- I hope I had cleared out some of the basic concepts of stock and
basic option investment in my previous article. As promised, I will
cover some of the most popular advanced option strategies in this
article.
Before getting to the subject, let’s clear out the following definitions
which will help us to understand the advanced option strategies a
bit easier.
Buy to open a call option at 10: the buyer
has the right, but not the obligation, to buy the stock at $10/share
even if the stock closes above $10/share at the end of the option
expiration day.
Buy to open a put option at 10: the buyer
has the right, but not the obligation, to sell the stock at $10/share
even if the stock closes below $10/share at the end of the option
expiration day.
Sell to open a call option at 10: the seller
has the obligation to sell the stock at $10/share even if the stock
closes above $10/share at the end of the option expiration day.
Sell to open a put option at 10: the seller
has the obligation to buy the stock at $10/share even if the stock
closes below $10/share at the end of the option expiration day.
In-the-money ( ITM ): the strike price is
lower than the stock price for call option and higher than the stock
price for put option.
Out-of-the-money ( OTM ): the strike is higher
than the stock price for call option and lower than the stock price
for put option.
At-the-money ( ATM ): the strike price is
at or near the stock price for both call and put option.
Contract: one option contract controls 100
stock shares.
Support: the level in which the stock will
likely bounce off from it and move up
Resistance: the level in which the stock will
likely bounce off from it and move down.
The first group of advanced option strategies I like to cover is the
spread trade. I will cover the first spread trade with details and
example to provide a better understand of it. Once we understand the
main concepts, the other spread trades should be easy to follow.
Bull Call Debit Spread:
As the name implied, this strategy is a bullish strategy involving
call options. To enter a bull call spread, we first buy to open a
long call option at a lower strike price. We then sell to open a short
call option at a higher strike price. We now have a net debit to enter
the trade. Net debit = $ buy to open - $ sell to open. Our maximum
loss in this trade is the net debit. Our maximum gain in this trade
is the difference between strike prices minus net debit. Our return
on investment ( ROI ) is our max. gain divided by our max. loss. We
will achieve our max. gain if the stock closes above the higher strike
price and both options exercised on the option expiration day. An
up trending stock with strong support is a good candidate for this
strategy. If we achieve 50% of our max gain, we should consider an
early exit. To manually exit the trade, we buy to close our short
call position and sell to close our long call position. To avoid being
naked by accident, we should always buy first and sell second when
we enter or exit the trade.
In summary:
Leg one: buy to open long call option at lower strike price.
Leg two: sell to open short call option at higher strike price.
Net debit = $ buy to open - $ sell to open.
Max. gain = Difference between strike prices – Net debit. To make
economic sense, we have to make sure the difference between strike
prices is greater than the net debit.
Max. loss = Net debit.
Break even point = Lower strike price + net debit.
ROI = Max gain / Max loss.
Stock candidate: up trending stock with strong support.
Main point: to achieve max gain, the stock has to close above the
higher strike price and both options exercised at the end of option
expiration day.
Let’s get to a numerical example to further illustrate the points.
This was one of my actual bull call debit spread trade I traded earlier
this year.
Leg one: buy to open March 20 long call at $6.50/share.
Leg two: sell to open March 25 short call at $2.10/share.
Difference between strike prices = $25 - $20 = $5.
My net debit = $6.50/share - $2.10/share = $4.40/share.
The stock closed above $25.00 on 3/17/06, the 3rd Friday of March.
I achieved my max. gain of $0.60/share ( Max. gain = $5 - $4.40 =
$0.60 ).
My break even point in this trade was $24.40 ( $20 + $4.40 = $24.40
). If the stock closed above $25.00 on 3/17/06, I achieved my max.
gain. If the stock closed between $24.40 and $25.00, I made some profit
but less than max. gain. If the stock closed below $24.40, I suffered
a loss in this trade. If I want to exit the trade before the option
expiration day, I buy to close my short call option and then sell
to close my long call option.
Analysis: When the stock closed above $25 on 3/17/06, I was the seller
of March 25 call so I was obligated to sell the stock at $25 even
if the stock closed above $25. My March 25 call option was exercised
and I had to sell the stock at $25/share. However, I was also the
buyer of March 20 call and I had the right to buy it at $20/share
even if the stock closed above $20/share. I exercised my March 20
call option and bought the stock at $20/share. Hence, I bought the
stock at $20/share and sold it at $25/share making a $5/share profit.
But I paid a net debit of $4.40/share to enter this trade bringing
my net profit to $0.60/share ( $5 - $4.40 = $0.60 ). My ROI in this
trade was 13.64 % . ROI = max gain/max loss = 0.60/4.40 = 0.1364 =
13.64%.
Bear Put Debit Spread: The stock has to close
below the lower strike price on the option expiration day and both options
exercised to achieve max. gain.
Leg one: buy to open long put at higher strike price.
Leg two: sell to open short put at lower strike price.
Net debit = $ buy to open - $ sell to open.
Max. gain = Difference between strike prices – net debit.
Max. loss = Net debit.
Break even = higher strike price – net debit.
Stock candidate: Looking for down trending stock with strong resistance.
ROI = Max gain / Max loss.
Bull Put Credit Spread: The stock has to close
above the higher strike price on the option expiration day and both
options expire worthless to achieve the max. gain.
Leg one: buy to open long put at lower strike price.
Leg two: sell to open short put at higher strike price.
Net credit = $ sell to open - $ buy to open.
Max gain = net credit.
Max. loss = Difference between strike prices – net credit.
Break even = higher strike price – net credit.
Stock candidate: Looking for up trending stock with strong support.
ROI = max. gain/ max. loss.
Bear Call Credit Spread: The stock has to close
below the lower strike price on the option expiration day and both options
expire worthless to achieve max. gain.
Leg one: buy to open long call at higher strike price.
Leg two: sell to open short call at lower strike price.
Net credit = $ sell to open - $ buy to open.
Max. gain = net credit.
Max. loss = Difference between strike prices – net credit.
Break even = lower strike price + net credit.
Stock candidate: Looking for down trending stock with strong resistance.
ROI = max gain/ max loss.
Diagonal Bull Call Debit Spread ( Calendar Spread ):
This is a variation of the Bull Call Debit Spread. The only difference
is we buy to open our long call position at least 3 months in the future
and sell to open our short call position in the current month.
LEAPS: stands for Long Term Equity Anticipation
Securities. This is another variation version of the Bull Call Debit
Spread. In LEAPS strategy, we buy to open our long call position 2 to
3 years in the future and sell to open our short call position in the
current month. The idea of LEAPS is to generate a monthly income without
owning a stock. This is a covered call related strategy. We should master
our covered call strategy before trying LEAPS.
The spread trades are not designed for “home run “ since they have
limited gain and loss. In fact, the spread trades are designed to generate
monthly income of 2% to 5% if we are moderately conservative and above
5% monthly income if we are a bit on the aggressive side. The spread
trades are confused for beginners: therefore, plenty of practices are
needed before placing a real spread trade using our hard earned money.
We must thoroughly understand the concepts of each spread trade. Knowing
the exiting point before entering the trade is crucial for a successful
spread trade. We must familiarize ourselves with the terms buy to open,
buy to close, sell to open and sell to close. Remember one option contract
controls 100 stock shares. One wrong word or number can be financially
disastrous.
I am an “ earning sensitive “ trader. I wait for the earning release
day before I jump in most of my trades, bullish or bearish. Fortunately,
one strategy takes care of my concern and I like to talk a little bit
about that strategy.
Long Straddle: The beauty of this strategy
is we have a good chance of making profit if the company misses or beats
the street estimate in a big way. The stock candidate for this strategy
should be an extremely volatile stock which moves a lot, preferably
more than 10 points, one way or another, if it misses or beats the street
estimate after the earning release. To enter the long straddle trade,
we buy to open long call and put at-the-money approximately 2 weeks
to one month before the announced earning release day. If the company
reports good earning and the stock shoots up high, we sell to close
our long put and let our long call position run with the stock in the
upward direction. In some cases, the stock shoots up high enough so
we can close out our long and put positions to recognize a profit. Understanding
the definition of call and put, we should know what to do if the company
misses the street estimate badly and the stock goes down fast.
Short strangle: This strategy is designed for
low volatile stocks which trade in an established trading range with
clear support and resistance. When the stock hits the resistance level
and begins to move down, we sell short call at a strike price above
the resistance level. When the stock moves down, hits the support level
and begins to move up, we sell short put at a strike price below the
support level. Remember we are naked when we sell short put and call.
Naked position is very tricky for beginning traders and I don’t recommend
it for beginners. To sleep better at night, instead of selling short
call and put, we can apply Bear Call Credit Spread and Bull Put Credit
Spread in the respective positions.
Selling short put: Selling short put is a bullish
strategy. Short put is also known as naked put. I like to use the word
“naked “ to remind myself when I own naked positions, I am pretty “exposed”
to the market and I better make sure I monitor my naked positions carefully.
If we are bullish on a stock, we can either sell a naked put or buy
a long call. When we sell a naked put conservatively, we usually sell
it at a strike price below the stock price and also below the support
level. As long as the stock traded above the strike price, we don’t
have to buy the stock and pocket the premium. Selling naked put is a
good bullish strategy to generate 1% to 2% monthly income. When we sell
a naked put, we should look for an up trending stock with strong support
and more importantly, we don’t mind to own the stock in case it drops
below the strike price and the stock is put to us. If the stock is put
to us, we simply turn around and sell the covered call for the following
month to further reduce the net cost of our stock. When we sell naked
put, our gain is limited to the premium we collect and our loss is,
in theory, unlimited if the stock goes down fast. However, the advantage
of selling naked put is we can make money if the stock goes either sideway
or up and time is on our side. When we buy long call, our loss is limited
to the premium we pay and our gain is, in theory, unlimited if the stock
goes up fast. However, the disadvantage of buying long call is we can
only make money when the stock goes up and time is against us. Traders
should consider these factors and make their decision accordingly. Common
sense tell us when we sell naked put, we should pick the time as short
as possible, usually 25 trading days or less. When we buy long call,
we should buy the time as long as it needs for the stock to move in
our favor. Conservative trader sells naked put out-of-the money and
buys long call in-the-money. The reverse is true for aggressive trader.
Since this is one of my favorite strategies, I would like to use a numerical
example to illustrate my points:
After analyzing an up trending XYZ stock which is currently traded at
$27/share in November, I like the stock and don’t mind to own it. XYZ
December 25 put has a bid price of $0.50/share. I sell the put and collect
a premium of $0.50/share, a 2% monthly income ($0.50/$25 = 2%) . Since
I do not own XYZ stock, I was selling a short or naked put. If the stock
closes above $25 on the 3rd Friday of December, I don’t have to buy
the stock and keep the $0.50/share premium, a 2% monthly income. If
the stock drops below $25, let’s say, at $24.75 on the option expiration
day, the stock is put to me at $25/share. However, consider the $0.50/share
premium I collected earlier, I actually buy the stock at $24.50/share.
I now own XYZ stock at a net cost of $24.50/share which allows me to
sell the January 25 covered call to further reduce the net cost of my
stock. If I get called out at $25 in January, I still make profit by
selling the naked put first and selling the covered call later.
Selling short call: Selling short, or naked,
call is a bearish strategy. If we are bearish on a stock, we either
sell short call or buy long put. When we sell a short call conservatively,
we should look for a down trending stock and sell the short call at
a strike price above the stock price and also above the resistance level.
Look over the definitions at the beginning of this article and figure
out the main points of this strategy. It is the exact opposite of selling
naked put. In my opinion, selling short call is riskier than selling
short put. Selling short, either call or put, is not for beginners in
option trading.
I believe the majority of us will be very confused when reading this
article with all those “ weird ‘ terms in option trading. I was no exception.
I was confused too but after trading it for a while, things begin to
clear out. Just think when we first learned how to drive, we were nervous
and scared especially when we changed lanes on the freeway, backed up,
or did parallel parking. Now after driving about 10 to 20 years, for
most of us, how do we feel? We all feel a lot more relax when driving
now, right? I even saw some people talking on their cell phone, eating
hamburger or reading map for direction when driving. Those are things
we could not or even imagined we can do when we first learned how to
drive. Now we are doing it with ease not because the driving is easier
but because we drive a lot. The key here is we drive a lot and we get
used to it after a while. In my opinion, the same thing is true for
any thing, option trading included.
The purpose of this article is not to educate readers and make them
become option traders overnight. It only serves as an introduction to
option trading strategies. Any one interested in option trading should
seek proper investment education best suits his/her needs. Investors
should pick their own strategies matching their investing styles and
risk tolerance. Remember to do a lot of paper trades before actual trading.
In my opinion, option trading is not an easy or difficult task. It is
just different. If we can do one thing which is difficult, confused
and risky to others but seems to be easy, simple and relatively safe
to us, we are in good shape financially. Like most other jobs, trading
has pressures too. We must learn how to handle those pressures emotionally
and financially in order to be successful. By no mean I imply I am a
successful trader. I am still a relatively new kid on the block and
I still have a lot to learn.
To close this article, I like to express my sincere thank to my wife
who has been giving me full support in this business. She was shock
when I first told her how much I paid for my investment education but
she also had faith and confidence in my decision making. She now jokingly
says I have the best job in the world. Well, I ARGUEABLY have one of
the best jobs in the world thank to her support and understanding.
Work cited:
Investools Inc. Advanced Options Workshop Manual. 2004.
Dennis Phan
post date: 11-12-06
每一項投資雖然也有它利潤的好處, 但也有承受虧損的風險, 在您作出決定投資之前, 最好找專家一談, 或從多方面考慮與明瞭, 才選擇出正確適合自已的投資.
Investing in options/stock market is risky. It is no guarantee. You
should consult investment advisors before making investment decisions.
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When I first came to this country, my American Dream
was pretty simple. I dreamed of finishing my college degree, owning
a house, having a good job to take care of my family and traveling
back to Southeast Asia to visit my home countries. Well, I accomplished
my “mission“ and now I have a bigger dream.
After finishing my BS degree at UCLA in the summer of 1986, I found
a job as an in-house real estate appraiser in a bank not too long
after my graduation. I had fun working as an appraiser because the
job involves math, taking pictures and working on the field a lot.
Those are the things that I like to do. I love math since I was a
kid and I also love taking pictures. Working on the field is another
advantage, to me at least. When I was on the field doing appraisals,
I always felt my work day was shorter. By the time I finished working
on the field and coming back to the bank, it was about time to go
home.
Since I worked in a bank, I was sensitive about financing issues.
I began to pay attention to the interest rate, inflation, and my retirement
plan. Calculating what I make until the year I retire, I found out
the numbers weren’t too appealing. To me, retirement doesn’t mean
to stop working, stay home and rely on my pension to spend for the
rest of my life. I won’t have a quality life, financially speaking,
that way. My favorite definition of retirement is “ to be able to
do whatever I want to do at whenever I want to do and still maintain
a good life style financially “. I knew there was no way I could make
it happens with my paid checks. I decided to make a move and tried
the stock market in the mid 1990’s.
Every one knows the so called “golden era “of the stock market in
the 1990s. You didn’t need to be knowledgeable to make money in the
market. All you needed was the desire to try and of course, capital.
I was a new kid in the block and I was excited. The reality hit me
in 2000, shortly after the NASDAQ hit its all time high in March and
began to go down. I began to realize to make money in the stock market;
I need to learn more instead of just simply buying and selling big
name stocks.
I began to search for a creditable investment education company. I
got one earlier last year through a marketing seminar held in Pasadena.
I was skeptical at first when I saw their presentation of how to get
in and out of the stock in order to be profitable. The other thing
scared me was the price of the 2-day class they offered. I finally
decided to try the class because I realized I have to educate myself
if I want to make money in the stock market in the long run.
I took the 2-day stock seminar in late February of 2005 and it was
proven to be one of the best investments I made, so far. I took it
on Thursday and Friday on the last week of February in 2005. I was
so excited about what I had learned that I woke up my wife several
times at night just to tell her how I felt. I could not sleep well
during that weekend. I couldn’t wait until the following Monday so
I could apply what I had learned in my stock trading. After trying
the company software for one week, I decided to go further to learn
how to trade options. It was proven to be an even better financial
move for me.
It took me about 8 months to finish my stock, basic and advanced option
courses through attending seminars, reading manuals, watching DVDs,
one on one coaching sessions and practices. After I finished my stock
and option courses in October 2005, I began to trade the way I’d learned.
Not surprisingly, I got back all of my tuition in just one month of
trading. I would like to take this opportunity to share my trading
opinions with those who are interested in trading and most importantly,
making money in the stock market.
I realize that to make money, I have to sell. A sale man has to sell
to earn his commissions. A store owner sells his merchandises to make
a living. A service company sells its services to the customers to
generate income. When I worked for the bank as an appraiser, I actually
sold my appraisal skill, knowledge and services to the bank to earn
my salary. The same thing happens in the stock market. We have to
sell to make money in the stock market as well. To me, selling a stock
is actually harder than buying it. Human nature always wants more.
Hence, we tend to keep the stock and sometimes fall in love with it
because it is going up. When we hit our target price or when the stock
hits its resistance and begins to bounce off from it, it is time to
sell and take profit. If we miss the run, we can always jump back
in either with the same stock or with another up trending one. What
happens to those who take profit too early? The answer is they never
go bankrupt. One common mistake most traders make is buying the stock
when it is “cheap” and “seems” to hit bottom. Never, ever catch the
falling knife. Have we ever tried to catch a falling piano or we simply
step away from it? The answer should be obvious here. Now think if
we want to go to the upper floors, do we take the up or down elevator?
I believe the majority of us will take the up elevator. If that is
the case, there is no reason to do differently in the stock market.
If we are bullish on a stock and want to make money when the stock
goes up, we should look for up trending stocks to jump in the “up
elevator” and enjoy the ride. When we reach our target or the floor
we want to be in, we should get out of the stock or the elevator.
The trend is always our friend. If we are bullish, look for up trending
stocks. If we are bearish, look for down trending stocks. When we
pick a stock to invest, don’t just look at the stock itself. We should
also look at its industry and make sure it is also in an up trend.
Think of a stock in an industry as a house in a neighborhood. If the
neighbor is bad, it is just a matter of time before the prices of
the houses in that neighborhood go down. Emotion, emotion, emotion
in stock trading is very similar to location, location, location in
real estate. If we are in an up trending stock and the stock has a
slight pull back, we have to control our emotion. Do not prematurely
get out of the stock and miss the up trending run later. Of course,
we have to look at the technical indicators to time our entry and
exit. The technical analysis is out of the scope for this article.
I will try to cover the technical analysis in the next article if
there is enough interest in it.
Another way to play the stock market is to play option. We need less
capital to play option and with a better percentage gain. However,
option is tricky and I do not recommend option trading for beginning
traders. One thing I strongly believe is that if we want to be a successful
option trader, we must be a successful stock trader first. We must
be familiar with stock analysis before we trade option.
The two main concepts we need to know in basic option trading are
CALL and PUT. If we buy a call at a certain strike price, we have
the right, but not the obligation, to buy the stock at the strike
price even if the stock closes above the strike price on the option
expiration day, usually the 3rd Friday of the month. If we buy a put
at a certain strike price, we have the right, but not the obligation,
to sell the stock at the strike price even if the stock closes below
the strike price on the option expiration day. Needless to say, selling
a call or a put is just the exact opposite of buying it. Sound confusing?
Me too when I first learned it but believe me, the more we trade option,
the more we will be familiar with the concepts and feel more comfortable
trading it. Selling short put and call are parts of advanced option
strategies which will be covered in the next article.
Call and put are opposite option trading vehicles. When a stock goes
up, call goes up and put goes down. When a stock goes down, call goes
down and put goes up. If we are bullish, buy call and make money when
the stock is up. If we are bearish, buy put and make money when the
stock is down. An easier way to remember call and put is the telephone.
When we CALL someone, we pick UP the phone. After we finish talking,
we PUT DOWN the phone. CALL UP, PUT DOWN should be easy to remember
now. Someone may ask why bother with the put, don’t we all want the
stock to go up to make money? We do, but we also want to make money
even when the stock goes down and the put is a good option strategy
to make money in a down market. I used to be one dimension trader.
I could only make money when the market went up. If the market went
sideway or down, I either broke even or lost money. Things change
after I finished my advanced option classes last year. Call makes
money in an up market and put does the trick in a down market. How
about a sideway market? That is when the covered call strategy comes
in and does the job. When we sell the call and we have the stock to
cover us, we are playing the covered call strategy.
Let’s give a numerical example about the covered call strategy here
to illustrate the point. We bought 100 shares of ABC stock at $38/share
in October. We then sell 1 contract of the November 40 call for $1/share.
If the stock goes sideway between $38 and $39.99 between now and the
3rd Friday of November, we are not called out. The $1/share premium
is ours to keep and the net cost of our ABC stock is now $37. If the
stock closes at, let’s say, $40.50, we are called out and we have
to sell the stock at $40 but with the $1 premium we collected earlier,
we actually sell the stock for $41/share. In case we are not called
out, we can choose to sell the covered call again in the month of
December and further reduce the net cost of our ABC stock. If we see
an up trend for the ABC stock in December, we simply keep the stock
and enjoy the ride.
The call and put strategies I outlined above are the main strategies
of the basic option. In my opinion, the money machine is hidden in
the advanced option strategies which I will cover in my next article
if there is enough interest in advanced option trading.
To close this article, I like to use a joke that most of us talked
about when we first set our feet in this country. When we first got
here, we liked to take pictures of the birthday parties we attended
then sent them to our friends and relatives back home. In the pictures,
there usually be a lot of food and people were having a good time.
We jokingly said when our relatives back home see these pictures,
they must be thinking we don’t have to work to earn money in America.
We simply go out to the street and collect it because money is everywhere
on the streets in America. Well, in my opinion, there is money to
be collected on the streets, Wall Street that is.
Dennis Phan
post date: 10-18-06
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