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Options Trading Strategies: Discover the Simplest Option Strategies to Limit the

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Options Trading Strategies

Discover the Simplest Options Strategies to Limit the Risks and Maximize Your Return

Table of Contents

Introduction

Chapter 1 – Option Objectives

Chapter 2 – Options Basics

Chapter 3 – Why Use Options

Chapter 4 – Options in Operation

Chapter 5 – Indexed Annuities

Conclusion

Copyright Notice

© Copyright 2015 by Bobbie Warren – All rights reserved.

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- From a Declaration of Principles which was accepted and approved equally by a Committee of the American Bar Association and a Committee of Publishers and Associations.

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While all attempts have been made to verify the information provided in this book, the author does not assume any responsibility for errors, omissions, or contrary interpretations of the subject matter contained within. The information provided in this book is for educational and entertainment purposes only. The reader is responsible for his or her own actions and the author does not accept any responsibilities for any liabilities or damages, real or perceived, resulting from the use of this information.

Introduction

Options are an exciting dimension of investing unknown to the uninitiated. They are actually rather mainstream to those who enjoy their potential for profit. They happen in a finite period of time and can be very lucrative. It is like placing a bet on the direction of the market in regard to a particular stock. No, it is not gambling as there is no mania about it. It has rules and regulations as well as common practices.

They can also be risky and merit considerable explanation. Remember, in the financial world, there is a risk/reward ration. The greater the risk, the greater the potential return, but also the greater the loss. It is a fact of investing life. Options are for people who have discretionary income and are not saving the funds for retirement. It is that portion of one’s portfolio that is called “aggressive.” But with the right instruction, you can minimize the risk and maximize your return. Every portfolio has two sections:

Defensive Investments: investment that have little or no risk to principle or income

Money market accounts

Bank accounts

CDs

Bonds

Aggressive Investments: investments that have risk to principle and/or income

Stocks or stock mutual funds

Options

Commodities and futures

Currencies

Real Estate

Hedge funds

Given that options are a method of earning profit in the stock market (in the US for the purposes of this book), there are ways to do it with prudence. If you are not the panicky type who watches the option clock tick away, you can prevail. This e-book will be devoted to explaining typical strategies and highlighting those for the average investor who wants to keep it simple. You can purchase options in a mutual fund or individually through a broker. Your financial advisor will assist every step of the way. Few people do option trading on their own, and if they are, indeed, adept, that could write this book!

Investing is all about making money and there are seven ways to do it.

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p<>{color:#000;}. Bank accounts, money markets, CDs

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p<>{color:#000;}. Stocks including equity mutual funds and options

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p<>{color:#000;}. Bonds: debt instruments: government, corporate, and municipal

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p<>{color:#000;}. Real Estate

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p<>{color:#000;}. Commodities and tangibles such as crops, coins, art, etc.

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p<>{color:#000;}. Currencies

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p<>{color:#000;}. Insurance including life insurance and annuities

These categories are like the seven notes in the western musical scale. They are the basics in the investing world, but there are variations on a theme such as a stock or bond mutual fund. While you can buy options on a variety of things, this book will be devoted exclusively to the stock market variety as it is the most common approach.

Note: there are commissions involved in both mutual fund purchases as well as individual options contracts. As your broker so you can compare the advantage of one over the other. Mutual funds for growth or income are a wise way to proceed as the risk is spread over dozens of investments. If you own stock already, you may want to improve the return by writing calls.

Chapter 1 – Option Objectives

The goals and objectives in investing are relative to the individual. This means that they reflect one’s age, circumstances in life, time horizon, and future needs. The goals for a young father in his thirties are quite different from a woman facing retirement in her late fifties. Basically there are four options:

Growth: the amount of profit one can derive over a given period of time.

Tax savings: the amount of tax that can be saved or deferred from one’s portfolio.

Income: the amount one can take in retirement.

Safety: the protection of principle.

If you are very conservative and loathe losing a penny, you will opt for number four. If you are practical and want to save taxes now, you might choose an IRA designed for that purpose. If you are young and have lots of time to watch what happens during different economic cycles, you would choose growth. This is the territory for option trading. Finally, if you are in retirement and want to supplement your social security benefits, you would go for income. Once you have determined the order of these goals, you can be introduced to an array of investment vehicles that work best for them including options. A caveat is that you cannot have all four in equal measure. You cannot have growth and safety in absolute amounts. Getting a good return may mean taking some risk, which you can afford to do when you are just starting out, and thus you sacrifice a bit of safety. The converse applies, if you opt for absolute safety with no losses, such as is obtainable with a bank account or fixed annuity, you will not get a high return on investment. If you want income, you may give up growth, and so it goes.

Ask yourself

How much can I save per month and not have it affect my life style?

When will I need to use the money I have saved and for what?

Is it too early to plan for retirement? How many years do you need?

What happens if I have to face an emergence or take care of a loved one?

How do you know if it is time to buy a house?

How much insurance does a person need realistically? Should I buy term or whole life?

How much risk can I tolerate? Do you need to take risk every time you invest?

What is estate planning and when do I start doing it?

Once you ask yourself the vital questions, you are ready to undertake option trading for a portion of your investment portfolio. They are not usually done alone but as a balance to less aggressive postures. Some experts advocate no more than 10% of one’s holdings. In any case, options may or may not be for you. They are not for the feint at heart. When in doubt, commit only funds that are not needed elsewhere, especially your savings for emergencies and retirement.

Chapter 2 – Options Basics

You have elected to pursue options to get a little more kick out of your portfolio’s return. Now is the time to select which type from speculative to more conservative. In essence you are betting on the movement of the market or an index, or are protecting a stock position you hold.

Options in the US are securities regulated by the SEC with strict terms and regulations. They are sold on the Chicago Board Options Exchange (CBOE) if they are a “listed” option. Each listed option on this national exchange represents 100 shares of ownership in a company known as a “contract.” Thus, they must be purchased from a licensed broker who understands your financial circumstances and has your best interests in mind. There are also European options beyond the scope of this book. In essence, they are contracts that give the option buyer the right to buy or sell an underlying asset (it is not an obligation per se) at a stated price (the strike price) on or before an expiration date. Because there is an underlying asset, options are often called “derivatives.” The option, in effect, derives value from this asset.

Brokers often use a real estate analogy to help investors understand the concept. Let’s say you are interested in a given house and you won’t be ready for four months’ time to make the purchase. You don’t want it to get away. You enter into an agreement with the seller such that you take an option to buy the property when you are ready for $500,000. For the privilege of this “option,” you pay the owner $500.

Several things could happen. The house could be re-evaluated at $700,000 due to a new school in the area that drives neighborhood prices up. You have an option at $500,000 and thus you make an instant profit if you turn over the home, which is very tempting in this circumstance. You, of course, deduct your option fee from your revenue so your net is $150,000.

Purchase price 500,000

option – 500

sale profit 200,000

net profit 150,000

But things can go another way. After you take the option, you discover leaks and the roof has to be completely redone. Now what are your choices? You took an option but you don’t have to exercise it or follow through. You simply lose the $500.

It’s easier than you think! At least so far. It can get pretty complicated, so let’s continue. You see that when you buy an option, you have the right, but not the obligation, and you pay for that right. You can let the expiration date simply pass by if the reason you purchased the option is no longer attractive. You, in effect, lose your investment.

[Calls and Puts
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You may have heard of puts and calls that constitute the essence of option trading. We talked about the right involved in option trading. With calls, you have the right to buy an asset at a certain stated price within a time frame. It is similar to what is known as a long position on a stock. In other words, as the option buyer, you hope the underlying stock will go up before the expiration date.

As for puts, these options give the buyer the right to sell an asset at a certain price within a stated period of time. It is the opposite side of the coin. It is like a short position on a stock in that you hope the price will go down before the option expires.

Options Terminology

Depending upon the “position”, there are four types of participation in options:

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p<>{color:#000;background:#fff;}. Buying calls


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p<>{color:#000;background:#fff;}. Selling calls


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p<>{color:#000;background:#fff;}. Buying puts


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p<>{color:#000;background:#fff;}. Selling puts

To use options lingo, holders are those who buy options and writers are those who sell them. Buyers have “long positions” and sellers have “short” ones. Here is the tricky part: call and put holders are buyers who are not obligated to buy or sell. They can exercise their option or not. Call and put writers are sellers who have the obligation to buy or sell. In short, there are always two sides to an option contract.

More jargon. The strike price is the term used for the amount the underlying asset (the stock) can be purchased or sold. A stock must go over this strike price for calls and under it for puts in order for an option to be exercised and make a profit—all before the looming expiration date. Thus, the speculative nature of the investment. When speaking of calls, they are said to be “in the money” if the stock share price is higher than the strike price. Similarly, a put is in the money if the stock share price is below the strike price. One speaks of the “intrinsic value” of an option when referring to the amount a call or put is in the money. The premium one pays for an option varies according to the stock and strike price as well as the time left until expiration (the “time value” of the option). Volatility also plays a role in determining option prices.

Long-Term Options

Options as discussed above are short-term. Results are immediately apparent in the general scheme of things as in our house example. You can also buy them for the long term lasting one or multiple years. It all depends on your goals and objectives and the time horizon for each. LEAPS is the term used to describe long-term equity (ownership) position in the securities industry: long-term equity anticipation securities. It is all about managing risk over time. Some people don’t like to wait. LEAPS are not available on all stocks, but most widely-held issues so that investors can avail themselves easily of this strategy.

Exotic Options

Most people do calls and puts as buyers and owners. This is the run-of-the-mill course of option buying and trading. There are other choices, however, that are as complicated as they are varied. Anything non-standard falls into the realm of exotic options. They can be variations or entirely new products on the option investment market.

Chapter 3 – Why Use Options

Investors incorporate various investment strategies in a well-balanced, appropriately allocated portfolio. Options are no exception. You can buy or sell them with varying consequences. They exist to make money and also for the purposes of speculating and hedging. Good planning is always the best recourse in the world of finance. Tried and true principles of diversification are always of value.

Speculation

[
**]We mentioned risk and reward and we are back to the topic of risk in this section. Options are one of the many ways to get a better return than stodgy blue chip stocks or mutual funds with all their associated fees and commissions that can eat away profits. The great thing about options is that you can make money whether or not the market rises depending upon your “position.” In effect, you are betting on the movement of the underlying security and that includes going down.

Speculation sounds scary and it can be. It implies loss to most people. A lot rests on your ability to be correct about the stock market’s status during a particular time frame. It is somewhat like having a crystal ball. There are no guarantees, however, that you are right. You are predicting the price change of a stock during your option period. Doing your homework will help assess its future direction. This can be tough but people do it all the time successfully. It may mean having to take a multitude of positions to prevail and this will spread your bets so to speak. Do the math and figure out the cost first before jumping in. Speculating in options can be viewed as leveraging your portfolio and making more out of existing positions. A contract you hold is worth 100 shares and the right price movement can be lucrative indeed.

Hedging

You have heard of the expression “hedging your bets” and know no doubt that it pertains to lowering risk about doing something. Growth stocks are hedges against inflation while indexed annuities are hedges against stock market downturns. You buy house or car insurance to hedge your bets against fire and theft. The same is true of options. They hedge against loss of your stock portfolio, for example. It is particularly valuable for large institutional holdings. Let’s assume that a company pension plan has stocks, but they want to enter the technology sector. To limit losses, they can use option income.

[[
]]Employee Stock Options

Employee stock options are a different type entirely but worth mentioning to avoid confusion as to the terminology. Lucky employees are those who are eligible to receive company stock by exercising their free option. It is a way of ensuring staff satisfaction and engagement by allowing them to participate in company ownership or equity. A variety is a stock option to purchase limited shares. These could be offered to employees, vendors, clients, etc. The contract is between the option holder and the company unlike a normal option which is between two unrelated parties. Free stock options are a blessing in disguise.

Chapter 4 – Options in Operation

Options are best explained by using examples so that you can see the numbers in action. The real estate analogy worked for the conceptual overview of options. Not we will get more specific.

A typical call

On May 1st, XYZ company stock is priced at $57. It costs $2.15 for a July 70 call. The expiration date of the option is the third week of July and the strike price is stated as $70. The investor will pay $215 for the contract of 100 shares. There are commissions but for simplicity’s sake, they will not enter into the calculations. Now the price of XYZ company must go above $70 for the call to have value. The breakeven equation would show the addition of the premium and thus the stock must rise to $72.15. (100 × $2.15 + $70=$72.15)

If there is a bear market and the XYZ stock drops to $67, you would let the option expire worthless. You are out $215 for this particular contract. On the other hand, say the stock prices jumps to $78 which is over the $70 strike price. The value of the option has gone up along with the stock price and is worth $8.25 × 100 = $825. You paid $215 so your profit is $825-$215= $610. Not bad for three weeks work! You can close your position, or sell it and enjoy the profits or wait to see if the price rises additionally.

If you let it ride, by expiration date, it could drop to $62, less than the strike price. Whoa! Not what you hoped would happen and time is up. The option expires worthless. You are back to your original loss of $215. 

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You can see that there are price swings in options contracts and that their value can rise. This is an example of leverage.

Exercising Versus Trading-Out

Other strategies exist besides buying or selling a call or a put on an underlying stock. We mentioned exercising options as appropriate. By contrast, most investors do not do this. In the example above, an investor can benefit by exercising at $70 and then selling the stock back at $78 in the market for a profit of $800 ($8 a share x 100). But this same investor could keep the stock purchased at a discount. Generally speaking, most option holders close out or trade out, meaning they take profits on their positions. One way is to sell the options in the open market for writers to buy back and close. Only about 10% of options are actually exercised. Over half are traded out and a third expire worthless.

Intrinsic Value/Time Value

There are a few more concepts to cover in regard to options pricing. In the example, the premium went from $2.15 to $8.25. Why? Because of time and intrinsic value. The latter pertains to the amount that the option is in the money (the stock price equals the strike price). The former, time value, refers to the possibility that the option could increase in value. The option premium of $8.25 consists of $8 intrinsic value plus $.25 time value. Most options trade above intrinsic value.

Note on covered call writing

A call option is written against an asset or underlying security.

Covered Call: long 100 shares XYZ sell 1 CALL

In this particular strategy, the investor can earn a premium just by selling the call while simultaneously he or she can reap the rewards of normal stock ownership such as dividends and voting rights. The caveat is that there may be a limit to the profit up to the option strike price. The covered call written can be out of the money during the option time period. This means that the investor might be betting on a rising stock market and sells this type of call on his or her own holdings. He or she will earn a premium and also get a capital gain during the stock market rally.

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On the downside, the options trader can experience severe losses depending upon how low the price goes. It is the same risk he or she faces as a stock owner. Writing calls is a hedge or cushion against such loss as you get the premiums as income while you wait. As an example, an investor can purchase 100 shares of XYZ at $100 in June and write a JUL 110 out-of-the-money call for $4. He or she pays $10,000 for the 100 shares and receives $400 for writing the option. The investment is thus $9,600. The option expiration date rolls around and the stocks ends up at $114. This is the profit zone! The strike price was $110 and the buyer of the call exercises it, forcing the call seller to liquidate the 100 shares at a profit of $1,400 plus the call premium of $400 for a total of $1,800.

As an addendum to what you have learned so far, you will note that the buyer of the call option for XYZ has no profit even though the stock underlying it went up 14 points. If it had gone the other way, the call writer would have a paper loss of $1,400 less his premium of $400 and the call buyer’s loss would not exceed his premium of $400.

Also note that you can sell a call without actually owning the underlying stock, which is referred to as “naked writing.” Maybe the investor believes the stock is going to fall. He sells the call option to a purchaser and takes in a premium. He now has the obligation to sell the stock at an agreed upon price if it is above the strike price. If it does not, he keeps the premium. That’s the definition of a good investment!

Puts

We have to mention some of the other option positions you can consider. A call results in the right, but not the obligation, to a buy number of security shares at a specified price, all within a defined time frame. A put is the opposite, the right, but not the obligation to sell. After that, it operates similarly as in our previous examples. An investor who opts for a put wants the stock underlying it to depreciate relative to the strike price. If he or she has bought a put for XYZ at $10, he or she has the right to sell 100 shares of the company at this price until the third Friday of the month. If the stock price drops to half and you exercise the put option, you have the right to purchase 100 shares of XYZ for $5 in the market and sell these shares to the option writer for $10 each. Your profit is $500. You bet the market would go down and you were right.

An investor who sells a put thinks the market will rise, on the other hand, is the one who sells the put. Remember that the seller is the “writer” who gets the premium and who will sell the XYZ shares at the price of $10 even if it is going down during the time period of the option.

Many advanced options strategies exist: iron condor, bull call spread, bull put spread, iron butterfly, and more. Another e-book will cover these opportunities in the future. It would also include options trading software for advance practitioners. Those who are serious about the subject would do well to research what’s now on the market.

Chapter 5 – Indexed Annuities

While owning an indexed annuity involves options purchases, you, as an investor, sit back and let the experts do the talking. It is interesting to note that other than an options mutual fund, you can enjoy the benefits of the methodology in your easy chair. Indexed Annuities are a unique class of annuities that use an “equity or stock index” as the basis for calculating the returns that will be credited to the annuity policy. The return is based on the performance of a particular stock index such as the Standard & Poor’s 500, the Dow Jones Industrial Average, the Nasdaq Composite or the Russell 2000 Index. There are no commissions, and usually no fees, that lower your initial investment or reduce your returns over time. They are safe and secure, ideal for retirement planning.

So where do the options come in. Because the insurance company that issues an indexed annuity guarantees your principal against downturns in the stock market, and because you lock in gains annually, the issuer has to make a profit in down years to cover your interests. They also have to provide an income stream when the annuity pays out during your retirement. The annuity company will take the premiums paid by investors to buy bonds and real estate holdings that generate an annual income. For purposes of our example, let’s assume they generate an average income of 5%, a renewable resource that is provided every year.

They will invest the majority of this income in options on the index or indexes that are selected by the owner of the indexed annuity. Therefore, if the market were to go up, the value of the option could increase (you do not get the dividends by the way, just the gains). This means you have the potential for attractive profits and the options will be exercised locking in that profit. On the other hand, in periods when the market declines, the option simply expires, and your principle was never in play and is safe. Therefore you have no losses. The company simply does it again in subsequent years. Because of its safety, these investments are ideal for retirement plans.

Conclusion

You want to squeak a little more growth out of your investment portfolio and you are well in advance of retirement. You want to diversify your holdings with some aggressive choices. Or you want to try your hand at a sophisticated and potentially lucrative realm. The enjoyment is in the process. However you slice it, options trading is exciting and dynamic and worth a closer look. It is common enough and has a place in many investor portfolios.

Having read the ropes of option basics, you can now decide if it is right for you. Don’t listen to any broker. Make your own decision. It pertains to your level of risk, not someone else’s. Brokers make commissions quickly with options, sometimes at your expense. We all want to reap the reward, but not all of us can pay the price. It feels great when you successfully exercise an option, but no so great when it just expires with no benefit.

We assume that you have read between the lines that option trading done correctly requires knowledge and experience. It is perfectly fine to do it on your own or use your broker for help. We mentioned mutual funds that are run by expert managers. Whatever you do, you must know the ramifications of your option selections: all sides of the question. You don’t want to be caught unknowingly on the wrong side of the equation.

In concluding this e-book, it is valuable to take a moment and talk about option trading mistakes. Too much risk (over aggressive positions) is obvious or the passage of valuable time, but the investor can in general make other errors such as “the price tag” problem. Novice traders with limited funds will often go for the cheaper premiums hoping to get rich quick as they say. But such options could be deeply out of the money and hardly worth the low price. The underlying stock price would have to move considerably to be profitable. Expensive options actually have greater chance of success.

The second big novice error is greed. Investing is very emotional swinging between the poles of fear and greed. When an option trade is going well, investors will be tempted to ride it to the end hoping for a big upside. They don’t close their positions about of fear of missing the big payoff. If they are riding down that same slippery slope, they may be afraid to miss a reversal and the losses will build. It is the mistake of not admitting defeat soon enough. The third big error is to bail out before the option has a chance either way due to under-controlled fear.

There is no point to investing in options with this kind of attitude. There must be clear objectives to keep you steered in the right direction. Plan in advance a point at which you would close a particular options trade as a rule of thumb. You can pick a bailout point, but not out of panic. Reason it through every step of the way. You will avoid emotional helter-skelter and the mistakes that go along with it.

In sum, options trading can make you money and even a killing now and then. Since losses are also typical, you would want to invest over time, not just once in a while. You will then see that your profits are an average of what you have done. It can take patience and time, but it is part of the strategy to net losses and gains. You know the feeling of winning in Vegas. You don’t stop there! You can play a while and take home some cash or you can stay in the game too long and lose.

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Options Trading Strategies: Discover the Simplest Option Strategies to Limit the

Options are an exciting dimension of investing unknown to the uninitiated. They are actually rather mainstream to those who enjoy their potential for profit. They happen in a finite period of time and can be very lucrative. It is like placing a bet on the direction of the market in regard to a particular stock. No, it is not gambling as there is no mania about it. It has rules and regulations as well as common practices. It is a supplement to other more prudent forms of investing and forms a small part of any prudent investment portfolio. Options can be risky and aggressive, but they have their conservative side as well. It is important to know the difference in the types available and to match options with personal objectives. It is not a guaranteed investment but offers great potential over time. Doing it once or twice is not really the best strategy. Advice is recommended as opposed to doing it on your own. Careful study will yield sufficient knowledge to start small.

  • Author: VAGABONGD PUBLISHING
  • Published: 2015-10-22 15:05:16
  • Words: 5225
Options Trading Strategies: Discover the Simplest Option Strategies to Limit the Options Trading Strategies: Discover the Simplest Option Strategies to Limit the