Options Trading



Options Trading

Definitions and keywords:

• Call Option- A buyer of a call option has the expectation that the underlying security is going to move up.

He pays a fee to the call option seller to control a bullish directional position of long 100 shares of stock.

• Put Option- A put option buyer has the expectation that the underlying security is going to move lower in price. He has the right to control a bearish directional position of short 100 shares of stock for a specified period of time at a certain strike price.

• Strike Price

o IN-THE-MONEY (ITM)

o AT-THE-MONEY (ATM)

o OUT-OF-THE-MONEY (OTM)

For call options, if the strike price is higher than the stock price, it is called OTM. Strikes near stock price will be called ATM. Any strikes lower than stock price will be called ITM (NOT PROFITING)

For put options it will all be opposite view.

• Breakeven Price

It is calculated by adding the cost (option premium) to the strike price.

E.g $0.40+ $25= $25.40

Note: Option contract has a 100x multiplier so our option cost (0.4x100= $40)

• Volatility

o Historical Volatility

o Implied Volatility

o Skew Factor or Volatility Skew

▪ Reverse Skew

• IV goes up as we go lower in strikes (forms left half of a U shape if drawn as a graph)

▪ Forward Skew

• IV goes up as we go higher in strikes (forms right half of a U shape if drawn as a graph)

▪ Smiling Skew

• Forms a U shape when drawn as a graph.

• How Options Are Priced

o Current price of underlying security

o Strike Price

o Days left to option expiration

o Volatility (historical or implied)

o Interest Rates (little effect)

o Dividend (little effect)

• Delta

o The value tells us percentage-wise how much the option price will move in conjunction with a move in the underlying stock.

Tools of the Trade



option-

.au



For EXCEL users,









Websites for the options exchanges

















Stock and option scanners







trade-



Others,





for commodity volatility charts







Free mag subscriptions,







5 Option Strategies

Strategy #1 – Buy DITM options

*Requirements: For pitting against buying common stocks the usual way.

1. Make sure to buy Deepest ITM options as possible when picking a strike price.

2. Make sure the delta is 90% or higher.

Which DITM to choose from? To get the best option, weigh the cost (premium), breakeven price and delta factor. Breakeven price should be as close to that of stock as possible.

NOTE: This strategy will be the counter plan to actually buying common stocks. Our cost has been reduced to almost 50% by buying DITM options that mimic the actions of the actual stock price.

Strategy #2 – Selling Naked Put

*Requirement: Only if you want to potentially own a stock that you really want to buy long on the long term.

When you sell 1 IBM Jan 08 $20 put, you are guaranteeing someone that you will purchase 100 shares of IBM at $18 AT ANY TIME until that option expires on the 3rd Friday of Jan 08.

Scenarios

Stats: 100 IBM stocks trading now Sep 07 at $22.63

You paid premium of $0.50 for contract (.50x100=$50)

1. IBM closes below $20 strike on expiration day e.g $19.80

• You will get assigned 100 shares at $20. The only way to get the shares is that the stock price MUST close below the strike price level on expiration day.

2. IBM closes above $20 strike on expiration day.

• The option expires worthless and you get to keep the initial $50.

*The main key about this strategy is not to gain income of profits but to POTENTIALLY OWN your pinpointed stock at a cheaper price.

Strategy #3 – Option Credit Spread

*Requirement: Nil

1. Bear Call Option Credit Spread – a neutral/ bearish directional option spread used with call options.

2. Bull Put Option Credit Spread- a neutral/ bullish directional option spread used with put options.

*With option credit spreads, we’re predicting where the market won’t go to, in comparison with straight calls/puts where we predict the market is going up or down.

For bearish securities, SELL a Bear Call Option Credit Spread.

(Then buy back)

For bullish securities, SELL a Bull Put Option Credit Spread.

(Then buy back)

*Whenever you’re selling option spreads (BULL PUT), you always sell the more expensive option and buy the less expensive option.

Why? When we sell the more ex option, we get a bigger premium paid by the buyer than the premium we pay for the less ex option. So we get a positive difference in selling the spread.

When the spread (bull put) is bought back, we are actually buying back more ex option and selling off the less ex option.

*Whenever you’re selling option spreads (BEAR CALL), you always sell the less expensive option and buy the more expensive option.

When the spread (BEAR CALL) is bought back, we are actually buying back the less ex option and selling off the more ex option.

E.g we will sell this bear call option at say, $140 and then buy it back at a cheaper price of $70.

*Use RSI indicator against price chart to determine entry and exit points.

Cushion amount calculated by subtracting the short strike of the spread from the current price of the commodity.

Breakeven price is calculated by taking the credit(in terms of points) we receive from buyer and subtracting it from our short strike option.

Beauty of selling OTM spreads is that we have a large cushion before the actual price hits our breakeven price.

Strategy #4 – Sell Covered Calls

*Requirement: You must own long stocks firstly, and the stock has not been able to meet your selling point.

1. You sell call options of your own long stocks to someone who hopes the price will go up beyond his strike price.

2. You receive his premium for selling the call options.

Scenarios

Stats: 100 IBM stocks trading now Sep 07 at $20

Buyer buys Jan 08 $28 Calls for $1.50

You pocket $1.50x100= $150

1. Stock Price falls below $28 strike

• If it trades below $20 before expiration date, BUY it back at a cheaper price because the option would’ve already cheapened in value. But you still gain some profit in the difference in both premium.

• If after expiration date, you do nothing, you get to pocket the full $150.

2. Stock Price climbs above $28 strike

• Buyer will get assigned the 100 IBM stocks at $28.

• You will have the $150 plus the profits from selling the 100 IBM stocks at $28.

• Total gain= $(150+2800-100x200)= $950

*Selling covered calls allows you to offset some of the capital you spent buying the long stocks.

Bonus: Strategy #5 – Ratio Option Spread

1. Buying an OTM option

2. Selling multiple less-ex, farther-OTM options against it in 1 single transaction.

3. The key is to sell enough OTM options to give you a positive net credit on the trade, even after factoring in commissions.

4. Either buy AND sell calls or puts. Not Calls+Puts.

5. Smiling Skew pattern in IV helps here as we will not need to sell a huge number of OTM options to offset the cost of the long ATM option.

*Objective here is to earn the sure but small premium (net) when all option contracts expire worthless.

E.g 1

Mini Dow trading now at 11000 mark.

We sell 56 contracts of 7000 Puts. Nets us $560.

|Dow Price |10400 Put strike P/L |7000 Put Strike P/L (OTM, selling)|Total P/L |

| |(ATM, buying) | | |

|7000 |51000 |560 |51560 |

|7500 |43500 |560 |44060 |

|8000 |36000 |560 |36560 |

|8500 |28500 |560 |29060 |

|9000 |21000 |560 |21560 |

|9500 |13500 |560 |14060 |

|10000 |6000 |560 |6560 |

|10500 |-30 |560 |530 |

|11000 |-30 |560 |530 |

|11500 |-30 |560 |530 |

Scenarios

1. As long as Dow closes above 7000 on expiration day, we pocket the $560.

2. If it closes below 7000, we lose the premium and unlimited losses. But that’s a great 4000-point cushion away until we incur losses. To protect against that, we buy NOT-SO-FAR put options like a 10400 PUT. So as Dow drops below and beyond 10400 from 11000, we start to gain profits.

*Profit zone is unlimited with the protection used!

E.g 2

Being Bullish on Soybean trading now at 604 ¾.

We’ll sell 820 calls and buy 680 calls.

Why?

1. After checking historical performances of soybean at this particular season that we’re going to trade, it has never gone beyond 820.

2. So any buyers of 820 calls through us will not profit from their side of the call option. Hence we can easily pocket the premium they paid.

3. To protect our previous trade in case soybean prices really soar above 820 to cause us a loss, we will buy 680 calls for a total amount less than whatever premium we got for selling the 820 calls.

4. We choose these 2 particular strike prices because of the IV skew discrepancy between them.

|Soybean |680 Call P/L |820 Call P/L |Total P/L |

| |(Buying) |(Selling) | |

|500 |-450 |531.25 |81.25 |

|550 |-450 |531.25 |81.25 |

|600 |-450 |531.25 |81.25 |

|650 |-450 |531.25 |81.25 |

|680 |-450 |531.25 |81.25 |

|700 |550 |531.25 |1081.25 |

|750 |3050 |531.25 |3581.25 |

|800 |5550 |531.25 |6081.25 |

|820 |6550 |531.25 |7081.25 |

|850 |8050 |-6968.75 |1081.25 |

|855 |8300 |-8218.75 |81.25 |

|860 |8550 |-9468.75 |-918.75 |

|900 |10550 |-19468.75 |-8918.75 |

|950 |13050 |-31968.75 |-18918.75 |

*Optimum exit point will be Soybean trading at 820 or anywhere slightly below it.

*Note that the latter breakeven point before we enter into the “losses zone” is calculated through option prices to be at 855.

*Again our profit zone is huge from Soybean price of 0- 855!

*The ratio spread can get tricky if the market makes a large adverse move very quickly soon after putting on the trade. Try to keep the distance between the strike prices quite wide, as that offers you even more protection.

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