Tuesday, September 7, 2010
Would Love Your Feedback!
Hi Everyone! I can't believe it's been more than a year since I first started this blog! I've been doing much of the talking here and now, I'd love to hear from you! Could you please kindly fill out this very, very short survey? If you are so inclined, drop me an email as well at felix [at] felixwong.ca. God bless!
Don't Be Afraid of Options - Part 6: Fancy Options
If you have read all of my posts on options, your knowledge of options would hopefully have increased. In this post, we are going to look at some of the fancier option strategies that are used by investors/traders. Without further ado, let's get started!
Strangles and Straddles
A few factors affect the price of an option. Without going too much into the Black-Scholes model that is widely used as a pricing model of derivatives, let's look at what might make an option more or less expensive. We know that an option is all about what might happen in the future. When I buy a call option, I'm betting that the underlying stock price will rise to a certain point in the future, before the expiry of the option. There are several factors that affect the likelihood of this happening.
Volatility is one of these factors. If you expect the underlying stock to fluctuate a lot (i.e. increased volatility) because of some future event (e.g. earnings or announcement of a new product, etc.), then it is possible to use strategies to capitalize on this. Two examples are the strangle and the straddle (please don't ask me how they came up with the names).
The Straddle
A Straddle
You can see in the above figure the behaviour of this position for the different stock prices at the time of expiry. If the stock moves below $138.55 or above $161.45, then the position would start to become profitable. At $161.45, the put option would be worth nothing since the strike price allows you to sell the stock at $150, and who would want to do that when he/she can sell it for $161.45? The call option, on the other hand, would be worth $11.45, because the stock has risen $11.45 above the strike price. So, you initially spent $11.45 on the 2 options, and now the call option covers that cost. Once the stock moves higher, that difference would go right into your pocket. In the same way, the put option would be worth $11.45 if the stock dropped to $138.55. The lower the stock moves, the more the put would be worth.
The absolute worst case for this strategy is if the stock moved to $150 and stayed there until expiry. Both options would expire worthless, and you would have lost $11.45/share.
The Strangle
A Strangle
A strangle is very similar, except that both the call option and the put option are out-of-money. So, if the stock price is at $148.50, I would buy a call option at $150, and a put option at $145. The call option would cost me $4.85/share and the put, $4.05/share. The total cost is $8.90/share. So, if the stock moves up or down $8.90 beyond the higher/lower strike price, respectively, the position would become profitable.
The strangle is a lower cost option over the straddle and it also becomes profitable more quickly than the strangle. The maximum lost, in our example, is $8.90/share versus $11.45/share for the straddle. The price range between the 2 strike prices (i.e. from $145-$150) is where your maximum lost occurs. The strangle is probably a better bet all around. I see no real advantage of buying a straddle over the strangle. Having said that, both strategies requires a large fluctuation in stock price in order for you to profit. The strangle, for example, requires a movement of $8.90, which is 6% of the current stock price. Sometimes, the stock doesn't even fluctuate that much in a few months, nevermind 1 month! I also did not include commissions cost in this analysis. By entering into a strangle/straddle, you have to buy 2 options, which doubles the cost of the position. If you decide close the position before expiry, you'd have to sell 2 options, incurring commissions costs again.
It is not uncommon for either of these strategies to be used when an unusually long period of inactivity has elapsed. If a certain stock has traded within a narrow range for a few months, it is likely that increased volatility is just around the corner. And since volatility of the stock has decreased recently, the price of its options may also have decreased in value. As such, it would be an opportune time to enter into a strangle/straddle position. Just keep the commissions cost in mind.
Spreads
Another concept that is popular is called spreads. The idea is to buy and sell a combination of options to create a semi-bullish or semi-bearish position. The semi-bullish position is called the bull spread, and the semi-bearish one is called, surprise, the bear spread. If you create a bull spread position using call options, it is further defined as the bull call spread. Let's look at one right now.
A Bull Spread
In the figure above, we have the behaviour of a bull call spread of POT. To create this position, a call option is bought with strike price at $145, while another call option with strike at $150 is sold. Here, the October $145 call costs $7.60/share, and the $150 call can be sold for $4.85/share. Therefore, we spent a total of $2.75/share to open this position ($7.60 - $4.85).
We all know what buying a call option at $145 gives us, which is limited loss and unlimited gains if the option rises above $145. What happens when we add selling a call option at $150? When we have sold a call option at $150, we give the right to buy 100 shares of the underlying stock at $150 to the buyer. If the stock price remains at or below $150, nothing happens. The option expires worthless and we get to keep the premiums. If the stock rises above, $150, we have to give our shares away for $150/share. Now, if the stock rises to, say, $155, the option is exercised, and our shares are called away. But we don't have 100 shares...so, what we do is use our $145 call option to buy 100 shares at $145, and then give the shares away for $150. Thus, we pocket $5/share, but we need to take away our initial investment of $2.75/share. Our profits are $2.25/share.
The advantage of a bull spread is that the initial cost is lower than a plain call option. Let's compare. With a bull spread, if the stock rises to $150, we make $2.25/share (like above) on $2.75/share investment. That's 82% gains. For a plain call at $145, we have to pay initially $7.60/share for the option. That's the first thing, higher initial cost. Then, when the stock price rises to $150, you make $500 by exercising the option to buy 100 shares at $145 and then immediately selling them for $150. The gain is $5/share, which is only 66% profits. So, on a percentage basis, the profits are decreased.
The disadvantage of a call spread is also precisely what it was designed to do, limit upside potential. Once the stock price rises beyond $150, your profits are capped off and you make only $2.25/share, even if the stock price goes up to $1000! Therefore, this position is semi-bullish, because you make money if the underlying stock price goes up, but your gains are capped if it goes up beyond the strike price of the higher option.
A bull put spread has essentially the same outcome, except that you buy a put option with a lower strike price, and sell a put option with a higher strike price. For bear spreads, the concept is exactly the same, but the position is profitable if the stock price decreases. I'm sure you are knowledgeable enough now to work out what options you need to buy and sell to make that happen.
Anything Else?
Heck, yes! If you can imagine a combination of buying/selling calls/puts, chances are people would have thought of it and have given it a fancy name already. If you want to do further research, start with butterfly spreads, calendar spreads, and ratio spreads. I typically like the KISS principle (Keep it Simple, Stupid) and avoid anything with more than 2 options. You really don't need to get that fancy to make money. Also keep in mind that if you sell uncovered calls/puts, you would need to have a margin account.
In the next and last post of this series, I will make available a spreadsheet that I have built to evaluate the various option strategies out there, and even ones that you make up yourself. Stay tuned!
Thursday, September 2, 2010
Don't Be Afraid of Options - Part 5: Let's Get Naked (with Options)!
Please excuse the title of this post...I had to! :)
We have learned about buying call options and put options, and also writing a covered call option. Let's continue with writing an uncovered or "naked" option in this post. Why is it called "naked"? This term has been coined because the seller of a naked option is left exposed to unlimited risk (in the case of a naked call). Recall that when you buy a call option, the most you can lose is the amount of money you have spent buying that call option. Also recall when you sell a covered call, when the underlying stock price rises above the strike price, all you have to do is hand over the shares that you already own of the underlying stock, and you're done. Not so with naked options.
Naked Calls
For a naked call option, what you do is exactly the same as a selling a covered call, except you don't own any underlying shares. Let's use an example to illustrate this. You think Ford (Ticker: F) at $11.71 is priced too high and predict that it would fall by January 2011. So, you sell a call option with a strike price at $12, set to expire in January 2011. You get paid a premium of $1.10/share, which is what this option is trading at currently. If the stock stays below $12, the option expires worthless and you get to keep the $1.10/share premium.
However, if your prediction was wrong and the stock rises to $14, the buyer of the option exercises his right to buy 100 shares at $12. Who would sell him those shares? YOU! Since you sold him the right to buy 100 shares at $12, you have the liability of fulfilling that contract. And since you don't actually own any shares of Ford, you need to buy 100 shares in the open market at $14/share and give them to the owner of the call option for $12/share. So, you earned $1.10/share in premiums, but lost $2.00/share because the buyer exercised the option ($14/share you paid - $12/share the option owner paid you). You netted -$0.90/share.
This is if you were lucky! If Ford had skyrocketed to $22, you would need to pay $22/share in the open market and sell them to the option owner for $12/share. You stand to lose $8.90/share ([$22 - $12] - $1.10 premiums). The higher the stock goes, the higher your losses. That is why your losses are considered unlimited. As long as the stock goes up, your losses go up. Therefore, I absolutely do not recommend writing a naked call. By exposing yourself to unlimited risk, you stand to gain only a fraction of what you could lose. This is the wrong side of the bet!
Naked Puts
Naked put options, although appearing similar to naked calls, are a completely different beast. For one thing, your losses are not unlimited. Say you sold a put option of Ford with a strike price of $11 and expiry date of January 2011 for $0.89/share. You essentially have sold the right to sell shares of Ford for $11 at anytime before the expiry of the option to the buyer. This is a bullish position. If shares remain higher than $11, then the buyer would not want to exercise the option, because he can sell it for more on the open market. However, if Ford tanks and goes to $10, the buyer can exercise that option, and you would have to buy the shares at $11. If Ford totally went bankrupt and the shares went down to $0, you would still need to pay $11 for those same shares. That's too bad...but that's the worst it can get. The share price cannot go into negative territory. Your maximum loss is simply the strike price of the option minus any premiums that you had received when you sold the option.
When Should I Write a Naked Put?
As I said, writing a naked put option is a bullish position. It is especially useful when you are trying to accumulate a certain stock. By writing a put option, you can potentially increase your returns and lower your risk (wait a minute, aren't those two polar opposites? Keep reading...). Let's use an example...I like examples, they make things easier to understand.
So, real life example...if you have followed my trading history, you would know that I've been accumulating True Religion stock. I began buying when it was $29.31. In merely 5 months, the stock has shed more than 35% of its value. It's trading at $18.75 today. This is one volatile stock! No worries, I kept buying as it came down. Lately, I've been thinking about writing naked puts (thinking only, because I need to "upgrade" my account, more on that below). I checked out the prices of TRLG's put options and were quite surprised at how much people were willing to pay. I looked at one with a strike price of $16 and expiry in April 2011, and people were asking for $1.95/share. That's more than 10% of the stock price!
So, if I can successfully upgrade my account, and sell that same put option, I would immediately get $1.95/share for it. If the stock goes down to $16 and the option is exercised, I simply buy 100 shares per each contract that I have sold. Is that bad news? No, not at all. If I had not sold the option, I would still have bought the shares. So, why not make $1.95/share while I'm at it?
In fact, by writing a naked put, I have lowered my overall risk. Compare this...if I were to only buy the shares when TRLG dropped to $16, and the stock fell some more to $15, I would have lost $1.00/share. However, if I had sold that option, I would have been paid $1.95/share for it, and as a result, I'm still up $0.95 (the shares costed me $16/share - $1.95/share of premiums = $14.05/share)! Now, that's having your cake and eating it too! So, please, don't listen to the industry's seemingly intuitive and believable lies, "if you want greater returns, you have to take greater risks." Selling naked puts when you are trying to accumulate a stock is what I call prudent investing!
The Catch
Yes, yes, there is a catch. Not a big one though. In order to be able to write naked calls or puts, you need to have a margin account, because after your initial transaction, you can still rack up additional losses. Depending on your broker, they would likely limit how much risk you are exposed to. So, chances are, they probably would not let you write too many risky naked options if you did not have the cash to back them up. You may either need cash sitting around in your account or the appropriate collateral (i.e. you may be required to sell your holdings) if the trade goes against you.
What Now?
I don't know about you, but I'm going to get my account upgraded! When I talk with friends and such, most tend to think of options and margin accounts as very risky things, without really knowing what they are all about. It's sort of like a gun. If a gun falls into the hands of an irresponsible person, it can be very dangerous and no one should allow that to happen. However, if on the other hand, the person in question is a trained police officer with years of experience, we would feel much safer if he had a gun in his possession, compared to if he had not. And so, that is the case with options. Learn to use the tool and don't be afraid of it.
I've almost exhausted all of the things I can talk about options, without going into really fancy stuff, but wait, the best is yet to come. I will give you a tool that can enable you to evaluate various option strategies, even those I have not talked about. Stay tuned!
We have learned about buying call options and put options, and also writing a covered call option. Let's continue with writing an uncovered or "naked" option in this post. Why is it called "naked"? This term has been coined because the seller of a naked option is left exposed to unlimited risk (in the case of a naked call). Recall that when you buy a call option, the most you can lose is the amount of money you have spent buying that call option. Also recall when you sell a covered call, when the underlying stock price rises above the strike price, all you have to do is hand over the shares that you already own of the underlying stock, and you're done. Not so with naked options.
Naked Calls
For a naked call option, what you do is exactly the same as a selling a covered call, except you don't own any underlying shares. Let's use an example to illustrate this. You think Ford (Ticker: F) at $11.71 is priced too high and predict that it would fall by January 2011. So, you sell a call option with a strike price at $12, set to expire in January 2011. You get paid a premium of $1.10/share, which is what this option is trading at currently. If the stock stays below $12, the option expires worthless and you get to keep the $1.10/share premium.
However, if your prediction was wrong and the stock rises to $14, the buyer of the option exercises his right to buy 100 shares at $12. Who would sell him those shares? YOU! Since you sold him the right to buy 100 shares at $12, you have the liability of fulfilling that contract. And since you don't actually own any shares of Ford, you need to buy 100 shares in the open market at $14/share and give them to the owner of the call option for $12/share. So, you earned $1.10/share in premiums, but lost $2.00/share because the buyer exercised the option ($14/share you paid - $12/share the option owner paid you). You netted -$0.90/share.
This is if you were lucky! If Ford had skyrocketed to $22, you would need to pay $22/share in the open market and sell them to the option owner for $12/share. You stand to lose $8.90/share ([$22 - $12] - $1.10 premiums). The higher the stock goes, the higher your losses. That is why your losses are considered unlimited. As long as the stock goes up, your losses go up. Therefore, I absolutely do not recommend writing a naked call. By exposing yourself to unlimited risk, you stand to gain only a fraction of what you could lose. This is the wrong side of the bet!
Naked Puts
Naked put options, although appearing similar to naked calls, are a completely different beast. For one thing, your losses are not unlimited. Say you sold a put option of Ford with a strike price of $11 and expiry date of January 2011 for $0.89/share. You essentially have sold the right to sell shares of Ford for $11 at anytime before the expiry of the option to the buyer. This is a bullish position. If shares remain higher than $11, then the buyer would not want to exercise the option, because he can sell it for more on the open market. However, if Ford tanks and goes to $10, the buyer can exercise that option, and you would have to buy the shares at $11. If Ford totally went bankrupt and the shares went down to $0, you would still need to pay $11 for those same shares. That's too bad...but that's the worst it can get. The share price cannot go into negative territory. Your maximum loss is simply the strike price of the option minus any premiums that you had received when you sold the option.
When Should I Write a Naked Put?
As I said, writing a naked put option is a bullish position. It is especially useful when you are trying to accumulate a certain stock. By writing a put option, you can potentially increase your returns and lower your risk (wait a minute, aren't those two polar opposites? Keep reading...). Let's use an example...I like examples, they make things easier to understand.
So, real life example...if you have followed my trading history, you would know that I've been accumulating True Religion stock. I began buying when it was $29.31. In merely 5 months, the stock has shed more than 35% of its value. It's trading at $18.75 today. This is one volatile stock! No worries, I kept buying as it came down. Lately, I've been thinking about writing naked puts (thinking only, because I need to "upgrade" my account, more on that below). I checked out the prices of TRLG's put options and were quite surprised at how much people were willing to pay. I looked at one with a strike price of $16 and expiry in April 2011, and people were asking for $1.95/share. That's more than 10% of the stock price!
So, if I can successfully upgrade my account, and sell that same put option, I would immediately get $1.95/share for it. If the stock goes down to $16 and the option is exercised, I simply buy 100 shares per each contract that I have sold. Is that bad news? No, not at all. If I had not sold the option, I would still have bought the shares. So, why not make $1.95/share while I'm at it?
In fact, by writing a naked put, I have lowered my overall risk. Compare this...if I were to only buy the shares when TRLG dropped to $16, and the stock fell some more to $15, I would have lost $1.00/share. However, if I had sold that option, I would have been paid $1.95/share for it, and as a result, I'm still up $0.95 (the shares costed me $16/share - $1.95/share of premiums = $14.05/share)! Now, that's having your cake and eating it too! So, please, don't listen to the industry's seemingly intuitive and believable lies, "if you want greater returns, you have to take greater risks." Selling naked puts when you are trying to accumulate a stock is what I call prudent investing!
The Catch
Yes, yes, there is a catch. Not a big one though. In order to be able to write naked calls or puts, you need to have a margin account, because after your initial transaction, you can still rack up additional losses. Depending on your broker, they would likely limit how much risk you are exposed to. So, chances are, they probably would not let you write too many risky naked options if you did not have the cash to back them up. You may either need cash sitting around in your account or the appropriate collateral (i.e. you may be required to sell your holdings) if the trade goes against you.
What Now?
I don't know about you, but I'm going to get my account upgraded! When I talk with friends and such, most tend to think of options and margin accounts as very risky things, without really knowing what they are all about. It's sort of like a gun. If a gun falls into the hands of an irresponsible person, it can be very dangerous and no one should allow that to happen. However, if on the other hand, the person in question is a trained police officer with years of experience, we would feel much safer if he had a gun in his possession, compared to if he had not. And so, that is the case with options. Learn to use the tool and don't be afraid of it.
I've almost exhausted all of the things I can talk about options, without going into really fancy stuff, but wait, the best is yet to come. I will give you a tool that can enable you to evaluate various option strategies, even those I have not talked about. Stay tuned!
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