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Option Cookbook
Option Cookbook
Option Cookbook
[Document subtitle]
[DATE]
[COMPANY NAME]
[Company address]
TABLE OF CONTENTS
INTRODUCTION .............................................................................................. 2
Options Strategies For The Long-Term Investor ......................................................................... 2
CHAPTER 1: BASIC DEFINITIONS ............................................................. 3
What Is An Option? ..................................................................................................................... 4
Option Definitions: Key Takeaways ............................................................................................ 8
Option Pricing .............................................................................................................................. 9
The Greeks: A Brief, But Sufficient Definition ......................................................................... 11
CHAPTER 2: BUYING STOCK AT A DISCOUNT.................................... 14
Option Strategy One: The Cash-Secured Put Write................................................................... 14
Summary .................................................................................................................................... 15
CHAPTER 3: DOWNSIDE PROTECTION ................................................. 16
Option Strategy Two: Protective Put Purchase .......................................................................... 16
Summary .................................................................................................................................... 17
Reducing The Cost Of Insurance: The Bear Put Spread ............................................................ 18
Summary .................................................................................................................................... 19
CHAPTER 4: COST BASIS REDUCTION USING OPTIONS ................. 20
Option Strategy Three: Selling Covered Calls ........................................................................... 20
Strike Selection .......................................................................................................................... 21
Time To Expiration .................................................................................................................... 22
Unwinding Larger Positions ...................................................................................................... 23
Summary .................................................................................................................................... 25
CHAPTER 5: COMBINING DOWNSIDE PROTECTION AND COST
BASIS REDUCTION ....................................................................................... 25
Option Strategy Four: The Collar .............................................................................................. 26
Summary .................................................................................................................................... 27
CHAPTER 6: TARGETING FUTURE STOCK PURCHASE OR SALE
LEVELS ............................................................................................................ 28
Option Strategy Five: The Short Strangle .................................................................................. 28
Summary .................................................................................................................................... 29
CHAPTER 7: PICKING UP THE PIECES .................................................. 30
Option Strategy Six: The Stock Repair Strategy........................................................................ 30
Summary .................................................................................................................................... 31
CHAPTER 8: CHEAP INSURANCE WHEN OPPORTUNITY KNOCKS
............................................................................................................................ 32
Option Strategy Seven: The Calendar Spread............................................................................ 32
Summary .................................................................................................................................... 34
STRATEGY SUMMARY ................................................................................ 35
BRIEF GLOSSARY OF OPTION TERMINOLOGY ................................. 38
INTRODUCTION
“Trading options [for the average retail investor] should be a lot like driving a car; while
I would expect you to have a driving license which would allow you to safely navigate
the potential hazards you might encounter on your journey, I wouldn’t expect you to
understand how the internal combustion engine works.”
Nicholas C. Sparrow, January 2019.
Few long-term buy and hold stock investors are aware of the versatility that options offer
and their potential use in improving the risk-reward characteristics of their investment
portfolio.
This book will examine how the addition of option strategies to a long-term buy and hold
equity portfolio can allow you to:
▪ Sleep better at night safe in the knowledge your portfolio is protected. Limit
risk and reduce losses during bear or down market periods.
▪ Enhance your portfolio returns by reducing the cost basis of your existing stock
positions over time. Earn additional income when markets are stagnant and offer
limited upside potential.
▪ Continue to benefit from bull market returns when stocks rally and hit new
highs. Protect profits while still allowing for upside appreciation in your portfolio
value.
With these goals in mind, we will examine seven key option strategies that can be applied
to any long stock portfolio.
No strategy is better than another, but rather each is designed to obtain a specific investment
objective depending on your stock holdings and the current market environment.
It is important that you understand which strategy should be implemented when and why,
and what purpose it serves.
What is not important is a deep knowledge of the Black & Scholes option pricing model,
a comprehensive understanding of the option Greeks or a high level of mathematical
competency.
No…
This book has been written to remove much of the mystique and complexity surrounding
options.
It aims to highlight extremely simple, but actionable strategies that you can implement in
your long-term investing, to improve your overall portfolio risk and long-term
performance.
That being said, however, chapter one covers some basic, but essential, options terminology
and definitions for those who have little or no experience regarding options or the factors
that affect their pricing.
Those already familiar with options contracts should feel free to skim through chapter one
and continue directly to chapter two, where the real journey begins.
CHAPTER ONE: BASIC DEFINITIONS
WHAT IS AN OPTION?
Option contracts are made up of just two basic building blocks; calls and puts. Let’s define
each of these through the use of two simple stories to illustrate the properties of each.
CALL OPTIONS
Jennifer is selling her house for $250,000, in a neighborhood close to a vacant parcel of
land. This plot is also for sale and there are two interested parties:
▪ David is interested in acquiring the land to build a nature reserve and botanical
gardens.
▪ Charlie, on the other hand, needs the space to build a large manufacturing plant.
Enter Kevin.
Kevin is interested in paying cash to buy Jennifer’s house, and can afford the $250,000, but
he won’t have the cash available until next quarter.
Of course, he is concerned that someone may come along in the meantime and buy the
house before he has the funds on hand.
Kevin decides to offer Jennifer $2,500 right now if she’ll take the house off the market for
the next three months and give him an option to buy it. This $2,500 is termed the option
premium.
The contract is known as a call option and entitles Kevin to buy the house for $250,000,
which is referred to as the strike price any time in the next three months before the
expiration date.
Now, if Kevin decides by that date that he doesn’t want to buy the house for any reason, he
simply walks away from the deal and Jennifer keeps the $2,500 option premium.
If he does decide to buy the house or exercise the option, Jennifer still gets to keep the
$2,500 option premium, but additionally Kevin would pay her $250,000 for her home.
There are essentially three outcomes in our story…
In the first scenario, David buys the parcel of land. The addition of the nature reserve and
botanical gardens improve the quality of the neighborhood and this in turn leads to an
increase in overall property prices.
Let’s assume the value of Jennifer’s home increases to $300,000.
In this case, Kevin of course will be very happy to exercise his option and buy the house
for $250,000.
In scenario two, Charlie buys the land and builds his manufacturing plant. Residents
become concerned as pollution from the factory causes air quality to deteriorate, and this
results in a fall in real estate prices in the area.
Jennifer’s home is now only valued at $200,000.
In this case, Kevin will not exercise the option to buy Jennifer’s home for $250,000. He
will just walk away from the deal having lost the option premium of $2,500.
Finally, the parcel of land is unsold, and the value of the home remains stable over the
three-month period at $250,000. In this case, either option might work for Kevin. He can
elect to pay $250,000 to purchase the house or simply walk away from the deal, losing only
$2,500.
Kevin is essentially controlling a $250,000 asset for 3 months with just $2,500 in capital.
Regardless of the outcome, the most Kevin can lose is the $2,500 he pays for the option.
Jennifer on the other hand is happy to take the $2,500.
She has no guarantee anyone else would buy the house at the current asking price, nor does
she feel the land deal would be closed during the following three-month period.
However, if Jennifer thought there were a number of interested buyers, she may have asked
for more than $2,500 in order to take the house off the market. She may have asked for a
premium of $5,000, for example.
Likewise, with other financial assets, the more the underlying asset is perceived to be able
to potentially appreciate in price prior to the expiration date, the higher the call option
premium demanded by the market.
So, with this example in mind, let’s define a call option specifically in the context of the
stock market.
A call option is a contract between two counterparties to exchange a stock at the strike price
by a predetermined date, known as the expiration date.
One party, the buyer of the call (In our example, Kevin) has the right, but not an obligation,
to buy the stock at that strike price by the future date.
The other party, the seller of the call (Jennifer, in regard to the house sale), has the
obligation to sell the stock to the buyer at the strike price if the buyer exercises the option.
Let’s take a look at an example.
If a stock is trading at $100 and you think it’s going to go up to $110, you might buy a 105-
call option, which is currently priced at $2. If the stock rose to $110 that would allow you
to buy the stock at $105 even though it’s valued at $110, netting you a $3 profit on each
share.
This payoff is highlighted in figure 1, below.
Figure 1: Call option payoff.
Remember, we need to deduct the option premium of $2 from the $5 profit from the
appreciation in the stock price, as this is kept by the option seller.
On the other hand, the person that sold you the call would be obligated to sell the stock at
$105, at a loss of $3 per share.
If the stock never rises above $105 by the expiration date, the call expires worthless, the
call buyer is out $2, and the call seller keeps the option premium.
PUT OPTIONS
Kevin owns a $50,000 truck that he uses for his plumbing business. He is concerned that
the truck may be damaged during the course of his work, or even worse, stolen.
Kevin decides to buy a zero-deductible insurance policy, or put option, on his truck for
$50,000, the strike price.
Jennifer’s auto insurance is able to provide this coverage for a one-year period, up to the
expiration date, for a cost or premium of $2,000.
Again, we can see there are three possible outcomes in this story…
In scenario one Kevin’s truck is neither damaged nor stolen during the year. As he has no
need to make a claim, Jennifer simply keeps the $2,000 in premium.
Kevin is resigned to losing this premium because of the protection and peace of mind the
policy has provided for him over this one-year period.
In the second outcome, Kevin’s truck is damaged in an accident and requires $20,000 worth
of repairs. He exercises his policy, or put option, and Jennifer pays him the $20,000 for the
repairs as agreed.
Kevin, of course, is delighted. The protection he has purchased is in place to cover events
just like this.
Our final scenario is the worst case for Kevin; his truck is stolen and requires replacing.
Again, Keven exercises his policy or put option, but this time for the full $50,000 which is
the cost to replace the vehicle.
Kevin is, of course, very relieved to have purchased the put option to cover this huge,
potentially devastating loss to his business.
Jennifer’s auto insurance is able to make a payment of this size because she has also sold
policies or put options to a number of other drivers, many of whom never make a claim or
exercise their options during this one-year period.
The $2,000 Kevin paid for this policy was a reflection of his excellent driving record. Had
he had a poor driving record, and the car was therefore more likely to be damaged, she
would have charged more, perhaps $4,000 for this one-year policy.
With a put option then, the higher the perceived risk the higher the premium demanded by
the market.
So, with this example in mind, let’s define a put option specifically in the context of the
stock market.
A put option is a contract between two counterparties to exchange a stock at the strike price
by a predetermined date, known as the expiration date.
One party, the buyer of the put (In our example, Kevin) has the right, but not an obligation,
to sell the stock at that strike price by the future date.
The other party, the seller of the put (Jennifer, in regard to the insurance policy), has the
obligation to buy the stock from the buyer at the strike price if the buyer exercises the
option.
Let’s take a look at an example.
If a stock is trading at $100 and you fear it might go down to $90, you might buy a 95 put
option as insurance. The $95 put is currently priced at $2.
If the stock falls to $90, that would allow you to sell stock at $95 even though it’s valued
at $90, netting you a $3 profit on each share.
This payoff is highlighted in figure 2, below.
Figure 2: Put option payoff.
Remember, we need to deduct the option premium of $2 from the $5 profit from the fall in
the stock price, as this is kept by the option seller.
On the other hand, the person that sold you the put would be obligated to buy the stock at
$95, at a loss of $3 per share.
If the stock never falls below $95 by expiration date, the put expires worthless, the put
buyer is out $2, and the put seller keeps the option premium.
Table 1: Rights and obligations of call and put option buyers and sellers.
For assuming this obligation and giving up these rights, option sellers are compensated by
the payment of a premium from the option buyer.
The option marketplace is dynamic and either party can close an open position by simply
buying or selling back any open option contract at any time prior to the expiration date at
the current prevailing market premium.
OPTION PRICING
An option’s price, or premium, is composed of two elements:
▪ Intrinsic Value
▪ Time or Extrinsic Value
INTRINSIC VALUE
The intrinsic value of an option is the value that option would have right now if we were
at expiration. It is determined by the difference between the current price of the asset and
the strike price of the option.
If you recall from our earlier example, the appreciation in property prices that came from
the development of the nature reserve and botanical gardens lead to an increase in the price
of the house from the strike price of $250,000 to a current market value of $300,000.
Options that have a longer time to expiration will, all else being equal, have more value
than those with a shorter time to expiry.
If Kevin had asked Jennifer to keep her house off the market for six, instead of three
months, she would have demanded a greater premium for this. There is more uncertainty
due to this additional time and greater potential for a change in the value of the house.
▪ Volatility
Stocks that exhibit a wide range of speculative movements in a short period of time are said
to be more volatile than those that are steady or stagnant.
Increases in volatility, or specifically increases in future expectations of a stock’s volatility,
can dramatically increase an option’s price.
As earnings approach, for example, it is not unusual to see option premiums increase
significantly to reflect the uncertainty of how the stock price might react on the
announcement.
▪ Interest rates
Interest rates are generally a less important factor, particularly for shorter-dated options.
However, it should be noted, a rise in borrowing rates increases the price of calls and
decreases that of puts.
MONEYNESS
Depending on where an asset price is in relation to an option’s strike price, puts and calls
are said to be:
Options that are ITM have an intrinsic value component to their price. That is, if they were
to expire right now, they would have value.
Calls therefore are ITM when a stock price is trading above the strike price.
Puts, on the other hand, are ITM when the current market is below the strike price.
When the stock is trading right around the strike price of an option it is said to be ATM.
Finally, when an option premium is composed purely of time or extrinsic value it is said to
be OTM. That is, if the option were to expire right now, it would have no value and so
would expire worthless.
Calls therefore are OTM when a stock price is trading below the strike price.
Puts, on the other hand, are OTM when the current market is above the strike price.
DELTA
Delta is the amount an option price is expected to change when the underlying stock
moves higher $1 in price.
We can think of delta as the “speed” of an option’s price; how fast it changes when the
stock price moves.
Calls have a positive delta between 0 and 1; when the stock moves higher so the price of
the call increases, but not by as much as the stock price. That is determined by the option’s
delta. Calls decrease in price when the security moves lower.
For example, a call with a delta of 0.40 is expected to move up in price by $0.40 when the
underlying stock moves higher by $1.00.
Puts, on the other hand, have a negative delta between -1 and 0; when the stock moves
lower so the price of the put increases, but not by as much as the stock price falls. That is
determined by the option’s delta. Puts decrease in price when the security moves higher.
For example, a put with a delta of -0.40 is expected to move up in price by $0.40 when the
underlying stock moves lower by $1.00.
In regard to moneyness, note that ITM options (those with intrinsic value) have higher
deltas than OTM options. ITM options then are more sensitive to movements in the
underlying stock price than OTM options.
ATM calls and puts have deltas that are close to +/- 0.50.
GAMMA
Delta is not a static number. It changes as the underlying stock moves, and an option strike
moves in or out of the money.
How fast Delta changes depends on an option’s Gamma.
If Delta is the speed, then think of Gamma as acceleration.
Gamma is the change in Delta we should expect to see when the underlying stock moves
$1 in price.
In Table 2, if our 0.40 delta call option has a gamma of 0.17, when the stock rallies by
$1.00 from $20 to $21 a share, we know we should expect the price of the call to increase
by $0.40.
Following this move though, we would now expect the delta of the call to be higher by
0.17, or 0.57.
An additional $1 move higher in the stock from $21 - $22, should lead to a larger $0.57
move higher in the call price due to this higher delta.
Gamma is highest for ATM options and also increases as options approach expiration.
THETA
Theta is a measure of the time decay of the option premium. It is the amount that an
option will decrease in value every day as it approaches its expiration date.
An option is a wasting asset and all else being equal, any option’s price will inevitably
decline as time passes.
For example, a $1.00 OTM option with 30 days to go to expiration might have a theta of
0.02.
All else being equal then, the option will be worth $0.98 tomorrow due to the effects of
time decay.
Note that if this OTM option, which recall by definition only has time value, decayed at
only a rate of $0.02 per day over the next 30 days, this would only account for $0.60 (rather
than the full $1 at which the option is currently valued) of theta over the 30 days the option
has before it expires.
This is because the rate of decay accelerates as expiration draws nearer and theta becomes
progressively larger.
An option with one year of time value then, decays at a significantly slower rate than a
short-term option expiring in just one week’s time.
VEGA
Vega is the amount an option price changes for every 1% change in implied volatility.
We have defined volatility earlier in this section while discussing an option’s extrinsic
value, but what is implied volatility?
In determining the price of any option, we need the following inputs in pricing models:
Note that all of these variables are known, with the exception of future volatility between
now and the expiration date.
What we see in the options market then, is an expectation of how volatile the market will
be, and this is implied in the option prices.
If options are relatively expensive, we can say implied volatility is high. Market participants
are expecting the stock to trade in a wide range between now and the expiration date.
Conversely, when option prices are cheap, the market is reflecting a low level of implied
volatility. Market participants are expecting the stock to be stagnant and trade in a narrow
range between now and the expiration date.
Returning to our definition of Vega then, if an option is trading with a +0.16 Vega for
example, and is currently priced at $1.00 (regardless of whether it is a put or call), we
should see the option’s price increase to $1.16 when its implied volatility rises by 1%.
A fall in implied volatility of 1%, on the other hand, would leave the same option worth
just $0.84.
SKEW
Option implied volatilities are not necessarily the same at every strike price.
There is generally a tendency in equity markets for downside options to be more expensive
relative to their ATM counterparts.
This observation is known as option skew and is a reflection of the fear that in general
stock markets tend to fall more quickly to the downside than they rally in price to the upside.
A demand for downside portfolio protection then, leads to an increase in the price of OTM
puts and an opportunity for smarter investors wishing to exploit this excess in option
premium.
CHAPTER TWO: BUYING STOCK AT A DISCOUNT
SUMMARY
The cash-secured put involves selling a put option and additionally holding the cash to
buy the stock if assigned.
In the event of assignment, you effectively buy the underlying stock at a discount to its
market value at the time of the put write. That price is determined by the option strike price
less the premium received.
However, you are not guaranteed that the put will be assigned.
In that case, you simply keep the premium received for selling the put option and can
reassess the position entering the next option cycle.
CHAPTER THREE: DOWNSIDE PROTECTION
So, let’s continue our example from the second chapter. You have purchased your 100
shares of AMZN stock using a cash covered put write and your net cost to purchase those
is $1,500 per share.
Assume that the market is currently trading at this level, and your position is breaking even.
However, in the short-term at least, you feel there may be trouble brewing ahead for the
stock price…
Earnings for AMZN are due to be reported within the next week and while you expect to
see the price go up in the longer term and want to hold the stock, there is a chance the price
could go down sharply on disappointing data.
Consider the following option premiums with AMZN trading at $1,500 per share.
AMZN 1,500 Put $80
AMZN 1,475 Put $67
AMZN 1,450 Put $57
AMZN 1,400 Put $40
The insurance policy with the best coverage comes from buying the $1,500 put.
This is because $1,500 is the highest strike price and allows the buyer of the put to sell the
stock at $1,500 at any time before the option expires. This is better than an option to sell at
a lower price, such as $1,400 for example.
However, it’s not that simple and this comes at a cost; notice that the $1,500 put has the
highest premium and is the most expensive. In fact, it is twice as expensive as the $1,400
put.
Notice as the strike prices fall, so the put options become progressively cheaper, as the
value of the insurance provided becomes less.
In the case of the $1,400 put, you would lose $100 per share before your insurance policy
is effective. None of the losses incurred between $1,500 and $1,400 are covered. The risk
of this first $100 is assumed by you.
There is a clear tradeoff between risk and the cost of insurance, and this is reflected in the
price of the option premiums.
Strike selection, therefore, depends on risk tolerance and how much protection is required.
Let’s assume you decide on a purchase of the $1,500 put. How does this change your risk-
reward and potential payoff as the stock price changes?
Note in Figure 2 (below) that the maximum loss now occurs at any price below $1,500 but
is capped at the premium paid for the option, or $80.
Above $1,500 the return is similar to that of the long stock position, however this trade
does not begin to make money again until the stock rallies by at least the amount of the
premium paid, or $80.
The break-even price, therefore, is $1,580, or the strike price plus the option premium paid.
The long stock position outperforms at any price above $1,420 (1,500 – 80), below which
point the losses are larger than the cost of the insurance policy or the put premium paid.
SUMMARY
Purchasing a protective put is comparable to taking out an insurance policy; the buyer
pays a premium for peace of mind and protection from a potentially catastrophic event.
Through strike selection, you can determine a balance between the amount you are prepared
to lose if the stock price goes down and how much you are prepared to pay for this
protection.
There is a clear risk-reward tradeoff and strike selection is dependent on your own tolerance
for risk.
Again, with AMZN earnings approaching you are concerned about a temporary setback in
the stock price. However, you see only minor downside potential and are not prepared to
pay as much in insurance costs.
Instead of simply buying a protective put, you might consider a bear put spread.
In addition to purchasing a long put to hedge your position, you could also sell a put at a
lower strike price with the same expiration date. This additional sale brings in premium
which can be used to partially offset the cost of the long, higher strike put.
Let’s take a look at an example, again with AMZN stock trading at $1,500 and the following
option prices:
AMZN 1,500 Put $80
AMZN 1,475 Put $67
AMZN 1,450 Put $57
AMZN 1,400 Put $40
The AMZN 1,500/1,450 bear put spread is constructed by buying the 1,500 put for $80 and
simultaneously selling the 1,450 strike for $57.
Since you are buying an $80 put and selling a $57 put your total outlay is reduced from
$80, to just the difference between the two, or $23. But how does this affect your insurance
policy?
In Figure 3 (below), we see in blue the performance of the bear put spread and long stock
combined, compared to just the long stock only.
Note that between $1,500 and $1,450 the position no longer loses money, but once the
lower put strike at $1,450 is breached, the position loses money at the same rate as the long
stock position. We have only insured against a $50 loss, albeit at a discounted rate.
Figure 5: 1,500/1,450 Bear Put Spread combined with long stock, AMZN.
This strategy reduces losses by $27 over a long stock position below $1,450.
This is because you protect the position in between the two strikes - $1,500 to $1,450, or
$50 – but you need to offset the premium you have to pay for this cover, or $23.
The reduction in loss, is the difference between the two, or $27.
SUMMARY
Applying a protective put or bear put spread to a long stock position allows you to still
participate in the upside movement of the stock, yet control and limit your risk to the
downside in the short-term.
You should expect the stock will rally higher at some point, since otherwise the best
decision is to simply sell the stock and consider alternative investment opportunities.
CHAPTER FOUR: COST BASIS REDUCTION USING OPTIONS
AMZN earnings have now passed and despite some short-term volatility in the stock price
you are confident that a long-term upward trend in price will continue.
If, by the expiration date, the stock is trading below $1,550, then the call option expires
worthless and as the seller of the call, you keep the full premium, or $25 per share.
In contrast to the protective put purchase, it is important to note that in the event that the
stock declines, the short call will only cover losses equivalent to the premium received from
the option sale.
This strategy, however, is not designed to provide downside protection, but rather reduce
the cost of your initial share purchase.
When the call expires worthless, you have effective reduced your initial share purchase
price by $25, since you keep the option premium.
This is known as cost basis reduction.
Rewriting calls month after month can be an effective way to reduce your stock purchase
price over time.
The ultimate goal?
Lowering your average purchase price on a stock you own and love to zero and creating a
free trade!
STRIKE SELECTION
The selection of a strike at which to sell a call should reflect how bullish you are over the
upcoming option expiration period.
There is a tradeoff between the premiums you can earn from selling the call option, versus
the upside potential to be earned from the appreciation in the underlying stock price.
Let’s take a look at our choices with AMZN trading at $1,525, and the following option
prices available. The following table also includes the respective call Deltas.
TIME TO EXPIRATION
From my own personal experience, covered calls that are written with 30-45 days to
expiration tend to provide the best risk-reward returns.
Longer-term options, while they have a higher premium, have a lower theta and so decay
more slowly. Additionally, longer term option series tend to have wider markets and less
liquid pricing, which should be an important consideration in any trading strategy.
There should then be an advantage to selling shorter term calls to take advantage of the
acceleration in time decay as expiration approaches then, right?
While weekly options do exist and are actively traded on many stocks and ETFs, the risk-
reward of very short-term positions (days rather than weeks) as a short premium seller is
not particularly favorable, and I would not recommend it.
A deeper level of experience is required to manage the short gamma risk and should be
avoided by novice investors.
AMZN stock trades at $1,500 and we note the following call prices in the market:
AMZN 1,500 Call $80
AMZN 1,525 Call $67
AMZN 1,550 Call $57
AMZN 1,600 Call $40
You decide to write, or sell 2 call options at each of these strikes. This will result in the sale
of 200 shares of stock at each price level if that is breached by the expiration date.
Let’s take a look at our profit potential, depending on where the stock is trading by the
option expiry.
AT EXPIRATION:
AMZN: $1,500. The stock price is unchanged.
All options expire worthless and you still hold 800 shares of AMZN stock. Proceeds from
the sale of the options total $ 48,800 (((80x2) + (67x2) + (57x2) + (40x2)) *100), or an
average of $61 (488/800) per share.
Call options can now be sold in the next expiry cycle, and the process repeated.
AMZN: $1,530. The stock rallies, and you are called away on 200 shares at $1,500 and
200 shares at $1,525.
Let us consider the additional profits accumulated from scaling out rather than selling
shares directly at $1,500.
You are now only long 400 shares of AMZN stock. These are now trading at $1,530 for a
profit of $30 per share.
The 400 shares you sold when they were called away were at an average price of:
200 @ $1,500 (+$80 option premium) = $1,580, for a profit of $80 per (/) share.
200 @ $1,525 (+$67 option premium) = $1,592, for a profit of $92 (25+67) / share.
Additionally, you collected option premiums of $57 and $ 40 respectively on the calls at
$1,550 and $1,600, both of which expire worthless.
Total additional returns amount to $82.25 per share, following a $30 rally in the stock price.
You can now consider selling 4 call options in the next expiration cycle to sell the remaining
400 stock you are still holding.
AMZN: $1,600. This level represents the maximum profit for this position and no further
gains are possible above this price.
All Stock is called away and you have taken profit on all 800 shares.
This scaling out results in total additional profits of $104.75 per share.
It’s important to note that this strategy works best in a slowly rising market.
Should the stock fall quickly, the calls can only provide a limited hedge to cover cash losses
and a market which explodes to the upside leaves the call seller a spectator on the sidelines
once the stock price trades through the option strike(s) to the upside.
Nevertheless, this is a powerful strategy that should not be overlooked.
SUMMARY
A covered call strategy consists of writing a call that is covered by an equivalent long
stock position.
Premium income can be earned in exchange for giving up any upside above the written
option strike and used to reduce the cost basis of the long stock holding.
Strike selection allows an investor to trade off downside protection against potential upside
profits.
CHAPTER FIVE: COMBINING DOWNSIDE PROTECTION AND
COST BASIS REDUCTION
A collar is so called because typically the call and put options used are OTM and so sit
either side of the current stock price, rather like the collar of a shirt rests either side of the
wearer’s neck and head.
When the premium collected from the sale of the call option more than offsets the cost of
the purchase of the put, there is no outlay or cost in constructing this position.
For this reason, this specific type of collar is known as a zero-cost collar.
Let’s continue our story with our AMZN stock holding.
You currently own 100 shares, and we find the market trading at $1,570 per share and the
following option prices available in the market.
AMZN $1,550 Put: $55
AMZN $1,585 Call: $56
AMZN $1,590 Call: $52
Note that due to skew in the option series, puts are typically more expensive than
equidistant calls.
In this example then, it is not possible to construct a zero-cost collar using the 1,550/1,590
strike prices, which are both struck $20 away from the current stock price.
The sale of the $1,590 call combined with the purchase of the $1,550 put requires an upfront
outlay of $3 per option, since the put option is more expensive than the call by that amount.
For this reason, you decide to select the 1,550/1,585 strike collar, which provides a small
credit of $1 per option.
This is an ideal strategy for any conservative investor.
Since the call option is OTM there is room for some small appreciation in the stock value,
while the put assures any losses on the downside will be known and limited.
In Figure 5 (below) we can see the maximum profit for this position occurs at $1,585, which
is the strike of the short call option. At this price, the stock is called away for a profit of
$16, which is $15 in the appreciation of the stock, plus the $1 premium received from the
purchase of the collar.
The maximum loss would occur if the stock falls below $1,550 but is limited to just $19
per share.
The position provides a predetermined exit, or take profit target on the upside at $1,585,
while a stop-loss is put in place at $1,550 on the downside.
While AMZN at this time does not pay a dividend, it should be noted that any payments
received during the life of the collar simply increase the maximum profit and reduce the
maximum risk by the amount of the credit received from the dividend.
SUMMARY
A collar, particularly when implemented for zero-cost or a small credit, is an effective
strategy to convert high risk, long stock ownership to a more conservative play with
known and limited risk and upside potential.
A collar holder is afforded all the privileges of stock ownership and so is entitled to any
dividend payments made.
CHAPTER SIX: TARGETING FUTURE STOCK PURCHASE OR SALE
LEVELS
Like the collar, the strangle involves two OTM options which surround, or strangle the
current stock price. The major difference is that in this case both options are sold or written.
Once again, let’s look how this might relate to your long position of 100 shares in AMZN
stock.
The market is currently trading at $1,500 per share.
Your view is still bullish, and you expect the market to rally towards $1,550 over the short-
term.
Additionally, any minor weakness in prices would be seen as a buying opportunity and a
chance to add to your current holdings.
Specifically, you would look to buy 100 more shares at $1,450 if the opportunity arose.
Note that, it is assumed you have sufficient funds on hand in your brokerage account to
cover this stock purchase, and the put write is therefore cash-covered.
Consider the following option prices which are trading at this time.
AMZN $1,450 Put: $60
AMZN $1,550 Call: $57
You can construct a short strangle position by selling a $1,450 put and a $1,550 call and
collecting a total premium of $117 per option.
If we break this position down in to two parts, you have effectively created:
▪ a covered put write. This is the sale of the $1,450 put option with the intention of
purchasing the shares if assigned and;
▪ a covered call, consisting of 100 long AMZN stock and the sale of the $1,550 call
option.
SUMMARY
The combination of a cash-secured put write and a covered call is a long stock plus short
strangle position.
It allows an investor to not only earn an additional premium through the sale of the call and
put options but sell or purchase stock at levels determined by the strike prices selected when
implementing the strategy.
CHAPTER SEVEN: PICKING UP THE PIECES
You construct a 1,500/1,550 1x2 call ratio spread by purchasing one $1,500 call and
simultaneously selling two of the $1,550 calls. This position generates a net credit of $34
(-80 + (57x2)) per share.
In addition to receiving this credit, which improves your cost basis to $1,566 from $1,600,
there is no margin requirement since the additional short call margin is negated by the 100
shares of long stock, like a covered call position.
What if AMZN were to recover just half of the initial loss and rallied back to $1,550, the
short call strike, by expiration?
The $1,500 call is ITM but has an intrinsic value of only $50 and so loses $30 from your
initial purchase price. But the two $1,550 calls expire worthless for a combined profit of
$114.
The options then net a combined total profit of $84 (-30 +114) and your long stock is called
away.
So, your stock position that was showing a $50 loss at this level (recall we purchased the
stock at $1,600 per share) is now showing a net profit after the adjustment of $34 per share!
In figure 6 (below) you can see this is the maximum profit possible and remains the same,
even if the stock continues to rally higher.
The breakeven point occurs at a price of $1,533.
Here the stock is running a $67 loss, which is exactly compensated for by the combined
options position profits.
By adding the call ratio position, you have lowered your breakeven price to $1,533 from
$1,600 and it did not cost anything; in fact, you received a $34 credit for doing so.
Importantly, there is no additional downside risk in this trade.
When selecting strikes for this strategy, you should use the short strike where you sell the
two call options as a gauge to where the price might reasonably rally back to, since the
maximum benefit occurs at or above this level.
It is important to note that despite the stock cost basis reduction, there is no additional
protection once the stock falls below the long call strike, or $1,500/share.
SUMMARY
A call ratio spread can be added to a long stock position to reduce the cost basis and fix a
losing trade. This type of adjustment is known as a stock repair strategy and can typically
be added at no cost or a credit.
CHAPTER EIGHT: CHEAP INSURANCE WHEN OPPORTUNITY
KNOCKS
With AMZN stock still at $1,750 a month later then, options prices are now as follows:
Time to Expiration:
Expired AMZN $1,700 Put $0 - (The original 1-month option)
1 Month AMZN $1,700 Put $60
2 Months AMZN $1,700 Put $95 - (The original 3-month option)
Despite the fact the stock is unchanged, you pocket a profit of $37.
The shorter-dated 1-month option has expired worthless, while the longer-dated 3-month
option has lost just $25 in value due to the passage of time.
At this point, you can write another front month put to further offset the cost of the longer-
dated option, and again attempt to purchase AMZN stock at a discounted price.
In fact, if we are able to receive an additional $58 in income or more, the trade is now free
since the two 1-month credits received exceed the price paid for the longer-dated put.
What happens if the stock had dropped down to your put option strike at $1,700, and the
short-term put was assigned?
With AMZN stock at $1,700 a month later, the option prices are now as follows. Note, your
position now includes 100 shares of AMZN stock.
Time to Expiration:
Expired AMZN $1,700 Put $0 - (The original 1-month option)
1 Month AMZN $1,700 Put $60
2 Months AMZN $1,700 Put $140 - (The original 3-month option)
AMZN Stock Long 100 shares @ $1,638
You now own 100 shares of AMZN @ an average price of $1,638/share. This is the $1,700
strike price less the 1-month option premium of $62.
The longer-dated put is now more expensive due to the decline in stock price, but has only
appreciated by $20, due to the effects of one month’s worth of time decay.
The total profit from the trade then is $82 (62+20), and the newly added long stock position
now allows for further participation in any rally in the share price.
In addition, the purchase of the longer-dated put still provides 2-months’ worth of
downside protection should the share price fall further below $1,700.
This however comes at a price, albeit relatively inexpensive. Recall, the current $1,700
2-month put is now trading at $140 per option. We initially paid $ 120 for this, but also
reduced this premium by the sale of the 1-month put for $62.
Our cost to insure our position then is only $58, a significant discount to that available in
the prevailing market of $140!
You should be aware though, that should the stock remain above $1,700 by the expiration
date, then the long put option will expire worthless.
It can, of course, be sold back at any time prior to expiration or closed immediately
following the expiration of short-dated put.
SUMMARY
A calendar spread is the purchase and sale of two options, at the same strike, in two
different expiration cycles.
A put calendar spread can be used to achieve two separate objectives:
▪ The short-dated option behaves like a cash-covered put and allows the purchase of
the underlying stock at a discount, should assignment of that stock take place.
▪ Additionally, it includes a long position in a longer-dated put which can be used to
provide downside protection in the event you become long the underlying stock.
Since this position is long Vega and placed for a cost or debit, it should only be entered
into when longer dated option premiums are relatively cheaper and implied volatility is low
and expected to rise.
STRATEGY SUMMARY
During the course of this book we have considered the following seven option strategies
and how they might be employed as a complement to a long stock portfolio.
Here is a brief summary of each strategy and its intended purpose.
The protective put/ bear put spread. Applying a protective put or bear put spread
to a long stock position allows you to still
participate in the upside movement of the
stock, yet control and limit your risk to the
downside in the short-term.
The stock repair strategy. A call ratio spread can be added to a long
stock position to reduce the cost basis and fix
a losing trade.
American Option: An option that can be exercised at any time prior to expiration. US
equity options are American.
Assignment: The process by which the seller of an option is notified of the buyer’s
intention to exercise.
At the Money: An option whose exercise price is equal to the current price of the
underlying contract.
Calendar Spread: The purchase (sale) of one option expiring on one date and the sale
(purchase) of another option expiring on a different date.
Call Option: A contract between a buyer and seller whereby the buyer acquires the right,
but not the obligation, to purchase a specified underlying contract at a fixed price on or
before a specified date.
Collar: A long underlying position that is hedged with both a long (purchase) out of the
money put and a short (sale) out of the money call.
Covered Write: The sale of a call option against an existing long position in the underlying
contract.
Delta: The sensitivity of an option’s price to the change in that of the underlying.
Delta Neutral: A position where the sum total of all portfolio deltas adds up to
approximately zero.
Gamma: The sensitive of an option’s delta to a change in the price of the underlying
contract.
In the Money: An option that has intrinsic value greater than zero. A call option is in-the-
money if the option strike price is less than the current price of the underlying contract. A
put option is in-the-money if the option strike price is greater than the current price of the
underlying contract.
Long: A position resulting from the purchase of a contract.
Naked: A long (short) market position with no offsetting short (long) market position.
Out of the Money: An option that has no intrinsic value. A call option is out-of- the-money
if the option strike price is greater than the current price of the underlying contract. A put
option is out-of-the-money if the option strike price is less than the current price of the
underlying contract.
Put Option: A contract between a buyer and seller whereby the buyer acquires the right,
but not the obligation, to sell a specified underlying contract at a fixed price on or before a
specified date.
Short: A position resulting from the sale of a contract.
Strangle: A long (short) call and long (short) put where both options have the same
underlying and expiration date.
Strike Price: The price at which the underlying contracts will be delivered in the event an
option is exercised.
Theta: The sensitivity of an option’s price to the passage of time.
Time Value: The price of an option less its intrinsic value. The price of an out-of-the-
money option consists solely of time value.
Vega: The sensitivity of an option’s price to a change in volatility.
Volatility: The degree to which the price of a contract tends to fluctuate over time.
Volatility Skew: The tendency of options at different strike prices to trade at different
implied volatilities.
Zero Cost Collar: A collar where the prices of the purchased and sold options are the
same.
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