puts for $1.65 each and the October $17.50 calls, also for

$1.65 each. Your combined cost per contract is $3.30 ($330) -- so, if

you buy three contracts of each, your up-front investment is $990.

Say management saw business improving, and the stock returns to $22.50 the next month. Your calls are now worth at least $5

each, up from $1.65 each, while the puts are worth very little -- you're losing money on them. Overall, though, your $990

investment is worth more than $1,500, a gain of more than 50%. On the flipside, if Autodesk's guidance is weak and the stock

falls to $12.50, your puts are worth more than $5 each and your calls have little value. Your profit in this case, as with the

opposite side of the spectrum, is 50%.

What if your thesis is wrong, and Autodesk stays within a few dollars of $17.50 for a few months? You're losing money on both

the calls and puts in this case, and you might want to close them ("sell to close") early to get some capital back -- unless you

believe volatility will increase significantly and soon.

Taking Follow-Up Action

Straddles can benefit from more active management once the position is in place. There are two ways to potentially boost your

profits while being defensive:

If the price of the underlying stock increases to the next higher strike price (compared to the strike price you used to set up

the trade), you may want to -- depending on the number of contracts in play and your commission costs -- close your

existing puts and buy puts at that next-higher strike price to increase your profit potential. This is called "rolling up" the

puts.

Inversely, if the underlying stock declines to the next lower strike price, you should consider selling your calls and buying

new calls at that next-lower strike price. This is called "rolling down" the calls.

While increasing the total cost of your strategy, these follow-up moves increase your chance for higher profits on any

subsequent stock move. Roll up and roll down sparingly, though -- reacting to every zig and zag in the stock can be a detriment

when you consider the commissions, option premium costs, and the fact the stock could easily swing the other way again.

Closing a Straddle

If your original thesis holds true and a stock makes a big move, you'll make more money on one side of your options than you'll

lose on the other. If you believe volatility is subsiding, consider closing ("sell to close") both of your positions at the same time to

lock in your profit. If you wait until expiration, you may slowly lose extra value in your options, or the stock may reverse on you

again.

If your strategy isn't working in time, you may want to close both positions early to recoup some capital and rethink your strategy.

Your calls and puts serve to hedge each other in the early going. However, both options will steadily lose value if the stock isn't

making a move one way or another.

Finally, although it's unorthodox, if you earn a quick profit on one side of your straddle, you may want to lock in that profit and let

the losing side stay active. You won't have much value left on that side anyway, and if the stock reverses, you may regain some


17 of 23 2009/12/13 12:06

of the losing option's worth without risking the profits you've already secured on the closed side.


18 of 23 2009/12/13 12:06






Motley Fool Options, ourdedicated options service, hasbeen piling up profits anddazzling members...

Motley Fool Pro, our slightlymore sophisticated tradingservice, employs options, ETFs,and other advanced hedgingstrategies to help membersachieve their financial dreams...


Options and Motley Fool Pro are by

invitation only...

So if you're interested in learning moreabout Motley Fool Options, or slightly

more advanced Motley Fool Pro, simplyclick the button below. We will notify youthe moment either service beginsaccepting new members.


Bottom Line on Buying Straddles

If you believe a stock is going to move significantly -- but you don't know which way -- buying a straddle is a way to profit on

either side. The enemy of the straddle-buying Fool is a stable or merry-go-round stock price, as the value of your purchased

options will steadily erode unless the stock makes a lasting, meaningful move in one direction or another. But when you expect a

big move either up or down, consider buying a straddle.

Writing Straddles

Sometimes a stock -- or the market as a whole -- just takes a nap, and buying or even shorting isn't likely to land you a profit. But

by writing ("sell to open") straddles, you can generate income from a steady stock, or simply from decreasing volatility, as the

market calms down or catches up on some Z's.

Setting Up the Trade

A straddle involves an identical number of calls and puts with the same

strike price and expiration date on the same underlying stock or index. As

you know, you buy the calls and puts to profit in either direction from high

volatility. Inversely, writing the calls and puts is a way to profit from low or

declining volatility. How? Simply by collecting option premium payments

on either side of a potentially sleepy position. There are risks, however.

Uncovered Straddle Writing

When writing an uncovered straddle, you usually don't intend to get the

underlying stock involved. You're just looking to profit on the value erosion

of the options you write, and you'll plan to "buy to close" them (or let them

expire) once you've earned your targeted profit. (Note: You need a margin

account to write an uncovered straddle.)

As an example, suppose a recently volatile stock just announced

earnings, and you expect its volatility will now all but cease. The options

still pay well, though, so you'd like to capture the option premium as

income. The stock is trading at $25, so you write $25 calls and $25 puts

and get paid $2 for each contract -- that's $4 total in option premiums per

straddle. This means as long as the stock ends the expiration period

between $21 and $29 ($4 above or below $25), you'll at least break even

before commissions -- and in most cases, earn a profit on the trade. (call

this the "profit range.")

For example, if the stock ends the period at $27, the puts you wrote expire

(giving you the full $2 value), and the calls break even, so the trade pays

you $2 per share overall.

If the stock ends lower in your profit range, let's say $23, the calls expire

and the puts break even, so you profit $2 per share overall here, too.

However, outside your profit range, it's another story. You face unlimited

potential losses as the stock rises above $29 per share, and you facing

growing losses (along with an obligation to buy the stock and wait for a recovery) the further it falls below $21.

As the table on the next page shows, the maximum profit from an uncovered straddle occurs when the stock ends exactly at the

strike price; you keep the entire $4 per share you were paid in this example. Your total profit declines as the stock moves away

from the strike price in either direction -- which is why you want minimal volatility whenever you write straddles.

Take a minute to study the table and grasp how this works. As the stock rises, the naked (or uncovered) calls you wrote

increase in value, working against you. As the stock declines, the puts you wrote work against you, but you'll still profit anywhere

between $22 and $28, and break even at $21 or $29. Remember, you were paid $2 for each call and put, or $4 total. But since


19 of 23 2009/12/13 12:06

you wrote the options, your desired outcome is that their value goes to $0, or as low as possible:

Stock Price At

Expiration

Ending Call

Value

Ending Put

Value

Your Total

Profit Per Share

$20 and lower $0 $5 and higher

as the stock

falls

($1) and worsening

as the stock falls

$21 $0 $4 Break-even

$22 $0 $3 $1

$23 $0 $2 $2

$24 $0 $1 $3

$25 (the strike

price)

$0 $0 $4

$26 $1 $0 $3

$27 $2 $0 $2

$28 $3 $0 $1

$29 $4 $0 Break-even

$30 and up $5 and higher

as the stock

rises

$0 ($1) and worsening

as the stock rises

To help achieve a successful uncovered straddle, you want the widest possible profit range (in other words, you want to capture

generous option premiums). In this example, the range is significant -- $4 in either direction -- assuming the underlying stock isn't

exceptionally volatile and your options expire in two to five months (rather than longer). But remember, the trade creates

unlimited potential losses outside the profit range.

One way to greatly mitigate that risk: When you write your straddle, use some of your option proceeds to simultaneously buy far

out-of-the-money calls and/or puts, too -- with strike prices at the two ends of your profit range (for this example, you might buy

$30 calls and $20 puts; or just buy calls to protect you on that side and be ready to buy the stock via your written puts if it falls).

Doing so, you've hedged and "covered" your written straddle, and because buying these options generally costs little, you'll still

begin with a net credit from your option writing and keep that profit if the stock stays in a now slightly tighter range. For example,

if you paid $0.80 total for the protective calls and puts, your profit range decreases by that amount on either side of the strike

price. If you don't buy protective options initially, be ready to do so if the trade starts to work strongly against you.

Given that a steady stock can suddenly make a big move for any number of reasons, it's risky to write uncovered straddles

without this added protection. However, another route is to simply own the underlying stock outright. Let's take a look.

Covered Straddle Writing


20 of 23 2009/12/13 12:06

Why Write A Straddle?

You believe a stock or index is going to hold

steady.

You believe a stock that was recently volatile

will calm down considerably.

You believe the market's overall volatility is

going to decrease.

Writing Straddles: The Basics

Write ("sell to open") an equal number of puts

and calls on the same stock or index.

Use the same strike price and the same month

of expiration on both options.

The strike price with a straddle is "at-the-

money": as close to the current underlying

stock price as possible.

When you write an uncovered straddle, you

don't own the underlying stock, so your risk is

high (more on this in a minute).

When you write a covered straddle, you own

the stock, lowering your risk. Here the straddle

works like a covered call strategy -- but your

returns are potentially goosed with additional

put-writing income.

The most you can earn writing straddles is

what the options pay you initially.

Owning the underlying stock takes away all of the naked call option

risk when writing a straddle. In fact, a covered straddle-writing

strategy is basically a covered call strategy, but it generally offers

more profit potential because you're also writing puts on the stock.

The key difference with a straddle is that both options are at-the-

money, so you're more likely to see your options exercised. As with a

covered call, it's important that you're ready to sell your stock if it

rises. And as with writing puts, you need to be ready to buy more

stock if it declines (or close the options early). The benefits of writing

a covered straddle are two-fold:

Your profit can be higher and your profit range wider than with

a mere covered call.

You have more ways to close your options profitably -- and still

keep your stock if you like.

Continuing the earlier example, let's assume you want to write a

straddle on a steady $25 stock -- but in this case, you own the

underlying shares. You write $25 calls and puts, getting paid $2

each, with the same expiration date. Since you own the stock, no

matter how high it climbs, you're covered on that side of your trade.

Let's consider some potential outcomes:

You end up selling your stock via the covered calls, but you

keep the $4 option premium you were paid on the puts and

calls, netting a sell price of $29 (compared with just $27 if you'd

only done a covered call and not a straddle).

The stock declines below $25. You end up buying more

shares, but at a net $21 given the option premiums you were

paid. You've added to your existing stock holding.

The stocks holds steady, around $24 to $26. You can "buy to

close" both the calls and puts by expiration and capture much

of the profit while keeping your existing shares. Nice!

Finally, as an example of the added flexibility here: Assume the

stock increases to $28 by expiration, and you decide you want

to keep your shares. Since you were paid $4 per share in

option income, you could close your calls for $3, still have a $1

per share profit on your straddle, and keep your stock. If you had only written covered calls and not a straddle, you'd need

to book a loss if you wanted to keep your stock.

Taking Follow-Up Action

Writing uncovered straddles requires keeping a close tab on your trade. If the stock is moving sharply against you in either

direction, you may want take action to limit your losses. One way to do so is to close the losing side of your straddle when the

stock reaches your break-even price. In this example, if the stock rises to $29, you might close your call options for a loss and let

your puts go, presumably to expiration, keeping your overall losses marginal. If the stock falls, just be ready to buy it via your

puts. Uncovered straddles don't usually lend themselves to rolling forward (to a later expiration date), rolling up (to higher strike

prices), or rolling down (to lower strike prices), so you can't depend on these defensive follow-up moves being available to you.

As mentioned above, if you buy out-of-the money protective calls (and puts, if you like) when you set up your straddle, your

potential profit on the straddle is lower, but you won't need to consider follow-up action.

Writing covered straddles is much less risky and requires less upkeep, but you still want to keep a watchful eye on your strategy,

since only your calls are truly covered. You need to be ready to accept more shares if the stock falls below your puts' strike

price. For this reason, some investors will use a lower strike price on the puts they write, providing more leeway -- but once you

start to stagger strike prices on your calls and puts, you're not using a straddle anymore, you're using a strangle.


21 of 23 2009/12/13 12:06

Bottom Line on Writing Straddles

You're not likely to write uncovered straddles without using some protective options as well. Writing covered straddles, however,

is a sensible way to increase option profits on a covered call strategy as long as you're also willing to buy more shares if need

be. With this strategy, you have another tool to profit no matter what the market throws your way -- in this case, even if the

market goes nowhere.

Options Glossary

Call option: A call option is the right to buy the underlying stock at a set price (the "strike price") at or before the option's

expiration date. A call rises in value as a stock rises and declines in value when the stock falls.

Delta: The amount that an option's price will change with any change in the underlying share price.

Gamma: A measure of risk in an option based on the amount that the delta will change with a $1 change in the stock (we don't

concern ourselves much with delta or gamma, since we're much more concerned about the underlying value of the equity we're

targeting, but they're still good things to know).

In the money: This term is used when an option has intrinsic value. Call options are in the money when the underlying stock is

above the call's strike price. Put options are in the money when the underlying stock is below the option's strike price (a stock is

at $22 and the put option has a strike price of $30, allowing the holder to sell the stock at $30).

Intrinsic value: This is the value of an option if it were to expire immediately. It's an option's value in direct proportion to the

underlying stock's current price. If a call option gives the owner the right to buy a stock at $10, and the stock is trading at $12,

the option's intrinsic value is the difference: $2. The option may actually be priced at $3, with $1 of time value (see below)

because it doesn't expire for a few months, and much could change by then.

LEAPS (Long-Term Equity Appreciation Securities): These are simply stock options that, when first offered, expire at least

two years in the future. Most new LEAPS become available every July. Although generally more expensive, we like LEAPS

because they give you a relatively long time for an investment thesis to play out.

Option contract: Each option contract represents 100 shares of the underlying stock. A contract is quoted at the price for just

one share, so you need to multiply it by 100 to get the full value. So, if you buy two option contracts for $1.50 each, it actually

represents 200 (2 x 100) shares of stock, and would cost you $300 ($1.50 x 200).

Out of the money: This is the opposite condition as "in the money." Here, an option has no intrinsic value, only time value. This

occurs when, for example, a stock is trading at $8 and a call option has a strike price of $10.

Premium: Not unlike an insurance premium, the value paid for an option contract is called the "premium." The more volatile a

stock is, generally the higher the premium on its options. Also, all else equal, the longer until an option expires, the higher the

premium it commands, accounting for more unknowns.

Protective collars: Profit on a stock you own if it declines, while assuring a higher sell price if that price comes along. You sell

covered calls on a stock you own to buy protective puts.

Put option: A put option is the right to sell a stock at a set price at or before the option's expiration date. A put's value increases

as a stock falls.

Straddles: Use both puts and calls simultaneously on a stock, with the same strike price and expiration date, to profit if the

stock makes a dramatic move either up or down (when you buy a straddle), or profit it stays in a range (when you write, or sell, a

straddle).

Strike price, expiration, and exercise: Every option has a strike price and expiration date (which is always the third Friday of

a month, after the market closes). The strike price is the value at which the underlying stock can be bought or sold. When an

option is converted into a stock transaction, the option has been "exercised."

Synthetic longs: Approximate stock ownership at a much lower net cost, or no cash cost at all -- this trade can often be set up

with a net credit to your account. Sell puts to buy bullish call options.

Time-value premium: This is the price of an option above its intrinsic value. It's the value placed on an option purely to

account for unknowns and expected volatility between now and expiration. Time value declines as expiration draws closer.


22 of 23 2009/12/13 12:06

Writing a contract: Selling a new option contract (opening a position) is usually called writing a contract; the brokerage

command to do so is usually "sell to open," just as when you short a stock. The new option seller is called the "option writer;" to

close the position, the trade command is called "buy to close."


23 of 23 2009/12/13 12:06

fool.com_ options trading

Documents