Check to see if this stock has liquid options available

STRATEGY ROAD MAPS

For your convenience, the following subsections provide step-by-step analyses of the basic strategies discussed in this chapter.

Long Call Road Map

In order to place a long call, the following 13 guidelines should be observed:

1. Look for a low-volatility market where a rise in the price of the under

lying stock is anticipated.

2. Check to see if this stock has liquid options available. 3. Review options premiums with various expiration dates and strike

prices. Use options with more than 90 days until expiration. 4. Investigate implied volatility values to see if the options are over

priced or undervalued. Look for options with low implied volatility. 5. Review price and volume charts over the past year to explore price

trends and liquidity.

6. Choose a long call option with the best profit-making probability.

Determine which call option to purchase by calculating: Limited Risk: Limited to the initial premium required to purchase the call.

Unlimited Reward: Unlimited to the upside as the underlying

stock rises above the breakeven.

Breakeven: Call strike + call premium.

7. Create a risk profile for the trade to graphically determine the trades

feasibility. The long calls risk profile slants upward from left to right.

8. Write down the trade in your traders journal before placing the trade

with your broker to minimize mistakes made in placing the order and to keep a record of the trade.

9. Make an exit plan before you place the trade. Determine a profit and

loss percentage that will trigger an exit of the position. Close out the entire trade by 30 days to expiration.

10.Contact your broker to buy the chosen call option. A margin deposit isnot required.

11. Watch the market closely as it fluctuates. If the market continues to

rise, hold onto the call option until you have made a satisfactory profit or a reversal seems imminent.

12. If the underlying market gives a dividend to its stockholders, this will

have a negative effect on the price of a call option because a dividend usually results in a slight decline in the price of a stock.

13. Choose an exit strategy based on the price movement of the underly

ing stock and the effects of changes in the implied volatility of the call option:

The market rises above the breakeven: Offset the position by

selling a call option with the same strike price and expiration at an acceptable profit; or exercise the option to purchase shares of the underlying market at the lower strike. You can then hold these shares as part of your portfolio or sell them at a profit at the current higher market price.

The market falls below the breakeven: If a reversal does not

seem likely, contact your broker to offset the long call by selling an identical call to mitigate your loss. The most you can lose is the initial premium paid for the option.

Short Call Road Map

In order to place a short call, the following 13 guidelines should be observed:

1. Look for a high-volatility market where a fall in the stocks price is

anticipated.

2. Check to see if this stock has liquid options available. 3. Review options premiums with various expiration dates and strike

prices. Options with less than 45 days until expiration are best. 4. Investigate implied volatility values to see if the options are over

priced or undervalued. Look for options with high implied volatility and, thus, a higher premium.

5. Review price and volume charts over the past year to explore price

trends and liquidity.

6. Choose a short call option with the best profit-making probability.

Determine which call option to sell by calculating:

Unlimited Risk: Unlimited to the upside as the underlying stock

rises above the breakeven.

Limited Reward: Limited to the initial call premium received as a

credit.

Breakeven: Call strike + call premium.

7. Create a risk profile for the trade to graphically determine the

trades feasibility. A short calls risk profile slants down from left to right showing the limited profit and unlimited risk as the stock rises.

8. Write down the trade in your traders journal before placing the trade

with your broker to minimize mistakes made in placing the order and to keep a record of the trade.

9. Make an exit plan before you place the trade. Determine a profit

and loss percentage that will trigger an exit of the position. For example, a 50 percent profit or loss is an easy signal to exit the position.

10. Contact your broker to go short (sell) the chosen call option. Margin

is required to place a short call, the amount of which depends on your brokers discretion.

11. Watch the market closely as it fluctuates. If the price of the underlying

stock rises above the strike price of the short call option, it is in danger of being assigned. If exercised, the option writer is obligated to deliver 100 shares (per option) of the underlying asset at the short call strike price to the option holder.

12. If the underlying market gives a dividend to its stockholders, this will

usually cause the price of the call option to decline slightly, which works in favor of the short call strategy.

13. Choose an exit strategy based on the price movement of the under

lying stock and the effects of changes in the implied volatility of the call option:

The market falls below the strike price: Wait for the call to

expire worthless and keep the credit received from the premium. The market reverses and begins to rise above the call strike

price: Exit the position by offsetting it through the purchase of an identical call option (same strike price and expiration date) to avoid assignment.

Covered Call Road Map

In order to place a covered call, the following 13 guidelines should be observed:

1. A covered call is a conservative income strategy designed to pro

vide limited protection against decreases in the price of a long underlying stock position. Look for a range-bound market or a bullish market where you anticipate a steady increase in the price of the underlying stock.

6. Choose a higher strike call no more than 45 days out to sell against

long shares of the underlying stock and then calculate the maximum profit, which is limited to the credit received from the sale of the short call plus the profit made from the difference between the stocks price at initiation and the call strike price.

7. Determine which spread to place by calculating:

Limited Risk: Limited to the downside as XYZ can only fall below

the breakeven to zero.

Limited Reward: Limited to the credit received from the short call

plus the strike price minus the initial stock price.

Breakeven: Calculated by subtracting the short call premium from

the price of the underlying stock at initiation.

8. Create a risk profile of the most promising option combination and

graphically determine the trades feasibility. Note the unlimited risk beyond the breakeven.

9. Write down the trade in your traders journal before placing the trade

with your broker to minimize mistakes made in placing the order and to keep a record of the trade.

10. Make an exit plan before you place the trade. You must be willing to sell the long stock at the short calls strike price in case the call is assigned.

11. Contact your broker to buy and sell the chosen options. Place the

trade as a limit order so that you limit the net debit of the trade. 12. Watch the market closely as it fluctuates. The profit on this strategy is

unlimiteda loss occurs if the underlying stock closes at or below the breakeven points. You can also adjust the position back to a delta neutral to increase profit potential.

The price of the stock rises above the short strike: The short

call is assigned and exercised by the option holder. You can then use the 100 shares from the original long stock position to satisfy your obligation to deliver 100 shares of the underlying stock to the option holder at the short call strike price. This scenario allows you to take in the maximum profit.

The price of the stock falls below the short call strike price,

but stays above the initial stock price: The short call expires worthless and you get to keep the premium received. No losses have occurred on the long stock position and you are ready to sell another call to offset your risk.

The stock falls below the initial stock price but stays above

the breakeven: The long stock position starts to lose money, but this loss is offset by the credit received from the short call. As long as the stock does not fall below the breakeven, the position will break even or make a small profit.

The stock falls below the breakeven: Let the short option ex

pire worthless and use the credit received to partially hedge the loss on the long stock position.

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Previous Issues

200809-19

By selling a put option, you will receive the options premium in the form of a credit

200809-18

The buyer of put options has limited risk over the life of the option, regardless of the movement of the underlying asset

200809-17

The purchase of a stock (or futures contract) and the sale of a call option against the purchased underlying asset

200809-16

If the underlying stock stays below the strike price of the short call until the options expiration, the option expires worthless and the trader gets to keep the credit received

200809-15

The sloping line indicates the theoretical profit or loss of the call option at trade expiration according to the price of the underlying asset

200809-14

Outside of trading options, there is only one method a trader has to make a profit during a downtrend in stocks

200809-13

The options strategies can be applied using stocks or futures