Options FAQ: Strategies

by The Options Industry Council | April 13, 2011 5:05 pm

Strategies Questions

Strategies Answers

Q: What is the risk in selling a covered call at a strike price considerably higher than the stock price at the time I wrote the call? If the option is exercised, I will profit from the call premium plus the difference between the stock purchase price and the strike price. It seems to me that the only risk is less profit if the call is exercised. What am I missing?

A: Whenever you write a covered call, you first have to decide that you would be happy to lose the stock at the net effective sale price (NESP= call strike price plus call premium). If NESP does not provide you with the profit you anticipated when you first acquired the stock, you probably should not write the call. Keep in mind that writing a deep out-of-the-money call (or, as you stated, “a…call at a strike price considerably higher than the stock price”) may offer very little premium. You will want to ask yourself if the net premium, after the transaction costs, is enough to justify the transaction. There is a rule of thumb often employed by many covered call writers: the potential return, if the stock is called, should be about twice the risk-free (Treasury bill) rate. As an example, if a 60-day Treasury yields 5% per annum, a two-month covered call write should produce an annualized 10% return.

A corollary is that the return engendered by the covered write should at least equal the risk-rate if the stock remains static. Another guideline regarding premium is that the downside protection gained by call writing should at least equal 3% of the stock’s current market price.


Q: I sold a naked call and then bought the same call. Is my naked call now covered?

A: Generally, if someone purchases the same call that was sold, it’s likely that the two transactions would be matched as opening and closing transactions and the position would be eliminated. While not common, there may be some strategies where an investor wishes to remain long and short on the same contract. If this is the case, the naked margin requirement would be eliminated, but the position still bears the risk assignment on the short call option.


Q: Can an individual person be both long and short the exact same option at the same time?

A: Generally, if you simultaneously buy options and sell the same number of options within the same series, you will have a flat position with regard to that option series. If you conduct the trades in different accounts or with different brokers, the positions would not be offset within the same account, but since you would be simultaneously long and short the same asset, you would still be flat from an economic point of view – your total position would net out to zero.

Whether you conduct the purchase and sale simultaneously, or at different times, your total position is viewed from a net long, net short, or flat position.

Financially, if the transactions are conducted concurrently, you would be buying at the ask price and selling at the bid price, immediately placing you at a net loss due to the bid/ask spread. Additionally, if you were to place an order to buy and sell the same security at the same time, which results in conducting both sides of the transaction with yourself, this would be considered a “wash sale”, as there would be no change of beneficial ownership, and is a violation of various rules and regulations.

In summary, there would be little or no advantage to being both long and short the same, exact option. The two positions would net to zero, there could potentially be a violation of exchange rules, and when you consider the commissions coupled with the bid/ask spreads, there would probably be more cost than benefit.


Q: Can I perform a spread by purchasing an at the money LEAPS® call, and selling a front month out of the money call?

A: Yes, the strategy you described is also known as a “diagonal call spread.” When considering implementing this strategy, you should be aware of the risks associated with the strategy, along with the (potential) rewards. In the worst case scenario, should you be assigned on the front month call and then exercise your LEAPS® to cover the assignment, your loss would be the net debit paid to establish the position less the difference between the strike prices of the two options.

It’s more difficult to establish a maximum gain for this strategy, which in many ways resembles the Covered Call. The best case scenario is for the stock to go sideways or gradually rise over the life of the LEAPS® call, thus allowing you to roll out your front-month option every month at a credit. Review the various LEAPS® strategies, including spreads in the LEAPS® section.


Q: I understand that there are discrepancies in options pricing between puts and calls and among the different expirations. Sometimes front months trade at much higher volatility levels and at other times the higher volatility is in the back months. But it is not clear to me how to benefit or to take advantage of this situation. For how long do these discrepancies exist, and where can I learn more about them?

A: It would be more appropriate to say that there are different levels of volatility and costs of carry for puts and calls and for different strikes and expirations. But this complexity is not artificial, it reflects actual differences in the factors that influence an options’ price. For example, most options pricing modes are based on the Normal Distribution Function – but stocks tend to deviate slightly from the Normal model, and traders compensate by tweaking the volatilities (skew) that they input into their model. In the case of puts and calls, the cost of carry tends to push calls to a premium and puts to a discount – but the early-exercise feature prevents puts from falling below their intrinsic value, which distorts the put-call parity that would exist for European-style options.

Traders can and do take positions that benefit from changes in cost of carry, volatility skew, etc. But it’s very difficult to calibrate such positions, and it generally requires making quite a few trades. So these types of strategies are usually only suitable for full-time investors who have very low marginal trading costs (although they often have high fixed costs, such as exchange memberships).


Q: What is the difference between a Call and a Put – and why does my broker tell me that I can’t sell a Put when I’m long the stock?

A: An equity option is a contract. The call contract conveys to its holder the right, but not the obligation, to buy shares of the underlying security at a specified price (the strike price) on or before a given date (expiration day). The put contract conveys to its holder the right, but not the obligation, to sell shares of the underlying security at the strike price on or before a given date (expiration day). After this given expiration date, the option contract ceases to exist. If assigned, the seller of an option is, in turn, obligated to sell (in the case a call) or buy (in the case of a put) the shares to (or from) the buyer of the option at the specified price.

In the case of a covered call, the investor sells a call option contract while at the same time owning an equivalent number of shares of the underlying stock. If an investor is assigned an exercise notice on the written contract he/she sells an equivalent number of shares at the call’s strike price.

As for why your broker might have concerns about selling a put option while long the underlying stock, if the investor is assigned an exercise notice on the written contract he/she buys an equivalent number of shares at the put’s strike price, effectively getting “longer” the underlying stock.

For more strategy related questions, visit the Strategies area on the website.


Q: Do I need to hold my option until expiration when it turns profitable. If my option has increased in value but, still has time value, lets say two or three months, is it such a bad idea to close the position and collect a profit?

A: In general, whether or not to hold a profitable position would depend on your outlook for the underlying stock and your risk/reward preference. If you think that the stock has experienced most or all of its anticipated move, you might want to close out your position and take the profit. If you think the underlying stock has a lot further to go, for even more profit, you might want to let your profits ride (and take the risk of a reversal in stock direction). And if you think the stock has further to go but want to take some money off the table, you might want to sell your options, or a portion of the position. One might even consider then buying some with a more distant strike, thereby earning a credit on the spread.


Q: What are the advantages of “vertical spreads”? And, are there any disadvantages? (Submitted 5/03)

A: One advantage is knowing what the risks and rewards are for that position. The vertical spread consists of buying one option and selling another with a different strike but both expiring in the same month.

Another advantage of a vertical spread versus a single option position is that it is possible to put a cap on the amount of risk the option writer (seller) assumes, and decrease the costs of the purchase if you are an option buyer.


One obvious disadvantage is that while limiting risk, the investor also sets a limit on their profit. So, the investor would put a cap on profit potential. Also, the investor should be aware that commissions and interest charges can effect the profitability of all spread strategies. It is suggested that the investor consult a tax advisor concerning the tax consequences of any spread strategy. Further, there are occasions where certain types of corporate actions may impact the profit/loss profile of a spread. Extraordinary dividends, tender offers and even mergers can alter the dynamics of a spread.


Q: If I buy an in the money LEAPS® call and sell a shorter term call against it which is just out of the money – what happens if I get called? How do I settle the trade? Do I have to exercise the in the money LEAPS® call to get the stock and then deliver the stock to the party that exercised the option that I sold? Or is there an alternate way to settle the trade?

A: One of the risks in entering into a calendar spread position is the early assignment on the “short” leg of the spread. Therefore, you will need to ensure that you are approved for uncovered options transactions by the ROP of your brokerage firm. The near-term, at-the-money or just out-of-the-money options with the higher premiums are tantalizing, but there is added risk too! The contracts have a chance of finishing in the money. How will you meet your obligation(s) to deliver the called stock? If it’s your plan, if called, to exercise your long LEAPS® position, you should carefully review the strike prices of the contracts in the spread to give yourself a chance that if called, you still have a profit. Remember, when you exercise an option contract you forgo any time value. You should understand in advance the rules for handling option assignments using this type of strategy. In most cases, if you are assigned on a short option position you must take some sort of action (e.g. exercise your long call, buy stock in the open market) to meet your stock delivery obligations.

In the event of assignment, if an investor chooses to exercise their LEAPS® call, because of the 1-day lag between exercise and assignment, using the long-term call to close out the position would require being “short” the stock for a day. You will certainly want to discuss this strategy with your brokerage firm.


Q: I’ve read some options books where experienced and successful traders described a strategy of buying ‘cheap’ options and selling ‘expensive’ options. How can one go about determining whether or not an option is ‘cheap’ or ‘expensive’ and indeed, what does it mean?

A: This is a strategy that may not be practical for the typical trader. You will want to consult your broker.

Options are considered “cheap” or “expensive” according to the level of their implied volatility relative to the historic or predicted volatility.

But it’s a little more complicated than that, because option strategies can be divided into either directional strategies and/or volatility strategies. It might not do much good to buy a “cheap” call option, for example, if the underlying company ended up in bankruptcy. “Cheap” is also a relative term. Remember that all out-of-the-money options at expiration are worthless.

In addition, there may be a reason that the market is pricing the option more inexpensively than in the past. If it is cheap today and cheaper tomorrow, then what’s going to happen the next day? Predictions are merely that – speculation. They may have a sound theory to them, but may not prove to come true.

We have a calculator on our site at: http://www.optioneducation.net/calculator/main_calculator.asp that you can use to calculate implied volatility. We also have an educational software package that comes on a CD, which you can order here: http://optionseducation.org/resources/investigator/default.jsp.


Q: I recently read that a buy-write (i.e., buying stock and simultaneously writing a call option against that stock position) and selling a put are equivalent. I am having trouble visualizing this. Any help?

A: A covered call (buy long stock and short a call) is sometimes referred to as a “synthetic” short put; the risk/reward profile of a covered call position is almost identical to a “true” short put. To review the risk/reward profiles for these (and other) strategies, view the Strategy Screener.


Q: Can you please provide an explanation of profit and loss diagrams for options? I am having difficulty interpreting their meaning.

A: An explanation is offered in Understanding Profit and Loss Graphs (PDF | 497k).


Q: What is a long straddle?

A: A Long Straddle is a combination of buying a Call and buying a Put on the same underlying security, both with the same strike price and expiration. Together, they produce a position that should profit if the stock makes a big move either up or down. Typically, investors buy the straddle because they predict a big price move and/or a great deal of volatility in the foreseeable future. For example, the investor might be expecting an important court ruling in the next quarter, the outcome of which will be either very good news or very bad news for the stock. However, since the straddle involves two premiums and two commission charges, for the position to be profitable, the move would need to be large enough to cover both premiums and commissions.

To learn more about straddles or other strategies, you might visit our Strategy Screener.


Q: Please explain the Long Strangle strategy.

A: The long strangle is simply the simultaneous purchase of a long call and a long put on the same underlying security with both options having the same expiration but where the put strike price is lower than the call strike price. This strategy may prove beneficial when the investor feels large price movement, either up or down, is about to happen but uncertain of the direction. For instance, a strangle may be considered when an earnings announcement is forthcoming, the outcome of which will introduce large price swings in the underlying in either direction. However, since the strangle involves two premiums, for the position to be profitable, the move would need a corresponding option price increase that is enough to cover the two premiums paid for the position.

To learn more about strangles or other strategies, you might visit our Strategy Index


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