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Strategies

NAKED TRADING

By definition trading options NAKED means you do not own the stock in the case of writing calls and you have no downside protection in the case of writing puts. This type of trading is risky and can generate costly losses if the trade moves against you. This type of option trading is the most aggressive utilized by The Option Profit and is not recommended for any trader who isn’t very fluid and knowledgeable with all levels and aspects of option trading, most importantly the risks involved and the potential for losses. Below are several hypothetical examples of naked trading with both calls and puts.

CALLS

XYZ is trading at 100 and you write (sell) the 105 call for a $3 premium on the nearest expiration month, giving you $5 upside protection. For this example, XYZ stock closes at 120 on expiration and the person who is long the call exercises her right to buy your XYZ at 105. You have to go out in the open market and buy XYZ for 120, then sell it at 105 realizing a $12 loss. This type of strategy would be used if an investor feels the underlying will move very little or decline in price. If XYZ closes at 120: buy at 120 – sell at 105 + $3 premium = (-$12)

PUTS

XYZ is trading at 100 and you sell the 95 put for a $3 premium giving you $5 downside protection. For this example, XYZ goes bankrupt and closes at $0 on expiration. The investor who owns the put will exercise their right

obligating you to buy the stock at 95, realizing a $92 loss.  If XYZ closes at 0: buy at 95 – sell at 0 + $3 premium = (-$92)

SPREAD THE MONEY

A spread is the simultaneous buy and sale of two options on the same underlying with different strike prices and/or expiration dates. Utilizing spreads are a great strategy to help limit your risk on a short trade or help cover a portion of the cost on a long trade. If an investor feels the underlying will move higher, a long put spread or a long call spread would be a good trade to put in place. Conversely, if an investor feels the underlying is going to move lower, a short put spread or a short call spread would be a good trade to execute. In both the long put and long call spread you sell the higher strike. In both the short put and short call spread you buy the higher strike. An investor may want to use on the money, in the money or out of the money strike depending on the market environment. An investor may also choose to utilize a calendar spread which can be beneficial in a number of ways. A calendar spread may help reduce the cost of the long position while allowing for additional potential gains. If an investor anticipates an upcoming event may move the underlying, but is unsure of the release date, a calendar spread allows them to re-enter into a position and not have to purchase additional legs. Below are a few hypothetical examples of spread trades and the market conditions in which they would be profitable. For these illustrations XYZ is trading at 100.

Long call spread:

If an investor feels XYZ is going to move higher they would go long the 100 call for $5 and write the 110 call for $1 reducing the cost of the long position. If XYZ closes higher than 104 on expiration they realize a gain, with $6 being the maximum profit, the difference between 100 and 110 minus the $4 cost of the premium. If XYZ closes below 100, the maximum loss is $4, the difference between the cost of the 100 premium and the sell of the 110 premium.

Short call spread:

If an investor feels XYZ is going to move lower or remain stable they would write the 100 call for $5 and go long the 110 call for $1, which creates protection if XYZ moves higher than 110. If XYZ closes below 100 on expiration, the maximum profit is $4, the sell of the 100 minus the purchase of the 110. If XYZ closes above 110 on expiration the maximum loss is $6, the difference between 100 and 110 minus the $4 premium received.

Long put spread:

If an investor feels XYZ is going to move higher or remain stable they would short a 100 put for $5 and go long a 90 put for $1. If XYZ closes above 100 on expiration the maximum gain = $4, the difference between the sell of the 100 and the buy of the 90. If XYZ closes below 90 on expiration the maximum loss is $6, the difference between 100 and 90 minus the $4 premium received.

Short put spread:

If an investor feels XYZ is going to move lower they would go long a 100 put for $5 and write a 90 put for $1, reducing the cost of the long position. If XYZ closed below 96 on expiration they would realize a gain with the maximum gain = $6, the difference between 100 and 90 minus the $4 cost of the premium. If XYZ closes above 100 on expiration the maximum loss is $4, the difference between the cost of the 100 minus the sell of the 90.

Calendar spread:

Although the earnings release date for XYZ falls after May expiration, Tom anticipates a pre-announcement prior to expiration which he feels will move XYZ higher. In the event the pre-announcement doesn’t occur, Tom wants to have an XYZ position on the date earnings are released. The ask on the May XYZ 100 call is $5, the bid on the May 110 call is $1, due to expected volatility from earnings; however, the bid on the June 115 call is $3. Tom buys the May 100 call for $5 and sells the June 115 call for $3. With the additional June premium Tom’s maximum gain isn’t limited to 6$ and reduced the cost of his May call to 2$ from 4$. Tom can now purchase the June call, if necessary, without having to pay for an additional June leg. Tom now has the potential to realize a gain in May or create a June spread by going long a June call establishing the potential to realize a gain in June.

The Math:

May 100 long call $5 – June 115 short call $3 = total cost of $2 If XYZ closes below 100 on June expiration the maximum loss is 5$ premium paid – 3$ premium received = 2$. If Tom goes long a June 100 call and XYZ closes above 115 on June expiration the maximum return is a 15$ gain on XYZ – 2$ premium paid on May call – premium paid to purchase June call.

ROLLING

Rolling an option is done by closing the closest month position and opening a position with a future expiration date. Rolling a long or short call option, put option, or spread is a simple strategy with which I encourage all option traders to familiarize themselves. There are both a variety reasons why a trader would roll as well as a variety of possible outcomes available to a rolling trader. Some of these include:

Increase upside potential:

Increase upside potential – by rolling out another expiration period. In this example XYZ is trading at 110 and we are long this month’s 100 call expiring today. We can buy XYZ at 100 or sell the 110 call for a 10$ gain (minus premium paid to buy the 100 call). We can also roll the 10$ received from selling the 100 call and use the gain to simultaneously buy the next month XYZ 100 strike call. By rolling out another month you’ve increased the amount of time you have to realize a potentially higher gain and used profit in doing so.

Generate additional premium:

Generate additional premium – by rolling out another expiration period. let’s say our XYZ is trading at 100 and you sold a 101 put for 5$ that expires today. Instead of having to buy XYZ at 101 you can close today’s 101 put option while simultaneously opening the same strike put to a future expiration. There is no time value for the option expiring today so, with XYZ trading at 100, you should pay ~1$ to close the 101 strike put. Since options with future expiration have time value the next month 101 put pays 5$. Now, by rolling, you have converted what would have been a loss in premium into a potential 9$ gain if next month’s 101 put expires worthless.  MATH =  5$ for first put position – 1$ to close + 5$ to open now future put position.

Move up or down a strike:

Move up or down a strike – by rolling out another expiration period. Again we will say our XYZ is trading at 100 and we sold the current month 101 put which expires today. As before we have to either buy XYZ at 101 or pay 1$ to close the positions. Since entering this trade we’ve become concerned about the market and feel this stock will drop. Now we can roll to the next month 101 and collect the 5$ premium or we can roll to the next month 90 strike put with only pays 1$. You are even on the 1$ premium allowing you to  keep the entire premium from the original trade. You also reduced the risk of you having to buy XYZ from 100  to 90 by moving down your strike. MATH = sold this months 101 put for 5$ – 1$ to close this months 101 put + 1$ selling the next month 90 put – original 5$ premium + 10$ downside risk.

Adding contracts:

Adding contracts -by rolling out another expiration period. In this example our XYZ is trading at 110 and we are long 25 contracts of this month’s 100 strike call. We can do any of the above mentioned things or we can use the profit to increase potential future gains by adding contracts. We sell the 25 contracts we  at this month’s 100 strike and take the 10$ gain to buy 50 of the next month out 110 calls with an ask of 5$. We have increased our upside potential strike from 100 to 110 but If the call expires worthless we have used  profits to finance the trade. On the other hand, if the stock climbs we now have exposure to 5k shares on the upside. Math = 25 contracts of this months 100 strike call  x 10$ = 2500 / 5$ premium spent rolling = 50 next month 110 strike call contracts

STRADDLE & STRANGLE

Straddle:

A straddle is entered into when an investor goes long or short the same number of put and call contracts on the underlying with each contract having the same strike price and expiration date. In a long straddle, an investor anticipates high volatility and goes long both the put and the call contracts. The investor now has the potential to profit from large moves in the underlying in either direction. If the underlying moves in either direction more than the combined cost of the premiums, the investor realizes the difference. In a short straddle the investor anticipates minimal volatility thus selling both the put and the call. The investor collects the premium for the sell of each position. If the total premium collected is greater than the cost to cover the losing position, the investor realizes a gain. Below are hypothetical examples of straddle trades and how they could be profitable assuming XYZ is at 100.

Long Straddle:

If the investor expects high volatility she would buy the May XYZ 100 call for $3 and buy the May 100 XYZ put for $3. On expiration, if XYZ is trading above 106 or below 94, she would realize the difference. If XYZ closes at 107 she realizes a $1 gain.

The Math:

long call contract ($3) + long put contract ($3) = ($6) + $7 gain on the 100 call = $1 gain.

Short Straddle:

If the investor expects minimal volatility he would sell May XYZ 100 call for $3 and sell the May XYZ put for $3. On expiration, if XYZ closes below 106 or above 94, he realizes the difference. If XYZ closes at 95 he realizes a 1$ gain.

The Math:

short call contract $3 + short put contract $3 = $6 – $5 loss on the 100 put = 1$ gain.

Strangle:

A strangle utilizes a strategy similar to the straddle but incorporates two strike prices.

Long Strangle:

If the investor expects high volatility he would buy the May XYZ 110 call and for $1 buy the May XYZ 90 put for $1. On expiration, if XYZ closes above 112 or below 88, he realizes the difference. If XYZ closes at 113 he realizes a $1 gain.

The Math:

Long call contract ($1) + long put contract ($1) = – $2 + $3 gain on the 110 call = $1 gain.

Short Straddle:

If the investor expects minimal volatility he would sell May XYZ 110 call for $1 and sell the May XYZ 90 put for $1. On expiration, if XYZ closes below 112 or above 88, he realizes the difference. If XYZ closes at 89 he realizes a $1 gain.

The Math:

short call contract $1 + short put contract $1 = $2 – $1 loss on the 90 put = 1$ gain.

COLLAR YOUR STOCK

Collar:

A collar is placed on the underlying position by selling a covered call and purchasing a protective put. With this strategy, upside appreciation is limited but allows the investor to decrease their downside risk. Typically, the investor would use the premium received from the sell of the call to cover some to all of the cost of the put. The investor gives up the potential for upside gains on the underlying past the covered call strike. In return, the investor limits any loss on the underlying below the put strike price. Below is a hypothetical example of a collar trade and the benefit it would offer an investor assuming XYZ is trading at 100.

Sell the XYZ May 105 covered call for $3 and buy the XYZ May 95 put for $3. The investor has given up any potential gain on her XYZ position above 105 but has capped any loss on her XYZ position to $5. If XYZ is trading between 95 and 105 on expiration no benefit is realized from the collar, however the option trade was executed at no cost.

The Math:

If XYZ closes at 110 on expiration, the collar trade capped the gain to $5 on the stock. If XYZ closes at 90 on expiration, the collar trade capped the loss to $5. Maximum gain = 5$ if XYZ closes at 105 on expiration.

BUTTERFLY & CONDOR

A butterfly spread consists of 4 trades using three strike prices, with one strike higher, one strike lower and two in the middle with the same strike. All strikes share the same expiration date. The condor is similar but the two middle positions have different strikes.

To enter into a butterfly call spread an investor would buy a higher strike call contract, buy a lower strike call contract, then sell two call contracts of the same strike in the middle. To enter into a butterfly put spread, an investor would buy a higher strike put contract, buy a lower strike put contract, then sell two put contracts with the same strike in the middle.

A condor transaction would follow the same principal with the middle contracts having separate strikes. With this strategy an investor would enter in the trade with the expectation that the underlying will close at or near the middle strike price. Typically, this strategy will have a minimum cost and offers potential for a minimum return with little risk. The investor will know both the highest possible return and the maximum potential loss at execution.

NOT SURE ABOUT DIFFERENCE BETWEEN TRADITIONAL AND MODIFIED BUTTERFLY?

The Math - Traditional Butterfly:

Anticipating XYZ will close at or near 105, an investor would buy a May 100 call for $6, buy a May 110 call for $1 then sell 2 May 105 calls for $3 each for a total cost of $1, the maximum potential loss. On expiration, if XYZ closes at 105, the investor would realize the maximum gain of $4, which decreases as XYZ moves away from the middle strike price in either direction.

@ 100 all expire worthless – $1 premium = $1 loss
@ 105 100 call = $5 gain – $1 premium paid = $4 gain
@ 110 100 call = $10 gain – $10 105 call loss – $1 premium = $1 loss

The Math - Modified Butterfly:

Anticipating XYZ, currently trading at 101, will close above 100 or below 90 an investor would sell a May 100 put for $6, a May 90 put for $1 then buy 2 May 95 puts for $3 each realizing a $1 premium, the maximum potential return. The potential for loss = $4 as the underlying moves towards 95.

@ 100 all expire worthless and $1 premium is realized
@ 95 100 put = $5 loss + $1 premium = $4 loss
@ 90 100 put = $10 loss + $10 gain on 95 puts + $1 premium = $1 gain

The Math - Traditional Condor:

An investor would buy May 100 call for $6 and May 110 call for $1, then sell a May 105 call for $3.50 and a May 106 call for $2.50, anticipating more volatility and allowing for a larger window to realize a potential $4 profit. The potential loss is $1, the cost of the purchases minus the premium received from the sells. If, at expiration, XYZ closes between 105 – 106 the investor realizes the maximum gain declining as the underlying moves away in either direction.

@ 105, 100 call = $5 gain – the $1 premium paid = $4 gain
@ 106, 100 call = $6 gain – 105 call $1 loss – $1 premium paid = $4 gain
@ 110, 100 call = $10gain – $5 105 loss – $4 106 loss -$1 premium loss = 0