Geldpress

If you want a great reference book for learning stock options and futures, look no further than Michael Mullaney’s book – The Complete Guide to Option Strategies.  It’s a Wiley Press book that came out in 2009 and is surely one of the best out there.

It’s a thick and comprehensive book that covers everything imagineable on the topic of options, starting with the basics, but including advanced topics such as option spread techniques, iron condors, butterfly’s and more.  It even includes several chapters of futures and options on futures trading.

Option traders are always looking for ways to reduce risk in their portfolio. One such method is through the use of synthetic positions. A synthetic position is a position that has nearly the same risk/reward and profit/loss curve as another. There is an equivalent synthetic position for all basic positions in a security.

Here is an example of a synthetic option position:

• Long Call Option synthetic is Long Stock + Long Put (married put)

A more complex example is the following synthetic equivalent:

• Option Collar syntehtic is the vertical call spread

When choosing between an option collar or a vertical spread, consider the following:

• Vertical spreads are cheaper on  a per share basis.  However, the question becomes what to do with the left over capital.  If the answer is to load up on many more vertical spreads, then you must understand the significantly increased risk from adding so much leverage.
• Tax considerations – a short term vertical spread will always result in short term tax consequences.  With an out of the money short term collar, the underlying shares can still be held for the long term.
• Adjustments – The adjustment techniques for stock option collars is completely different from that of vertical call spreads.

For more information on the tax considerations of stock options, please refer to the book below:

Capital Gains, Minimal Taxes 2009: The Essential Guide For Investors And Traders by Kaye Thomas

For more information on adjustment techniques of vertical spreads and stock option collars, the absolute best book on the market is shown below:

The Option Trader Handbook: Strategies and Trade Adjustments (Wiley Trading) by George Jabbour

The stock repair strategy can be used to lower the breakeven point on a previously purchased stock that has dropped in price.  Consider an example where you purchase 100 shares of a stock for $110 per share and it drops to $100 per share, for a loss of $10 per share or $1,000.  Under normal circumstances, you would need the stock to rally 10% back to the original $110 purchase price just to break even.  Using the stock repair strategy allows the trader to lower the break even point by utilizing a ratio option spread.

To explain the strategy, lets find a stock close to $100 per share.  Precision Cast Parts (symbol PCP) is an optionable stock that closed today’s session at $99.11.  Let’s assume that we purchased 100 shares of PCP for $110, and are now down nearly $1,100.  Note the current 52 week high is only $105 so don’t over analyze the example.  Let’s just assume we bought it 2 weeks ago for $110.

To utilize the stock repair strategy, the trader would initiate a ratio spread by purchasing (1) at the money option and selling (2) out of the money options.  Let’s take a look at the December option chain for PCP.

By doing nothing, the breakeven point of PCP is $110.  The stock would need to recover back to the original $110 purchase price for the trader to break even.  But consider the changes to the December expiration day breakeven point after adding a December 1:2 ratio spread at the 100/105 strikes.

• Original stock purchase price $110
• Current stock price $99.11
• Purchase (1) December 100 call for $4.20 (midpoint of bid/ask)
• Sell (2) December 105 calls for $2.30
• Adding the ratio spread results in a credit of $40 (2.30+2.30-4.20)

Note that implementing the ratio spread without owning the stock would result in a naked option leg and unlimited risk.  But both of the (2) 105 calls are covered in this scenario due to the fact that we still have the 100 underlying shares.  Essentially what you have is a covered call plus a vertical call spread.  Consider the following expiration day prices as an example of how the above stock repair strategy example lowers the break even point of the previously purchased stock.

• $80 – All options (100 and 105 strikes) expire worthless.  The unrealized loss is now $3,000 (110 – 80).  This is no different than owning the stock without adding the stock repair strategy options.
• $105 – The loss on the stock is only $500 (110 – 105).  The gain on the 100 strike option is $80 (500-420).  The (2) 110 options expire worthless and the gain on them is the $460 total premium collected.  With a $105 strike price on expiration, the trader is already beyond breakeven and slightly profitable with $40 in profit. (-500 + 80 + 460).

Things to consider when utilizing the stock repair strategy:

• The choice of strike prices for each leg of the ratio spread will change the breakeven point for your particular situation.
• The choice of expiration month will change the breakeven point
• Depending on the expiration day price, tt may be is possible to repeat the stock repair strategy multiple times to collect additional profit.  Consider the example above where the stock closed at $105 on expiration day.  A new stock repair strategy ratio spread could be opened for January or other expiration month.
• Options can be closed, opened, rolled, or morphed at any time.  It is not necessary to hold them until expiration.

For more information on trading and adjusting options positions, check out the following highly recommended book:

The Option Trader Handbook: Strategies and Trade Adjustments (Wiley Trading) by George Jabbour

There are several posts on covered calls at Geldpress, including:

• Time for cover – the covered call
• Covered Calls – Scottrade, Tradeking, Fidelity
• The VIX index and covered calls
• Covered Call Writers Love High Volatility
• Picking A Strike Price For Covered Call On McDonalds
• Covered calls – removing the covers and going naked

I successfully use covered calls, married puts and collars within my own accounts on a regular basis. My recent trading activity in Mosaic (symbol MOS) will show some examples of covered calls and their adjustments.  It is not necessary to keep a covered call on though the expiration date.  When the underlying stock within a covered call drops significantly, there will often be an opportunity to buy back the covered call (BUY TO CLOSE) for a modest profit.  Buying back the covered call early leaves the shares naked, and fully able to capitalize on a rebound in share price, without the limits of the profit restricting covered call.  It is purely a judgement call on exactly when to buy back the calls, but as a general rule consider buying back covered calls early for the following reasons:

1. You are still bullish on the underlying shares, and happy to own them naked (without the protection of the covered call)
2. You can realize a significant profit on the covered calls by closing them early, and there is a potential for a rebound in the share price.
3. The potential for realized profit occurs with at least 1-2 weeks prior to expiration.

A summary of the points regarding the activity above:

• Purchased 400 total shares at an average price of $51.39
• Sold (2) MOS Sep calls for $2.86 and (2) MOS Dec calls for $6.91 – SELL TO OPEN
• On Sep 10th, I rolled the Sep calls to October for more protection and to collect more premium.  This resulted in a $210 realized profit from the (2) sep 50 calls when they were closed (BUY TO CLOSE).
• On Oct 5th, with Mosaic stock down, I bought back the Oct 50 calls for a $566 realized profit.
• Mosaic reported earnings on Oct 5th at the close.  To prepare for a potential disaster, I protected the Mosaic position by buying (4) Sep 45 puts. (married put)
• With earnings over, I sold off the puts on October 6th.  I took a realized loss on the puts of $376.
• On Oct 6th, I re-covered some of my naked Mosaic position by adding (1) Nov 50 covered call.  The final 100 shares were left naked to gauge the reaction of the market on Mosaic over the next few days.
• On Oct 16th after a small rally in Mosaic (I was hoping for a major rally, but settled for a small one), I covered the remainder of my shares with another November covered call.  Note that by waiting, the second covered call sold for $120 more than the first.
• My current position is long 400 shares of Mosaic, short (2) November covered calls, and short (2) December covered calls.

The point of the above is only meant to display one such example of trading, rolling and adjusting covered calls, and not to dissect all the other possible trading ideas possible – better or worse.  Trading is a judgement call, and the above is a recent history of my own trades and adjustments based on how I felt at the time the trades were made.  You are free to have your own opinions.

Disclosure: Still long Mosaic covered calls.

Disclaimer: Trade at your own risk!  The above is an example only of recent activity in my own account, and not to be considered an opinion or trading advice of any kind.

For more information on covered calls, please consider purchasing one of the following books:

Covered Calls and LEAPS–A Wealth Option + DVD: A Guide for Generating Extraordinary Monthly Income (Wiley Trading) by Joseph R. Hooper

Covered Call Writing Demystified: Double-Digit Returns on Stocks in a Slower Growth Market for the Conservative Investor by Paul D. Kadavy

The Option Trader Handbook: Strategies and Trade Adjustments (Wiley Trading) by George Jabbour

Options trading seems to be following the same trend as poker – at least in terms of the number of books.  Poker used to be a niche game played by a few old men in cowboy hats until they started putting it on television.  Walk through the gaming section of your local bookstore and you are bound to find at least a few dozen books on poker.

Trading is the same way, especially options trading.  The relatively new Mad Money, Fast Money and Options Action are so popular that authors and publishers are racing to put out the newest books to capitalize on the trend.  Here is the latest spread trading book from Greg Jensen – Spread Trading, an Introduction to Trading Options in Nine Simple Steps.

I’m not sure if I agree with the title of comparing options trading to something simple, but in browsing through the book, it does look like its well written and with some great content.  Click on the book below to purchase.

Spread Trading: An Introduction to Trading Options in Nine Simple Steps by Greg Jensen

Trading in Mosaic (symbol MOS) was very active Friday, with trading volume over 27 million shares in a name that averages only 7.9 million shares per day.  The activity was sparked by rumors that Brazilian mining firm Vale was considering a buyout of Mosaic.  The shares were up substantially, and briefly touched $54.36, before settling at the end of the day to $49.56.

Option activity in Mosaic was just as hectic, as can be seen from a snapshot of Friday’s chain below.

While its not possible to know exactly who exercised which strategy, it is clear that there was a lot of activity, and the bulk of the activity was on the upside call side.    August calls from the 50 strike all the way to the 80 strike had option volume exceeding the total open interest, and in some cases at over 7:1 – the August 70 strikes.  Some possibilities are the following:

• A large strangle trade (~13,000 contracts) in the August 50 CALL / August 45 PUT combination
• Large upside directional CALL plays in the August contracts between the 55 and 70 strikes

Note that since Friday’s close, more news has come out about the rumored buyout.  FromYahoo Finance on Saturday:

Brazilian mining giant Vale says it is not interested in acquiring fertilizer companies, denying a recent press report that it was eyeing potash and fertilizer producer Mosaic Co. of the United States.

It will be interesting to see where Mosaic opens on Monday.  But if the shares take a big dip based on the rumor denial, all those upside call buyers could get washed out.  The 13,000 unit strangle player on the other hand, could fare much better.  His expiration day low end breakeven point is roughly $38.80 (45 – 2.20 – 4).  With so much time premium left before August expiration, his breakeven point would be quite a bit higher.  Depending on where the shares open tomorrow, he may already be in the money.

Disclosure: Current positions in Mosaic.

Remember when Bear Stearns went belly up in March 2008, plummeting to a near zero stock price?  (incidentally,this was just days after Chief CNBC Clown Cramer recommended it for the last time)

Option volume on the PUT side of Bear Stearns was at record levels just days and weeks before the implosion, implying that somebody knew the disaster was coming.  And those somebodies captured serious profit from their ill gotten bets.

For those that believe in the power of big money and their big bets in the option markets, there are at least a few FREE services out there that report on unusually high option activity volume.  Here is a roundup of three of them.  Please add any other free high volume option alert services you find in the comments section.

• Schaeffer’s Research posts 2 tables of Unusually High option volume – calls and puts.  The tables are at this link.
• Andrew Wilkinson takes it a step further.  He publishes a daily option update that provides info on high option volume trades.  But he also provides a description of what the possibility of those high volume trades are.  Andrew’s daily articles are at this link.
• The Optionmonster website offers detailed option activity as part of its fee based Heat Seeker functionality.  But a basic membership to the site is free with registration, and a snapshot of some of the Heatseeker activity is available for free on the registered users home page.

Calendar spreads are a type of option spread system that involves  buying and selling two different options across two different expiration months.  Traders love to use calendar spread in range bound markets.  A true calendar spread would involve the same strike price for both options.   Some traders prefer to utilize what is called the delta advantage with calendar spreads.  For a call options, recall that the delta of an at the money call is about .50, and the delta increases as the options increase their distance into the money.  So a deep in the money call option would have a delta that approaches 1.0.

There is a substantial difference in the outcome of calendar spreads that are at the same strike vs those that have a delta advantage.  The following examples will better explain the difference.  Consider the following calendar spread examples, using WalMart (arbitrary, not a recommendation!), and today’s closing market prices for the options.  The Optionsxpress Trade Calculator tool is utilized to generate the graphs for these examples.

Example 1 – Purchase (10) Jan 2010 LEAP option on WMT at the 45 strike for $5.65, and SELL (10) July 2009 50 strike options on WM for .47.  This is the delta advantage example.  The profit/loss graph is shown below, as of the July expiration date.

Example 2 – Purchase (10) Jan 2010 LEAP option on WMT at the 50 strike for $3.00, and SELL (10) July 2009 50 strike options on WM for .47.  This is the true calendar spread, with no delta advantage.  The profit/loss graph is shown below, as of the July expiration date.

Analyzing the Differences – Consider three extreme examples of price movement near the front month expiration of July 17th.

• Price settles at or near 50 – Both calendar spreads – with and without the delta advantage – do well, and are profitable.   But the delta advantage spread does exhibit a higher profit, as shown above ($1257 vs $854).
• Price spikes well above 50 – The delta advantage spread remains profitable.   There is still a $321 profit near a price spike to 56.69.  However, with a true calendar spread and no delta advantage, a large upward price movement could be disastrous.  A $1283 loss is realized at a price movement to $57.17.
• Price drops well below 50 -  The delta advantage loses money.  Notice that a price drop to $45 on July expiration results in a loss of about $2135.  The standard calendar spread – no delta advantage – also loses money on a big price drop but not nearly as much.  Notice that even a price drop to $46.52 only results in a position loss of $738.

The bottom line is that when utilizing calendar spreads, you should analyze the possible outcomes ahead of placing the trade.

Also check out:

• Option Bible On Diagonal Calendar Call Spreads
• Understanding the bear call credit spread
• From LEAP to calendar spread and back again
• Goal Of Deficit Cutting Is Stupid

Disclosure: Currently  Long and Short WMT via delta advantage calendar spreads, and covered calls.

Disclaimer:  No accuracy guarantees for anything on this site.  Trade at your own risk!

Let’s say you are bullish on a $45 stock in the short term.  What are your options?  You could buy 100 shares outright for $4,500.  You could sell a covered call against the stock to reduce your cost basis.  But the covered call reduces your potential profit, and if your bullish sentiment is correct, do you really want to reduce your potential profit?

Another option is to buy at the money (ATM) front month calls on the stock.  Even if you paid $2 for a front month call option, the most you risk would be that $200 premium per contract.  And your maximum gain is completely untapped.  If the stock goes to $55, then your ATM 45 strike calls become worth at least $10 each, for a 500% return.  Of course if the stock stays at or below $45 into expiration, you also risk losing 100% of your money.  But if you have a chance to lose 100% of your money, losing 100% of $200 is better than losing 100% of $4,500.  And that is the power of options!

What if you really liked the stock at $45, and were happy to own it at that price eventually, but wanted an inexpensive method to gamble on a potential explosive upside.  This is possible, and you can finance part or all of the purchase of your call options by selling naked puts against them.  With this method, and depending on the strike prices chosen, it’s even possible to get free call options.  Nothing is completely free of course, and every strategy has an associated risk with it.  Here is an example scenario.

• Assumption: Stock trades at $45, 45 strike call trades for $2, and 44 strike put trades for $1.50
• Buy (1) 45 strike call for $200 total
• Sell (1) 44 strike put for $150
• Total cost of the trade is $200 – $150 = $50

What are some possible outcomes? – If the stock goes to $50 at expiration, then your 45 strike call is worth $500 and the 44 strike put expires worthless.  Your profit is the $500 value of the call minus the $50 to put on the trade, or $450 total profit.

If the stock drops to $40 at expiration, the 45 strike call expires worthless.  By selling the 44 strike naked put, you are forced to buy the shares for $44 each, or $4,400 total for 100 shares.  At that moment in time, since the shares are only worth $40, then you have a paper loss of $4,400 – $4,000 – $50 = $450.  But the original assumption was that you were happy to own the shares anyway at the original price of $45, but wanted to take a short term “gamble” on potential upside first.

By using this strategy, there is an important consideration to keep in mind.  Your broker will almost definitely require naked put sellers to maintain cash in their account to cover the full potential loss.  By selling (1) contract of a 44 strike put, your broker will likely require you to keep $4,400 cash in your account (referred to as your margin requirement balance) just in case.

Also from Geldpress:

• Total Bailout Cost Now $12.8 Trillion
• Warren Buffett And Hank Paulson – Negotiator And Thief
• Best Book For Understanding Option Greeks
• Option Collar Length – Front Month Or Leaps
• Option Bible On Diagonal Calendar Call Spreads
• Triple Leveraged ETF’s And Counterparty Risk

For more information on the diagonal calendar call spread, check out this article:

• Option Bible On Diagonal Calendar Call Spreads

Calendar spreads involve buying and selling options on the same underlying security over two different months.   Some people refer to calendar spreads as covered calls on steroids.  When the strike prices of both options are the same, it is a calendar spread.  When the strike prices are different, it’s commonly referred to as a diagonal calendar spread.  Here is the option chain on US Bank showing calls for June and January.

The option play I recently executed was the following:

• Buy CALL options in the January 2010 LEAP for US Bank at the 17.50 strike
• Sell CALL options for June at the 19 strike. (The 20 strikes also look appealing for more bullish traders)
• The approximate cost is about $310 per spread contract ($440 for Jan 17.50 minus $130 for June 19)

In order to execute this trade, Level 3 (option spreads) options trading is required.  The delta on the 17.50 strike options will be higher than the delta of the 19 strike options.  A higher delta means that if the shares in US Bank explode higher, the LEAP options should gain more value than the June 19 options lose in value.  On the other hand, if the shares in US Bank drop significantly prior to June, then the loss on the spread is significantly less than the loss on the LEAP’s outright.  By spreading the options, the potential gain is reduced, but the potential loss is reduced along with it.  If we are indeed in a tight trading pattern, then it may be possible to continuously ROLL the front month options forward as option expiration approaches, and collect premium month after month after month.

Calendar spreads, whether normal or diagonal, can be adjusted like any other options positions or spreads.   Possible adjustments are some of the following.

• On an aggressibe stock price dip that is perceived to be temporary, it’s possible to buy back the front month calls (BUY TO CLOSE) for a profit, and let the LEAP’s run naked.
• On an aggressive stock price rally that is perceived to be long lasting, it’s also possible to buy back the front month calls (BUY TO CLOSE) for a loss, and let the LEAP’s run naked.
• At or near June expiration, it’s possible to ROLL the front month options forward and collect additional premium.  Rolling would involve buying to close the existing option and selling to open the next month in the cycle (July).
• The LEAP option can also be adjusted by ROLLing the option UP or DOWN after a big price swing.  Rolling down an option will increase the delta.  Rolling up an option allows the trader to collect some of the premium, and reduce the delta to the preferred target range of delta.  It’s all based on personal preference and your own trading style.

Disclaimer: No accuracy guarantees of anything on this site.  Trade at your own risk.  The above information is *NOT* advise of any kind.