the power of options to slash your risk and make you money

7/31/2019 The Power of Options to Slash Your Risk and Make You Money

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Te Power o Optionsto Slash Your Risk andMake You Money

Michael C. Tomsett

Contents

Introduction 2

Chapter 1 Getting Started 5

Chapter 2 Vocab and Defnitions 8

Chapter 3 How to Read an Options Listing 15

Chapter 4 Basic Strategies 17

Chapter 5 Time to Cash in on the Opportunities 29

Chapter 6 A Little Advanced Trading (but Not Much) 39

Chapter 7 What Options Can Do or You 47


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Introduction Te Power o Options

Read the directions and directly you willbe directed in the right direction.

Lewis Carroll,Alice in Wonderland, 1865

I you eel like Alice, lost in Wonderland, when you start to explore options,youre not alone.

So many traders and teachers and even so-called experts struggle with options.It gets even uglier when they attempt to bring it down to earth or their readers.

Yet thats just what Money Map Press Publisher Mike Ward has asked me to door you. My job in this book is to show you the beauty o options that part willbe easy and then demonstrate how these trades work.

I anyone can do it, I can. I have written six books about options, and probably

more importantly, I have been trading options mysel or more than 35 years(meaning I have already made every possible mistake you can make).

Heres my promise to you.

I promise to make everything as clear I can, and to keep it as simple as possible.Ill show you how to open an options account in a matter o minutes, so you canget your options trading career o the ground as painlessly as possible. Ten Ill

help you expand your vocabulary so you can talk options. Next, I will show yousome easy techniques, and a ew more complicated ones. You can start o paper-trading them to get the hang o it, or you can jump right in.

Finally, Ill show you how Money Maps expert editors, including Keith Fitz-Gerald, Martin Hutchinson, Peter Krauth, Shah Gilani, and Kent Moors, havemade real money or their VIP Subscribers.

Te Power o Options to Juice Up Your ProftsDone right, options can create a cash cow in your portolio oten quickly,and oten at considerable levels. Consider the case o the SPDR Gold rust(NYSEArca:GLD).

In January 2011, GLD shares were trading or about $130.


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Say you elt pretty condent GLD was going to go up in the next 12 months.You could have gone long GLD by buying 100 shares. Youd have to be readyto plunk down $13,000 or them, but lets say you happened to have the cash onhand. Youd have done pretty well; 12 months later, GLD was trading at $160,and your 100 GLD shares were worth $16,000. Tats a nice 23.7% gain.

Or you could have used options.

Lets say, instead, you bought oneJanuary 2012 $135 call. (A call is just a beton the price o GLD going up rom $130; the same thing youre betting onwhen you buy the stock.)

In January 2011, the call was trading at $9.00. So you would have spent about

$900. (Ill explain why shortly.) Yet by the expiration month, the price had risento $28.00, so that option contract you bought was worth $2,800. Tats morethan a 300% gain on the very same price move o GLD. And theres more.

Te Power o Options to Manage Your Portolio

Options are amazing, versatile tools. Tey can be very speculative and high-riskand give you spectacular returns. On the other end o the spectrum, they can bevery conservative, produce consistent double-digit returns, and serve as tools orportolio management.

Heres what I mean by portolio management. You can apply option strategiesto a traditional portolio o long stock positions remember, those are stocksyou own because you expect them to go up in price to manage, reduce, andeven eliminate risks.

For example, you can buy puts to play a bear market. Tis means you can avoidthe high risks o shorting a stock (because you are long the puts), yet still protrom a alling market (even while everyone else sings the blues). Tere is just noother way to do this so saely.

Risk management has become one o the most exciting uses o options, as wellas the ocus o much o the huge increase in options trading in recent years.Because truly, this is a huge trend.

Dont Miss the Options Party

By now, youre probably starting to see how and why traders use options. Youcan be a part o it. All you need is some good inormation (youre looking at it), ashort learning curve, and a sense o where the market is heading.


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Te option market is not as isolated as you might think, nor is it some exclusive

club or the experienced high-risk trader. Options have become mainstream.

o get an idea o how the market has grown since its beginnings in the early

1970s, take a look at this table.

oday, options are being traded on hundreds o stocks, EFs, and indices. No

longer are they viewed as exotic, high-risk, and impossible to understand. And

there is no reason that you should not be grabbing your share o those prots.

In the pioneer days o options, back in 1973, you could buy a call option on one

o 16 publicly traded companies. Puts the other side o the coin; a bet that a

stock will all werent available at all.

I remember my rst exposure to options, in the late 1970s. I was working in San

t R f o tr

There are a number o orces behind the surge in option trading in recent

decades:

Greater knowledge among traders. Sure, some people are stuck in the past, but

generally speaking, todays traders are more inormed, more open to a range o

strategies and portolio management possibilities.

Broader education o individual investors, too. A guy sitting in ront o his desktop

computer, or even his iPad, has just as much access to the market as anyone

else. One o the great advantages o the Internet has been the vast growth o ree

education, not just about options, but about the market as a whole.

Increased market volatility. The volatile markets o the past ew years have

scared many investors completely out o the market. They park their cash in

low-yielding (but sae) accounts in their bank or brokerage house. They might

buy bonds or shares o conservative mutual unds, or limit their stock investmentsto a ew trusted companies. But consider what has happened recently to some

o the saest companies, like General Motors or Eastman Kodak. Options are a

smart way to hedge not only a portolio, but to hedge risk itsel.

option tRading Volume oVeR the YeaRsYr nbr f Crc tr

1973 (frst year options were available) 1.1 million

1980 (frst time over 100 million) 109.4 million

1999 (frst time over 500 million) 507.9 million

2005 (over one billion per year) 1.5 billion

2010 (most recent data) 3.9 billion

Source: Chicago Board Options Exchange, 2010 CBOE Market Statistics


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Francisco as an accountant, and one o my riends told me I should sell options.He explained it like this:

You own 100 shares and you sell a call. You get the money rightaway and you keep it no matter what. It could get exercised and

your stock sold, but most o the time the call expires. Ten youcan sell another one.

Tis, in a nutshell, is how covered call writing works, and to this day it remainsone o the most popular and protable strategies. But when I rst heardabout it, I wasnt buying it.

So you can sell something, get the money, and wait or it to expire; then do it again?How could you sell something you didnt own? Tats exactly where a lot o traders

nd themselves when they rst hear about options. Its a journey rom there to a ullunderstanding. But the journey isnt as long or as dicult as you might think.

O course, some people are too close-minded to take the leap and try somethingnew, no matter how powerul a tool. Tats their loss.

With the help o our experts to guide you through the option maze, you couldeasily nd yoursel trading options and making money very soon. Read on. I

am going to walk you through the basics o option trading. (And well leave theWhite Rabbit behind.)

Chapter 1 Getting Started

Skewered through and through with oce pens, and bound handand oot with red tape.

- Charles Dickens, David Copperfeld, 1850

Here it is. Te most important piece o advice I have or anyone thinking abouttrading options.

Dont let the red tape hold you back.

A lot o experienced and sophisticated investors shy away rom anything thatinvolves paperwork. Tey think theyre not qualied or not ready, or simply thatits not worth the trouble. Dont be one o them.

Yes, you will have to ll out an options application with your broker, but its easy.


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You had to le a similar orm just to open a trading account in the rst place. Now, iyou want to upgrade your account to options approved, its just a small step away.

Te application may look intimidating at rst glance. It is ull o disclosures andlegal qualications. Yet the purpose is simple enough. Your broker just wants you

to state that you know enough about options to make your own trading decisions.

And not to worry Its not a quiz.

Te disclosures will gauge your level o experience, but their real goal is to let thebrokerage rm o the hook in case things go terribly wrong. (O course, thats notgoing to happen to you.) I a broker lets anyone trade without at least appearing tocheck them out rst, they could be liable or your losses. And no one wants that.

Because options are by denition speculative, the New York Stock Exchange (NYSE),Financial Industry Regulatory Authority (FINRA), and National Association oSecurities Dealers (NASD) all have rules and policies about suitability. Tats thereal reason you have to go through this (very small) hoop.

So youll ll out the application theyll le it away into the just in casedrawer and everyones happy.

Whats on the Application

Te option application will ask some questions you would expect: name, address,

g o arv

Heres a pretty standard example o what youll have to agree to:

I, JOHN SMITH, (SSN ***-**-****) hereby apply or an Option Account and agree

to abide by the rules o the listed options exchanges and the Options Clearing

Corporation and will not violate current position and exercise limits.

I have read, am aware o, and accept the provisions on Option Trading in the

sections entitled Option Trading in the Client Agreement and Online Disclaimer

(Options Account Agreement) that will govern my option account, and agree to

be bound by them as currently in eect and as amended rom time to time.

I acknowledge that I have been urnished and have received the document

Characteristics and Risks o Standardized Options. I am aware o the risks in

options trading, and represent that I am fnancially able to bear such risks and

withstand options-trading losses.Source: TD Ameritrade


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employment and employer name, annual income and all sources o income. Teyalso want to know your net worth and liquid net worth; marital status; and numbero dependents.

Ten there are a ew questions you might not expect.

Like about your aliations. Are you a member o a stock exchange, or do youhold 10% or more in stock o any publicly traded companies? Most likely not.You will also be asked to identiy both your stock trading and option tradingexperience: knowledge level, number o years actively trading, average number otrades per year, and the average dollar amount o trades.

So the application has a ew surprises, but nothing dicult to complete.

Te biggest time-consumer is the pages o disclosures and qualiers, aboutoption trading risks, margin accounts, and nancing disclosures all o whichyou are required to acknowledge and sign o on.

Once you send in the application, the brokerage reviews it and assigns you toan options approval level. Te level denes your ability to take risks based onknowledge levels and experience. While terminology varies among brokerage

rms, there are always our levels:

lv 0 At this basic level, you are not allowed to do very much. You can

write covered calls and protective puts, and not much more.

lv 1 You can do everything in level 0, plus buy calls or puts and open long

straddles and strangles.

lv 2 Now youre getting somewhere! Here you can do everything in the

previous two levels, plus open long spreads and long-side ratio spreads. (And

no, there is no VIP lounge or mileage bonus or getting to this level.)

lv 3 This is or the big dogs. At this level, you can enter into just about

any kind o options positions. This includes all o the other level trades,

plus uncovered options, short straddles and strangles, and uncovered ratio

spreads.

Your broker is going to assign a level to your options account based on what

you say on the application, and (although they dont tell you this) based on theamount o cash you put into your account when you open it. You need at least$5,000 to trade on margin (and option trading requires a margin account),and the more you start out with, the better your chances or landing in thehigher levels.

Remember, this is all designed to cover the brokerage risks o letting you trade


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options. Te higher the level, the higher your risks. But remember, the higher

your level, the higher theirrisks especially i you lose a lot o money and then

hire a lawyer to sue, claiming you didnt know what you were doing.

Now, is your brokerage rm actually going to investigate your claims about

knowledge and experience levels? Probably not. But again, they do want you

to ll out the orm so they cannot be held responsible, just in case your lawyer

later tries to claim you were allowed to trade above your experience level. Should

it ever go to trial, the application is potentially your brokers Exhibit A; it is

designed to make sure they dont lose that lawsuit.

So, just like that, were ready to trade options.

Lets start by nailing down a ew simple concepts.

Chapter 2 Vocab and Defnitions

Ours is the age o substitutes; instead o language, we have jargon;instead o principles, slogans; instead o genuine ideas, bright ideas.

- Eric Bentley, Te Dramatic Event, 1954

Tis is the hardest part o learning options getting used to the language. Once

you nail that, youre most o the way there.

Here are the terms you are going to need to learn to understand and use options.Keep in mind that the best way to master jargon is by applying it in real situations.

Ive broken down the jargon into our groups. Lets jump right in with

Vocab Group No. 1: Standardized terms

Tese are the key xed ingredients o an option xed, meaning they never

change. Tey tell us what the option stands or and what it is worth.

An option type reers to the kind o option. Lucky or us, there are only two kinds.

A callis a contract that gives its owner the right to buy 100 shares o stock ata xed price (known in advance). Aputis just the opposite, and completes thetransaction. Its a contract giving its owner the right to sell 100 shares o stock.


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Tese concepts are the keys to exactly what an option is. Te option is a contractgranting you as buyer control over 100 shares o stock. Tis is always the case one option per 100 shares. So when you buy a call, one major benet is that youcontrol100 shares. Tis means that:

a. You can exercise the call and buy 100 shares at a xed price per share(though you would only do this when the current market price was higherthan the xed strike; it makes no sense to pay ull price when you dont haveto); or

b. You can sell the call and take a prot (the prot comes into the picture whenthe stock rises, making the option more valuable, too).

A put gains in value when the stock pricealls. You still have control over 100

shares, but in a dierent way. When you own a put:

a. You can exercise the put and sell100 shares at a xed price per share.

b. You can sell the put and take a prot (the prot is there i the stock pricealls, making the option more valuable).

Once you get call and put straight in your mind, youre most o the way there.

Every option controls 100 shares o a specic stock, index, or und. Tis is calledthe underlying security. It cannot be changed during the lietime o the option,and options are not transerable. By the way, we in the biz oten just call thisasset the underlying, so be ready to hear that.

Every option has an expiration date. Tat is the third Saturday o the expirationmonth, but the day beore (the third Friday) is the last trading day, since themarkets are closed on Saturdays. Ater expiration date, the option no longer exists.

Finally, there is the strike price, which is the xed price per share o theunderlying. I an options owner decides to exercise (meaning she decides tobuy 100 shares through a call, or to sell 100 shares through a put), the strike isthe xed price.

Tese our standardized terms dene each and every option and, collectively,set them apart rom one another. Again, none o the terms can be changed or

transerred. I you have an open options position and you want to make a change,you need to close it and replace it with a dierent option.

All our dening terms are expressed in every option listing.

ake a look at this next gure showing the collective terms or a call and aput on Google Inc. (NasdaqGS:GOOG). Te values were based on closing


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i prcc: hw tr o Wrk

Buying and selling options on a stock is not the same as buying or selling shares

o the stock itsel (though how the stock price moves will certainly aect you).

I you exercise an option, you get the right to buy (call) 100 shares or sell (put)

100 shares. But you can also buy and sell the options and make money rom

changes in their value.

When you buy a call or a put, you enter a buy to openorder. You have to speciy

that it is a buy order, whether it is a call or a put, the underlying stock, strike

price, and expiration date all o the standardized terms. Once the order has

been executed, money is taken out o your account to pay or the option.

At some point beore expiration, you either exercise the option (meaning buy

100 shares by exercising a call, or sell 100 shares by exercising a put); or you

can sell the option. The value o every option declines due to time decay, and

as expiration approaches, time decay accelerates. Osetting this, options

gain value i the stock prices in the desired direction. I you own a call, you

hope the price o the underlying will rise. I you own a put, you want it to all.

When you sell the option, you enter a sell to closeorder, and proceeds are then

placed into your account. I you are able to sell or a price higher than your

original purchase price, you make money; i it is less, the net round trip (buy

and sell) results in a net loss.

This gets more interesting when you sell an option, or go short.

In this case, your opening move is to enter a sell to openorder. You speciy the

terms, and when the option sale is executed, unds are placed in your account. I

the stock price moves up (i you sell a call) or down (i you sell a put), you can lose

money. So you want the price to all i you buy a call, or rise i you buy a put. Funds

are placed into your account and the money is there or you to take out, spend, or

reinvest. Its real money and its yours, at least or the moment.

The short position can expire, in which case all the money you got is 100%

proft. Or you can close the option by entering a buy to closeorder. When this

is executed, money is taken out o your account. I the original sales price was

higher, the round trip yields a net proft. But i your closing buy price is higher,

the net dierence produces a net loss.


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prices o the stock and options aso February 6, 2012. Note that allo the terms are highlighted: type(call or put), underlying security(Google), expiration date (March2012), and strike (610). Te listing alsosummarizes the current value or eachoption. Here, the calls value was 18.39(or, $1,839), and the put was valued at14.10 ($1,410).

Vocab Group No. 2: Actions and status terms

Tese next terms describe how options act, as well as how they change in value,based on the distance between the current price o the underlying, and the xedstrike price o the option.

Lets start with thepremium you will pay (i you buy the option) or receive as a creditin your account (i you sell it). Tree attributes determine the price o the premium:

1. Te distance between the strike price o the opinion and current price o theunderlying security;

2. Te amount o time until expiration; and

3. Te level o volatility in the underlying security. Te greater the volatility, thehigher the risk, and the higher the options premium.

Options are subject to exercise remember that word? meaning the owner hasthe right, at any time beore expiration, to buy (through exercise o a call) or to sell100 shares (through exercise o a put). Te owner will buy only i the underlyingsecuritys current value is higher than the strike o the call, or sell only i it is lowerthan the strike o the put.

By exercising the call, the owner buys 100 shares below market value; byexercising a put, the owner sells 100 shares above current market value. I thestocks price is lower than the call strike or higher than the put strike, there is

no risk o exercise. It just wouldnt make sense to pay more or a security thanmarket or to sell it or less.

Exercise can also occur automatically, but only on the last trading day beoreexpiration. On that Friday, the Options Clearing Corporation (OCC)automatically exercises all calls when strike is below current value o theunderlying, and automatically exercises all puts when strike is above current

GOOG 610 Mar call at 18.39

strike

stock(Google)

type

expirationmonth

currentvalue

GOOG 610 Mar put at 14.10

strike

stock(Google)

type

expirationmonth

currentvalue


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market value o the underlying.

Tis condition with the call strike below current value o the underlying, or the

put strike above is reerred to as in the money (ITM). Tis distinction is o greatinterest to anyone who has shorted options, because with the status o being

IM comes the risk o exercise, which can occur at any time. It is also a key

attribute o owning options. When an option is in the money, the premium will

move point or point with changes in the underlying security.

When the current value o the underlying is below the calls strike (or above

the puts strike), its status is out o the money (OTM). In this condition,there is no immediate risk o exercise and the option premium will be less

responsive to movement in the underlying. Te degree o change relies on thesame three actors.

One nal denition (and itll make perect sense to you now):

When the current value o the underlying and the options strike are identical,

the option is at the money (ATM). While this condition does not usually lastlong, it is a benchmark or identiying how value changes. Comparisons o

option premiums oten are based on assumed value when AM.

Vocab Group No. 3: Valuation

Remember, the options premium is based on the proximity between strike and

current value o the underlying; the time remaining to expiration; and volatility

(another word or market risk). Tese next terms are really just another, more

detailed, way o saying that

An options premium consists o three parts:

Intrinsic value is the part o option premium equal to the points in the money.

For example, i a 35 call is valued at 5 ($500) and the current price per share o

the underlying is $37, then the call is two points in the money (37 - 35). So the

call has two points o intrinsic value (and three points are something else).

For a put, the same rule applies just in the opposite direction. Lets say a 40 put

is valued at 3 ($300), and the current price per share is $42. Te put is two points

in the money, so there are two points o intrinsic value included in the premium.

(Te remaining point, again, is a dierent kind o value.) I an option is at the

money or out o the money, it contains no intrinsic value.


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by the holding period (in months). Finally, multiply by 12 to get the one-yearannualized return.

h r srk pr Cc

Three weeks 35 2.25 ( 2.25 35 ) 0.75 months x 12 = 102.9%

Two Months 35 2.25 ( 2.25 35 ) 2 months x 12 = 38.6%

Five Months 35 2.25 ( 2.25 35 ) 5 months x 12 = 15.4%

Nine Months 35 2.25 ( 2.25 35 ) 9 months x 12 = 8.6%

15 Months 35 2.25 ( 2.25 35 ) 15 months x 12 = 5.1%

Chapter 3 How to Read an Options Listings

I ignorance paid dividends, most Americans could make aortune out o what they dont know about economics.

- Luther Hodges, in Te Wall Street Journal, March 14, 1962

Ahh, the options listing rust me, it isnt as bad as it looks.

Youve already run across a rather long set o symbols that looks something like this:

GOOG120317P600000

Tis code is simply the ticker symbol or your option. And once you break it down,youll nd that it holds a wealth o inormation, including all the standardized

terms we just talked about. Te rst three or our letters are just the stock ticker orthe specic underlying stock, in this case, Google Inc. (NasdaqGS:GOOG):

GOOG120317P600000

Te next two digits tell you the year the option expires. Tis is necessary becauselong-term options last as ar out as 30 months, so you may need to know whatyear is in play. In this case, the Google option is a 2012 contract:

GOOG120317P600000

Te next our digits reveal the month and the standard expiration date. Teexpiration date does not vary; its always the third Saturday o the month. Andthe last trading day is always the last trading day beore that Saturday, usually


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the third Friday (unless you run up against a holiday). In this case, youve got aMarch contract (03). And the third Saturday o March 2012 is the 17th.

GOOG120317P600000

Now youll see either a C or a P, to tell you what kind o option youre dealingwith a call or a put. Tis one happens to be a put:

GOOG120317P600000

Ater that comes the xed strike price, which is 600:

GOOG120317P600000Finally, any ractional portion o the strike is shown at the end. Tis comes uponly as the result o a stock split, where a previous strike is broken down tobecome a strike not divisible by 100:

GOOG120317P600000

Now that youre a pro, lets take it a step urther.

Reading the Options able

Te numbers part doesnt have to be painul or tedious. In act, when realmoney (translation: your hard-earned cash) is at stake, I think youll nd thisdata is suddenly much more interesting.

An options listing gives you the status o the our standardized terms you alreadyknow: type o option, expiration, strike, and the underlying security.

Te listing is set up or all o these criteria, and then also provides the twocurrent prices or each strike the bid and the ask. Why two prices? Well, thebid is the price at which you can sell an option, and the ask is what youll pay tobuy it. And the dierence between the prices the bid-ask spread is the protor the market maker who places the trades.

Now lets look at a typical options listing.

Tis one is or options on the SPDR S&P 500 EF (NYSEArca:SPY), withtwo dierent expiration dates and ve dierent strike prices. Ater those dates,all o the options will expire worthless, so you have to take action (closing aposition, exercising, or or short sellers, being exercised) by the last trading day


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some crazy price swing, so thepremium is higher. In the chart,on the previous page, the Marchcontracts have that extra month,so their premium is considerablyhigher than the positions thatexpire in 10 days.

Teres a trade-o, o course.

Later expirations means youhave to leave those positionsopen longer. So the desirabilityo a higher premium dependson whether you take up a longposition or a short one.

Long positions are moreexpensive when you have moretime to expiration. At the sametime, this provides more chanceor the underlying to move inthe desired direction. So pickinga long position is a balancing actbetween time and cost.

Short positions, on the other hand, benet rom time decay. When you sell anoption, you receive the premium and wait out the time decay. Depending on

whether the option is IM or OM, you can let it expire, close it out with abuy to close order, or roll it orward. (More on that soon.)

And thats all! See, I told you it wasnt that complicated.

Chapter 4 Basic Strategies

Investors want to believe. Always looking or a better way, a

chance to gain an advantage in the market, they are particularlysusceptible to arguments that use statistics.

- Mark A. Johnson, Te Random Walk and Beyond, 1988

d l dffr Frtrw Y off

You may see option listings are set up in a

ew dierent ormats. Dont let it throw you.They all provide the same inormation.

For example, the Chicago Board o Options

Exchange (CBOE) lists all available options

in one series. I you want more detail, you

need to go to the next page. Check out

http://www.cboe.com/DelayedQuote/

DQBeta.aspx to see how it looks.

Most brokerage frms list in a ormat closer to

the one on page 17. Charles Schwab provides

an option summary page highlighting the

most popular options or each underlying; you

can go to a more detailed page, where you

can pick a range o strikes and expirations

or review. You can also link directly to the

trading page to place orders. This is typical o

online brokerage listings.


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Tere are hundreds o option strategies. And they can be vastly dierent in termso tactics and desired outcome. Covered calls are very conservative, or example,while uncovered or naked calls are high-risk. How you select them depends onyour risk tolerance and comort level with dierent degrees o exposure.

But in act, there are really only a ew basic strategies, and everything else is builton these in some orm.

At Money Map Press, we use eight general strategies (and amilies ostrategies). Tese will cover most o the approaches you are likely to see and totake in your own trading. And in the next chapter, Ill walk you through a real-lie example o each one how our Money Map experts made real money orreal subscribers with options plays.

But I do want to mention something rst.

Tis same huge range o possible strategic designs is what makes the optionsmarket so interesting, challenging, protable and also nice and risky.

Are you surprised by mycharacterization o risk as nice?

Well, risk and opportunity arereally the same thing, and everyoption trader needs to accept this.I you want to go ast and get someserious movement, well, you haveto climb on board the rollercoasterrst, even i it scares you a little bit.

Okay, here we go.

1. Long calls

Te long call is a cinch. You simplybuy a call oten or as little as 5%o the value o the 100 shares itcontrols. You wait or the underlying

to rise in value, which is what yourbetting on. And then you either sellthe call (at a prot) or exercise.

Now, as attractive as the long callmay be at rst glance, it is not easy

g l g sr

The traditional (and best-known)

sequence o trades is buy-hold-sell.

This sequence is known as the long

position. Im sure youve done it

yoursel. As long as the position is

open, you own the security whether

stock, option, index, und, or any other

product. When it comes to long options,though, about three out o our expire

worthless, so theyre no slam-dunk.

Less amiliar, but o great interest in

option trading, is the short position.

In this opposite ormat, the sequence

is sell-hold-buy. By going short,you expose yoursel to a dierent

set o risks, specifcally the risk o

exercise. However, when you sell

options, you receive the premium

rather than paying it.


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to make money consistently. Its a matter o time, timing, and proximity, andalmost never a matter o price only.

Let me explain that.

Time describes the endless dilemma o the long call trade. You want to nd thecheapest long call you can, knowing that you need to build prots, not just abovethe strike, but ar enough above to cover your cost, too. So the more expensivethe call, the urther the price needs to move. At the same time, ocusing oncheap calls will leave you with very little time or the call to appreciate.

Timingis the key to creating protability in long call positions. I you aregoing to pick calls at random, youll lose more oten than youll win. But

i you know how to time your trade, your odds o proting go way up. Allstocks, EFs, and indexes go through predictable cycles. Te time to buy callsis right when the underlying is at the bottom o a cycle. Tis is where thechances o reversal and upward movement are highest, whether you seek ave-day turnaround or a two-month turnaround. Whatever your timerame,timing is key.

Proximity is the third decision point in picking a long call. Te distance between

the price o the underlying and the options strike is what determines not onlycurrent premium price, but how responsive that price is going to be to movementin the underlying. When the two are ar apart, you cannot expect a lot o point-or-point reaction, even in the money. Te extrinsic value (implied volatility) willdampen reaction due to the distance.

In other words, the urther away rom the strike, the less the underlying pricematters in terms o option premium. Tis is especially true or deep OM

options. Te way the market prices options, the less chance that price will catchup to strike, the less aith there is in even strong price movement.

AM options tend to be ar more responsive to underlying price movement.Tats because the chance o the call moving into the money is quite high. Andonce it is in the money, you do get that point-or-point intrinsic reaction (eventhough, or options with a lot o time to expiration, you are going to experiencesome osetting changes in premium; the more time let, the more unknown

changes can occur, and this is actored into the proximity play).

With any option position, but especially going long, you need to set goals orwhen to exit the position. Your goals should include knowing when to takeprots, as well as when to cut losses. Without goals, you have no exact idea whenor how to get out o a position even when it becomes protable.


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2. Long puts

Just like the long call, trading long puts involves the three issues o time, timing,and proximity. Te only dierence is, its a play on the underlying alling invalue. Buying puts at the top o the cyclical swing even a very short-term one

improves timing and presents opportunities to take prots, oten in only a mattero days. (See Chapter 6 or more on how short-term swing traders can benetrom the use o options.)

3. Short (covered) calls

Te covered callis one o the most popular strategies the rock star o options.

Now, it may be a rock star, but it is generally thought o as a conservativestrategy. Tats because, when properly designed, a covered call generates protsno matter how the stock price moves.

(Are you starting to see the beauty o options?)

It consists o owning 100 shares and selling one call against those shares. Its or atrader who believes the stock price will go down. Te position is covered in thesense that, i the call is exercised, the stock is called away, but you dont lose (eventhough the stocks value will be higher than the strike). Te idea is that the assuranceo known prots rom the covered call is worth the occasional lost opportunity.

You have to be cautious in how you set up the covered call to make sure that youprogram net gains no matter what.

Heres the idea: With the covered call, you create a cushion with the premiumyou receive, so that your breakeven is below your original cost per share. Forexample, i you sell a call and get three points, that moves your breakeven downto three points below your cost. Tat is the initial benet to selling covered calls.But it does not address the larger market risk o having long stock. I the pricealls below your strike, you lose. Te short call is not a culprit in this scenario;in act, the call reduces your exposure. But it does not eliminate the market risk,and thats the point I want you to keep in mind.

On the upside, you ace a dierent risk that the underlying price could movewell above the strike, meaning the call will be exercised, and your shares calledaway at the strike. Since the market price would be higher at this point, it createsa loss the dierence between the xed strike and the underlying current value.Is this potential loss acceptable to you, or not? I not, then you should not writecovered calls. But realistically, its unusual or the underlying price to soar so ar


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above the strike. Most o the time, the short call is going to expire worthless, orcan be closed at a prot, or can be rolled orward. Yet even i none o these canoccur, you can exercise the call at any time beore expiration.

o ensure the greatest success in writing covered calls, ollow these guidelines:

1. Focus on very short-term contracts. Returns on short-term calls are betterthan on longer-term ones, because time value declines at an accelerated rate. Iyou sell covered calls that expire in one to two months, you can maximize yourannualized return (we covered that term in Chapter 2). Even though you getmore cash premium selling longer-term contracts, you make more in the endwith short-term ones. You are better o writing six two-month calls than one12-month short call. Another reason to avoid longer-term covered calls is that

they keep you and your cash tied up that much longer. Anything can happen,but in the market, the longer you remain exposed, the greater the risk.

2. Buy the right strikes.Te ideal short call is going to be slightly out o themoney. Tis is where the premium is at its best. Far OM calls are going tohave dismal premium in comparison, especially or soon-to-expire contracts.An IM premium will be higher, but more likely to get exercised. SlightlyOM is the way to go.

3. Remember, exercise can happen at any time.Te most likely day o exerciseis on the last trading day or any IM option. Te second most likely dateis going to be on or right beore the ex-dividend date. raders exercise tobecome stockholder o record and get the current quarters dividend. So iyou want to avoid early exercise, stay away rom covered calls on stocks withex-dividend in the current month. Or, as long as they are AM or IM, youprobably dont have to worry.

4. Open proftable positions. Pick strikes above your basis in the underlying sothat you get a capital gain, and not a capital loss, when exercise occurs. Tisis oten overlooked, but it is essential. Now, there is an exception: You cansell covered calls below your basis, so long as premium is rich enough andexceeds the loss. For example, you buy stock at $37 per share. Te 40 call is notattractive, but the 35 call can be sold at 5. I the call is exercised, you will losetwo points in the stock, but the net outcome is a three-point prot.

5. Remember the underlying.Another easily overlooked aspect o covered callselling is the stock, EF, or index you select. Youre going to nd the most

attractive premiums in the most volatileunderlying. Lower premiums aresymptoms o low-volatility issues. Tis is yet another balancing act. High-volatility underlying issues are higher-risk, so i you buy shares solely to writecovered calls, you expose yoursel to higher market risk a problem that caneasily oset the benets o the covered call.


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You can also cover a short call by osetting it with a later-expiring long call, orwith a call that expires at the same time, but at a higher strike. However, theseorms o cover are dicult to make practical; the cost element net o outcomeswill usually be negative.

A lot o people wonder i you can create a covered put in the same way as acovered call. No. Heres why: I you have shorted stock, a short put protects youto a degree, in the event the stock price rises; its kind o like insurance. But on apractical level, a long call provides better protection because it will oset loss inthe stock all the way up. A put protects you only to the extent o the premiumyou receive. And i the stock declines as short sellers want, the short put is at risko exercise. So, realistically, all short puts are uncovered.

And the bigger risk is going to be ound in the uncovered, or naked call.

When you sell a call naked (without owning 100 shares o stock), you acea bigger risk. In theory, a stocks value could rise indenitely; but at exercise,you have to satisy exercise at the strike price. So, or example, i you sell anuncovered 30 call, and the stock then skyrockets to $90 per share, your loss is$6,000 (minus whatever premium you got or selling the call). O course, itspretty unusual or stock prices to rise so dramatically. But it could happen. Andtherein lies the risk.

Every short put is uncovered, unless you oset it with a later-expiring long put.However, the risk is much smaller. Can you guess why?

Even in the very worst-case scenario, a stocks value cannot all below zero. Sorisk is quantied as the dierence between the strike and zero. Actual risk ismuch less, o course. Te true risk to an uncovered put is the dierence betweenthe strike and tangible book value per share (again, less the premium received).Realistically, a stock is very unlikely to all lower than its tangible book value.

Te risk, in all short options, is exercise. For covered call writing, exercise can bedesirable since it produces a net yield; but or other covered call writers, as well asvirtually every uncovered option writer, exercise is not desirable. It can be delayedor avoided by rolling orward. (See the sidebar on page 24 or more.)

You can also take the covered call up a notch creating even more prot inexchange or somewhat higher risks with a ratio write. Tis is just a coveredcall involving more calls than you cover with shares. For example, i you own 200shares and sell three calls, you set up a 3:2 ratio write. Te market risk is greater,but so is the premium income by 50%. For this reason, many covered callwriters like the ratio write, and accept the risk.


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immediate market risk, because the higher strike is still OM. But i the pricecontinues to rise and approaches the $42.50 threshold, you can close or rollorward one or both o the higher-strike calls.

4. Short putsRemember, with the call, you oset the exercise risk by owning 100 shares ounderlying or each call sold. When you sell a short put, however, you cannotcover the position in the same way.

But uncovered puts are not as risky as uncovered calls. Tats because theunderlying price cannot all indenitely, though the price can rise indenitely(at least in theory). So in the worst case, your risk with the short put is thedierence between the strike price and zero. (Te price cant go negative.)However, the truemaximum risk is the dierence between strike and tangiblebook value per share.

A couple o rules here.

First, ocus on puts expiring within one month. Tat will help you maximizeyour prot potential. ime value is going to evaporate very quickly, so eveni the stock price alls below the strike, you can close the short put oten at aprot IM. You can also roll orward the short put. However, the likelihoodo expiring worthless is quite high, so the short put, like the covered call, is apotential cash cow.

Second, the risk here is exercise, in which case you have to buy shares at thestrike, which will be above market value. So i you are going to write shortputs, make sure you consider the strike a good price or the underlying; berealistic about the potential o exercise at any time; and be willing to eitherhold onto shares or develop a strategy or osetting the paper loss.

5. Insurance puts

You already know how the insurance put works. You buy the long to osetpossible losses in the underlying. I the price alls below the puts strike,

the intrinsic value o the put rises or each point lost in the underlying. Tedownside, o course, is that you have to pay the premium or the put meaningthe cost o insurance reduces any potential net gain in the underlying.

With this in mind, the insurance put makes sense when a specic conditionexists: Te current price o the underlying is higher than your basis (and thepaper prots should be higher than the cost o the put); at the same time, you do


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not want to sell the underlying, because you think more upside potential is likely.

For example, say you bought stock at $38 per share and the current priceis $44, a paper prot o six points. You can buy a 44 put or 2. In the eventyou have to exercise the put, you will take a $600 prot. Subtracting the

$200 cost o the put, this leaves our points o prot with the insurance put.However, i the stocks value continues to rise, you make more prot in theuture and the cost o the insurance put is absorbed through higher prots inthe underlying.

Again, you can always close the insurance put at a prot i the market value othe underlying declines. In this scenario, the underlying loss is oset by the putgain. It also leaves in place the potential prots i the underlying rebounds.

As an alternative, i you decide the underlying is simply too weak to keep, youcan also exercise the put and sell your shares at the strike.

6. LEAPS options

Tis one can be an attractive alternative to the otherwise very short liespan omost options. And the potential or gains in either long or short LEAPS tradesis substantial.

TeLEAPS, or long-term equity appreciation securities contract, is simplya long-term option. Tey are available, as calls and puts, on 20 indexes andapproximately 2500 equities. Te lie span o a LEAPS option is as long as 30months. In the options world, that is something akin to orever.

LEAPS provide a lot o interesting strategic possibilities. You can open longLEAPS call positions as a contingent purchase strategy, so 100 shares canbe bought in the uture; or you can buy puts as insurance or as contingentsales positions.

Te big disadvantage o a long-term option is going to be the very high timevalue you have to pay or the luxury o a long-term play. Tis is true, at least, iyou buy long-term contracts. But i you sell them instead, that high time value

works in your avor.

Tats why my avorite way to play the LEAPS is to sell an AM call. Yourreturn can be signicant. And the premium provides a cushion that makesLEAPS sales very desirable, especially i it s part o a long-term contingencyplan. I you are willing to sell shares at a specic price at any time between nowand two years rom now, selling a LEAPS option brings in high current income


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and a desirable exposure to exercise.

Let me show you how this works.

In mid-February 2012, shares oGoogle Inc. (NasdaqGS:GOOG) were at

$610. Te January 2014 610 call was trading at 99.60 just under $10,000 percontract. I you sell that call, thats a 16.3% return based on the strike, or 8.5%annualized [(16.3 23 months) x 12 months = 8.5%]. So i you bought Googleshares anywhere at or below $610, this is a very attractive net return. Tere isalso the chance that the stock price will decline below $610 over the coming 23months. In that case, the premium value o the call would decline, and you couldclose your position or a nice prot.

Finally, Im going to explain the basics o spreads and straddles. Tats where thehedging potential o these combined strategies comes in...

7. Spreads

You enter a spread by buying and selling an equal number o calls or puts on thesame underlying, but with a dierent strike or expiration.

Spreads come in many variations. But there are some common eatures, like thecombined positioning o osetting calls, puts, or both, and in congurations bothabove and below the current value. Tis price cushion makes spreads attractiveon both long and short sides.

Te best way to analyze spreads, and to decide which one is a good match oryou, is to study prot zones and loss zones.

A long spreadis constructed with a long call and a long put. O course, you willpay a premium to own both. Tis sets up a loss zone in a middle range betweenthe two strikes, and extending above and below those strikes the numbero points paid or the options. I you open a long spread, you have to expectconsiderable price movement beore expiration.

A short spreadalso creates income rom selling both a call and a put. Yourprot zone is created both above the top strike and below the bottom strike,equal to the premium you get when you open the short spread. So long as theunderlying market price remains in between the strikes, there is no exerciserisk. Even in the event o exercise within this range, o either option, thepremium income covers you. However, i the underlying price moves aboveor below this middle-range prot zone, then it becomes a loss zone. And thearther it moves, the greater the loss.


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On short spreads, you can mitigate or deer that loss zone by either closing one

o the short positions, rolling orward, or covering the short (with stock purchase

in the event o the short call, or in either case with a later-expiring long option).

Spreads o this type with the same expiration but dierent strikes are called

vertical spreads.

Horizontal spreads (also called calendaror time spreads) have the same strike but

dierent expirations, and can be either long or short. Ill give you an example o

one in the next chapter.

Spreads with dierent expiration and dierent strike are called diagonal spreads,

and also can be either long or short.

8. Straddles

Straddles are similar to spreads, but they have the same strike and expiration.

Whats especially appealing about straddles is, you can prot based on how

much the underlying moves regardless o the direction o the price movement.

A long straddle will have a middle-range loss zone extending both above andbelow the strike by the number o points you pay or the two options. I the

underlying price moves above or below this middle loss zone beore expiration,

your prot zone is set up. Long straddles can also be timed to take advantage o

volatile price swings in the underlying.

In ashort straddle, the premium you get or selling the call and the put set up a

prot zone extending rom the strike, both above and below. Te zone covers the

same number o points as the premium you received. So i your total premium

was 7 and your strike was 30, your prot zone extends rom the high o $37

per share, down to $23 a range o 14 points. I the underlying closes within

this range, you earn a prot. Your breakeven prices, beore deducting trading

costs, are $37 and $23. I the underlying price moves above $37 or below $23 by

expiration, you will have a loss.

Te short straddle can avoid exercise on both sides. Either side can be rolledorward i the underlying price moves too ar in the money (it will always

be IM on one side or the other). It can also be closed; i time value has

evaporated, even an IM short option might be closed at a small prot. Or,

as long as the price is within the prot zone, accepting exercise produces a net

prot due to the combined premium income rom selling the two options.


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to calculate the return rom the covered call based on its exercise price.

Now, a 3% return might not seem like much, but remember, it only took 86 days

to get there. So when you annualize it, this amounts to a nice 12.7% [(3% 86

days) x 365 = 12.7%].

Heres whats interesting Te underlying price didnt change very much by the

closing purchase date. It didnt have to. Te entire change in value rom $1.65

down to zero represented time decay, even with the brie move into the money

in July. So those who ollowed Martins advice got a nice credit, right up ront

$165 or each contract and then got to just sit back and watch the time value

o the contract dry up.

Protective puts

Remember, a protective put provides you a orm o insurance against alling

value in the underlying. Te intrinsic value o the long put rises one point or

each point lost in the value o the stock or index. For the example, heres another

good one rom Martin, or his Permanent Wealth Investorsubscribers.

As Martin explained on January 4, 2011, when the new 2013 series o puts werepublished or the SPDR S&P 500 EF (NYSEArca:SPY):

Since the market has risen signicantly over the last year, I think

we should aim to buy options with a strike price o 700, rather

than the 600 strike price we bought last year. But there is no

need to buy the new option immediately these options tend

to be somewhat overpriced in their early months o existence, as

the market sees more buyers than sellers.

Te December 2013 700 options are currently trading at $38

to $44, well above our proposed buy price o $25 (to give us

one $2,500 contract or each $100,000 o portolio value). I

the market drops sharply in the near uture, we are still well

protected by our 2012 option, so I propose putting in an order,

good until canceled (GC), to buy the 700 series o 2013 at $25.

A urther market upsurge and/or a decline in 2013 option values

as they become more seasoned will then cause our order to ll.

A December 2013 put with a strike o 700 was valued on January 4, 2011, at $24.50.

You could have bought this and had up to two years o price protection. By January

17, 2012, 378 days later, the put had increased to $48.00, a nice prot o 95.92%.


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BuyGLD April 2011 $140 calls or up to $1.05. And buyGLDApril 2011 $120 puts or up to $0.95. Apply only 2.5% o yourtrading capital to this combined position. We are paying $2.00 inthe hopes that gold goes through the roo or collapses altogether.

Te outcome? A very nice prot on the 140 call, rom $1.14 cost up to $2.43sale; and a total loss on the put, rom a cost o $0.85 down to zero. Net outcome:$2.43 sale versus $1.99 cost, or a net prot o $0.44.

Te chart shows how the price o GLD moved during this period. Te ast ve-point rise presented an opportunity to sell the call side o the straddle at a protadequate to cover the entire cost. Te put was let open until expiration; therewas always a chance the price would all, and the put would become protable.

Tis didnt happen, though, and the straddle was protable because o the astappreciation in the call.

Long strangles

Kent Moors oEnergy Sigma raderopened a good strangle on Frontline Ltd.(NYSE:FRO) on December 20, 2011:

Our move today is a called a strangle. Tis occurs when a calland a put are bought on the same underlying stock... with thesame expiration date... but at dierent strike prices. Te callallows a purchase at a given price (the strike), providing a proti the underlying stock is moving up. Te put also allows thepurchase at a given price, but is protable i the underlying stockdeclines. Tis approach is used when actors point to a stockmoving signicantly in one direction or the other, but there is noclear indication which one.

chart courtesy of StockCharts.com

Feb 7 14 22 Mar 7 14 21 28 Apr 11 18 25

152150148146144

142140138

136

134

132

130

GLD (SPDR Gold Trust Shares) NYSE

putexpiration

date

purchasedate

call saledate


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Te price movement was minor during the month, but the call was protable.

Again, the idea behind the strangle is to create potential prot zones above the callstrike and below the put strike. In this example, the midrange between the two strikeswas protable or either side, so long as the price moved ar enough in one direction

or the other. Tat didnt happen, but I hope you can see that the potential is there.

Calendar spreads

Te calendar spread (also called a time spread) has two options with dierentexpiration and the same strike. Keith used this strategy to tremendous eect in hisGeiger Index back in 2010, when oyota Motor Corp. (NYSE:M) was lookinglike a seriously troubled company. As you may remember, oyota had just recalledmillions o cars and trucks worldwide and briefy halted production and sales.

On February 25, 2010, Keith wrote:

Now lets capitalize on some chaos with a stock that even wedidnt believe the Geiger had selected oyota Motor Corp.(NYSE:M). Heres what to do: Sell oneM April 2010 $70put, and simultaneously buy oneM July 2010 $70 put. Based onmarket conditions as I write this, this trade will cost approximately$2.20 (or less).

But heres the exciting part. Unlike some o the limited risk/limited return trades the Geiger has preerred in recent months,this one has home-run potential o 100% or more by the timewere done with it. And thats worth noting because it speaks to

the patience and deliberateness that makes the Geiger so eective.

Lots o traders think you need to swing or the ences every timeyou step up to bat. In reality, its the cautious batter that putsplayers on bases (and prots in our pockets) to win the game.Homers are really only hit every once in a while, but boy, arethey un to tee up just like this trade.

Te other thing thats worth noting here is that the Geiger issuggesting buying this spread instead o selling it. Tat means iit cost us $2.20 to put on, thats all the skin we have in the game.Our risk is completely limited to the money we spent, and thereare no unknowns to come back to haunt us.

Keith used the calendar spread as a starting point or a nice series: the calendar


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spread, then a vertical spread. Here is a table o the outcome between February

and June 2010:

ty ar 70 /by Jy 70 Cr sr

ac d n b/cr

Rt

Buy 1 calendar spread (April/July 70 put spread) 2/25/10 $-2.20 $-2.20

Sell to open 1 Apr 70/65 put vertical spread 3/11/10 $0.50 $-1.70

Sell to open 1 May 75/70 vertical put spread 3/24/10 $0.75 $-0.95

Buy to close 1 Apr 70/65 vertical spread 3/31/10 $-0.05 $-1.00

Buy to close 1 Apr 70 put 4/14/10 $-0.05 $-1.05

Sell to open 1 July 65 put 4/14/10 $0.45 $-0.60

Buy to close 1 May 75/70 vertical put spread 5/11/10 $-0.46 $-1.06

Sell to close 1 July 70/65 vertical put spread 6/8/10 $1.72 $-0.66

g: 62.26%

Now, while protable, this was a very unusual trade. It was a complex series o

positions, including a roll, replacement o one calendar spread with two vertical

spreads, and eventually an overall net prot o 62.26%.

While not every transaction has to be this complex and very ew that Money

Map editors bring you will be anywhere close this one demonstrates how

skillul management o positions with net prot and looming strikes in mind,

all timed to take advantage o time decay, can and does produce some very

impressive outcomes.

chart courtesy of StockCharts.com

22 Mar 8 15 22 29 Apr 12 19 26 May 10 17 24 Jun 7 14

82818079787776757473727170

TM (Toyota Motor Corp.) NYSE

purchasecalendarspread

open firstvertical

spread

open secondverticalspread

close firstverticalspread

close Apr70 put andsell to openJuly 65 put buy to close

second verticalspread

sell to closesecond vertical

spread


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Chapter 6 A Little Advanced rading

(But Not Much)

Let me smile with the wise, and eed with the rich.

-Samuel Johnson, in James Boswell, Lie o Samuel Johnson, 1791

In this brave new world o options trading, it has become impossible (or at least

very unwise) to ignore the potential that options oer.

Who doesnt want additional prots, lower risk, better diversication, or

powerul leverage?

Tats why Im dedicating this chapter to a ew more advanced trades that you

can use to expand your playbook and potential prots. Even i youre not ready

or them, you should be aware o them. Tese are great strategies. Tey allow you

to augment the opportunity, while still keeping your risks in check. Lets go over

each one quickly, so you can decide or yoursel i any look appealing to you.

Collars

When properly timed and placed, the collaris a method or riding the price ostock upward, while eliminating the risk o losing prots i the stock price were

to tumble. Te only problem with a collar is that, while it removes all possibility

o loss, it also caps your potential gains.

Te collar is made up o three parts:

100 shares o stock,

One long put, and

One short call.

Tis is an elegant strategy; the call is covered by the stock, and the price o the

put is paid by income rom the call.

Ideally, both options are out o the money (OM). For example, i the stock

price is $41.25, the short call strike is 42.50 and the long put strike is 40. I the

stock price moves above the 42.50 call strike, the shares are called away, and your

prot is limited to the dierence between the basis and the strike.


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I the underlying moves below the puts strike, the paper loss is oset by intrinsicvalue o the put, which can be sold to recapture the loss, or exercised to sell stockat the puts strike (which is below the market value o stock when the position isopened, but limits the loss to the proximity o strike and price).

Now, you could open a collar by buying all three parts at the same time. But inpractice, youre more likely to want to create it ater some underlying stock youown has appreciated when you want to protect those paper prots and wouldbe willing to sell above a certain price (the call strike).

For example, say you bought 100 shares oRaytheon Co. (NYSE:RN) at $37,and the stock has appreciated to $41.25. At this point, you may not be ready tosell outright, but you surely want to protect the prots youve already earned.

You could create a collar. Buying a protective put at 40 ensures a prot o threepoints (40 - 37). And the put is paid or with the sale o a 42.50 call. I it isexercised, your capital gain is $550 [(42.50 - 37) x 100]. In this way, the collarprotects those paper prots while ensuring prots o some kind, no matter whatthe outcome. Plus, you continue earning dividends rom owning the stock.

Even better, as you might guess, the chances o the call getting exercised are relatively

small. You can avoid exercise by closing the call i and when the price moves close tothe money, or by rolling the call orward (and using the additional premium to buy alater-expiring put and continue the collar at higher strikes on both sides).

Id say thats a powerul strategy no matter what happens.

Other spread varieties

First, let me give you that denition again. Remember, a spreadis an optionposition established by buying and selling an equal number o options on thesame underlying, but with dierent strikes or expirations. Te strategy limits risk,but it also limits prots. Tere are dozens o variations on the spread. Im justgoing to point out a ew special ones.

First, theres the butterfy spread, and its a thing o beauty.

Because it combines both long and short options, the overall cost o the butterfyspread is minimal, or can even create a small credit or you. Te butterfy presentsan interesting way to hedge options against one another. It has two sides:

A bull spread; and

A bear spread.


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spread with puts makes just as much sense.

In the reverse calendar spread, the short position expires later. Tis invariablymeans that the net dierence between the two is a net credit (because the shortoption has more time value). Tat is advantageous, no doubt about it. But it sets

up a dierent potential problem: What are you supposed to do when the longside expires, and you are let with the uncovered short position?

Te rationale or the reverse calendar spread demonstrates why traders like it.

First o all, you make money when the short side expires later, so the initialposition is set up as a credit. Second, i the underlying moves in a desirabledirection or the long option, you can close it at a prot.

For example, i you use calls, the sooner-expiring long call gains value whenthe underlying price rises. However, the longer-term short call is less likely torespond to price movement; the arther away expiration is, the less responsive theoption premium. So a trader can dispose o the long call at a prot, while hopingthat time value o the later-expiring short call will decline as expiration nears,enabling a buy to close, also at a prot. However, the exercise risk is very realor the uncovered short side.

Te same rationale applies when you use puts.

Te sooner-expiring long put gains value i the stock alls, and you can thenclose the put at a prot. However, the longer-term short put needs to lose timevalue in order to squeeze a prot rom that one.

Te second variety o reverse spread is the backspread, also called the reverseratio spread. Naturally, this one is related to the better-known ratio spread, inwhich you sell more calls than you have covered with stock. For example, say youown 300 shares oMicrosot Corp. (NasdaqGS:MSF) and sell our calls onMSF, creating a 4:3 ratio write.

In the backspread, you sell one call, oten covered by 100 shares o stock. At thesame time, you buy higher-strike calls. Depending on the premium levels at play,

the number o higher-strike calls and time to expiration will vary. A backspreadworks best when the options create a net credit. Tis is quite possible to do, solong as the higher-strike long positions are ar enough out o the money to maketheir value relatively small. Te increments between strikes will also aect theviability o the backspread.

In this example, you own 100 shares o MSF you bought at $38, and you sell a 40


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call, reaping a premium o 5 (in dollar terms, thats $500). I this call is exercised, you

keep the $500 premium, plus you get a $200 capital gain on the stock.

Tis is a very attractive situation. Not only will you prot i and when the short call

is exercised but the $500 premium gives you a ve-point cushion o downside

protection. But what i the stock price rises ar above the level o the 40 strike?

Given that the short call produces a $500 prot, you can expand the position

into a backspread.

For example, the 42.50 calls may currently be worth one point each. You can buy

two o the 42.50 calls and pay $200. Now your net on the call position is $300 still

an impressive level o income in the event o exercise. However, i the underlyingrises above $42.50 per share beore the long calls expire, two things occur.

First, the short call is exercised and stock called away at $40 per share. Te prot

is $500 ($200 capital gain plus $300 option premium). Second, the long calls

remain open, and i the stock price rises above $42.50, the options gain two

points o intrinsic value or each point gained in the stock. Accordingly, these

can be closed at a prot twice the level o prot in the stock.

As a urther contingency, i you want to get back the shares that were called

away, you can exercise one (or both) o the 42.50 calls. Tat way you can buy

shares at the strike, or less than market value.

Te backspread, oddly enough, provides a orm o upside protection and osets

the potential loss critics o covered calls like to cite: the lost prots rom xing

a strike in the event the stock rises above that level. With the backspread, you

prot rom the covered call and rom the long call positions. So a strongly risingstock price creates more prots, not lost opportunity.

Straddle varieties

Straddles also can be expanded into some very interesting advanced strategies.Tese are just as fexible as spreads. Tey can consist o long or short positions,

calls or puts, or, in advanced ormulations, combinations o both.

One especially noteworthy strategy is the calendar straddle.

Much like the butterfy combines a vertical use o bull and bear spreads, the

calendar straddle combines a short position near-term straddle and a long

position long-term straddle.


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Tis is likely to create a net debit because the long-term later-expiring optionswill have more time value. So the calendar straddle should be used only toaddress a very specic perception o likely price movement in the underlying.

Te net risk in this position is, in act, the net debit up to the date o expiration

o the short-term positions. Ideally, it will be possible to close one or both sideso the short straddle at a small prot. Tis is realistically possible given the rapidtime decay o both sides. So by closing the short leg o the calendar straddle, youcan hold the remaining long side at leisure until expiration.

wo points to remember here

First, it might be possible to close the short positions with enough net prot

to oset the net debit rom the overall straddle; in that case, you end up with aree longer-term straddle. One side will always be in the money, in this case. Soeither the long call or the long put can be closed at a prot. Te best o all worldsoccurs when the underlying moves rst in one direction and then in the other, sothat both long options can be closed protably.

Second, a protable close o a long position normally is a problem becausethe underlying has to move ar enough in the money to oset the original

cost o the two options. Tis is a long shot. However, in the calendar straddle,it is entirely possible to prot rom both long and short sides. I you are ableto close the short positions to cover the initial debit, your net basis in theremaining long positions is zero. So any intrinsic value will be protable.Furthermore, i you accomplish that zero basis, you might also be able to closeboth sides and prot rom the combined intrinsic value in one option and timevalue in both.

Not bad, eh?

Te calendar straddle can be a very protable strategy, and it minimizes marketrisk, because the combined call and put on both sides creates prots in anycircumstances, when price is either above or below the strike. It will almostalways be at one or the other. Given this eature on the long side, the worstoutcome occurs when the underlying is exactly at the strike. And thats rare.

Condors

I want to make sure we cover one nal strategy. You may never use it, butyoull almost certainly hear about it. Te condoris popular with traders whoare willing to live with modest prots, in exchange or conservative limitationson risk levels. It works best when the underlying is going to have very low


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Capital limitations: Te limitations o a portolio, in terms o available cashand margin, may make swing trading inadequate. Many swing traders have touse small numbers o shares and limit activity to three or ewer issues.

Short-selling risks: Playing the top o the swing and using stock involves

selling open positions, but swing traders are then supposed to short stock inexpectation o a downswing. Shorting is a high-risk move, however. So manyonly play the bullish side.

Prot limitations: Te limited amount o capital available to swing trade alsolimits potential prots. Tats because, other than the use o margin, stock-based swing trading has no leverage.

Using options solves each o these problems. First, it opens up the potential o

swing trading by liting those capital limitations. Each option controls 100 shareso stock, so you can get some serious leverage going. Yet or long options yourmaximum risk is limited to the cost o the option, which you can keep quite lowwhen you choose the right one. Select an option set to expire within one month,with strike AM. Tats ideal, in terms o price, as well as potential intrinsic gain.

Perhaps more important, the short-selling risk which is considerable isentirely removed by the use o long puts at the top o the swing. Your maximum

risk is the cost o the put premium. In comparison, short selling stock caninvolve much greater risks (not to mention the cost o borrowing stock andpaying interest to your broker).

Finally, because each option controls 100 shares o stock, prot limitations area thing o the past. Tink about it You can swing trade many more positionsand earn the same prots per option as you would or an equal degree o pricemovement or 100 shares.

An option-based swing trading strategy can be based on long calls and longputs only; on long calls at the bottom and short calls at the top; on short calls atthe bottom and long calls at the top; on any combination o these long or shortpositions; and with covered calls in a 1:1 arrangement or using ratio writes.

Tis is one o the ew option strategies in which soon-to-expire long positionsoer the maximum advantage. With expiration looming, and little to no timevalue remaining, intrinsic value is going to track the underlying movement veryclosely. Because the swing normally lasts between three and ve days, optionsare much better than shares o stock within this strategy.

Synthetic varieties

Another way you can use options (in a swing trading strategy or otherwise), is


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through the creation o asynthetic stock position. Tis is a combination o optionsdesigned to mirror the movement o the underlying, or little or no cost. Tatsan intriguing idea, isnt it?

Asynthetic long stock position consists o buying a long call and selling a short

put. Te premium you get rom the put will cover most (i not all) o thepremium you have to pay or the long call. As the stock rises, the long calls valuegrows and the short put loses value. Growth in the call mirrors the underlyingpoint-or-point as long as the synthetic strikes are at or near the market valueo stock at the time the position is opened. Te risk o the synthetic longstock position is that i the underlying market value alls, the long put will beexercised, and 100 shares o stock put to you at the strike.

In a synthetic short stock position, you buy a long put and sell a short call.Here again, the short option premium pays or all or most o the longoptions cost. Te combined long put and short calls mirror stock movementas it moves downward.

Heres the risk. I the underlying price rises, the short call gets exercised. Iuncovered, this could be a considerable loss especially i the underlying price moveis substantial. You can eliminate this risk i you pair the synthetic short stock position

with ownership o 100 shares o stock, creating a covered call with a protective put,which depending on proximity o the strikes could be either a straddle or a collar.

But again, the synthetic short stock addresses both sides o the risk picture. I theunderlying rises, the 100 shares are called away at the strike, creating option prot,dividend income, and capital gains. I the underlying price declines, the put growsin intrinsic value point-or-point with the decline. You can sell the put at a prot,to oset losses, or exercise it, so that the 100 shares can be sold at the higher strike.

Chapter 7 Heres What Options Can Do or You

Tere are two classes o people who tell what is going to happenin the uture: Tose who dont know, and those who dont knowthey dont know.

- John Kenneth Galbraith, in Te Washington Post, February 28, 1988

It used to be that the buy and hold approach to investing was the only strategypeople really used. Investors used to hold stock or years and years and even pass


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it down rom one generation to the next.

oday, holding periods have allen to the point that the average is now measuredin days. Tats because o the Internet and discount brokerage. ogether theyhave proven to be quite an empowering combination. odays markets have

opened up to just about everyone.

Te cheaper, aster market has been great or value investors. Its even greateror anyone who wants a lot o action in their portolio. Sure, options can bespeculative, but they can also be eective tools or portolio management reducing and controlling risk while bringing home the cash. Tis trend willonly continue as the exponential growth o option trading spreads throughoutthe market.

I you have only recently started looking at the world o options, one thing isor sure: You are not alone. And in the uture, you will have a lot o company,but its not really competition. More participants will be good or the entiremarket and or your ability to combine investing in equities and trading tohedge risk.

Some critics o the options market have claimed that high-volume trading harmsthe rest o the market. Tey say buying and selling options adds to volatility, orthat it somehow exploits the more conservative investor. Some even call optionstraders pirates.

Are option traders pirates? No way.

Teres nothing manipulative or abusive about maximizing your own protopportunities and enhancing your portolio.

Say you head to the supermarket to pick up some essentials, and you notice thatthe store is holding a one-cent sale on the very peanut butter thats at the top oyour shopping list. Doesnt it make sense or you to take advantage o that deal?Te low-price oer is made or a reason, and smart consumers take advantage oit. I some other peanut butter company complains that no one is buying theirproduct that day, do you think they are being exploited? O course not!

In act, I challenge anyone to demonstrate how option trading hurts the market.

Tere is no evidence that it is unair or that it distorts the market. Te activitymight contribute to a shorter holding period in equities, but there is a biggerreason or that change. Te equities market has become ar more volatile thanit was decades ago and not because o the Internet or the options market, but


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the power of options to slash your risk and make you money

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