Long Strap

Outlook: Neutral to Bullish

Strap  -  Buy TWO Strike Calls, Buy ONE Strike Put.
          -  An adjustment strategy to Straddle , buying one more Call..
             

Strategies...

•      Buy TWO Strike Calls (ATM)
•      Buy ONE Strike Put (ATM) with same expiration.
•      Strap is more expensive than straddle,only do strip when there is a big jump in stock price.
•      Make profit with stock price moving in either direction, preferably to the upside movement.
•      Limited downside risk, uncapped upside potential profit.

Example...

Oracle Corporation (NASDAQ:ORCL) is traded at $26.30 on May, 2012. To do a Strap, you

•         Buy TWO Sept 2012 $26 Calls at $2.00.
•         Buy ONE Sept 2012 $26 Put at $1.70.

Long Strap

Long Strap

Advantages...

•     Profit from volatile stock's movement, preferably upside move.
•     Uncapped potential profit

Disadvantages...

•     Expensive - Buy TWO Calls & ONE Put (ATM)
•     Significant movement of stock to cover all costs.
•     Time decay accelerates as options close to expiration.

Maximum Profit:          Uncapped Profit

Maximum Loss:           $2.00 + $2.00 + $1.70 = $5.70
                                      (Two Call Premium + One Put Premium)

Breakeven Up:            $26.00 + $2.85 = $28.85
                                     (Strike Price + half Premium Paid)

Breakeven Down:       $26.00 - $5.70 = $20.30                                 
                                    (Strike Price - Premium Paid)

Long Strip

Outlook: Neutral to Bearish

Strip  -  Buy TWO Strike Puts, Buy ONE Strike Call.
         -  An adjustment strategy to Straddle , buying one more Put..
              
Strategies...

•  Buy TWO Strike Puts (ATM)
•  Buy ONE Strike Call (ATM) with same expiration.
•  Strip is more expensive than straddle,only do strip when there is a big jump in stock price.
•  Make profit with stock price moving in either direction, preferably to the downward movement.
•  Limited downside risk, uncapped upside potential profit.

Example...

AT&T Inc. (NYSE:T) is traded at $34.10 on May, 2012. To do a Strip, you

•     Buy ONE Aug 2012 $34 Call at $0.80.
•     Buy TWO Aug 2012 $34 Put at $1.20.

Long Strip

Long Strip

 Advantages...

•     Profit from volatile stock's movement, preferably downside
•     Uncapped potential profit

Disadvantages...

•     Expensive - Buy TWO Puts & ONE Call (ATM)
•     Significant movement of stock to cover all costs.
•     Time decay accelerates as options close to expiration.

Maximum Profit :        Uncapped Profit

Maximum Loss :         $0.80 + $1.20 + $1.20 = $3.20
                                    (Call Premium + Two Put Premium)

Breakeven Up :          $34.00 + $3.20 = $37.20
                                   (Strike Price +  Premium Paid)

Breakeven Down :     $34.00 - $1.60 = $30.80                                  
                                   (Strike Price - Premium Paid/2)

Long Strangle

Outlook: Neutral

Strangle -   Buy Lower Strike Put, Buy Higher Strike Call
               -   Adjusted strategy to Straddle, slightly cheaper
            
Strategies...

•     Buy lower strike Puts (OTM)
•     Buy Higher Strike Calls (OTM)
•     Select highly volatile stock
•     Strangle is cheaper than Straddle (buying OTM options in strangle, ATM  options in Straddle)
•     Make profit with big move in stock in either direction.
•     Limited downside risk, uncapped upside potential profit.

Example...

McDonald's Corporation (NYSE:MCD) is traded at $90.20 on May, 2012. To do a Strangle, you

•     Buy Sept 2012 $92.50 Call at $2.10.
•     Buy Sept 2012 $87.50 Put at $3.00.

(To do a Straddle, you buy Sept $90 Call at $3.30, and Sept $90 Put at $4.20. You pay more by using Straddle strategy)

Long Strangle

Long Strangle

Advantages...

•     Cheaper than Straddle
•     Profit from volatile stock's movement
•     Uncapped potential profit

Disadvantages...

•      Significant movement of stock to cover all costs.
•     Time decay accelerates as options close to expiration.

Maximum Profit:          Uncapped Profit

Maximum Loss:          $2.10 + 3.00 = $5.10
                                     (Call Premium + Put Premium)

Breakeven Up:           $92.50 + $5.10 = $97.60
                                   (Strike Price +  Premium Paid)

Breakeven Down:      $87.50 - $5.10 = $82.40                                 
                                    (Strike Price - Premium Paid)

Long Straddle

Outlook: Neutral 

Straddle - Buy Calls and Puts with the SAME Strike Price and Expiration Date.
               - Most popular volatility strategy 

Strategies...

• Buy at-the-money Call and Put with expiration 2-4 months away.
• Do Straddle before any announcement of a company (to  profit from volatility of the stock)
• Ensure movement of stock price is enough to cover the premium paid to both Call and Put.
• Make profit with stock price moving in either direction.
• Limited downside risk, uncapped upside potential profit.

Example...

Wal-Mart Stores, Inc.(NYSE:WMT) is traded at $65.70 on May, 2012. It's earning report will be released next week, to do a Straddle, you

• Buy July 2012 $65 Call  at $2.00.
• Buy July 2012 $65 Put at $1.40. 

Long Straddle 

Long Straddle

Advantages...

• Profit from stock's movement
• Uncapped potential profit

Disadvantages...

• Pay options premium TWICE.
• movement of stock must be significant to cover all costs. 
• Time decay accelerates as options close to expiration.

Maximum Profit:          Uncapped Profit

Maximum Loss:           $2.00 + $1.40 = $3.40
                                      (Call Premium + Put Premium)

Breakeven Up:               $65 + $3.40 = $68.40
                                     (Strike Price +  Premium Paid)

Breakeven Down :              $65 - $3.40 = $61.60                                   
                                    (Strike Price - Premium Paid)

Options Basic Concepts

Options Trading...

• What Is Options

• Why Option Trading

• American & European Style Options

• Options Intrinsic Value & Time Value

• In-the-money, At-the-money and Out-of-the-money

• Why Not Exercising the Option

• What is Bid-Ask Spread 

• Market Order & Limit Order 

FOUR simple options trading strategies...

•        Call Option - Buying A Call 
•        Put Option - Buying A put
•        Short Call - Covered Call & Naked Call
•        Short (Naked) Put

What Is Options

What is Options...


Options is a derivative financial instrument that specifies a contract between two parties for a future transaction on an underlying stock at a reference price (the strike).

Call Options 

• Call buyer has right to BUY underlying stock at reference price. 
• Bullish - believe future stock price will rise higher than reference price

Put Options 

• Put buyer has right to SELL underlying stock at reference price.
• Bearish - believe future stock price will fall lower than reference price.

Vertical Strategies

Vertical Strategies - Buying or Selling a Call or Put Option with SAME Expiration Date but Different Strike Price.

• Bull Call Spread
• Bear Put Spread
• Bull Put Spread
• Bear Call Spread

• Bull Call Ladder
• Bull Put Ladder
• Bear Call Ladder
• Bear Put Ladder

Bear Put Ladder

Bear Put Ladder -  Sell lower strike Put, Sell middle strike Put, Buy higher strike Put

Strategies...

•         Sell lower strike Put
•         Sell middle strike Put with the same expiration date.
•         Buy higher strike Put with the same expiration date.
•         Extension to Bear Put Spread strategy by shorting another Put at lower strike.
•         Short-term strategy, cause of uncapped risk.
•         Maximum Profit if stock falls between the middle and lower strikes.

Example...

Amazon.com, Inc.(NASDAQ:AMZN) is traded at $215 on May 29, 2012.

•             Sell Jun 2012 $200 Put option for $2.20.
•             Sell Jun 2012 $210 Put option for $4.90.
•             Buy Jun 2012 $220 Put option for $9.80.

Bear Put Ladder

  

How does Bear Put Ladder work...

Bear Put Ladder

Net premium paid:             $9.80-$4.90-$2.20=$2.70

Maximum Profit:                $220 - $210-$2.70=$7.30
                                             (Lower strike - (Higher strike - Middle strike) + net premium paid)

Maximum Loss:                  $200 -($220-$210) + $2.70 = $192.7
                                           (Lower strike - (Higher strike - Middle strike) + net premium paid)

Breakeven (Downside):      $200 - $7.30 = $192.7                                     
                                            (Lower strike - maximum profit)

Breakeven (Upside):         $220 - $2.70 = $217.30                                    
                                          (Higher strike  - net premium paid)

Bear Call Ladder

Bear Call Ladder -  Buy lower strike Call, Buy middle strike Call, Sell higher strike Call

Strategies...

•         Sell lower strike Call (OTM)
•         Buy middle strike Call with the same expiration date.
•         Buy higher strike Call with the same expiration date.
•         Extension to Bear Call Spread strategy by buying another call at higher strike.
•         Longer-term strategy, cause we net long position.
•         Make uncapped profit if stock price rises above higher strike.

Example...

Best Buy Co., Inc.(NYSE:BBY) is traded at $19.20 on May 29, 2012.

•             Sell Sep 2012 $20 Call option for $1.49.
•             Buy Sep 2012 $22 Call option for $0.84.
•             Buy Sep 2012 $24 Call option for $0.44.

Bear Call Ladder

 How does Bear Call Ladder work...

Bear Call Ladder

  

Net premium gain:             $1.49 - $0.84 - $0.44 = $0.21

Maximum Profit:                Uncapped potential profit

Maximum Loss:                  $22 - $20 - $0.21 = $1.79
                                            (Middle strike - Lower strike - net premium gain)

Breakeven (Downside):      $20.00 - $0.21 = $19.79                                    
                                            (Lower strike - net premium gain)

Breakeven (Upside):         $24.00 + $1.79 = $25.79                                  
                                          (Higher strike  +  maximum loss)

Bull Put Ladder

Bull Put Ladder -  Buy lower strike Put, Buy middle strike Put, Sell higher strike Put

Strategies...

•         Buy lower strike Put(OTM)
•         Buy middle strike Put (OTM) with the same expiration date.
•         Sell higher strike Put (OTM) with the same expiration date.
•         Bull Put Ladder is a Bull Put Spread with a additional put leg.
•         Extension to Bull Put Spread strategy by buying another put at lower strike.
•         Short-term income strategy

Example...

Microsoft Corporation (NASDAQ:MSFT) is traded at $29 on May 25, 2012.

•             Buy July 2012 $24 Put option for $0.15.
•             Buy July 2012 $26 Put option for $0.32.
•             Sell July 2012 $28 Put option for $0.74.

Bull Put Ladder

How does Bull Put Ladder work...

Bull Put Ladder Table

Net premium gain:             $0.74 - $0.15 - $0.32 = $0.27

Maximum Profit:                $24 - $0.27 = $22.27
                                             (Lower strike - net premium gain)

Maximum Loss:                  $28 - $26 - $0.27 = $1.73
                                            (Higher strike - middle strike - net premium gain)

Breakeven (Downside):      $24.00 - $1.73 = $22.27                                     
                                            (Lower strike - maxium loss)

Breakeven (Upside):         $28.00 - $0.27 = $27.73                                     
                                          (Higher strike  - net premium gain)

Bull Call Ladder

Bull Call Ladder -  Buy lower strike Call, Sell middle strike Call, Sell higher strike Call

Strategies...

•     Buy lower strike Call (either ATM or slightly OTM)
•     Sell Middle Strike Call (OTM) with the same expiration date.
•     Sell Higher Strike Call (further OTM) with the same expiration date.
•     Expect stock rise to middle strike price but not above the short higher strike price.
•     Preferably shorter term to expiration

Example...
JPMorgan Chase & Co.(NYSE:JPM) is trading at $33.50 on May 26, 2012.

•         Buy June 2012 $34 Call option for $1.00.
•         Sell June 2012  $36 Call option for $0.35.
•         Sell June 2012  $38 Call option for $0.10.

Bull Call Ladder

How does Bull Call ladder work?

Stock price at $30...

•             Buy  June 2012 $34 Call = Call not exercise, $0
•             Sell  June 2012 $36 Call = Call not exercise, $0
•             Sell June 2012 $38 Call = Call not exercise, $0
•             Net premium paid: $1.0-$0.35-$0.10=$0.55
•             Profit: -$0.55

Stock price at $34.55...

•             Buy June 2012 $34 Call = Exercise call, gain $0.55
•             Sell June 2012 $36 Call = Call not exercise, $0
•             Sell June 2012 $38 Call = Call not exercise, $0
•             Net premium paid: $1.0-$0.35-$0.10=$0.55
•             Profit: $0.55-$0.55=$0

Maximum profit: Stock price between middle strike and higher strike ($36-$38), if stock price =$36

•             Buy June 2012 $34 Call = Exercise call, gain $2
•             Sell June 2012 $36 Call = Call not exercise, $0
•             Sell June 2012 $38 Call = Call not exercise, $0
•             Net premium paid: $1.0-$0.35-$0.10=$0.55
•             Profit: $2-$0.55=$1.45

Stock Price at $39.45...

•             Buy June 2012 $34 Call = Exercise call, gain $5.45
•             Sell June 2012 $36 Call = Buyer exercise call, loss $3.45
•             Sell June 2012 $38 Call = Buyer exercise call, loss $1.45
•             Net premium paid: $1.0-$0.35-$0.10=$0.55
•             Profit: $5.45-$3.45-$1.45-$0.55=$0

Stock price rise to $40...

•             Buy June 2012 $34 Call = Exercise call, gain $6
•             Sell June 2012 $36 Call = Buyer exercises call, loss $4
•             Sell June 2012 $38 Call = Buyer exercises call, loss $2
•             Net premium paid: $1.0-$0.35-$0.10=$0.55
•             Profit: $6-$4-$2-$0.55=-$0.55

What if stock price rise to $100, your loss is -$60.55 (66-64-62-0.55). Maximum risk is uncapped cause you selling more calls than you're buying. The higher the stock price rise, the more money you lose.

Bull Call Ladder

Advantages...

•         Lower cost
•         Gain money from wider stock price range ($34.55-$39.45)

Disadvantage...

•          Uncapped risk if stock price rises
•          Only for advanced trader
•          Not clear if we have a bullish or bearish strategy.

Maximum Profit:           $36-$34-$0.55=$1.45
                                     (middle strike - lower strike - net premium paid)

Maximum Loss:            UNLIMITED

Breakeven (Downside):  $34+$0.55=$34.55
                                         (Lower strike + net premium paid)

Breakeven (Upside):      $38+$36-$34-$0.55=$39.45
                                      (Higher strike + middle strike - lower strike - net premium paid)

Bear Call Spread

Outlook: Bearish or neutral to bearish

Bear Call Spread - Sell lower strike Call, Buy higher strike Call


Strategies...

• Sell lower strike Call
• Buy same number of higher strike call with the same expiration date.
• Ensure trend is downward
• Preferably with one month or less to expiration

Example...

Amazon.com, Inc. (NASDAQ:AMZN) is trading at $212 on May 26, 2012.

•     Sell the Jun 2012 $220 call option for $3.50.
•     Buy the Jun 2012  $230 call option for $1.15.

Bear Call Spread

Why Sell Jun $220 Call? You get instant premium = $3.50. You're obligated to sell the stock at $220 if stock price rise.

Why Buy Jun $230 Call? Capped upside risk. If price skyrocketed, you can exercise this option and buy back stock at $230.

How does Bear Call Spread work?

Stock price rise to $250...

•         Sell the Jun 2012 $220 Call = Call exercised buy call buyer, loss $30
•         Buy the Jun 2012 $230 Call = you exercise the call, gain $20
•         Net premium gain: $ 3.50-$1.15 = $2.35
•         Profit: -$30+$20+$2.35=-$7.65

Stock price at $222.35...

•         Sell the Jun 2012 $220 Call = Call exercised by call buyer, loss $2.35
•         Buy the Jun 2012 $230 Call = Out-of-the money, $0
•         Net premium gain: $ 3.50-$1.15 = $2.35
•         Profit: $0

Stock Price fall to $200...

•         Sell the Jun 2012 $220 Call = Call not exercised
•         Buy the Jun 2012 $230 Call = Out-of-the money, $0
•         Net premium gain: $ 3.50-$1.15 = $2.35
•         Profit: $2.35

Bear Call Spread

Advantages...

•     Short-term immediate income, net premium = $2.35,
•     Capped upside protection. (No matter how high  the price rises, loss in Buying and Selling Put is locked  to difference in strikes [$230-$220=$10])

Disadvantage...

•     Capped downside if the stock fall. (No matter how further stock price falls, you maximum profit limit to net premium gain=$2.35)

Maximum Profit:    $3.50-$1.15=$2.35
                              (premium received - premium paid = net premium gain)

Maximum Loss:     ($230-$220)-$2.35=$7.65
                              (Different in strike - net premium gain)         

Breakeven:           $220+$2.35=$22.35
                              (Lower strike + net premium gain)

Bull Put Spread

Outlook: Bullish or Neutral to Bullish

Bull Put Spread - Buy lower strike Put, Sell higher strike Put

Strategies...

• Buy lower strike put
• Sell same number of higher strike puts with the same expiration date.
• Ensure trend is upward
• Preferably with one month or less to expiration

Example...

VeriFone Systems Inc (NYSE:PAY) is trading at $38 on May 26, 2012.

•     Buy the Jun 2012 $33 put option for $0.35.
•     Sell the Jun 2012 $37 put option for $1.20.

Bull Put Spread

Why Buy Jun $33 Put? You have right to sell the stock at $33 if stock price fall. 

Why Sell Jun $37 Put? Capped downside risk. Jun $37 Put will not be exercised if price fall lower than $37.

How does Bull Put Spread work?

Stock price rise to $40.00...(or higher)

•     Buy the Jun 2012 $33 Put = Out-of-the-money, $0
•     Sell the Jun 2012 $37 Put = Put not exercise, premium gain=$1.20
•     Net premium gain: $ 1.20 - $0.35 = $0.85 
•     Profit: $0.85

Stock price at $36.15...

•     Buy the Jun 2012 $33 Put = at-the-money, $0
•     Sell the Jun 2012 $37 Put = Put exercised, loss $0.85
•     Net premium gain: $ 1.20 - $0.35 = $0.85
•     Profit : $0

Stock Price fall to $30...

•     Buy the Jun 2012 $33 Put = In-the-money, gain $3
•     Sell the Jun 2012 $37 Put = Put exercised, loss $7
•     Net premium gain: $ 1.20 - $0.35 = $0.85
•     Profit : $3-$7+$0.85= -$3.15
•  

Bull Put Spread

Advantages...

• Short-term immediate income, net premium = $0.85,
• Capped downside protection. (No matter how further price goes down, maximum loss in Buying and Selling Put is locked to the difference in strikes $37-$33=$4)

Disadvantage...

• Capped upside if the stock rises.(No matter how high stock price rise, you maximum profit cap to net premium gain=$0.85)

Maximum Profit:    $1.20-$0.35=$0.85
                              (premium received - premium paid = net premium gain)

Maximum Loss:     $37-$33+$0.85=$3.15
                              (Different in strike + net premium gain)          

Breakeven:           $37-$0.85=$36.15
                              (Higher strike - net premium gain)

Bear Put Spread

Outlook: Bearish

Bear Put Spread - Buy Higher Strike Put,  Sell Lower Strike Put


Strategies...

• Sell lower strike put
• Buy same number of higher strike puts with the same expiration date.(either ATM or sightly OTM)
• Downward Trend

Example...

Hewlett-Packard Company (NYSE:HPQ) is trading at $22.50 on May 26, 2012.

    Buy the Nov 2012 $22 put option for $2.10
    Sell the Nov 2012 $17 put option for $0.55.

You're bearish on this stock, so you bought Nov 2012 $22 put.

Why Buy a Put?  Buying a puts will cap your downside. If price goes down, you have the right to sell your stock at price $22.

Why Write/Sell a Put? Selling a put means you expect stock price rise or remains sideways in the next few months. You'll receive premium $0.55 by writing a put, and now your maximum risk has reduced to $1.55 per share.

Bear Put Spread

How does Bear Put Spread work? 

Stock price fall to $17.00... 

• Buying Nov $22 Put Option = In-the-money $5.00,
• Selling Nov $17 Put Option = At-the-money, $0
• Net premium paid: $ 2.10 - $0.55 = $1.55 
•  Profit : $5.00 - $1.55 = $3.45

Stock price fall to $20.45...

• Buying Nov $22 Put Option = In-the-money, gain $1.55
• Selling Nov $17 Put Option = Put not exercise by Put Buyer, $0
• Net premium paid: $ 2.10 - $0.55 = $1.55,
• Profit : $1.55-$1.55=$0

Stock Price rise to $23.00...

•  Buying Nov $22 Put Option = Out-of-the-money, $0
•  Selling Nov $17 Put Option = Put not exercise by Put Buyer, $0
•  Net premium paid: $ 2.10 - $0.55 = $1.55
• Profit: -$1.55

Bear Put Spread

 

Disadvantage... Capped upside profit if the stock falls.

Maximum Loss:     $2.10-$0.55=$1.55
                               (premium paid - premium received = net paid)


Maximum Profit:    ($22.00 - $17.00)-$1.55=$3.45
                              (Different in strike - net paid)


Breakeven:           $22.00-$1.55=$20.45
                              (Higher strike - net paid)

Bull Call Spread

Outlook: Bullish

Bull call spread - Buy Lower Strike Call, Sell Higher Strike Call

Strategies...

• Buy lower strike calls (prefer at-the-money or slightly out-of-the-money)
• Sell same number of higher strike calls with the same expiration date.
• Ensure the trend is upward.

Example...

Hewlett-Packard Company (NYSE:HPQ) is trading at $22.50 on May 26, 2012.

• Buy the Nov 2012 $22 call option for $2.20.
• Sell the Nov 2012 $28 call option for $0.40.

Bull Call Spread

Why Buy Call? You're bullish on this stock and expect stock price will rise.

Why Call Writing?  You can improved opportunity for profit with reduced risk. It's cost $2.20 to buy a call, you gain $0.40 by selling a call. You initial cost has reduced to $1.80.


How does Bull Call Spread work?  


Stock price rises to $30...

• Buy the Nov $22 Call  = In-the-money,gain $8,
• Sell the Nov  $28 Call = Call exercised by buyer, loss $2
• Net premium paid: $ 2.20 - $0.40 = $1.80,
•  Profit : $8.00 - $2.00 - $1.80 = $4.20

Stock price traded at $23.80...

• Buy the Nov $22 Call  = In-the-money,gain $1.80,
• Sell the Nov  $28 Call = Call not exercises, $0
• Net premium paid: $ 2.20 - $0.40 = $1.80,
•  Profit : $1.80 - $1.80 = $0

Stock price traded at $20...

• Buy the Nov $22 Call  = Out-of-the-money, not exercise the call.
• Sell the Nov  $28 Call =  Call not exercises, $0
• Net premium paid: $ 2.20 - $0.40 = $1.80,
•  Profit :  -$1.80 

 Gain/Loss Table...

Bull Call Spread

Disadvantage? Capped upside if the stock rises higher than $28.

Maximum Loss    :      $2.20-$0.40=$1.80
                                 (premium paid - premium received = net paid)
Maximum Profit   :     $6.00-$1.80=$4.20
                                  (Different in strike - net paid)
Breakeven           :      $22.00+$1.80=$23.80
                                 (Lower strike + net paid)

Short (Naked) Put

Outlook: Bullish

A put is an option to sell. You buy a put, you have the right to sell stock to put writer at the strike price. As a put writer, you have the obligation to buy the stock if option being exercised.

Short (Naked) Put is an alternative way of buying a stock at price cheaper than market current price.

Put  Buyer:  expect stock price fall below the strike price,

Put Writer:  expect stock price rise or stay sideways.

Strategies...

• Select stock with adequate liquidity.
• Sell put option below current stock price.
• Short the put option with a maximum of one month to expiration.

Example...

Amylin Pharmaceuticals, Inc.(NASDAQ:AMLN) is trading at $28 on May 25, 2012.

Sell the June 2012 $25 put option for $0.35 per share.

Short Put

Stock price rise to $30...

• June $25 put option:   Not exercised by buyer , $0
• Premium gain: $0.35
• Profit :  $0.35

Stock price is traded at $24.65...

• June $25 Put: Exercised by buyer, loss $0.35 
• Premium gain: $0.35
• Profit : $0.35 - $0.35 = $0

Stock price is traded at $20...

• Jun $25 Put: Exercised by Put Buyer, loss $5
• Premium gain: $0.35
• Profit : -$5.00 + $0.35 = -$4.65

Maximum Profit   : $0.35 per share (put premium)

Maximum Loss    : $25.00-$0.35 = $24.65 (Strike Price  - Put Premium)

Breakeven           : Stock traded at price $24.65

The worst outcome, stock falls to zero, put writer obligates to purchase the stock at the strike price. Minus the put premium received earlier, the maximum loss is the difference of strike price and put premium.

Short Call - Covered Call & Naked Call

Outlook: Bearish

If you're expecting a fall in the stock price, selling/writing a call option could immediately bring some cash to your brokerage account. 

There are two types of call writing:

Covered Call: Owning a stock and selling a call.

Naked Call: Write option without owning the stock.

Strategies...

• Select stock with adequate liquidity.
• Sell call option with a strike price higher than current stock price.
• Preferably shorter term to expiration

Example...

VeriFone Systems Inc (NYSE:PAY) is trading at $38 on May 25, 2012.

• Sell the June 2012 $40 call option for $0.90.

Short Call

Stock price fall to $35...

• June $40 Call option: Not exercised by buyer , $0
• Premium gain: $0.90
• Profit :  $0.90

Stock price is traded at $40.90...

• June $40 Call : Exercised by buyer, loss $0.90
• Premium gain: $0.90
• Profit : $0.90 - $0.90 = $0

Stock price is traded at $45...

• June $40 Call: Exercised by Put Buyer, loss $5
• Premium gain: $0.90
• Profit : -$5.00 + $0.90 = -$4.10
• (The further stock price falls, the higher the risk)

Maximum Profit   : $0.90 per share (call premium)

Maximum Loss    : Uncapped loss if stock rises

Breakeven           : Stock price = $40+$0.90 = $40.90

Covered call writing is one of the low-risk income strategy, you can generate income from the option you sold.

Naked call writing is a very risky strategy, you expose yourself to unlimited loss. If stock price skyrocketed, you need to buy back stock at the current market price to cover your short position.

Market Order & Limit Order

You can purchase an option either by market order or limit order.

What Is Market Order & Limit order... 

Market Order: You buy or sell the options at the current market best price. Market maker will fill-in the best price for you, which is the current bid and ask price.

Limit Order: You select a price which you think is reasonable to pay for an options.

Tiffany & Co.(NYSE:TIF), Jun TIF 65 Call is traded at bid-ask spread, $1.60-$1.65...

Placing a Market Order: You pay $1.65 to buy a call; you will receive $1.60 by selling a call. In a volatile market, options price are changing quickly, your market order will get filled immediately

Placing a Limit Order: The spread is small, $0.05, not much room for bargain, you have to follow the bid-ask price. What if you place an order beyond the bid-ask spread (either pay to low to buy an option or request too high to sell an option) your order will not get filled.

Edison International(NYSE:EIX), Jul EIX 27.50 call is traded at bid-ask price, $15.40 and $19.00...

Placing a Market Order: To buy a call option, you need to pay $19.00 and you will receive $15.40 by selling a call. You placing yourself at the  mercy of market maker.

Placing a Limit Order: You think $19.00 is too high, you only willing to pay $18.00 for this call, so you fill in your limit order at $18.00,  your order may get filled. You save $1.00 by negotiating with the market maker. 

What is Bid-Ask Spread

What is Bid-Ask Spread in options...

Bid price - The highest price at which the market maker/traders willing to buy an option from you.

Ask price - The lowest price at which the market maker/traders willing to sell you an options.

Example...

Tiffany & Co.(NYSE:TIF), Jun TIF 65 Call is traded at bid-ask spread, $1.60-$1.65 currently. You can purchase the call option from the market at $1.65 (ask price). If you already own the option and now want to sell it, the  market maker only willing to pay you $1.60 (bid price).

Keep in mind, you always pay higher price to buy an option(ask price), receive lower price to sell an option(bid price).

What determine the spread...

In a high-volume situation (high demand for buying and selling options), bid-ask spread is narrow cause market maker can easily match up the trades. 

At low-volume situation, it more difficult to find a matching trade, so they set a wider spread to offset their risk.

More explanation for options spread:  Read more>>Market Order Vs Limit Order

Put Option - Buying A put

What is Put Option...

The buyer of a put option has the right to sell 100 shares of stock at the strike price and exercise the option before the contract expire.

The seller/writer of a put option has the obligation to buy 100 shares of stock at the strike price if the option is being exercised.

Trade...

On 24 May 2012, Hewlett-Packard Company (NYSE:HPQ) traded at $21.00, you believe the stock price will fall,  you consider buying a put instead of shorting the stock to give you more leverage.  So you enter into a put contract with strike price $20.00 at price $1.50 per share expires in June. Paying $150 to own a put contract, you're " long one LOW June 23 Put".

What is your maximum LOSS...

Your maximum loss on this trade is $150.00.

Long Put

Stock price fluctuates from time to time, what will happen to your options...

In-the-money: If stock price fall to $16.00, by exercising the options you will gain $200.00 [20-16-1.5=2.5]. Your total return is 166.66% [250/150]

Break-even: If stock price is $18.50, by exercising the option you gain $1.50,  break-even after deducting the option costs [20.00-18.50-1.50=0]

At-the-money &  Out-of-the-money : If stock price goes higher than strike price $20.00 or equal, you're not going to exercise the option, you loss $150.00, the premium paid. Your loss is capped.

Most options trader will sell the option instead of exercising it. (Why Not Exercising the Option)

In-the-money, At-the-money and Out-of-the-money

In-The-Money

A call option is in-the-money if the stock price  is higher than the strike price.
A put option is in-the-money if the  stock price  is lower than the strike price.

At-The-Money

When the stock price is equal to the strike price, an option is at-the-money.

Out-of-The-Money

A call option is out-of-the-money if the stock price  is lower than the strike price.
A put option is out-of-the-money if the stock price  is higher than the strike price.

Call Option - Buying A Call

What is Call Option...

The buyer of a call option has the right to buy 100 shares of stock at the strike price and exercise the option before the contract expire.

The seller of a call option has the obligation to sell 100 shares of stock for purchase at the strike price.

Trade...

On 23 May 2012, Lowe's Companies, Inc.(NYSE:LOW) traded at $ 25.50, you expect the stock price will go up and buy a call option with strike price $23.00 which costs $3.00 per share. Paying $300 to own a call contract, you're " long one LOW June 23 Call".

What is your maximum LOSS...

Your maximum loss on this trade is $300.00.

Long Call

Stock price fluctuates and what will happen to your options...

In-the-money: If stock price goes up to $30.00, net profit of $4.00 [30-23-3=4]

Break-even: If stock price is $26.00, by exercising the option you gain $3.00,  break even after deduct the option premium paid. [26-23-3=0]

At-the-money &  Out-of-the-money : If stock price fall to $15.00, lower than strike price $23.00, you're not going to exercise the option. Your loss is $3 per share, the premium you paid.

Most options trader will sell the option instead of exercising it before expiry date. (Why Not Exercising the Option)

Options Intrinsic Value Vs Time Value

When buying an option, you need to know how much of its price is intrinsic value and how much is time value.

Option Price = Intrinsic Value + Time Value

     Intrinsic value = Stock's Current Price – Call Strike Price

In May, Wal-Mart Stores, Inc.(NYSE:WMT) is traded at $63.50. You believe that the stock is going to rise in price, so you purchase call option.

Call Option with Different Expiration Date...

The asking price for June 60 call is $3.80 per share.

Intrinsic Value = 63.50 - 60.00 = $3.50

Time Value = 3.80-3.50 = $0.30 

The asking price for July 60 call is $4.30 per share.

Intrinsic Value = 63.50 - 60.00 = $3.50

Time Value = 4.30-3.50 = $0.80

You paid $0.30 per share to control this stock for one month, $0.80 per share for two months. The longer the time to expiration, the higher the price of an option.

 Is June 60 call cheaper than July 60 call...

We can't say June option is cheaper than July.  In this case, July Call option has extra one month of life after June call expires. You are paying extra $0.50 (in this example) to have a longer window of opportunity for the upward price movement of stock WMT.  

Same strike price but different Expiration Date in Options...


Just imagine, WMT goes nowhere and remain at $63.50 in June, you will loss $0.30 (time value) per share.  intrinsic value still remains at $3.50 [63.50-60.].

In July the stock start to rise to $68.50 and now the option worth $7.00 per share, if you sell your options  you will gain $2.70 per share [7.00-4.30=2.70].  (Read More>>Why Not Exercising the Option)

Before buying an option, you must ask yourself whether the stock price increase high enough before option expires to overcome the time value and give you profit. If YES, you have a good reason to enter the trade.

Why Not Exercising the Option

On May 2012, you bought 10 call option of stock: The Walt Disney Company (NYSE:DIS)
Current price     :      $43.50
Strike price        :      $45.00
Expiration          :      21 June 2012
Option Price       :     $2.00 per share
(one option contract represent 100 shares) 

Today, 23 May 2012, DIS stock price goes up to $ 50.00, and the call option you bought now traded at price $4.50 per share. You decided to reap the profit, two things you can do

To exercise the option...

You pay $45,000 to buy 1,000 shares of  DIS and sell 1,000 stocks at market price $50 per share, the profit you gain is $3,000 after minus the option cost. Total return 3,000/47,000 = 6.38%.

To sell the option...

 You sell your option at $4.50 per share,  profit $1500 ($350 - $200). Your return is 2500/2000 = 125%.

If you wish to exercise the option, you need to have enough CASH in your brokerage account which is $45,000 in above example. In fact, selling the option is more profitable than exercising it.