Strategy - BUY A PUT
- Strategy Outlook
Investor takes a view that the market will fall significantly in the short-term.
- Implementation of this Strategy
Put option is bought with a particular strike price. The more bearish the investor
is, the lower the strike price would be.
- Upside Potential
Profit potential is limited (limited because the price of the underlying security
cannot fall below zero).
- Breakeven Point at Expiry
Strike price minus premium paid.
- Downside Risk
Limited to the premium paid - incurred if at expiry the market is at or above the
strike price of the put option purchased.
- Margin
Not required.
- When to buy a Put?
Purchasing puts without owning shares of the underlying stock is a purely directional
strategy used for bearish speculation. The primary motivation of this investor is
to realize financial reward from a decrease in price of the underlying security.
This investor is generally more interested in the quantum of his initial investment
and the leveraged financial reward that long puts can offer than in the number of
contracts purchased.
Experience and precision are keys in selecting the right option (expiration and/or
strike price) for the most profitable result. In general, the more out-of-the-money
the put purchased is the more bearish the strategy, as bigger decreases in the underlying
stock price are required for the option to reach the break-even point.
A long put offers a leveraged alternative to a bearish, or "short sale" of the underlying
stock, and offers less potential risk to the investor. As with a long call, an investor
who purchased and is holding a long put has predetermined, limited financial risk
versus the unlimited upside risk from a short stock sale.
Purchasing a put generally requires lower up-front capital commitment than the margin
required to establish a short stock position. Regardless of market conditions, a
long put will never require a margin call.
As the contract becomes more profitable, increasing leverage can result in large
percentage profits.
Warning: If the market does little then the value of the position will decrease
as the option time value falls.
Strategy - SELL A CALL
- Strategy Outlook Investor is certain that the underlying security will
not rise but is unsure whether it will fall.
- Implementation of this Strategy
Call option is sold with a particular strike price. If the investor is very certain
of his view then at-the-money call option should be sold,
if less certain then out-of-money call should be sold.Call option is sold with a
particular strike price.
If the investor is very certain of his view then at-the-money call option should
be sold,
if less certain then out-of-money call should be sold.
- Upside Potential
Limited to the premium received if the underlying security at expiry is at or below
the strike price of the call option sold.
- Downside Risk
Unlimited. Losses on the position will increase as the market rises. If the investor
is not very certain of his view bearish spread might be a better alternative.
- Margin
Required.
- When to sell a Call?
There are a variety of reasons that you may choose to sell calls. The successful
covered call writer chooses a specific call to sell based on his expectations and
objectives.
There are two major factors that you should consider before writing a call:
- Your expectations for the underlying stock
- Your particular strategy objective
If you expect the underlying stock to rise, your objective may be an above-average
return - a combination of premium income and any appreciation of the stock price
up to the strike price. Thus, if the call is exercised, you have met your objective.
If you expect the stock to remain stable, your objective may be to generate
cash flow or produce income on a dormant position.
If you expect the stock to decline but are unwilling to sell out the stock
position, your objective may be to offset some or perhaps all of the loss on the
stock. In order to decide which call to write (sell), you must have a clear understanding
of the relationship between the current market price of the underlying stock and
the exercise price of each call and how that will affect your strategy.
This relationship is defined in three ways:
Out-of-the-money: The strike price of the call is higher than the price of
the stock. Because the strike price is higher than the stock's current price, you
will receive the smallest premium for an out-of-the-money call and therefore get
the least downside protection with this type of call. However, the out-of-the-money
call provides you with the opportunity for upside potential on your stock because
you can profit on a rise by the stock all the way up to the strike price of the
call. Therefore, when you sell an out-of-the-money call, you establish a selling
price for your stock above the current market price and the premium increases the
total return.
This type of call may be well suited to the trader who expects a moderate rise in
the price of the stock.
At-the-money: The strike price of the call is at or near the price of the
stock. Because the stock is trading at or very close to the strike price, you will
receive a higher premium than the out-of-the-money call option and moderate downside
protection. If the stock declines, you retain the premium as a profit, whether or
not the call is exercised.
In-the-money: The strike price of the call is lower than the stock price.
Because the stock price is above the call's strike price, you would receive the
largest premium for an in-the-money call and the maximum in downside protection.
A willingness to have the stock called away is a very important consideration in
planning a covered writing strategy.
The higher the price of the stock in relation to the exercise price of the call,
the greater the chance of an exercise.
Thus, you incur the greatest likelihood of having your stock called away when you
sell an in-the-money call.
If the market does little, and time passes, this helps as the short position gains
when the time value erodes.
Strategy - BEAR SPREAD
- Strategy Outlook
Investor thinks that the market will not rise, but wants to cap the risk. Conservative
strategy for one who thinks that the market is more likely to fall than rise.
- Implementation of this Strategy
Call option is sold with a lower strike price and another call option bought with
a higher strike price, producing a net initial credit,OR Put option is sold with
a lower stike price and another put bought with a higher strike, producing a net
initial debit.
- Upside Potential
Limited in both cases - net initial credit Puts: difference between strikes
minus initial debit Maximum profit if market at expiry is below the lower strike.
- Downside Risk
Limited in both cases - Calls: difference between strikes minus initial credit
Puts: net initial debit
- Margin Possibility for margin requirements to be off-set.
When to use a Bear Spread ?
- Moderately Bearish An investor often employs the bear put spread in moderately
bearish market environments, and wants to capitalize on a modest decrease in price
of the underlying stock. If the investor's opinion is very bearish on a stock it
will generally prove more profitable to make a simple put purchase.
- Risk Reduction An investor will also turn to this spread when there is discomfort
with either the cost of purchasing and holding the long put alone, or with the conviction
of his bearish market opinion.
Note:
The bear put spread can be considered a doubly hedged strategy.
The price paid for the put with the higher strike price is partially offset by the
premium received from writing the put with a lower strike price.
Thus, the investor's investment in the long put and the risk of losing the entire
premium paid for it, is reduced or hedged. With a bear spread options strategy,
the trader is looking for price to decline.
If the price rises, the most the trader can lose is predetermined.
The greater the maximum profit potential, the greater the risk. The further the
short call is in-the-money, the greater the profit potential. However, this carries
greater risk as it is more likely the short call will close in-the-money.
It is aggressive in the sense that the security needs to decline further in price.
The further the security needs to fall, the greater the risk.
Strategy - DIAGONAL SPREAD
- Strategy Outlook
Investor thinks that the market will be flat or rise only slightly in the short-term,
but will then fall later.
- Implementation of this Strategy
Sell a near-dated put option and buy a longer dated out-of-the-money put.
- Upside Potential
Large, if the bought option is held after the short option expires (the position
then becomes a straight-forward buy put).
If the position is closed at expiry of the near option, maximum profit will accrue
if the market is at the level of the sold strike.
- Downside Risk
Limited to the difference in strikes plus/minus the initial debit/credit when establishing
the spread.
- Margin
Yes, but limited.
When to enter into a Diagonal Spread ?
The diagonal spread is entered into when there is a firm long term bearish view
of the market but the investor would prefer to cash in on any immediate upside potential
of the stock.
This could be in anticipation of any favourable corporate news/earnings report that
could be profitably employed in the short term though the long term outlook is adverse.
Warning: There is a risk of the sold options being called (i.e. being exercised).