Geldpress

Trading stock options can be fun, addictive, and potentially profitable. People are drawn to stock options because of the potential for out-sized and highly leveraged returns. But leverage works in both directions, and trading stock options can also be fatal to account values when trading without the proper knowledge and experience.

On the surface, stock options are a simple tool to both manage risk and enhance returns.  But to avoid costly mistakes, it is necessary to have a more intimate view of stock options.  That view should include a thorough understanding of the option greeks (delta, gamma, theta, vega, rho), pricing models, trading strategies and adjustments, and portfolio management.  All option books provide a snapshot of the option greeks, but for that intimate view of the option greeks, you will need this new book by Dan Passarelli, Trading Option Greeks.

Trading Option Greeks: How Time, Volatility, and Other Pricing Factors Drive Profit by Dan Passarelli

Like all option books, this book starts with a high level overview of stock options – opening and closing positions, expiration cycles, standardized contracts, and expiration day price modelling.   But the book accelerates from there to provide a deep understanding of all of the option greeks.   And there is an entire chapter devoted to the subject of volatility, something close to the hearts of options traders experienced in the financial turmoil that started in 2007.  Rounding out part one of the book are discussions on put-call parity and synthetic positions, volatility-selling strategies, and the effect of dividends on option pricing.

Part 2 of the book digs right into some complex trading strategies such as vertical spreads, iron condors, butterflies, calendar spreads and diagonals.  But every strategy discussed is done so with a keen view on the affected option greeks.    The example on the bear spread explicitly shows the assumed values of all option greeks at the beginning of the trade.  As the assumed time and stock price changes, all of the option greeks change as well.   The dynamic relationship between option greeks and time and stock price is the key to really understanding and trading options profitably.  Dan’s book is the best one out there that delivers on this premise, while at the same time providing details on complex option trading strategies.

Part 3 of the book provides 3 additional chapters on the subject of volatility.  And it ties in the volatility discussion with advanced trading styles that few people understand and implement well.  Delta neutral and gamma neutral trading are methodologies to reduce volatility in account values.  It involves taking multi-sided positions and spreads that balance out the greeks.  It’s easy to start a new delta neutral and gamme neutral portfolio, but managing it and keeping it neutral is a little more work.  Passarelli’s book covers both sides of that difficult equation in great and easy to understand detail.

Part 4 of the book adds additional insight into more trading strategies – straddles and strangles, and other complex spreads.  And it also gives general guidance on the psycological aspect of trading, and the trader’s thought process.   If I had to conceive the idea for my own options trading book, this book would come very close the vision.  It’s another one of those must and must own options books that belongs on every traders bookshelf.

Trading Option Greeks: How Time, Volatility, and Other Pricing Factors Drive Profit by Dan Passarelli

The market is heading up this morning, but I’m still not to eager to risk it all on the upside.  Portfolio hedging is still crucial in these markets.  There are many ways to hedge a portfolio, such as the collar.  The collar trade is a three way combination of purchasing shares out right, selling a covered call against the position, and also buying a protective put against that same position.

• Bring Your Collar Into These Volatile Markets

A collar limits the risk to the downside through the use of the protective put.  But it also caps the upside premium due to the covered call.  For those that want to protect to the downside, but leave the upside potential untapped, then a married PUT is the way to go.  A married PUT is the combination of buying shares in a security, and also buying a protective PUT to protect the position.

Hedging positions with either covered calls, collars, or married puts requires decisions on several factors, including:

• The strike prices of the covered calls and/or married puts
• The expiration months of the covered calls and/or married puts

There are many guidelines to help answer those questions, but experience, and your own risk tolerance are the best guides.  Protective puts can be very expensive.  For this reason, those with higher risk tolerance prefer to either go without them, or use them at lower strikes and close in expirations months.

Another portfolio hedging method that I often use is more of a hybrid model, with the expectation to adjust the hedging along the way.  I may start off with long shares held completely naked without any hedging.  If I’m nervous prior to earnings, then I’ll add a short term protective put (near term) just to get through earnings.  Protective puts can easily be removed after earnings.  If there is an artificial price spike then a covered call can be put on at or below the perceived price resistance level.

For a more in depth view of stock options and adjustments, I highly recommend the following book:

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

Here’s a helpful tip for those wanting to learn and utilize stock options in today’s market – sell options when volatility is high and buy options when volatility is low.  If you are still uncertain as to whether 2008 is a high or low volatility market, then you probably need to just stay out of the market.

For those that recognize the answer that 2008 is a high volatility market and want to SELL OPTIONS, then covered calls are one of the best ways to do so.  Once you pick a stock to utilize a covered call on, you then need to pick an expiration month and strike price to sell for your cover.  Below is the December option chain for McDonalds from Yahoo Finance, as of the close of day November 13th.  McDonalds closed today’s trading session at $52.91.

If you are going to do a covered call on McDonalds, here are the steps:

Step 1 -  Buy and read the following book from Amazon.  It’s just to dangerous to think you can trade options after reading this short post.  Just click on the book cover below to purchase.

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

Step 2 – Pick an expiration month.  November expiration has only 1 trading day left so that is out of the question.  December expiration is on December 19th, which gives plenty of time to collect some good premium, especially in this high volatility market.  January expiration is also an option.  Going beyond January is also possible, but not very appealing to me personally because it ties up the position for to long without much benefit of additional premium.

Step 3 – Analyze the potential return for getting called out of the position based on each strike you are considering.  The most popular strikes are going to be at the money, or a few strikes in or out of the money.  The separation of “IN” and “OUT” of the money is shown above by the change from yellow to white shading.

Example:  Analyze the potential called out return of purchasing 100 shares of McDonalds and selling a December 50 strike.  Assume today’s closing price and option chain are still available.

- Buy 100 shares for $5,291 and SELL TO OPEN (1) contract of the December 50 for $520.

- Net outlay and net risk is $5,291 – $520 = $4,771

- Assume McDonalds follow through with the promised dividend payment of $50 prior to expiration

- If McDonalds ontinues to trade above $50 on December 19th, then you will be forced to sell your 100 shares for $50 each, or $5,000

- Total collected from being called out is $5,000 + $50 (dividend) = $5,050

- Profit from trade = $5,050 – $4,771 = $279

- Net return if called out = $279 / $4,771 = 5.8%

- Downside protection breakeven point = $4,771 – $50 (dividend) = $4,721

Can you live with this scenario?  If so, then it is a good candidate.  If not, then perform the same analysis for other strike prices, and possibly other expiration months.

Step 4 – Decide on the combination of strike price and expiration month that is the most appealing to you personally.  It is a personal and subjective decision that takes your personal risk tolerance into play.  Nobody can tell you the correct answer except for you.

Good Luck, and as always, trade at your own risk!

If you have been attempting iron condors on the Russell 2000 index, then you may be feeling some pain lately, in the form of lost money.  Iron condors can do very well when the underlying index trades within a smooth and pre-determined channel.  Take a look at the Russell 2000 over the last year, and notice two distinct environments – a friendly iron condor environment and a potentially fatal iron condor environment.

There are many iron condor trade alert services that promise big monthly gains with iron condors.  And I’ve seen some make claims that iron condors are big money makers with only 5 minutes of work per week.  In a friendly iron condor environment that may be the case, but if you are not prepared for the unfriendly iron condor environments (Hint:  NOW!), then you probably should just stay away altogether.  Unfriendly iron condor environments can be navigated through successfully, but they are tricky and require knowledge and planning – prior to the unfriendly environment striking.

In the latest issue of SFO, John Sarkett interviewed Dan Harvey, considered the “Supertrader of Index Condors”.  Dan Sheridan of Sheridan mentoring is also mentioned in the article.  The article is freely available and highly recommended for any iron condor trader.  In the article, Dan Harvey outlines his condor trading rules and guidelines:

• Place your short strikes correctly with low deltas of between five to seven
• Watch the current psychology of the market
• Study position greeks, charts and graphs every night
• Make timely adjustments when necessary
• If you stay in the iron condor trade during expiration week, then make sure you are 2.5 to 3 standard deviations out of the money to avoid delta and gamma risk
• Optionally, place contingent orders to protect against unpleasant surprises

Dan refers to three alternative adjustments to make to iron condors entering undesirable territories, including:

1. Mickey Mouse ear – an example would be a long put debit spread near the lower limit of the original condor channel.
2. Embedded calendar – Dan mentions adding an embedded calendar two standard deviations out of the money, and either taking profit and repositioning further out on a continuation movement, or stopping out for a loss on a reversal.
3. Mighty Mouse ear – This adjustment is more expensive than the mighty mouse ear or the embedded calendar.  It refers to buying additional puts two to three strikes in front of the short strike.

Iron condors are great when they work, but you must be prepared for the potential losses, and learn the skills necessary to adjust and steer clear from trouble.  In addition to reading the entire SFO article, I’d also recommend purchasing the following book on option trading adjustments.

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

As many people are aware, covered calls are a great way to hedge your positions, and potentially enhance the returns on your portfolio.  I have written quite a bit about them, as well as selling naked puts.  The volatility in these markets makes 2008 the year of the covered call and naked put selling.  For those that understand the theory on options and covered calls, but are stuck on the order entry syntax, here is a primer for a few popular platforms.

Prerequisites for covered calls:

• You understand the concepts of options and covered calls.
• You know how to pick your own strike price and expiration month.
• You have purchased or intend to purchase 100 shares of stock to COVER your call.
• You have an account approved for options.  If not, call your broker and ask for an options form.

Assumptions for the examples below:

• Today is November 7, 2008 and the example below assumes writing a covered call on Apple (symbol AAPL).  Note:  This is NOT a recommendation!
• AAPL trades at 98.24, and the December option chain for AAPL is shown below, per Yahoo Finance:
• Write a 100 strike December covered call on Apple

Steps of writing a covered call:

1. Start by purchasing 100 shares of an optionable security.  Our example uses Apple (AAPL).
2. Decide on expiration month and strike price to sell.  Our example uses a December 100 strike.
3. Open the trade options order form for your broker.   The Scottrade options order form is shown below.
4. In the buy/sell (or similar) box, there are usually four choices – Buy to Open, Buy to Close, Sell to Open and Sell to Close.  For a covered call, select “Sell to Open”.
5. Contacts – For a single covered call involving 100 shares, then the number of contracts is 1.  The money received from selling a covered call is equal to 100 times the quoted price in the option chain.
6. Symbol – This is where syntax matters.  In the image above, Yahoo Finance lists the AAPL December 100 strike as “QAALT.X”.  But the option syntax on the order entry forms for each broker can be completely different.  For Scottrade, it would be entered as “.QAALT”, for Fidelity it would be “-QAALT”, and for Tradeking it would be “QAALT”.  Call your broker directly if you need help with the syntax.
7. Order Type – Market or Limit.  For options trading, I NEVER use market orders! I’ll start with a limit order somewhere in between the BID and the ASK.  If it doesn’t get filled after a few minutes, then I’ll change my order accordingly and try again.  As an example, if my limit order of 8.35 is accepted, then 100 times that amount ($835) gets deposited into my account immediately.
8. Duration – Day order only means that if it doesn’t get filled today, then the order is cancelled.  Good until cancelled means that your broker will keep the order open until it gets filled or until you cancel it.  In some cases, your broker may have a time limit such as 30 days where they will cancel open orders regardless.

Aftermath of writing a covered call – In theory you could do nothing and just wait.  If Apple is above 100 per share at December expiration, your broker will automatically take your 100 shares away from you, and deposit an additional $10,000 in your account.  If Apple is less then 100, your shares But you do have other options.  You can close the contract early by using a “BUY TO CLOSE” order.  Doing so would leave you with just your 100 Apple shares and you would then have the option to sell a January, or other covered call and collect additional premium.

Appearance in your account – There are two things that confuse first time covered call writers.  The first is that covered calls appear as a negative quantity in your account.  Once you sell a December Apple 100 strike, it appears in your account as a quantity of negative 1, with a corresponding debit value (i.e. -$835).  Second, options are less liquid than stock.  It is possible that even if a stock rallies 10 or 20% on a single day, the last option may not have traded for several days prior.  In those instances, the value of the options in your account usually reflect the last traded amount, and not an amount resembling the current BID/ASK values.

Other Geldpress articles on covered calls:

• Time for cover – the covered call
• Covered calls – removing the covers and going naked
• Interesting covered call on AIG – 150 percent return (No longer relevant, but interesting to read)
• Covered call writers love high volatility

Also, I highly recommend the following book on covered calls.  Free articles are great, but if you are going to trade, then you need to get serious and spend a few dollars on a good book.

Don’t delay!  Buy it NOW!  You’ve lost enough money already!

The $81.90 is a worthwhile investment to slow or stop the bleeding in your accounts, and the 4% Amazon commission will help support this site.  Also, check out the Geldpress bookstore for other great options books.

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

Leveraged ETF’s, despite their significant risks (counterparty risk correlation risk to name a few), are gaining in popularity.  There are several institutions offering double exposure ETF’s, and now a new entrant is even offering TRIPLE EXPOSURE ETF‘s.  Here is a sampling of the leveraged lineup:

• Proshares - offers single and double exposure index, sector and international ETF’s.  Also offers inversed double exposure ETF’s.
• Rydex - similar offering to that of proshares, with 14 double exposure ETF’s.
• Powershares -In general, their ETF’s hold fewer positions than traditional ETF’s, but they are not leveraged as of yet.  But I do like their dollar bull ETF (symbol UUP).
• Horizon Betapro ETF’s – Offers HBP Bull+ ETFs for double the daily performance of their underlying equity index or commodity, and HBP Bear+ ETFs for double the daily performance opposite that of the underlying index or commodity.
• Currencyshares – Not quite a leveraged lineup, but certainly worth mentioning.  These ETF’s offer a convenient way to bet on foreign currencies.  Personally, I’m more of a dollar bull then ever, but I do like the Japanese yen strength these days.  The symbol is FXY, but buy it at your own risk!
• Direxion Funds – Currently offers 1.25x and 2.5x leveraged ETF’s.
• Direxion Shares – In an industry first, they will soon offer triple leveraged (300%) ETF’s.  There will be 16 available, including the Large Cap Bull 3X (BGU), Small Cap Bull 3X (TNA), Large Cap Bear 3X (BGZ) and the Small Cap Bear 3X (TZA).

The most interesting fromt he list above are the new 3X leveraged ETF’s.  From the prospectus, there are numerous risks associated with these ETF’s.  The ones that stand out to me are:

• Correlation risk – In a nutshell, it’s virtually impossible to achieve exactly 3X the performance of the index, so don’t be surprised if the underlying goes up 1% and the 3X ETF only goes up 2.5%, and vice versa.
• Counterparty risk – Direxion uses counterparties that have access to financial instruments used to target those 300% returns.  There is no guarantee that those counterparties are, or will remain solvent in the future.  (Hint:  Bear Sterns, Lehman Brothers)  From the prospectus, “The Funds will not enter into any agreement involving a counterparty unless the Adviser believes that the other party to the transaction is creditworthy“.
• Credit risk – From the propsectus, “A Fund could lose money if the issuer of a debt security is
  unable to meet its financial obligations or goes bankrupt”.

More on correlation risk – In general, the leveraged ETF issuers do not disclose their methods for achieving 2X or greater leverage.  With the 2X funds, my own speculation tells me that the counterparties involved are either double short or double long the underlying.  The counterparties pay significant margin interest which is then passed on to the issuing fund (proshares or rydex for example), and eventually to the investors.  But with 3X funds, it’s more likely they need to access the futures and options markets to achieve the triple leverage.   If so, that could significantly increase the correlation risk for the following factors:

• Time decay – Options and futures have time premiums and time decay, which could cause more correlation differences in the 3X funds.
• Spread risk – The BID/ASK spreads on options and futures is increasing with the increasing volatility of the markets.  The institutions certainly would get the best prices, but the spreads are still not free, and the options/futures spreads are certainly larger than the spreads on stocks and ETF’s.
• Liquidity of options and futures market – It’s great for amateur investors, but if these 3X funds take off, they could find it difficult to roll contracts due to the volume involved.

Also check out:

• Correlation Error With Leveraged ETF’s

The VIX set another new intraday record today, topping out at 89.53.  As a reminder, the VIX is a measure of the average 30 day volatility of the S&P 500.  A reading below 20 is normal.  Over 30 is rare, over 50 is extremely rare, and levels near today’s high at just below 90 are simply unimaginable. Here is a 5 year chart of the VIX to show what I mean.

How can a high VIX help us? – Option traders can love and hate extreme volatility like we see in today’s market.  On the one hand, they hate it, because the cost of portfolio insurance just went up significantly.  But in the same respect, if you are seller of options, as is the case with either writing covered calls or selling naked puts, then high volatility can be your friend.

Pricing of options -There are 6 components that go into the pricing of options – stock price, strike price, risk free rate of return, time to expiration, dividends, and volatility.  Many covered call writers prefer to write at the money (ATM) covered calls, meaning if they buy a stock for $50 per share, then they would sell a 50 strike covered call option against it.  They also tend to write covered calls somewhere between 1-2 months prior to expiration.  The risk free rate of return and dividends(especially when dividends are small) are minor components of pricing options.  The implied volatility of the stock market can have a huge impact on the pricing of options, whether for portfolio insurance (buying puts), or collecting premium (selling covered calls).

Volatility and Strike price case study on covered calls -Take a look at the chart below that models the 56 day covered call prices for a $50 stock.  The 56 day example is based on today’s date (October 24th), and the December options expiration (December 19th), which is currently 56 days away.  You can download the geldpress option calculator here, and modify it at will.

Explanation of the chart above:

• Assumption:  Buy 100 shares of a $50 stock, and sell to open (1) December Call.
• The at the money (ATM) strikes are highlighted, but in the money (45 strike) and out of the money (55 strike and 60 strike) are also listed.
• From today (October 24), there are 56 days until December expiration.
• Notice that as the volatility increases, the premium collected for selling covered calls goes up dramatically.  Covered call writers LOVE the high volatility of today’s markets.
• Selling a 50 strike December covered call with an implied volatility of 70 yields $552.07, which is over 11% time premium (552 divided by 5000).  Getting called out of this position results in an 11% return on investment in just 56 days!

For additional information on:

• stock options
• covered calls
• volatility
• check out the Geldpress bookstore.

The Volatility Edge in Options Trading: New Technical Strategies for Investing in Unstable Markets by Jeff Augen

Do you send your dog into the streets without a collar?  If not, then why do you continue to trade stocks without the appropriate collar protection?

For anyone wondering, NO, it is NOT NORMAL for markets to go down over 30% in just a few weeks, then shoot up 11% in a single day.  Take a look at this chart of the S&P (via SPY) for September and October.  Does this look like a safe environment to trust your money?  Certainly not without a collar on your trades!

What is a collar trade? - Simply put, a collar trade is an option strategy that limits both the losses and the gains on your investments over a pre-determined length of time.  Since option contracts are always in lots of 100, and the collar trade utilizes option contracts, then placing a collar around your trades also requires share increments in 100.  In order to implement a collar, it is also necessary to also understand PUT options and covered calls.

Put options – Put options on equities are essentially insurance policies for your investment portfolio.  In exchange for paying an up front premium, you are entitled to SELL 100 shares of a certain stock, at a certain price, for a pre-determined amount of time.  The best analogy is car insurance.  You pay an insurance company $600 for a 6 month policy on your $20,000 car.  If your car is completely destroyed within that 6 month period, then the the market value of the car quickly goes to ZERO.  But the insurance company is required to pay you $20,000 for that worthless car.  Your car insurance premium is like the PUT OPTION premium you pay for stocks.

Covered Call – You can read the Geldpress article on covered calls here.  But in summary, a covered call is a call option you sell against stock you already own (in 100 share lots).  You collect a premium by selling the covered call, and the purchaser of that premium owns the right (but not the obligation) to purchase your shares of stock for a pre-determined time period, at a pre-determined price.

More on the collar – The collar trade involves 3 transactions.  The first transaction is buying 100 shares of stock.  As a single transaction, buying stock has limited, but substantial risk (it can only go to ZERO) and unlimited gain (it can theoretically go to infinity).  To limit the downside risk, you could purchase a PUT option on the shares of your stock.  But PUT OPTIONS can be expensive, especially in volatile markets, where the cost of portfolio insurance via Puts becomes very expensive.  To reduce the expense of protecting your stock with put options, you can also sell an out of the money covered call, and collect back some or all of the premium you paid out for the put option insurance.

Collar Example – (NOTE – ARBITRARY EXAMPLE ONLY!!! TRADE AT YOUR OWN RISK!!!)

Step 1 – Pick a stock that you are happy to own, but also want to limit risk, and don’t mind limiting some of the gain.  Example:  Apple (symbol AAPL)

Step 2 – Pick a time period that you need the collar trade insurance policy to last.  Then look to the option chains of that expiration period to find the best risk/reward trade off for your own investing style.  This is a subjective exercise.  Arbitrary collar trade time period – January 2009 option chain.

Step 3 – Decide on the strike price for the PUT option for the time period you need collar insurance for.  Use the current or purchase price of the stock as a guideline.  As of the time of this writing, AAPL trades at $107.62.  The January 100 PUT trades for an ASK price of 13.05 ($1305 per contract).  Purchasing 100 shares of Apple, and (1) contract of a a January 100 PUT on Apple would cost $10,762 + $1,305 = $12,067.  The two transactions by themselves protect the purchaser on the downside, but the cost of the insurnace ($1305) now require Apple shares to rally beyond $120.67 just for this trade to be profitable.

Step 4 – Attempt to reduce the cost of the expensive PUT option in Step 3, by also selling covered calls against your Apple position.  But remember that any covered call you sell can also reduce your profit potential on the trade.  Choosing the strike and expiration of the covered call portion of the collar trade is also a subjective exercise, but as another arbitrary example, you could sell (1) covered call on Apple using the January 2009 140 strike.  As of the time of this writing, it had a BID price of $5.10 ($510 per contract).

Step 5 – analyze total cost of trade.  The total cost of the collar trade on Apple, using the examples given is the cost of the stock, plus the cost of the put insurance, minus the cost of the covered call.  Adding it up, we get $10,762 + $1,305 – $510 = $11,557.

Step 6 – analyze maximum risk of the collar trade.  Even if Apple goes to ZERO prior to January 2009 expiration, you could still exercise your PUT option and collect the $10,000 from your PUT insurnace policy.  Therefore, the maximum loss of this trade is $11,557 – $10,000 = $1,557.

Step 7:  analyze the maximum gain of the collar trade. If Apple hits $160 at January 2009 expiration, then the PUT insurance expires worthless.  But the $140 covered call you sold as a way to reduce your PUT insurance worked to reduce your profit potential by $20 per share, or $2,000.  Your covered call will be exercised at the 140 strike price, giving you $14,000.  The maximum profit is equal to the strike price of the covered call (times 100) minus the initial cost of the trade, or $14,000- $11,557 = $2,443.

Other variations/adjustments to the collar trade:

• Put’s and covered calls do not need to be in the same month.  You could buy a January Put and sell a November covered call.  After November expiration, you can sell a December, and then again for January.
• You can remove the Put at any time, if you want to recover a portion of your insurance premium and open up the risk to the downside.
• You can also remove the covered call at any time if you sense that the underlying shares are about to rally and you want to uncap your upside potential.
• You can adjust the strike prices or expirations at any time by rolling your options.  For the put, you sell to close the existing put, and buy to open the new put.  For a covered call, you buy to close the existing covered call and sell to open a new covered call.

Other related option articles from Geldpress:

• Time for cover – the covered call
• The VIX index and covered calls
• Covered calls – removing the covers and going naked
• Understanding the bear call credit spread

Book recommendations for more detailed information, and examples:

McMillan on Options, Second Edition (Wiley Trading) by Lawrence G. McMillan

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

What a crazy day in the markets.  The rules are changing, and nobody seems to understand exactly what the rules are.  Just when you figure it out, they will certainly change on you again.  Capitalism is dead.  We are now a cross between socialism and communism.  Bernanke and Paulson just announced the largest government bailout in history, and sparked an enormous short squeeze market rally.  It’s way to early to determine the cost of this insanity on US taxpayers.   And whatever the new rules seem to be (more bans on short selling), they are sure to change again next week.

All of this uncertainty has managed to drive share prices higher, although it will likely only be temporary.  The markets seem to realize this, as evidenced by the huge BID/ASK spreads in virtually all of the option markets.  Take a look at the BID/ASK spreads below for the Russell 2000 October call contracts.  Anyone placing a MARKET order today on anything is practically begging the market makers to rip them off. Use limit orders, now more then ever!

It was a pretty brutal week in the markets this week, especially for the long investors.  The Dow Jones lost 2.8% for the week.  The S&P 500 lost 3.2% and the Nasdaq was off even more at 4.7%.  In markets like this, hedging the downside is crucial, as is maintaining cash reserves.  The cash reserves can be used for modest returns (2-4% in treasuries or CD’s) and is also very handy to buy deeply discounted stocks after a vicious week like the one that just ended.

The volatility index (^VIX) closed up over 12% for the week.  It topped out at 24.67 and now sits at 23.06, a healthy and potentially profitable level for outsized returns by SELLING options.  Covered calls are one way to play the increased volatility.   But selling puts can be just as effective.  There are two methods of selling puts – naked and covered.

Recall that the buyer of a put has the right to SELL shares of the underlying at a predetermined price, for a predetermined duration.  That means that the seller of a put may be forced into buying the shares that the put buyer is PUTTING to us.   The best time to sell puts is when volatility is high (as the shares go down, volatility generally increases), and when you are willing and able to purchase the shares at a later date, and for a lower price, if they are put to you.  Let’s explore the idea, using some of the Dow Jones components as examples.

Exxon Mobile (XOM) closed the day at 75.62.  The September 75 puts traded last at 1.36.  If you sell to open (1) contract of the XOM September 75 put, you will bring in a credit of $136.  By selling the put, you are granting the buyer the right to force you to buy 100 shares of XOM for $75 per share, or $7,500.  For this reason, most brokers will require you to maintain $7,500 of cash or margin in your account to cover the potential purchase for as long as the put contract is open.  As long as XOM remains above $75 through September expiration, then you will not be forced to buy it for $75, and that initial credit of $136 is yours to keep.  If XOM goes below $75 prior to September expiration, then you may be forced to buy 100 shares for $7,500.  However, in this case, when factored with the initial credit of $136, your effective purchase price is only $7364 (7500-136 initial credit).  If you liked XOM enough to buy it at $75.62, then in many cases it makes sense to sell a put in lieu of buying the shares outright.  The risk of selling the PUT when compared to buying the shares, is that any significant rally in XOM shares goes on without you.  Your maximum credit by selling the put is only $136 in this case, regardless of how high XOM goes.

As another example, consider Boeing (BA).  It closed today’s session at 62.89.  The September 60 put last traded for .90 ($90 credit per contract).  The October 60 put last traded for 2.00 ($200 credit), and the October 55 put last traded for .80 ($80 per contract).  If you are willing to own 100 shares of Boeing for $55 or $60 per share anyway, then selling one of the September put contracts in lieu of buying the shares may work in your favor.  By selling the puts, you may be forced to buy the shares at the agreed upon price (strike price), but if not, the initial credit is still yours to keep anyway.

Put Options : How to Use This Powerful Financial Tool for Profit & Protection by Jeffrey M. Cohen

Note and Disclaimer: examples used are arbitrary and not recommendations.