Options for Rookies

One Big Risk When Trading Options: Not Quite Understanding the Details

Here is my delayed response to Bill's question (from Jan 28).

Mark,

My concerns about the strangle options play [Note: he's referring to selling strangles] is that it just seems too simple, and that I may be missing something important. 

It is simple.  Just sell some options.  That's all there is to it.  But it's quite risky with potentially unlimited losses.  We both recognize that 'unlimited' is just a word and the stock is rarely, if ever, going to drop 50% or double overnight.  But losses can be large when compared with potential profits.

My gut feeling right now is that my constant vigilance and a plan to modify or exit the strangle in the case of an extreme move will provide me with adequate safety in my efforts. I'm also selecting very high-quality stocks which have a history of slow and narrow moving ranges, and which will not be reporting earnings during my holding period. Also, my strangle positions individually will represent not more than 5-6% of the portfolio total value, so any one position is not going to destroy things on its own if it turns bad and out of control. 

Those position attributes go a long way towards the low risk you seek.  But that does not take away from the fact that you are selling naked strangles.

Here's my short list of questions: 

It may be a short list, but there is no way I can help you with a short reply.

1. I had assumed that an option which reached its strike price would be subject to assignment, and would be from the "in the money" direction; if this is true then does it mean that my "out of the money" strangle positions are automatically subject to possible assignment, from the outset? 

a) You assumed incorrectly.  I am always surprised when someone comes to me with this (or similar) question.  No one in his/her right mind would EVER - under ANY REASONABLE CIRCUMSTANCES - exercise an option when it 'reaches it's strike price.

I just cannot comprehend from whence that idea originates.  I would be extremely appreciative if you can provide a clue.

Just look at any stock and the options on that stock.  Notice that there are in-the-money calls and puts.

Notice that the open interest of these options is not anywhere near zero.  Zero would be the open interest if everyone exercised those options.

Keep in mind that just because you sold the option when it was out of the money and discover that it has move to become at ATM or ITM option - does not change anything.  It's now an ITM option like any of the other ITM options.  Those other ITM options were not exercised by their owners.  Yours will not be exercised either.

If they are not exercised, then you are NOT subject to being assigned.  Sure it can happen once in a lifetime, but get it out of your head that you are subject to exercise. And if you were assigned an exercise notice, it would be a major gift to you.  When an option is exercised, all residual time premium in that option is forfeited.  In other words, you get to buy that option at parity.  What a bargain price!

Your question tells me that you are an intelligent person, so I assume this is crystal clear to you,  What I don't understand is where you learned that you might be assigned under these circumstances.

Just take a look at that option data I had you look at earlier.  Do you see that the slightly ITM calls and puts carry a time premium in addition to intrinsic value?  Anyone who owns that option and no longer wants to own it - would SELL and collect the full option premium.  Exercising allows the capture of only the intrinsic value and the time value is tossed into the trash.  No one would do that.

b) NO.  Your OTM options are not going to be assigned either.  I grant that the option owner has the right to exercise at any time, but would never do so.  NEVER.

That does not mean they cannot be exercised when expiration arrives - if - at that time they are no longer out of the money.  But that's not what you asked.

c) Look at this from this perspective. A stock is trading at $36.  You sell a 30 put and a 40 call and collect a total premium of $200.  The next day you are assigned on both options.  What happens? 

You must sell stock at 40 to the call owner.  You must buy stock from the put seller.  You sell @ $40 per share and pay $30 per share.  In addition to the $1,000 profit, you keep the $200 premium.

What do you think the probability is for that to happen?

d) Let's go further.  let's say you sell ITM options as your strangle.  Although this is done by few traders, it's referred to as selling the 'guts' strangle.  You sell the 40 put and the 30 call.  You collect a premium of $1,200.  When assigned on both options - either today, tomorrow or at expiration, you sell at 30 and pay 40.  That costs $1,000.  But you were paid $1,200 and have a $200 profit.

That is not going to happen tomorrow.  There is no reason to exercise any option that has residual time premium.

e) One more perspective:  You can buy stock at $36.  Would you pay $7 for the 30-strike call and then immediately exercise it?  Of course not.  That would be equivalent to paying $37 for stock.  No one is going to do that.

2. I don't feel any particular fear from being assigned; my brokerage just shorts my account (I don't have to actually hold the underlying) and then I would manage it as a short position of a common stock--it could actually yield additional gains if this happens in a down day of course--but even if it's moving up in price a quick "buy to cover" removes the issue with minimal losses.

I understand the issue of potentially disastrous losses if some unusual event were to occur which would move the underlying price at an accelerated rate--and this is why my position size is intentionally small as stated above.

a) There is no reason to fear assignment. In fact, you can only benefit and essentially never lose.  Instead of being short a call worth a few bucks, you are short stock.  If the stock rallies you have lost NOTHING.  Being short the call gives you the identical upside risk.  Identical.

So, if you must do a quick 'buy to cover' with short sock, you would be forced to make the same trade (by to close on the call).  You lose NOTHING extra.

b) And if the stock tumbles below the strike of the call, then you make more on being short the stock than you would have earned by being short the call.  Having been assigned an exercise notice prior to expiration (and those are the scenarios we are discussing - or at least I hope so) turns out to be a free gift.  Essentially you get to buy back the call option for 'less than zero.'  Example: Sell a 50 call and collect $300.  Maximum profit: $300.

Assume You receive an assignment notice and the stock drops to 48.  You buy it back.  You made $300 from the call and an extra $200 on the stock.  Maximum profit just moved above that $300.  Being assigned early was a true gift.  No possible losses and possible gains.  If you understand equivalent positions, then you were given put option at no cost.

c) But your statement about minimal losses, or disastrous events, tells me that you don't recognize that being short the stock is better than being short the call.  there are no 'minimal losses' associated with being short the stock.  You incur the same losses when short the call.  You must understand that. You are trading options and you must understand what is risky and dangerous and what reduces risk and is beneficial.

d) Good idea - about position sizing.  It's one excellent method for controlling risk.

3. The issue of actual selection of expiration and strike price is a little mysterious to me--in the way that it seems so simple.

I'm using the nearest expiration date (Feb 20 right now) as my expiration of choice because it allows me to roll the funds over into the next expiration with the highest frequency; the reduction in premium compared to a longer expiration date is minimal and I also like being able to count on a probable smaller move in the underlying during the shorter period.

Regarding the strike price selection I'm simply using the furthest strike price available from the current price of the underlying; this yields the highest premium and minimizes the possibility of the underlying striking my holdings.

Currently I've sold 3 Feb HAL 36 puts and 3 Feb HAL 25 calls; price of the underlying at this writing is 29.53 and the 90-day highs and lows are 34.87 and 25.50.

The first question to be answered is, am I making some kind of gross error in my assumptions?

Please feel free to fire both barrels at me if I'm in over my head here!

Thanks in advance for taking the time to help me out.

Bill

a) I would never shoot both barrels.  My goal is to help you understand how options work.  If you are making a mistake, I want to help you correct it, not make you feel worse. I do get frustrated by some of the questions I receive, but I can tell by your specific problems that you did not learn about options from this blog or The Rookie's Guide to Options.

Choosing the expiration date is not a 'who cares?' decision. It's important.  Rolling funds with the highest frequency is not always a good idea.  It most certainly makes your broker happy because this method assures that you pay he highest possible amount in commissions.  Not only that, but if your broker charges you anything for exercises or assignments, then you are paying a bunch of extra fees.  I hope you are comparing annualized returns on your profits (when you earn them) and comparing what those returns would be if you traded options with a longer lifetime.

Yes, shorter-term options have less time for something to go wrong, but when you consider than trading a one-month option three times costs you thrice the commissions and thrice the assignment fees, does it still give you the results you desire?

Don't forget this: less time and a lower probability of a big move means that the premium collected is also less.  Often so much less that it's a very bad trade.  And my guess it that you made very bad trades. But because you did not share the premium collected when asking your question, I can't know that for a fact.

In addition to telling me which options you sold, I would have like to know how much you collected to sell them.  And what you pay in commissions and assignment fees.

b) All I can say about your strike price selection is OMG.  Are you serious?

Collecting the 'highest premium' means nothing.  In fact it means less than nothing.

Please think seriously about this question:  Do you understand how to make money by selling options?  It is not from selling the most premium.  It is from selling the most 'time premium.'

Your trade is EXACTLY EQUIVALENT (same profit and risk of loss) as selling the farthest OTM call and put.  That's what you are doing.  It's the same thing.

c) Are you making some gross errors in your assumptions?  I'm glad you asked because that is the ONLY question that matters. I cannot tell you - but I am going to tell you how to figure it out.

Let's examine the HAL position.  You sold the 36 put and the 25 call.  When expiration arrives and you are assigned an exercise notice, you must sell stock @ $25 and buy stock @ 36.  That will cost you $1,100.

How much did you collect when selling the strangle?  Obviously your profit is the amount ABOVE $1,100 that you collected, less commissions and assignment fees.  I have no idea how much that is, but I'd guess that it's not much above zero.  I'd guess that you are taking the risk of something bad happening for almost no compensation.

By the way, when you enter your orders to sell the call and put, I hope you are entering the orders at a spread, and not as single orders. It's also essential that you set a limit price and NEVER, under any circumstances, sell the strangle 'at the market.' That would be a a very poor decision.

But I have no idea if this was a bad trade.  I'd bet that you collected less than $1,100, guaranteeing a loss.  Only you how much you collected when selling the strangle.

d) There is one problem with selling the guts strangle that I ignored above.  When the stock pays a dividend, it is VERY likely that you will be assigned an exercise notice on the call option one day prior to the stock's ex-dividend date.  That means you must pay the dividend.  When that happens, be certain to subtract the cost of that dividend from your profits (if you have any). But, more than that, some brokers charge interest for you to be short stock.  Years ago, they paid a rebate when short stock.  That is no longer true.  So subtract those interest charges from your profits (if any).

e) When I mentioned above that nothing bad happens when assigned an exercise notice - that's almost always true.  You may have an interest charge to pay.  Verify with your broker whether they charge interest when you are short stock.

f) It's my pleasure to help you out, but your question - and my reply - has brought to the surface a problem that has been developing for awhile now.  I'll have more to say about that in Friday's post.

603

One Trader's Thoughts on a Dividend Capture Trade

Jason sent an example in reply to this Q & A.

An example. Pfizer is going ex-dividend next month. Paying $0.18 div and currently trading at $18.50. March 18 call selling for 1.10. Break-even of stock minus div and premium of 17.22.

If called 4.13% earned, if uncalled 6.84%.

Sell stop limit on shares at 17.22 and buy back the call (not sure what this would cost, so don't know how to include for further loss.

***

Thanks for the example Jason,

I'm asking questions below.  I'm NOT looking for answers.  I just want to be certain you think about this and have a plan.

I believe your prices are not accurate.  Right now (Jan 28, 2PM), the stock is 18.75 and the call is only $1.11  That makes a big difference.  Be that as it may, I'll go ahead and use your numbers as well as the ones that I see right now.

1) If you are adopting this strategy for the purpose 'capturing the dividend,' then it's fairly risky.  The dividend (plus option premium) is small and the potential loss is larger.

2) If you are doing this because you like PFE and want to own its shares, then this plan is viable. You already considered risk when deciding that you want to own the shares.

3) You obviously have an exit point in mind:  A stop-loss on the downside and an assignment (sale at the strike price) on the upside.

What happens when the stock is between those prices?  Do you hold and write another covered call, or do you sell?  There's no dividend for another three months, and you appear to be interested in collecting dividends.  Do you hold despite the fact that the dividend is 'far' away?

4) How do you determine the P/L if uncalled?  What stock price are you using?  I believe you made a mistake.

I find it difficult that you believe you can earn almost 7% if uncalled and only 4% if called.  The stock is higher when you are assigned that exercise notice.

When writing covered calls, being assigned yields the maximum possible profit [Yes, I know if the stock price is a penny or two less than the strike, you save on the assignment fee].

5) To estimate the cost of call repurchase, guess a buy-back date, raise implied volatility (due to price decline) by a small amount, and calculate the option's fair value.

6) With your numbers, if called, you sell @$18, and earn $60 (pay $18.50 sell at $19.10) + dividend.  Less cost of carry (interest you did not earn because cash is tied up in stock).

Using the current  numbers that I see, that's $36 earned + dividend, less cost to carry.  Earnings are almost $54.

The put is $53.  If you sell the Mar18 put instead of buying stock and selling calls, you earn $53. 

That's $1 less.  But you save cost to carry, you save on commissions.  You save on an exercise fee. [If you are going to unload the stock @ 17.22, you can buy the put (to close the trade) and will not incur an assignment fee]  At that point, the put should cost the same as selling stock plus buying the call.

I see no advantage to your buying stock for the dividend. 

I am comparing covered call vs. cash-secured naked put.  I am not telling you to avoid either.  Your investment decision apparently suits your needs, and you cannot bet that.

The two strategies are equivalent and have the same P/L profile.  The dividend is taken into consideration by the option prices.  The evidence for that example comes with using my numbers.  You can double check to see that yours are accurate.  But I caution you to use live bid/ask prices, and never use 'last.'

Don't get your data from Yahoo.

600

The Covered Strangle. No-Brainer or Risky Trade?

Having just blogged about the fact that equivalent positions are truly equivalent, I received this question that's based on the same topic.

***

Mark,

I have done covered calls for a while. Looking to increase returns without taking on much more risk.

Wondering about a covered spread approach where I own the stock, short OTM calls, short OTM puts, and enter a stop sell order to automatically liquidate shares if stock hits my put strike price to cover situation where stock could be put to me.

This seems like a no brainer to enhance returns without anymore risk but wondering if I've overlooked anything.

Thoughts?

Jason

***

You are referring to a covered strangle. This is another example where it's important to understand equivalent positions.

It is NOT a no-brainer.  This has real risk and obviously a very decent reward potential.

Stop-loss

I agree that the stop-loss order does limit risk, but are you aware of how much risk that is, or are you just assuming it's acceptable?

If you are stopped out of the trade, you can lose a substantial sum on the 'no-brainer' put you sold to enhance profits.   That put is now ATM, making it worth substantially more than the premium you received when selling it.  In addition,  IV has probably increased - and that's also going to hurt.  The passage of time is not going to help enough to offset very much of the loss.

Add to that your covered call position.  I acknowledge that if you were going to exit this trade at the same stop loss point, then you are already aware of how much this trade can lose. 

What concerns me is that you entered the stop loss so that 'the stock could not be put' to you.  That's not a good reason for entering a stop-loss order. [As an aside, I believe that stop-loss orders are very inefficient where options are concerned.  You would be forced to enter a market order when the stock is falling, and that's going to get you a very bad fill because you would be paying the asking price when the bid-ask spread is likely to be extra wide.]

Being assigned an exercise notice

First, no one would exercise a put option that is ATM, so there is no immediate danger of being assigned an exercise notice.  The reason for exiting a trade via stop-loss should NOT be to avoid assignment.  It should be because you decided that the loss at that point is enough.   You recognize the trade has not worked and you want to exit.

Second, when you are writing covered calls, having stock put to you is not so bad.  After all, the covered call and naked put represent a similar trade (in your case with different strike prices).  Having the stock put to you doubles your stock ownership and is merely another covered call position that has gone bad. 

Downside risk

When writing an OTM call, I assume you understand that you have downside risk, and that the call offers very little in downside protection.  If you want to get so aggressive as to sell additional naked puts, I suggest you consider that markets do not always rise, and perhaps writing an ATM, or even an ITM covered call instead of your OTM can provide much-needed protection.  Either provides additional (but limited) downside protection, but the downside is where your risk lies.  That protection is needed when you are about to double your position size (by writing extra puts).

It's important that you recognize that writing an OTM covered call is the same position as selling a naked, ITM put. The loss on that portion of your covered strangle is going to hurt when the stock drops several strike prices and you are stopped out of the trade.  When that happens, don't be surprised when you get a bad fill on buying your OTM call with a market order (higher IV and wider bid/ask spread).

Summary

This is far riskier than you imagine.  You have doubled your position size, going from one naked put to (the equivalent of) two naked puts.  Yes the 2nd is more OTM and not likely to result in your being forced to exit - but 'not likely' events occur all the time.

Rethink this.  If you don't 'see' it then please use some graphing software to plot your positions.  Then you can decide whether the extra risk is worth taking.  It may be a good trade for you.  I want you to be aware of the risks before making the trade.  You should also understand the probability of getting stopped out (that's the delta of the naked put you are selling) of the entire trade.

Be careful.  'No-brainer' options strategies don't exist.

594

Honest: Equivalent Positions are Equivalent

Hi Mark,

I've been thinking about the equivalence of some option strategies, and how to determine which position would be better.

Take for instance a put debit spread: Buy XYZ Jan 60 Put Sell XYZ Jan 50 Put and a call credit spread: Buy XYZ Jan 60 Call Sell XYZ Jan 50 Call

If both the above have the same profit & loss potential, how do you evaluate which is the better position? With the debit spread, time decay would chip away at it, while the credit spread would increase in value. 

NK

***

You are trying to turn something very simple into something that's more complex.

1)If the positions are equivalent, neither one is better. Time decay is the same for each spread.

They provide, by definition, equal profit/loss pictures. That 'equal profits' takes into considerations dividends, if any, and interest costs - which make a different when interest rates are high. What is not included are trading costs.  

2) One is better than the other - when it is priced out of line. That does happen on occasion, but not frequently. 

One is better than the other if trading costs are reduced (think naked put vs. covered call).

One is better than the other if it is easier to exit the spread - if you elect not to hold to expiration (again naked put much better than covered call).

Look at your example. If you buy the put spread, your best result (XYZ < 50) makes the put spread worth 10. If you sell the call spread, your best result occurs when XYZ < 50, and the spread is zero. Thus, each makes the maximum profit in the same price range.

Similarly, XYZ > 60 gives you the maximum loss. The put spread is zero and the call spread is 10.

3) At every possible price, the sum of the two positions is 10. Thus, if you pay 10-x for the put spread, it's the same trade as selling the call spread for x.

If you pay $7.10 for the put spread, then selling the call spread and collecting $2.90 provides the same payoff.

Which is better? Neither. But there are reasons why selling is better than buying. If you buy the put spread, you pay interest on that cash. Today that may be essentially zero, but that's not always the case. If you sell the call spread, you collect interest on $290. To the extent that interest is above zero, you always want to collect the cash rather than pay. Unless the spread prices account for that difference in interest costs.

But if you can buy the put spread @ $700 instead of $710, then that's the better deal (assuming that the call spread can still be sold @ $2.90. It's not a better deal if the call spread can be sold @ $3.00). 

For traders with very small accounts, selling may result in a problem if assigned prior to expiration.  Buying eliminates that risk (if assigned, just exercise) - and to prevent a margin call, buying may be preferred.

One final consideration. You buy the put spread because you are bearish. If you are correct and both options are ITM at expiration, most brokers charge two exercise/assignment fees. If you sell the call spread, both options expire worthless and the broker is paid nothing. So once again, selling is better than buying.

593

Choosing among equivalent trades

Mark,

Thanks so much for your advice. I read through your blog and also did a simple analysis this morning. It shows clearly, as you highlighted in your blog and mail,  that Collar is equivalent to put credit spread as well as bull call spread.

In the option studies, I found it is difficult to determine which to choose (put credit spread or bull call spread) when entering a trade.

One thing I considered is: if I would like to buy the stock at lower price, I will go for put credit spread. Is it right?

Also, in spread, e.g. bull call spread, there are 3 types of options

  a) buy ITM call, sell ATM call

  b) buy ITM call, sell OTM call

  c) buy ATM call, sell OTM call

I have read several option books recently, none of them have given me a clear guideline. Your advice and thoughts are highly appreciated.

Jack

***

Hello Jack,

1) If you proved it to yourself that the collar is equivalent to selling a put spread or buying a call spread, why don't you believe the proof?

If the trades produce exactly the same financial results - and that's one requirement for the positions to be equivalent - why does it matter which you choose?  It does not matter - unless the markets are inefficient. That is a rare occurrence.

Unless you already own shares, avoid the 3-legged collar and cut trading expenses by choosing a 2-legged put spread.

Here is how to determine which to trade - and this seldom applies, but is worth checking.  Assume it's a 5 point spread and that you can collect $2.10 when selling the put spread.  If you can pay less than $2.90 for the call spread, then that is the spread of choice.

But - remember, buying means you pay interest on that $290 instead of collecting interest on the $210.  Thus, the call spread must not only be < $2.90, but enough less to compensate for the cost to carry the position.

 

2) 'Buying the stock at a lower price' does NOT depend on the spread chosen.  You wind up with a stock position only when expiration arrives and the stock is between the strike prices of the spread.

When you own the call spread, your long call is in the money and you exercise.  You pay the lower strike price.

When you sell the put spread, your short put is in the money and you are assigned an exercise notice. You pay the higher strike price.

To compensate for paying the 5-point higher strike price for the shares, you already collected the $500 difference when you sold the put spread instead of buying the call spread.  Equivalence!

 

3) The selection of strike prices is not something that can be  easily described.  When buying the call spread, you risk more, and can earn less when the options are in- or at the money.  In return, your chances of earning a profit increase.

My point:  You cannot just choose strikes based on whether option is at-, in- or out of the money.  Much more goes into the decision.

 

The term 'bull' is redundant in 'bull call spread.' 

• When you buy a call spread, it is a bullish trade
• When you sell a call spread, it is a bearish trade
• When you sell a put spread, it is a bullish trade
• When you buy a put spread, it is a bearish trade

  528

Lightning Round. Q & A.

Hi Mark,

You responded to one of my emails a few days ago - and just wanted to say that I set up a side by side Collar and Put Spread in a spreadsheet and now I COMPLETELY understand why you said what you said below [The positions are equivalent].

The two positions basically have the same profit/loss profile, and yes, the temptation is there to put on more spreads because they're more "affordable". But with each additional spread, the risk mounts.

You have succeeded in teaching this Rookie an important lesson. It's also become clear through this what leverage really means. Wow!

The pieces are falling into place.

Thanks!

Rob

***

Rob,

Good news.  Thanks for sharing. 

When you see the P/L graphs side by side that makes it easier to understand that the positions are equivalent.  I tend to avoid using such graphs because I assume the 'proof' that the positions are equivalent should be enough. 

When managing risk, the primary consideration is position size.  Get that right and you will not have any extra trouble if the position moves against you and an adjustment becomes necessary.  When you trade too many contracts for your risk tolerance or pocketbook, you begin with a position that can quickly move out of your comfort zone.

Any of these call or put spreads is equivalent to one collar (long or short).  Thus, the admonition:  don't trade too many spreads just because it appears that the cash at risk is small.

***

I looked at the blog, but haven't seen this covered.  The question is:

Do you ever sell your condor spreads separately?  For example, let's say you believe that there is more likelihood of a downside move than upside.  So you sell the call spread first, then wait a bit to sell the put spread.  Or vice-versa.

Brian

***

Good question Brian. 

It seems natural to do just as you suggest and 'leg' into iron condors by trading either the call or put spread first.  I've done this enough times to tell you that it does not work as efficiently as you would anticipate.

a) Selling the put spread first.  When you anticipate a rally, it's okay to sell the put spread portion of the iron condor.  The plan is to sell the call spread on a rally, and thus collect a higher premium for the call spread.

If you sell option spreads that are out of the money by a significant amount, then you will discover that the call spreads don't get any wider unless the up move is big.  And if it's that big, you may no longer want to sell the call spread.

The reason that the spread doesn't widen is twofold:  First the spread has a small delta and it takes a decent move to make the spread worth more.  Second, and more importantly, the spread has positive vega.  Thus, when the market rallies, most of the time implied volatility (IV) decreases.  That IV decrease causes the value of the call spread to decrease - at the same time that the long delta increases the value of the spread.  These counter forces tend to keep call spreads from becoming more valuable on rallies, unless the strike prices are near enough to the stock price to have a significant delta.  When that happens, the delta overwhelms vega and the spread widens.

The only good news to this scenario is that the put spread has been narrowing - due to delta and IV working together. That means you may prefer to take a profit on the put spread rather than sell the call spread.

b) Selling the call spread first.  If you have a bearish bias, this plan actually works.  If you sell a call spread and the market declines, two good things happen for you.  First, the put spread widens by a small amount due to delta.  Second, the spread widens even further as IV increases.

Thus, taking the bear leg is a much more successful plan than taking the bull leg.  Warning:  Do not allow this factor to convince you to take bearish legs.

Another interesting situation that I discovered when I used to leg into these trades is:  When the market falls, the put spread widens.  But the call spread narrows by so little that you gain little with your successful leg.  In other words, the fact that IV increased is enough to widen the market price of the whole iron condor and the benefit of taking the successful leg is small.  Depending on your point of view, it may turn out that there is too little reward for taking a successful leg, to bother.

***

Tomorrow's webinar: 

Tuesday October 27, 2009 at 6:00 PM (Eastern Time). 

Title: Collars; Combining Covered Calls and Married Puts

Register for webinar by clicking here.  All events are free and open to everyone.

The webinar platform is by webex.  To participate, you must download the platform to your computer.  You can do that as you register.  No telephone lines will be used for the event.

492

Puts are Calls. Calls are Puts.

One of the fun aspects of writing a blog and communicating with investors is the opportunity to answer questions.  Some questions are very sophisticated, while others are basic.  It's those basic questions that require the most attention because the questioner is likely to be a rookie who is caught in a situation he/she does not understand.  If that rookie cannot be guided through this difficult spot, it's possible that he/she may throw up hands in disgust and abandon options.

That's the reason I pay special attention to questions to which the answer may seem obvious.  It's not obvious to the person who poses the question.

I recently found this question at EliteTrader, an online forum.

"When call IV (implied volatility) drops does that mean options traders are getting bearish on the stock?"

What I don't know is what situation made the poster ask this question.  But that's no reason not to provide a useful reply.

Answer: No.  Implied volatility, by itself, is not an indicator of market sentiment.  NOTE:  It does not matter whether call IV declines or put IV declines.  As soon as one declines, the other follows suit.  That's the result of arbitrage strategies (reversal/conversion).  If call prices decline, those arbitrageurs will buy calls , short stock, and then drive down the price of puts by selling them.

When implied volatility declines for the options of a specific stock or index, it can suggest one of a few alternatives, but market direction is not one of them:

a) Buying interest has declined.  That means fewer traders want to buy the options, and there is no force driving option prices (and implied volatility) higher.

b) Selling interest has increased.  The quickest way to drive down option prices is for sellers to appear on the scene.  That does not mean call sellers or put sellers.  In fact, it makes no difference which options are sold.  If there is selling pressure on the options, prices decline.

You may ask how can it not make any difference whether traders are selling puts or calls.  The answer is that to the professionals who provide liquidity - from the market makers to the off-the-floor traders sitting behind computer screens, an option is an option and it makes no difference whether it's a put or a call. 

Why?  If a trader buys calls, he/she has two choices:  Keep the calls, or turn them into synthetic puts by selling 100 shares of stock for each call purchased.  Thus, in this case, a call is readily converted into a put.  That's another way to state that calls are puts.

If the trader buys puts, the purchase of 100 shares per put changes those puts into synthetic calls.  Thus, puts are calls.

As a result, declining call IV produces the same result as declining put IV and as mentioned above, if the IV of the puts does not drop automatically (after call prices decline), arbs will appear on the scene to remedy any imbalance.

c) If IV is elevated because of a pending news announcement [That news has a good chance of causing the stock price to gap, and that possibility makes options worth more money, and IV rises], once the news is released and a major move is no longer in the future (it has already occurred after the news was released), there is no longer any reason to bid option prices higher.  Thus IV falls (for both puts and calls).  Again, it has nothing to do with market direction.

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Calls are Puts. Puts are Calls.

Calls are puts?  How is that possible?  Aren't there two types of options: calls and puts?  Don't investors buy calls when bullish and puts when bearish?

It's just like chemistry where scientists try to synthesize specific molecules to perform specific functions.

Calls and puts, when combined with a long or short stock position can be equivalent to each other.  This is one of the reasons why it's not important to pay attention to how many calls or puts are trading.  If the very bullish investor wants to disguise his/her intentions, that investor can simply buy a whole bunch of puts - opening what appears to be a bearish trade, and then buy stock to turn the position into the equivalent of owning calls.

We begin with the basic equation:  long stock is equivalent to owning one call and shorting one put - when the expiration date, strike price, and underlying asset are identical.

S = C - P

We know this is true because:  When expiration arrives, if the call is in the money, you exercise the call and own long stock.  If the put is in the money, you allow the call to expire worthless and when assigned on the short put, you own 100 shares of stock.

Thus,    C = S + P
and       P = C - S;     or -P = S - C

In plain language:

A call is equivalent to owning 100 shares of stock and one put

A put is equivalent to owning one call and shorting 100 shares of stock;  or a short put is equivalent to a covered call (long stock, short call).

There's additional information about equivalent positions.

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Are equivalent positions really equivalent?

The following question from a reader leaves me puzzled:

"You bring up an interesting point and something that I read in the book that I did not completely understand - I did think about what you said about married puts being equivalent to a call (synthetic) - but even though in an equation that may be equal, isn't it different in real life?"

As I said; puzzled:  true in the equation, but different in real life?

I'd appreciate some feedback.  When you see an equation as 'proof' that something is true - do you doubt that it's true in real life?  In other words, is the proof meaningless?

When I've been telling you that writing a covered call is not different from selling a cash-secured put, do you believe that to be true?  Or do you believe that either one of these strategies is better than the alternative?  I'm not talking about commissions.  I'd like to know if anyone believes these strategies produce different financial results - after dividends and interest considerations are included. 

Do any of you use one strategy instead of the other because you believe it makes more money?  I certainly understand if you use one because you feel it's easier to trade or your broker doesn't allow both.

Along the same lines, do those of you who use collars truly believe that the position gives the same results as selling a put spread or buying a call spread?  I know it true.  But do any readers have doubts?

The problem for me is that I know that equivalent positions are truly equivalent.  When the options are not mis-priced (which is essentially all the time), when dividends and interest costs are included in the calculations, profit/losses are equal, no matter which of the equivalent positions you trade. 

In the real world, some positions are easier to enter and/or exit.  That may be a good reason to prefer trading one, rather than the other.  But isn't that decision is based on convenience, reduced commissions, or some practical consideration other than believing that one is just more profitable than the other?  

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Credit Spreads: Choosing The Strike Price; How Far OTM?

In response to a reader (rluser) who raised an important question about The Rookie's Guide to Options, here's the question and reply.

When you discuss covered calls and collars, you indicate that ATM is a most conservative stance... After explaining the equivalence [of a collar and the sale of a put spread], you shift to credit spreads (and two winged spreads), but you prefer to be more OTM without clearly articulating what drives you to make this strike shift.

I don’t want to appear to be inconsistent.  It’s true that selling a put credit spread is equivalent to owning a collar position, when the strike prices and expiration date are identical.  It’s also true that when discussing the collar (Chapter 13), I always used strike prices that were fairly close to being at the money.

In this chapter on credit spreads, I’m recommending the use of options that are further OTM.  There are two basic reasons for this difference. 

• One: The collar examples use individual stocks (with fewer strike choices than indexes).  Most investors who use collars have a bullish bias, but want to own an insurance policy with a small deductible (a put that’s not too far OTM) – so they have good protection against loss.  If you own a 30-strike put on a $50 stock, that’s not going to be very helpful if the stock declines. 
  

• Two: Selling put spreads is a strategy used by investors who have a bullish bias and the investor can choose to sell CTM, OTM, or FOTM options.  Investors may even decide (if very bullish) to sell ITM put spreads. 

But, that’s not the only way to use put spreads.  It’s reasonable for a trader to sell put spreads on indexes, when the strike prices are 15 to 25% out of the money, in an attempt to earn a trading profit, as opposed to owning a longer-term investment.

It’s not necessary to be bullish when adopting this technique, and thus, it’s often a good idea to sell options that fall into that 15-25% OTM category.

Bottom Line: CTM (close to the money) options are appropriate for collars, but any strikes can be used when selling credit spreads. One is an investment, one is a short-term trade - not by definition, but as most trades use them.

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Q and A. Credit Spreads vs Debit Spreads

I recently responded to this question on a public forum (EliteTrader:

"Why are vertical debit spreads (bull call & bear put spreads) not discussed much? Instead, it seems that Iron Condors and credit spreads are the preferred topic. When you consider the risk/reward ratio of a debit spread vs. a credit spread, especially if both of which are about 2 or 3 strikes otm, it seems that the preference would be a vertical credit spread because of the risk/reward."


It's true.  Iron condors are a popular strategy and many blogs discuss this strategy (unfortunately including those that want to charge high fees to teach investors how to trade them). 

As far as credit spreads and debit spreads go, the reason both are not discussed equally is there there is no need to do so.  When the underlying asset, the strike prices, and the expiration are identical, then buying the call spread and selling the put spread (both bullish plays) are equivalent.

For example, these trades are equivalent:

        Buy 10 RUT  Mar 490/500 call spreads.  Pay $X
  Sell 10 RUT  Mar 490/500 put spreads.  Collect $10 - X

[If you can collect $4 for the put spread, don't pay more than $6 for the call spread.  In fact, don't pay as much as $6 because you must pay interest on the $600 cash required whereas you could be collecting interest on the $400 cash received.]

By equivalent, I mean that:

The potential profit is equal

The maximum loss is equal

At any RUT price, when the settlement price (RLS) is determined on expiration Friday, the profit or loss from either position is equal to that of the other.

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Q & A. Bull Call Spread with Protection

Mark,

Your articles are brilliant [thanks, but let's not overdo it], but have you come across this scenario?

I wish to put on a bull call spread, with a long ATM [at the money] put for protection.

Take this scenario, for SPY December 2010s:

60/140 call spread cost: 40 - 3 = 37

60/140 bull put spread; collect -4 + 46 = 41 (how much do I post as collateral for this trade?)  [You must put up the maximum value of the spread, (difference between the strike prices), but you can use the cash collected ($4,100). Thus, $3,900.  But double-check with your broker.  Some brokers have strange margin requirements. If you buy the ATM puts, the margin requirement is reduced.]

With those basic calculations, I have 37 of today's dollars at risk, if SPY should fall below 60. [Don't ignore the fact that you will lose $100 for every point that SPY is below 97 (the spread is worth 37 when SPY is 97 in Dec 2010.]

A long ATM 100 strike put costs almost $20 - so paying $20 to protect $37 does not make sense.

Am I being too greedy to want upside potential and protection on the downside?

Covered call or naked put does not offer me the higher returns I am looking for, but it does help on the downside I suppose.

Hello Zack,

I'm glad you like the blog.

Buying ATM puts, especially very long-term puts, is expensive.  There's no getting around that.

No, you are not being greedy.  Upside potential with protection is an intelligent thing to do.  In fact, I use that concept when I buy iron condors.  But - whether it's worth the cost is a decision only you can make.

If you buy the call spread, please don't ignore the cost of carrying the position for two years.  Interest rates may be low, but they are not zero.  Selling the put spread eliminates that concern but creates other problems - if you are assigned an exercise notice (before expiration) on the SPY 140 puts, you must pay $14,000 cash to buy SPY shares. I know you are bullish, but if SPY does not rally significantly, at some point the put owner will exercise.  For simplicity, and safety, stay with the call spread.

Expectations

If you hold until expiration, and SPY finishes between 60 and 100, you collect $4,000, losing $1,700 plus interest.  At 5% interest, your cost to own a $5,700 investment for two years is $570.

If SPY is above 100, your position is worth more - up to a maximum of $8,000 (when SPY is 140 or higher).  Your profit depends on your cost.  If you pay 37 + 20, your maximum gain is 23.  Not bad.  $2,300 minus interest on an investment of $5,700 is  not bad - but it's not spectacular.  No you are not being greedy.

How do those numbers look to you?  You are using a bunch of cash for two years - that's not so good.  But if you earn the maximum, that's a nice result.  This is a comfort zone decision:  You like this trade or you don't!  But it's definitely a bullish play with limited risk and limited reward.

Equivalent

I'm going to show you an equivalent position - risk and reward are equivalent and this position will be easier for you analyze.

Look at your position on paper and then and sell the Dec10 60/100 box.*  [Don't sell it in the real world, just on paper.]

*A market neutral position:
Sell SPY Dec10 100/60 put spread
Sell SPY Dec10 60/100 call spread
Collect roughly $4,000 (the value of the box at expiration, minus interest to carry).

The resulting position:

Buy SPY Dec10 100/140 call spread.
Buy SPY Dec10 60 put.

Total Cost (at today's closing prices), $17.50.
Maximum loss $17.50 (whey SPY is between 60 and 100)

Maximum upside gain: $22.50  (above 140)
You also have the chance to collect some cash if SPY is under $60.

Do the numbers look ok?  Are you comfortable with that risk/reward profile?  This is clearly a personal choice. If 'yes,' go for it.  If 'no,' there are alternative bullish plays.

CCW and NP

Covered calls and naked puts don't offer the protection you require.  Writing the 60 call or selling the 60 put is not a good idea, and you would have to sell puts with a higher strike to earn a decent profit.  The increased risk, coupled with the high margin, says that this is not for you (or anyone who believes in limited risk).

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Q & A. Rolling a Covered Call

I received this Comment:

Scottrade will not allow selling puts so I did a covered call on FSYS back about a month ago with an Oct expiration on the 50 strike which is now well over the $5.70 I received...about 11.20 bid 11.90 ask.

 My calculations are that if FSYS is above the 50 at expiration I will get 1739 for the shares and 570 for the premium. If I buy back the calls and sell now, the profit is 1300 per 100 shares. Or should I buy back the calls and roll to the 70 strike with a current premium of about $370...what is your opinion Thanks, I read the book

 Dave

 ***

 Hello Dave,

 

1)    Scottrade doesn’t seem to understand that writing a covered call entails the same risk as writing a cash-secured naked put.  They are not alone and short of changing brokers, there’s not much you can do about that.

 

2)    If the stock is above the strike at expiration, you receive $5,000 for each 100 shares.  You also keep the premium.  That makes your sale price $55.70 per share (and that’s the price to report to the IRS).  I don’t understand where your ‘1739’ comes from.

 

3)    It’s often a good idea to buy back the calls early and to sell the stock (I do NOT mean simply buy back the calls and hold the stock) before expiration.  You sacrifice a small amount of potential profit, but your money is free for reinvesting and all risk is eliminated.  The question is:  just how much potential profit are you willing to sacrifice?  That’s up to you.  I note that there is still a considerable amount of time premium remaining in the calls ($4) and that buying back now would sacrifice a substantial portion of your maximum profit on this position.  This is obviously a volatile stock with high option premium, and that always increases risk.  But because you are considering rolling to the 70 strike, you are obviously not too concerned with the possibility that the stock will drop below 50 anytime soon.  I don’t know why you chose this specific covered call, but if it was to generate a small profit, you have already earned that profit.  If it was to collect all, or nearly all, of the time premium in the call option, you are far from meeting that goal.  That’s why I cannot offer advice on whether you should close the position now.  That has to be your decision based on your profit objectives and tolerance for risk.

 

4)    As far as rolling to the Oct 70 calls, that requires the investment of a substantial chunk of cash (to buy the Oct 50s and sell the Oct 70s).  Are you that bullish on the stock? Do you want to move from a reasonably conservative play of owning a position that is equivalent to being short a put that is 9 points out of the money to being short a put that is 11 points in the money?  I cannot decide that for you, but sellers of naked puts traditionally sell options that are out of the money. 

 

5)    I want to take this opportunity to point out something that’s easy to miss.  Your initial idea was to sell the Oct 50 put.  At some point your plan was to buy back that put, earning a profit.  Did something change?  If you had sold that put, would you be thinking of rolling it to the Oct 70 put instead?  I seriously doubt that you would.  My point is:  If you wanted to write the naked put, then stay with that plan.  The fact that your broker forced you to adopt a position (covered call) that is equivalent to the position you wanted (naked put) does NOT mean you should revamp your methodology to accommodate your broker.  I believe you are considering this roll - not because you like that new position better - but because you own stock and want to sell out of the money call options.  I suggest you think of your position as being short the naked put and trade the position as if you were short that naked put.  If you would buy back that Oct 50 put and roll to the Oct 70 put – a very bullish trade, then it may be okay (but risky) to roll to the Oct 70 put.  Instead, if you would be happy to see the stock rally and the value of your naked ‘put’ decline, then do nothing and your only decision is when (if ever) to repurchase that put.  I’d hate to see you change strategies because your broker does not allow you to own the exact position you want to own.  The two positions are equivalent and you should think of them that way.  Let me know if that makes sense to you.

 

Mark

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Equivalent Positions II: Tying It All Together

If you are new to the world of options, today discussion may appear to be a bit confusing. But if you go slowly and re-read the linked posts, you’ll understand the discussion.

If you’ve been trading options for awhile and never bothered to learn about equivalent positions, this post contains information that can make your trading more efficient.

Here is summary of some recent blog posts:

•  Some option positions are equivalent to others, and covered call writing is equivalent to writing naked puts.

 

•  To significantly reduce the risk of writing naked puts, turn it into a credit spread by buying a put that is further out of the money than the put sold.

 

•  Collars are a good, conservative strategy for any conservative investor.

 

 

Let’s take a closer look at a collar, which consists of three legs: long stock, long put, short call. ZZY is trading at $67 per share and you want to collar that stock. To do that you may decide to write one Dec 75 call and buy one Dec 60 put.

 

Separating the collar into two parts:

 

Collar: Part One Collar:          Part Two

Long 100 shares of ZZY           Long 1 ZZY Dec 60 put

Short 1 ZZY Dec 75 call

 

Part one is a covered call position, and we know that a covered call is equivalent to being short the put with the same strike and expiration.

 

The collar, part one is equivalent to:  Short 1 ZZY Dec 75 put

The collar, part two is:  Long 1 ZZY Dec 60 put

 

This position is a put credit spread (short a put and long a put with a lower strike price).

 

So what, you ask? This is proof that the collar position is equivalent to the put credit spread – but only when the put owned is the same and the put sold has the same strike and expiration date as the covered call.

 

If the conservative approach offered by collars appeals to you, consider selling the put credit spread instead. First, there are fewer commissions to pay, and second, the put spread is easier to trade because there are only two legs in the position, instead of three.

 

 

NOTE to more experienced traders: The collar is also equivalent to buying the bull call spread, when the strike prices and expiration date are the same as the puts that are part of the put credit spread. In other words, buying the ZZY Dec 60/75 call spread is equivalent to selling the ZZY Dec 60/75 put spread.

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Recommended Option Strategies: Advice for Covered Call Writers

I encourage option rookies to begin their option-trading careers by writing covered calls. To me, this is the simplest strategy to understand when you have never previously used options.

The first drawback to this strategy is that it’s bullish. There’s nothing wrong with being bullish, but not everyone wants to own bullish positions all the time.

The second problem with covered call writing (CCW) is that you can lose a substantial sum if unexpected news causes the stock price to plummet. It’s true that the call option you wrote reduces your loss, but it still may be an unhappy experience.

Are there alternatives?

You can adopt a strategy that is much safer than CCW. In return for that safety, you must sacrifice a portion of your potential profits. It’s the same as buying insurance. Most of the time that protection doesn’t save you any money, but it does allow you to feel more comfortable with your position, and that has to be worth something!  If that insurance turns out to be necessary, you are going to be very pleased that you had the foresight to buy it.

If you read the recent post about equivalent positions, then you know that writing a covered call is equivalent to (same risk and reward profile) selling a naked (uncovered) put option when the strike price and expiration date are the same for the put and call options. In other words, these two positions are equivalent:

Position One:                       Position Two:

Buy 100 shares of XXZ           Sell 1 XXZ Nov 35 put

Sell 1 XXZ Nov 35 call

If this is news to you, take a few minutes to read the post on equivalent positions.

How does knowing that these are equivalent help?

Because these are equivalent positions, if you want to buy 300 shares of XXZ and write three Nov 35 calls, you you can simplify the process (only one commission to pay your broker, instead of two) by selling three Nov 35 puts. Most brokers require that you maintain enough cash in your account to buy 300 shares of XXZ -- just in case you are assigned an exercise notice.

Now you are short three puts. What next? Next you buy put options – specifically a put that is further out of the money than the put you already sold and which expires on the same day. Example, buy three XXZ Nov 30 puts. You may buy a put with an even lower strike price, but that provides less insurance.

What’s the bottom line? By selling puts instead of writing covered calls, and by buying a put for protection, your position is now a bullish put credit spread. But it’s not quite as bullish as selling the put naked or writing the covered call. Your hope is to see the both options expire worthless. That provides the maximum possible profit for the position.

See the previous post for a discussion of credit spreads.

 

If you have any questions regarding this (or any) post, please feel free to ask that question by clicking the ‘comments’ link below.

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Equivalent Positions: An Introduction

One of the interesting features about options is that there is a relationship between calls, puts, and the underlying stock. And because of that relationship, some option positions are equivalent – that means identical profit/loss profiles – to others.

Why is that important? You will discover that some option combinations – called spreads – are easier, or less costly to trade than others. Even with today’s low commissions, why spend more than you must?

 

The basic equation that describes an underlying and its options is: Owning one call option and selling one put option (with the same strike price and expiration date) is equivalent to owning 100 shares of stock. Thus,

S = C – P;  where S = stock; C = call; P = put

If you want a simple proof that the above equation is true, consider a position that is long one call and short one put. When expiration arrives, if the call option is in the money, you exercise the call and own 100 shares. If the put option is in the money, you are assigned an exercise notice and buy 100 shares of stock. In either case, you own stock. NOTE: If the stock is at the money when expiration arrives, you are in a quandary. You don’t know if the put owner is going to exercise and therefore, you don’t know whether to exercise the call. If you want to maintain the long stock position, the simplest way out is to buy the put, paying $0.05, or less, and exercise the call.

Example of equivalent positions

There is one equivalent position that you, the options rookie, should know because these are strategies you are likely to adopt.

Take a look at a covered call position (long stock and short one call), or S-C.

From the equation above, S – C = -P.  In other words, if you own stock and sell one call option (covered call writing) then your position is equivalent to being short one put option with the same strike and expiration. That position is naked short the put.  Amazingly some brokers don't allow all clients to sell naked puts, but they allow all to write covered calls. The world is not always efficient (you already knew that).

Thus, writing a covered call is equivalent to selling a naked put. This is not a big deal to anyone who is an experienced option trader, but to a newcomer to the world of options this can be an eye-opener.

The more you trade options, you more you will become aware of other equivalent positions.  You may even decide to play with the equation for yourself and discover others.

to be continued...

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