Traders Toolbox: Learning Options Part 3 of 4

Two of the more common option strategies are horizontal spreads (identical strike prices, different expiration days) and vertical spreads (different strike prices, same expiration day). Other spread types are combinations or variations of these categories: Diagonal spreads are a mixture of horizontal and vertical spreads; butterfly spreads combine two different vertical spreads.

Selling a March 450 S&P call and buying a June 450 S&P call is an example of a horizontal spread, also known as a time, or calendar spread. The object is to profit from the quicker decay of time value of the nearby short option compared to the more distant long option. The trader is, in effect, selling time value. Most time decay occurs in the last three months, and especially the last month, of the contract. This strategy is generally most profitable with equity options than with future options.

If you sell the March option at 7.75 and buy the June option at 11.75, you establish the calendar spread at a 4.00 debit. (Debit spreads are spreads that the trader pays to establish, while in credit spreads the trader collects premium). The March contract then drops to 1.25, while the June option drops to only 10.50. You could then “lift” (offset) the spread, buying the March back at a 6.50 profit and selling the June for a 1.25 loss, for a total profit of 1.25 (5.25 minus the 4.00 paid to establish the spread).

In a vertical spread, the options share the same expiration date but have different strike prices. An example would be buying a March 445 S&P call at 6.50 and selling a March 455 S&P call at 3.00 with the futures at 450.00, for a 3.50 debit on the spread.

In the market rallies, the deeper in-the-money long option would gain more than the short option would lose. If the futures are unchanged at expiration, the 445 call will be worth 5.00 (its intrinsic value) and the 455 call will expire worthless, for a 1.50 profit on the trade. Once the futures price rises above the higher strike, against on the lower strike are offset by losses on the higher strike, so profit is limited. If the market falls, loss is limited to the amount paid for the spread.

Option spreads are characterized as bear or bull strategies depending on whether they will profit in up or down markets. The previous example is a bull call spread, because it would make more money in a rising market. A bear call spread would consist of selling the lower strike option and buying the higher strike option.

Bull and bear spreads also can be established using put options. For example, a bull put spread would consist of buying a December 445 S&P put and selling a December 445 put. Selling the 445 put and buying the 445 put would be a bear put spread. Generally, you should use calls for bull spreads and puts for bear spreads.

You can alter spreads by modifying the number of options, for instance establishing a vertical bull call spread with two short calls for every long call, also known as a ratio spread. Whether all or some of the options in a spread are in-, at- or out-of-the-money also will affect the risk/reward profile of a spread.

Other strategies focus on the magnitude of price movement rather than direction. Straddles and strangles are two strategies traders use to take advantage of volatility swings. A straddle consists of buying at-the-money puts and calls with the same strike price and expiration day, for example, buying a June 100 bond call and a June 100 bond put. The straddle buyer expects a futures price move large enough (in either direction) that they profit on the in-the-money option will be more than the cost of putting on the spread. If you thought the market would remain virtually unchanged, you could sell the straddle (at a credit) and reap the profits as time eroded its value.

A strangle consists of combining out-of-the-money call and puts. With June bonds at 102, a strangle buyer might purchase a June 104 call and a June 100 put, again expecting a sizable move in either direction. (An advantage to this strategy is it is cheaper than a straddle, but the market also has to move more to make it profitable.) For a trader who expects bond prices to stay between 100 and 104, however, selling this straddle offers an excellent opportunity to “sell volatility.” If the market does stay between these prices, the seller will keep his premium.

Traders should be aware that because of higher commissions and increase slippage, a marginally profitable options trade can actually be a loser when all is said and done. Understanding volatility and time decay concepts will help identify strategies with the highest probability of success.

Part 4 will be posted Saturday afternoon (5/14/11). Don't miss the final lesson of this series!

Best,
The MarketClub Team

Grain Trader Report for Monday May 2nd

As part of INO.com’s ongoing effort to bring solid educational information for investors, we are pleased to offer you free access to one of the most sought after grain traders in the industry.  Grain floor trader Matt Pierce shares his Monday grain report with us for free.  If you would like to receive this report via email for free each week, simply visit Grainanalyst.com and tell them INO sent you.

Trends:

Click here to Continue reading "Grain Trader Report for Monday May 2nd"

How To Buy A Stock For A 15-20% Discount

Let's face it, we're ALL looking for discounts. I don't care if you're rich, poor, hurt by the economy, or not...everyone loves a discount. And since this is a site that focuses on trading/investing, what better then to learn about how to get a discount for a stock! To help us learn the art of the discount, I've asked Phil Davis from PhilStockWorld.com to come and enlighten us. Enjoy the article and tell us where you've found great discounts!

------------------------------------------------------------------------------------

If this market hasn’t convinced you that buy and hold is a gamble - I don’t know what will.

Holding any stock for more than a day has been a sure recipe for heartache (sometimes just an hour will do it) but it’s possible to regularly get much better prices than the ones paid by the average retail investor using a very basic option strategy. This strategy, which we call a "buy/write" – buying the stock and writing options against it - is one of our most effective tools for dealing with a choppy market.

There are, of course, many, many stocks trading near multi-year lows and it’s still important to select ones that have strong underlying fundamentals that we actually don’t mind holding long-term but, as long as you’re willing to own 200 shares of a stock, this system can reliably give you a 10-20% discount off the current market price.  It’s simple, easy to follow and is ideal for trading in a volatile market.

Continue reading "How To Buy A Stock For A 15-20% Discount"

Trader Toolbox: Learning Options Part 1 of 5

Options on futures have come of age. In fact, at some exchanges, options trading outstrips growth in futures trading by a 2:1 margin. But this growth has a major flaw: Many people use options for the wrong reasons. Sound options trading begins with understanding basic concepts and dispelling common misconceptions about he potential benefits and limitations of these instruments.

The Basics - An option contract gives you the right to buy or sell something at a set price for a limited amount of time or at a specific future date. Options are common in many businesses, such as real estate, where an investor might purchase an option that will give him the right to buy a parcel of land at an agreed upon price for a six-month period, regardless of fluctuations in the market price of the land.

Options on futures are no different. A trader can buy an option in June allowing him to buy December T-bond futures at 100.00, even if the market price in December is 105,00. The buyer pays a price for this opportunity, called the premium. The option buyer is sometimes called the writer.

There are two kinds of options: calls and puts. A call option gives the owner the right to buy futures at a specific price; a put option gives the owner the right to sell futures at the specific price. This predetermined price is called the exercise price, or strike price. A call option owner who "exercises" his right becomes long futures, while an option seller is "assigned" a short futures position. When a trader sells an option, he risks having a losing futures position at any time. In return for assuming this risk, he receives the option premium.

The owner, on the other hand, is under no obligation to exercise, and may sell the option or hold it through the term of the agreement. The last day a buyer can exercise an option is called the expiration date, which is established by the exchange. For example, the owner of a March 445 S&P call call buy March S&P futures at 445.00 until March 17, if he so chooses. The option expires at the end of trading on this day.

Most listed options in the United States are American style options, which allow the holder to exercise any time up through expiration day. European style options can be exercised on expiration day only.

Ins and Outs - The strike price of an option can be described three ways:

In-The-Money refers to calls with strikes prices below the current market price of the underlying future and puts with strike prices above the market price. If coffee futures are trading at 195.00. a 194.00 call is in-the-money, as is a 196.00 put.

At-The-Money options are calls and puts with strike prices equal to the current futures price. If coffee is 197.00, both 197.00 coffee calls and puts are at-the-money.

Out-Of-The-Money refers to calls with strike prices above the current futures price, and puts with strike prices below the future price. With coffee at 194.00, a 195.00 call and a 193.00 put would both be out-of-the-money.

With March bonds at 100.22, the owner of a March 98.00 call could exercise his option, become long bond futures at 98.00, sell the futures at 98.00, sell the futures and make 2.22. If the trader paid less than 2.22 for the opions, he would make a profit on the trade.

Because option buyers are not required to exercise, their market exposure is limited to the premium paid for the option. For sellers, however, risk is equivalent to an outright futures contract, because they can be assigned a futures position at any time.