Options Framework

1. Options 101 6. Whiplash Orders

2. Best Strategy 7. Buy-Writes
Week 1 3. Option Approval Levels 8. Early Exercise
4. Show or Fill Rule 9. No Options for Me
5. Bid-Ask Exercise Self-Test 1

4. Profit and Loss Diagrams

1. Leverage
5. Are Options Good For The
Week 2 2. Open Interest
Market
3. Large Bid-Ask Spreads
Self-Test 2

Gearing Up For Trading

3. Time Value & Intrinsic Value

1. Buy or Sell
Week 3 2. Types of Orders
4. Fair Value
Self-Test 3

3. Hedging
1. Put-Call Ratio
Week 4 2. Percent to Double
4. Options Expiration Cycles
Self-Test 4

1.Basic Options Pricing 4. Delta Gamma

Week 5 2. Black-Scholes 5. More on Deltas
3. Implied Volatility Self-Test 5

Basic Strategies

1. Call Options 4. Straddles & Strangles

Week 6 2. Put Options 5. Strips & Straps
3. Covered Calls Self-Test 6
Intermediate Strategies
3. Deep-In-The-Money Covered
Calls
1. Equity Collar
Week 7 2. Spreads
4. Selling Options on Expiration
Day
Self-Test 7

1. Ex-Dividend Dates
5. Ratio Spreads
2. Dividend Play
Week 8 3. Option Repair
6. Christmas Tree
Self-Test 8
4. Naked Put Alternatives

Advanced Strategies & Topics

1. Calendar Spreads 3. Condor

Week 9 2. Butterfly Self-Test 9

1. Backspreads
Week 10 2. Box Spreads
Self-Test 10

1. Synthetic Options 4. Jelly Rolls

Week 11 2. Synthetic Short 5. Wrangles
3. Systematic Writing Self-Test 11
Options 101: We cover the very basics of options.
What is an Option?
While options may seem mysterious to most investors at first, the basics are actually quite simple
to understand.

Options are simply legal contracts between two people to buy and sell stock for a fixed
price over a given time period.

These contracts are standardized, meaning they control a fixed amount of shares and expire at
the same time. Because of this standardization, they are traded on an exchange, just like shares
of stock. The contracts are usually highly liquid, which means there are many buyers and sellers
standing by who are willing to buy or sell. You can buy an option contract with the same speed it
takes you to call your broker and buy stock.

There are two types of options: calls and puts.

Long Call Options

A call option gives the owner the right, but not the obligation, to buy stock ("call" it away from the
owner) at a specified price over a given time period.

In trading lingo, any asset that you buy is called a longposition. If you buy a call option, you are
the owner, and are long the contract. Notice that the owner, the long position, has the right, but
not the obligation, to buy stock. You are allowed to purchase the stock for a fixed price, but are
not required to do so. In other words, you have the option to buy -- which is where these financial
assets get their name.

The price at which you can buy the stock is called the strike price, which is kind of a slang term
that came into use, because that's the price where the deal -- the contract -- was struck.
Generally, each contract controls 100 shares of stock, called the underlying stock, which we will
talk more about later. For now, just understand that unless otherwise stated, each contract
controls 100 shares.

Each contract is good only for a certain amount of time. Usually you can find contracts with as
little as a couple of weeks and as long as three years of time remaining. However, these are
standardized time frames, so you don't get to pick the exact date you want it to expire.

Just as stock is traded in shares, options are traded in units called contractsSee Trading Units
contracts.

If you buy one IBM March $100 call option (one contract), you have the right, but not the
obligation to buy 100 shares of IBM (the underlying stock) for $100 per share (the strike price)
through the expiration date in March, which is usually the third Friday of the month[1].

If you think about the definition of a call option, you have probably encountered similar
agreements outside the financial markets. Your local pizza place may have a coupon good for the
next 30 days that allows you to buy a large pizza for $10. That's similar to a call option. It's like a
contract locking in your purchase price over a fixed time period. After that time period, the option
to buy at that price expires. While the pizza shop may make an exception and allow you to use
the coupon after the expiration date, there is no such thing with a call option. Once it's expired, it's
gone.

Think of a call option as a coupon giving you the right to buy stock at a fixed price through an
expiration date. The big difference between a coupon and a call option is that you must pay for
the option while coupons are generally handed out for free.

Long Put Options

A put option allows the owner to sell their stock ("put" it back to someone else) for the strike price
within a given time. As with call options, the put buyer (long position) has the right, but not the
obligation. If you buy an IBM March $100 put, you have the right, but not the obligation, to sell
100 shares of IBM for $100 per share through the third Friday in March.

Buying a put option is similar to buying an auto insurance policy. You can buy a policy for a
premium and collect the insurance value if you wreck your car. If you don't wreck your car, you
are only out the amount of the premium. Likewise, you can buy a put option for a premium and
turn it back to the insurer (the put seller) if your stock should crash (fall below the strike price). If
the stock stays above the strike, you would let the "insurance" expire and lose only the premium
you paid.

Short Calls and Puts

Notice that with either calls or puts the buyers (the "long positions) have the right, but not the
obligation, to buy or sell. The investor on the other side (the seller of the option, also called the
"short position) has the obligation to fulfill the contract; he or she has no choice. If a long call
owner decides to buy the stock, the short call trader must oblige and sell. Likewise, if long put
owners decide to sell their stock, the short put traders must purchase the stock. Regardless of
whether the short option seller is forced to buy or sell stock, the premiumreceived from the initial
short trade is theirs to keep. That's their compensation for accepting the risk.

Call Option Put Option

Long
Right, but not the obligation, to Right, but not the obligation, to
position
buy stock at the strike price sell stock at the strike price
(the buyer)
Short
Possible obligation to sell stock Possible obligation to buy stock
position
at the strike price at the strike price
(the seller)

The Options Clearing Corporation (OCC)

Many new traders to options may be concerned that the short side will not deliver. In other words,
if you want to use your option to either buy or sell shares, is there a risk of the short seller
refusing?

There is no need to worry about contract performance from the short seller. In other words, if you
decide you want to purchase 100 shares of IBM at $100 with your call option, there is no need to
worry about the seller of the call (the short call position) not delivering the shares. This is because
an intermediary called the Options Clearing Corporation (OCC is really the buyer to every seller
and the seller to every buyer. The OCC is well capitalized and does not run the risk of default.
Because of this, investors do not even need to know who is on the other side of the trade, as the
OCC guarantees contract performance. Ever since the inception of the OCC in 1973, no investor
has ever lost money due to default by the other party. Keep in mind this does not mean the OCC
guarantees contract profitability but only that you are guaranteed to buy or sell shares with your
long option position if you decide to do so.

The function of the OCC is to provide investor confidence, thereby providing better prices and
liquidity .

Exercising Options
If you wish to buy stock with your call option or sell stock with your put option, you simply call your
broker and tell them you want to exercise the option. Three business days later, the transaction
will take place. For example, if you own a $50 call option and decide to exercise it, your account
will be debited for $5,000 ($50 per share times 100 shares per contract) plus commissions and
credited 100 shares of stock on the third business day. Similarly, if you own a $50 put and
exercise it, you will receive $5,000 minus commissions and will be debited for 100 shares of stock
on the third business day. Keep in mind that you cannot exercise portions of an option -- you
either buy or sell in lots of 100 shares. For instance, if you own one contract, you cannot call your
broker and use it to only buy 75 shares. You either buy all 100 or none at all. Of course, if you
own more than one contract, you can certainly exercise only a portion. If you have five contracts,
you could certainly, for example, only exercise two of them and buy 200 shares.

What If I Want Out Of My Contract?

You can always get out of any contract -- long or short -- by executing an offsetting position. For
example, if you are long a March $50 call, you can simply sell a March $50 call (called "selling to
close") and you no longer have the right to purchase the stock for $50. If you have sold a $75 put
(called "selling to open") and no longer want the obligation to buy the stock for $75, you can
simply buy a $75 put (buy to close), which relieves you of your obligation. Bear in mind that the
price you receive or pay is determined by the market and can be very different from where you
entered the contract.

For instance, if you sell a $75 put with the stock at $80, you may receive a small amount, say $2.
Later, if the stock is trading for $70, you may wish to get out of the contract. However, that $75
put may now be trading for $6 meaning you sold for $2 and had to pay $6 to exit for a loss of $4
per contract.

In fact, most options are closed out in the open market this way. It's probably less than 5% of the
time that contracts are actually exercised. Just be aware that you can always get out of a contract
at any time -- it just may cost a lot to do it.

How are Options Similar to Stocks?

• Options are securities.
• Options trade on national SEC See Securities Exchange Commission" (Securities
Exchange Commission Securities Exchange Commission" )-regulated exchanges.
• Option orders are transacted through market makers and retail participants with bids to
buy and offers to sell, and can be traded like any other security.
How Do Options Differ From Stocks?
• Options have an expiration date, whereas common stocks can be held forever (unless
the company goes bankrupt). If an option is not exercised on or before expiration, it no
longer exists and expires worthless.
• Options only exist as "book entry, which means they are held electronically. There are no
certificates for options like there are for stocks.
• There is no limit to the number of options that can be traded on an underlying stock.
Common stocks have a fixed number of shares outstanding.
• Options do not confer voting rights or dividends. They are strictly contracts to buy or sell
the underlying stock or index. If you want a dividend or wish to vote the proxy, you need
to exercise the call option.

[1] Technically, options expire on the Saturday following the third Friday of the expiration month.
However, this is for clearing purposes and there is nothing the option trader can do with an option
on Saturday. The third Friday of expiration month is the last trading day so, for practical purposes,
it is the day you want to consider as expiration.
 What's The Best Option Strategy?
You've probably heard many opinions as to which option strategies are the best: Covered calls
are best because they reduce the risk but still allow for a profit. Naked puts are the best because
you're getting paid to buy stock. Straddles are the best because they allow you to make money
whether the market is going up or down.

If you've been trading options for a while, you no doubt have heard many others. But, when you
hear comments such as these, all you're hearing are opinions of one trader's preference for a
particular risk-reward profile. In order to really understand option trading, you need to understand
that all option strategies come with their own sets of risks and rewards and the market will price
them accordingly. Be careful of anyone telling you that a particular strategy is superior to
another; they either do not fully understand options or are trying to sell you something.

Traders who tout superior option strategies focus on one aspect of the strategy -- either the risk
or reward side -- and completely neglect the counterpart. They will make comments such as,
"Calls are superior to stock because the return on investment is much higher." It's easy to make
them consider the risk side by replying, "Sure, but lottery tickets are superior to calls because the
return on investment is even higher!"

The best option strategy is the one that directly matches your set of risk and reward tolerances for
a given outlook on the underlying. This is the level of option trading you want to achieve. Learn
to dissect a position into its component parts and see if you are willing to accept the associated
risks. Learn the various strategies and how to further tailor them to match your needs
better. Don't spend your time looking for the superior option strategy. It doesn't exist.

Understanding risk and reward

To fully understand the relationships between risk and reward with options, we need to look at
profit and loss diagrams. (Please see our section next week on "profit and loss diagrams" if you
are not familiar with them. We will show you in detail how to construct and read them next week.)

If you compare the profit and loss diagrams of any two strategies, there will always be a part of
the diagram where each strategy dominates.

For example, let's revisit the earlier comment. Are call options superior to stock? Assume one
investor buys stock for $50 and another buys the $50 call for $5.

We can plot the profit and loss at expiration for each position, and we will get the following
diagram:
For example, the trader who buys stock at $50 will make $5 profit if the stock is trading for $55. If
you look at the above chart, you can see that the profit and loss line (red) crosses the $5 profit
line for a stock price of $55. Likewise, if the stock is trading for $45, the trader will incur a $5 loss.

The diagram also shows that the long $50 call buyer (blue) will lose $5 if the stock is $50 or below
and will break even if the stock is $55. At a stock price of $60, the $50 call buyer will make $5
profit (the call option will be worth $10 but the trader paid $5)

Notice the profit and loss diagram for stock (red). It is superior to (lies above) the profit and loss
line for the long call (blue) for all stock prices above $45. This is because the call option buyer is
effectively paying $55 for the stock ($50 strike for a cost of $5). If the stock stays above $45, the
long stock position is the better strategy (the red line is above the blue line). But if the stock falls
below $45, the call option becomes the better strategy (the blue line is above the red line), as the
most the long call will lose is the premium. It should be evident that one strategy is not better
than the other; it depends on your outlook of the stock and the amount of risk you are willing to
accept.

An investor who believes the stock will stay above $50 is better off buying stock. Of course, there
is a tradeoff of accepting a potential $50 maximum loss. Conversely, an investor who believes
the stock is heading higher but doesn't want the exposure to the downside is better off buying the
call. The tradeoff is that he will pay $55 for the stock instead of $50, but in return, only be
subjected to a $5 maximum loss.

If traders are more concerned with the downside risk, they will bid up the price of the call. If they
feel the price of the call is too high relative to the stock, they will sell the call (either naked or
covered). These actions will price the call fairly with respect to investors' opinions, and neither
strategy will be superior to the other.

What about naked puts? They must be better than stock because you are actually getting paid to
buy the stock, right?

Let's look at the profit and loss diagram between stock purchased for $50 and a naked $50 put
sold for $5:
Again, in some areas of the chart the long stock position dominates, and in others it does
not. The long stock position is better for stock prices above $55. With the stock above $55, the
long stock investor will realize unlimited profits, while the naked put will profit only by the premium
received from the sale of the put.

However, if the stock is below $55, the naked put is the better strategy. Below a $50 stock price,
both investors lose but the naked put seller is ahead by the premium.

Maybe a long call is better than a naked put? Some may reason that the long call position makes
more money than the short put if the stock rises and loses less if it falls, so it is a better
strategy. Let's assume a long $50 call and short $50 put are each traded for $5:

Looking at the above chart we see that the long call position (red) does dominate for all stock
prices above $60 and below $40. But if the stock stays between these prices, the naked put is
clearly the better choice. Your outlook on the stock and tolerance for risk will determine which
strategy is best for you.
Pick any two strategies and look at their profit and loss diagrams. You will always see that each
strategy will dominate over a given range of stock prices. Try switching one position from long to
short. Try changing strike prices. You will soon see that it does not matter; one strategy cannot
dominate another for all stock prices.

Strategies come in all shapes and sizes. Now you should have a better understanding
why. Different strategies alter the risk-reward relationships and it is up to you, the trader, to
decide which is best. Do not be afraid to alter the strategy to meet your taste -- that is what
option trading is all about. If you accept somebody's strategy as the "best," you are, by default,
accepting his or her risk tolerances too. If those tolerances are not in line with yours, you will
eventually learn, the expensive way, that no strategy is superior to another.
 Option Approval Levels
In order to trade options, your broker will undoubtedly require you to fill out an options application
and assign you one of several option approval levels based on your needs, knowledge, and other
factors, including net worth.

Often times people wonder why they must be approved for options trading even though they may
"completely" understand the particular strategy they are trying to execute. The reason is that
there can be substantial risks in options, especially from factors outside the strategy.

For example, most people believe that the most you can lose from a long call position is the
amount of the premium -- the amount you paid to buy it. While it is true that a long call can never
have negative value by itself, the mechanics of the options markets do allow for further losses if
you do not understand them as shown in the following example.

Example:
I actually witnessed this trade at a brokerage firm. A trader was long 20 calls at $4. In his mind,
the most he could lose was $8,000, which was the total paid for the contracts.

However, if an equity option expires 3/4 of a point or more in-the-money, the Options Clearing
Corporation (OCC) will automatically exercise the option for you.

On the last trading day, the customer thought the option would expire worthless, as it was slightly
out-of-the-money. A small rally in the stock pushed it to just over 3/4 of a point in-the-money at
the close. Because he did not close out the option or contact his broker with instructions to not
exercise, the option was automatically exercised and the customer was long 2,000 shares on
Monday morning. Unfortunately, the stock opened down 15 points on bad news and the
customer sold the stock at a $38,000 loss ($30,000 from the 15-point decline and $8,000 for the
cost of the option to acquire the stock!).

This is a perfect example of how large losses can occur if you do not understand the strategies,
risks and mechanics of the options markets, and exactly why your broker will require (or at least
should require) you to fill out an approval form.

Once you are approved, your broker will assign you one of several option approval levels. While
there is no official standard, the following list should serve as a general industry guideline as to
the permissible strategies under each level. Check with your broker for specific details with their
firm.

Option approval levels

There are usually four option approval levels available through most brokerage firms. For
whatever reason, option levels are generally ranked from 0 to 3 although some firms do use 1 to
4. Level 0 is considered to be a basic level and level 3 is the highest. The levels are cumulative
meaning that, for any given level, all strategies below that level are acceptable too. For example,
all strategies allowed under level 0 and level 1 will be allowed in under level 2.

Here is a list of the basic definitions and strategies allowed under each level:
Level 0

Covered calls
Allows you to buy stock and write calls against it.

Long protective puts

Allows you to buy puts but only for a specific stock and in the amounts you hold. For example, if
you have 500 shares of INTC, you could purchase up to 5 put contracts to protect your position.

Note: Some firms will allow index puts to provide overall protection, especially for large accounts,
where buying puts on each position would be cost prohibitive.

Short puts against short stock

Allows the investor to sell puts if the stock is short in the account. Careful, a lot of brokers will tell
you that short puts require level 3 but this is considered to be covered (by the short stock) which
is why it is generally allowed in a level 0. If your broker does not sound sure, have them check
with a manager.

This is generally the only level that will be approved for Individual Retirement Accounts (IRAs),
but there are some firms that will allow level 1 in an IRA.

Level 1

Long calls and puts

Allows the outright purchase of a call or put. Level 0 also allows the purchase of a put too but
only for protective purposes. Level 1 allows you to speculate that a stock or index will fall.

Plus all strategies under level 0

Note: There is a strategy called a "rollup" where you sell one option and buy another. For
example, you may be long 10 $50 strike calls and the stock is now trading at $60. One strategy
is to sell the $50 strike to close and buy the $60 strike to open. You can send these orders as a
spread to the market maker in hopes of a better deal; after all, it is a spread order as you are
buying one option and selling another. But it is not a spread position, because once the order is
executed, you will just be long 10 $60 strikes; there will be no short positions in the account. This
is because one trade was to close and the other to open.

This is a very powerful strategy and one discussed in a later article. Just be careful if you use this
strategy in a level 1 account, that your broker doesn't reject the trade becaues he thinks it's a
level 2 transaction.
Level 2

Spreads
Allows the investor to buy and sell options as a basic spread position with limited risk. So, the
basic bull and bear spreads and long calendar spreads (buy a far month and sell a near month)
will qualify. You cannot have a short calendar spread (buy near month and sell far month) or do
ratio spreads (such as buy 10 $50 strikes and sell 20 $60 strikes) as this would expose you to
potentially unlimited losses.

Plus all strategies under levels 1 and 0

Level 3

Uncovered (also called naked) positions

This is the highest approval level and anything goes -- as long as you have the equity to do
it. Here, the investor can sell a call or put with no corresponding long or short position,
respectively, to cover. Short calendar spreads and ratio spreads are all approved.

All strategies under levels 0, 1 and 2

Note: Many investors like the strategy of naked puts, as it is effectively a way to get paid to buy
stock you like. In order to do this, level 3 is generally required. However, if you do not qualify for
level 3 and have a lot of equity (usually $500,000 or more but entirely up to the brokerage firm)
you may be able to get approved for "cash secured puts." The firm will hold cash to the side
assuming you will be assigned. That way, the firm is protected under the worst possible
circumstances. I just mention this here as many investors attempt approval for level 3 for the sole
purpose of naked puts, and are disappointed if they do not get it. If this happens to you, you may
want to check to see if the brokerage firm will allow cash secured puts.

Getting started
If you are new to options, do not be concerned if your broker does not give you the desired
approval level immediately. Often times they want to see some option trading history before
increasing your approval level. For example, you may want to execute spread orders and need
to be approved for level 2. Your broker may require you to start at level 0 or 1 and then increase
you to a higher level in six months or so with a successful demonstration of option trading at the
given level.

Please understand that option approval levels exist for a reason. If you are not immediately
approved for your desired level, there are plenty of option strategies you can use with the level
you receive.
 "Show Or Fill" Rule
This is a great little tip for all option investors -- especially those who trade smaller numbers of
contracts, say 1 to 5.

It is known as the "Limit Order Display Rule" or sometimes called the "Show or Fill Rule" (the
official name is "Exchange Act Rule 11Ac1-4). It is not a rule that the market makers make very
well known for obvious reasons, as we shall soon see. However, knowing this rule can make a
big difference in your option profits!

Before we look at the rule, we need to understand some basics to the quoting system used for
stocks and options.

Let's say you get a quote on an option as follows:

BID $5 ASK $5-3/4

What exactly does this mean? It means the market makers are "bidding" $5 for the option; this is
the price they are willing to pay. They are "asking" $5 3/4; this is the price where they are willing
to sell. There is often a lot of confusion to these terms but they are really quite simple if you think
of the following analogy. If you sell your house, you are "asking" a certain price, right? If you are
buying a house, you put in a "bid" for it. Bid means buy, ask (sometimes called the offer) means
sell.

The reason for the confusion is this: Retail investors who buy options are used to paying the
"asking" price so they often think the ask price represents the buyers. Similarly, if they sell their
option, they are used to receiving the bid price so they think the bid price represents the sellers.

But think about this. If you are buying the option, you need a seller to take the other side of the
trade. The reason you can buy the option at the ask price is because the market maker, the
person on the other side of the trade, is willing to sell for that price. Now you have a buyer
matched with a seller and the trade can be executed. Likewise, if you sell your option, you can
be matched with the buyer at the bid.

When you get a quote, the bid price represents the highest bidder and the ask price represents
the lowest offer or seller*. This makes sense, as we are not concerned with the person who is
willing to sell that same option for some higher amount, say $10, or the one who is willing to buy it
for a lower amount such as $1.

Trading "in between" the BID-ASK spread

Let's go back to the original quote:

BID $5 ASK $5-3/4

Say you wanted to buy the option and did not want to pay $5-3/4 but were willing to pay $5-
1/2. You could put in a bid (remember, you are buying the option so you would be a bidder)
simply by calling your broker and instructing them to buy at a limit of $5-1/2. Prior to the "show or
fill" rule, the market maker could leave the quote unchanged, letting your high bid of $5-1/2 not be
shown as follows:
BID $5 ASK $5-3/4

Say you wanted to buy the under the "show or fill" rule. The market maker must do one of two
things: either fill your order or show your order as follows:

BID $5-1/2 ASK $5-3/4

You are now posted as the highest bidder, have narrowed the spread, and have given someone
the incentive to sell because of the now higher bid. The markets always benefit from narrow
spreads.

Let's say another trader comes along who does not want to sell at the $5-1/2 bid price, but is
willing to receive $5-5/8. This trader could put in an order to sell their contracts at a limit of $5-
5/8. Assuming the market maker does not fill the trade, the quote now looks like this:

BID $5-1/2 ASK $5-5/8

Again, the spread has been narrowed further and a stronger incentive is now given to the market
to buy since the asking price has just been reduced from $5-3/4 to $5-5/8

KEY POINT: It is an exchange policy (at least for the major ones) to have all quotes good
for at least 20 contracts.

Here's how you can benefit from this knowledge!

Going back to the original quote:

BID $5 ASK $5-3/4

Say you want to buy a small number of contracts such as 3. Now, if you put in a bid of $5-1/2,
the market maker either needs to fill you or show you.

Now, obviously, the market maker does not want to sell you the option at $5-1/2 because he's
asking $5- 3/4. But, if he doesn't fill you, he must show your order and change the quote to:

BID $5-1/2 ASK $5-3/4

Here's the benefit! The market maker is thinking: "If I show the order and post the bid at $5-1/2, I
may have to buy another 17 contracts since my quotes must be good for at least 20
contracts. I'm really only willing to bid $5, so let me fill this order to get it out of the way!"

How can you profit from this? Think of all the times you bought at the ask price or sold at the
bid. Those 1/4 and-1/2 (or much more) point spreads on both sides really start to add
up. Placing trades "in between" the bid and ask can make all the difference on your profits,
especially for smaller numbers of contracts.

* Technically, the BID and ASK represent the best bid and offer at the margin, the point where
price is determined. For example, someone could come in and bid $6 but would be filled at $5-
3/4 because they are outside the margin. The quote would not jump to $6 on the bid even though
they are, technically, the highest bidder. It's a technical point, but for our purposes, you can think
of the BID as the highest bidder and the ASK as the lowest offer.
 Bid-Ask Exercise
If you're still confused with bids and offers, don't feel bad -- the concept throws many new (and
even advanced) investors. Here's a little workshop that coaches you through getting the quotes
posted that should bring you a new level of understanding (or confusion!) to you.

Let's start by assuming I am the market maker for ABC stock. I post bids to buy the stock and
offers to sell the stock. If you wish to buy or sell, you can either put in a "market" order or a "limit"
order. If you're not familiar with market and limit orders, don't worry. We'll cover those in detail in
the next course. All you need to know for now is that market orders are guaranteed to execute,
which means you will likely buy at the asking price or sell at the bid price. If you want to try for a
better price, you can enter a limit order. With a limit order, you specify the price but your order will
not execute unless you can be filled for that price (or a more favorable price).

The Day Begins

The market has just opened and I have no customer orders on the books. Let's assume that I'm
willing to buy up to 500 shares at $30 and I'm willing to sell up to 500 shares for $30.50. Notice
how the price I'm willing to pay is less than the price I'm trying to sell them for. This is analogous
to a car dealer who buys used cars at wholesale and then sells them at retail, keeping the
difference as profit.

I therefore start the day by entering quotes into my system, posting a bid of $30 and an asking
price of $30.50.

I log online and get a quote for ABC stock. My screen looks like this:

ABC STOCK
BID $30 ASK $30.50
SIZE 500 x 500

The "size" field shows the number of shares available at the bid and ask prices respectively. This
would be read as "500 by 500" and means that 500 shares are on the bid and 500 on the ask.
Most quote systems give this information but, if not, your broker will certainly have it.

Now let's see what happens as orders come to me from retail customers. We'll show how they
affect my books as well as the quotes I get online. Let's start by assuming you have some shares
you'd like to sell.

Order #1
You have 200 shares but you do not want to sell at my bid price of $30. You decide to put in a sell
limit order at $30.40, which is in between the bid and ask prices.

At this point, I see your order and realize that it is more competitive than my offer (you are willing
to sell for less than $30.50). So I must do one of two things: Either fill it at $30.40 (or higher) or
display it so that other investors may see it.
Key Point
Any time a limit order is placed in between the bid and ask, that limit order is a more competitive
price. That's because, by definition, it must be a price that is higher than the bid and lower than
the ask, which are both more favorable to the market.

Let's assume I decide to not fill the order.

The quote you're watching will change to reflect the lower asking price. The quote you get from
your broker or online is called the "inside quote" and reflects the best bid and offer. Your screen
now changes to this:

ABC STOCK
BID $30 ASK $30.40
SIZE 500 x 200

Notice how the asking price is reduced from $30.50 to $30.40 (that's your order) as well as the
size. Your order is only good for 200 shares so the size of the offer falls from 500 to 200.

Any time an order is placed "in between" the bid and ask without it being filled, it will result in a
changing of the quote!

Because I am the market maker, I must keep track of all quotes even though I only show the best
bid and offer. My computer software will show this:

ABC STOCK
BIDS 500 $30.50
500 $30 200 $30.40
OFFERS

Basically all that happens is that the bids or offers that are "away" from the market get shifted.
When we say "away" from the market, we mean that they are not as favorable a price. In this
case, my offer of $30.50 (shown in red) is shifted higher and your order takes its place.

Notice too how your quote system online only shows the one row of my book (in blue). That is all
you will ever see even though there are many quotes above and below that. Once again, this is
because the market is really only concerned with the highest bid and lowest offer (the inside
quote).

Let's run through a few more examples so we can get some orders on the books. Then we'll look
at how to fill orders based on the book.

Order #2
Another investor comes along and enters an order to buy ABC stock. They think it will fall a bit
first and place a limit order to buy 400 shares at $29.

Once again, I get this order and notice that it is not as competitive as my bid of $30 so will just
move that order out in the "wings" to be filled at hopefully a later time. In other words, because
this new order is not in between the bid and ask, it is therefore less competitive and just gets
pushed aside for now. My system now looks like this:
 ABC STOCK
BIDS 500 $30.50
500 $30 200 $30.40
400 $29 OFFERS

The lower bids (worse for the market) get moved lower and the higher offers (worse for the
market) get moved higher. Remember, the market is only concerned with the highest bid and the
lowest offer. All others get "swept aside" for the meantime. This practice always keeps the best
bid and offer in the middle of my screen.

Order #3
A new order comes in to buy 100 shares at $28.50. This buyer is the weakest of all bidders (the
lowest), so it gets moved to the very bottom. My system now looks like this:

ABC STOCK
BIDS 500 $30.50
500 $30 200 $30.40
400 $29
OFFERS
100 $28.50

Notice how the "buy" orders are always placed under the "bid" column and the "sell" orders are
always under the "offers." This is in line with what we said earlier: The bid price represents buyers
and the offer price (asking price) represents the sellers.

Order #4
Hopefully you're getting the idea of how this works so let's go ahead with several orders and
assume the following orders are received:

• Sell 300 shares at $30.75

• Sell 150 shares at $30.45
• Buy 250 shares at $29.50

The first order to sell 300 shares at $30.75 is the highest of all current offers, so they go to the
very back of the line:

ABC STOCK
300 $30.75
BIDS
500 $30.50
500 $30 200 $30.40
400 $29
OFFERS
100 $28.50

The next order is to sell 150 shares at $30.45. They are higher than the best offer of $30.40 but
are not the worst one either. They get wedged between the offers of $30.40 and $30.50 as shown
below. The same idea applies to the last order to buy 250 at $29.50. They get wedged between
the orders to buy 400 at $29 and 500 at $30:
 ABC STOCK
300 $30.75
BIDS 500 $30.50
150 $30.45
500 $30 200 $30.40
250 $29.50
400 $29 OFFERS
100 $28.50

This process continues with all bids and offers are placed in descending order. If an order comes
in that is the most competitive bid or offer, it will be placed at the very front of the line. Otherwise,
the order takes its appropriate place in line.

Let's do one more like that to be sure you understand.

Order #5
An order comes in to buy 100 shares at $30.20, which is in between the current quote of $30 to
$30.40. Therefore, the order jumps to the front of the line as shown. In other words, because it is
are now the highest bid, it moves to the front of the line. The only way to get moved to the front of
the line, whether buying or selling, is to place a limit order in between the bid and ask. My
computer screen now looks like this:

ABC STOCK
300 $30.75
BIDS 500 $30.50
150 $30.45
100 $30.20 200 $30.40
500 $30
250 $29.50
OFFERS
400 $29
100 $28.50

Filling Orders
Now let's look at some orders that actually get filled. The reason that none of the orders got filled
in the first examples is because none of the buyers accepted the offer price (called "taking the
offer" in trader's jargon) or sold at the bid (called "hitting the bid"). All orders were either "in
between" the bid and ask or away from the market. Now we're going to focus on what happens
when orders actually get filled.

Order #1
An order comes in to buy 200 shares "at market."

Because those investors listed in the "offers" column are sellers, I know I can match this buy
order with the person there and fill the order. The trade "200 at $30.40" is removed from my
books and all the offers are now shifted down. The best offer is now $30.45:
 ABC STOCK
300 $30.75
BIDS 500 $30.50
100 $30.20 150 $30.45
500 $30
250 $29.50
OFFERS
400 $29
100 $28.50

Of course, your screen will reflect this change as well. You will now see:

ABC STOCK
BID $30.20 ASK $30.45
SIZE 100 x 150

The buyer receives a confirmation from his broker that he bought 200 shares at $30.40, and the
seller receives a confirmation of the sale under the same terms.

Order #2
An order comes in to buy 350 shares at market. Market orders must be filled, so I look at my
books and will have to split some orders. I will give the person 150 shares at $30.45 and 200
shares from the order above it at $30.50 as shown by the arrows:

ABC STOCK
300 $30.75
$30.50
BIDS 500 Only 200 shares get
filled from here
$30.45
100 $30.20 150 We'll use all 150 of
these
500 $30
250 $29.50
400 $29 OFFERS
100 $28.50
After that order is filled, my screen looks like this:

ABC STOCK
300 $30.75
BIDS
100 $30.20 300 $30.50
500 $30
250 $29.50
OFFERS
400 $29
100 $28.50

The person who had the order to sell 500 shares at $30.50 will receive a confirmation from his
broker that 200 shares were sold at $30.50, and he will still have an open order to sell the
remaining 300 at $30.50.

The investor who placed the order to buy 350 shares at market will also receive partial fills. Their
broker will inform them that they bought 150 shares at $30.45 and 200 shares at $30.50. This
explains why it is not uncommon to see "partial fills" on your account!

Your screen now reflects the new inside quote and size:

ABC STOCK
BID $30.20 ASK $30.50
SIZE 100 x 300

Order #3
See if you can handle this next order. An order comes in to sell 700 shares at market. How would
you fill it? Look at the chart below and see if you can figure it out then continue reading to see if
you have the correct answer.

ABC STOCK
300 $30.75
BIDS
100 $30.20 300 $30.50
500 $30
250 $29.50
400 $29 OFFERS
100 $28.50

The market order must be filled so we find some buyers (bidders) to match up to this seller.
Specifically, we need 700 shares. We look in the bid column and will fill:

• 100 shares at $30.20

• 500 shares at $30
• 100 shares at $29.50
Now, in reality, the market maker will usually step in and provide some liquidity. For instance, I
could decide to fill 100 shares at $30.20 and 600 shares at $30, thus giving up 100 shares from
my own account. It is not required, but is usually done to provide more liquid markets. For now,
let's assume that the order is filled as we originally stated in the bullet points above. My books
now look like this:

And your quotes will now show:

ABC STOCK
300 $30.75
BIDS
150 $29.50 300 $30.50
400 $29
OFFERS
100 $28.50

ABC STOCK
BID $29.50 ASK $30.50
SIZE 150 x 300

Notice how the spread -- the difference between the bid and ask -- has widened to $1. At the very
beginning of this exercise, the quote was $30 to $30.50, which is only a half-point spread. The
spreads will generally widen if the market maker only fills orders based on the book like we've
been doing in these examples. This is why market makers usually step in and provide some
liquidity to keep an orderly market. If they didn't, the spreads would just keep getting wider and
wider as orders are filled.

Hopefully this exercise sheds some light on what happens with the bids and offers and how the
orders are handled. More importantly, you just need to be aware that when your broker quotes
you a bid price, that is the price of the highest buyer and, consequently, the price where you can
currently sell. Likewise, if you get a quote on the ask, that is the price of the lowest selling price
and, consequently, the price where you can currently buy.
 Whiplash Orders
When you place an option order, there are many types of orders and contingencies from which to
choose. For example, there are market orders and limit orders, day and good-til-canceled, all-or-
none and many others. Most traders are very familiar with these and they can greatly help your
trading skills by making use of each of them under various conditions.

However, there is one type of order that is rarely talked about, in fact, it is even unknown by most
brokers. It is called a whiplash order. It can be one of the most valuable option trading tools
available to you.

A refresher on limit orders

Before we get into the whiplash order, it is important to understand the basic limit order.

A limit order is when you specify the price at which you are willing to buy or sell. For example,
you can tell your broker to buy 10 contracts at a limit of $3. This means the order cannot be filled
unless it is for $3 (or less). The drawback is that the order may never fill. Likewise, you can
place an order to sell your contracts at a limit of $15; now your order will not fill unless you get
$15 (or higher). Limit orders guarantee the price but not the execution.

One reason that options are so difficult to trade with limit prices is because the option is tied to an
underlying stock. Many traders, especially with index options, like to sell their options when the
stock or index hits a certain level. For example, say the OEX is trading at 725 and you hold 10
OEX Dec $730 calls. You want to sell them when the index hits 735. The question now is how
much will the calls be worth?

Many traders often refer to the Black-Scholes Option Pricing Model to figure out what the limit
price should be. The problem with this is that we do not know when the index will hit that level. If
it happens quickly, the option will be worth much more than if happens over the course of a
month. Further, we do not know what the implied volatility level will be. In short, we have no way
to determine a good estimate.

So, what can a trader do?

Whiplash order
This is where the whiplash order comes in handy. The trader in the above example could tell his
broker to sell 10 $730 OEX calls When Level of Stock Hits 735, or WLSH = 735. The letters
WLSH resemble a shortened version of the word "whiplash," hence the name. By the way, most
brokerage firms will require whiplash orders to be at least 10 contracts.

Now, when the index hits 735, this order will become a market order and be sold. Keep in mind,
this order does not guarantee a profit. Why? Say the trader paid $20 for the contract and the
index hits $735 with only a few days to expiration; the call may only be $5 leaving the trader with
a net loss of $15.

The WLSH order can be modified with a greater than (>) or less than (<) sign too. For example, a
trader can instruct his broker to sell the contracts WLSH > 735 (or WLSH >= 735) or buy WLSH <
715.
You can get fancy and cross stocks or indices if you prefer. As some examples, you can sell your
OEX calls when NDX hits a certain level. Likewise, you can sell your MSFT calls when the NDX
hits a certain level or maybe buy INTC when MSFT goes below a certain level.

Crossing indices (or stocks) is probably not the best way to trade, but there may be certain
circumstances where it may be warranted.

You should contact your broker to see if they handle whiplash orders or similar orders under a
different name. They can be an invaluable tool for the option investor!
 Buy-Writes And Sell-Writes
A buy-write (also called a covered-write) is simply a covered call -- long stock plus a short call
(please see our section during week 6 on covered calls for more details).

The difference in the buy-write is in the way the order is handled.

Most investors who enter covered call positions buy the stock first, then sell the call at a later
time. The problem with delaying the sale of the calls -- even if it's only a matter of seconds -- is
that you will be exposed to market movement and downside risk in the interim.

Example:
Say a stock is trading for $100 and a $100 call is trading for $5.

An investor wants to enter into a covered call position. They feel that effectively paying $95 for
the stock and selling it for $100 over the next month will be adequate potential profit relative to
the risk they are taking. So they put in a market order to buy the stock, but get filled at $101
because heavy trading caused the stock to move up. Then they immediately put in the order to
sell the call. The stock starts to fall and they sell the call for $4-1/2.

The five-point profit they were seeking has now been reduced to $3-1/2. They bought stock for
$101 and sold the call for $4-1/2 effectively paying $96-1/2 for the stock instead of the desired
$95 at the outset.

This is very common for people who enter covered calls in this manner. This is sometimes called
"legging in" to a covered call because each of the "legs" -- the long stock and the short call -- is
entered as a separate order.

To prevent this risk, known as execution risk, the above investor could have entered a buy-
write. There are two ways to enter a buy-write order: (1) As a market order (2) As a limit order

If the investor enters the buy-write "at market," this means the entire order -- both the long stock
and short call -- must get filled simultaneously and the investor is willing to take the prevailing
prices at the time their order arrives to the floor or market makers. In the above example, had the
investor entered a buy-write, they may have paid $101 for the stock but also may have received
$5-1/2 for the call for a net debit of $4-1/2. This is still not the $5 point profit they were expecting,
but certainly better than the $3-1/2 they got.

If the investor enters a buy-write as a "limit order," they will specify the price they want to
pay. The risk here is that the order does not get filled. However, if it does, you know the price will
be at your limit or lower.

Example:
Say we see the following quotes:

Bid Ask
XYZ Stock $95-3/4 $100
XYS Mar $100 Call option $5 $5-1/2
If the investor were able to get filled at the current prices, this buy-write would fill for a net debit of
$95. This is because the investor can currently buy the stock for $100 (the ask) and sell the call
option for $5 (the bid). This is also called "the natural" quote because a debit of $95 is where the
buy-write would be filled naturally if the trade could be executed immediately.

The investor may tell their broker, "I'd like to place the following buy-write: Buy 500 XYZ and sell
the Mar $100 calls for a net debit of $95." Now, the only way the trade can get filled is if the buy-
write is filled at this price or lower.

Remember, this is the net debit the investor is willing to pay so the order could come back filled
as:

Stock purchased for - $101

Call sold for + $6
For net debit of $95

(or any other number of combinations of stock and option prices as long as the net debit does not
exceed $95).

If you enter a limit order on a buy-write, it must always be entered as a net debit for the fact that
the price of the call can never exceed the price of the stock. (Please see our section on "Basic
Option Pricing" during week 5 for more information.)

Placing a buy-write with the market maker is similar to trading in a car. If your car is worth
$10,000 and you are trading it in on a $25,000 car, you may tell the dealer, "I want to buy that
one and sell this one for a net cost of $15,000."

Now, it should make no difference to you if they charge you $26,000 for the new car as long as
they give you $11,000 for your trade. Or, the dealer may only want to give you $9,000 for your
trade, but then must be willing to sell you the new car for $24,000. You are doing the same thing
with the market maker on a buy-write limit order; you are specifying the net difference you are
willing to pay for buying the stock and selling the call.

Of course, you may decide to try for a little better deal. Using the above quotes again, you may
see the "natural" is $95, but tell your broker to place the order for a net debit of $94-3/4.

Regardless, any time you put in a limit order, you may not get filled. So you need to decide which
is more important -- getting filled or getting the price you want. You can only guarantee the
execution or the price, not both.

By the way, if you do enter into a buy-write, you can close it out anytime with a simultaneous
order too. You can tell your broker to sell the stock and buy back the call which is called an
unwind. Unwinds will always be executed for net credits.

Sell-write
Many investors do not know this, but there is a trade opposite the buy-write, which is known as a
sell-write. To enter a sell-write, the investor simultaneously shorts the stock (sells it) and then
writes the put. The resulting position is a covered put; the sell-write is just a method of executing
the two trades together to avoid execution risk.

Now, if the stock falls, which is what the investor is betting on, he may be assigned on the short
put and be forced to buy the stock. But this is what the trader desires, as he can profitably cover
the short stock position through the assignment of the put. As with the buy-write, the short option
position is considered "covered" because the risk of the short put -- the downside -- is covered by
the short stock. This does not mean this strategy is risk-free; the trader has unlimited liability to
the upside. The short put just provides a little upside hedge.

Example:
A trader is bearish on XYZ trading at $100. He decides to place a sell-write. What is the
"natural" based on the following quotes?

Bid Ask
XYZ Stock $95-3/4 $100
XYS Mar $95 put option $5 $5-1/2

The natural is $100-3/4 because the trader can currently sell the stock for $95-3/4 and sell the put
for $5 for a total credit of $100 3/4. Notice what the sell-write accomplishes. The trader now has
a higher net credit, which is what you want when you are short-selling. If the trader were just
shorting the stock, he or she would only receive $95-3/4 but instead, with the sell-write, receives
$100-3/4. Remember, when short-selling, you sell high and buy low. The sell-write gives you a
higher credit.

Because of this higher credit, the sell-write provides a little upside hedge for the trader. If the
trader is wrong about the direction of the stock, he or she can afford for the stock to now move up
$5 -- the premium received for the put -- to a level of $100-3/4 before heading into losses. The
trader who only shorts the stock will be exposed to losses for any price above $95-3/4.

What if the stock falls? If the stock falls far enough, the sell-write trader may be forced to buy the
stock at $95 due to the short $95 put. But, as the trader sees it, that's okay because he or she
was going to have to buy it to cover the short stock position anyway.

The trade-off with this strategy is this: Say the stock crashes to a price of $50. The short seller
would gain the full profit of $45-3/4 (shorts the stock at $95-3/4 and buys it back for $50). The
sell-write trader, even though the stock is trading at $50 will be required to pay $95. The
maximum the covered put writer could ever make, in this example, is $100-3/4 - 95 = $5-3/4.

Again, it's all about risk and reward. Neither strategy is superior to the other.

There is another important point to consider with the sell-write. In the above example, we said
the trader might have to pay $95 with the stock at $50, right? Remember, it is the long put
position that decides whether or not to exercise it. So, while you may be ready to close out the
sell-write, even though you must pay $95 with the stock trading at $50, you do not have the
choice! It is up to the person who is long the put. In these cases, it is sometimes best to
simultaneously buy back the put and buy the stock, or unwind the position, even though it will
result in less profit.

I have seen it happen where investors enter a sell-write, watch the stock plummet, and then wait
to get assigned on the stock yet never do. In the meantime, the stock runs back up, sometimes
into losses, and they never get to profitably close out the trade.

Buy-writes and sell-writes are nice strategies to understand because they allow you to get more
favorable pricing from the market makers. After all, you are presenting them with two trades
rather than one so you can definitely give yourself an edge. In addition, you are aiding the market
makers in their "three-sided positions" (please see our section during week 11 on synthetics), so
they are eager to work with multiple orders.

If you like covered calls, you should take the time to explore buy-writes! The 1/4 and -1/2-point
differences (or more) can make a huge difference at the end of a trading year.
 Early exercise with options
Call options allow the buyer to purchase stock at a specified price over a specified
time. However, there are two types of call options, one known as American style and the other
known as European style.

An American style option allows the buyer to exercise early while the European counterpart
requires the buyer to wait until option expiration before purchasing stock with the call option. The
question now is this: Is it ever advantageous to exercise an American style call option early; that
is, prior to expiration?

The answer will be very obvious to you once we go through some analogies, but surprisingly, this
is one of the most common sources of option errors.

If you trade options, be sure you understand this section, as it will keep you from making one of
the costliest mistakes in option trading.

Exercising early
Let's start with the answer and then we will show why it is true:

It is never optimal to exercise a call option early except to capture

a dividend.
There are many ways to show this is true. Unfortunately, most of the methods involve fairly
complicated methods comparing two different portfolios of stocks and options,then comparing
them after early exercise to see if one portfolio has an advantage over the other. I don't
particularly like these methods as proofs for most investors, as they can get complicated, but we
will show you one of these methods at the end anyway. For now, let's show why you should
never exercise a call option early (except to capture a dividend) by using a simple story.

Say your broker calls you one day with a hot deal. He has 1,000 shares of ABC stock that he
must get rid of. The stock has moved up sharply over the past couple of weeks, from $30 to the
current price of $75. He tells you, "This is the hottest stock on the market and is certain to move
higher. If you buy it now, I will not charge you a commission."

You think it doesn't sound like such a bad deal. You have been hearing about the company in
the news lately and were thinking of buying shares anyway. You tell your broker, "I do not like to
make these kinds of decisions in such a short time. I'd really like to research the stock to see
exactly what this company does."

Because you have been a customer of the brokerage firm for so long, the broker makes you this
final offer. "I will give you 10 days to research the stock and, if you decide that you want to buy it,
I will reserve the shares for you at the current price of $75. If, after 10 days, you decide you do
not want them, just let me know and I will not charge you anything."

On your first day of research, you come to the conclusion that this company will be bigger than
Microsoft and Intel combined. You will be wealthy beyond your wildest dreams if you could just
purchase this stock. You must have the shares!
Now, here's the question: Do you call your broker after the first day and buy the
shares? Remember that he has given you 10 days to make up your mind and will reserve the
$75 price for you.

Hopefully you realize the answer -- you wait until the tenth day. Why? There are two
reasons. One, because the brokerage firm is holding the stock and they are the ones at risk! If
the stock falls, you will just tell your broker you don't want the shares at $75, as you will just
purchase them in the market yourself.

Second, as with any payment, you should prefer to pay as late as possible so that you can earn
interest on your money in the meantime. Your purchase price will be $75,000 regardless of
whether you buy today or on the tenth day. The answer is clear; you wait as long as possible and
call your broker on the tenth day to purchase the stock.

This example may seem blatantly obvious -- almost absurd -- as to the correct answer. But don't
laugh; many advanced option traders make this mistake every single day. The situation we just
described above is a call option and many traders, mistakenly, elect to call the shares away early.

How is it a call option? Think about what your rights are with a call. You have the right, but not
the obligation, to purchase stock for a fixed price over a specified time frame. In the example
above, you had the right with no obligation to purchase the shares for $75 for a period of ten
days. The reason the example seemed absurd is because you were not required to pay any fees
for the privilege of locking in the $75 price.

In fact, if your broker required you to pay a fee, you would exactly have a call option (technically it
would be called a forward agreement since the "call option" was not purchased as a standardized
contract).

Insights Into Option Pricing

If your broker did decide to take a fee for the arrangement, is there a price where he must
accept? Yes, and that price is $75. At $75, you have effectively removed all risk to the
brokerage firm so they would have no reason to not accept this bid. In fact, if you read our
section on "Option Pricing Basics" during week 5, you will see that the highest price a call can
trade is the price of the stock and now you know why. This is also why buy-writes (buying stock
and selling calls simultaneously) must be entered as a net debit because the price of the option
can never exceed the price of the stock.

Why traders feel they must exercise early

Traders who exercise early make the mistake of not realizing exactly what is happening in a call
option agreement. Often, this is how they view the situation. Say the trader purchases a $100
call option for $15. The stock is now $130 with over a month left of time. The option is trading for
$32. Here is the mistake: The trader often feels he does not want to "lose" the value of the call
option. So, before the market gets the best of him, he decides to exercise it and walk away the
winner. Wrong! Remember that the trader is locked into the price of $100. The stock can be
trading for $200 and have split twice by expiration, and the stock price is still $100 to the owner of
the call option. If he exercises early, however, the stock could completely collapse and he would
have been better off not exercising. Also, by not exercising early, the $100 stays in the money
market longer to earn more interest.
So what should you do if you feel your option is really high in value and you want to get out
before it falls? Sell the call to close. Why? In this example, the trader exercised early and
received stock worth $130, but paid only $100 for a gain of $30. After subtracting the cost of the
call, $15, his net gain is $15. But if he sold the call to close in the market, he would receive $32
for a net gain of $17 after subtracting out the $15 cost. In other words, if you exercise your call
option, you will only receive the stock in exchange for the strike price; you receive only the
intrinsic amount. If you sell the call to close, you will collect the intrinsic amount plus the time
premium. You will always be better off selling the call to close if you do not want to
continue holding the call option.

The last thing you want to hold is the stock; that is the reason you buy the call option in the first
place!

Trading Example
One day a trader called in complaining after viewing his balances on the computer that
morning. His net worth on the account was $120,000. It was $124,000 the day before yet all of
his stocks were trading about the same price or a little higher.

After searching through the transactions, it was discovered that he exercised 10 calls the day
before. The option was 20 points in-the-money but the call was selling for $24 the previous
day. When he exercised, the four points of time premium were wasted and that's what happened
to his $4,000! If he had sold the contracts to close the previous day, his balance would still have
been $124,000.

Remember, when you exercise a call, you only receive the difference between the stock price
and the exercise price; if you sell the call to close, you receive that same amount plus some time
premium.

Still not convinced?

If you are still not sure whether or not that you should exercise a call option early, think about this
scenario. Say a trader has a covered call position and bought stock at $100 per share and sold a
1-year $100 call for $25. Now, if they get assigned, they will lose the stock but make a 33% profit
(effectively buying the stock for $75 and selling it for $100 a year later). An investor who enters
this trade considers the 33% profit a good deal, based on the risk of the stock, for one year's
time.

Now, think about this, what is the best thing that could happen to this trader? The best thing
would be for him to check his account the next day and see the stock called away. Now he has
received 33% in a day instead of a year, which is a much better return (too big to print!). Well, if
it's a better deal for the short call position to be called early, it must be an equally bad deal for the
long call. This is because options are a zero-sum game; that is, the one trader's gains are
exactly the other trader's losses.

Because the long call has control, that investor will do what is best for him -- he will wait until the
very end of the year to exercise the call and receive the stock.

Mathematical models
It was mentioned at the beginning that we would look at a mathematical model in addition to the
simplistic proofs covered so far. Here, we will look at one of many mathematical proofs that show
it is never optimal to exercise a call option early on a non-dividend paying stock.

Consider two portfolios, A and B.

Portfolio A: Present value of exercise price in cash + call option

Portfolio B: Stock

At expiration, the cash will grow to be worth E, the exercise price. Portfolio A will use this cash to
secure the exercise price. If the stock is above the strike price and Portfolio A exercises the call,
the investor will receive the value of the stock price minus the exercise price (S - E) plus E from
the cash which can be written: S - E + E = S. So, if Portfolio A exercises at expiration, Portfolio A
is worth the stock price -- exactly as Portfolio B, which contains only the stock.

However, if the stock price falls below the exercise price, E, at expiration, then Portfolio A will lose
the value of the call and only be worth E, the cash. Portfolio B will be worth less than Portfolio A
because the stock price is below the exercise price.

So, Portfolio A is always worth at least as much as Portfolio B.

But if Portfolio A exercises early, the portfolio is worth S minus E (from the exercise) minus the
present value of E, which must be less than S. Why? Because you are subtracting off E and
then adding back a number a little smaller than E (because it's the present value). Now, this is
the only time Portfolio B can dominate Portfolio A, so A should not exercise early.

I told you I don't like these proofs and now you probably see why!

If you read our section on synthetics during week 11, you will recognize that Portfolio A is really a
synthetic call option. By exercising early, Portfolio A gives up the protective value of the put. So
no matter which method you use, it is never optimal to exercise a call option on a non-dividend
paying stock early.

Capturing a dividend
We have been saying to never exercise a call option early except to capture a dividend. Why
would an investor want to do that? There are a couple of reasons. One, the stock may have
announced a huge, special dividend. As a call option owner, you are not entitled to anything
other than the price appreciation in the stock above the strike price. If the dividend is large
enough, you may find it beneficial to exercise the call early in order to be the owner of the actual
stock and therefore be entitled to the dividend. In this case, the investor should wait as long as
possible and exercise the call the day before ex-dividend date.

The second reason that investors will exercise the call option early is to reduce a loss due to a
dividend. Say a stock is trading at $100 and will pay a $1 dollar dividend tomorrow. A trader
bought a $95 call a while back for $10, and it is now trading for $5 plus a little time premium. The
option will expire in a relatively short time.

However, the stock will be trading for $99 tomorrow morning ex-dividend (the price of the stock is
reduced to reflect the dividend payment from the company). What will happen to the call? It will
trade for $4 because the stock is down $1, so the trader may elect to exercise the call early to
reduce the loss.
So exercising early to capture a known dividend is really a loss reduction strategy as opposed to
a profit-seeking one.

One exception for margin traders

Here is a great tip you will not see in any books or hear from brokers. Say you trade on margin
(borrowed funds) and are holding a very deep-in-the-money call, maybe a $30 call with the stock
trading for $100. Assume there is some time left on the option; it could be a few days or even
months.

If you exercise early, you will meet the Fed call for the stock just by exercising! This is because
the call is so deep-in-the-money. Because you are receiving stock so highly valued relative to the
strike, your margin cash available and buying power will explode to the upside. So if you are in a
situation where you need to generate cash available or buying power to take advantage of a
certain stock, or perhaps to meet a margin call, exercising early may be your answer!

The reason you never see this in the textbooks is because, by itself, exercising early gains you
nothing in the asset. It is only due to other market mechanics of margin trading where it may
benefit you. So, keep that in the back of your mind if you ever are lucky enough to have a call
option go very deep-in-the-money and need to trade on margin. You should definitely check with
your broker for specific details.

Early exercise with puts

Early exercise with puts, unlike calls, may be advantageous to the long position. This is because
put options represent a cash inflow to your account. If the put option is very deep-in-the-money
(technically where delta is equal to one), the put should be exercised. As an example, assume
you are holding a $100 put option with 3 months of time remaining. The stock is trading at $40
and you see no hopes of it coming back above $100 by expiration. If you wait until expiration,
you will receive $100 for your stock. If you exercise now, you will receive $100 for your
stock. Which do you prefer? As with any cash inflow, we prefer to have it paid earlier as
opposed to later, so we exercise the put and take our $100 now.

Although options can be used as a tool to buy or sell stock, most option contracts, somewhere in
the neighborhood of 98%, never become exercised. This is because most option traders use
them as a hedge. For example if an option trader has 100 shares of stock at $50 and also has a
$50 put. The stock closes at $40. Rather than using the put to sell the stock, the option trader
will close out the put for a $10 gain and use that to offset the $10 loss in the long
position. Because of this fact, most option traders are not very familiar with exercising
options. Make sure you become very aware with when and why to exercise. Not understanding
can be costly.
 No Options For Me!
(Think twice -- you may already be using them)
Speculation still seems to be a forbidden word with the financial press. Magazines, television
shows and many professionals alike will tell you that speculation is bad for the market and is the
cause of the recent volatility.

There are so many investors who adamantly believe this and refuse to buy or sell options; they
insist on holding only stocks. But if you refuse to use options, you are
speculating. How? Options were created as hedging tools. Whenever you hedge, you give up
some upside profits in exchange for some downside protection (the opposite if you are short the
stock). So if you buy stock and refuse to buy or sell options, you are speculating that nothing will
go wrong with your long stock position. You are willing to hold out for more profit at the expense
of downside exposure to a price of zero. In fact, it can be argued that investors who don't use
options are among the most speculative of all!

If you're still in doubt, would you believe that stock can be viewed as an option?

Valuing corporate securities as options

When Black and Scholes developed their famous option-pricing model, they were certain there
were many uses for it other than just valuing call options. One of the uses they suggested was in
valuing corporate securities.

Consider a firm that has issued one zero-coupon bond that matures to a value of $1,000,000 in
five years. With this money, the firm produces things and hopes to have a value in excess of this
$1,000,000 in five years, and pays off their debt, leaving the stockholders with whatever remains
in value. However, if the firm's value is less than $1,000,000 at maturity of the bond, the
stockholders will simply turn over the assets to the bondholders and will be free of further liability.

Let's look at the payoffs for stockholders and bondholders at maturity:

If value of the firm is less than $1,000,000, say, $800,000:

Bondholders get: $800,000
Stockholders get: $0
Total value of firm = $800,000

If the value of the firm is greater than $1,000,000, say $1,500,000 at maturity:
Bondholders get: $1,000,000
Stockholders get: $500,000
Total value of firm is $1,500,000

We see with the above payoffs that the total value of the firm is partitioned between the
stockholders and bondholders. Notice how the stockholders get nothing at expiration if the value
of the firm is below the value of the matured debt. But if the value of the firm is greater than the
matured debt, stockholders receive the excess value.

Now compare this to options.

You own a $100 call option that someone has written as a covered position:

At expiration, if the value of the stock is less than $100, say $80:
Call writers get: $80
Call owners get: $0
Total value of firm is $80

In other words, if the value of the stock is below the strike at expiration, the covered call writer is
left with the stock at its current value of $80. The long call position receives nothing.

If the value of the stock is greater than $100, say $150 at expiration:
Call writers get: $100
Call owners get: $50
Total value of firm is $150

If the value of the stock is above the strike at expiration, the covered call writer will be assigned
and receive the $100 strike price. The call owners will receive the stock and pay the strike for a
value of the stock price minus the strike price. The stockholders, in this case, receive what's left
over after the bondholders are paid.

If you look closely, you will see that the payoff for the call option above exactly resembles the
payoffs to the stockholders for the corporation discussed earlier.

Using the Black-Scholes Model

If you read our section on synthetics, you may recall the put-call parity formula:

Stock + Put - Call = Present value of the exercise price

We can rewrite this for the above corporation as:

Stock + Put - Call = Present value of the debt

This can be rewritten at maturity as:

Stock - Call = Value of debt - Put

So the Black-Scholes Option Pricing Model tells us that the value of the covered call position (left
side of equation) in our hypothetical firm is equal to the debt at maturity with a put written against
it (right side of equation).

This means the bondholders have, in essence, written a put against the firm. How? In other
words, if the value of the firm is less than the debt that is due at maturity, you "put" the firm back
to the bondholders and walk away losing only what you paid for the stock -- just as when you buy
a call option.

The value of this put is part of what gives your stock its value!

If you like owning stocks for this reason, you should consider using options in some
fashion. Options allow you to do exactly what you're doing with stock -- but for a lot less
money. They can also be used to create downside hedges in exchange for upside
profits. Because of these uses, you can create better risk-reward profiles that are simply not
possible with stock alone.

There are many fascinating insights that can be learned from the Black-Scholes model. Once
you have a better understanding of options, you will start to see that stockholders are option
players in disguise and the Black-Scholes Model can be used to value corporate securities too. If
you acknowledge this, you may start to open your eyes to the world of options, and create new
trading opportunities that you never thought possible.
 Option Exam 1 - Week 1
1) Which of the following is a covered call position?

a) Buy stock and sell a call

b) Buy call and buy a put
c) Buy calls and sell stock
d) Buy stock and buy puts

2) An investor is long stock at $100 and short the $100 call. Later the stock is trading for $110
and the investor buys the $100 call to close and simultaneously sells to open the $115 call. This
investor has executed a(n):

a) Rolldown
b) Rollup
c) Unwind
d) Sell-write

3) An investor buys stock for $50 and writes a $55 call for $2. What is the cost basis for the
stock?

a) $52
b) $55
c) $48
d) $57

4) What is the risk of a covered call position?

a) The stock rises and you are forced to sell it

b) The stock sits still
c) There is no risk
d) The stock falls

5) An investor wishes to buy stock currently trading for $100 and write the $100 calls currently
trading for $7. In order to not face execution risk, the investor can enter a(n):

a) Buy-write
b) Sell-write
c) Unwind
d) Rollup

6) Which of the following styles of options can exercise early?

 a) Asian
b) American
c) European
d) Australian

7) You purchased a $50 call and the stock is now trading at $65. You are a little nervous that the
stock may fall, so you want to secure some profits. You should:

a) Sell the call to close

b) Exercise early

8) The quote on an option is currently bid $7 and asking $7-1/2. If you place a limit order to buy 1
contract at $7-1/4, what will the new quote be (assuming the order is not filled)?

a) Bid $7, asking $7-1/4

b) Bid $7-1/4, asking $7
c) Bid $7-1/4, asking $7-1/2
d) Bid $7, asking $7-1/2

9) The quote on an option is bid $10 and asking $10-1/2. If you place a limit order to sell 1
contract at $10-1/4, what will the new quote be (assuming the order is not filled)?

a) Bid $10-1/2, asking $10-1/4

b) Bid $10, asking $10-1/2
c) Bid $10-1/4, asking $10-1/2
d) Bid $10, asking $10-1/4

10) You just placed an order to sell naked puts, but your brokerage firm rejected it. You have
plenty of cash in the account. What is a possible problem?

a) You do not have the proper option approval level

b) It is not possible to sell naked puts
c) Naked puts can only be sold against short stock
d) You must sell the puts on an uptick
Measuring The Leverage Of Options
You have probably heard that one of the biggest advantages of trading options is leverage. By
leverage we mean that for a given percentage change in the stock, the option will increase by a
larger percentage, thus leveraging, or magnifying, the return on investment.

For example, say a stock is trading for $100 and a $100 call is trading for $5. If the stock closes
at $115 at expiration, a 15% move, the option will be worth $15, a 200% move.
One way to view this leverage is to realize that the option trader, in this example, has leveraged
the returns by a factor of twenty. In other words, for every 100 shares the stock investor buys
($10,000 worth), the option buyer can buy 20 contracts ($10,000 / $500 per option = 20).

If the stock trader invested $10,000, it would grow by 15% to a value of $10,000 * (1.15) =
$11,500, or a profit of $1,150. The option trader's account will be worth $10,000 x 200%
increase= $30,000. If we multiply the profit of the stock trader, $1,500, by 20, we end up with
$30,000, which is the value of the option trader's position. In this example, the option trader's
total account value will always be worth 20 times the stock trader's profit, assuming the $100 call
option has intrinsic value.

Gearing
The leverage described above is known as gearing, and is actually just an old British term that
means leverage. It is not uniquely defined, but the two most common definitions are (1) The
stock price divided by the option price or (2) The strike price, divided by the option price.

Using definition 1, the way to find it is to simply divide the stock price by the option price:

Gearing = stock price / option price

In our example, the stock was $100 and the option was $5, so $100/$5 = 20.

This is just another way of saying the stock trader required twenty times the amount of capital to
control the same amount of shares.

Using the second definition, gearing would be:

Gearing = strike price / option price

This gives the same answer of 20. But what if the strike was $110? Now the gearing is $110/$5
= 22. In this way, the option trader may pay $110 for the stock but is controlling it for $2, so is
leveraged by a factor of 22.

Omega
There is another term you may encounter that describes leverage and is called omega. Omega
measures the relative percentage changes between the stock and the option -- called an elasticity
measure. For instance, assume the call in the above example has a delta of 1/2. With the stock
at $100 and the call at $5, if the stock were to move $1 (a 1% move) the call will move roughly
1/2 point for a 10% increase. Because the option moved 10 times faster relative to the stock
(10% compared to 1%), the elasticity, or omega, is 10.

Omega = Delta / option price

1 / stock price

This can also be written: (stock price / option price) * delta

Using the above formula in our example, we have a $100 stock price divided by a $5 call option
with delta of 1/2, so:
 $100/$5 * 1/2 = 10

Regardless of which measure you use, the higher the leverage the more speculative the position.

It should also be noted that option traders should invest in the equivalent share amount as they
would a stock purchase, and not the equivalent dollar amount. For example, the trader above
invested $10,000 on 100 shares. If he elected to use the call option instead, it is advisable to
purchase one contract representing 100 shares as opposed to buying $10,000 worth of the $5
option or 20 contracts.

The reason is due to the leverage. If a trader is not used to dealing in 2,000 share orders (20
contracts), the leverage and losses can become too great too fast. By using share equivalents,
the stock and option positions will behave similarly and not leave the trader with losses he was
not prepared to take.

Leverage can be a very powerful -- and destructive -- tool. If you understand the various ways to
measure leverage, it will make you more comfortable with your option picks and strategies!

Open Interest
You will often hear the term "open interest" in option trading. It can be very helpful to understand
what this means, and how the number is either increased or decreased.

Because of the way options are traded, the Options Clearing Corporation (OCC) must account for
the total number of outstanding contracts. To do so, one could either tally all long positions or all
short positions and get the total number of outstanding contracts. This is because each contract
has a buyer and a seller (a long and a short position). Some people mistakenly believe that the
open interest is the total number of long and short positions. However, this would double count
the actual number of open contracts.

For example, say there are currently no contracts at all trading on a particular stock. If Larry
decides to buy 10 contracts, he must find someone who is willing to sell 10 contracts. If Moe
would like to sell them, then a buyer and seller can be matched and the total open interest is now
10 contracts.

Notice how open interest is not the total long and short positions. If we count all longs and shorts
using the above example, we have 10 contracts long and 10 short, which give us a total of 20 --
exactly double the correct answer.

Now say another trader, Curly, wants to buy 10 contracts. If he "buys to open" and Larry "sells to
close," then, in effect, all that has happened is that Larry and Curly have switched places and
there are still only 10 contracts outstanding. Why? Because Larry originally "bought to open"
and then "sold to close," so he's out of the picture altogether. Now Moe and Curly are effectively
matched.

Whenever one party is opening a position and the other party is closing a position, open
interest remains unchanged.

Should Moe be concerned that Larry is not on the other side of the trade anymore? No, because
technically, OCC acts as a middleman and is the buyer to every seller and the seller to every
buyer. The trades are all guaranteed (for contract performance, not profit!) by the OCC.

Let's say Larry wants back in the action and "buys to open," but this time, another trader "sells to
open." Assuming this trade was also for 10 contracts, the total open interest is now 20 contracts.

Whenever both parties are opening positions, open interest will increase by the amount of
the contracts traded.

In the above example, Moe and Curly have open positions and are accounting for 10 of the 20
contracts in open interest. If Moe "buys to close" and Curly "sells to close," the total open interest
will fall to 10.

Whenever both parties are closing, open interest will decrease by the amount of the
contracts.

New traders are often confused with situations similar to this: Say a new trader "buys to open" 10
contracts on an option that has no other volume for the day, and the option had 100 open interest
yesterday. The next day, open interest still shows 100. The new trader often thinks that a
mistake has been made because they "bought to open" 10 contracts, so the open interest must
surely be 110 now. Hopefully it is evident to you now why this may happen -- the other side of
the transaction must have been "selling to close" keeping the open interest unchanged.

How to read the open interest numbers

The open interest figures for a particular contract are counted as round lots of 100 -- just like the
option contracts. So if you see open interest of 250, this really means that a total of 250 *100 (or
the equivalent of 25,000 shares) is being traded in this option.

This is important to understand for trading purposes, especially if you are placing large dollar
amounts in a particular option. Say an option shows 3,500 contracts open interest (or a total of
350,000 shares) being represented. On the surface, there appears to be a lot of liquidity in this
option. However, a better method is to take the 350,000 shares and multiply it by the market
price of the option. Whether you use the bid, ask, or last trade usually won't make a huge
difference unless there is a very high bid-ask spread. Let's say the last trade was 1/8. In terms
of total dollars in the contract, that's only $43,700, which by market standards, is not too liquid.

Conversely, the Nasdaq 100 Index (NDX) is currently trading around 3,320 with the Nov $3,350
call trading about $186 (yes, this index is extremely expensive due to the volatility!). There are
"only" 558 open interest, which doesn't appear to be too liquid. But if we take 558 * 100 * $186,
we see there is over $10,000,000 in liquidity.

Before you place relatively large option orders, check the liquidity by calculating the total dollars
in open interest in that option.

Example:
You are bullish on MRVC trading around $38-1/2. You want to "buy to open" 30 contracts of the
Dec $30. Are there potential liquidity problems?

Checking open interest we see there are only 8 contracts for a total of 800 shares represented by
this contract. The price is $12-1/4, which is 800 * $12-1/4 = $9,800 dollars being
represented. This appears to be a potential liquidity problem at this point. This is not to say that
things cannot change as December expiration approaches, as they certainly can. However, it is
important to make your decisions with all available relevant information. Would you feel
comfortable with a trade this large and only $9,800 worth of liquidity?

If not, it may be best to spread your risk through other strikes or expirations.

Large Bid-Ask Spreads

Often when you are trading options, you will notice that the bid-ask spreads can become quite
large -- as much as three or four points and more for some of the more volatile indices. These
large spreads are usually found for deep in-the-money options and long term LEAPS®.

Understanding why this happens will help you with trading as well as understanding the
importance of not placing market orders for options that fall into these categories.

To start, you need to understand how prices are determined.

How prices are determined
All prices are determined by equating supply and demand. Although there are substantial
differences in the way various securities markets go about equating these two forces, the basic
idea applies. For example, option equilibrium is determined in the opening rotation, by the
specialist for the New York Stock Exchange and by numerous market makers for the Nasdaq
market. All methods have their own benefits and drawbacks but the effects are the same -- they
try to determine the fair price of the security.

Let's start with a simple example of how prices are determined, then include the assumption of a
bid-ask spread later.

Say there are 11 people who are bidding (wanting to buy) for a particular option and 11 people
offering to sell. The following chart shows their bid and offer limit orders. Also, to make things
easier, we will assume all participants are placing equal numbers of contracts.

Bids Offers
7 1/8 5 7/8
7 6
6 7/8 6 1/8
6 3/4 6 1/4
6 5/8 6 3/8
6 1/2 6 1/2
6 3/8 6 5/8
6 1/4 6 3/4
6 1/8 6 7/8
6 7
5 7/8 7 1/8

Keep in mind that a bid of $7-1/8, for example, means that is the highest price that person is
willing to pay; they will gladly pay less, just no higher. An asking price (or offer) of $7-1/8 is the
lowest for which that person is willing to sell; they will surely sell for more, just not less.

The question now is what is the fair price for the option? Again, to make things a little easier, we
will assume no bid-ask spreads at this point.

Say the option opens up with a price of $7-1/8, the highest bid. Because we are assuming there
is no bid or ask spread, any buyer can buy for $7-1/8 and any seller may sell for the same
price. What will happen? If you look closely at the above chart, you will see that there is only one
buyer (the one bidding $7-1/8) but 11 sellers. Why 11 sellers? Obviously, the lowest offer of $5-
7/8 will certainly be willing to sell for $7-1/8. So all 11 offers will want to sell, but only one person
is willing to buy -- you have unequal supply and demand.

What happens if you have unequal supply and demand numbers? If you have unequal numbers,
in this case more sellers than buyers, the sellers will start competing for that buyer's business and
the price will fall. In order to keep buying or selling pressure from being prevalent, there must be
equal numbers of buyers and sellers. It can also be shown, although we will not do it here, that
when the numbers are equal, that will be the point of maximum profit for the market makers, so
they have great incentive to find this point.

Back to the example, what if the option price opens at $6? Now there will be 10 buyers; all of
them will buy except for the person who bid $5-7/8. For the sellers, only two people will sell: the
person who is willing to sell for $5-7/8 and the one willing at $6. Again, we have unequal balance
between supply and demand except, this time, there are more buyers. The buyers will start to
compete for the business of the two people willing to sell and the price will be bid up.

The price where there is no imbalance is $6-1/2. If the option's price is $6-1/2, you will have 6
buyers and 6 sellers.

Looking at our bids and offers in the above chart graphically:

We see that at a price of $6-1/2, we can exactly clear the market; there is a buyer for every seller
at that price.

However, because of the nature of the markets, market-makers will put in bid-ask spreads as a
profit margin for matching buyers and sellers. So they may post this option as bid $6-3/8 and
offered at $6-5/8. Now, because of the bid-ask spread, we have three forms of inefficiencies, and
investors must now:
1) Pay a higher price ($6- 5/8 vs. $6-1/2)
2) Sell for a lower price ($6-3/8 vs. $6-1/2)
3) Have less volume (5 instead of 6)

These are the three inefficiencies created by bid-ask spreads.

Now, think about this: What would happen if the volume were reduced to only four buyers and
sellers?

If the volume is reduced to four contracts, the bid-ask spread will widen as shown by the dotted
gray line above. Notice how much wider the dotted line is compared to the red line that
represented the initial bid-ask spread (shown in red).

Often you will hear that the large spreads are a result of market-makers "playing games," or trying
to cheat you on your order. Bear in mind that the only way they make money is to fill orders, not
just produce quotes. If the spreads are too wide, investors will not be attracted to the security
and will produce no volume. In addition, if the spreads are unfairly too wide, you can be assured
another market maker will compete for the business and narrow the spread. Market makers are
reflecting the liquidity risks by the bid-ask spreads and their ability to spread the risk by hedging
the position. If you feel a bid-ask spread is too wide, remember, you are always free to "tighten
the spread" by either bidding higher or selling for less (please see our section on "Show or Fill
Rule".)

So, what you want to get from all this is that the market determines the bid-ask spread--not the
market-makers. So if you see an option (or stock, for that matter) with a large bid-ask spread,
just understand that this is the sign of a potential liquidity problem. If placing orders in these
securities, it is generally advisable to consider going "in between" the bid-ask spreads to improve
your trading results.

For example, say the quote is bid $6-1/4 and ask $6-3/4. If you want to buy, you can buy at the
asking price and pay $6-3/4. Or you can put in a bid above the current bid of $6-1/4. Say you put
in a bid of $6-1/2. The quote will now jump to bid $6-1/2 and ask $6-3/4. Notice that your higher
bid has tightened the spread. There is now a higher bidder on the market (that's you) at $6-1/2,
which gives a seller incentive to sell because of the higher price. The reverse holds true for
sellers. If a seller places an offer below the $6 3/4 quote, say $6-5/8, the quote will now become
bid $6-1/2 and ask $6-5/8. The new lower asking price will give another investor incentive to
buy. Notice how the spread has been further narrowed from the original 1/2 point spread (bid $6
1/4 and ask $6-3/4) to a 1/8th point spread (bid $6-1/2 and ask $6-5/8).

Large bid-ask spreads can be frustrating, especially when using options, because of the
leverage. Use this information before entering into the position and do not be afraid to compete
for a better price (unless there is some reason you absolutely must have the trade). If you do not
get the option, this only represents a lost opportunity, which is usually better than a lost profit from
being forced to exit a position that holds large bid-ask spreads.

Profit And Loss Diagrams

As the saying goes, a picture is worth a thousand words. This is so true when it comes to profit
and loss diagrams on options. By looking at a picture, you can immediately see where your max
profit and loss is, feel how the position will behave, and know where the danger zones are for any
strategy.

Unfortunately, there are basically two types of option investors. Those who can read profit and
loss diagrams, and those who can't!

Being able to read and understand the profit and loss diagram is critical for understanding
options.

Important Note: Before we get started, there is one very important point that needs to be made
here. When we speak of profit and loss diagrams, we are talking about the profit and losses at
expiration of the option. Prior to expiration, it is very difficult to say what the profit/loss diagrams
will look like because of the many factors that affect an option's price.
So what exactly is a profit and loss diagram? Let's start with the simplest one -- a long stock
position.

If you are long stock (meaning you own it), you will make one point of profit for every point
increase in the stock above your cost basis. Likewise, for every point drop below your cost, you
will lose exactly one point. This is easy to show on a spreadsheet. Assume we buy 1 share of
stock at a price of $50:

If the stock price is: Your profit/loss will be

$45 -$5
$46 -$4
$47 -$3
$48 -$2
$49 -$1
$50 $0 (the break-even point)
$51 +$1
$52 +$2
$53 +$3
$54 +$4
$55 +$5

Assuming you paid $50 for the stock, this table shows that you will have a loss of $5 if the stock is
trading at $45. If the stock is trading for say, $53, you will have a profit of $3 per share. If the
stock is trading for $50, you will have no profit and no loss -- you are just breaking even.

You must admit, even though this is a relatively simple position, it's not readily apparent as to the
behavior. So let's take the above numbers and put them in a picture -- a profit and loss
diagram. All we have to do is plot the stock prices from the table above on the horizontal axis
(the x-axis) and the profit/loss numbers on the vertical axis (the y-axis). Once we do, we get the
following picture:
How do you read the chart? Using the chart below, look at any stock price along the horizontal
axis such as $53, for example. Now trace a line to the profit/loss line (blue) and see where that
point lines up with the vertical axis to the left. It lines up with $3 profit, which is exactly what we
calculated in the spreadsheet previously. At a stock price of $46, we see the profit/loss line
shows a $4 loss.

It should be evident that it is much easier to look at the picture rather than the spreadsheet to see
how a long stock position, at $50, will behave. We know immediately that the break-even point is
at $50 -- the point where the profit/loss line crosses zero on the horizontal axis. We can also
immediately see that there is unlimited loss (at least all the way down to a stock price of zero
since you can never lose more than what you paid) and an unlimited upside potential as the line
continues up to the right without bounds.

What if you are short the stock? Shorting stock involves borrowing the shares and selling them
with the intent of buying them later at a cheaper price. You are, in essence, doing the reverse of
the traditional "buy low - sell high" strategy. You are trying to "sell high - buy low." The profit and
loss diagram for short stock looks like this:
A short position will always behave the opposite of the corresponding long position. In this case,
we see that profit is made as the stock falls and unlimited losses occur as the stock rises. The
unlimited loss part is what makes the short stock position so dangerous!

Got the hang of it? Ok, let's try something a little more complicated and see what a long call
position looks like.

Long call position

A long $50 call gives the owner the right, but not the obligation to buy stock at a price of $50 over
a specified amount of time. The trader, in this case, paid $3 per share for that right and,
consequently, that is all that can be lost. So, no matter how low the stock falls, this trader's
maximum loss is just the premium of $3.
Looking at the chart below, we see the call option trader has, in effect, limited the downside risk
below $50, as compared to the long stock position, but still retained all of the upside potential. Of
course, this does not come for free. If you notice, the break-even has been moved upward by $3,
the price of the call option, to $53. This is the most powerful benefit of options; they allow you to
custom-tailor the profit/loss profiles to exactly suit your needs.

Short Call
Let's see what a short call looks like. Remember, we said at the beginning that a short position
would be exactly the opposite of the corresponding long position.

The profit/loss diagram for the short call (red line) is telling us that the maximum profit is $3, the
amount of the premium. This will be made for any stock price (at expiration) below $50. Because
the $50 call will be worthless to the owner (the long position) at expiration, the short position will
profit by the entire premium of $3.

Notice how this short call is the mirror image of the long call position (blue line). For the long call,
$3 is the maximum loss; this is the amount of the short call's maximum gain. The short call's
break-even point is at $53, because at this point at expiration, the option will be trading for $3,
(remember, this is the profit for the long position). The short's position will be worth -$3 and this
is the amount for which the call was sold for a net profit/loss of zero. If the stock moves above
$53, unlimited losses will occur for the short call beyond this point. Because of the high
leveraged nature of options, the short call (also called a naked or uncovered call) position is the
riskiest of all! Why? Because you can only make a limited gain on the position, but are assuming
an unlimited risk to do so.

An interesting point should be made here. Look again at the above chart with the long call and
short call positions. Because they are mirror images of each other, this shows that no net flow of
cash is created from the options markets. In other words, any option trader's gain is exactly
somebody else's loss; the money merely changes hands. The financial press is often known for
making the statement that the options markets should not exist for this very reason. This is a big
misconception. The options markets were created as a way to hedge risk; it is a way for hedgers
to meet speculators. So the next time you hear about a devastating loss due to derivatives,
remember, the trader/traders on the other side of the trade made exactly that amount of a gain.

Okay, let's work one backwards. I'll show you the profit/loss chart and see if you can identify it:

Look at the chart and try to read it: The trader in the diagram can only lose $5, no matter how
high the stock goes. But, an unlimited amount (down to a zero stock price) can be made if the
stock falls below $50. Which option position has these characteristics?

If you said a long $50 strike put, you're right! A long put is a bearish position; you make money if
the stock falls (assuming it falls far enough to offset the premium). A short stock position, as we
saw earlier, is bearish too. But, the long put position is not exposed to the unlimited upside risk
as the stock moves higher. Again, this does not come for free. The long put position, in this
example, must have the stock fall below $45 before money is made. The short stock position will
make money for any fall in the stock below $50.
Okay, just to make sure you have it, let's look at a short put, which remember, should be the
mirror image of the long put above.

And we see that it is. It is easy to see from the profit and loss diagram that a short put is bullish,
as maximum profit is made when the stock is above $50. The trader is exposed to unlimited
losses (down to a stock price of zero). This short put position will break-even at a stock price of
$45, since the put will be worth -$5 at expiration, which is exactly the amount of the premium
collected.

Combination Strategies
The above strategies are relatively simple, but are intended to teach you the basics in reading a
profit and loss diagram. Now we will get a little more complicated and really see their value when
we look at combination strategies. These are strategies that combine two or more positions to
really custom tailor those risk-reward profiles you may be seeking but were unable to do with
stock alone.

For starters, let's view the profit/loss diagram for a covered call position, which is one of the most
popular strategies in options. The covered call is a strategy in which the investor buys the stock
and sells (or writes) the call against that stock. The investor will take in some money for doing so,
which in effect, provides a small downside hedge -- it lowers the break-even point. However, the
investor also gives up some of the upside potential in the stock.

Let's piece the two positions together. Remember that the profit/loss for long stock looks like this
(assuming that $50 is paid per share):
Now let's add the covered call. Say the investor sells a $60 call against the stock for a premium
of $5. This means the investor will receive $5 per share but may have to sell the stock at
$60. On the surface, it doesn't seem like a bad deal as you are getting paid to sell your stock at a
profit. As we will soon see, with the help of our profit/loss diagram, there is a price to pay.

By selling the $60 call, the investor "gives up" any appreciation in the stock above $60; he has
sold those rights to somebody else -- the person who bought the call. But the investor also
reduces the downside risk, slightly, in exchange. The total covered call position now looks like
the red line below:

The red line is our profit and loss diagram for the covered call position. We see that the break-
even has now been reduced to $45 because of the $5 premium received from the call. However,
for any stock price above $60, there is no more appreciation in the position as there is for the long
stock position. The maximum that can be made, in this example, is $15. How? If the stock is
$60, we make $10 on our stock because we paid $50, but also made $5 from the call for a total of
$15. If the stock is higher than $60, it does not matter; we are under contract to sell it for $60, so
our profit is still $15.

Now here is the price you pay for entering into a covered call position. YOU are holding ALL of
the downside risk! You cannot sell your stock until expiration of the call unless you are willing to
buy the call back, which could be a loss. Otherwise, you must wait for expiration in order to fully
profit by the $5 premium.

The Myth Of Covered Calls

There is a lot of bad information floating around out there about covered calls. If you ask most
people, brokers included, you will hear that the "risk" of a covered call position is that you may
have to sell your stock for a price below market. In other words, the stock may be trading at $100
but you have to sell it for $60. Look at all of the points on the above chart at $60 or above -- the
points where you will likely be assigned on the option and must sell your stock. Is this the "risky"
area of the chart? NO! It is our maximum profit zone, exactly the points where you want to
be. There are a lot of professionals and academic journals that surprisingly make this mistake. It
is a huge myth in the marketplace. The risk of any position is not missing out on some reward.

If you are really sharp, you may have noticed that the covered call profit/loss diagram is exactly
the same shape as that for the short put shown earlier. These are called "synthetic equivalents"
(and will be discussed in detail at a later time). Covered calls are often considered among the
"safest" strategies while naked puts are considered to be one of the riskiest. Covered calls and
naked puts are, incorrectly, considered by many to be polar opposites in terms of risk. Even
option approval levels with your broker will usually require the lowest level for covered calls and
the highest level for naked puts. Yet, from a profit and loss standpoint, they are exactly the same
strategies.

Now you should understand the beauty of profit/loss diagrams. They can help uncover the
myths.

The risk with the covered call is the same as with the naked put. The risk is that the stock goes
down.

So who should enter into a covered call position? If you write calls against stock you would hold
regardless, then writing calls can be a great strategy because you were willing to assume the risk
with or without the covered call.

But if you are buying the stock because of the premium, then you should strongly reconsider your
strategy. People who do this are known as premium-seekers, as they seek out the very high
premiums on the options, then buy the stock just to gain the premium. I have witnessed, on more
than one occasion, million dollar accounts becoming virtually worthless doing nothing but covered
calls using this method.

Long straddles
The long straddle is a position where the trader buys a call and a put with same strikes and
expiration. The idea behind the strategy is that a large move is expected but the trader is unsure
about which direction. Usually, this strategy is used prior to an earnings report, FDA approval for
a drug company or some other big announcement. If the report is favorable, the stock may run
wild to the upside; if not, it may tank. So the strategy plays both sides.

We will be discussing straddles in detail at a later time, but we do want to make the point that
playing straddles solely for news announcements is usually not a good strategy, as the price of
the calls and puts will already factor in the expected rise or fall of the stock. This means that it
will usually be difficult to get out of the straddle for a profit. A bigger reason to play straddles is if
you think the market has underestimated the volatility.

Say a trader buys a $50 call for $5 and a $50 put for $3 for a total of $8. What does its profit/loss
diagram look like:

It is easy to see now where your profit zones are. This trader will need to see the stock go above
$58 (the strike plus both premiums) or below $42 (the strike minus both premiums). If the stock
stays between these two points, at expiration, the trader will lose a maximum of $8.

Be aware of seminars or books that announce, "We'll show you how to make money regardless
of where the stock moves" as they are usually talking about straddles.

The downside to the straddle is that you are basically buying a very expensive call and a very
expensive put. In effect, you are buying the call for the price of a call and a put. You are also
buying a put for the price of a call and a put. This is because you must buy both options to
complete the straddle yet only one will be in-the-money at expiration (unless the stock closes
exactly at $50 or under a rare partial tender offer where both options can expire in-the-
money). This makes the straddle very tough to profit from unless you get a tremendous move in
the stock. So, while you may "make money" on either leg of the spread, that's not necessarily the
same as being profitable.

Okay, ready for one more?

Ratio spread
Let's look at a more complicated position -- the ratio spread. I am only showing this to
demonstrate the power of the profit and loss diagrams and why you should learn to use them. I
will not even discuss the strategy (although it will be available in another section), but instead, I
want to see if you can identify the critical points.

First of all, let's say a trader buys 10 $50 strike calls for $5 and sells 35 $65 strike calls for $1-
3/4. That's a ratio spread, or ratio-write with calls.

Now, think about this for a minute. Just by looking at the above ratio spread, can you tell what
the trader wants the stock to do? Where the maximum profit and loss is? Where the danger
zones are?

It's pretty tough, isn't it?

Now let's use the profit and loss diagram for the ratio spread described and see if we can answer
the questions a little easier:

Much easier, isn't it? We can now see that the trader will make money if the stock either
collapses below $50 or rises up to $65, which is the point of maximum profit. After $65, the trader
starts to lose some profits and will reach a break-even point around $73. Beyond $73, unlimited
losses will occur.

Would you have been able to analyze the trade in this way just knowing that the trader bought 10
$50 calls at $5 and sold 35 $65 strikes at $1-3/4? Don't feel bad, most people can't. But that's
what profit and loss diagrams are for.

Learn to use them, as they will greatly help your understanding of option strategies!
 Are Options Good For The Market?
Many times I am asked if options are good for the market. After all, there is no new equity
created as when new shares of stock are issued. What seems to be happening is that we are
allowing a legalized gambling arena. At least, this is what the popular financial press would have
us believe.

Further, we saw Baring's Bank, a 233-year old institution that helped finance the Napoleonic
Wars, brought down single-handedly by an options trader. Certainly options cannot be good for
anybody, right?

Before you take that view, let me show you why options were created and why they are actually
good for the market. Options were created out of economic necessity, and are a logical
extension of a well-developed financial market.

To help you understand, assume that there are no options and only stocks. Say you want to buy
shares of ABC stock, trading for $100, and you're a long-term investor -- none of this short-term
speculative stuff for you! When you decide to purchase shares for your long-term hold, what's
better for you, one seller or two? Obviously, two sellers are better, as they will compete for your
business and help to lower your purchase price. Likewise, when you sell your stock, would you
prefer one buyer or two? Again, you should prefer two, as they will compete for your business
and help to raise your selling price.

In other words, the more market participants you have, the better off you are whether buying or
selling. Another way to say this is that the bid-ask spreads will be narrowed, causing more stock
to transact -- and more wealth to be created. The spreads will narrow because the buyers will
compete by raising the bid price (giving incentive for sellers to enter the market), and the sellers
will compete by lowering the asking price (giving incentive for buyers to enter the market). The
financial markets always benefit from narrow spreads.

Notice in the following diagram how the bid-ask spreads (red-dotted line) cause less shares to be
sold (122,000 instead of 128,000) when compared to no spread (solid blue line).
Now, back to the buying of your stock. At this time there is only one seller, who also is a long-
term player and has held this stock for ten years. Notice the nice, neat, clean market we have
here with no speculators. However, with only one seller, this is certainly not a good situation for
you.

Now let's meet Sam Speculator. Sam likes to speculate on market direction. He's willing to take
big risks and gamble for big profits. Long-term investing for him is measured in hours. He just
happens to think ABC stock will fall a few points. He would short the shares (which would be
good for you since you'd have another seller), but he's very afraid to because of the recent
volatility in ABC. He doesn't want to take the risk of the stock moving higher. So he sits on the
sideline, leaving you with just the one seller.

Now let's enter the options market. Call options give market participants a way to purchase
stock, while put options provide a way to sell stock for a fraction of the cost of the stock. In
addition, the owner of a call or put option has risk that is limited to the amount paid for the
option. This idea gets Sam's attention. He puts in a bid to buy 10 of the $100 strike puts for a
price of $5 1/2.

The market maker sees this order and wants to fill it, as this is how he makes money. He will
create a synthetic put by selling stock and buying a call. In other words, the market maker must
"manufacture" the long put option that Sam wants. But where will the market maker be able to
buy the call? He doesn't know either, so he puts in a bid to buy one for, say, $5-1/4.

Another investor, Conservative Connie, also hates the idea of speculation in the
markets. However, she will gladly sell someone a call option against stock in her IRA account, as
it will give her income without the need for selling her shares. She happens to own ABC stock, so
she sells the market maker the call and pockets the $5-1/4 per share. She's willing to assume
the downside risk on ABC (if she wasn't, she wouldn't own it). Connie doesn't think the stock will
fall; Sam thinks it will. Together, they bring more stock to the market.

Notice what's happened. The market maker shorts stock, which is really what Sam wanted to do
but was afraid of the risk. The market maker then protected himself with the purchase of a call
and sold that package (a synthetic put) as a long put to Sam.
You wanted to buy shares of ABC but now have two sellers instead of one. The market maker, in
essence, has partitioned his risk between two other players. Together, Sam and Connie hold the
synthetic short position (Sam is long the put and Connie is short the call). Because those two
participants were willing to accept the associated risks, the market maker was able to short the
stock, thus lowering the asking price of the stock you're interested in buying!

Options, in this example, gave us an arena in which to meet speculators. It doesn't matter where
they live or what they want to use the option for. In this example, Connie was willing to assume
the downside risk of the stock if she could get paid for it. Sam was willing to pay for
that. Unfortunately, Sam doesn't know Connie. But, through the options market, Sam and
Connie are matched.

Ultimately, the options markets bring in more participants, making the spreads narrower for
all. So speculators are actually a necessary part of financial markets, and although it's
sometimes difficult to see, they make the markets better and more efficient.

If you're still not convinced, think about the bond market. Bonds are almost always associated
with conservative investing. If you buy a bond, you may see yourself as a responsible,
conservative investor. In fact, you may even hate the idea of borrowing! No credit cards or debts
of any kind for you. Now for the hidden truth. Who do you think is on the other side of that bond
trade? A borrower -- a speculator -- hoping to make a profit by earning more with the borrowed
funds than they will owe in interest. If you love the idea of loaning money, be glad there are
speculators in the world. No speculators, no bond market.

Speculators are an essential part of any well-functioning market. While it is a tragedy that Nick
Leeson single-handedly brought down Barings Bank with options, that is the fault of the user and
not of the options market.

Keep in mind there were also investors on the other side of those trades, and for every option
trade there is a winner for every loser, as shown in the following chart:

Notice how the profit and loss diagrams are mirror images for the long and short
positions. Money merely changes hands from one person to the other. In this way, options can
be viewed as a "bet" between two people, but that should not trick you into believing that's why
they were created.

Somewhere in the world, a conservative mutual fund manager may have desired puts as a hedge
for his mutual fund, and bought the puts that Nick was selling. Options are about transferring
risk. Nick Leeson was selling straddles on a Japanese index speculating on a quiet market; he
was accepting the risk the mutual fund manager wanted to hedge.

Because of this, that mutual fund may have had a great year and provided for a new home for
someone or protected their IRA account. The fund may have sent someone to college who,
otherwise, never would have had a chance. But we will never know the name of this person as
we know Nick Leeson's. We will never know, because that is not horrific news, so it just vanishes
into the background. It's easy to overlook what you cannot see. But they are there every time
another loses on an option trade.

Options are good for the market. They create narrower spreads and provide excellent hedges for
conservative investors. They are also excellent speculating tools for those who use them
responsibly.

Option Exam 2 - Week 2

Use charts above to answer questions (1-4).

1) Which profit and loss diagram represents a long straddle?

 a), b), c), d),

2) Which represents a long call?

a), b), c), d),

3) Which exposes the investor to the largest loss?

a), b), c), d),

4) Which represents a long put?

a), b), c), d),

5) A particular option contract has 1,500 open interest, which your friend says is a fairly high
number, so it appears to be liquid. However, you disagree because you notice that it is trading for
1/16, which means the total dollars invested in the contract are:

a) $93.75
b) $9,375.00
c) $937.50
d) $9.37

6) What does open interest represent?

a) It is the total number of long positions plus the total of all short positions
b) It is the total number of long positions
c) It is the number of people interested in the contract and have placed limit orders to
purchase
d) It is the number of people who have submitted exercise instructions

7) On Monday, open interest for a particular option is 1,000. You place an order to buy to open 10
contracts and are the only volume for the day. The next day open interest is still 1,000. What
happened?

a) The exchange made a mistake and didn't count your order

b) The exchanges only count trades of 100 contracts or more
c) The person selling the contracts was selling to close
d) The person selling the contracts was selling to open
8) Who determines the spreads between the bid and ask?

a) Market makers
b) The market participants -- all of the investors in that security
c) The exchanges
d) NASD (National Association of Securities Dealers)

9) What can you infer if you see a large bid-ask spread?

a) The market makers are trying to cheat you

b) The security is fairly illiquid
c) There is added risk in the security
d) Both b and c

10) If the underlying stock increases 20%, a particular option contract may increase 300%. This
magnification in profits (and losses!) is called:

a) Gambling
b) Leverage
c) Profits
d) Elasticity
PART 2 : Gearing Up For Trading

Buy or Sell
Better to buy or sell options?
There are a number of investors who adamantly believe you are better off selling options as
opposed to buying. They reason that since most buyers lose money, it must be better to be a
seller. While this may make sense on the surface, it completely neglects other factors of option
trading. With a little effort, we will show you that neither the buyer nor the seller has a long-term
advantage.

This is not to say that, under certain conditions, a buyer or seller cannot have a theoretical edge
on the trade. That happens all the time. We are talking about making an unconditional statement
that one side has an advantage over the other.

Equilibrium -- the efficient markets theory

Is it better to own a Porsche Boxster or a Ford Taurus?

Many people are tempted to answer that the Porsche is clearly the better choice.

What if the Ford Taurus and Porsche Boxster are both priced the same? With both cars priced
the same, most would agree that you are better off with the Porsche. If so, people will buy the
Porsche over the Taurus. This will put buying pressure on the Porsche and raise its price relative
to the Taurus. Say the Porsche is now bid up to a price $3,000 above the Taurus. Most would
agree that it is still a better deal and continue to buy it. This action will continue until the markets
are not so sure that an additional $1 is worth jumping from the Taurus to the Boxster. If it were
worth it, they would do it.

While it may seem counterintuitive, as long as there is no net bidding up or down of prices
between the two cars, you are equally well off with either one. While the Porsche may be faster
and have higher quality and resale value (not to mention it just looks cooler), it also comes with
higher repair bills, insurance rates, and theft occurrences. The car market will reflect all pros and
cons in the prices of the two cars.
Similarly, the financial markets will price all assets to reflect their risks. Quality assets are bid up
and riskier assets are sold off. This is why a government T-bill yielding 5% is equal to a more
risky bond priced to yield 10%. The government bond is higher quality but also has a lower
yield. The markets realize that, all else constant, you are better off with the T-bill so it will
continue to bid that price up until there is no net difference between the two bonds. If there were
an advantage, the markets would continue taking action and reflect it in the price.

In more technical terms, the market's action in the above examples is a form of the efficient
market theory (called the semi-strong form), which states that all publicly available information is
priced into the asset. The markets will price all assets so that the risk-reward ratios are equal
across the board.

So is it better to be a seller of options as opposed to a buyer? Now you should know that, on
average, there is no difference between the two choices. The markets will reflect the risk in the
prices. If it were always true that, say, sellers of call options were better off, the market would
continue to sell calls and drive down their price. The price will stop falling when buyers purchase
all that is for sale and there is no net selling. At that point, equilibrium is reached and the assets
are priced fairly.

Do not be lured into strategies that claim you are always better off as a buyer of this or a seller of
that. If you do, you may encounter a very expensive understanding of efficient markets.
 Types Of Orders
Even if you have the winning stock and matching option strategy, you still need to get the order in
correctly to carry out your intentions. There is a whole list of terms, restrictions, and general
market lingo you will need to know in order to maximize your use of options. Whether you are
new or experienced with options, this section will greatly help with your trading.

This is especially important with Web trading. Most firms offer great incentives to place your
orders over the Web. However, you are now at risk by checking off the wrong box or entering the
wrong amount. You will be given many choices when placing trades over the Web, so you need
to be aware of what these terms mean.

Opening and closing transactions

The first thing you need to understand regarding an option order is that you must specify whether
you are opening or closing the position. For example, if you want to be long a call option, you will
need to place the order as "buy calls to open." This is very different from a stock trade where you
just designate the order as either buy or sell. The reason the options markets need to know if you
are opening or closing the position is so the OCC (Options Clearing Corporation) can account for
the open interest. For example, you may be buying the call to open and the person on the other
side of the trade is selling to close their position. In this case, there is no net change on open
interest, as one party is opening and the other is closing (please see our section "Open Interest"
for more information). The OCC must track open interest, as there is no limit to the number of
contracts that can be traded on any individual stock or index as with stocks. With stocks, you can
only buy or sell up to the available number of shares outstanding.

Basically, if you are initiating a position for the first time, you are opening. If you are getting out of
a position, you are closing.

There is a common mistake new traders make when selling covered calls: They often feel they
must designate the order as some type of buy. This mistake usually stems from the fact that
most other financial instruments (stocks, bonds, mutual funds, etc.) are initiated with a
buy. Remember, you are selling the call and opening the position, so your first transaction would
be "sell calls to open," then you would "buy calls to close" if you want to undo the position.
Always check with a broker if you are unsure. There is nothing worse than being on the wrong
side of the market because of a mistake on the order. I have seen this result in very costly
mistakes!

Market versus limit orders

The next thing your broker will want to know is whether you are buying at market or at a limit.

A market order guarantees the execution but not the price.

In fact, a market order is the only way to make certain you will get the trade (the only exception is
with a "short sale" on stock which must be executed on an uptick). However, in order to do that,
you must be willing to accept the best available price at the time your order hits the floor. So,
while you may see an option quoting $5 - $5-1/2, placing a buy order at market does not
guarantee you the asking price of $5-1/2 as many people think. It's entirely possibly for the stock
to be in a fast market (which means the quotes are not accurate due to delays in processing
orders), and you find yourself being filled at something like $7. In most cases, this is unlikely, but
just be aware that with a market order, you are saying that you are willing to pay any price. You
will have no recourse with your broker by placing a market order and being filled at a higher price
with a buy order, or a lower price with a sell order.

With a limit order, you tell your broker that you are willing to buy or sell, but only at a certain price
called the limit price. If you say, "buy calls to open" at a limit of $6, this means your order will only
be filled if it can be filled for $6 or less. Of course, your risk is that your order will never get
filled. If you are selling at a limit of $6, your order can be filled only at $6 or higher.

Limit orders guarantee the price but not the execution.

Also, a limit order may be filled in part unlike a market order. For example, if you place an order
to buy 30 contracts at a limit of $6, it's possible that you get filled on 20 contracts or some other
number less than 30. What you are really telling your broker is that you are willing to buy up to 30
contracts. If you only want all 30 or nothing at all, you will need to use an "all-or-none" restriction
discussed later.

When placing an order, you need to figure out which is more important -- making sure it is filled
(market orders), or making sure you get a certain price (limit orders). There is no way to
guarantee the execution and price -- you get one or the other.

By the way, if you are placing a limit order on options, you need to be aware of the following
rule: Options quoted at $3 or less may be entered in 1/16ths and options quoted above $3 must
be entered in minimums of 1/8ths. So, if you see an option quoting $3-1/2 to $3-3/4, do not send
in a limit order at $3-9/16; the floor will return your order to be re-entered in 1/8ths. Under
decimalization, the new MPV's (Minimum Price Variations) are as follows: options under $3 may
be entered in .05 increments while options over $3 must be entered in .10 increments.

Or-better orders
There is a type of limit order which sort of blends a market and limit order, called an "or better"
condition.

With an or-better order, you place buy orders above the current asking price, and sell
orders below the current bid price.
Say an option is $5 on the ask. You can tell your broker to buy at a limit of $5-1/2 or better, for
example. Now, when your order hits the floor, you will be filled as long as it doesn't exceed $5-
1/2. Some people think this is a recipe for ruin as the floor will probably fill you at the higher $5-
1/2 price. This is not true, as the traders are bound by time-and-sales, which reflect the current
prices at the time your order was received. With or-better orders, your order is still not
guaranteed to fill, but the odds are much higher compared to a straight limit order. I would almost
always use "or better" orders if the underlying stock is moving quickly.

Day, good-until-cancelled, immediate-or-cancel, fill-or-kill

If you use a limit order or an or-better order, you must also specify a time period that the order is
to remain open. Technically there are four different time designations: day, good-until-cancelled,
immediate-or-cancel, and fill-or-kill. By far, most trades are entered as either day or good-until-
cancelled, but we will go over each so you understand them all.

Remember: a limit order is not guaranteed to fill, so your broker will need to know if you want the
order cancelled at the end of the day (day order), or cancelled after a much longer period (up to
six months) with a good-'til-cancelled order, also called GTC. The New York Stock Exchange
allows firms to keep the orders on the books for up to six months. However, individual firms are
free to make the requirements stricter. They may, for example, only hold a GTC order for two
months. Check with your broker as to their firm's policy on GTC orders.

Be careful with GTC orders, though -- especially when buying! There have been many cases
where people place GTC buy orders and then forget about them. Weeks later they see an option
position in the account trading for a huge loss and wonder how it got there. It's probably not a
good idea to use GTC buy orders on options for this very reason unless you actively monitor your
account.

However, using GTC sell orders can be a very good portfolio management tool. For example,
say you buy an option at $5 and are willing to sell it for $8. By placing a GTC order to sell it at $8,
you now never have to worry about not being at your computer to place the order if it trades that
high -- the computer will take care of it for you. Further, you will not be tempted to hang on
hoping for more if you see it trade at $8, as the computer will automatically sell it. Using GTC sell
orders can be a great tool for disciplined trading.

Instead of day or GTC, you can elect your timeframe to be immediate-or-cancel or fill-or-kill also
known as IOC and FOK orders respectively. Both orders are asking for an immediate execution
or cancellation of the order. The difference is that immediate-or-cancel orders allow for partial fills
while fill-or-kill orders must be filled in entirety.

For example, if you enter an order to sell 50 contracts at $7 immediate-or-cancel, the market
maker may fill a portion of that order at $7 or higher; they are not required to fill the entire 50 lot
order. A fill-or-kill order would require that they fill the entire 50 contracts immediately, or none at
all. These orders are often used to pressure the market makers into making a decision, and
consequently, are usually cancelled! It is recommended that you do not use these orders. Any
trader who gets filled by using them probably would have been filled with a day or good-til-
cancelled order as well. There is not a big advantage to the immediate-or-cancel or fill-or-kill
orders, and there's a great chance it may hurt the execution.

Why don't you use day, GTC, IOC, or FOK time frames with market orders? Remember, market
orders are guaranteed to execute, so they will default to a day order and normally be filled within
seconds.
All-or-none
If you place a limit order, for example, to buy 30 contracts at a limit of $5, it is possible to get filled
on only a portion, say 20 contracts. With a limit order, you are telling your broker to buy up to the
amount designated (30 contracts in this example). If, however, you want to insure that you get all
30 contracts or nothing at all, you need to use an "all-or-none" restriction, also designated
AON. If you use this restriction, you are telling the floor to fill the entire order, or nothing at all.

There is a big danger in using all-or-none orders! Any order marked all-or-none goes to the back
of the line (for listed stocks), or is held in the back pocket of a trader for options. This means that
it is possible you'll never get an execution, even though many traded at your price or better, and
you cannot hold the exchange to time and sales! The trader can always come back and say that
all contracts could never be filled at once and you will have no recourse against your broker or
the exchange.

Also, all option quotes are good for at least 20 contracts. So, if you are placing option orders for
20 contracts or less, you will be doing yourself a huge disservice by placing all-or-none
restrictions on these orders.

Minimums and minimum lots

If you don't like the idea of all-or-none restrictions, you can opt for a minimum. For example, say
you are selling 50 contracts but want at least 30 or nothing at all. You can place the order to sell
50 with a minimum of 30.

Further, if you only want your trade filled in minimums of 5 contracts thereafter, you can tell your
broker "minimum lots" of 5. So the order would look like "sell 50 contracts, minimum 30, and
minimum lots 5." Now the order must be filled with at least 30 initially, and in 5 lot increments
thereafter, such as 35, 40, etc. up to 50.

Minimums and minimum lots are a nice alternative to all-or-none orders.

Market on close
There is a really nice tool that's not widely used by most traders. It's called a market-on-close
order or MOC. With an MOC order, you try to buy or sell your contracts at a limit price during the
trading day. If it is not filled, it converts to a market order within the last five or so minutes of the
trading day. For example, say you bought 10 contracts at $2 and they are now selling for
$10. The market looks really strong and there is a possibility it could trade much
higher. However, you don't want to lose your profit.

You could place an order to sell your 10 contracts at a limit of $12 MOC. Now, if the option
trades at $12 or higher, you will be filled. But, if it doesn't trade that high, you will be sold very
close to the closing price of the day. Keep in mind this could be much less than you
anticipated! But MOC orders can be a great tool, as they allow you to try for better prices during
the day, but get you executed by the end of the day regardless.

Net credits and net debits

Net credits and net debits are types of limit orders, but are used for multiple option orders. For
example, you may enter a buy-write, which allows you to simultaneously buy stock and sell a call
against it (please see our section on "Buy-Writes" for more information). If the stock is trading for
$50 and the call is trading for $3, you can enter the buy-write for a net debit of $47. This tells
your broker that you are willing to buy the stock and sell the call as long as the net charge to you
does not exceed $47. The floor could fill the stock purchase price at $50-1/2 but would have to fill
the call for $3-1/2 or any other combination that nets a $47 debit. Often, traders will try to
"negotiate" a better deal, and may enter the above order for a net debit of $46-1/2 for example.

Net credit orders are just the reverse of net debits. Say you bought the above buy-write for $46-
1/2 debit and it is now trading for $48-1/2. You could enter the reverse of this trade, called an
"unwind," which sells the stock and buys the call for a net credit of $48-1/2. Now the order cannot
be filled unless the net proceeds to you are $48-1/2 or higher.

Stop orders
Stop orders can be a great risk-management tool. They can also cause great losses is you're not
sure how they work.

If you are planning to use stop orders on your option trades, make sure you understand this
section.

How do stop orders work?

There are two basic types of stop orders: stop orders and stop limit orders. There are very
important difference between the two, so we'll look at them individually.

First, the basics of stop orders are the same for stocks and options. There is one major
difference with options though, and we'll look at that at the end. For now, we'll just concentrate
on how basic stop and stop limits work with stocks.

Stop order

A stop order is a conditional order to buy or sell at market. You specify a price at which point the
trade is "triggered" and becomes a market order to either buy or sell.

For example, say you paid $30 for a stock and it is now $50. You feel it could climb much higher
so would like to keep holding it, but at the same time, you do not want to see it fall back to
$30. You could place an order to sell your shares at a stop price of $45, for example. When you
specify a stop price, that is the "trigger price," and is not necessarily the price you will get for your
shares. So if the stock trades at $45, your order is triggered and becomes a market order, which
will be filled at the next best available price.

It is very important to note that the stock needs to trade at or through your price in order to
become triggered. Here is where a lot of traders get themselves in trouble. Using the above
example, say the trader places a stop at $45 and the stock closes that day at $45-1/2. The order
is not triggered, so the trader at this point still has his shares. However, the first trade the
following morning is $38 on bad news. Because the last trade is through the stop price of $45,
this trader will be filled at market -- around $38, which is very different from the stop price of $45.

Remember, the stop price is only a trigger point -- the point where the order is activated. It is not
the price you will necessarily receive!

Stop orders used to be called "stop loss" orders until the Securities and Exchange Commission
ruled to change the name because it was misleading. It sounds like the order will prevent a loss,
which is definitely not true.
Trading Case
One of the worst cases I can remember was with a trader who had 3,000 shares of one of the
"dot com" stocks back when they were hot. This person paid around $100 per share, so he had a
decent profit with the stock trading around $120. He placed an order to sell the shares at a stop
price of $110. The stock started to fall radically with every couple of trades decreasing the stock
by a point or so. The stock traded at $110 and continued to fall. The customer was impatiently
calling to find out where he finally sold his stock. After all, a price of $110 was still a nice profit for
him.

The confirmation came back with all shares being sold at $87. This fill was deemed good by time
and sales; that was the fair price when his order hit the market maker.

Stop orders do not prevent losses!

Stop limit orders

The trader in our first example was hoping to get around $45 per share if the stock fell. Under
normal circumstances, if the stock falls slowly, stop orders work great. It's only when you see the
large gaps down where the prices can be very different.

What if the above trader would rather hold the stock instead of selling it at $38? Is there a way to
prevent the sale? Yes, and that is done with a stop limit order.

With a stop limit order, you specify two prices. One is the trigger point and the other is the sell
limit price. The above trader could have placed a stop limit order by telling his broker to sell at a
stop price of $45 and a stop limit of $45. If the stock trades at $45 or below (the stop price) the
order will be activated as with a regular stop order. However, instead of becoming a market
order, a stop limit order becomes a limit order to sell. This order is saying to activate it at $45 (the
stop price), but do not sell for anything less than $45 (the limit price). The limit price can be equal
to or less than the stop price.

In the above example, when the stock opened at $38, the trader with the stop limit order would
also have their order activated. However, they will still hold the shares because they could not be
sold for $45 or higher. If the stock does rise to that price during the day (or later if a good-til-
cancelled order), the stock will be sold. If you do not want this to happen, you need to cancel the
order.

Notice again that the stop limit order did not prevent a loss either. This trader still has the shares!

Buy stops
Buy stops work the same as sell stops but just in the other direction. Usually they are used by
short sellers -- those who borrow shares to sell hoping to buy them back cheaper at a later
time. In order to prevent the stock from getting away from them to the upside, these traders often
place buy stops.

For example, say a trader shorts shares at $100. The risk to this trader is if the stock moves
higher. In order to make sure the stock doesn't get away from him, he may place a buy stop at
$110. This is saying to buy the shares at market if the stock trades at $110 or higher. Again, this
is not necessarily the price he will pay.

If the trader does not want to pay more than a certain price, he can elect to place a buy stop
limit. As an example, he could say buy the shares at a stop price of $110 with a stop limit of
$111. If the stock trades at $110, the order will be activated, but will only fill if the shares can be
purchased for $111 or lower.

Traders also use buy stops to buy stocks on momentum. For example, say a stock has been
sitting flat for a very long time at $30. The rumor is that a new product is expected to be released
that could send it into the hundreds of dollars per share. Rather than buy it now and possibly wait
a long time for that day to come, traders may put in a buy stop order at $35, for example. Now,
the only time the trader will be filled is if the stock is trading at $35 or higher. In effect, the trader
is buying the stock only if it appears the market is starting to rally the stock.

Incidentally, it is possible to be filled at a higher price on a stop or stop limit order. This is fairly
uncommon, but if the stock bounces at the time your order is triggered, it may be trading at a
higher price when the market maker fills it.

Stop orders on options

Stop orders on options work about the same as for stocks with one big exception. With stocks,
the last trade will trigger a stop order. With options, the asking price will trigger the order and you
will be sold at the bid.

A sell stop will be triggered on the ask and sold at the bid; a buy stop will be triggered on
the bid and purchased on the ask.

This is very important for option traders due to the leverage in options. Gains can quickly
become losses if you are not careful.

For example, say a stock is trading at $100, and a $100 call is bid $7 and offered at $7-1/2. A
trader bought 10 contracts earlier for $5 and now places a stop order at $6. To the novice option
trader, this trade seems nearly risk-free as the trader paid $5 and will get out at $6 (less some
commissions) if the stock should fall. The stock starts to fall but there are no trades on the
option; however, the quotes on the option will change as the stock falls. Eventually, the option
quote is bid $5-1/2 and offered at $6. Now the stop order is triggered because the offering price
is $6, but the trader is sold at the bid price of $5-1/2. That little 1/2 point spread cost the trader an
additional $500 on top of the commissions.

Time stops
Another stop order many option traders use is that of "time stops." A time stop is more of a
mental stop order that the trader keeps in his head; it is not one that can be placed with your
broker.

Say a trader buys a 6-month option for $10 and is hoping to sell for $15 before expiration. The
trader may set a time stop and sell the option if it has not hit $15 by a certain day. The reason
traders do this is to prevent holding the option too close to expiration day and seeing the entire
premium fall to zero from time decay.
Stop orders can be great tools when used under the right circumstances. Be sure you thoroughly
understand the mechanics before using them, as the results can be upsetting if your expectations
are not realistic.

There are many other types of orders and restrictions but these will be the majority of the terms
you will come in contact with. Always check with your broker with specific questions, as individual
firms can have different policies. Keep in mind that these orders were developed for various
reasons, each with its own set of benefits and drawbacks. If you learn the different types of
orders, you will become more flexible in your option strategies.

Time Value & Intrinsic Value

An option's premium, the amount you pay, can be broken down into two component parts: time
value and intrinsic value. It is important to know how to break an option's price into these two
components as well as understand the interpretation if you want to become better at trading
options.

In-the-money versus out-of-the-money

Before you can break an option's premium into time and intrinsic values, you need to understand
the terms in-the-money and out-of-the-money, also called the moneyness of an option.

An option is in-the-money if the stock price is higher than the strike for calls and lower than the
strike for puts. If a stock is trading for $100, a $90 call is in-the-money and a $90 put is out-of-
the-money. The following chart may help:

Calls Puts
Stock price ABOVE strike In-the-money Out-of-the-money
Stock price BELOW strike Out-of-the-money In-the-money

An option that is exactly at the strike price is said to be at-the-money. Now, it's rare to find a
stock trading exactly at the strike price, so it is customary to call the nearest strike (whether in or
out-of-the-money) the at-the-money strike. For example, if a stock were trading at $99-1/2, most
traders would consider the $100 strike at-the-money even though the strike is slightly out-of-the-
money. Likewise, if the stock were slightly higher, say $100-1/4, most would call the $100 strike
at-the-money even though it is slightly in-the-money.

Intrinsic value
If an option is in-the-money, it is said to have intrinsic value. This is the value of the option if you
were to immediately exercise -- the difference between the stock price and the strike. For
example, if the stock is trading for $101 and you hold the $100 call, you could realize a $1 point
gain by exercising the call option; you would receive stock worth $101, but pay only $100*.

*Generally a trader should never exercise a call option early. Please see our section on "Early
Exercise" for more information. The value you could gain by exercising early is purely a definition
of intrinsic value.

Another way to view intrinsic value is to calculate the value of the option if it were to expire
immediately. Using the above example, if the $100 call option expired, it would be worth $1, the
same value as if you exercised early. Why will it be worth $1? If it is trading for less than that,
say $1/2, arbitrageurs will correct for it by buying the option for $1/2 and selling the stock for
$101, for a net credit of $100-1/2. By immediately exercising, they can cover the short position by
paying only $100, the strike, for an arbitrage profit of $1/2. This would continue until the option is
priced at a minimum of $1 (please see our section under "Basic Option Pricing" in week five).

For puts, the idea of intrinsic value is the same but in the other direction. If the stock were trading
for $99, the $100 put would have an intrinsic value of $1. The holder of the put could exercise
and sell stock worth $99 but receive $100 -- a $1 gain.

Also, if the put option expired immediately, it would be worth $1. If it is worth less than this, say
$1/2, arbitrageurs will buy the put for $1/2 and buy the stock for $99, for a total purchase price of
$99-1/2. Then they would immediately exercise it, sell the stock for $100, and capture a $1/2
arbitrage profit. This would continue until the option is priced at a minimum of $1.

Probably the easiest way to understand intrinsic value is to think of it as the number of points the
stock is in your favor in relation to the strike price. For example, if you are long a call, you are
bullish and want the stock to go up. If you have the $100 strike call with the stock at $103, then
your option is 3 points in-the-money; the stock is trading $3 points to the bullish side (above) of
your option. If you are long the $105 put, you are bearish and want the stock to fall. With the
stock at $103, the stock is two points to the bearish side (below) of your strike.

Time value
Time value (or time premium) is easy to calculate. It's what is left over after accounting for
intrinsic value. Assume a $100 call is trading for a premium of $3. If the stock is trading for $101
then the $100 call has intrinsic value of $1; the remaining $2 is called time premium. The
following formula may help:

Premium - intrinsic value = time value

What if the stock were trading at $100? Now, the $100 call is at-the-money and has no intrinsic
value. With the option trading for $3, the entire premium is all time premium. This would be true
for any stock price at or below $100; the option would be comprised entirely of time premium.

For puts, let's assume the stock is $98 and you are holding the $100 put, which is trading for
$5. The option has $2 intrinsic value and therefore has $3 time value.

Examples:

Call option premium Stock Intrinsic Value Time value

$50 call = $3 $52 $2 $1
$100 call = $7 $105 $5 $2
 $80 call = $5 1/2 $79 $0 $5 1/2
$75 call = $4 3/4 $77 $2 $2 3/4
Put option premium
$100 put = $5 $97 $3 $2
$75 put = $2 3/4 $77 $0 $2 3/4
$40 put = $3 $38 1/2 $1 1/2 $1 1/2
$85 put = $6 1/2 $79 $6 $1/2
Notice in the above examples that the intrinsic value plus the time value equals the total price
(premium) of the option.

How much time premium do options have?

Generally there will always be some time premium on an option, even if only a small
amount. With all else constant, the longer the maturity of the option or the more volatile the
option, the more you will pay in time premium. Why? With all else constant, investors will prefer
to buy longer-term options, as they will have more time for it to gain intrinsic value. Likewise,
investors will prefer more volatile options, as they have a greater chance of making bigger moves,
thereby giving the option more intrinsic value.

Also, the deeper-in-the-money you go, the more time premium will decrease. So if the stock is
$100, the $80 call will have less time premium than the $85 call, and the $85 will have less than
the $90, etc. If the option is deep enough in the money, the time premium will equal the risk-free
rate. Why? If the stock is at $100 and the $80 call is sufficiently in-the-money, investors can buy
the stock and sell the $80 call (covered call position) thereby "guaranteeing" them $80 at
expiration. As with any guaranteed trade, the interest rate will be the risk-free rate. Now, it
should be mentioned that a covered call is never truly guaranteed, as it is always possible for the
stock to fall below the strike price of the short call. However, if it is sufficiently deep-in-the-money
where the markets perceive it to be guaranteed, then the market will only reward you the risk-free
rate for that trade. The important point to understand is that as you move to lower and lower
strikes for calls (higher strikes for puts), they become more and more likely to have intrinsic
value. Because of this, they will have correspondingly lower amounts of time premium.

Parity
If there is no time premium on an option, it is said to be trading at parity. For example, with the
stock at $103, a $100 call trading for $3 would be trading at parity; there is no time premium on
this option. Usually, the only time you will see an option trading at parity is at expiration with
options that are fairly deep-in-the-money.

How do i use this information to trade?

We said earlier that it is important to understand time value and intrinsic value in order to
understand what you're getting into with a particular option. Any option that has high time
premium is risky (in trading terms, it will have a high gamma value). The reason it is risky is
because the underlying stock must move, in the proper direction, enough to make up for the time
premium. If it does not, you will end up with a losing trade.

For example, if you buy a $100 call option for $10 with the stock at $100, the stock must get to
$110 (stock price plus time premium) in order to break even. If the stock moves to $108 at
expiration, the $100 call will be worth $8, yet you paid $10 for a $2 loss.
Now compare this to the trader who may have purchased the $80 call, which may have been
trading for $21 ($20 intrinsic + $1 time premium). With the stock at $110 at expiration, the $80
call will be worth $30. This trader bought for $21 and sold for $30 -- a profit of $9, which is
certainly different from the $2 loss taken with the $100 call (for more on this, please see "Deltas
and Gammas" during week 5).

If you are looking for very quick moves in the underlying, you can afford to buy options with higher
time premium. However, if you are only interested in speculating on the direction of the
underlying stock, you should consider deeper-in-the-money options to avoid the high risk
associated with high time premium options.

But avoiding the speed game is not for free. If you buy a deep-in-the-money option, you will pay
more in total dollars (more intrinsic value and less time value). By doing so, you now have more
money at risk if the stock should move against you. In addition, if the stock should fall, the deep-
in-the-money option will fall nearly point-for-point through a certain range of stock prices before
slowing. It is a delicate balancing act to find the appropriate option that suits your needs.

Option trading mistakes

One of the biggest mistakes new option traders make is to buy an option just because it is
"cheap." The inexperienced trader will usually look to out-of-the-money options because they can
buy more contracts for a fixed dollar investment, or similarly, pay less money for a given number
of contracts. For example, if a stock is trading at $50, a new trader who is bullish on the stock will
usually look at a $55 strike or higher. They often wonder why one should buy an in-the-money
option as the stock has already exceeded the strike price. They feel they are "wasting" money by
paying for the intrinsic value.

Usually cheap options are composed entirely of time premium and can also be far-out-of-the-
money. Make sure you know where your break-even points are and that it matches your
sentiment with the underlying. For example, if the stock is $100 and you want to buy the $115
option for $2, that stock will have to move to $117 by expiration in order to break even on the
trade. If you do not think this is likely, you should probably consider another option. A deeper-in-
the-money option will be more costly but have less time premium; it will not need to move as far
to break even.

Many strategies rely on the behavior of time premium. If you plan to increase your trading
knowledge of options, you need to have a solid understanding of time and intrinsic values.
 Fair Value
FAIR VALUE

Futures Markets
You may have heard financial sources, such as CNBC, talk about the futures quotes prior to the
market open. Advanced market participants will watch the futures trading to get an idea of where
the market will open. However, even advanced traders get confused as to exactly what this
means. Often they associate the change in futures prices as the indication. For example, if the
futures are trading up 20, many mistakenly believe this mean a positive indication for the
open. Likewise, they feel if the futures are trading down 10, that the markets will open negatively.

While it may appear to make sense, this interpretation can get you into trouble especially if you
are trading in pre-market based on the indication. In order to understand how to interpret the
quote, you need to understand a concept called "fair value."

Before we can talk about fair value, we need to understand some basic mechanics of the futures
markets. When you buy a futures contract, you are entering into an agreement to buy and take
delivery of a commodity (or financial future) at a future date. This sometimes confuses people
who are new to futures but you've probably entered into similar agreements although not
specifically futures contracts. For example, if you have a contractor build a house or a car dealer
order a car. You agree to take delivery at a future date and exchange cash at that time. The
important thing to keep in mind is that, with futures contracts, the buys and sells are locked
in! This is very different from the options market where the buyer has the right, but not the
obligation to purchase. If you buy a futures contract, you must purchase the goods. If you sell a
futures contract, you must deliver the goods. Of course, if you do want to get out of your
obligation, you can execute a reversing contract just like in the options market.
Futures markets are used as hedging tools for both buyers and sellers. For example, a farmer
would probably be a seller of wheat futures. He can grow the crops today and know in advance
what his price will be at harvest. Likewise, Kellogg would probably be a buyer of wheat futures to
lock in their purchase price of wheat for use in cereal.

The financial futures (SPX and NDX among others) are used for similar purposes. They allow
fund managers to hedge portfolios. There are four contract months, each is the last month of the
quarter. So, the contracts are March (represented by the letter "H"), June (M), September (U)
and December (Z). Whenever you hear CNBC quoting fair value, they are always talking about
the near-term contract.

Fair Value Review

Fair value is the relationship between the index (also called the "spot") and the corresponding
futures contract. It has nothing to do with the fundamental value of the companies representing
the index. Fair value tells us what the value of a futures contract "should be." But, because
futures trade on separate markets from the spot market, they are subjected to their own sets of
supply and demand so may wander off in different directions from the stock market. In fact, the
futures trade all night long on GLOBEX, from 4:45pm until 9:15 am EST. But, if the futures get
too far out of line, the arbitrageurs will correct for that prior to the opening bell.

Definition: Fair value is nothing more than the cost to carry the index to delivery to the
future. What do we mean by cost of carry? It is the interest that could be earned on money in a
risk-free asset such as a money market or T-bill. So, if you have an asset that costs $100 and
must carry it for one year, your cost would be $10 if interest rates were 10%; this is the amount of
money forgone by not having the money in the risk-free asset.

To simplify things, let's look at a simple commodity such as gold and assume the following:

Gold price: $200

Interest rate: 10%
1-year futures contract: $250

If you buy this futures contract, you are saying you will buy gold for $250 per ounce in one
year. The person who sells this contract is saying they will sell gold for $250 per ounce in one
year. Of course, as things change (i.e., supply and demand for gold, time remaining on contract
etc.) so will the price of this contract.

Fair value to carry the gold is $200 * (1.10) = $220.

If you borrowed $200 to buy the gold, it would cost you $20 in interest; if you bought it with your
own money, you would miss out on $20 in interest. So, either way you look at it, there is a $20
cost to buy the gold and hold for one year.

Because the 1-year futures contract is above the fair value, arbitrage is possible.

Note: In order for a transaction to qualify as arbitrage, two conditions must be met: (1) The
transactions must guarantee a profit (2) there can be no initial cash outlay. The second condition
is necessary otherwise the straight purchase of a government bond would qualify as arbitrage
since profit is guaranteed.

With the fair value above the spot price, arbitrageurs will take the following strategy:
Today
Borrow $200: +$200
Buy gold in spot market: -$200
Sell the futures contract: $0
Net cash outlay: $0

1 year later
Deliver the gold against futures contract and receive: +$250
Pay the interest from loan ($200 + 10%) -$220
for an arbitrage profit of $30. $30

This is an arbitrage profit because there was no initial cash outlay to acquire the asset but we
guaranteed our selling price by selling the futures contract.

Traders will buy the spot and carry it to the future thus creating their own futures contract. This is
called "cash and carry" arbitrage. These actions will put buying pressure on the spot price and
selling pressure on the futures contract, which will eventually eliminate the arbitrage opportunity.

In a perfect market, any futures price above $220 will result in cash and carry arbitrage.

What if the futures price is too low? Assume the following prices:

Spot price: $230

Interest rate: 10%
1-year futures contract: $250

Fair value = $230 * (1.10) = $253

In this case, the futures contract is below fair value. It "should be" priced at $253 but is only $250
so arbitrageurs will do the following strategy:

Today
Sell short gold: +$230
Lend proceeds at 10%: -$230
Buy the futures: $0

1 year later
Take delivery of the spot through futures
contract and cover short position: -$250
Collect proceeds from loan: +$253
For arbitrage profit of $3

Notice that this is arbitrage because there was no cash outlay at beginning. We guaranteed the
profit with the purchase of the futures contract. These actions should put buying pressure on the
futures contract and selling pressure on the spot market, which will eventually eliminate the
arbitrage opportunity.

In a perfect market, any futures price below fair value will result in this "reverse cash and
carry arbitrage."

Remember, if the futures price is above fair value, arbitrageurs will buy the spot. If the futures
price is below fair value, they will sell the spot.
We have seen how traders can arbitrage when futures are too high or too low. The only time they
cannot arbitrage is when the futures contract is priced at the cost of carry -- the fair value!

Market Imperfections
We just showed that arbitrage is theoretically possible if the futures contract is either above or
below fair value. However, in the real world, there are many imperfections that make arbitrage
impossible even though the futures contract may be higher or lower than fair value. Some of
these imperfections are:

1) Transaction Costs
2) Bid/Ask spreads
3) Restrictions on short sales
4) Different borrowing/lending rates
5) Execution risk
6) Lack of storability (for non-financial commodities)

Because of these imperfections, arbitrage may disappear even though the futures are not
priced at their fair value.

For example, assume the following but with a 3% transaction cost:

Gold price: $200
Interest rate: 10%
1-year futures contract: $225
Transaction costs: 3%

We know that fair value is $200 * (1.10) = $220 and the futures price is $225 so it appears that
arbitrage is possible. Let's see if it is:

Today
Borrow $206 +$206
Buy gold in spot market ($200 + 3%) -$206
Sell the futures contract: $0
Net cash outlay: $0

1 year later
Deliver the gold to make delivery of futures contract: +$225.00
Pay the interest from loan ($206 + 10%) -$226.60
For net loss -$1.60

Now, because of transaction costs, the arbitrage situation is eliminated. In this example, the
futures would have to be priced at $226.60 or higher to execute a "cash and carry" arbitrage.

Using the above example but with futures priced too low, what happens with a 3% transaction
cost?

Gold price: $200

Interest rate: 10%
1-year futures contract: $215
Transaction costs: 3%

We know that fair value is $200 * (1.10) = $220 so it appears the futures contract is priced too low
at $215. Arbitrageurs will attempt to arbitrage by executing a reverse cash and carry.
Today
Sell short gold: +$194 (sell at $200 less a 3% transaction cost)
Lend at 10%: -$194
Buy the $215 futures: $0
Net cash outlay $0

1 year later
Take delivery of the spot through
futures contract and cover short position: -$215.00
Collect proceeds from loan: +$213.40
For net loss: -$1.60

With the spot at $200, the futures contract would have to trade below $200*(0.97)*(1.1) = $213.40
before arbitrage could be implemented. So, with 3% transaction costs, the futures must trade in
the range of $213.40 and $226.60 before arbitrage can be successful.

Any futures price inside this range results in NO arbitrage.

An easier way to state this is that if the spread (the difference between the futures and spot) is
above $26.60 or below $13.40 then arbitrage will occur.

For instance, using the above example with the spot at $200 and the futures at $215, the spread
would be $215 - $200 = $15. Because $15 lies between the "no arbitrage" bounds of $13.40 and
$26.60, then no arbitrage can occur.

Often you will hear sources refer to "buy and sell program" values. This is exactly what the buy
and sell programs tell us. If an index has buy programs at $26.60 and sell programs at $13.40,
then if the spread (the difference between the futures and spot) rises above $26.60 the
arbitrageurs will buy the index and sell the futures for a guaranteed profit. This creates buying
pressure on the index, which is why it is labeled as "buy." If the spread falls below $13.40, then
arbitrageurs will short the index and buy the futures for a guaranteed profit. This causes selling
pressure on the index and is therefore labeled "sell."

So, the futures are allowed to wander within an "invisible fence" around the fair value as shown in
the chart below. The fence is created by the transaction costs and other market imperfections
listed above. Again, any spread within this fence results in no arbitrage.
Also notice that the number of points above and below fair value is the same. In the above
example, fair value is $220 with buy programs at $26.60 and sell at $13.40. This is 6.6 points
above and below the $20 fair value. Assuming equal transaction costs on the buy and sell
programs, the number of points above and below fair value will always be equal.

It is important to keep in mind that it is the spread (the difference between the futures and
spot) that counts.

In the above example, the spread must expand to $26.60 or higher before the sell programs
start. The spread can increase by several cases such as: (1) the futures can increase while the
spot stays the same (2) the spot can decrease while futures stays same (3) futures rise and spot
falls (4) futures and spot rise but futures rise at a faster rate.

This shows that program trading (arbitrage) does not necessarily guarantee a correction toward
fair value. If the futures and spot are both rising, but the futures is rising at a faster rate then the
index may stay in sell territory for extended periods of time, possibly the entire day. As long as
the spread remains outside the upper arbitrage bounds, sell programs will continue. In a similar
but opposite way, buy programs can exist for extended times. If the spread shrinks (i.e., the spot
market is falling faster than the futures), then buy programs will continue.

How Is Fair Value Calculated?

Now that you understand that fair value is nothing more than the cost of carry of the underlying
asset, there is just one adjustment you need to make to fully understand how fair value is
calculated for the S&P 500 (SPX) or Nasdaq (NDX) futures.

If you buy all the stocks in the index on margin and carry them to the future (cash and carry
arbitrage) you will receive some dividends, which offsets your cost of carry. So, if the risk-free
rate is 5% and you receive 3% in dividends, effectively your cost of carry is (5%-3%) = 2%.
Futures contract * (1+ (interest - dividends) ) ^ days/360

And that is the formula for Fair Value!

Example: Say the NDX index closed last night at 3465. The futures closed at 3490. However,
the futures traded throughout the night and are now trading at 3550. Also assume that fair value
calculations put fair value at 3550. What does this imply for the opening of the Nasdaq market?

The futures are currently 3550 but closed at 3490 so the futures will be indicating UP 60 points
(3550 - 3490). But, the fair value formula says the futures "should be" trading at 3550 so they
are, in essence, priced fairly. This is actually a neutral or flat indication for the opening even
though the futures are up. The futures may be up from their closing price the day before, but they
are currently trading for fair value.

Most Important Concept!

Here is where most people get tripped up when looking at futures quotes. Say we use the same
example above but now, instead, the futures are trading for 3495. Here, the futures closed at
3490 but are now trading for 3495 so the quote will show the futures up 5.

KEY POINT: If you get nothing else from all this, please understand that just because the
futures are UP that this, in itself, does not tell you the indication for the opening of the
market. You need to know where fair value is.

Likewise, just because the futures quote is down does not mean that it is a negative
indication for the market.

In this second example, the futures are trading for 3495 but "should be," based on the fair value
calculation, trading for 3500. In essence, they are still cheap even though their price increased
overnight. Arbitrageurs will buy the futures and sell the spot. So, even though the futures are up,
in this case, it is actually a negative indication for the market!

The concept of fair value is of little use for retail investors other than to satisfy their curiosity as to
the direction of the market at the opening bell. Where many investors get in trouble is to either
buy or sell in the pre-market (such as selectnet) based on the futures quote. Before you base
your decisions on the futures quote, make sure you know where it is in relation to fair value. It is
only then that you will truly know the expectation of the market on the opening bell.

Option Exam 3 - Week 3

1) A stock is currently $50 and the $45 call is trading for $6. How much time premium is there?

a) $6
b) $1
c) $5
d) $0

2) A stock is trading for $100 and the $105 put is trading for $7. How much time premium is
there?

a) $2
b) $7
c) $0
d) $5

3) Assuming a call option has intrinsic value, which of the following defines intrinsic value?

a) Stock price minus the exercise price

b) Exercise price minus the stock price
c) Stock price plus the exercise price
d) Exercise price plus time premium

4) Which of the following types of option orders must be filled?

a) Market order
b) Limit order
c) "Or better" order
d) Day order

5) Which of the following orders guarantees the price but not the execution?

a) Limit order
b) Market order
 c) "Or better" order
d) Both a and c

6) Which order guarantees the execution but not the price?

a) Market order
b) Limit order
c) "Or better" order
d) Immediate or cancel

7) Stop orders prevent losses:

a) True
b) False

8) A stock is trading for $100 and a trader places an order to sell at a stop price of $97. If the
stock falls below $97, the trader's shares will be sold at $97.

a) True
b) False

9) If you place a limit order to buy 50 contracts, is it possible to get filled on less than 50?

a) No, all 50 must be filled

b) Yes, partial fills may occur unless and "all-or-none" restriction is used

10) You want to buy an option that is trading for $5 and sell an option trading for $2. If you place a
limit order, it must be for a(n):

a) Net debit
b) Could be either net debit or credit
c) Net credit
d) You cannot specify net credits or debits for options

11) You are always better off being the seller of options, because the majority of option contracts
expire worthless.

a) True
b) False
12) The S&P futures are trading down 5 points this morning. This implies there would be a
negative opening if the markets were to open right now.

a) True
b) False

13) You purchased a $50 call for $2 and it is now trading for $7. You can guarantee a profit by
placing an order to sell at a stop price of $6.

a) True
b) False

14) Stop orders for options work the same way as for stocks.

a) True
b) False

Put-Call Ratio
Technical analysis is quickly becoming widespread as an active trader tool. Used only by
professionals just a few years ago, this same information is available to nearly everybody through
the World Wide Web.

Technical indicators try to predict market turns; that is, at what point a stock or index will rise or
fall. If we knew these points, the gains could be unimaginable so the incentive is certainly there
for investors to try to figure out where these points are.

Of all technical indicators, the put-call ratio is probably the most recognized that uses options as
its focal point.

From a mathematical standpoint, the calculation of the put-call ratio is very easy. It is the total
volume for all put contracts divided by the total volume of call contracts traded on the Chicago
Board Options Exchange (CBOE).

Put-call ratio = Total CBOE put volume / Total CBOE call volume

The indicator suggests that a market downturn is threatening when the put-call ratio hits a low
level and vice versa. The rationale is quite simple: most speculators of options are
unsophisticated and typically will be lured to buy calls when the market is at a top, and buy puts
when the market is at a bottom.

If speculators start to buy a high number of call options relative to puts, the indicator decreases
(because you are dividing by a larger number) and it is read as a negative indicator. Likewise, if
speculators are loading up on puts, the ratio increases and it becomes a bullish
reading. Because the put-call indicator works in a backward fashion (bullish indicator when
markets bearish and vice versa), it is called a contrarian indicator.

Where these "high" and "low" points are is a matter of debate. There are many interpretations
and many traders and technical analysis firms that make small modifications to the formula to
meet their specific needs. But as a general rule, a level of 80 is bullish and 45 is bearish.

Keep in mind that no technical indicator is perfect by any means! So do not speculate just
because the indicator is giving a particular reading. Use it in conjunction with other information
and your own opinions.

There are two important points to remember when using the put-call ratio. First, remember it is a
contrarian indicator. There are many novice traders who have been burned by buying puts just
because the indicator was high; they should have been buying calls.

Second, put-call ratio is much harder to interpret now with sophisticated traders and the use of
synthetics. If a trader buys a put, it will get calculated as a bearish position by the put-call
ratio. But what if the trader is buying a put as protection for a long stock position? Now he is
certainly bullish and should be counted as so. Likewise, someone selling puts would be counted
towards the bullish side (selling puts by themselves is bullish). But if this investor were selling
puts against short stock, they should be counted as bearish because they are now synthetic short
calls. So in theory, the indicator may be of significance. The reality is, unless you know how the
investor is using the put or call, the indicator is highly uncertain.

Percent To Double
Investors are constantly coming up with tools to find the ideal option trade. In essence, they are
looking for ways to beat the market. Of course, many businesses are willing to sell those
products to them, and one of the most pointless is the analytic tool called "percent to double"
(there is a similar indicator called price-to-double which is the same information, just expressed in
prices and not percentages).

I'll show you the basic idea of percent to double and you will immediately see why it's of no
value. Be wary of brokers who tell you they add value to your option trades because they have
access to percent-to-double values.

Here is the idea behind percent-to-double. Say a stock is trading for $100 and a $100 call option
is trading for $5. Percent-to-double is supposed to tell you what percent the underlying stock
needs to move in order for the option price to double. For example, a broker may tell you an
option has a percent-to-double of 20%. This means that if the stock moves up 20%, the call price
will double from its current price.

On the surface, it sounds like it may be of value since a lot of option traders will close positions
when they double their money. So it would be nice to know just how much the stock needs to
move in order to reach that point.

Here's why it does not work. Say the above $100 call is priced at $5 with delta of 1/2. In order
for the option to double, it would have to be trading for $10. Now, how many points does the
stock need to move to create a 5-point move in the option? With a delta of 1/2, it may seem that
the stock would have to move 10 points. However, delta is accurate for sudden, small changes in
the stock price. If this stock were to move 10 points, you can be assured the delta will no longer
be 1/2; it will be something much higher. So dividing the number of point movement required in
the stock by delta will not work.

Further, we need to know how long it will take the stock to move. If you are told your option has a
percent-to-double of 20%, we really need to know over what time period. Does that mean the
stock must move 20% immediately, sometime today, next week or next month? Every single
moment in time will produce a different percent-to-double figure. To complicate that even more,
you have implied volatilities that are constantly changing, too. If the stock does move that high
but implied volatility drops, your option will not double.

Another problem is that as the stock moves higher and the option becomes more in-the-money,
the bid-ask spreads become very wide. So even if percent-to-double forecasted correctly, it
would be in reference to the asking price and not the bid price, which is what you will receive for
selling the option.

If you are still not convinced, use percent-to-double for your next hundred or so option trades --
you will not see one time that it forecasts correctly. There are just too many variables that affect
the option's price.

The only time percent-to-double will work is at expiration. With the above $100 call trading at $5,
we do know that the call will double in price if the stock closes at $110. With the stock at $110,
the $100 call will be trading for $10 (the intrinsic amount) -- exactly double the price. But notice
that in order for it to work, we had to wait until expiration -- and then it is too late.

Even if percent-to-double did work, there is just no value to the information. The markets already
have that information priced into the option. It may seem that a percent-to-double of 1% is much
better than 20%. However, think about this example: Say there are two stocks, A and B. Stock
A is $100 and hardly moves, and the $100 call is $1/2. Stock B is a high-flying tech stock
capable of moving several points in a day. It is priced at $50 with the $50 call at $5. Stock A has
an at-expiration percent-to-double of 1%, and B has one of 20%. It should now be apparent why
there is a difference. Stock B is much more likely to move, so the markets will bid it's option price
up; that's why its price is $5 while A's is only $1/2. You have no added value by knowing the
percent-to-double.

Unless you are familiar with option pricing, be careful with software that tries to pick out the "best"
trades for you. Remember, the markets will always price in the proper risk-reward ratios. Using
some of these tools can lead to a false sense of security and disappointing trades.
 Hedging
Did you hold your tech stocks last month hoping for an upside
bounce? YES! Are you now wishing you had sold
instead? YES! Well, now you can reap the benefits of both.

Here's how...

Portfolio insurance is nothing new to professional traders yet unknown to most retail
investors. Before you say, "I don't need any insurance," think about this: Many investors' homes
and cars are insured, yet valued less than their stock portfolio. In addition, we have recently seen
some of the bluest of blue-chips such as Proctor and Gamble, Home Depot, Eli Lilly and Hewlett-
Packard lose over twenty-five percent of their value in a single day. Don't think it can't happen to
the tech stocks you hold. If you are not familiar with portfolio insurance, read on and find out how
the professionals take the emotions out of investing.
 It is often said that knowing when to sell is the most difficult part of investing. This is
because of the two most significant factors that drive the markets: greed and
fear. When stocks are flying, we hang on hoping for more. When they fall, we sell
the shares out of fear, often forgetting about the long-term reasons we bought them
in the first place. We are afraid to take profits yet quick to take losses, which is not
a very good formula for making money in the markets!

Now, we are not advocating short-term trading. After all, the stock market has a very long history
of an upward bias, and statistically speaking, you are better off buying and holding. But the
emotional side of the investor rarely allows this strategy to work. The roller coaster starts, your
profits become losses, and there you are selling at a loss again. Is there a better way to trade?

In certain circumstances, you may want to consider portfolio insurance. Basically, portfolio
insurance can be defined as an added asset to your portfolio that will increase in value as a
particular stock or index falls in value. Financial professionals call this a hedge, and we will look
at many ways to place a hedge in your portfolio, some without any out-of-pocket expense!

To understand hedging, you need to understand some basics of the options markets, as this is
one of the primary tools used for hedging. Options were created as a way for investors to buy
and sell risk, and while this may seem unusual, it actually occurs in many ways in our everyday
lives. For example, driving a car involves the risk of wrecks, injury, and theft. You do not want
this risk, but for a fee, your auto insurance company does. You have, in fact, transferred the risk
to them. When you buy a one-year magazine subscription, you are transferring risk. The
magazine company is at risk if the price of its magazines goes way up. Of course, you are at risk
if the price stays the same or falls. But for the up-front fee, you both consider the risks mutually
beneficial. Out of economic necessity, the options markets were created in 1973 as a
standardized way for the financial markets to transfer risk.

In most cases, options can be purchased through most brokerage firms with just as much ease
as a stock. Usually, you will need to fill out an options application and wait a few days to get
approval. Do not worry if you do not get approved or are not comfortable with options, as we
have another way for you to hedge yourself that will be discussed later.

More about options

What exactly is an option? Options are assets that give owners the right, but not the obligation,
to buy or sell certain securities (or indexes) at a fixed price over a given amount of time. Since
the owner has the "right, but not the obligation," this means that the owner of an option chooses
whether or not to buy or sell -- it is their option to do so, hence the name.

There are two basic types of options; calls and puts. Call options give the owner the right to buy
the stock (or "call" it away from the owner), while put options give the owner the right to sell the
stock (or "put" it back to the seller). This is a contractual obligation, controlled through a clearing
firm (called the Options Clearing Corp. or OCC), so there is no need to worry about a defaulting
party on the other side of the transaction. Because they are contractual obligations, options are
traded in units called contracts, just as stock is traded in shares, with one contract usually
representing 100 shares of stock.

Options are standardized meaning there are only certain prices at which you can agree to
buy/sell stock as well as specific time frames. The prices are set by the exchange at fixed
intervals and are known as strikes, because that is the price where the contract is struck. As for
the time frames, you will always find at least four different months being traded for stock
options. There will always be the current month, the following month, and at least two additional
months. Also, there may be longer-term options that can go as long as three years. Options do
have a specified expiration date which, for trading purposes, is the third Friday of the month.

That's a lot of information, so an example should make things clear. Let's say it is October and
you are bullish on XYZ stock trading at $50. You could purchase a January $50 call option that
gives you the right, but not the obligation, to purchase XYZ for a price of $50 through expiration in
January. Now, of course, there is a fee for this, called the premium, and let's say it is $5. This
means that you are paying $5 per share, but remember, each contract controls 100 shares so the
total purchase price for one contract would be $500 plus commissions. Now, you have the right
to buy the stock at $50 per share at any time through expiration. If XYZ is trading for $70 when
the option expires, the call option must be worth $20 (the difference between the stock price and
strike). However, if XYZ is trading at $70 before expiration, then the option will be worth at least
$20 as there will still be time remaining on the option and investors are willing to pay for
time. How much they pay is up to the market and determined solely by supply and demand for
the option. Of course, if the stock closes below $50, the option expires worthless so the most you
can lose is the amount paid, in this case, $500.

You may be thinking, "Hey, wait a minute, how do I know the market makers won't try to rip me
off and only offer me $15 for the call when I decide to sell?"

If XYZ is trading at $70 and the market makers are bidding $15 for the $50 call, then the
arbitrageurs will step in and come to your rescue! These are people who watch for price
discrepancies in the market and are able to make riskless transactions for guaranteed
profits. These transactions happen at lightning speeds and do not last for long. Arbitrageurs will
buy the call for $15, sell short the stock, and receive $70 for a net credit of $55. They will then
exercise the option (use it to buy stock) for $50 and keep the $5 profit -- exactly the amount the
market maker, in this example, was trying to steal! This process will continue until it disappears,
at which point, the option will be trading for $20. So have no fear, the market makers cannot
steal the intrinsic value (the difference between the stock and strike) of your option!

What if you were bearish on XYZ? Well, you could instead buy a January $50 put. Now you
have the right, but not the obligation, to sell your stock for $50 per share through expiration in
January. If XYZ is trading for $40 at option expiration, the put must be worth $10 (the difference
between the strike and the stock price). If XYZ is trading at $40 before expiration, the put must
be worth at least $10, as there will still be time remaining. If a market maker decided to only bid
$8 for the put, arbitrageurs will buy the put for $8, buy the stock for $40 (far a net debit of $48),
exercise the put and sell the stock for $50 for a guaranteed profit of $2. Again, this process
(which would be measured in seconds) will continue until the put is priced fairly at $10.

So far, we have only considered the owners or buyers of calls and puts. What about the person
who sold them? Well, the seller of any option has an obligation to perform. If you sell a call, you
must sell your stock if and when the owner of the call chooses to buy it. If you sell a put, you
must buy the stock if and when the owner of the put chooses to sell it. It is only the owner (the
long position) who has the right; the seller (short position) has an obligation.

Hedging your portfolio

Now that you have the basics of options, let's look at ways to hedge and see if hedging sounds
like a good idea to you!
Assume we are back in late May and you bought Intel (INTC) at $55. Later, in mid July it's
trading above $70 and you decide to hedge by buying a January $70 put trading for $10.

By placing this trade, you have guaranteed yourself a profit of at least $5 per share through
expiration in January. This is because you can always sell your shares for $70 but it cost you $10
for a net of $60. Because you paid $55 for the stock, the put guarantees you $5 per share profit.

Now consider the advantages of this trade. If the stock continues to move higher, we still
participate in the upside (less our $10 premium). But if the stock starts to fall, as it did in mid-July
when we bought our put (see chart above), we now have removed the emotional side out from
our trading! The put allows us to focus on fundamental values in the company, and not the short-
term downtrend. We can hold the stock, hoping for an upturn, yet never regret it as we have
locked in a profit. There's also no fear of a maintenance call (for those who trade on
margin). Best of all, it's easy to sleep at night knowing you never have to look back thinking "I
should have sold that back when it was $70" because now you have the option to do so! It's not
a bad deal if you think about it -- guaranteed profit of at least $5, with no limit to the upside, and
we have all the way until January reap our rewards.

Some people think the "downside" to this trade is if the stock continues to run higher and you
"wasted" your $10 on the put. However, is your home insurance a waste just because it never
caught fire? Of course not, and you shouldn't feel that way about the put either. In fact, because
you still participate in all of the upside movement of the stock, the best thing to happen is for the
stock to climb higher, leaving your put worthless.

Let's look at our profit and loss profile (at option expiration) on the trade above with and without
the put.

Profit/Loss for long

Profit/Loss for
Stock Price stock @ $55 + long $70
long stock @ $55
put @ $10
100 + $45 + $35
 90 + $35 + $25
80 + $25 + $15
70 + $15 + $5
60 + $5 + $5
50 - $5 + $5
40 - $15 + $5
30 - $25 + $5

It is easy to see the value of the protection here. Look at the profit/loss for the two positions in
the table above. If the stock closes at $100, the long stock position will have a gain of $45 points
($100 minus the $55 cost), while the long stock/long put position will have a gain of $35 (this is
due to the $10 spent on the put). There will always be a $10 difference between the two
positions for all stock prices at $70 or above. So the investor that hedged the portfolio will only be
off by $10 in terms of profit and loss to the upside, but look at the difference to the downside!

For any stock price below $60, the hedged portfolio dominates. For example, say the stock
closes at $40. The investor who bought the shares at $55 is down $15 points. The investor who
hedged is also down $15 on the stock but the $70 put must be worth at least $30 points (the
difference between the strike and the stock price). This gives a profit of $15; however, we must
subtract out the $10 cost of the put, which gives us a total profit of $5. This $5 profit will hold for
all stock prices below the $70 strike of the put. This is exactly what happens in a fully hedged
position. The loss on the stock is exactly offset by the gain in the option.

Options can be very versatile and there is no need to necessarily have hedged our imaginary
position above at $70. If you are willing to take a $5 point "deductible," you could have elected to
purchase a $65 put which would be cheaper than the $70 for exactly the same reason your auto
insurance is cheaper when you assume some of the risk through a deductible. The options
market will always give less value to a put with a lower strike with all other factors being the
same. So the choice is yours...do you want more protection or cheaper cost?

Hedging with no out-of-pocket expense

There is another hedging technique that may be interesting to you. This one allows you to hedge
all the downside risk, as above, but without paying for it! Of course, nothing is free in the financial
markets, so what's the catch? The catch is that you must be willing to give up some or all of your
upside potential in the stock. We do this by selling call options against the stock and then using
that money to buy the puts. Remember that when we sell an option we have an obligation. So if
the person who buys the call from us elects to buy our shares, we must sell. This hedging
strategy is sometimes called a collar.

Let's run through an example with the same INTC trade above. Again, we bought shares at $55
and the stock is now $70. The $70 put is trading for $10. We could sell the $75 call option and
buy the $70 put. Depending on where they are trading, this trade may result in only a slight debit
instead of the $10 we paid before. Or we could buy the $65 put and sell the $75 call for a credit
of about one. That's right, depending on which options we choose, we can actually get paid to
put on the hedge. But be careful, the only way to get a credit is to allow for a bigger downside
loss. It doesn't mean that it's necessarily a bad trade, it's just that the credit doesn't come for
free.

For example, say we sell the $75 call and buy the $65 put for a net credit of $1. This means we
actually get paid $100 per contract. Now, what does the profit and loss look like at option
expiration?
 Profit/Loss for long
Profit/Loss for stock @ $55 + long $65
Stock Price
long stock @ $55 put + short $75 call for
credit of $1
100 + $45 + $21
90 + $35 + $21
80 + $25 + $21
70 + $15 + $16
60 + $5 + $11
50 - $5 + $11
40 - $15 + $11
30 - $25 + $11

Now compare this profit/loss (at expiration) table to the previous one. We can easily see that we
have sacrificed upside potential, as our max gain with the collar is only $21 regardless of how
high the stock goes. However, because we didn't pay $10 for the put, our downside is much
higher with a credit of $11 instead of $5.

To recap, hedging is a method of maintaining upside potential, whether limited or unlimited, and
reducing our downside loss. Hopefully, it is now apparent that hedging can be beneficial!

Hedging without options

There is a really nice way to hedge your portfolio without the use of options. Through the use of
"bear" mutual funds, mutual funds that go up in price as the market falls, one can easily hedge a
portfolio. However, some funds are better than others for hedging. One that we like to utilize
from time to time is the ProFunds UltraShort OTC Fund (USPIX). This fund is unique in that it
produces double the inverse of the Nasdaq 100 (NDX), the most volatile of all indices. So if the
NDX is down 5%, this fund will be up 10%. Of course, the reverse is true too; if the NDX is up
5%, the fund will be down 10%. Further benefits are that you are not on margin, as would
normally be the case to produce a 2:1 performance ratio. Also, you do not need options approval
and there is no expiration as with options. You are also not exposed to "time decay" which is the
portion of the option premium that erodes with the passage of time. On the downside, mutual
funds only trade at one time -- in the evening after the close -- so you cannot trade them intra-
day. But if you have a heavily laden tech portfolio and are looking for a relatively cheap way to
hedge, USPIX is tough to beat!

These are just the basics of options and hedging, and are intended to show the benefits of
hedging, which can be very important at certain times in the market.

We will be recommending various hedges for winning positions and we want you to be aware of
the idea and philosophy behind them. Please understand that these are just the basics; there are
numerous factors to consider before placing a hedge. Some of the factors are the deltas and
gammas (options sensitivity measures) as well as implied and historical volatilities. Sometimes
we will utilize roll-up or roll-down strategies as well as dollar-cost or constant-dollar methods. But
that's what we are here for. As a subscriber, you can be assured that we look at all relevant
factors, combine them with a lot of research and expertise, and relay the information to you as
quickly as possible to insure winning trades.

Remember, in a bear market, the money returns to its rightful owner. Hedging can keep you from
giving it back!
LEAPS are long-term options that usually trade in January for a maximum of three years out,
although there are exceptions. If a stock trades LEAPS, then new LEAPS will be issued in May,
June, or July, depending on the cycle. When January month is "hit" in the normal rotation (other
than by default as the current or near-term contract), a new LEAP will be added. The January
option will become a normal option and the root symbol will change.

Again, this is difficult to explain without the use of examples so let's look at INTC options.

It is currently November and INTC has the following months trading:

Month Root Symbol

November INQ
December INQ
April INQ
January '01 INQ
January '02 WNL
January '03 VNL
From what we learned earlier, we know there must be a November and December contract and
we see that there is. You can never tell which cycle a particular stock is on just by looking at the
first two months; remember, all options will have these months being traded.

We see that January '01 is the next contract traded. Normally, this would tell us that this stock is
on a January cycle. However, INTC has LEAPS, too which means there will always be a January
option traded so we still cannot be sure which cycle it is on just because we see January next in
line. Looking out to the next month, we see April is trading. Because April is part of the January
cycle, we can now be certain that INTC trades on a January cycle.

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Based on what we know, the four months highlighted above should be trading for INTC, and we
see they are when compared to the above table. When November expires, December and
January become the current and near-term months respectively, and July will be added.

In this case, no LEAPS will be added because the LEAPS are currently out three years to '03.

However, when May expiration comes around, June, July, October will be trading and January
will be added. At this point, the '02 LEAPS will have their root symbol changed to INQ and the '04
LEAPS will be added.

So depending on which cycle your stock is on, look for new LEAPS to be added sometime in late
May, June, or July. Otherwise, the basic option expiration cycle applies.

Let's go back to the questions asked at the very beginning and see if we can find out the
answers:

It is now October and MRVC has April options but SCMR does not.

1) Why is that?

2) When will April options become available for SCMR?

Looking at the options for MRVC there are:

November, December, January, April

For SCMR:

November, December, March, June

It is evident there are no LEAPS as there are only four contract months trading. We know there
will be November and December for each. For MRVC, the next month is January so it is on a
January cycle and SCMR is on a March cycle.

When will April options become available for SCMR?

Because April is not part of the March cycle, the only time April options will become available will
be when February expires. At that time, March will be the current month and April will be the
near-term contract.
Option expiration cycles can be a little confusing if you are new to them. With a little work, they
will become second nature. They are important to know because many strategies require some
type of position management during the holding period, yet the proper contracts may not
exist. Understanding these cycles can give you an added edge in option trading!

Additional questions:
1) It is now August and your stock trades on a March cycle. Which months should you
expect to see trading?

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

We will see the current and near-term months trading, which will be August and September. In
addition, we will see two contracts from the original March cycle, which will be December and
March.

2) When will the May contracts start trading?

Because May is not part of the March cycle, the only time they could trade is when March
contracts expire. At that time, April will be the current month and May will be the near-term.

3) When will the June contracts begin trading?

Since June is part of the March cycle, it could start trading months in advance, so we need to be
careful here. Run through them step-by-step.

When August expires, we will have September, October, December and March for a total of four
contracts so no June contracts, will trade at this point.

When September expires, we will see October, November, December and March, so June
still will not trade.

When October expires, we will have November, December and March for a total of three. At this
time, June contracts will be rolled out.

Option Exam 4 - Week 4

1) The put-call ratio is calculated as:

a) The total CBOE put volume / the total CBOE call volume
b) The total CBOE call volume / the total CBOE put volume
c) The S&P 500 put volume / the S&P 500 call volume
d) The S&P 500 call volume / the S&P 500 put volume

2) The put-call ratio is a contrarian indicator.

a) True
b) False

3) A relatively high put-call ratio is bearish.

a) True
b) False

4) "Percent to double" is the best indicator to detect options that are undervalued.

a) True
b) False

5) Which are the three option expiration cycles?

a) March, April, May

b) January, February, March
c) March, June, September
d) None of the above

6) It is now January and you are looking at option quotes in the newspaper. You see contracts
trading in January, February, April and July. This particular stock is on a(n):

a) February cycle
b) January cycle
c) March cycle
d) Not enough information
7) For any stock, there will always be contracts trading in at least _____ different months.

a) 5
b) 4
c) 3
d) 2

8) It is now January and a stock has options trading on a March cycle. Which four months are
trading?

a) January, February, March, April

b) January, February, May, August
c) January, February, March, June
d) January, February, April, July

9) It is now January and a stock has options trading on a March cycle. When will the October
options start trading?

a) When January expires

b) When February expires
c) When August expires
d) March cycles will never have an October option

10) It is now January and a stock has options trading on a March cycle. When will the November
options start trading?

a) When January expires

b) When March expires
c) When September expires
d) March cycles will never have a November option
 Basic Options Pricing
In 1973, Fisher Black and Myron Scholes introduced their landmark publication with a formula for
calculating the "fair price" of an option. It is arguably the most significant publication in finance or
economics over the past fifty years or more. Myron Scholes received the Nobel Prize in 1997 for
his contribution.

The reason it is so significant is because, prior to, there was no way to fairly determine the price
of an option. In this case, buyers bid very low and sellers offer very high. There becomes very
little liquidity and the market never gets off the ground.

This financial breakthrough led to the creation of the Chicago Board Options Exchange (CBOE)
because prior to, there was no way to fairly determine the price of an option. Options were traded
through the over-the-counter market (OTC) on an unregulated basis and did not have to adhere
to the principle of "fair and orderly markets." Today, largely due to Black and Scholes, the CBOE
trades tens of millions of contracts per month.

Black and Scholes basically developed an "options calculator," known as the Black-Scholes
Model, that will tell you what a call should be worth if you know five main factors (six if you include
dividends):
1) Stock price
2) Exercise or strike price
3) Risk-free rate of interest
4) Volatility of the underlying stock
5) Time to expiration

The calculator is similar to a loan calculator that will tell you what your payment should be if you
know the loan amount, time, interest rate and compounding periods. Similarly, if you know the
five factors in the Black-Scholes Model, you can determine what the call option should be worth.

Trading without theoretical values

The Black-Scholes Model is an invaluable tool for floor traders and retail investors alike.
However, there are certain principle relationships that must remain within the options markets,
with or without the Black-Scholes Model, otherwise arbitrage opportunities will be available. This
is where we will be focusing as, if you know these relationships, it will greatly improve your
trading skills and knowledge of option pricing and strategies.

Option pricing relationships

Pricing Relationship #1:

The Lower the strike, the higher the price of a call option.

If you have two call options, one that is a $50 and $55 strike with all other factors alike (i.e. same
underlying stock and time), the $50 will always be more expensive than the $55. Why?

There are a number of ways to show this, and whichever way is easiest to remember is fine -- just
as long as you understand it.

First, we can look at it from a probability standpoint:

;-------No Value ------ -------- Value ---------

$0 ------------------------------- $50 ------------------------$100

Looking at the diagram above, say a stock can only trade between $0 and $100 and you have the
$50 strike call. You have, in effect, a 50-50 chance of having intrinsic value at expiration. If the
stock is above $50, your option will have some value; if it is below $50, it will be worth nothing.
So, how do we increase our chances of having intrinsic value at expiration? Simple -- we buy a
call with a lower strike price.

No Value ---------------- Value ------------------

$0 --------------$25 ----------------------------------------------$100

For example, buying the $25 strike gives us far more room to the right (intrinsic value) as
compared to the $50 strike. Thus, our chances are better of having some value at expiration. The
markets figure this out and will accordingly bid the $25 strike higher than the $50.
The second method to show this relationship is simply from a financial cash flow standpoint.
Remember, the option gives you the right to purchase the stock. Using the example above, at
expiration, assuming you did want to buy the stock, would you rather pay $25 for it or $50? Again,
the markets realize this and will bid the lower strikes above the higher strikes with all other factors
constant.

Okay, this may sound good in theory, but how do we know that it will actually happen in the real
world? Say we quote two options one day and see the following prices:

$50 call priced at $5

$55 call priced at $6

What will happen? We found out above that the markets should bid the $50 strike higher, but for
some reason, it is lower. If this were to happen in the real world, traders known as arbitrageurs,
will do the following trades simultaneously:

Buy the $50 call: -$5

Sell the $55 call: +$6
Net Credit +$1

They will receive a credit of $1 into their account. If the stock collapses, both options expire
worthless and the arbitrageur will keep the $1. If the stock is trading higher, say $70, then the $50
call will be worth $20 and the $55 will be worth -$15 (remember, this call was sold. It will be worth
$15 to the person who bought it) for a net credit of $6 ($5 for the difference in calls plus the $1
credit from the initial trade).

This credit of $6 will be the result for any stock price at $55 or higher. What if the stock is
between $50 and $55? If the stock closes at $52, the $50 call is worth $2, and the $55 expires
worthless, leaving the trader a credit of $3. So the worst that can happen is the arbitrageur makes
$1, and the best is that he makes $6. Because there is a guaranteed profit with no cash outlay, it
is an arbitrage. Do not worry -- arbitrageurs will guarantee that the lower strike calls will always be
worth more than the higher strikes!

Insights into option pricing: Why can't I enter a buy-write for a net credit?

This leads to some interesting insights about option pricing. Theoretically, the optimal strike to
own would be a $0 strike price (these don't exist, but just say they do). What should it be worth?
Well, the price of a call can never exceed the price of the stock, otherwise -- you guessed it --
arbitrage is possible. Say a $0 strike is trading for $51 with the stock at $50. Arbitrageurs will buy
the stock for $50 and sell the $0 strike for $51 thus guaranteeing them a $1 profit.

This is why buy-writes (orders where you simultaneously buy the stock and write, or sell, the call)
can never be done at a credit. Now you know why! The call option can never be worth more than
the stock.

For puts, the opposite relationship will hold for exactly the opposite reasons listed above. Put
options will always be worth more with higher strikes with all other factors the same.

As a practice, you may want to pull up option quotes on your favorite stock and see if lower strike
calls are always worth more than the higher strikes and the opposite for puts.
Check:
Why is there an arbitrage opportunity in the following quotes? How would you perform the
arbitrage? (Answers at the end.)

$60 put = $12

$70 put = $10

Pricing Relationship #2:

At expiration, a call must be worth either zero or the difference between the stock price
and the strike price.

All this says is that a call must be worth intrinsic value (the difference between the stock price and
strike) at expiration. If there is no intrinsic value, it's price will be zero at expiration.

If the stock is trading at $57 at expiration, the $50 call must be worth exactly $7 (actually, in the
real world, bid/ask spreads will make it worth slightly less). Why must an option always be worth
intrinsic?

If it is not, an arbitrage opportunity is available. Say the following quotes exist:

Stock trading at $57

$50 call trading at $5

The arbitrageurs will realize the call is mispriced and do the following trades simultaneously:

Short the stock: +57

Buy the call: -5
Net credit +52

The arbitrageur will short the stock and buy the call as above. Now all he has to do is cover the
short. How will he do this? Simple, he will use the option, which gives him the right to buy at $50,
and exercise it immediately. Upon doing this, he will have received +$57 then spent $55 for a net
of $2; exactly the amount the call was mispriced. Because this is a guaranteed transaction with
no cash outlay, it is an arbitrage.

Check:
Stock is trading for $100
$110 put is trading for $9

Is there an arbitrage opportunity? How would you do it? (Answers at the end.)

Pricing Relationship #3:

Prior to expiration, a call option must be worth at least the difference between the stock
price and the present value of the exercise price.
This one is a little complicated, but still important for many strategies. What this says is that for
any call option, the minimum price it must trade for is the cost of carry.

Why? Think about this. Say a stock is trading for $100 and your best friend came to you and said,
"I'm getting a huge bonus in one year but really want to buy 1,000 shares of this stock now.
Would you be willing to buy it for me and I will pay you the $100,000 in one year?"

If you see your friend as risk-free, you should, at a minimum, charge him $5,000 for your forgone
interest. That's all this relationship is stating. Of course, if there is an element of risk, you should
charge more than $5 per contract. This leads to another important insight of call options -- they
are a form of borrowing money!

Let's look at this closely. If your friend owes you $5 in one year, how much is it worth today? To
answer that, we need to know the present value of $5 owed in one year at 5% interest.

What does present value mean?

The present value of money is simply the value of a future cash flow today -- the value at the
present. It's really very easy. Say you have $100 in a bank at 5% interest. In one year, you would
have $105, right? That's called the future value of money -- it is a sum of money today ($100)
valued in the future ($105). Now, present value just works backwards. If you are owed $105 in
one year, how much is it worth today? Simple, just undo the above calculation -- $105/1.05 =
$100. We would say the present value of $105 due in one year is $100 today if interest rates are
5% and the investment is risk-free. In other words, an investor should be indifferent between
$100 today or $105 due in one year.

Because your friend is borrowing $5 for one year, that amount is worth $5/1.05 = $4.76 today.
Because your principal, the $100, is being returned in one year, the only thing you will be missing
in one year is the $5 interest. So the call option, in this case, should sell for at least $4.76. Why
would it trade higher? If the markets see the stock as risky, investors would rather buy the option
versus the stock to reduce their downside risk. They will bid the option higher. So volatility makes
options -- both calls and puts -- more expensive.

Assume now that your friend wants to buy the stock from you in a year but only wants to pay $80
even though it's currently trading for $100. Now at the end of the year, you will be out $5 in
interest plus $20 in principal for a total of $25 loss in one year. How much is that worth today?
Take the present value: $25/1.05 = $23.81, and that's how much the $80 call must at least trade
for! Any price lower than this leads to arbitrage.

Mathematically, the formula for this relationship can also be written as:

Minimum call price = Stock price - Present value of the strike price.

Examples:

Let's use the above formula to calculate the minimum price of a call instead of the intuitive
method used earlier. If the stock is trading at $100 and interest rates are 5%, how much should
the 1-year, $100 strike call trade for?
Stock price - present value of the strike price =
$100 - ($100/1.05) = $4.76

For the $80 strike call:

$100 - ($80/1.05) = $23.81

Why does this formula work? Remember, we said the call should trade for at least the cost of
carry. If the stock is trading for $100 today, we can rewrite this relationship as:

$100 stock price today = $100 exercise price/1.05 + $5 interest/1.05

In order to isolate the interest amount or cost of carry (shown in bold), we can rewrite the formula
as $100 stock price - $100 exercise price/1.05 = cost of carry, which is exactly the formula above.

If the call option does not trade for this minimum amount, what will happen? This one is tricky to
see, but an arbitrage opportunity does exist. Here's how the arbitrageurs will do it.

Say we see the following quotes:

Stock: $100
$100 call: $3
Time: 1-year option
Interest rates: 5%

We have already determined that this call option should be worth $4.76 yet we see it trading for
$3.

Arbitrageurs will do the following trades simultaneously:

Short 1000 shares of stock: +$100,000

Buy the call: -$3,000
Net credit $97,000

Now, the arbitrageurs will owe 1,000 share of stock from the short sale. By purchasing the call,
they will always be able to buy back the stock for $100 if the stock is trading higher. They will
leave the $97,000 in the money-market (or T-bills) and receive $101,850 ($97,000 credit * 1.05).

The arbitrageur now has two choices depending on where the stock is trading at the end of the
year. If the stock is above $100, they will just use the call option, pay $100, and keep the $1,850
(difference between the $101,850 received in interest and the $100,000 that must be paid to
cover the short position). However, if the stock is trading below the strike price, traders will just let
the option expire worthless and buy the stock in the open market, thus increasing the profits
further.

Insights into the Black-Scholes Option Pricing Model

The Black-Scholes Option Pricing Model, in a simplified form, can be written as:

Stock price *(risk factor1) - (present value of the exercise price) *(risk factor2)
Without the "risk factors," you will see the Black-Scholes formula is exactly the same as our
formula above. Black and Scholes are simply saying that a call must be worth at least the cost of
carry plus an additional amount if risk is present. It is the calculations of these risk factors that
won the Nobel Prize!

Pricing Relationship #4:

The more time to expiration, the greater the price of calls and puts.

This relationship should be fairly obvious. The longer the life of the option, the more you will pay
for it. The more time you have, the better your chances for the option going in-the-money. The
markets, knowing this, will bid the longer-term options higher. This it true for calls and puts.

Can we be assured this will happen in the real world?

Say we see the following quotes one day:

3-month $50 strike call = $5

6-month $50 strike call = $4
(with all other factors being the same)

What will happen?

Arbitrageurs will buy the 6-month and sell the 3 month for a net credit of $1. If the stock falls
below $50, the arbitrageur will keep the $1. What if the stock is higher than $50 when the 3-
month expires?

If the stock is trading at, say, $70 after 3-months, the person who owns the 3 month call will
exercise it and buy the stock from us for $50. That's okay because we'll just exercise our call and
buy the stock for $50. The reason we can exercise our call option early is because equity options
are American-style, which means they can be exercised at any time*. We still keep our $1 and
have not lost a thing.

*It is important to note that, under normal circumstances, it is never optimal to exercise a call option early except to
capture a dividend. However, to complete the arbitrage, we must exercise early.

Here's a tricky question: What if these are European style calls? European-style options can only
be exercised at expiration, not before as with American-style calls.

If this is the case, and we are assigned on the 3-month call, we would have to buy stock in the
open market at $70 and sell it for $50. That's a loss of $20 to us although we still have our
original $1 credit from the original transaction. It may appear as though we are faced with a $19
loss since we cannot exercise our call option.

So what happens now? Are we stuck? No, and here's why:

All we have to do is sell our call to close in the open market. Remember, under Pricing
Relationship #2, the call must be worth at least the difference between the stock price and
exercise price; therefore our call will be trading for at least $20 ($20 intrinsic value + time
premium). So selling our call in the open market, we can complete the arbitrage!
Pricing Relationship #5
For any two options, the difference in price cannot exceed the difference in strikes.

This relationship says that for any two call options, the difference in their prices cannot be greater
than the difference in their strikes. An example will make this easier. Say we see the following
quotes one day:

$50 Call = $10

$55 Call = $4
(with all other factor constant)

We know from Pricing Relationship #1 that the $50 call should be worth more than the $55, and
we see that it is. However, Relationship #5 says that there cannot be this much of a difference
because the difference in strikes is $5, yet the difference in price is $6. So the difference in prices
has exceeded the difference in strikes.

How will the markets correct for this? You should know by now that arbitrage is the answer!

Arbitrageurs will buy the $55 call and sell the $50 for a net credit of $6.

Buy $55 -$4

Sell $50 +$10
Net credit +$6

If the stock collapses, the arbitrageur will keep $6. This will be true for any stock price below $50.
If the stock close between $50 and $55, say $52, the trader will lose $2 on the short $50 call, but
still keep the initial $6 for a net gain of $4.

The worst that can happen is for the stock to close above $55, for the trader will be assigned on
the $50 strike. We must then buy the stock at market and sell for $50. Of course, we can always
exercise our $55 call to buy the stock, so no matter how high the stock moves, the worst we can
be hurt is by the amount of the spread, in this case, $5. Because we made $6 initially, we will end
up with a credit of $1.

So the arbitrageur will make a minimum of $1 and a maximum of $6.

An easier way to understand Pricing Relationship #5 is to view the two contracts as if they were
money. Imagine you are bidding on a foreign currency and can buy any denomination of bills. If
you bid for 100 Yen, for example, you would never bid more than double that amount for 200
Yen.

Likewise, options must obey the same principle. If you think about it, there really is no difference
in owning a $50 call vs. a $55 call in terms of financial liability. The person with the $50 strike can
pay $50 for the stock; the person with the $55 strike can pay $55. So the market will never give
you more than the difference in strikes.

The same will hold for put options too.

Insights into option prices

Look at the call option quotes for your favorite stock. Look very deep in-the-money. What is the
difference in asking prices? If you look deep enough, it will be exactly the difference in strikes and
no more. If you look for the at-the-money quotes, you will see they will be less than the difference
in strikes, usually about half. The markets will not give you the full value of the difference in
strikes, because at-the-money options involve more risk so the markets will bid these spreads
downward. Finally, look for the far out-of-the-money quotes. There will be virtually no differences
in the asking prices; their spreads have collapsed to zero.

Now you should have a basic understanding of why this relationship is true for any option quotes!

How to easily figure your maximum gain on spreads

Now that you understand some basics in option pricing, you should be able to easily figure out
the max gain and loss for spreads! Say you buy a $50 call for $3 and sell a $55 call for $1. Think
about it this way: the maximum this spread could ever be worth is $5, right? However, you paid
$2 for it (paid $3 and sold for $1 for a net of $2). So the maximum gain is $3 on this spread. The
maximum loss is the amount you paid, $2. See, it's really not that hard once you understand why
the prices must hold.

These are just some of the most basic yet most important relationships to understand about
options. It should be evident now, too, that market makers cannot just "throw any quote on the
board they please" as many people will have you think. There is a very intricate web of pricing
relationships that cannot be broken otherwise arbitrage opportunities will arise.

Understanding option pricing is a key element to success in trading!

As a subscriber to 21st Century Options, you will have access to our selected trades that are
based on, among other factors, differences in theoretical prices. If you are having poor results
with your trades, let us help you by giving you access to a team of professionals that will put the
odds on your side.

Answers:
Why is there an arbitrage opportunity in the following quotes? How would you perform the
arbitrage?

$60 put = $12

$70 put = $10

There is an arbitrage opportunity because, all else constant, a higher strike put will always be
worth more than a lower strike put. Because a put represents a cash flow in to your account upon
exercise, it is more desirable to have a higher strike so it should trade for a higher price.

To arbitrage:
Buy $70 put -$10
Sell $60 put +$12
Net cash +$2

If the stock collapses, you will make $10 from the spread plus $2 from the original transaction for
a total of $12. If the stock flies to the upside, above $70, both contracts become worthless and
you keep the $2. If the stock closes between $60 and $70, you will make money on the $70 but
the $60 will expire worthless. So you will make at least $2 and possibly $12 from this arbitrage.

Question #2
Stock is trading for $100
$110 put is trading for $9

Is there an arbitrage opportunity? How would you do it?

Yes, an arbitrage opportunity exists because any option, call or put, must trade for at least the
intrinsic amount. In this case, the put option is trading for $9 but should be at least $10.

To arbitrage:
Buy stock -$100
Buy $110 put -$9
Net outlay -$109

Exercise the option and receive $110 for a net credit of $1. This is the exact amount by which the
option is mispriced.

Black-Scholes
The black-scholes factors
According to the Black-Scholes formula for option pricing, there are five main factors that affect
an options price. Technically, dividends are a sixth factor but aren't of much concern, as they are
generally factored into the price of the option, since all market participants know the amount of
the dividend and when it will be paid. However, if it is a surprise dividend or dividend increase or
cut, then it becomes a much more relevant factor.

According to the Black-Scholes model, the factors are:

1) Stock price
2) Exercise or strike price
3) Interest rates (risk-free rate)
4) Volatility of the underlying stock
5) Time to expiration
6) Dividends

We will look at each of these in turn and see exactly the effects they have on calls and
puts. Some will be fairly intuitive and others not but all are important if you really want to
understand options.

Stock price
The stock price is probably the most obvious of all the factors that affect an option's price. This is
simply due to the fact that the option's price is derived from the underlying stock -- hence the
name derivative instrument.

As the stock price increases, the price of a call will increase and the price of the put will
decrease with all other factors constant.

This is a theoretical statement, so do not be alarmed if your call option is not up with the
underlying stock trading higher. In fact, anybody who has traded options for any length of time
has experienced this. There are sound reasons why this happens, so let's see if we can make
sense of it.

First of all, there are many strikes for any given option. In fact, new strikes will be added if the
stock is moving, either up or down, significantly. If a stock is trading at $120 up $2, a $100 strike
will likely be up a significant portion of that $2 -- maybe up $1-1/2 or so -- depending on the
volatility and time remaining on the option.

What about a $150 strike? Here, it is difficult to say. We know it is worth more theoretically, but it
is up to the market to determine just how much. As an analogy, say you are betting on a runner to
complete a twenty-six mile marathon and the runner has just taken the first step across the start
line. Do you adjust your bet upward? Probably not, even though, theoretically, the runner is
closer to the finish line than he was one step earlier. From a theoretical viewpoint, you should be
a little more confident on your bet that he will complete it. It does not mean you will adjust your
bet.

This holds for the options, too. An option can be thought of as a bet that the stock will cross the
finish line -- the strike -- by expiration. As the stock moves higher, all calls become worth more
theoretically. Whether or not the market reflects added value remains to be seen.

This same reasoning holds for puts, but in the opposite direction. Because a put option confers
the right to sell stock, it should be worth more as the stock moves lower. As the stock falls, all
puts become worth more theoretically.

Exercise (or strike) price

The exercise price is closely related to the stock price. In fact, they are really just two ways of
looking at the same thing. When we were considering the stock price above, we assumed the
strike price remained constant (as well as all other factors). Now, if we hold the stock price
constant but lower the strike, effectively we are doing the same thing; that is, in either case we
are putting the call option more in-the-money or at least in that direction.
As the exercise price (strike price) is decreased, calls become worth more and puts less
with all other factors constant.

By the same reasoning, as the exercise price is raised, puts become worth more and calls will be
worth less.

Another way to understand this is by thinking of what a call does. It gives you the right to
purchase stock. Now, would you rather buy stock for $100 per share or $120 per share? Of
course, you'd rather pay $100 and so would everybody else in the market, so market participants
correspondingly bid the $100 strike higher, which is just a reflection of the higher demand.

Similarly, a put option gives you the right to sell your stock. Because everybody would rather get
$120 per share, investors bid the $120 put higher than the $100 strike.

Interest rates
How interest rates affect calls and puts are a little more difficult to understand. It may be helpful
to think about the following analogy. Calls are a form of borrowing money. Although you pay for
the call option, in effect you are borrowing funds. Here's why: Say you buy a one-year $100
strike. You control all stock prices above $100 for the next year but are not obligated to pay him
until one year from now. So effectively you are borrowing money from the call writer. Because
interest rates affect the cost of carry to the seller:

An increase in interest rates will increase the price of a call option and decrease the price
of a put option with all other factors constant.

Although this is fairly easy to show mathematically, it is easier to remember if you understand it
conceptually. So let's look at another line of reasoning.

Say interest rates are very high -- 20%. You have $100,000 in the money-market that you would
like to invest in stocks. You can either buy the stocks today, or for a fee, buy a call option which
gives you control of the stock but allows you to defer payment. The choice should be clear: buy
the call option so you can hang on to your money and continue to earn interest. The markets
follow this same line of reasoning and bid the calls higher.

What about the puts? Puts give you the right to sell your stock, which represents a cash flow into
the account, which is nice to have if interest rates are really high. So do you elect to buy puts to
defer the sale? No, in fact, you may even sell the puts to generate cash into the account so it can
earn the high rate of interest. Because few of the market participants are willing to buy puts
relative to those wanting to sell them, the price of puts will fall.

There is one thing to be careful with here. All of these factors we are discussing assume the
other factors remain constant. In the real world, this is rarely the case. So if interest rates rise
suddenly, do not be surprised if your call options decrease in price and don't increase as we have
said so far. This is usually due to the fact that stock prices will fall with increases in interest
rates. We know that falling stock prices correspond with falling call prices. But it should be
evident that all factors did not stay the same in this case -- we assumed interest rates rose and
stock prices fell.

Volatility
Without a doubt, volatility is the single-most important factor of the Black-Scholes model. In fact,
it is the only true unknown in the equation. For example, if you asked 10 different people what
the stock price is, they would all give you exactly the same answer. Likewise, they would quote
the same strike price, risk-free rates of interest, and time remaining on the option. However, what
should they tell you is the correct volatility measure for the stock? The 10-day average? The 20-
day? The 50-day? Or should they quote the projected expected future volatility? It should be
easy to see why this is the most important factor in the model -- it is the only one that nobody
knows for sure.

If volatility increases, both call and put prices will increase with all other factors the same.

Now, you may be thinking if volatility increases, the stock becomes riskier. Why would somebody
pay more for a risky asset? After all, junk bonds trade for lower prices than government bonds
because of the risk.

The reason for the apparent contradiction is that options have a limited downside; the owner can
only lose what they put into it.

Look at the following diagram. Assume one investor buys stock at $50 and another purchases a
$50 call for $5:

30 35 40 45 50 55 60 65 70 75
Gain on stock
purchased at -20 -15 -10 -5 0 5 10 15 20 25
$50
Intrinsic gain
on $50 call
-5 -5 -5 -5 -5 5 10 15 20 25
purchased at
$5

If you purchased stock at $50 and the stock closes at $30, you are down $20. However, the call
owner is only down $5. In fact, that's the most the call owner can lose; however, they can match
the stock purchaser on profit for all stock prices above $50. So more volatility just means a
higher expected return for the option buyer -- whether calls or puts. So investors will bid up the
prices of options that are tied to risky stocks.

Time to expiration
This factor is fairly straightforward. We said earlier that an option could be viewed as a bet that
the stock will be above the strike price (for calls) or below the strike price (for puts) by
expiration. In other words, you are in effect betting that the option will have intrinsic
value. Because of this, the more time available, the more likely the stock will have intrinsic
value.

The more time to expiration, the more valuable are calls and puts.

From a trading standpoint, the more time you buy, the better. This is because calls and puts
become increasingly cheaper (on a per month basis) the more time you buy. For example, if a
one-month option is trading for $5, you would have to look at a four-month option to double the
price to $10. Many people think that a two-month option would double the price but it doesn't -- it
takes four times the amount of time to double the price. So the implication is that it becomes a
better and better deal for the option buyer to buy time. Likewise, it becomes a worse and worse
deal for the options seller to sell longer-term options.
Please don't confuse this to mean that it is wrong to sell longer-term options or that it's wrong to
buy little time because that's not necessarily true. It depends on many factors with the particular
strategy at hand. All that is being said is that, everything else constant, option buyers should buy
lots of time and option sellers should sell short amounts of time.

Special note: There is one small point that should be made here. It is possible for a deep-in-the-
money European put option to become more valuable with the passage of time. This is due to
the fact that the European option holder must wait to receive the cash from the put. So a deep-in-
the-money European put will be worth the present value of the future cash flow and will increase
in price with the passage of time. However, options on the equity market (stocks) are always
American style so this caveat doesn't hold for most of our discussions on equity trading
strategies. Just be aware that there is one exception to this rule.

Dividends
Last, we will consider the effect of dividends on calls and puts. This one is also fairly
straightforward.

If a stock pays a dividend, the price of the stock is reduced by the amount of the dividend
(rounded to the nearest 1/8th of a point) the next trading session. The reason the price is
reduced is because the company has paid out cash -- one of its assets -- so is now worth less
than before it paid the dividend. For example, say a $100 stock will pay a $1 dividend
tomorrow. On the opening, the stock will be trading for $99 unchanged (this is considered to be
unchanged since the fall is not due to supply and demand factors).

Think about it for a moment. If the stock price is down and all other factors stay the same, what
will happen to the call? You've got it, the call price will fall.

Dividend increases cause call prices to fall and put prices to rise with all other factors the
same.

Why will put prices rise? Because the put owner can force the seller to buy the stock, which is
now worth even less after the dividend is paid, so the put options become more valuable.

The following table will help as a recap. The table shows the effect on call and put prices with the
six factors being up. Of course, the reverse will be true if the factors are down.

If this factor is up: Call price Put price

1 Stock price
2 Exercise price
3 Risk-free rates
4 Volatility
5 Time to expiration
6 Dividends
Most strategies are some form of a play on the five main factors that affect option prices. If you
understanding these factors, you are on your way to becoming a better options trader!

Implied Volatility
As you learn more about options, you will eventually run into the term "implied volatility." It is an
essential concept in option trading; in fact, many strategies rely on "volatility" as opposed to
directional plays with the underlying stock. For example, short straddles and calendar spreads
are volatility plays, as the long position does not want the stock to move (or at least move very
far).

Understanding implied volatility allows you to find the best options to use, even if just a long or
short position. It will also allow you to understand why, sometimes, the stock moves up but your
long call moves down which seems contradictory -- until you understand implied volatility.
We'll take it slow, but you will understand implied volatility when we're through.

A little statistical background

We will be using the term standard deviation throughout, so we need to have a basic
understanding of what this means. Standard deviation is a statistical measure telling you how
likely it is that something deviates from the average. We will not be doing the exact calculations,
but it is necessary to understand the concept.

For example, the average adult male is about 5'9" tall. How often will we see one taller than
6'5"? In order to answer this, we need to know how the numbers are distributed. One of the
most popular distributions is called a normal distribution or bell curve. If we assume that the
heights of adult males are normally distributed and we have calculated the standard deviation,
then all we need to do is find where 6'5" falls on the bell curve. With a little math, we can figure
out how likely it is that we will see someone 6'5" or taller.

With the standard bell curve, about 68% of the area lies within one standard deviation, and about
95% lies within two standard deviations. Essentially all information lies within three standard
deviations under a bell curve.

Volatility
Before we attempt to explain implied volatility, we should clarify what is meant by the term
volatility. Although we hear generic phrases like "that stock is volatile," it is actually a statistical
concept with a very precise meaning. Volatility is the annualized standard deviation of stock
price movements.

We'll show you what this means with an example:

Say there is a stock trading at $100 with a volatility of 20%.

If we assume that stock prices are random, then about 68% of the time (or two out of three
chances), the stock will be between $80 and $120 after one year. This is found by adding and
subtracting 20% the volatility to the $100 starting stock price.

Remember, this is one standard deviation from the starting point of $100, so that, means that plus
and minus 20% will occur 68% of the time.

To continue, we would expect 95% of the time to see the stock in one year trading between $60
and $140 (or 19 out of 20 chances). This was found by adding 2 * 20%, or two standard
deviations from our initial price of $100. Because 95% of the bell curve area lies within two
standard deviations, we expect to see the stock within two standard deviations (between $60 and
$140) 95% of the time.

Now, it may seem a little odd to make a statement like "95% of the time, the stock will be between
$60 and $140." After all, doesn't it make sense that it either will be or won't be between these
prices? What we mean by this statement is that if the exact conditions were to occur over and
over many times, 95% of the closing prices after one year would be between $60 and
$140. While it is true that after one year, the stock either will or will not be between these prices,
we do not know that beforehand so we say "95% of the time it will be between these prices."
It should be intuitive that the higher the volatility number, the wider the range of closing prices we
would expect to see after one year. For example, one would expect a wider distribution of closing
price possibilities for a stock with 40% volatility versus 20%.

The black-scholes option pricing model

Now that we have a grasp as to what volatility means, let's find out what implied volatility is all
about. In order to do that, we need to return to the Black-Scholes Option Pricing Model (please
see our section under this title if you need more information).

The Black-Scholes Option Pricing Model is basically an options calculator. It is similar to a car-
payment calculator where you may input the amount you are financing, the interest rate, the term
of the loan, etc., and the result is your payment. Similarly, with the Black-Scholes Model, you put
in the five key factors that affect an options price: stock price, exercise price, risk-free rate of
interest, volatility, and time to expiration and out pops the price of the call option. This is the price
we would expect to see the option trading for.

Let's look at this closely:

Stock price + exercise price + risk-free rate + volatility + time = call option price

Say we want to find out the price of a 3-month, $100 call option. If we ask hundreds of investors
for the stock price, we should get the same answer. All they have to do is look at the quote. The
exercise price is given and so is the time so we'll get exactly the same answers there. While
everybody may not return the exact answer as to the risk-free interest rate, they should all be
very close. Further, interest rates do not greatly affect option prices especially over a three-
month period. So 4 out of the 5 factors (all in blue) are basically givens; that is, if we asked
hundreds of people for these four pieces of information (stock price, exercise price, risk-free rate,
time to expiration), we should get exactly the same answers (allowing for a slight variation in the
risk-free interest rate).

Now for volatility. What should these hundreds of investors tell us is the correct volatility to
use? Some may say the historic volatility is 20%, so let's use that figure. Others may say the
historic is 20%, but the stock has been at 30% volatility over the past month, so let's use
that. Still, others may say it has been 30% recently, but they feel it will be higher so we should
use 35%.

The point is that the only true unknown factor of the Black-Scholes Model is volatility, and that's
why it is so important to understand. It is the one variable that determines option prices!

Let's run through an example with actual numbers.

$100 $100 5.5% 20% 90 days $4.61

Stock price + exercise price + risk-free rate + volatility + time = call option price

If we actually run the above numbers through a Black-Scholes Option Pricing Model we find the
$100 call option should be trading for $4.61.

BUT, let's say we look at the option quote and it is actually quoting $5 1/2. In this case, the call
option price becomes a given; our hypothetical hundred traders would all return this same value
as well.
Implied volatility
Something must be out of balance as 20% volatility returns a call price of $4.61, yet we see it
quoting $5-1/2. The only term we can adjust on the left hand side of the equation is volatility (red)
as all the other factors (blue) are givens.

Now the question becomes, what volatility will produce an option price of $5-1/2 with all the other
factors the same? If we go back to the Black-Scholes Model, we can try different volatilities until
we come up with a price of $5-1/2. If we do, we see the volatility that makes the equation true
(that is, the call option price $5-1/2) is 24.6%.

We would say the implied volatility of the option is 24.6%. This means the market is telling us it
feels the forward volatility or future volatility of this stock over the next 90 days is about 25% and
not the historical 20% we had observed earlier. In fact, this is one of the main benefits of an
options market; it allows a window in which to monitor the opinion of the market.

Trading volatility
One of the main tactics of option traders is trading volatility. In order to understand why, we need
one more statistical concept known as mean reversion. While this sounds intimidating, it's really
very simple; it suggests that many types of data revert back to the mean.

For example, if you flip a coin many times, you would expect to have "heads" land 50% of the
time. Now, it shouldn't shock anybody if, after the first ten flips to see 7 heads and 3 tails -- a
70% hit rate. But if you keep flipping, that will eventually revert closer to a mean of 50%. In other
words, on average, the averages win!

The same holds true for options and has been proven in many studies. For example, if a stock
has an historic volatility of 20% but the markets are trading it with a volatility of 30% (implied
volatility), then on average, we should expect to see the volatility revert to the mean of
20%. What happens to calls or puts when the volatility falls? The price comes down as
well. The reverse is true, too. If implied volatility rises, so will the prices of calls and puts.

So as a whole, traders tend to buy options with low implied volatility hoping that the volatility
reverts to the higher average and increases in price. Likewise, they tend to sell options with high
implied volatility hoping the premiums deflate as they fall to the historic means.

Volatility trap
Now we may be able to shed some light as to why sometimes the call you hold falls in price even
though the stock rises. This happens to puts as well. You may see the stock fall, yet have your
put decline in value.

Say you are interested in a stock trading at $50 that has an historic volatility of 25% and is about
to announce earnings. You feel they will have a record quarter and great comments from the
analysts, so you decide to buy 10 $50 calls.

Now think about this. You are probably not the only investor who had the same thought. You
very likely deduced this from current information and recent comments from the company or
analysts. So the entire market is probably doing the same thing. By acting on this information,
the price of the calls keeps getting bid higher and higher. Let's say it is bid up to an implied
volatility of 40% instead of the historic 25%.
You buy your call option with very high implied volatility (remember, options with high implied
volatilities are the ones professional traders look to sell). The stock releases great numbers and
comments from the analysts and is now up 2 points. But your option is now being priced with a
volatility of closer to 25%. Why, there are no new buyers speculating for a good earnings
release; it's now old information. According to the Black-Scholes Model, you will get a two-point
increase in the stock price but a 15% decrease in volatility, which can leave you holding an option
that is down in price even though the stock is up. This phenomenon is called a volatility trap.

Be careful when buying or selling options. Check with your broker to see what the implied
volatilities are relative to the historic levels. If they cannot get this for you, you should consider
finding one that can, as the information can be crucial for winning option trades.

Learn to use the tactics professionals use to put the odds on their side. If you are selling calls,
perhaps even a covered call, you should check the implied volatilities. If the implied volatility is
high, this is one more piece of information suggesting the odds are on your side. If you want to
buy an option, check to see if the implied volatilities are low and if it will tilt the odds in your favor,
assuming your assumptions about the underlying stock are correct.

Please note that buying an option with high implied volatilities or selling one with low implied
volatilities is not necessarily wrong. It's just that you have now added another dimension stacked
against you.

How volatile is the market?

One way to monitor the overall volatility of the market is with the Chicago Board Options
Exchange (CBOE) indicator called the VIX (volatility index) and can be quoted under that same
symbol. The VIX was created in 1993 and calculated by taking a weighted average of the implied
volatilities of eight S&P 100 (OEX) calls and puts. The options have an average time to maturity
of 30 days, so the VIX is intended to indicate the implied volatility of 30-day index options.

Learn to interpret and use implied volatilities in your trading. It will open your eyes to a new way
of trading options and add a new list of strategies to implement.

Delta Gamma
The single most important concept in option trading is that of delta and gamma. Investors not
aware of these terms or concepts are setting themselves up for a disappointing
trade. Understanding these advanced option terms will improve your investment results
immediately!

Let's start with a simple trading question:

You are bullish on XYZ stock and want to invest in options. Which of the following do you
do?
A) Buy calls
B) Buy puts
C) Sell calls
D) Sell puts

If you answered A, as most people do, you just set yourself up for a potentially losing trade. And
no, you didn't misread the question; you just fell into the most common error in option investing.

To really emphasize why so many people lose with options, think about this: We never even got
to the point of which option to buy, yet have already made a critical mistake. There was no
discussion as to whether we should buy a 1-month, 3-month, 6-month, or even LEAPS
option. There was no discussion as to which strike. We just invested a lot of money and sent a
wounded horse to the starting gate.

Let's find out what the mistake is and how to correct it.

Options have two components to their value

Stocks, compared to options, are much easier to trade. All you have to do is decide whether the
stock is going up or down. You only need to determine the direction. Of course, anyone who has
ever invested in stocks knows that this, in itself, can be incredibly difficult.

With options, there are two components to their value -- direction and speed. It is this second
component, speed, that makes options such tricky investments. Delta measures direction, and
gamma measures speed. Although there are specific numerical measures of delta and gamma,
we are only going to consider them in a much simpler, conceptual format.

Delta, as mentioned, measures direction. A long call position has positive delta; in other words,
the value of the call will go up (positive) as the price of the underlying stock rises. Put options
have negative delta; their value will go down (negative) as the price of the stock rises. Of course,
the opposite is also true. If the underlying stock goes down, calls will lose and puts will gain in
value.

What if we are short a call? Then our position will have a negative delta meaning our position will
lose value as the stock rises. Similarly, if we are short a put, then we have positive delta; our
position will gain in value as the stock rises.

It should be easy to see now that there are two ways to obtain positive deltas; long calls and short
puts.

KEY CONCEPT: If you are bullish on a stock, you want positive delta for your option
position. If bearish, you want negative delta.

What about gamma? Gamma measures the speed component of an option. In a conceptual
sense, gamma can be measured, as can any object with speed, with time. So time premium is a
way to determine gamma. The higher the time premium of an option, the higher the
gamma. Because the time premium is the portion of the option's price that erodes with the
passage of time, it is this portion that is exposed to slow or no movement in the underlying stock.

Example:
XYZ stock is trading for $50

XYZ $50 call trading for $5

XYZ $30 call trading for $21

Here, the $50 call is all time premium. Therefore it will have a higher gamma component. The
$30 call has only $1 time premium, so compared to the $50 call, its gamma component will be
much lower. Gamma can also be thought of as a risk measure. We can say the $50 call is
riskier, in terms of speed, than the $30 call, because if the stock sits still, the $30 call can only
lose $1 (3.23% of value), while the $50 call can lose the entire $5 (100% of value).

Another way to look at the risk factor is in terms of break-even points. The $30 call will need to
have the stock trading at $51 by expiration in order to break even. Why? If the stock is $51, the
call will be worth exactly $21, the price paid for the option. However, the $50 call must have the
stock trading at $55 to break even. So again, the $30 call, with respect to speed, is less risky. In
other words, the $30 call does not need as much movement in the stock to break even as
compared to the $50 call.

Although it may seem counterintuitive, long calls and long puts both have positive gamma. This
is because you need speed in the underlying stock if you have a long position; you need to make
up for the time premium you paid.

KEY CONCEPT: If you are looking for quick speed of movement in the underlying stock,
your option position should have positive gamma. If you expect the stock to move slowly
or sit flat, your option position should have zero gamma or even negative gamma.

Putting it all together

Example

We are bullish on XYZ trading at $100

1-month $105 call is trading at $7

1-month $95 put is trading at $5

We determined at the beginning of this lesson, that most investors would be inclined to buy calls
because we are bullish. So let's buy a call and see what happens!

We are long the $105 call at $7. At expiration, the stock is trading at $110. The question now is,
are we correct in our bullish assumption? There is no question that we are. The stock is up a
whopping 10% in a month (that may not seem like a lot, but that's an annualized rate of over
200% -- at that rate, you would more than triple your money in a year). So just how much of a
killing did we make on our call?
The $105 call will be trading for $5, exactly the intrinsic amount. We paid $7 and sold for $5, yet
we were correct in our bullish assumption. That's a 28% loss on the investment for being
correct! Sound familiar?

Now that we know about deltas and gammas, let's see if we can correct the mistake. This trader
just made the classic mistake of trading options only on delta -- the direction of the stock. Let's
polish up the trade a bit.

We know that the trader is bullish so we should have positive delta -- either long calls or short
puts. But now let's say that we ask the trader, "How quickly do you think the stock will
move?" Let's say he says, "I think it will move up but slowly."

Now we are in position to set up a winning trade -- assuming the trader's assumptions are
correct.

We now know he wants positive delta (because he's bullish) but also needs negative gamma
(because he believes it will move slowly). The following chart should help us determine what we
should do:

Delta Gamma
Long Calls + +
Long Puts - +

So how can we get positive delta and negative gamma? We can short the puts, which will give
us the opposite signs as listed in the table above. Long puts have negative delta and positive
gamma, so a short position will have positive delta and negative gamma -- exactly what the trader
needs!

Now, if he shorts the $95 puts, he will receive $5 and keep the entire $5 instead of losing $2 as
he did with the calls. What if the trader doesn't want to be short or doesn't have the option
approval level to be short? We could do a credit spread that would lessen the risk. Or, we know
he desires negative gamma but a gamma close to zero would also work. Remember, time
premium is synonymous with gamma, so to get a gamma of zero (or close to it), we could also
look at deep-in-the-money calls.

With XYZ at $100, the $80 call may be trading in the neighborhood of $20-1/2 ($20 intrinsic + a
small amount of time premium). If he buys the $80 call he will spend $20-1/2 and with the stock
closing at $110. He will be able to sell the option for $30 for a profit of $9-1/2 (46% gain), which is
certainly better than the 28% loss taken when he traded only on direction alone.

Now you should be in a position to fully answer the question asked at the beginning. The correct
way to answer is this: We should have clarified the gamma component with the investor; in other
words, is the investor bullish quickly or slowly. Once we determine that, we can then recommend

either long calls or short puts, or a host of other strategies that would properly align the deltas and
gammas with his directional opinion of the stock.

It should now be evident that there are TWO components you need to determine when dealing in
options -- direction and speed. In order to make a profitable trade, a position with positive
gamma must move up; a position with negative gamma does not have to move up, it just cannot
move down. These are two very different situations. If you don't consider both, you will almost
certainly set yourself up for a losing trade.

More Delta Gamma

The concept of delta and gamma are of utmost importance for the option trader. In our section
"Deltas and Gammas" we learned that delta measures direction and gamma measures speed of
the option. But it was presented in a format to understand the concepts without the use of
numbers.
In this section, we will broaden the concept of delta and zero-in on an exact definition you can
use and understand.

The importance of delta cannot be emphasized enough; understanding it will most likely change
the way you pick your option trades.

The concept of delta

Delta is a mathematical relationship between the option and the underlying stock. It expresses
the dollar amount the option will increase for a very small move in the underlying stock. How
much is a small move? Technically we mean very small (as in infinitesimal) but it will probably be
easier to understand if you think of a $1 move in the underlying stock.

For example, say an option is trading for $50 and has a delta of 1/2. If the stock were to move up
$1 to $51 rather quickly, we would expect the price of the option to move up $1/2 from $5 to $5-
1/2. In other words, the stock gained 1 point but the option only gained 1/2 point. If that same
option, instead, had a delta of 1/4, then the price of the option would have moved to $5-1/4 -- only
1/4 the move of the stock.

Delta will always be a number between 0 and 1 for calls (0 and -1 for puts). There are some
exceptions to this but they are usually minor and not too important for trading purposes. Delta
constantly changes primarily from moves in stock price, time or volatility.

We now want to find out why the option does not move point-for-point with the stock. This may
sound trivial, but it will change the way you see and understand options!

It will take some basic math but we will make it as easy as possible. We will start first with a
simple analogy to get the idea of why deltas exist.

Why does delta exist?

This often confuses the new options trader. Often they will purchase an out-of-the-money call
option that sits relatively flat in price -- even though the underlying stock is moving up. They
wonder how that can be since call options are supposed to go up in value as the stock moves
up. If you understand the following analogy, you will understand why the market will not price
your option point-for-point with the underlying stock unless the option is very deep-in-the-money
or in-the-money with little time remaining.

Analogy: Promotional cell phone coupon

Assume you are holding a promotional coupon that allows you to purchase a particular cell phone
for $100. The phone actually sells for $120. Also assume that this coupon is marketable; that is,
it can be bought and sold freely and there are a large number of buyers and sellers.

Notice that this is similar to a call option; it gives the buyer the right to buy the asset for a fixed
price.

If these assumptions are true, the coupon should be trading for $20. This is because someone
could buy the coupon for $20 and use it to buy the phone for $100. The total purchase price
would be $120, which is the market price of the phone. In this case, there is no net advantage to
owning the coupon. The markets will always make sure there is not net advantage to owning one
asset over another, otherwise arbitrageurs will correct for it.
Let's look at two different scenarios and see how the coupon will react:

Scenario I
It is announced to the market that the price of the phone will increase to $130. What will happen
to the price of the coupon? For the same reasons as above, it will immediately move to $30. A
consumer could buy the coupon for $30 and use it to pay $100 for the phone thus paying $130 --
the market price.

Notice that the phone jumped by $10 (from $120 to $130) and so did the coupon (from $20 to
$30). We could say the delta of the coupon is one. In other words, the coupon appreciates
dollar-for-dollar with moves in the underlying asset, in this case, the phone. This will be true for
any price appreciation or depreciation in the phone (assuming the phone price does not drop
below $100 because the coupon cannot have negative value).

Scenario II
Let's say the phone company executives are meeting tonight and will decide if the phone price
should be raised from $120 to $130. These executives are in a deadlock and have decided to
break the tie by flipping a coin: heads they raise the price, tails they do not. It is announced to the
market that the price of the phone may increase to $130 with a 50%-50% chance; otherwise the
price will stay the same.

Now comes the tricky part. What happens to the price of the coupon?

Think about this, the price of the coupon will either move to $130 or stay at $120 with a 50%-50%
chance. If the market does not bid up the price of the coupon, there is an inherent advantage for
a speculator; they will bid up the price hoping the decision is to raise the price of the phone. The
reason is this: If faced with this same situation multiple times, half of the time investors would
make $10 (when phone is raised to $130 and coupon jumps from $20 to $30) and half the time
they will not make anything (when phone price stays the same and coupon stays priced at
$20). So on average, if given this opportunity multiple times, investors will make $5; they make
$10 half the time and make nothing half the time.

Mathematically, this can be shown as follows:

(1/2) * (+$10) = $5
(1/2) * ( $0 ) = $0
Net gain +$5

Mathematically, this is called the expected value and is key to understanding delta. The expected
value is nothing more than the sum of the probabilities multiplied by the outcomes.

So what should speculators do? They should bid up the price of the coupon to where there is no
net advantage -- they bid it to $25. If not, the market will continue to compete for the
difference. For example, if the market only bids the price to $24, now speculators have a $1 net
advantage.

The expected value is:

(1/2) * (+$6) = +$3
(1/2) * (-$4) = -$2
Net gain +$1

With the coupon priced at $24, speculators are putting $4 at risk in order to make $10. Half the
time they will win for a net gain of $6, and half the time they lose for a net loss of $4. If they were
allowed to do this many times, they would expect to win, on average, $1 per time. So they
continue to bid the price of the coupon to $25 so there is not net advantage.

When priced at $25, the expected value of the coupon is:

(1/2) * (+$5) = +$2.5

(1/2) * (-$5) = -$2.5
Net gain $0
When the prices rises to $25, the buying pressure stops.

What happens if the markets immediately price the coupon to $30 as they did in scenario I? For
similar reasons, if the market prices the coupon at $30, again there is an inherent advantage for
the speculator; they will sell it because it is theoretically overpriced.

The expected value will be:

(1/2) * (+$10) = +$5

(1/2) * ($0) = $0
Net gain +$5

Half the time speculators will make $10 by selling the coupon at $30 and buying it back for $20
when the phone price is not raised; otherwise, they make nothing (sell coupon for $30 and buy it
back for $30). Again, there is a net advantage to being short so speculators will compete for this
money. For the same reasons as above, they will continue selling the coupon until the price is
$25.

When the price falls to $25, the selling pressure stops.

Understanding delta
Let me give you a simple definition of delta and hopefully you will understand why the markets will
not give you dollar-for-dollar moves on your option.

Definition:
Delta is the probability that the option will have intrinsic value at expiration.

Now that you know exactly what delta is, you should immediately understand why it exists. If an
option has a delta of-1/2, then the markets will only compensate you for-1/2 of the move in the
underlying -- otherwise there will be a net advantage for speculators to buy or sell! This is exactly
what happened with the cell phone example in scenario II.

Once the option is deep-in-the-money or in-the-money with little time remaining, the market will
increase the price of your option dollar-for-dollar with moves in the underlying. This is because
the market is effectively saying that the option will expire with intrinsic value. This is exactly what
happened in scenario I with the cell phone coupon. It was announced that the price will be
increased; in other words, it is 100% guaranteed to happen. When the market heard this news,
they priced the coupon dollar-for-dollar.

New Uses For Delta

You may hear that delta is of little concern for the average investor and only used as a theoretical
hedging value for floor traders. While it is true that it can be used in this sense, there are also a
great deal of insights that are practical, if not necessary, for retail investors.

First, because we know delta is the probability that the option will have intrinsic value at
expiration, it will shed some light on your option picks. Often, new traders are attracted to the
short-term, out-of-the-money option because it is cheap. If it has a long way to get to the strike
and little time to do it, what kind of probability do you think the markets are assigning to it? If you
said very low, you're right. The delta on short-term, out-of-the-moneys are usually in the
neighborhood of 0 to 20%. Now you know why they don't appreciate dollar-for-dollar with moves
in the underlying. Usually, these options are lucky to see a few cents appreciation in them, but
are often eaten away by bid-ask spreads.

If you're not having a lot of success with your option trades despite getting the direction of the
stock right, try using ones with higher deltas!

What are the chances I will have my stock called away?

Here is another use and one we get a lot of questions on. Many times investors will be in a
covered call position (long stock and short call) and ask, "What do you think the chances are that
I will have my stock called away?" Most brokers will tell you there is no way to know but this is
completely false. The answer is the delta. If you are long stock and short a call with a delta of
0.70, at this time, the markets are telling you there is a 70% chance you will lose your stock.

Keep in mind that we said "at this time" there is a 70% chance. Obviously as information
changes, so will the delta.

Why Deltas Change

The main factors that affect delta are stock price movement, time and volatility in the underlying
stock. Let's find out how these factors affect delta and why.

Again, we could use a lot of math, but a simple analogy will probably work better.

Let's assume you are an odds maker for an upcoming basketball game. It's the Miami Heat vs.
the Orlando Magic. You do your analysis and decide that the Heat have a 60% chance of
winning.

There are now 10 minutes remaining in the game and the score is Miami: 70 Orlando: 72. As the
odds maker, should you change your odds at this point? Probably not, as the score is too close
and there is too much time remaining to be sure.

Example 1:
Let's say that, instead, the score is Miami: 80, Orlando:70 with 5 minutes remaining. Now,
because your team is a good bit ahead, although not unbeatable, you will probably decide to
increase your odds, right? You may now, for example, think Miami has a 70% chance of winning.

Your job as the odds maker is to decide which team will win. Well, that's exactly what the market
does with options. The market tries to determine which options will win -- which ones will have
intrinsic value at expiration. So as your option goes deeper-in-the-money, the odds of it expiring
with intrinsic value will increase; that is, the deltas will increase.

As the stock rises, call deltas increase and put deltas decrease.

Now back to the basketball game.

Example 2:
Let's now assume that the score is Miami: 86, Orlando: 80. If we still had 5 minutes on the clock,
this would be a close one to call. Instead, let's drop the time to only 30 seconds remaining. Now
you would almost certainly boost your odds to nearly 100%; it's almost a sure thing the Heat will
win.

Notice the difference with the above examples. In the first example, a ten-point difference in
scores boosted the odds from 60% to 70%. However, in the second example, a 5-point
difference with little time boosted us to nearly 100%. Remember, you are trying to determine
which team will win. In this case, you as the odds maker see no way for the Magic to win at this
point, so you boost the odds for the Heat to nearly 100%.

As time decreases, options with intrinsic value will have delta increase. Out-of-the-money
options will have deltas decrease.

In other words, the options that are "winners" (have intrinsic value) are becoming more likely to
stay that way as time decreases.

Example 3:
Still assume that the score is Miami: 86, Orlando: 80 with 30 seconds on the clock as in the
second example. But this time, some key players for the Heat suddenly get removed from the
game. Because of this, the Heat's scoring ability has now been reduced. As the odds maker,
instead of increasing the Heat from 70% to 100%, you would either not increase them as much or
possibly decrease them.

A losing team is helped by adding key players to the game (or having key players removed from
the winning team).

This is what happens when volatility is increased in the underlying stock. A losing option (out-of-
the-money) is helped by increased volatility; it now has a chance to become a winning option and
the deltas will increase. Similarly, an in-the-money option is hurt by volatility; it may now end up
out-of-the-money.

As volatility increases, out-of-the-money options will increase deltas and in-the-money

options will lose deltas.

An easy way to remember time and volatility concepts is that they are synonymous.
As time or volatility increase all options become more at-the-money!

To be a good trader, it is not necessary to know the actual number for delta as much as it is to
know the relationships between delta, stock price, time, and volatility.

Let's run through some examples to be sure you've got it.

1) The stock is at $50. Which option has a higher delta, a one-month $60 call or a 6-month
$60 call? Why?

Remember, the market is trying to assign odds as to which option will be a winner or in-the-
money. Because both are out-of-the-money, you would have to assign a higher probability to the
6-month call. It is much more likely to be a winner relative to the one-month call. The 6-month
call will have the higher delta. If the underlying stock move up $1, the 6-month call will appreciate
more relative to the 1-month.

2) The stock is $100. Which has a higher delta, a one-month $90 call or a 3-month $90
call? Why?

Both of these options are currently winners because they are in-the-money. But the 3-month
option is more likely to become a loser relative to the 1-month so the 1-month, will have a higher
delta. If the underlying stock moves up $1, the 1-month option will appreciate more relative to the
3-month.

Remember, once you are winning, you want the time clock to go to zero!

3) The stock is $50 and a 3-month $55 call has a delta of 0.45. Suddenly, there is increased
volatility in the stock. Does delta increase or decrease?

The option is currently "losing" because it is out-of-the-money. But with the added volatility, it is
much more likely to become a winner. Delta will increase.

4) A stock is trading at $75. What is the delta of a $75 strike call?

Because this option is at-the-money, it is riding the fence of being in or out-of-the-money. The
delta will be very close to-1/2. Technically, the delta will be a little higher because of the
continuous compounding assumption in the Black-Scholes Option Pricing Model. But for most
trading purposes, an at-the-money option has a delta of-1/2.

5) You want to use a call option as a substitute for stock. Would you look at short or long
term? In-the-money or out-of-the-money?

If you really want the option to behave virtually like stock, you should look at short-term, deep-in-
the-money calls. Because, these are in-the-money with little time, there is close to a 100%
chance they will expire with intrinsic value, so the market will have to increase the option dollar-
for-dollar with moves in the underlying stock.

If you continue to work with the concept of delta, it will greatly help you with your option trades
whether beginning or advanced. It will shed new light on the risks involved with short-term out-of-
the-money options. It will show why longer-term options are more desirable than shorter term if
you are looking at out-of-the-money options. You will start to understand strategies in new ways
and more closely match your positions to your opinion on the market. You will become a more
informed and accomplished options trader, and that can only mean better trades!
Option Exam 5 - Week 5
1) What happens to the price of call options if interest rates increase? (Assume all other factors
remain constant.)

a) Call prices increase

b) Call prices decrease
c) Call prices remain unchanged

2) What happens to the price of calls, all else constant, if the exercise price is decreased?

a) Call prices increase

b) Call prices decrease
c) Call prices remain unchanged

3) What happens to put option prices as the stock price rises (assuming all else is constant)?

a) Put prices rise

b) Put prices fall
c) Put prices remain unchanged

4) What happens to the prices of both calls and puts, all else constant, if time remaining to
expiration is increased?

a) Both calls and puts increase in price

b) Calls increase and puts decrease in price
c) Both calls and puts decrease in price
d) Puts increase and calls decrease in price

5) If the stock price rises by one dollar, the price of the call option will rise by how much?

a) One dollar
b) It depends on the delta
 c) More than one dollar, to reflect the added risk of options
d) Sometimes more, sometimes less than one dollar

6) If the delta of a call option is 0.70, what will be the delta of the corresponding put option?

a) 0.70
b) 1.70
c) -0.30
d) -0.70

7) The delta of a call is 0.80 and the implied volatility just increased. Assuming all other factors
the same, what happens to the delta?

a) It will increase
b) It will decrease
c) It will stay the same
d) Cannot be determined

8) What do delta and gamma measure?

a) Delta measure direction, gamma measure speed

b) Delta measure speed, gamma measure direction
c) Delta and gamma measure speed at different times
d) Delta measure direction for calls and gamma measures direction for puts

9) Which is true regarding delta?

a) Calls and puts have positive delta

b) Calls have negative delta, puts have positive delta
c) Calls and puts have negative delta
d) Calls have positive delta, puts have negative delta

10) Which is true regarding gamma?

 a) Calls and puts have positive gamma
b) Calls have negative gamma, puts have positive gamma
c) Calls and puts have negative gamma
d)Calls have positive gamma, puts have negative gamma

11) If an option is trading for $7 but "should be" trading for $6 according to the Black-Scholes
Option Pricing Model, how would you account for the discrepancy?

a) Market makers are cheating

b) Implied volatility is high
c) Implied volatility is low
d) Bid-ask spreads must be wide

Week 6 : Basic Strategies

Long Call
Long and short calls
A long call option gives the buyer the right, but not the obligation, to purchase stock for a fixed
price over a given amount of time. It is the call buyer that has the right to purchase stock; the
short call seller has the obligation to sell stock if the long position exercises their option. There
should be no concern for default by the short side as the Options Clearing Corporation (OCC)
guarantees the performance of the contract.

The long call strategy is therefore bullish, as the value of the call rises with increases in the
underlying stock. Please understand that when we say call prices rise as the stock rises, this is
assuming that all other factors stay the same. It is quite possible for calls to fall in value as the
stock rises due to time or volatility decreasing.
Investors are typically attracted to the long call strategy for two main reasons:

1) Leverage

2) Protection (hedge)

Long call options provide leverage, that is, they cost far less to control shares of stock as
compared to an outright purchase; therefore, their performances will be magnified (up or down)
relative to the stock. They also provide protection by limiting your downside risk.

Example:
You are bullish on MRVC trading for $39-1/2.

If you want to buy 1,000 shares, it will cost you $39,500. You could, instead, buy 10 January $40
calls which are trading for $9-1/2. This would cost you $9,500.

If the stock is trading at $60 by expiration, the long stock position would be worth $60,000 while
the call would be worth $20.

Leverage
Your return on the long stock is 52% (not annualized) while the return on the option is 110% (not
annualized). This is what they mean by leverage. The investor who bought the call options, in
this example, more than doubled the returns as compared to the long stock position.

Protection
What if the stock falls substantially? The long stock position has $39,500 at risk, which,
theoretically, could end up at zero. The long call only has $9,500 at risk. This is what is meant
when you hear that long call options provide protection -- they limit your downside risk. The long
call position is controlling the same number of shares (1,000) for $30,000 less at risk ($9,500 vs.
$39,500).

It should be noted that the long stock position, in this example, while beaten in return on
investment (50% vs. 110%) would never lose in terms of total dollars. For example, the long
stock position earned $60,000 - $39,500 = $20,500, while the long call earned $20,000 - $9,500 =
$10,500. The long stock position earned nearly twice the amount of dollars, which is why its
return is roughly half the return for the long call. So be careful in your understanding when you
hear that options beat stock in terms of returns. Assuming two investors are controlling the same
number of shares, the option will outperform stock in terms of return on investment and not total
dollars.

What if our long call position puts the same dollars at risk as the long stock position? Long stock
would have cost $39,500 so, for that money, the call option buyer could purchase 41 contracts
(controlling 4,100 shares) at $9-1/2. Now, the call position will be worth 4100 * $20 = $82,000 at
expiration. The return on investment is back to the 110% as in the example above. However,
this option investor is controlling 4,100 shares and not 1,000. This is another way to view
leverage; for the same dollar investment, one can control more shares through the options
market.

So regardless of how you cut it, options do provide leverage!

Profit and loss diagram

We can see the effect of the protection by the profit and loss diagram above (if you are not sure
how to read this chart, please see our section under "Profit and Loss Diagrams"). Again, the
most the option investor can lose, in our original example, is the $9,500 paid for the 10
contracts. Yet, they participate in all of the upside returns above the $40 strike price.

This added downside protection does not come for free. We can also see that the break-even
point is raised from $39-1/2 to $49 for the call buyer.

Strategies using long calls

One very useful strategy that many investors use is that of diversification through call
options. For example, say you have $50,000 to invest and would like 500 shares each of ten
great companies. The good news is you will probably make money over the long term; the bad
news is this may cost you $300,000. Well, with long calls you can invest in all of them for
$50,000 or less. Now you have a lot of diversification without the need for a lot of money to
achieve it.

Deep-in-the-money-calls
Probably one of the most underutilized strategies in options is that of long deep-in-the-money
calls as a substitute for long stock. Using our previous example, MRVC is trading at $39-1/2. We
were looking at the $40 strike for $9-1/2. However, this is all time-premium as the stock is still
below the strike price. So there is substantial risk if the stock does not move quickly enough
(please see our section on deltas and gammas). This is why we saw the break-even point
pushed to $49 in the profit and loss diagram.
Let's say we have two traders with $40,000 to invest. The first trader buys 1,000 shares MRVC
at $40 for a total outlay of $40,000. The second trader buys a deep-in-the-money call such as the
Jan $20 trading for $21-3/8 for a total price of $21,375, and leaves the remaining $18,625 in the
money-market.

The second investor who buys this option will be participating nearly point-for-point to the upside
just like the long stock position that paid $40,000. But let's say the stock falls substantially --
down to nearly $20. Now the long stock position is down $20 points, while the long call position is
down less than this. Why? Because now the option is more at-the-money and the time premium
is increasing; it provides a crutch for the option holder. So long deep-in-the-money option holders
enjoy the benefit of point-for-point upside movement and less than point-for-point downside. In
the worst-case scenario, the first investor is bankrupt while the second investor still has $18,625
sitting safely in the money-market.

Think about how powerful this strategy can be especially for those volatile tech stocks you may
be trading. You participate in all of the gains to the upside but not to the downside. It's a tough
strategy to beat.

Short calls
The strategy behind the naked (or uncovered) short call is neutral to bearish. The investor is
betting that the stock will either fall or sit still.

Important note! This is very different from the short call against long stock position (covered call
strategy), which is neutral to bullish. All too often investors make the big mistake of hearing
"short call" and immediately associate the covered call as a bearish position. Things change
when you start pairing options with other positions! So please keep in mind that we are talking
about naked, or uncovered, calls in this section.

When selling naked (uncovered) calls, the investor takes in the premium, and in exchange is
willing to assume the upside risk of the stock. Let's take a look at the profit and loss diagram
assuming the MRVC investor above shorts 10 Jan $40 calls at $9-1/2:
We see the maximum this investor can make is the $ 9-1/2 points, or $9,500 for 10
contracts. The investor is also exposed to unlimited upside exposure if the stock continues to
climb above $49 1/2. Why? The investor starts to lose profits for any stock price above $40 --
the strike -- at expiration. However, because of the $9-1/2 points we received as an initial credit,
the investor can afford to have the stock rise to $40 + $9-1/2 = $49-1/2 before losses will be
incurred. It should be evident that this is among the most dangerous of all option positions!

Long call options are among the most basic of strategies, yet are very powerful due to the
leverage. They are relatively easy to understand, so they're usually the first option trade for most
investors. However, be sure to see our sections on "Deltas and Gammas" and "Implied Volatility"
before entering into a long or short call position.

Long Put
Long and short puts
A put option gives the buyer the right, but not the obligation, to sell stock for a fixed price over a
given amount of time. It is the put buyer, also called the long position, who has the right to sell
stock. The short put seller, on the other side of the trade, has the obligation to purchase stock if
the long position exercises their option. There should be no concern for default by the short side
as the Options Clearing Corporation (OCC) guarantees the performance of the contract.

The long put strategy is therefore bearish, as the value of the put rises with decreases in the
underlying stock. Please understand when we say that the put will rise if the underlying falls, that
is assuming all other factors remain the same. It is entirely possible for the put to fall in value
even though the underlying is falling, but this is usually due to changes in other factors such as
time or volatility.

Investors are typically attracted to the long put strategy for two main reasons:

1) Leverage
2) Protection (hedge)

Long put options provide more leverage than short stock for speculators who are bearish. In
other words, for a given dollar investment, the return on investment for the owner of a put option
is much higher as compared to the investor who shorts stock. However, this leverage works both
ways. The long put owner may lose 100% of their investment with just a small adverse move,
whereas the short seller will lose only a small fraction.

Example:
You are bearish on Intel (INTC) currently trading for $31-3/4. Let's compare a short seller with a
long put buyer.

With short sales, there is usually more leverage than with the purchase of stock. The reason is
that most speculators will only post the required Reg T amount of 50%.

If a speculator wants to short 1,000 INTC, they would need to post a minimum of 50%, so the
total credit would be $31-3/4 * 1.5 * 1,000 = $47,625. Remember, when you short stock, you
receive a credit; you will purchase the stock later for a debit.

The accounting looks like this:

Credit = $47,625
MVS = $31,750
Equity $15,875

Notice that your equity is $15,875 and when divided by the market value short of $31,750 gives
you 50% equity, which is the Reg T amount.

Let's assume the stock falls to $25 per share. Now the account looks like this:

Credit = $47,625
MVS = $25,000
Equity $22,625
Notice that the credit balance does not change; it is simply cash sitting in the account. The
market value short (MVS) will change which will change your equity. If the MVS falls, your equity
will rise and vice versa.

The stock fell, in this example, about 21% from $31 3/4 to $25 giving the investor a 42% increase
in equity from $15,875 to $22,625. The reason the investor doubled the move of the stock is
because they only posted 50% of the requirement which doubles the leverage.

Let's look at the puts now. A March $30 put is $1 1/4 and an investor could instead elect to
purchase 10 contracts to control 1,000 shares and pay only $1 1/4 * 10 * 100 = $1,250. Later,
with the stock at $25, the $30 put will be worth at least $5 (more if there is some time remaining
on the option). Here the investor paid $1 1/4 but sells for $5 (and maybe more) for a minimum
300% increase.

Leverage
Your return on the short stock is 42% (not annualized) while the return on the option is 300% (not
annualized). This is what they mean by leverage. The investor who bought the put options, in
this example, has a return on investment that is over 7 times higher as compared to the short
stock trader.

Protection
What if the stock rises substantially? The short stock position has an unlimited amount of risk as
a stock can keep rising without bounds. The long put holder, however, is only at risk for the $1
1/4 points regardless of how high the stock moves. Therefore, the long put holder also gets a
"peace of mind" by holding the option; they know the maximum loss up front.

As with call options, one must be careful in interpreting return on investment. In the above
example, the option trader had a much higher return on investment (300% vs. 42%). However,
the short stock position has more dollars. The short stock seller gained $6,750 while the option
trader gained $3,875. This will always be the case, as the put buyer must pay some sort of
premium. The smaller the premium, the more the total dollars will match that with the stock
trader.

Profit and loss diagram

We can see the effect of the protection by the profit and loss diagram above (if you are not sure
how to read this chart, please see our section under "Profit and Loss Diagrams"). Again, the
most the option investor can lose is the $1,250 paid for the 10 put contracts. Yet, they participate
in all of the downside moves below the $30 strike price.

This added upside protection does not come for free. We can also see that the break-even point
is lowered from $30 to $28-3/4 for the put buyer.

Long puts can also be used as an "insurance policy" against long stock. Say you own 1,000
shares of Intel so your total position is worth $31,750, but you fear it may fall in the short
term. You can purchase 10 of the $30 strike puts for $1-1/4 (which raises the cost basis of your
long shares by the same amount), and be hedged for all prices below $30. For example, assume
the stock falls to $25. Your stock is now worth $25,000, which is down $6,750. But your long $30
put is worth at least $5,000. At expiration, you can elect to do one of two things:(1) hang on to
your stock and sell the put for $5,000; this will help to offset the $6,250 loss, or (2) Exercise your
put and sell your shares for $30.

Notice that the put, at expiration, is worth $5,000 yet the long stock position was down $6,750 for
a difference of $1,250. This is the cost of the put, and it will never be recouped.

Long puts can be especially useful if you trade stocks on margin and are close to a maintenance
call. Sometimes it is worth a little bit of money to insure yourself from a forced sale of your stock.

If you didn't want to spend $1-1/4 for the put option, you may decide to buy a lower strike put
such as the $25 strike. The $25 will be cheaper than the $30 because you are, in effect,
assuming a $5 point deductible as compared to the $30 strike. In other words, protection with the
$25 strike will not start until the stock is trading below $25. As with any insurance policy, the
higher the deductible, the lower the premium.

Short puts
The strategy behind the naked (or uncovered) put is neutral to bullish. The investor is betting that
the stock will either rise or sit still. Another strategy for short put sellers is to use short puts as a
way to purchase stock. In other words, it changes the scope of the investment if you are selling
puts on stock you want to purchase anyway. Selling puts against stock that you don't mind
owning is similar to getting paid to place buy limit orders below the current market.

For example, using the above INTC prices, say you want to purchase shares of Intel, but you
think it may fall to $28 in the short term. Many investors would place a buy order with a limit of
$28 and just hope it hits. If it doesn't, they have completely missed any profitable
opportunity. Compare this to the short put seller. The short put seller may want to purchase the
stock, but is afraid it may fall to $28. This investor sells the $30 put for $1-1/4. Now, if the stock
rises, at least this investor receives $1-1/4. If the stock falls to $28 at expiration, the short put
seller will be forced to buy a $28 stock for $30; however, they received $1-1/4 for it, which makes
their cost basis $28-3/4. Granted, their cost basis is a little higher than the investor who used the
limit order. But the limit order will have zero profit if the stock rises; they miss out on all
opportunities.

Using short puts as a way to purchase stock you want to own can be a tough strategy to beat!

From a profit and loss standpoint, the short put looks like this:

We see the maximum this investor can make is the $1-1/4 points from the sale. But if the stock
falls, the investor starts heading into losses. Keep in mind that if you are willing to purchase the
stock regardless, then it's difficult to say these are truly losses, at least when compared to a
speculator who sells puts with the intention of never buying the stock. The short put seller who
intends to purchase the stock is, in fact, potentially deferring the purchase but getting paid if it
rises. If the stock falls, he may be forced to buy stock, but he was going to purchase it
anyway. Now, the big tradeoff with the short put selling for stock you want to buy is this: the stock
may take off to the upside, and you're left with only the premium from the put.
An alternative hedging strategy is to do the following: Buy half the amount of shares you are
willing to purchase and sell puts on half the shares. Using the above Intel example, if you are
willing to purchase 1,000 INTC today, maybe just buy 500 shares and sell $5 for the $30
puts. Now, if the stock moves higher, you will profit on the 500 shares plus the premium from the
puts. If it moves down, you were willing to assume this risk anyway, but now you've lowered your
cost basis by $1-1/4 on the additional 500 shares.

Put options are great tools for hedging. However, be careful in using puts as an ongoing form of
insurance. The reason is due to the relatively high costs of puts. It's not uncommon to see put
option premiums reach 20% (or more) of the underlying stock price on an annualized
basis. Historically, stocks have returned about 12% per year so if you use puts as a continuous
form of insurance, you'll be losing at an annual rate of about 8%. Instead, use puts for specific
points in time that concern you such as upcoming earnings reports or other announcements that
may affect your stock. If you want to speculate on stock prices, using puts may be a better bet
than shorting stock once you understand all the risks.
 Covered Calls
For many investors, the covered call is their first encounter with options. It is a popular strategy
because it generates cash into the account and is relatively simple to understand. Unfortunately,
there are a lot of misconceptions about this strategy and some can lead to devastating
losses. This may be the single-most important piece of information you will read on options, as
there are many professionals and academic journals that fall prey to one of the most critical
mistakes with covered calls. I will point out the mistake later.

What is a covered call?

A covered call (also called a covered write) is a strategy where the investor buys stock and then
sells a call against it. By selling the call, you are giving somebody else the right to buy your stock
at a fixed price.

The reason this strategy is called "covered" is because you are not at risk if the stock moves
higher. This is different from the trader who sells calls "uncovered" or "naked," as that position
will continually lose money -- theoretically an unlimited amount -- as the stock moves
higher. Because of this risk, naked call writing is among the most dangerous of all option
strategies. But, with covered writing, this upside risk is removed; you will always be able to
deliver the shares no matter how high the stock is trading. The short call is "covered" by the long
stock.

For example, you may buy 1,000 shares of JDSU at $102 and sell a one-month $115 strike call
currently trading for $4-1/2. Now, for the next month, you may have to sell your shares at a price
of $115. This is regardless of where the stock is trading. If the stock is trading at $200 at option
expiration, you will most likely be forced to sell your shares for $115. Of course, for this right, the
person buying the call paid you $4,500. So on the surface, it doesn't seem to be a bad deal. It's
like getting paid to place a sell limit order at $115.

However, there is significant risk to the downside. With our JDSU trade above, we paid $102 for
the stock and received $4-1/2 for the option. The stock could fall $4-1/2 points to $97- 1/2, and
we'd still be okay -- that's our break-even point. That's another small benefit of covered-calls;
they provide a little downside hedge. In other words, they reduce the cost basis of our long stock
position. But if the stock continues downward from there, we get more and more into a losing
situation. In fact, the maximum we could lose, theoretically, is the $102 we paid for the stock,
less the $4-1/2 we got for the option -- a total of $97-1/2 points. In other words, we are at risk for
everything below the break-even point.

Many professionals and even academic journals will tell you that the risk of a covered-call
position is that you may lose the stock! Nothing could be further from the truth. Risk, for most
people, is not defined as missing out on some reward. It is defined as loss of principle. So if you
get nothing else from this page, please understand that the risk of a covered call is that the stock
goes down, not up. This is the mistake referred to at the beginning.

If a professional tells you the risk of a covered call is losing the stock through assignment of the
short call, ask him why it's called a covered position? He will likely tell you, "That's because
you're not at risk if the stock moves higher -- you will always be able to deliver the shares." Think
about it...on one hand the broker tells you the risk is that the stock moves higher and on the other
they tell you you're not at risk if it moves higher. Which is correct?

Are you still not convinced that's the risk? Well, think about this. Say you were thinking of buying
a stock trading at $100 and asked your broker what the risk of the investment is. He claims,
"Well, the risk is that you buy it for $100 and then sell it later at $120, only to watch it trade higher
at a later date." If that were really the "risk," the optimal strategy would be to bet the farm and
buy all the stock you can. Buying at $100 and selling at $120 certainly doesn't sound like a lot of
risk, does it? The same holds for the covered call -- you are the one holding the stock. The risk
is that the stock goes down.

Two types of covered call writers

This brings us to another critical point of covered call writing. There are two basic categories of
call writers; those who use it as an income producing strategy against stock they like, and those
called "premium seekers."

If you write calls against stock you like, then the covered call strategy can be argued to be one of
the most powerful strategies for most investors. After all, you are getting a little downside hedge
and getting paid to sell the stock at a price you see as favorable. If it is a stock you like, then you
obviously are willing to assume all of the downside risk. You would hold the stock whether
options were available or not.

However, there are those who do not understand the downside risk side of covered calls. These
are sometimes called the "premium seekers." These people look through the option quotes, find
one that pays a high premium relative to the stock price, and then enter into a covered
call. Usually they follow up this trade with a comment like, "By the way, what exactly does this
company do?"

If you trade covered calls this way, stop! I have seen million-dollar accounts fall below $10,000
doing nothing but covered-calls using this method.

Trading Example: I remember one investor who bought 7,000 shares of a stock trading at $55 (to
make matters worse, it was on margin or borrowed funds). He thought he was laughing all the
way to the bank when he discovered that a three-week option was bidding $8 for a $55
stock. "Wow, that's over 15-fold on your money," he exclaimed. "At that rate, it would take less
than two and a half years to turn $1,000 into $1,000,000."

The trader bought the shares and wrote the calls waiting patiently for his windfall to arrive. At
option expiration, the stock was trading at $4. Yes, he did get to keep the entire $8 premium for
the calls. I'll let you decide if it was worth it.

There was a reason the markets were bidding up the options so high. They wanted someone
else to hold the risky stock. The risk is that the stock falls.

A word of caution
Many times you will hear people say that the risk of the stock going down in a covered call
position should not be of great concern. They reason that you can always write another call after
the first call expires and eventually "write your way out of the stock." There is a big danger in
believing this. Covered calls realistically only give you one chance over the short term to write
the calls. This is not to say that you will never be able to write a second call against your
stock. It's just that you may have to wait a long time to do it.
For example, say a stock is trading at $100 and you write a $105 call for $5. At expiration, the
stock is now $75. At this point, you decide to write another call. You'll be lucky if the $105 call is
trading for $1/16 which, after commissions, will net you zero. How about the $80 call? Yes, you
will definitely get some money here and let's assume another $5. If you write this call and the
stock goes up to $80 or higher at expiration, you just locked yourself into a loss! How? Your cost
basis is $90 ($100 originally paid for the stock less two calls written for $5 each) and you just
gave someone the right to buy your stock for $80, which locks in a $10 loss.

Sometimes you will hear people tell you to "roll down" or "roll up" if the stock is moving
significantly. However, there are drawbacks with those strategies as well, so let's take a look at
each. Please just understand that covered calls do have a sizeable amount of risk and that you
may not be able to realistically keep writing calls month after month.

Rolldown
We just saw a situation where an investor bought stock for $100 and wrote the $105 call for $5,
but got locked into a loss because they wrote the $80 call at expiration. Many investors
incorrectly think you can beat the market to the punch by rolling down your strike as the stock
falls.

A rolldown, for covered calls, is simply a strategy where the investor buys the short call to close
and simultaneously sells a lower strike call to open. The new position is a covered call but at a
lower strike; the investor has thus "rolled down" their strike price.

For example, say the stock is now trading at $100. The above investor could buy the $105 call to
close and simultaneously sell the $100 call to open. However, they will receive a credit less than
the difference in strikes (you'll find out why during week 5 when we talk about basic option
pricing). So the investor has given someone the right to purchase their stock for $5 less than
originally anticipated, yet received less than $5 to do so -- a net loss.

Let's say they roll down for a net credit of $3 and see what happens. Remember, the original
trade was buying stock at $100 and selling the $105 call for $3, which gives a cost basis of
$97. Once the rolldown is executed, we're assuming the investor receives an additional $3,
which gives a new cost basis of $94 for a $6 gain if the stock is called at $100. Keep in mind the
original trade had a profit of $8 if called at $105. The reason the investor has reduced their profit
margin by $2 is because that's the net loss on the rolldown. Credits can be deceiving with
options. A net loss develops because the investor gave somebody the right to purchase his or
her stock for $5 less, yet only received $3 for it.

If you roll down long enough, you will eventually lock in a loss. Be very careful when rolling down
and keep track of your effective cost basis.

Rollup
The opposite of the rolldown is the rollup. To enter a rollup with covered calls, you buy the call to
close and simultaneously sell a higher strike call to open.

Let's assume our investor is, instead, faced with the stock trading up to $110 now. If they rollup,
they may, for example, buy the $105 call to close and simultaneously sell the $110 call to
open. Again, we'll assume they pay less than the difference in strikes, which will always be true
prior to expiration. If the investor rolls up to the $110 strike for a net debit of $3, they have paid
$3 to gain $5.
On the surface, this doesn't appear to be a bad deal. However, keep in mind that with the original
position, the investor is more likely to receive $105 from the exercise of the $105 call. Now they
are short the $110 call, which is the same price of the stock, which means there is inherently
more risk with the rollup. This does not mean that investors should never rollup a covered call,
but rather use it sparingly in situations where you are very confident that the stocks price won't
fall too dramatically.

Another way to view the additional risk is that, with each rollup, you are raising the cost basis of
your long stock position. If you chase a fast rising stock with rollups long enough, you will
eventually end up holding a long stock position with a relatively high cost basis on a stock that
may come crashing down.

Most people try to roll up to get themselves out of a "losing" situation. For example, the above
investor wrote the $105 call. If the stock is suddenly trading for $120, most investors try to undo
the "damage" by rolling up. However, you should always remember your reason for writing the
call. If you purchase the stock for $100 and are willing to sell it at $105 for a $5 fee (the option
premium), you should probably let the stock go. If you never intended to sell your stock, then you
must question why you wrote the original call in the first place. Remember, a short call is an
agreement to give someone else the right to purchase your stock. If that's not what you wanted
to do, then writing calls is the wrong strategy.

Getting out of a covered call

Many times investors write calls and regret it later when they see the stock trading for a much
higher price. If you have a renewed confidence in the stock, you may want to consider closing
out the short call.

Many investors, however, have trouble with this as they feel they are taking a huge loss. This is
absolutely false. Let's take a look at an example and see why. Say an investor has $40,000
cash in the account with no other positions. If he buys 100 shares of stock for $100, he now has
$10,000 worth of stock and $30,000 cash. Now assume he writes a $100 call for $3, which gives
him $30,300 in cash for a total account value of $40,300.

Now assume the stock is $130 at expiration, which makes the $100 call worth $30. If the investor
buys the call to close in order to not lose the stock, they must pay $30. Because they received $3
initially, they feel they have incurred a loss of $27. But they often fail to realize that the stock
position is now worth more, too. If they buy the call to close, they will pay $3,000 but now their
stock is worth $13,000! That's because they are no longer obligated to sell the stock for $100
once they buy the $100 call to close. The stock is worth $13,000 and the cash is reduced to
$27,300 for a total account value of $40,300 -- exactly the same as before the closing of the call.

If you exit a covered call position by buying the call to close, you're really swapping cash for an
unrealized capital gain in the stock. In the above example, the investor lost $3,000 for sure in
cash, in exchange for an unrealized gain of $3,000 in the stock.

So if you have new information on the stock and decide you want to keep it, buying the call to
close is not the worst thing to happen. You really don't lose anything at the moment you buy
back the call -- but you may if the stock falls afterward. Buying covered calls to close doesn't
really destroy account value; it just changes the values of the assets in the account.

If you decide to get out of a covered call position by buying back the call, be sure you are
comfortable holding the stock at the current valuations.
Profit and loss diagram
In the profit and loss diagram, we are assuming an investor buys stock at $50 and writes a $60
call for $5. You can see the break-even point has been reduced to $45 because they paid $50
for the stock but received $5 for the call, giving them an effective cost basis of $45. Also, we see
that for any stock price above $60 -- the strike -- the profit is capped at $15, which is the
maximum. Again, you must wonder why many professionals tell you this is the risk zone. It
should be evident from the chart that the downside risk is that the stock falls.

Covered calls are a very useful strategy if used properly. If you use this strategy, make sure you
are writing calls against stock you would hold regardless. Otherwise, treat the position as highly
speculative and invest accordingly.
 Straddles and Strangles
A long straddle is a strategy where the investor buys a call and buys a put with the same strike
and time to expiration.

The most common use of the strategy is when the trader expects a large move but is unsure
about which direction. This strategy is often suggested, even by professionals, to be used prior to
a big announcement such as an earnings report or FDA approval for a drug company. If the
report is favorable, the stock may run wild to the upside; if not, it may come crashing
down. However, please bear in mind that other participants in the market are thinking the same
thing, so the put and call will be bid up to much higher prices making it difficult to recoup your
costs!

Probably a better use of the straddle is to buy them if you expect increases in volatility. Increased
volatility will increase the price of both calls and puts. So, if you are faced with a big
announcement or news, you should buy the straddle only if you think the market has
underestimated the volatility.

Nonetheless, the strategy attempts to play both sides of the market hoping that the move in the
underlying stock, whether up or down, is sufficient to cover the cost of the losing option.

Example:
A trader buys a March $50 call for $5, and a March $50 put for $3 for a total of $8.

The profit and loss diagram looks like this:

Because the trader buys both the call and put, the break-even points will be raised
significantly. In this case, the stock must rise above $58 (the strike price plus both premiums) or
fall below $42 (the strike price minus both premiums). Because only one of the options -- either
the call or put -- can expire in-the-money[1], the downside to this strategy is that you are
effectively buying a very expensive call and a very expensive put. Why? Again, only one of the
options can have value at expiration not both. However, both premiums must be recovered
before a profit can be made. It's like buying a call for the price of a call and a put and buying a
put for the price of a call and a put. If you think making money with calls or puts is tough, the
straddle will magnify this difficulty.

[1] Actually, this is true the majority of the time; either the call or put finish with intrinsic value. However, if there is a partial tender
offer for the underlying stock, both the call and put may go in-the-money! This happens because the target stock will be trading
higher and so will the calls. But after the purchase, the target stock will normally fall back to the original price. Traders will start
pricing the puts with this intrinsic value causing both the calls and puts to be in-the-money.

Be very careful if you hear of seminars or books that profess to show you how to "make money in
any market" as this is the strategy they are often alluding to. If the stock moves up or down,
technically you are making money on one of the legs -- either the call or put -- but being profitable
is another story.

This is not to say that the straddle is a bad strategy. Just don't get lured into thinking it's a sure
bet. The two premiums will almost always make the straddle a sure loser (in trader's jargon, the
high gamma and negative theta components usually won't allow it to be profitable). Use the
straddle when you are, in fact, expecting a really BIG move in one direction or another and you
feel the market has underpriced it.

The short straddle

If the long straddle is almost a sure loser, then the short straddle must be the ultimate option
strategy, right? Not so fast. Yes, it's true that over time the short straddle will win far more than it
will lose; however, when straddles go against you, they can bite hard! You need to be prepared
to accept a large loss before entering into the short straddle.

From a profit and loss standpoint:

Here, the short trader will receive $8 in our hypothetical example and have break-even points of
$42 and $58. Beyond these points, large losses can quickly develop!

Alternative strategy - the covered straddle

There is a nice alternative for the short straddle called a covered straddle. Here, the investor is
long the stock and then sells the straddle. Assuming the number of call options does not exceed
the equivalent number of long shares, the investor is fully covered to the upside. The risk is that
the stock falls. But if the investor is willing to buy more shares, this can be a powerful strategy!!

Example:
An investor is long 500 shares of stock purchased at $50. He then sells 5 contracts of the above
straddle for $8. The investor will receive 500 * $8 = $4,000. If the stock is above $50 at
expiration, the investor will be assigned on the short call and sell his shares -- effectively for $58.
But if the stock is below $50, the trader will be assigned on the short puts and be forced to buy
stock at $50, which is effectively $42 when you consider the $8 premium from the straddle. You
can see the benefits of this strategy! If you are willing to buy more, and are not afraid to sell your
shares, the covered straddle is a tough one to beat. It is called a covered straddle because the
long shares cover the most serious risk in that the stock moves higher.

Strangles
A related strategy to straddles is one called a strangle and sometimes called a combination[2] or
"combo" for short.

[2] The term combo varies between markets. In the equity markets, a combo is usually long calls and long puts with different
strikes. In the futures markets, however, a combo is usually a synthetic stock position -- long calls and short puts with the same
strikes.
The idea behind straddles and strangles is the same in that the investor is looking for a large
move in one direction or another. The strangle differs in that the strike prices are different. The
expiration months are the same.

Earlier, we assumed a trader with the stock at $50 bought the $50 call and $50 put for a total of
$8. Now let's say that same trader buys a strangle instead. He may buy the $55 call and the $45
put for a total of only $5. But the tradeoff is big; this trader's break-even points are now $40 and
$60 instead of $42 and $58 with the straddle trader.

This is sometimes called a $45/$55 strangle.

This does not mean that strangles are a poor strategy. It just means you should be careful in
choosing it. Use it when you really expect monstrous moves in the underlying, and not because
it's cheaper than the straddle.

From a profit and loss standpoint:

It is easy to see that the stock must make a really large move in order to be profitable! Also,
there is no reason the trader must limit themselves to a 5-point difference in strikes. One could
also enter a $40/$50 strangle or any other combination as long as they cover the same expiration
months. Keep in mind though, as you make the difference in strikes wider, your break-even
points become wider as well.

The short strangle

The short strangle is similar to the short straddle but, from a risk/reward standpoint, it may be a
better deal for most investors simply for the fact that the break-even points are stretched so wide.
In-the-money and out-of-the-money strangles
One small point should be clarified here. In the above example, we assumed the stock was at
$50 and the trader bought a $45 put and $55 call to complete the strangle.

This is specifically known as an out-of-the-money strangle because both the call and put are out
of the money. There is another alternative position -- sometimes called a guts by floor traders
where the trader will buy, say, the $45 call and the $55 put.

Be careful when discussing strangles with your broker, as this is a very common mistake! Say
the $45 call is trading for $8, and the $55 put is trading at $6 for a total purchase price of $14. It
is very easy to think that the maximum loss is $14. However, this position has a built-in box
position because one of the options must always be in-the-money. This particular strangle must
be worth $10 at expiration (of course, the bid/ask spreads will make it worth slightly
less). Why? Work through some numbers and you will see that it is impossible to have both the
call and put expire worthless. In the original example, the call and put would expire worthless for
any stock price between $45 and $55.

The maximum loss for this in-the-money-strangle is only $4. In addition, you get the benefits of
in-the-money calls and puts working for you so your time decay is diminished significantly.

Just be aware that there is a difference. An out-of-the-money strangle has the put with the lower
strike and the call with the higher strike. In this case, the maximum loss is the total cost of the
two positions.

The in-the-money strangle has the call with the lower strike and the put with the higher strike --
exactly the opposite of the out-of-the-money strangle. Here, the maximum that can be lost is the
premium minus the difference in strikes. In our example, $14 -$10 = $4.

Straddles and strangles are popular strategies, especially in a lot of beginning courses because
they are combination positions yet easy to understand. From a practical trading standpoint, the
long straddle/strangle is not too practical because of the wide break-even points. Typically, the
stock will bounce around between these two points and you will just watch you position erode
from the time decay (high negative theta of the position).

From a traders viewpoint, the short positions are much more desirable, but just be sure you are,
in fact, willing to assume risks if it should go against you.

In fact, you can even combine these strategies. If you short a straddle and buy a strangle, you
effectively put protective wings on the upside and downside risks of the short straddle. The
combination of these two positions -- short straddle and long strangle -- is also called a butterfly
spread! (Please see our section on Butterfly Spreads for more information.)
 Strips and Straps
Options are very versatile and one of the most powerful tools you can learn as a trader is how to
combine them to create unique profit and loss profiles that exactly meet your needs.

Although the terms are not used much anymore, strips and straps are two very basic
combinations that demonstrate this ability.

Strips
A strip is a strategy where the trader buys one call and two puts with the same strike and
expiration dates.

If you read the section on straddles, you will see these strategies are similar. With a strip,
though, the investor is unsure about the direction, but is putting a little more emphasis on the
downside move.

First, let's look at the straddle which is one long one call and one long put with the same strikes
and expiration dates. Assuming this investor paid $8 for the two positions, the profit and loss will
look like this:
 The strip, because it has two puts instead of one will look like this:

It is evident from the profit and loss diagram that the investor will profit more from a fall in the
stock as compared to a rise. This strategy exactly matches the investor's sentiment of the
stock. The tradeoff is that the strip costs more than the straddle simply for the fact that you are
buying an additional put for the strip. Because of this additional cost, a bigger rise in the stock
will be necessary before break-even is achieved to the upside with the strip as compared to the
straddle. Conversely, the strip will show a profit quicker as compared to the straddle if the stock
should fall. Both strategies hit maximum loss at the strike price, as all options will expire
worthless here.

Strap
A strap is basically the opposite of the strip: the investor buys two calls but only one put. In this
case, the investor is betting that there is a higher chance the stock will rise but is still uncertain so
wants to play the downside as well. Looking at the profit and loss diagrams for the straddle and

strap:
Again we see the traders biases built into the strategy. If the stock rises, as he believes, he will
profit at a much greater pace. However, if the stock falls, he will still profit but will have a much
lower break-even point as compared to the straddle.

These simple strategies should suggest just how powerful options can be. Not only can you build
your profit and loss lines in the direction you want, you can adjust the rates of profit and losses.

In addition, there is no reason to stop here! An investor could easily buy three puts for every one
call, or three calls for every put. Hopefully you get the idea. Options are very versatile!

Option Exam 6 - Week 6

1) If you are extremely bullish on a stock and want to use options, you should:

a) Buy calls
b) Buy puts
c) Sell calls
d) Buy straddles

2) A _____ can be used as an "insurance policy" to protect your long stock position.

a) Long call option

b) Long put option
c) Short put option
d) Short call option

3) If you are bearish on a stock, you would:

a) Sell calls
b) Sell puts
c) Buy puts
d) Either buy puts or sell calls

4) The most you can lose on a long call or long put is:

a) The amount you paid

b) The exercise price
c) The stock price minus the exercise price
d) Theoretically unlimited amount

5) The most you can lose on a short call is:

a) The amount you received

b) The exercise price
c) Exercise price minus the stock price
d) Theoretically unlimited amount

6) If you expect a large swing in the stock price but are unsure about direction, you may decide to
use:

a) Long calls
b) Short calls
 c) Short straddles
d) Long straddles

7) The most you can lose on a long straddle is:

a) The call premium plus the put premium

b) The call premium minus the put premium
c) Only the call premium
d) Only the put premium

8) A strip is a strategy similar to a straddle except it biases the position in favor of what kind of
move in stock price?

a) Downward
b) Upward
c) Sideways

9) A strap is a strategy similar to a straddle except it biases the position in favor of what kind of
move in stock price?

a) Downward
b) Upward
c) Sideways

10) If you expect the stock to sit relatively still, you may decide to use which strategy?

a) Short straddle
b) Long put
c) Long call
d) Long straddle

Week 7 : Intermediate Strategies

Equity Collar
The equity collar or sometimes just collar is a popular strategy among institutional and floor
traders. It can also a great strategy for retail investors, although most are unfamiliar with it.

Equity collars involves long stock paired with a long put and short call to provide limited upside
profits in exchange for limited downside losses.

Equity collar example:

Assume an investor is long 1,000 shares of stock at $100. He is willing to sell the stock at $105,
but is also worried about the downside risk. He could sell the $105 calls, and use those proceeds
to finance the long $95 puts. These three positions, long stock, short call, and long put make up
an equity collar.

There is no reason this investor must sell the $105 call and buy the $95 put. Instead, he could
sell the $100 call and buy the $100 put, or sell the $110 call and buy the $100 put. There are
many ways to position the collar including out-of-the-money, at-the-money and in-the-money
options. Each has a unique set of risks and rewards and we will look at many variations.

First, notice a couple of things about the collar. The above investor was long stock and then sold
the $105 calls -- a covered call position. However, the risk of a covered call is to the downside
(please see our section on "Covered Calls" and "Synthetics" if you are not sure why). So to
reduce the downside risk, the investor used the proceeds from the sale of the calls to buy the
puts.

If the stock rises above $105, he will be forced to sell his stock for $105 per share regardless of
how high it goes. But if the stock falls, he can always elect to sell the shares for $95 per share.

From a profit and loss standpoint, the collar looks like this:

We are assuming this investor paid $100 per share for the stock, sold the calls, and bought the
puts for a credit of $1. If the stock falls below $95, he will exercise the put and receive $95 for a
total profit of $96 after taking into account the $1 credit. Bear in mind that the investor paid $100
for the stock, so this is still a $4 loss overall.
If the stock rises above $105, he will be assigned on the short calls and be forced to sell the stock
for $105. With the $1 credit, this yields a profit of $106 for any stock price above $105. Because
the investor paid $100 for the stock, a $6 profit is made for any stock price above $105.

Sometimes it is easier to view the profit and loss diagram to take into account the cost of the
stock. We can view the above chart by subtracting out the $100 cost for the stock and see the
true profits and losses for all stock prices:

If you read our section on "Basic Spreads" and "Synthetics," you may have noticed the above
profit and loss diagram looks very much like a bull spread. In fact, the collar strategy is a
synthetic bull spread. Also, you may remember the three-sided position used by market makers
called a conversion. Because the strike prices are unequal in this example, this strategy is
sometimes called a split-price conversion.

If you're still not sure why it is the same as a bull spread, the following may help. Keep in mind
that a bull spread with the above positions would be long $95 call and short $105 call.

Collar = Long stock + long $95 put + short $105 call

Synthetically, the long $95 put = short stock + long $95 call

So replace the long $95 put with short stock and long $95 call as follows:

Collar = Long stock + (short stock + long $95 call) + short $105 call

The long and short stock cancel out and you're left with a long $95 call + short $105 call -- a bull
spread.

Collars for credits or debits?

There are many investors who believe the best strategy with collars is to execute them for
credits. After all, why not get paid to have the long put and short call position?
Investors who believe this are not understanding profit and losses with the total position. If you
execute a collar for a credit versus a debit with all else the same, you will open the doors to a
larger loss. Once you understand synthetics, you will see you are paying for the credit
synthetically by allowing a larger loss potential. This is not to say that it is not a good strategy to
execute for credits. Just be sure that you understand the total picture, and that it is in line with
your expectations on the stock. In other words, do not execute for credits if your bigger concern
is the downside risk of the stock.

Let's run through several examples to make sure you understand it.

Corning (GLW) is currently trading for $59-3/4 with the following option quotes for January
(approximately 2 months to expiration):

Calls Puts
Bid Ask Bid Ask
Jan $50 13 5/8 14 3/8 4 4 3/8
Jan $55 11 11 3/4 5 7/8 6 3/8
Jan $60 8 1/2 8 3/4 8 1/4 8 3/4
Jan $65 6 1/4 6 3/4 10 7/8 11 5/8
Jan $70 4 3/4 5 1/8 14 1/8 14 7/8

Same strike collars (Conversions)

Say an investor buys 1,000 shares and sells 10 $60 calls and buys 10 $60 puts -- a collar with
both strike prices the same. If you read our section on synthetic options, you will recognize this
strategy as a conversion.

The investor will pay $59-3/4 for the stock, receive $8-1/2 for the call (the bid) and pay $8-3/4 (the
ask) for the put. The options (not counting commissions) cost 1/4 point. The most this investor
will gain on the stock is 1/4 of a point if the stock rises above $60 at expiration. But because it
cost 1/4 to establish the collar, there is no net gain from the position; it is effectively locked at $60.

This investor is guaranteed to receive $60 at expiration in two months. If the stock is above $60,
he will be assigned on the short calls and receive $60; if it closes below $60, he will exercise the
puts and receive $60.

Notice that the investor's cost basis is also raised by 1/4 point. He paid $59-3/4 and paid 1/4
point for the options for a total of $60.

What does this cost? If interest rates are roughly 5%, then $60 * 5% * 2 months (2/12 year)= 1/2
point. So, strictly from a monetary standpoint, this collar is not a good strategy, as it will cost you
1/2 point in lost interest. Basically, this investor is buying stock today for $60, and guaranteeing
the sale in two months at $60 for no money, as he will be losing out on interest he could be
earning if he just sold the stock today.

Now, this may be a good strategy for someone who is deferring a sale of stock. In the past, this
was done with a box position where the investor would short 1,000 shares against their long
1,000 effectively locking in the current price, as did our collar trader above. Recent tax law
changes have effectively eliminated the box position as a tax advantaged trade. But we can still
execute it synthetically. Notice that the trader is long shares at an effective price of $60. The
short $60 call and long $60 put constitute a synthetic short position. So the investor truly is long
and short the same stock -- a box position. This is exactly why our trader will not profit -- or lose -
- anything from the above collar.

Collars for credits

Say our same investor, instead, chose to sell the $60 call for $8-1/2 but buy the $55 put for $6-
3/8. Now, he has a credit of $2-1/8 effectively, reducing the cost basis on the stock by this
amount to $57-5/8 ($59-3/4 - $2-1/8 = $57-5/8). Notice, though, that his "insurance" from the put
doesn't start until $55, so he can still lose $2-5/8 points (he pays $57-5/8 and sells for $55) if he
exercises these puts. This is what we were referring to when we said traders who execute collars
for credits wind up paying for it by additional downside risk.

The trader who executed the collar for a net zero had no downside risk, but when executed for a
credit, now has a $2-5/8 risk. This is exactly why the market will "pay" you credits for this type of
collar. Effectively this credit trader is assuming a "deductible" of $2-5/8. Notice too that the
market only paid him $2-1/8 for it. Again, the credit collars do not come for free.

This is a great strategy if the trader is very fearful of downside risk below $55 yet willing to sell his
stock for $60. He will profit by the $2-1/8 credit if the stock sits flat through expiration.

Collars for debits

Now let's assume the trader sells the $70 call for $4-3/4 and buys the $60 put for $8 3/4 for a net
debit of $4. Now the cost basis on the stock is raised from $59-3/4 to $63-3/4. In exchange, he
can sell his stock for $60 for a $3-3/4 loss, but may be forced to sell the stock for $70 realizing a
$6-1/4 profit.

This time, the trader is allowing a larger loss -- $3-3/4 instead of $2-5/8. Why did this happen
when he paid a debit to begin with? This is due to the fact that the $70 out-of-the-money call was
sold. The trader wants more profit if the stock rises, because all else being equal, all investors
would rather have more profit than not. The markets will effectively charge you for that privilege.

Notice that no collar combination will prevent a loss! This is due to the fact that the markets will
not assume the risk for free. If you buy the stock at $59-3/4, no matter which combination of
short calls and long puts you choose, you must accept some downside risk after accounting for
the debits or credits from the collar. If you buy the $60 put for $8-3/4, you just bumped your cost
basis to $68-1/2. True, you are guaranteed to be able to sell your stock at $60 but this leaves a
loss of $8- 1/2 points. By selling calls against the long put position, it will lessen the expense of
the put, but never to the point of no loss. Even with the zero debit at-the-money collar we looked
at earlier, the trader still lost on foregone interest and retained no upside potential in the stock.

The only time a collar can lock in a profit is if the trader had purchased the stock previously at a
lower price, say, $50. With the above prices, he can now execute a number of collars to
guarantee a profit and still leave upside potential. But this still doesn't come for free either, as the
trader was holding the stock for some time and assuming all off the downside risk. Now that the
stock has moved in his favor, he may be able to lock in gains with a collar.

This is when collars are especially attractive. Consider using them when you have significant
profits especially if there is a big announcement such as earnings that may cause the stock to
plummet. The collar can still yield healthy upside potential while greatly reducing downside risk.

Collar comparisons
The following chart shows four of many possible combinations of collars that could be constructed
from the above option quotes. There are two important things to notice: (1) None of the collars
prevent a loss, and (2) The higher the debit, the lower the loss and the higher the reward. This
confirms what we said earlier when it was noted that a trader who places collars for credits is
allowing for more downside risk. Notice in the chart how the trader receiving the $6-5/8 credit has
the lowest profit and highest loss. Again, this does not mean that it is not a good strategy to
execute for credits. Just be sure you understand that it does not come for free.

Reverse equity collars

We mentioned earlier that equity collars are actually bull spreads. This allows the investor, in
most cases, to participate in additional upside in the stock as well as reduce the downside
exposure. What if the investor's main concern is the downside? Is there a way to hedge that
portion in exchange for the upside gains? Yes, and that is called a reverse equity collar.

In order to execute a reverse equity collar, one needs only to buy the higher strike put and sell the
lower strike call -- an in-the-money collar. Notice how, up until now, we have always purchased
the put with a lower strike, and sold a call with a higher strike. This will always net a synthetic bull
spread. If we execute the reverse, we end up with a synthetic bear spread.

Using the option quotes in the above box, let's assume a trader buys stock at $59-3/4, buys the
$65 put for $11-5/8, and sells the $55 call for $11 for a net debit of $5/8. The following chart
shows the profit and loss diagram for a reverse equity collar:
Notice how the chart favors the downside; that is, it becomees more profitable as the stock falls,
which is not the case with a regular collar.

Once again, this shows just how versatile options can be, and why all investors should take the
time to understand them.

Collars are fairly complex in that they require three positions. Most brokerage firms will require
level 1 option approval level to place a collar and they can be used in an Individual Retirement
Account (IRA). They are fairly simple to understand once you become familiar with them, and a
powerful hedging tool to add to your list of tactics.

Spreads
Bull and bear spreads
Spreads are strategies where the investor buys one option and sells another. There are many
different types of spreads, and we will look at most of the major strategies. Spreads get their
name because you are, in fact, spreading the risk when you enter into one of these
transactions. One of the positions, either the long or the short, acts as a hedge and either makes
the position cheaper or acts as protection from a runaway stock. We will look at this in a lot of
detail later. But for now, just understand that you are spreading the risk and this, among other
factors, is what makes spreads so popular and powerful.

In most situations, the trader is buying and selling an option in the same underlying stock or
index. For example, long MRVC $35 call and short MRVC $40 call. These are collectively known
as intra-market spreads because they are spreading within the same market. If you are long
MRVC $35 and short INTC $45, this is an inter-market spread. The intra-market spreads are by
far the most common and will be our only focus. Just be aware that you do not have to be long
and short the same underlying for it to be considered a spread.

Important note: A lot of references will be made regarding pricing relationships about options. If
you are not familiar with basic option pricing, you may want to read that section first before
continuing.

The four basic spreads

The most basic spreads are the bull spread and bear spread. Each can be accomplished by
using calls or puts for a total of four basic spreads. If you understand these four spreads, you will
add an invaluable tool to your arsenal of option strategies!

Bull spreads
As the name implies, bull spreads need an upward movement in the stock to be profitable. The
term bullish actually gets its name from the way a bull attacks; it lowers its horns and then raises
its head -- from low to high. Bull spreads can be placed with either calls or puts.

Bull spreads using calls

The bull spread using calls is one of the most common spreads. This strategy involves the
purchase of a lower strike call and the sale (equal number of contracts) of a higher strike call with
all other factors the same (i.e., same underlying stock or index and time to expiration).

For example, a trader may buy 10 MRVC Jan $35 calls and sell 10 MRVC Jan $40 calls. This is
sometimes referred to as a $35/$40 call bull spread.

Because the lower strike call will always be more expensive than the higher strike [1], this trade
will result in a net debit. In order to make up for this debit, the trader will need the stock to move
higher, hence the name bull spread. This spread is also known as a debit spread, price spread or
vertical spread. We'll show you how to remember these names later.

[1] Remember, calls give you the right to purchase stock. With all else constant, investors will prefer to pay less for a stock, so
they'll bid up the price of lower strike calls relative to the higher strikes. Again, please refer to our section on "Basic Option
Pricing" for more information.

In this case, the trader is said to be long the $35/$40 bull spread. Why? As with any position, if
you buy it, you are long; if you sell it, you are short. Because this trade resulted in a net debit (the
trader paid for it), the trader is long the spread.
In a call debit spread such as this one, the short call (the $55 strike) acts as a way to bring in
cash -- it reduces the cost basis of the long $50 strike. This is a great tool for option trading as it
can allow you to buy lots of time without having to pay a lot of money.

Example:
Say it is November, you are bullish on SCMR, trading around $64, and want to buy 10 June $60
calls which are currently trading for $20-1/2. That trade will cost you $20,500 and could expire
worthless. Because of the high price, many people avoid buying time in options and instead look
at, say, a November $60 currently trading for $8. That call will cost you $8,000 for 10
contracts. Now, granted you can lose less money with the November contract; however, you
have a much higher probability of doing so. Is there a better way? Yes, and the bull spread
answers this problem for a lot of traders. Let's do a bull spread with SCMR and see the
difference:

Buy 10 SCMR Jun $60 = $20 1/2

Sell 10 SCMR Jun $65 = $18 1/4
Net cost $ 2 1/4

Now, for only $2,250 expense, you will own 10 contracts but have all the way until June (8
months) to profit from it. Your tradeoff is that you will not profit above $65, but, that's not so
bad. If the stock does get above $65 at expiration, this trade will be worth $5 for $2-1/4 down, or
a profit of 122% or roughly 231% on an annualized basis. By using the spread tactic, you reduce
the time-decay of the position and put the odds on your side that you will, in fact, get a very
healthy profit.

Because options are so versatile, spreads can be versatile too. If you want more upside
potential, maybe sell the June $70 call instead:

Buy 10 SCMR Jun $60 = $20 1/2

Sell 10 SCMR Jun $70 = $16 7/8
Net cost $3 5/8

Here you will pay $3,625 for 10 contracts. Yes, you now have more money at risk, but you also
get more reward in that you profit all the way to $70 instead of $65. The financial adage "more
risk, more reward" cannot be escaped, even in the options market. You can custom-tailor the
spreads to exactly meet your needs. If the stock reaches $70 or higher at expiration, this trader
will make $10 points for $3-5/8 initial investment for a profit of 175%, or 358% annualized.

What does the position look like from a profit and loss standpoint? (Please see our section on
"Profit and Loss Diagrams" if you are not familiar with these diagrams.)
We can see that the most the trader can lose is the $3-5/8 -- the amount paid. The most the
spread can be worth is $10 points, so the max gain must be the difference or $6- 3/8. Where is
the break-even point? The trader needs to make back the $3-5/8 initially paid. If the stock is
trading for $63-5/8 at expiration, the long call will be worth exactly $3-5/8 and the short call will be
worthless; the break-even is therefore $63-5/8.

This trader will profit if the spread widens. In other words, he wants the spread to increase in
value so that it can be sold for a profit.

No matter how high the stock goes above $70, the most this trader will make is $6 3/8. The bull
spread has a limited downside as well as upside; the trader is trying to capture the 10-point move
between $60 and $70.

Bull spreads using puts

A bull spread with puts is a strategy where the trader buys a low strike put and sells a higher
strike put in equal quantities. Because a higher strike put will always be worth more (all else
constant)[2], this trade will result in a credit to the account.

[2] Put options give the owners the right to sell stock. With all else constant, investors prefer to sell for higher prices so they will
bid up the prices of higher strike puts relative to lower strike puts. Again, please refer to our section on "Basic Option Pricing" for
more information.

For example, a trader may buy 10 MRVC $40 puts and sell 10 MRVC $50 puts. This is also
called a $40/$50 put bull spread.

This spread is also known as a credit spread, vertical spread, or price spread.

This trader is said to be short the $40/$50 bull spread because of the resulting credit to the
account. This trader is hoping for the spread to "shrink" (as is any short seller) so that it may be
purchased back later at a profit. How will a bull spread using puts shrink? Only if the stock
moves up (actually, this spread can also profit by sitting still too; it just cannot move down) hence
the name bull spread.

Example:
Say you are bullish on MRVC trading at $39 1/2. You elect to do the following bull spread with
puts:

Buy 10 Apr $40 puts = $12 1/2

Sell 10 Apr $50 puts = $16 1/4
Net credit $3 3/4

You will receive a credit of $3,750 to your account and will profit by this amount if the stock closes
above $50. If the stock is $50 or higher at expiration, both puts expire worthless and the spread
shrinks to zero -- exactly what you want it to do!

Let's look at the profit and loss diagram for the short $40/$50 bull (credit) spread.

It is easy to see, by looking at the chart, you will make $3- 3/4 maximum; that's assuming the
stock closes at $50 or higher on expiration. However, this $3-3/4 credit does not come for
free. In exchange, you must be willing to assume a downside risk of $6-1/4. Why? Remember,
the higher strike put is more valuable, and that is the one you sold. If the stock falls, the higher
strike put becomes more valuable to the owner and equally less valuable to you! But, if the stock
continues to fall below $40, then your long $40 put starts to become valuable to you. So the
spread can only be worth $10 at a maximum to the owner or negative $10 to you, the
seller. Because you brought in $3-3/4 for the initial trade, the most you can lose is $10 - $3-3/4 =
$6-1/4. Where is the break-even point? You took in $3-3/4 initially, right? So the $50 put can go
against you by this amount at expiration. So if the stock is trading at $50 - $3-3/4 = $46-1/4 at
expiration, then your short $50 put will be worth negative $3-3/4 to you, and your long put will be
worthless; you will just break even.

Notice also, that the above two profit and loss charts have exactly the same shape. This is
another way to identify a bull spread, as they will always have this similar shape.

Which is better -- the credit or debit spread?

There are a lot of people and books that claim there is no difference between the two types of
spreads. This is totally false. There is a big difference in the underlying assumptions, depending
on what they are, the call or put spread will be better suited.
We saw that, for the debit spread, the trader must have the stock move higher as the trader must
make up for the debit. The credit spread; however, does not need the stock to move; it just
cannot move down.

Example:
PWAV is currently $44-1/2. Let's compare the debit and credit spreads:

Debit Spread
Buy Dec $45 Call = $6 7/8
Sell Dec $50 Call = $4 1/4
Net debit $2 5/8

Credit Spread
Buy Jun $40 Put = $4 3/4
Sell Jun $45 Put = $6 3/4
Net credit $2

The trader using calls (debit spread) will pay $2-5/8 while one using the puts (credit spread) will
receive $2. If the stock sits still, the call trader will lose $2-5/8 while the put trader will gain $1-
1/2. How? If the stock is still $44- 1/2 at expiration, both calls will be worthless; the long bull
spread will lose the entire premium.

For the credit spread, if the stock is $44-1/2 at expiration, the short put will be worth -$1/2 and the
long put worthless. The credit spreader will take a loss of $1/2 from the short position, but keep
the $2 from the initial trade for a gain of $1- 1/2.

So is the credit spread the best? After all, in this example, it seems like you get the best of both
worlds. You get paid for the position, and you don't need the stock to move in order to
profit. Here's the catch, if you are wrong in your assumption about the direction of the stock and
it falls, the debit spread can only lose the amount of the debit or $2-5/8 while the credit spread
can lose $3.

The differences in the two types of spreads, either debit or credit, have to do with your
assumptions on how quickly the underlying stock will move (please see our section on deltas and
gammas for further details).

Cheap or chicken
You may have noticed something about the two spreads we have been discussing. The debit
trader is really only interested in purchasing the more valuable call. By entering the spread, the
trader can reduce the premium paid for this long position.

For the credit spreader, their goal is to short the more valuable strike and receive a premium;
however, the trader is now exposed to potentially unlimited losses. So by entering the spread,
they hedge themselves in case the stock moves the other way.

There is a somewhat comical, although valuable way of understanding the philosophies between
credit or debit spreads. We can say the debit spreader is "cheap" since they do not want to pay a
lot for the long call position by itself. Selling the higher strike reduces the price.
For the credit spreader, they are "chicken," as their goal is to short the more valuable strike. But
they are fearful of the unlimited downside risk, so buying another position gives them a hedge.

So remember "cheap" or "chicken" to help identify the underlying philosophies!

Bear spreads
A bear spread, as the name implies, desires the stock or index to fall. The term bearish gets its
name from the way a bear attacks; it raises its paws and strikes down -- from high to low. As with
the bull spreads, bear spreads can be executed through calls or puts.

Bear spread using puts

This strategy involves the purchase of a high strike put and the sale of a lower strike put with all
other factors the same.

Because you are buying the higher strike put, it will always be worth more and result in a debit. In
order for the trade to make money, the stock must fall -- hence the name bear spread.

Let's say you are bearish on INTC; you think the price will fall. You could enter the following
spread:

Buy Apr $45 put = $6 1/2

Sell Apr $35 put = $2 1/4
Net debit $4 1/4

This trader would be long the $45/40 bear spread. As before, this trader is long because a
premium is paid.

Let's run through the idea of the spread again. This trader is really interested in owning the $45
strike because it is the most valuable of the two puts. However, he does not want to pay $6-
1/2. By entering the spread, he can own it for only $4-1/4. Using our "cheap or chicken" method,
this trader is "cheap." The tradeoff is that he can only profit to a fall of $35.

At expiration, if INTC is $45 or higher, this trader loses the entire premium of $4-1/4. If the stock
is $35 or below, the trader will make the full spread of $10 less the amount paid of $4-1/4 for a
total profit of $5-3/4. In order to break even, the trader must be able to sell the long position for
$4-1/4, which means the stock will have to be this amount in-the-money or $40-3/4. As with any
debit spread, this trader wants the spread to widen so that it may be sold for a profit.

Let's take a look at these numbers on the profit and loss diagram:
The chart confirms what we figured out intuitively. Also notice that the bear spread profit and loss
diagram is opposite that of the bull diagrams above. The bear spread profits from a downward
move in the stock.

Bear spread using calls

This trader is really only interested in shorting (selling) the $45 call. However, because of the
unlimited risk to the upside, he buys a $55 call for protection. This follows the "chicken"
philosophy. Now it should be evident why the trader would spend the money to buy the $55 call.

For example, a trader could buy a $50 call and sell a $45. Because the lower strike will always
be more valuable, this trade will result in a credit.

Let's use INTC again but with calls instead.

Sell Apr $45 call = $8 1/8

Buy Apr $55 call= $4 5/8
Net credit $3 1/2

At expiration, if INTC is below $45, both puts expire worthless and the trader will profit by the $3-
1/2 credit. If the stock is above $55, the trader will lose $10 on the spread, but will offset this loss
by the initial premium for a net loss of $6-1/2. In order to break even, the trader can afford to
have the lower strike call move $3-1/2 points against him for a closing stock price of $48-1/2 at
expiration. At this point, he will owe $3-1/2 for the short position, which exactly offsets the original
premium so he breaks even.

The following profit and loss diagram should confirm this:

Again, as expected, this bear spread has the same shape as the bear spread above. We see
that the maximum profit is in fact $3-1/2 and the maximum loss is $6-1/2.

Because this trader received a credit from the initial transaction, he wants the spread to narrow
so that it can be purchased back cheaper or expire worthless. Either way will result in a profit.

A word of caution
One of the biggest mistakes investors make using spreads is to fail to understand the risk-reward
concept. This usually leads to unsuitable trades based on the investor's risk-reward profile or
outlook on the stock. Let's look at an example:

INTC is now trading for $44-7/8 with the following quotes for December available:

$35/$40 spread =; $4 1/4

$40/$45 spread =; $3 3/8
$45/$50 spread = $2 1/2
$55/$60 spread = $11/16

Novice investors will look at quotes such as these and think the $55/$60 spread is the best
because they pay only $11/16 and can make a maximum of $5 on the spread for a $4-5/16
profit. It certainly sounds better than paying $4-1/4 for the $35/$40 spread and only making $3/4
profit.

The reason the $55/$60 spread is relatively cheap is because it is an out-of-the-money spread;
remember, the stock is trading at $44-7/8 so neither option is in-the-money. It is a higher risk
strategy, relative to the other spreads listed, so it should be trading for a cheaper price and have
a higher reward.

The $35/$40 spread is an in-the-money spread as both options have intrinsic value. This spread
will grow to a maximum of $5 without the stock moving -- just as long as the stock does not fall
below $40 by expiration. It is much less risky than the other two spreads so should be trading for
a higher price and have a lower reward.
When looking at profit and loss diagrams on spreads, you can immediately see the relative risk in
strategies. Take a look at the profit and loss diagrams for the four spreads listed above:
You can see the $35/$40 spread in the upper left (red) has a large loss area and a low reward
area. As the spreads move more out-of-the-money, the profit and loss line shifts upward to
reflect a lower loss and higher reward. For example, look at the $55/$60 spread in the lower right
(orange). It has only an $11/16 loss but a $4-5/16 reward, which certainly sounds appealing.

This is where the mistake is made. Again, most novice investors immediately jump to the
$55/$60, in this example, because of the amount of profit that can be made relative to the amount
invested. Remember, you cannot get around the risk-reward relationship! With the $35/$40
spread, you will probably keep the $1/4 profit; with the $55/60 spread, you will probably lose the
$11/16.

It doesn't mean that either spread is right or wrong. Just be careful that you are picking the
correct one that matches your opinion of the move in the underlying stock.

One final note of caution: in the above example, we looked at a $35/$40 spread that cost $4-3/4
and could yield 1/4 profit. Even though you will probably keep the 1/4 point, be sure to factor in
commissions before entering into low yielding spreads such as this. The commissions will, in
many cases, lock you into a loss. Low profit spreads are common with floor traders as they may
only pay a couple of bucks in commissions and they are really stacking the odds on their side that
they will make a profit. For retail investors, you need to be sure the commissions are not too
high.

Spreads that lock you into a loss are entertainingly called alligator spreads -- as you will never get
out alive!

Bull and bear spreads -- how can I keep all these names straight?
It can be confusing to remember which strategies are bullish and which are bearish, especially if
you are new to spreads. Fortunately, there is a really neat device that will help you remember!

Whenever you BUY a LOW strike and SELL a HIGH strike, remember BLSH, which looks like
"Bullish" and you'll get the right answer. Of course, the reverse is true too. If you buy the high
strike and sell the low strike, it is a bearish strategy.

This method works for calls or puts so it can be very helpful.

Examples:
Buy $40 call and sell a $45 call.
You are buying the low strike and selling the high strike, so it is a bull spread.

Buy $120 put and sell $100 put.

You are buying the high strike and selling the low, so it is a bear spread.

Buy $40 put and sell $45 put.

You are buying the low strike and selling the high, so it is bullish.

Buy $50 call and sell the $40 call.

You are buying the high strike and selling the low for a bearish position.

Be careful with this method though. A lot of people remember the "BLSH" mnemonic but often
forget that it is in relation to the strike prices. It is very easy to look at the price of the option and
this is incorrect; in fact, it will get you the exact opposite answer!

Example:
Earlier we looked at the following trade:

Buy 10 SCMR Jun $60 = $20-1/2

Sell 10 SCMR Jun $65 = $18-1/4

It is easy for people to look at the prices of the options instead of the strikes. In this case, they
may think we are buying high ($20-1/2) and selling low ($18-1/4) and think it is a bearish strategy
-- exactly the opposite!

Just be careful and remember that the BLSH method works great -- for calls or puts -- if you use it
in relation to the strike prices.

How to remember the different kinds of spreads

There are many names for spreads, and some are used interchangeably. If you understand
where these names come from, it will help you to identify the type of trade. For example, you
may hear the following names for different spreads: price, time, vertical, horizontal, calendar, time
and diagonal just to name a few. So how do you remember them?

If you look at option quotes in your local paper, you will most likely see a similar grid with the
months across the top and the strikes down the side:
Now, look at the Jan $50 and Jan $60 highlighted in red. Depending on which one you buy and
sell, it could be either a bull or bear spread. Because it's also spread on the vertical axis, it can
be called a vertical spread or price spread , because it is the prices that are being spread.

So all the bull and bear spreads that we've talked about are also vertical spreads or price
spreads.

If you spread horizontally such as the Mar $55 and Feb $55 in blue, then this is known as a
horizontal spread, calendar spread, or time spread because we are actually spreading time, not
price.

Lastly, if we spread time and price such as the Mar $65 and Feb $70 in green, what do you think
it's called? You've got it, that's a diagonal spread!

As always, if any of these spreads results in a net debit, the trader is said to be long the spread
and short if it results in a credit.

These are just the basics of spreads. There are many more strategies involving spreads listed on
our Web Site. We hope you take the time to learn more about them.
 Deep-in-the-Money (DIM) Covered Calls
Many investors are aware of the covered call strategy; in fact, it is the first option strategy most
encounter. The strategy involves buying stock and then selling a call against it. This position is
considered covered, because no matter how high the stock moves, the trader will always be able
to deliver the stock in the event of an assignment from the short call. If the stock rises, you may
be forced to sell your stock, and if not, you keep the premium from the option sale.

It can certainly be a great strategy for an investor who would hold the stock whether options
traded on it or not. In other words, as long as the investor is willing to assume the downside risk
of the stock, covered calls can provide income and provide small downside hedges.

Most traders entering covered call positions buy the stock and then sell a strike above the current
stock price. For example, they may buy stock at $50 and then sell a $55 or higher strike
call. Because these calls are out-of-the-money, they do not carry much time premium, so they
don't provide much of a downside hedge if the stock falls. Falling stock prices, not rising as some
think, are the risk of a covered call. Covered calls constructed with out-of-the-money calls are
more of a revenue generating strategy than a risk reducing strategy.

Deep-in-the-money covered calls

We would like to introduce you to a variation of the covered call strategy, one that utilizes deep-
in-the-money calls. For example, a trader buys stock at $50 but sells a $40 strike call. Now, I
know some of you are thinking, "Wait a minute, why would I want to buy stock at $50 and give
someone else the right to buy it for $40? That's a guaranteed loss!"

It is exactly this thinking that keeps most beginning option traders from using deep-in-the-money
calls against stock. The piece of the puzzle they are missing is the time premium of the call
option. The $40 call in the above example may be selling for, say, $11. So even though it
appears you may be taking a 10-point loss at expiration, the call buyer is paying for that up
front. This $40 call has $10 intrinsic value and $1 point of time premium. It is the $1 time
premium that the deep-in-the-money call writer is trying to capture. Deep-in-the-money call
writers intend to have the stock called.

If the option is trading at parity (all intrinsic value and no time premium), then deep-in-the-money
calls certainly would not be a good strategy. For example, if the $40 call is trading for exactly $10
(trading at parity), by entering the covered call position, you are buying the stock for effectively
$40 (buying stock at $50 and selling the call for $10), then selling your stock at a later date for
$40. Effectively, you are giving up the interest on $40 through option expiration and paying two
commissions to do so! Clearly, options trading at parity are not a winning strategy for covered
calls.

But as long as there is time premium on the deep-in-the-money call, the strategy changes. Now
the deep-in-the-money call writer is putting the odds on their side that they will get assigned and
be forced to sell the stock in exchange for the time premium.

What makes this strategy appealing is that you are, in most cases, receiving a high rate of return
and getting a huge downside hedge. You are getting the best of both worlds.

Now, don't get me wrong and think you will be overcompensated for the strategy. The markets
will price them according to the relative risks involved. But if you are using this strategy on stock
you like regardless, you will probably find this strategy to be one of the most appealing, especially
when you see the balance between returns and downside protection.
Example:
Extreme Networks (EXTR) is currently trading for $53 5/8. The December options with 16 days to
expiration are quoted as follows:

Time
Strike Bid Ask
Premium

42 1/2 12 3/4 14 1 5/8

45 10 5/8 11 7/8 2

47 1/2 9 1/8 10 1/8 3

50 8 1/8 9 1/8 4 1/2

52 1/2 6 1/2 7 1/2 5 3/8

55 5 3/8 6 3/8 5 3/8

57 1/2 4 5/8 5 3/8 4 5/8

60 3 3/4 4 1/2 3 3/4

Say you buy the stock at $53-5/8 and sell a deep-in-the-money call such as the $45 strike. The
net cost to you is:

Buy stock = -$53 5/8

Sell $45 call = $10 5/8
Net cost $43

Effectively you are buying stock at $43 and putting the odds heavily on your side that you will sell
it for $45. In fact, because the delta is currently 0.70, the markets are saying there is now a 70%
chance the sale will occur. If that happens, you earned 2 points (time premium) as interest on a
$43 investment for only 16 days of time. That's a simple return of 4.65%, an annualized return of
over 106%, and an effective compounded return of over 178%.

So far so good. Now let's look at the downside hedge. Because you received $10-5/8 for the
call, the stock can fall by this amount and you'd just be at break-even. With the stock trading at
$53-5/8, it could fall to $43 for nearly a 20% downside hedge!

If the stock is above $45 at expiration, you make an annualized rate of 178%; if it's down to $45,
you're at break-even. It's tough to beat, especially if it's a stock you don't mind holding, and
you're willing to assume the downside risk.

There are, of course, many ways to use the strategy. Maybe you're not so concerned with the
downside risk and want more upside return. You may elect to sell the $47-1/2 or $50 strikes
instead. If you're more concerned with downside risk, you may go for sale of the $42-1/2 strike
with $1-5/8 time premium.

You should now see the benefits of using deep-in-the-money calls compared to the usual out-of-
the-money calls used by most traders. Using the above quotes, many would be inclined to sell
the $60 calls. While that will yield a whopping 20.3% simple return and 6,397% compounded
return if the stock is above $60 at expiration, it only gives $3-3/4 points or 6.8% downside
hedge. Further, those returns are realized if the stock is above $60 -- there is a huge chance that
it will not be. The out-of-the-money call strategies are, for most investors, disproportionately
stacked with upside returns in relation to their downside hedge.

Why does this strategy work?

If you are still not clear as to why this strategy works, think about the following analogy:

Say you have a used car for sale for $20,000. A buyer comes to you with the following offer: he
will give you $15,000 now and the balance in 3 months. If you take the offer, you are effectively
loaning $5,000 to the buyer. Therefore, the only way you should accept the offer is to take
additional money (interest) above the $5,000 payment that he will owe you in 3-months.

Notice the similarity with the deep-in-the-money covered call strategy above. The buyer (long call
position) is offering to buy your stock for $53-5/8. Instead of giving you the full amount up front,
he will pay you $10-5/8 now and the balance in 16 days effectively borrowing $43.

You are not taking a loss by purchasing stock at $53-5/8 and selling it for $45 any more than you
are taking a loss by giving someone the right to buy your $20,000 car for $5,000. In both cases,
the buyer is paying part of that future obligation now and paying you interest (time premium on
the option) to float the balance. If the interest rate is appealing to you, you will take the offer.

Buy-writes
You can add a little edge to deep-in-the-money covered calls by entering the trade as a buy-write
where both orders, the long stock and short call, are executed simultaneously. Because market
makers love combinations of stock, calls, and puts to get them into locked positions, they will
usually give you a break on the natural quote. For example, notice the spread on the $45 calls
above: $10-5/8 to $11-7/8 for a $1-1/4 spread. It is very feasible to enter an order to buy the
stock and sell the $45 call for a net debit of, say, $42-1/2. While this is only $1/2 point better than
the natural $43 debit we assumed earlier, look what it does to the returns! Now you are buying
stock at $42-1/2 and potentially selling it for $45. That's a 5.88% simple return (compared to
4.65% earlier) and 261% effective annualized compounded rate (compared to 178%). What a
difference a half point can make.

You do not need to necessarily look at volatile stocks for this strategy to work either. For
example, take General Electric (GE), which is considered to be one of the bluest of blue-
chips. The stock is trading for $48-7/8 and the January $43-3/8 strike is trading for $7 to $7-
1/4. If you sell the call for $7, that's $1-1/2 points of time premium for 51 days to
expiration. Chances are you will be assigned on the short call; if so, you effectively paid $41-7/8
(paid $48-7/8 for stock and sold call for $7) and sold for $43-3/8 in 51 days. That's a simple
return of 3.58% or effective annualized compounded rate of 28.2%. Granted, not as impressive
as the returns we saw earlier but not as risky either. Your break-even point would be $41-7/8 for
a 14% downside hedge.
Two warnings
If you trade in small lots (say 100 to 300 shares), make sure the commissions do not eat away
your profits before entering the buy-write. To check, calculate the total net debit including
commission to enter the position and the total credit to sell it (called unwinding the position). If
you are trading in small lots (or being charged very high commissions), it will not be uncommon to
see the difference between your net credit from the sale and net debit from the purchase be close
to the same. If that's the case, it's definitely not worth doing. Make sure there are significant
dollars left over and that you feel that amount is worth the risk.

The second warning is to make sure you are not being compensated at only the risk-free
rate. The time premium on an option will approach the risk-free rate as you look deeper-in-the-
money. For example, in the GE example above, we assumed the trader buys stock at $41-
7/8. So the trader is missing out on interest on $41-7/8 by entering the covered call. If we
assume a risk-free rate of roughly 6%, the cost of carry for this position is $41-7/8 * 6% * 51/360
= 0.355 or about 36 cents. Because the time premium of $1-1/2 is higher than 36 cents, this
strategy will make financial sense as long as the commissions do not eat away the profits. If
enough strikes were available, you could keep looking further in-the-money and eventually find
one that is trading for exactly the cost of carry (if you are familiar with delta, it will be where delta
equals one). This will be true for all strikes below this strike too.

To enter a deep-in-the-money covered call with options that exactly pay the risk-free rate of
interest is to pay two commissions to enter the position yet earn the exact amount had you just
left the money in the risk-free money market. Why will the markets only reward you the risk-free
rate if you look deep enough into the calls? Because the deeper in-the-money you go, the less
risky the strategy becomes. At a certain strike and below, the markets will view the deep-in-the-
money covered position as nearly risk-free, and will only reward you the risk-free rate.

As a reminder, covered calls should really be attempted with stocks you would own
regardless. Remember, the downside risk is that the stock falls.

Covered calls can be a very rewarding strategy, especially when you get the risk-reward ratios in
proportion to your taste. If you feel the out-of-the-money covered positions you've tried did not
feel quite right, try deep-in-the-money calls for a revitalizing change.
 Selling Options On Expiration Day
If you are an avid options trader, you may have noticed that in-the-money calls and puts will often
trade for less than the intrinsic amount (the difference between the stock price and the strike) on,
or near, expiration day. This is especially true for deep-in-the-money options. For example,
today is February 16th (option expiration day), and Juniper Networks (JNPR) is trading for $83-
5/8. You would think the Feb $70 call would be trading at parity -- exactly intrinsic -- and be
quoted at $13-5/8.

However, it is currently quoted at $12-3/8 on the bid. Many investors accept this as normal
functioning of the market and will sell their options to close below intrinsic value. For example,
say you hold 10 of the above JNPR Feb $70 calls and want to sell them. You could sell at the bid
and receive $12-3/8 * 10 * 100 = $12,375.

Is there a better way? Yes!

If you read our section on "Basic Option Pricing," you may recall that, in theory, an option cannot
trade for less than intrinsic. The theory says that if an option does trade below intrinsic,
arbitrageurs will sell the stock and buy the call for a guaranteed profit. This buying and selling
pressure will continue until intrinsic value is restored.

So how do you trade your in-the-money option that is trading below parity? The same way the
arbitrageurs would.

Instead of selling your call at the bid, simply place an order to sell the stock, then
immediately exercise the call option.

The stock is currently $83-11/16 on the bid. So you place an order to sell 1,000 shares at $83-
11/6. Now it doesn't matter if you have the stock or not. Why? Once the sell order is executed,
you simply submit exercise instructions to your broker and buy 1,000 shares at $70. You
received $83-11/16, but paid $70 to deliver the shares. Your proceeds are $13-11/16 * 10 * 100
= $13,687, for a difference of $1,312! Now, your broker will charge you an extra commission to
sell the stock, but I think you can see it can be well worth it.

There is one important note to make here. There are people, brokers included, who will tell you
to "short" the stock, instead of a regular sell order, and then exercise the call. However, shorting
the stock subjects you to unnecessary risk and can be more costly. How? If you short the stock
you must have an uptick, and there is never a guarantee of this. So it is possible you may never
get the stock sold! In addition, if you short the stock, you will be subjected to a 50% Reg T
charge and may not earn interest on that amount while waiting for settlement of the exercise (3
business days).

The regulations always allow you to sell shares (without it being a "short sale") that are not held in
your account. Many investors keep shares in safe deposit boxes and deliver the shares within
the three-day settlement period. This is perfectly acceptable. Now, it's possible your firm does
not allow shares to be sold that are not in the account. Sometimes the deep-discount brokers
have restrictions like this because they spend too much time chasing down people to deliver the
shares they promised to deliver, and do not generate the revenues to make it worth their
while. Further, it costs the firm money to file extensions in the event the shares are not
delivered. However, even if your firm requires the shares to be in the account in order to be sold,
let your broker know that your are immediately submitting exercise instructions to purchase the
shares. There is no reason they shouldn't allow it; the Options Clearing Corporation (OCC)
guarantees delivery of the shares at settlement.

Once you sell the stock, immediately submit exercise instructions. It is very important to submit
your exercise instructions on the same day, otherwise the sale of stock and purchase from the
option exercise will not have matching settlement dates. While this is not a major problem (it's
not going to cause you to lose the sale or anything), it's something your broker does not want you
to make a habit of. I won't go into the details, but as long as you submit your exercise
instructions on the same day you sell the stock, you will be fine.

What about put options? Assume the JNPR Feb $100 puts are trading for $15-7/8 on the bid. If
you sell 10 contracts, you'll receive $15,875. But with the stock trading at $83-3/4 on the ask, we
see they are below intrinsic and "should be" priced for $100 - $83-3/4 = $16-1/4.

If your put options are trading below intrinsic value, simply buy the stock, then exercise
your put.

So you would pay $83-3/4 to buy the stock and receive $100 from the exercise of the put, leaving
you with the intrinsic amount of $16-1/4 or $16,250 -- a difference of $375 when compared to the
trader who just sold the puts at the bid price of $15-7/8. Again, the extra commission will be well
worth it.

In fact, years ago, there used to be an order called "exercise and cover" meaning that the broker
would sell the stock and cover the sale by exercising the call (or buy the stock and exercise the
put). With the increased liquidity in the options markets, this order has disappeared although
there are certainly times it could still be used.

Why will options trade below intrinsic? There are a number of reasons, but the overall reason is
that the market makers are having a difficult time spreading off the risk with the current liquidity.

For example, as discussed earlier, the Feb $70 calls are trading for $12-3/8 but "should be"
trading for $13-5/8. This is strictly a result from having more seller than buyers. Everybody
wants to sell their calls and nobody wants to buy; the new equilibrium price is $12-3/8, which is
below the theoretical value.

You may be wondering why nobody is buying the calls and selling the stock to restore the
equilibrium. The answer is, they are. Market makers are buying at $12-3/8, then selling the
stock. However, there's just not enough volume or interest to bring it to equilibrium. In the
meantime, the stock continues to fall, so by the time they short the stock, they may be in for a
loss (even though market makers are immune to the "uptick" rule). With a bid at $12-3/8, they
feel that is worth the risk while awaiting executions.

What about retail investors? Why don't they join in and buy the call and sell the stock? They
can. However, they must purchase the call on the ask at $13-5/8 and sell the stock at the bid of
$83-5/8, leaving zero room for error! If you sell stock at $83-5/8 and buy the $70 call, you will
have a net credit of $13-5/8, which is exactly what it will cost you to buy the call.

Now, you may think to compete with the market makers and try to notch up the bid price a bit. In
other words, if you bid $12-5/8, you will now be the highest bidder and the quote will move to $12-
5/8 on the bid and $13-5/8 on the ask. If you purchase the call for $12-5/8, you could certainly
sell the stock and make money. But here's the catch: if you bid at $12-5/8, the market makers
will bid $12-3/4, giving them a call option for 1/8th! How? Market makers would love to buy the
call option below the "fair value" and hold an asset that will behave just like the underlying
stock. But if the stock falls, the market maker will sell it back to you at $12-5/8 and be out 1/8ths
of a point. In other words, they will use your buy order as a guaranteed stop order. If they buy it
for $12-3/4 and it doesn't work out, they know they have a buyer at $12-5/8 -- you! This is called
"leaning on the book" and is a common practice among market makers.

Just because the market is offering you a price below the fair value, this doesn't mean you must
accept it. Learn to correct for it and improve your option trading results!
 Option Exam 7 - Week 7

1) Which best describes an equity collar?

a) Unlimited losses regardless of direction

b) Limited downside losses, limited upside returns
c) Limited upside returns, unlimited downside losses
d) Unlimited upside returns, limited downside losses

2) An equity collar is similar to a(n):

a) Bear spread
b) Bull spread
c) Ratio write
d) Condor spread

3) A reverse equity collar is similar to a(n):

a) Bear spread
b) Bull spread
c) Ratio write
d) Condor spread

4) Covered call strategies typically provide a very little downside hedge in the even the stock falls.
If this is a concern, you could use:

a) Deep-in-the-money covered calls

b) Out-of-the-money covered calls
c) At-the-money covered calls

5) An investor buys a stock trading for $100 and wants to write the $80 call for $21 1/4 with three
months of time. Assuming interest rates are 5%, the investor should write the call.

a) True
b) False
6) An investor has written a call against stock (covered call) and wants to get out of the position
by selling the stock and buying the call to close. However, he does not want to be exposed to
market movement. He can enter:

a) A buy-write
b) An unwind
c) A sell-write
d) A straddle

7) An investor buys a low strike call and sells a high strike call. This is a(n):

a) Bear spread
b) Bull spread
c) Ratio write
d) Condor spread

8) An investor buys a $50 call for $5 and sells the $60 call for $2. This is a(n):

a) Debit spread
b) Credit spread
c) Unwind
d) Sell-write

9) Using the same information in #8, what is the maximum the investor can lose per spread?

a) $2
b) $3
c) $4
d) $10

10) An investor buys a $55 call and sells a $50 call for a net credit of $3. The most this investor
can lose per spread is:

a) $2
b) $3
c) $4
d) $5
11) An investor buys a $100 put and sells the $95 put. This is an example of a(n):

a) Bull spread
b) Bear spread
c) Condor spread
d) Ratio spread

12) An investor is considering two different bull spreads. With one he can pay $2 and possibly
make $10. The other he can pay $8 and possibly make $10. With the $2 spread is the better deal
because it allows for more profit.

a) True
b) False

Week 8

Ex-Dividend Dates
As you invest in stocks, you will encounter the words "ex-dividend date." This is a term that is
important to understand -- what it is and how it works. Ex-dividend dates govern who gets
dividends, split shares, spin-off shares, or any other form of payment or distribution from the
company.

Many option strategies depend on the payment of a dividend on the underlying stock and, if you
miss the payment, the strategy could be shot. Even if you are not using options, it helps to
understand ex-dividend dates if you wish to collect a dividend on a stock.

Many stocks pay dividends, which are simply distributions of cash given to shareholders. If a
stock pays a 10-cent dividend and you own 100 shares, you will receive 100 shares * 0.10 = $10
from the company.

In fact, stock splits are really just dividends paid in the form of stock. If you have 100 shares and
they split 2:1, your account statement will show a 1-share dividend paid on your statement. That
just means that you received 1 share for each share owned. In this example, you'd receive 100
shares * 1 share dividend = 100 shares, which when added to your original 100 shares equals
200 shares and is what you'd expect after a 2:1 split on 100 shares.

There's no question as to who gets the dividends (or split shares) if you've been the one holding
the stock all along. But what if you purchased the stock close to the time the dividend is paid? Will
you get it or will it be the person who sold the stock?

To answer that question, we need to know the ex-dividend date.

What Is the Ex-Dividend Date?

The ex-dividend date, also called the ex-date, is the date the stock trades without the dividend.
Just remember that "ex" means without, and you will not be prone to one of the most common
mistakes made by investors (and brokers too).

Let's say a stock is about to pay a dividend, and the ex-date is June 10. If you buy the stock on
June 10 or later, you will not get that upcoming dividend. Remember, ex means without. If you
buy the stock on the ex-date (or later), you are buying the stock without that dividend.

If you buy the stock before June 10, you will get the upcoming dividend when it is paid.

If you just focus on the ex-date and nothing else, it is very easy to determine who gets the
dividend and who does not.

More Examples:
1) ABC stock will pay a 5-cent dividend and the ex-date is August 18. You sell your shares on
August 18. Will you get the dividend?

Answer: Yes. The buyer of your shares purchased them on the ex-date. They purchased the
shares without the dividend, which means you are entitled to it.
2) Using the above example, what if you sold your shares on August 17 or before?

Answer: You will not get the dividend. The buyer of your shares is purchasing them before the ex-
date, which means they are entitled to it.

If you want to receive the upcoming dividend, you must purchase the shares before that ex-date.
Likewise, if you are selling your shares but want to receive the upcoming dividend, you must sell
those shares on or after the ex-date.

Hopefully you can see how straightforward dividends can be if you just concentrate on the ex-
date.

Why Is There So Much Confusion in Practice?

The reason for all the confusion is that when a dividend is announced, there are usually three
dates associated with it:

• Record date
• Ex-date
• Payable date

Usually, companies only publish the record date and payable date in the newspaper. In many
cases, the companies will not even be able to tell you what the ex-date is, even if you call investor
relations, and we'll show you why shortly.

The only date that matters to the company is the record date. Before the company pays the
dividend, they look up a list of names of all investors who are owners of their stock as of the
record date and pay the dividends to those names. For example, XYZ may announce they will
pay a dividend to all shareholders of record as of March 15. If you own the stock as of this date or
before, you will get the upcoming dividend.

Here's where the confusion sets in for most investors...

In order to be the owner of record, the stock transaction must be settled by the record date. Keep
in mind there is currently a three-business day settlement period! If you want to be a record
holder as of March 15, you need to purchase it as of March 12 (assuming those are business
days with no holidays). If you purchase the stock on March 12, the stock transaction will settle on
March 15, and you will be owner of record as of March 15. Now you can see where all the
confusion comes from. It all has to do with the timing of the settlement period.

Back to the Ex-Date

Fortunately, the ex-date was created by brokerage firms to mathematically figure out the
purchase date that makes you owner by the record date. In the previous example, March 13
would be the ex-date. If you purchase on or before March 12, you will be owner of record by
March 15.
Corporations are not stockbrokers and they are not, in many cases, even aware of the three-
business day settlement period. They only publish the record date. This is why most firms will not
even be able to tell you what the ex-date is.

Many investors believe if they purchase shares on or before the record date, they will get the
dividend. This is false! In the previous example we said March 13 was the ex-date. If you
purchase your shares on March 13, it will settle three business days later on March 16 -- one day
too late. The stock will not settle by March 15, and you will not get the dividend.

Hopefully you see how much easier it is if you just focus on the ex-date, which you may have to
call your broker to get. If you wish to focus on the record date, that's okay too, but just be sure
you are purchasing the stock far enough in advance to make settlement by the record date.

Stock Splits
As mentioned, stock splits are really nothing more than dividends. If a stock is about to split 2:1
and you want to get the split shares, you can call your broker and ask for the ex-date, which we'll
assume is May 10 for this example. If you buy 100 shares before May 10, you will end up with
200 shares. If you buy 100 shares on May 10 (or later), you will buy the shares at the cheaper
price but will not get the additional shares.

Does It Matter If I Get the Dividend?

In most cases, it doesn't even matter if you get the dividend or not. Many new to investing find
this hard to believe. After all, it certainly seems like you'd be better off buying the stock and
getting the dividend rather than not getting the dividend, right?

The reason there is not a difference is that the stock price is reduced by the amount of the
dividend (rounded up to the nearest 1/8) on the ex-date! For instance, say a stock closes at $100
on March 19 and is scheduled to pay a $2 dividend with an ex-date of March 20. On March 20,
the stock will open at $98 unchanged to reflect the $2 dividend that was paid. The reason the
stock will show unchanged is because the drop in price from $100 to $98 was due to the dividend
and not changes in supply and demand for the stock.

Let's compare two investors: one who buys the stock before ex-date and another who buys it on
the ex-date. You will be convinced there is no difference.

The investor who buys before the ex-date will pay $100 for the stock and receive a $2 dividend.
The stock, however, will trade for $98 on the ex-date, and the total value of the position will still
be $100 ($98 in stock and $2 in cash). This investor is down $2 in the value of the stock, which is
offset by the $2 dividend.

A second investor who buys the stock on the ex-date will only pay $98 for the position and not
receive the dividend. While they are not down $2 on the value of the stock, they did not receive
the dividend either. Both investors are holding stock worth $98, and neither investor is down
overall.

So it doesn't really matter mathematically whether you get the dividend or not (although there
could be tax benefits to one choice over the other).

Rules Violation: Selling Dividends

Many brokers take advantage of investors by touting an immediate return on your money by
purchasing stock just before the ex-date. Using the above example, a broker may call and say, "If
you buy this stock for $100, you will get an immediate 2% return on your money the very next
day." By now you should understand why this is not true.

If you buy the stock for $100, it will be worth $98 the next day, and you will have $2 in cash for a
total position value of $100, which is neither a gain nor a loss. If this were really an immediate
return of 2%, the position would be worth $102 the following day.

Further, buying the stock just to get the dividend is a bad idea for tax reasons. If you buy one
share of stock for $100, you are paying with after-tax dollars; you do not owe taxes on the $100.
However, if you buy the stock, the very next day your position is still worth $100, yet you owe
taxes on $2. Basically, the dividend represents an immediate taxable return of capital (where
previously there was none) and not a return on your money.

For these reasons, the NASD prohibits brokers from selling you stock solely for the reason of
getting the dividend. Obviously, if the broker thinks the stock is going to be much higher in the
next day or two and recommends buying it for that reason, that's okay. They just cannot sell you
the stock based solely on the immediate return of the dividend. If they do, they are guilty of
"selling dividends" and in violation of NASD rule 2830, which states:

NASD Rule 2830 (e): No member shall, in recommending the purchase of investment company
securities, state or imply that the purchase of such securities shortly before an ex-dividend date is
advantageous to the purchaser, unless there are specific, clearly described tax or other
advantages to the purchaser, and no member shall represent that distributions of long-term
capital gains by an investment company are or should be viewed as part of the income yield from
an investment in such company's securities.

While some option strategies rely on payments of dividends (please see "Dividend Play" in this
week's courses), keep in mind that you will never receive dividends from holding options. If you
own a call option and wish to receive a dividend, you must exercise the call option and take
delivery of the underlying stock before the record date.

A Real Life Example

The following is an excerpt from a Business Wire news article:

FAIRFIELD, Conn. -- (BUSINESS WIRE) -- Dec. 14, 2001 -- The Board of Directors of GE today
raised the Company's quarterly dividend 13% to $0.18 per outstanding share of its common stock
and increased its share repurchase program to $30 billion from $22 billion.

"GE has paid a dividend every year since 1899," said GE Chairman and CEO Jeff Immelt.
"Today's increases, in both our dividend and our share repurchase program, signal our
confidence in our ability to extend this track record of returning value to shareowners."

The dividend increase, from $0.16 per share, marks the 26th consecutive year in which GE has
increased its dividend. The dividend is payable January 25, 2002, to shareowners of record on
December 31, 2001. The ex-dividend date is Thursday, December 27.

Questions:

1) If you buy 100 shares of GE on December 27, will you get the dividend?
2) What is the last day you could purchase the stock and get the dividend? If you buy 100 shares,
how much money will you receive? When will you receive it?

3) Why do you suppose there are four days between the ex-date and the record date?

Answers:

1) No. December 27 is the ex-date, and you will not get the dividend if you buy on or after this
date.

2) The last date you could purchase shares to get the dividend is December 26. If you have 100
shares, you will receive 100 * 0.18 = $18.

3) Notice that the ex-date is Thursday. This means that the last day to buy the stock and get the
dividend is Wednesday. If you buy on Wednesday, the stock will settle three business days later
on Monday, December 31, which the article shows as the record date.

Using Options to Take Delivery

If you wish to take delivery of the stock in order to get the dividend, you should wait as long as
possible (please see our course in week 1 on "Early Exercise" for reasons why you should wait
as long as possible) and exercise the call option the day before the ex-date. You must exercise
the option the day before the ex-date because options take one day to settle, which will be on the
ex-date. At that time, the stock will be delivered in three business days with your name as owner
of record. As always, if there are any questions, you should contact your broker before entering
the trade.

In cases where you are trying to capture a dividend (or avoid one), focus on the ex-date, and
there will be no unwanted surprises!
 Dividend Play
One of the more interesting strategies is known as a dividend play. It is ironic that it is nearly risk-
free yet entails a lot of uncertainty. It is uncertain because you are betting on the move of the
trader on the opposite side of your position.

The dividend play strategy is executed by purchasing stock and selling deep-in-the-money calls
prior to ex-date (the day the stock trades without the dividend). Doing so creates a position
where the trader will break even as a worst-case scenario, but may capture the dividend if the
long call position fails to exercise.

For example, say a stock is trading for $100 and is about to pay a $1 dividend. Also assume that
a $70 call is trading for $30 (trading at parity). A trader can buy the stock and sell the call for a
net debit of $70. On ex-date, the stock will fall by the amount of the dividend to $99 causing the
deep-in-the-money call to fall to $29. The trader will lose $1 on the price of the stock, but gain it
back from the dividend. But the short call can be purchased back for $1 less. Overall, the trader
profits by the amount of the dividend.

However, if the trader is assigned, he will receive $70 (the strike), which is the amount paid
originally, and break even. If not, he keeps the dividend.

The transactions are as follows:

Long Stock = -$100

Short $70 call = +$30
Net debit $70

On ex-date, the account values are as follows:

Stock = +$99 (stock price reduced by amount of dividend)

Short $70 call = -$29 (call price falls $1 due to stock price reduced by dividend)
Dividend = +$1
Net credit $71

The trader can now sell the stock for $99 and buy back the short position for a total credit of $70,
which exactly offsets the original debit. In addition, he will keep the $1 dividend.

Look back to the original position and now assume the trader is, instead, assigned before ex-
date:

Original position:

Long Stock = +$100

Short $70 call = -$30
Net debit $70

He will lose the stock from the assignment but also lose the $30 obligation because the call has
been assigned. In exchange, he will receive the $70 exercise price, which is exactly what was
paid originally.

Because of the low transaction costs, traders see it as a low risk, but potentially profitable trade.

Variations with vertical spreads

There is a variation of the dividend play that uses vertical spreads. For example, say the stock is
$100 and the $65/$70 vertical spread (long $65 call and short $70 call) is trading for $5 -- exactly
the intrinsic amount.

It is possible for a market maker to attempt to purchase this spread at $5 even though there
appears to be no justification -- in most cases, you will pay $5 for the spread and sell it for $5, but
pay two commissions to do so.

So why would a market maker want to pay $5 for the spread? They may exercise the $65 call
and hope they are not assigned on the $70 call. By exercising the day before ex-date, they will
capture the dividend of the underlying. Of course, if assigned on the short $70 strike, they will
lose the gains and break even.

The transactions are as follows:

Long $65 call = -$35

Short $70 call = +$30
Net debit $5

Trader exercises the $65 call and is now:

Exercise $65 call = -$65

Long stock = +$100
Short $70 call = -$30
Net credit $5

Effectively, the trader has legged into a covered call position (long stock plus a short call). Notice
that the long $65 call was originally priced at $35. By using it to buy stock, he is now long stock
worth $100, but paid $65 for it -- a net value of $35. The market maker is simply changing the
form of the position and not the value.

On ex-date:
Long stock = +$34(remember, the trader paid $65 for stock now worth $99)
Short $70 call = -$29
Dividend = +$1
Net credit +$6
The trader gains by the amount of the $1 dividend. But assume he is assigned instead:

Now he will lose the stock and receive $70 for it. In addition, he will lose the short call obligation
due to the assignment.

Receive $70 strike = +$70

Paid $65 for the stock = -$65
Net credit $5

Because the calls are both so deep-in-the-money, it is possible to execute the same strategy with
a short vertical as well (sell the $65 call and buy the $70 call). In a similar fashion, the market
maker will exercise the $70 in an attempt to capture the dividend and hope he is not assigned on
the $65. If he is assigned, he breaks even.

The market maker can take advantage of the strategy with any deep-in-the-money call spread; he
will exercise whichever call is long and hope he is not assigned on the other.

This strategy also explains why it is possible to see quotes such as bid $5 and ask $5 for deep-in-
the-money call spreads. The market makers, in these cases, are often trying to buy or sell the
spread for $5 in an attempt at a dividend play.

Remember, this strategy is only useful if you are paying very low commissions. We mention it
because it is useful for understanding why you may see your stock called the day before ex-
dividend date.
 Option Repair
If you have been buying stocks for any length of time, you have probably been in the situation
every investor dreads -- seeing your stock down twenty or more percent from your purchase
price.

Some of you may be thinking that will not happen to you because you use stop orders to prevent
such losses. Well, even if you use stop orders, large losses can occur between trading days
(known as gap downs). For example, a stock can close at $75 one night and open the next day
at $60. If you have a stop order in at $75, you will be filled at $60. If you have a stop limit at $75,
you will not be filled at all. In either case, the stop did not work as expected and you're down!

Fortunately, with the use of options, we can sometimes get out of these precarious positions with
ease. To do so, you need to understand the option repair strategy.

Option repair strategy

This strategy is a very clever, yet simple strategy. Many investors would not think to do it, which
is what makes it a powerful tool to add to your list of strategies.

The repair strategy does have a couple of assumptions. First, you must be at least moderately
bullish on the stock over the short term. If you think the stock is heading south, you are probably
best selling at a loss or buying protective puts as a full or partial hedge. Second, you are
assumed to be trying to get out of the position by just breaking even (or close to it). In other
words, this strategy is not used as a high profit one; it is designed to get you out of a bad situation
for nearly break-even. So if you're in a losing stock situation and thinking, "Just get me my
money back and I'll walk away," then this may be the strategy for you.

With the above assumptions, we can accomplish a break even with the repair strategy.

Here's how the strategy works:

Say you buy 1,000 shares of stock at $50 and it is now trading for $40 -- down 20%.

You think the stock will rise to $45 but not much past that; you must be somewhat bullish in order
for the strategy to work. The way to design a repair strategy under these assumptions is to look
for a ratio call spread you can write for free (if you are not familiar with these, please see our
section on "Ratio Spreads"). How do we do that? In our example, we may buy 10 $40 calls for
$5 and write 20 $45 calls for $2-1/2.

Here are the transactions:

Buy 10 $40 calls for $5 = -$5,000
Sell 20 $45 calls for $2-1/2 = $5,000
Net cost $0

Notice that we bought 10 and sold 20 -- a ratio call spread. Normally, a ratio writer is subjected to
unlimited upside risk. However, because you already own shares, you can cover 10 of the short
$45 calls with your stock and the remaining 10 contracts with the $40 call. Effectively you are
writing 10 $45 contracts as a covered call plus entering 10 $40/$45 bull spreads. Because we
can write a twice as many calls as we need to purchase, the long $40 calls cost us nothing!

In most cases, you will be limited to no more than a five-point difference in strikes. In other
words, this strategy will usually not work by buying the $40 and selling the $50 calls, because that
is a ten-point difference in strikes.

Now, if the stock does move to $45 at expiration, the long shares will be worth only $45 (the short
$45 calls will expire worthless). The $40/$45 bull spread will be worth $5 points for a total of $50
points.

Here are the transactions in detail:

Transaction Account Value

Buy the stock at $50 $50,000
Stock falls to $40 $40,000
Buy 10 $40 calls, Sell 20 $45 calls for $0 $40,000
Stock rises from $40 to $45 Long stock now worth $45,000
Long $35/$40 spread worth $5,000
Total account value = $50,000

In effect, we have leveraged the account for an upside move for no money down or additional
risk. Our trade-off is that we cap our upside returns. But if you are not long-term bullish, then
capping the upside in exchange for break-even may make perfect sense for a particular situation.

In the example above, does the stock need to close at exactly $45 in order for the strategy to
work? No, it will work as long as the underlying stock rises to $45 or higher. Say the stock rallies
all the way back to $50 at expiration. Now your long stock is worth +$45 (remember, you have a
$45 covered call against the shares), and your long $40/$45 calls spread is worth +$5 for a total
of $50.

Any stock price above $45 at expiration will result in the total position being worth $50.

It is also helpful to look at the various option strikes and months, known as option chains, to help
make your decision as to which options to buy and sell. You can get these through most
brokerage firms or from the Chicago Board Options Exchange at http:/www.cboe.com.

The option repair strategy is yet another demonstration as to the versatility of options. We have
taken these "risky" assets and used them in a way to leverage our returns for no money down. If
you take the time to learn and understand these assets, you will greatly improve your portfolio
performance.

Naked Put Alternatives

Spreads as an alternative to naked puts
This section probably belongs under "Basic Spreads," but it is so powerful we feel it qualifies as
its own strategy. It is one that is highly overlooked, even by the most seasoned investor.

If you ever use the strategy of naked puts, you will want to reconsider once you see the difference
a spread can make!

Naked put strategy

As a review, recall that the strategy of selling naked puts is actually neutral to bullish. If the stock
sits still or rises, the trader will profit by the amount of the initial credit. However, many traders
add a twist to this strategy and use it as a way to purchase stock. They sell puts on stocks they
do not mind owning if the put is assigned. Because of this, they feel it is a win-win strategy. If the
stock rises, they keep the premium; if it falls, they got paid to buy a stock they wanted to buy
anyway.

It is these investors we want to target in this section. We'll show you an alternative strategy for
selling naked puts.

In fact, this strategy is especially useful for investors who wish to sell naked puts (which requires
level 3 option approval) but only have approval to enter spreads (level 2). This strategy allows
you to effectively sell naked puts in a level 2 account!

Using far-out-of-the-money spreads

Assume you are willing to buy 1,000 shares of Intel (INTC) currently trading around $42-
1/2. Instead, you elect to sell a naked put, and the Jan $40 put is trading for $3. If you sell 10
contracts at $3, you bring in a credit of $3,000 and keep this amount regardless of what happens
to the stock. If the stock should fall below $40, the strike, you may be required to purchase it at
$40 if the long position decides to exercise. From a profit and loss standpoint your max gains
and losses are as follows:

Maximum gain: $3,000

Maximum loss: $37,000

The most you can make is $3,000, but the risk is that you may be forced to buy stock at $40,
which theoretically, could be worthless. You offset this $40 loss with the initial credit for a max
loss of $37,000.

Now I know some of you are saying that Intel will never go to zero, so the argument is
invalid. Well, it's probably true that it won't go to zero, at least anytime soon, so that may not be a
probable risk. It is, nonetheless, the worst that can happen from a naked put, and that's how we
have to base our decisions. Besides, there are many newer companies that can go very close to
zero even though they were high-fliers at one time, so the risk is very real. Microstrategy (MSTR)
rose from $7 to over $300 within a year -- only to return to $3 for the longest time. Currently, it is
trading around $16- 1/2. If you sold the $300 puts, believe me, it felt like worthless stock no
matter how much you received for the put. Iomega (IOM) went from $3 to over $100 in a short
time and back to $3 even quicker. Egghead.com (EGGS) fell from $55 to the current price of $1-
1/2. There are numerous examples, so please do not discount the maximum loss zone.
Back to the example. Let's now compare a trader who enters a spread order. He will sell the $40
put for $3 but simultaneously buy a far-out-of-the-money put, say a Jan $25, trading for
$1/4. Because these are simultaneous orders, it's very likely to get a better fill between the two
prices, but we will ignore that for now.

From a profit and loss standpoint:

Maximum gain: $2,750

Maximum loss: $12,250

This trader will take in a credit of $2,750 instead of the $3,000 the naked put trader
received. This is because the spread trader will use $1/4 ($250) of his proceeds to buy the $25
strike put. In doing so, he now eliminates 25 points of risk to the downside. His maximum loss is
only $12,250 versus $37,000 for the naked put.

The result is this: The naked put trader increased his returns by only 1/4 point in return for
accepting an additional $24,750 potential loss ($37,000 versus $12,250). That is a very
expensive 1/4 point.

Naked puts are a great strategy, especially if you are selling against stocks you would like to buy
regardless. However, when things go bad, they can really go bad. This is the real risk of naked
put writing. Using spreads can eliminate this risk cheaply.

Comparing the two profit and loss diagrams:

We see the two traders are virtually identical for all stock prices down to $25. In fact, they are
only separated by 1/4 point, which was the difference in initial proceeds. However, if things go
bad and INTC falls below $25, the spread trader will be very happy to have the long $25 put as
insurance.

Which profit and loss diagram looks more appealing to you? Would you pay 1/4 point for it?
In addition, most brokerage firms will charge you the lesser of the full spread requirement
(difference in strikes less the credit) or the naked requirement. So you will never be worse off,
from a margin standpoint, with the spread order. Granted, it will cost you an extra commission,
but in most cases, this will be well worth it.

Using far-out-of-the-money spreads as an alternative to naked puts is a form of catastrophe

insurance. The trader in the above example is "insured" for all prices below $25. Again, it is
unlikely for Intel to fall below this point, which is why the markets are pricing the $25 put at
$1/4. However, when using any form of insurance, it is wise to buy insurance on high-severity
and low-probability events, and that's exactly what a far-out-of-the-money put spread does for
you; it insures against low-probability catastrophes.

Take a look at the following charts to see just how big and fast a catastrophe can happen!

Headline: Lilly shares fall more than 31% as ruling speeds generic prozac (8/09/00)

Headline: Apple computer falls more than 52% on 4th-quarter earnings

estimates (9/28/00)
Headline: Priceline.com down 42% on 3rd-quarter estimates (9/27/00)

Headline: Xerox down 26% as sales decline and 3rd-quarter loss expected (10/03/00)
Headline: Eastman Kodak falls 25% on profit warning (9/26/00)

Headline: Intel falls 22% on 3rd quarter revenue warning (9/22/00)

Headline: Lucent shares fall 23% on 4th quarter earnings (10/10/00)

Hopefully you will see far-out-of-the-money put spreads as an enhanced alternative to naked put
selling. Many investors have gone broke selling naked puts on "good" companies. However,
good companies do not always report good news as the above charts demonstrate. It is during
these times the value of the far-out-of-the-money spread strategy will be realized.
 Ratio Spreads
Ratio spreads are a very powerful strategy and can be done with calls or puts. In theory, they are
probably the perfect trade as they provide for buying the valuable options and selling off higher
amounts of the "worthless" options to finance the long position. But they do come with great risks
to the tune of unlimited losses at an accelerated rate if the stock moves above the strike of the
short position.

The mirror image of the ratio spread is the backspread. If you place a ratio spread, the trader on
the other side has a backspread.

Call ratio spreads

A call ratio spread consists of buying a lower strike call and then selling a higher number of
contracts of a higher strike price.

Example:
A trader is bullish on MRVC currently trading $37-3/4. The trader thinks the stock will go above
$40 by December but not above $50. A ratio spread, under these circumstances, may be a
perfect strategy:

Buy 10 Dec $40 calls = $5 1/4

Sell 20 Dec $50 calls = $2 1/4
Net debit $3/4

We have arbitrarily chosen the ratio of 10 and 20 (buying 10 and selling 20). The trader could
have bought 10 and sold 11, or bought 50 and sold 150, or any other ratio among the infinite
combinations. We will see shortly why a trader will choose one ratio over another.

First, we need to understand how we arrived at a net debit of $3/4 in the above trade.

There are two fairly easy ways to figure this out, and whichever one works for you is fine. The
first and probably best way to understand the ratio spread is to break the trade up into the
smallest component parts. To do this, we need to find the highest number that is common to the
10 calls we're buying and the 20 we're selling (in math terms, the greatest common factor).

The highest number, in this case, is 10; there is no number higher than 10 that can go into both
10 and 20 evenly. If we divide the buy 10 and sell 20 calls by our greatest common factor, we
arrive with buy 1 call and sell 2, a basic unit. The trader in the above example is just executing
this basic spread 10 times.

In other words, he could call his broker and say, "Buy 1 and sell 2, Buy 1 and sell 2, Buy 1 and
sell 2..." The trader could repeat this order 10 times and, in the end, would have purchased 10
and sold 20.

In trader's jargon, this person executed 10 1 by 2 spreads which is usually written as 10 (1 x -2)
spreads.
Examples:

If a trader:
buys 7 and sells 21: This is 7 (1 x -3) spreads
buys 3 and sells 7: This is 1 (3 x -7) spread
buys 16 and sells 24: This is 8 (2 x -3) spreads

Now that we know the basic unit is 1 by 2, let's look at the above trade again. Effectively the
trader has done this:

Buy 1 Dec $40 calls = $5 1/4

Sell 2 Dec $50 calls = $2 1/4

The trader purchases 1 for $5-1/4 and sells 2 for a total of 2 * $2 1/4 = $4-1/2. They paid $5-1/4
and received $4-1/2 for a net debit of $3/4.

The second method may be a little easier:

Buy 10 $40 calls for $5 1/4 = -$5,250

Sell 20 $50 calls for $2 1/4 = +$4,500
Net debit $750

The trader buys 10 calls for a total of $5,250 and sells 20 for a total of $4,500. The net difference
is $750. Because he is trading 10 spreads (yes, you still have to be able to break it down into
component parts!), we need to divide $750 by 1,000 (because 10 contracts represent 1,000
shares) for a net debit of $3/4 per spread.

Important note: It is very important to understand how to calculate these figures if you are
executing a ratio spread, because it is a complex strategy and will require level 3 option
approval. If your broker calculates this incorrectly, they may hold you either partially or fully liable
for the trade. Why? Because on the options application you will have to check the box
designating "excellent" knowledge to get level 3, and they may hold you to this.

Now we know the trader is trying to execute 10 (1 x -2) spreads for a net debit of $3/4. The total
debit from his account will be 1,000 * $3/4 = $750.

Can the market maker fill only part of the trade?

Yes, but not just arbitrarily. Because the minimum spread, in this example, is 1 by 2, the floor
trader could give your broker a confirmation of buy 1 sell 2, buy 2 sell 4, buy 3 sell 6, and so on
up to the total of buy 10 and sell 20. They could not, for example, return a confirm of buy 2 sell
20. It will always have to be a multiple of the basic unit, which is 1 by 2 for this trade.

An "all-or-none" restriction will prevent partial fills but are generally inadvisable, as option quotes
are good for a minimum of 20 contracts. If you put an "all-or-none" restriction on the order, it is
possible to get no execution, and you cannot hold the floor to time and sales. So use "all-or-
none" orders sparingly and it's probably best to never use all-or-none's for orders of 20 contracts
or less.

Let's assume our trader gets filled on all 10 (1 x -2) spreads and spends $750 to do so. What
does the position look like from a profit and loss standpoint? (If you are unsure how to read these
charts, please see our section under "Profit and Loss Diagrams.")

We see that the trader will lose the entire $3/4 per spread, or $750, if the stock is below $40 at
expiration. The trader will maximize profits at $50, the strike price of the short position. What will
be the max profit? The maximum this spread can be worth is $10, the difference in strikes;
however, the trader paid $3/4, so the max profit will be $10 - $3/4 = $9 1/4.

It is easy to see where the danger is with the ratio spread; there is unlimited upside risk. The
trader will start to lose profit with the stock above $50 at expiration, and will break-even at $40-3/4
and $59-1/4. The downside break-even is simple to figure; the trader paid $3/4 for the position,
so he must make this up. If the stock is at $40-3/4 at expiration, the long call position will be
worth $3/4 and the short position will expire worthless, so the trader will break even.

It can be a little tough to figure the break-even on the upside, so we'll spend some time here. For
all the math people, one easy way to figure it is to understand that the slope will be negative one
due to the 1:2 ratio of the spread. With a slope of negative one, the stock must move 9-1/4 points
(the max profit) to the right of $50 (the stock price at max profit), which puts you at a stock price
of $59-1/4. This method does require a solid understanding of graphs and slopes so do not use it
if this does not make sense to you. I only mention for those who do understand mathematical
slopes, as it is easy to calculate in your head if you do. As an example, if the trader entered a
$40/$50 1 by 3 ratio spread for a net debit of $3/4, the break-even point to the upside would occur
at twice the rate; a slope of negative 2. Now, instead of moving 9-1/4 points to the right, the stock
will only have to move half this distance or $4-5/8 for a break-even price of $54-5/8.

To be on the safe side, especially if you are new to ratio spreads, the following method will be the
best, but does require basic skills in algebra. Start by understanding that the definition of break-
even is where revenues equal expenses, so:
If we let S represent the stock price at expiration,

Our profits will be (S - $40), because we will have intrinsic value of this amount on the long
position. Our expenses will be 2* (S - $50) - $3/4. This is because we sold two contracts for
every one purchased and they will have S - $50 for value which is a liability to us. In addition, we
spent $3/4 for the trade, which is also an expense. Now put the two equations equal to each
other and solve:

S - $40 = 2 * (S - $50) - $3/4

S - $40 = 2S - $100 - $3/4

After collecting all like terms to one side, we see S = $59-1/4.

If you understand nothing about the break-even point to the upside, at least understand
this: there is unlimited risk to the upside in a call ratio spread! The larger the ratio, the
more accelerated the losses become.

Why enter a call ratio spread?

This is a popular tool among floor traders and there are good reasons it is well liked. The basic
reason is this: it allows the trader to buy the "good" option cheaply by financing it with the "junk"
option -- the one he feels will never have intrinsic value. By doing so, the return on investment is
radically magnified.

Example:
Assume our trader above was bullish and just bought 10 calls of the $40 strike with two months to
expiration. He would have paid $5-1/4 per contract or $5,250. Let's also assume the stock
closes at $50 -- our trader's expectation -- at expiration. This position would be worth 10 points
on 10 contracts for a total of $10,000; however, the trader will net $4,750 after costs. The return
on investment is roughly 90-1/2% or 4,675% annualized!

Now let's look at our trader who entered the ratio spread. Effectively, he is buying the 10 $40
strike contracts for only $3/4 of a point instead of the $5-1/4 of the long call trader. Of course, this
does not come for free, as the ratio trader is faced with unlimited risks to the upside; the long
trader would simply make more money as the stock moves higher. Assuming the trader's
assumption that the stock will not rise (or at least significantly) above $50, let's see how the ratio
spread fares:

Buy 10 Dec $40 calls = $5 1/4

Sell 20 Dec $50 calls = $2 1/4
Net debit $3/4

Again, assuming the stock closes at $50, this trader will also make $10 points on the spread, as
the short $50 calls will expire worthless. The return on investment here is 1,233% or
561,865,400%

You can certainly see where the incentive is to trade ratios! Be careful, the market does not allow
for these returns for nothing. The ratio spreader took a proportionately higher risk to capture that
kind of profit.

Why would a trader enter a different ratio?

We have demonstrated the advantage of the ratio spread,which is magnified gains if you are
correct in your assumptions. If the trader feels really sure about his assumptions and is willing to
take the risk, he may decide to enter into a larger ratio. Let's run through the above example
again, but this time, assume the trader enters a 1:3 ratio spread.

Buy 10 Dec $40 calls = $5 1/4

Sell 30 Dec $50 calls = $2 1/4
Net Credit $1 1/2

This trader actually gets a credit from the net transactions, effectively getting paid to take the 10
long $40 strike calls. Again, do not be fooled into thinking it comes for free!

How did we figure the credit? The trader bought 1 for - $5-1/4 and sold 3 for a total of + $6- 3/4
for a net of $1-1/2 credit per spread.

We know he bought 10 (1 x -3) spreads for a total credit of $1,500. By the way, this is still
considered a buy even though a credit is received. This is because the trader wants the spread
to widen.

The profit and loss diagram looks like this:

It is now easy to see the differences. As the number of sells increases relative to the buys, the
profit and loss diagram will shift upward as in the 1:3 ratio (red) compared to the 1:2
(blue). That's the good part; the long position gradually becomes cheaper to own, and the trader
will receive a credit if enough of the short calls are sold. Now for the downside, as more are sold,
the downside break-even point approaches much more rapidly, which means you head into
losses at a faster rate.

For the 1:3 spread, the trader received a credit of $1-1/2 so there is no downside breakeven. The
trader will have a $1-1/2 profit even if the stock collapses. The maximum gain is the 10 points on
the spread plus the $1-1/2 received, for a total of $11-1/2.
As for the upside break-even point, (for the math people again) we know the slope is negative 2,
so the $11-1/2 maximum gain will fall at twice the rate or $5-3/4. So if the stock price is $55 3/4
at expiration, this trader will be at break even.

Algebraically, our revenues at expiration are:

S-$40 + $1-1/2

And the expenses are:

3 * (S-$50)

Putting these two equal to each other:

S - $40 + $1-1/2 = 3 * (S-$50)
S - $40 + $1-1/2 = 3S - $150
2S = $111.50
S = $55-3/4

If you want to check it, assume the stock is at $55 3/4 at expiration. The long calls will be worth
+$15 3/4 (intrinsic value) and the short calls with be worth 3 * $5-3/4 = $17-1/4 which is a liability
because it is a short position. So, the trader has +$15- 3/4 and - $17-1/4 for a net loss of $1-1/2
which exactly offsets the $1-1/2 credit received at the onset of the position.

The real risk to the trader is if the call ratio trader is if the stock makes a large move to the upside,
especially between trading sessions. For example, the trader in the above trade could be holding
the position with the stock now at $48. The next trading day, the stock opens at $60 and
continues trading higher. In this instance, the trader never has a chance to get out of the position
until large losses have occurred. Floor traders will generally close them out long before the risk
gets too great, and if the stock collapses, often end up with a credit from the trade.

Ratio spreads with puts

Ratio spreads can be established with puts as well. A put ratio spread allows the investor to play
the downside for much less money then either a long position or regular spread position.

To establish a ratio spread with puts, the trader will buy one strike price and sell a higher number
of contracts of a lower strike price.

Assume a trader is bearish and we have the following quotes on MRVC:

Buy 10 Dec $40 puts = $7 1/2

Sell 20 Dec $30 puts = $2 3/8
Net debit $2 3/4

The trader effectively buys 10 $40 strike puts for $2-3/4 instead of $7-1/2.

The profit and loss diagram looks like this:

We see, as expected, that the put ratio spread is exactly opposite the of the call ratio
spread. Here, that maximum gain is at the strike price of the short $30 put. At this point, the
spread will be worth $10 to the trader for a net of $7-1/4 after the $2-3/4 cost is
subtracted. Below $30, the trader starts to lose profits and hits break-even at $22-3/4. If the
stock should fly to the upside, the maximum the trader can lose is the original $2-3/4.

Ratio spreads are a wonderful tool for trading. The spreads can all be custom-tailored to suit
your specific needs and sentiment of the underlying stock. They can, depending on how they're
used, have substantial risks and will require the use of naked options approval (usually level 3 for
most firms) from your broker.

Practice doing "paper trades" if you're new to ratio spreads, as they will greatly improve your
understanding of options, strategies, and position management techniques.
 Christmas Tree
A Christmas tree strategy is similar to a ratio spread. For calls, it involves the buying of one strike
and the sale of two higher strikes (for example, buy $50 call, sell a $55 call, sell a $60 call); for
puts, a trader will purchase one strike and sell two lower strikes (for example, buy $50 put, sell a
$45 put, sell a $40 put). If you read our section on condor spreads, you may recognize the
strategy as a long condor spread without the upper protective wing (for calls) or the lower
protective wing (for puts).

The idea behind this strategy is that the trader lowers the cost basis of the long position by selling
two options against it, thereby accelerating the rate of return on investment. However, unlike the
ratio spread where multiple calls of a single higher strike are sold against the long position, the
trader instead sells multiple strikes. It is a lower risk, lower reward strategy relative to the ratio
spread.

Example:
A trader is bullish on a stock trading at $100 and wants to go long a Christmas tree. He will buy
the $100 call, sell the $105 call, and sell the $110 call for a net credit of $1. The profit and loss
diagram looks like this:

The trade is usually placed at a small credit and reaches maximum profit at the strike of either
short position. If the stock moves above the highest short call, $110 in this example, the trader
will start to lose profits and eventually end up with losses if the stock rises far enough.

The trader is effectively taking a little more conservative stance (although there is still the risk of
unlimited losses) relative to the ratio spreader.

Examples:
Corning (GLW) is currently trading for $59-3/4 with the following option quotes. Let's compare a
ratio spread with a Christmas tree and see how they differ. Investor A buys the $60 call and sells
two $65 calls.

Calls Puts
Bid Ask Bid Ask
Jan $50 13 5/8 14 3/8 4 4 3/8
Jan $55 11 11 3/4 5 7/8 6 3/8
Jan $60 8 1/2 8 3/4 8 1/4 8 3/4
Jan $65 6 1/4 6 3/4 10 7/8 11 5/8
Jan $70 4 3/4 5 1/8 14 1/8 14 7/8

This produces a credit of $3-3/4 as follows:

Buy $60 = -$8 3/4

Sell 2 $65 = +$12 1/2
Net credit $3 3/4

Investor B enters a Christmas tree and buys the $60, sells the $65 and sells the $70 for a net
credit of $2-1/4 as follows:

Buy $60 = - $8 3/4

Sell $65 = +$6 1/4
Sell $70 = +$4 3/4
Net credit +$2 1/4

Notice the higher reward, $3-3/4 credit versus $2-1/4, with the ratio spread indicating the higher
risk.

From a profit and loss standpoint:

It is now easy to see the differences in the two strategies. The ratio spread has a higher reward if
the stock should fall or hit $65, the point of maximum profit for both strategies. If the stock
collapses, the ratio spread will keep the initial $3-3/4 credit while the Christmas tree will keep $2-
1/4. If the stock hits $65, the ratio spread makes an additional $5, the difference in strikes, for a
total profit of $8-3/4. Similarly, the Christmas tree will make $5 at a stock price of $65 for a total
of $7-1/4.

However, the ratio spread starts to lose profits for any stock price above $65, while the Christmas
tree does not start to lose them until $70 -- one strike higher.

At a stock price of $66-1/2, the two strategies are even; this is the point where the red line
crosses the blue line. Beyond $66-1/2, the Christmas tree strategy dominates the ratio
spread. This can be seen by the fact that the blue line (Christmas tree) is above the red line
(ratio spread) for all stock prices above $66-1/2. Likewise, the ratio spread wins for all stock
prices below $66- 1/2 and we can see that its profit and loss line is above the Christmas tree's for
all stock prices below this level.

The ratio spread will start heading into losses after the break-even $73-3/4, while the Christmas
tree will not start taking losses until the stock exceeds $77-1/4.

Christmas tree using puts

The Christmas tree with puts is used for the opposite reasons as above. Here, the trader is
bearish and wants to buy puts but sell two additional lower strikes to offset the cost.

Assume a trader is bearish on a stock trading at $100 and wants to go long a Christmas tree
using puts. He will buy the $100 put, sell the $95 put, and sell the $90 put for a net credit of
$1. The profit and loss diagram looks like this:

The trader will start to profit if the stock falls below $100. At a stock price of $95, he will reach the
maximum profit of $6 ($5 difference in strikes + $1 credit) and remain at this maximum amount to
a stock price of $90. Below $90, the trader starts to lose profits and will head into losses below
the break-even point of $84.

Examples:

Let's use the above option quotes again and compare a ratio spread with a Christmas
tree. Investor A again will enter a ratio spread and buy the $60 put and sell two $55 puts to
finance the purchase. His net credit is $3 as follows:

Buy $60 put = -$8 3/4

Sell 2 $55 = +$11 3/4
Net credit $3

Investor B enters a Christmas tree and buys the $60 put, and sells the $55 and $50 puts for a
credit of $1 1/8:

Buy $60 put = -$8 3/4

Sell $55 put = +$5 7/8
Sell $50 put = +$4
Net credit $1 1/8

The profit and loss diagrams for the two strategies look like this:

Again, we see the ratio spread and Christmas tree make money if the stock falls below
$100. This should be the case, as both traders own the $100 put. However, Investor A with the
ratio spread will dominate as a higher credit was received from the initial trade ($3 versus $1-
1/8). This can be seen by the fact the red line is above the blue line through this range.

If the stock falls to $90, the ratio spread will reach maximum profit of $8 ($5 difference in strike
plus the initial $3 credit).
If the stock falls below $90, the ratio spread starts to lose profits; the Christmas tree will not start
to lose them until the stock falls below $85. The two trades are strategies that will be equal at a
stock price of $88.

Below $88, the Christmas tree dominates and we can see its profit and loss diagram is above the
ratio spreads throughout this range. The ratio spread will incur losses below the break-even point
of $82, while the Christmas tree's losses will occur below the break-even point of $79.

The Christmas tree is a nice strategy for those wanting to utilize short positions to offset the cost
of long positions. They are a nice alternative for ratio spreads but still have unlimited loss
potential, so will require level 3 option approval from your broker. Christmas trees are a lower
risk, lower reward strategy relative to the ratio-spread counterpart.

If you like to enter ratio spreads, run through some numbers with the Christmas trees as
well. You may find you like the risk-reward structure much better.
 Option Exam 8 - Week 8

1) A Christmas tree strategy is similar to a:

a) Straddle
b) Ratio spread
c) Buy-write
d) Sell-write

2) Which of the following is a Christmas tree?

a) Buy $100 call, sell 2 $105 calls

b) Buy $100 call, sell a $105 call, sell a $110 call
c) Buy $100 call, sell 2 $105 calls, buy a $110 call
d) Buy $100 call, sell a $105 call, buy a $110 put
3) A $50 call is quoting $8, the $55 call is $6, and the $60 call is $3. What is the net debit/credit
for a long Christmas tree?

a) Net debit $1
b) Net credit $1
c) Net debit $11
d) Net credit $11

4) A long Christmas tree has:

a) Unlimited upside risk

b) Limited upside risk
c) Unlimited downside risk
d) Limited downside and limited upside risk

5) Christmas trees are usually initiated for a(n):

a) Credit
b) Debit
c) Net zero

6) Compared to ratio spreads, Christmas trees are usually:

a) A higher risk, lower reward strategy

b) A higher risk, higher reward strategy
c) A lower risk, higher reward strategy
d) A lower risk, lower reward strategy

7) You wish to write a naked put. However, your broker is only able to get you approved for
spreads and not naked positions. You should:

a) Transfer the account

b) Consider far out-of-the-money credit spreads
c) Just stick to stocks

8) In order to execute an "option repair" strategy, you must be _____ on the underlying stock.
 a) Bearish
b) At least mildly bullish
c) Neutral

9) An "option repair" strategy has:

a) Limited risk
b) Unlimited risk

10) When might you see the bid and ask for a spread the same price?

a) After ex-date
b) Prior to ex-date

Week 9 : Advanced Strategies and Topics

Calendar Spread
A calendar spread is any spread where the trader buys a particular month, and then sells the
same strike of a different month. For example, a trader may buy a March $50 strike and sell a
January $50. Notice that the trader is spreading months, hence the name calendar spread. Also,
because months represent time, these are equally known as time spreads or horizontal spreads.

If the trade results in a net debit, the trader is said to be long the calendar spread; if it results in a
net credit, then he is short the spread.

With a calendar spread, the trader is expecting the stock to sit flat -- this trade is actually a
play on time-decay and volatility as opposed to direction.

Many traders have trouble understanding why you want the stock to sit still, so let's go through
the reasoning. Say a trader buys the above trade -- long March $50 for $10 and short Jan $7 for
a net debit of $3. Because the trader is long the spread, he will want the spread to widen so that
he may close it for a profit.

Now, if the stock sits still, as we approach January expiration, what will happen to the
spread? Both options will lose money as time goes by, but the short January option will lose far
more than the long March option. The January will be nearly worthless, while the March will still
have significant time remaining. For instance, the January option may be trading for $1/2 while
the March, with over two months remaining, may be worth $7. The trader paid $3 and can close
it for a net credit of $6-1/2 for a $3- 1/2 gain.

Let's say the stock nosedives and is trading for $20. Now, both options will be virtually
nothing. You may see the January for $1/16 and the March for $1/8, but the point is: the trader
will close out the spread for next to nothing for a loss of about $3. If the stock collapses, the
spread will also collapse toward zero.

What if the stock rallies and is trading way up? If the options are very deep-in-the-money,
regardless of the time remaining, they will converge on intrinsic value. You will see a small
difference in the March $50 calls just to reflect an additional two months cost-of-carry, but the
difference will be negligible.

We may see the Jan $50 trading for $30-1/2 and the Mar $50 for $31 but, again, the spread has
narrowed to 1/2 point so the trader will incur a $2-1/2 loss.

From a profit and loss standpoint, the long calendar spread looks like this:
It should be evident that a long calendar spread wants the stock to sit still. Conversely, a short
calendar spread will want the stock to move, either up or down by a large amount as shown by
the profit and loss diagram below:

Many traders make the big mistake of entering into a calendar spread when bullish on the
stock. If they are lucky enough to get the direction correct, they are greatly disappointed to see
the spread collapse.
If you are bullish or bearish on a particular stock and entering into a calendar spread, you want to
be short the spread -- you want the spread to narrow. In other words, if you short the spread, you
will receive a credit. If the stock moves way up or way down, the spread will narrow and you can
purchase it back for a profit.

If you are expecting the stock to sit still, you want to be long the spread. You will spend money to
do so but the spread will widen if you are correct and the stock is relatively quiet.

Calendar spreads add a whole new dimension for most traders; that is, a limited risk way to profit
from a stock doing nothing. Granted, short calls, short puts and covered calls can make money
from a neutral outlook on the stock as well. However, their risk with an adverse move in the
underlying is often too big for many investors. Calendar spreads can be a great way to profit from
a neutral outlook while greatly limiting your risk.
 Butterfly
As you become more involved in trading options, you will no doubt hear about a strategy known
as the "butterfly spread."

The butterfly spread is one of many strategies that belong to a family collectively known as "wing
spreads"; they get this name, as you will soon see, from the shape of their profit and loss
diagrams.

The butterfly spread is avidly written about in many options books, so it tends to attract traders
who want to venture into new strategies. But because the strategy involves three or four
separate commissions (and sometimes more depending on how the spread is constructed) to
open and the same number to close, it is very costly and typically not a good strategy for the retail
investor.

The butterfly spread is really designed for floor-traders to take advantage of pricing discrepancies
between spreads. While it is not an arbitrage play, it stacks the odds in their favor, largely due to
the fact they are not paying retail commissions.

The long butterfly spread

A basic butterfly spread involves three strike prices, which we shall generically call low, medium,
and high. For the long butterfly, the trader will buy 1 low strike, sell 2 medium strikes, and buy 1
high strike all with the same expiration dates. The butterfly can be executed with either calls or
puts (or a combination). The high and low strikes must be the same distance from the medium
option.

Example:
A stock is trading at $100, and a trader wants to place a butterfly spread. The trader may buy 1
$95 call, sell 2 $100, calls and buy 1 $105 call. Notice how the high and low strikes are the same
distance, in this example $5, from the medium strike. This would be called a $95/$100/$105
butterfly. Sometimes traders will just refer to the "body" of the butterfly and call it simply a $100
butterfly.

The long butterfly spread is always executed in a 1-2-1 pattern -- buy 1, sell 2, buy 1. Of course,
you could elect to do multiple spreads in which case your pattern would be 2-4-2 or 3-6-3 or any
other combination as long as the middle strike is always double the number of contracts as either
the high or low.

If you execute a 2-4-2 pattern, this is considered 2 butterfly spreads; a 3-6-3 is considered to be 3
spreads.

Understanding the butterfly

There are many ways to view a butterfly spread. In fact, there are probably an infinite number of
ways to construct one although most investors who are faintly familiar with them will tell you there
are only two ways (either with calls or puts) and always three strikes. A trader can use calls,
puts, combinations of the two, and synthetic versions of each piece of the butterfly to create the
same profit and loss diagrams. All ways are equally correct as long as the profit and loss
diagrams look the same.

One of the easiest ways to view the long butterfly is as a combination of a long bull spread and a
long bear spread. For example, the trader in the above example went long 1 $95 call, short 2
$100 calls, and long 1 $105 call. We can look at that trade in another way as follows:

Long $95 call This is the bull spread

Short $100 call

Short $100 call This is the bear spread

Long $105 call

We see the long bull and long bear spreads consist of exactly the same pieces as the butterfly
spread: long 1 $95, short 2 $100, long 1 $105.

If you understand the butterfly spread in this way, it will help to understand why it is so useful to
the floor traders.

Why floor traders love butterflies

Let's assume a stock is trading for $101 and we see the following quotes on some call options:

Option Quote
$95 call $10
$100 call $8
$105 call $6

We know from basic option pricing that the $95 call should be more than the $100 and the $100
more than the $105, and we see that they are. In addition, the differences in price do not exceed
the strikes, so no problems there (if you are unsure about these principles, please see our section
under "Basic Option Pricing").

However, after checking these basic relationships, market makers will additionally check spreads
and straddles for other possible mispricings.

Here is what they will look for: the $95/$100 bull spread becomes more valuable as the stock
rises. In fact, the maximum profit is achieved if the stock price is above $100 at expiration. With
the stock at $101, the bull spread, at this point, would be at maximum profit if the options were to
expire instantaneously.

Now let's look at the bear spread. The bear spread consists of the short $100 call and the long
$105 call. This spread will become more valuable as the stock falls; in fact, the maximum profit
here will occur if the stock is below $100 at expiration. The bear spread, unlike the bull spread at
this point, will be below maximum profit if the options expire instantaneously.

So if you had to pick a spread to be the winner, which would it be? Obviously, it should be the
bull spread because it is theoretically worth more. But look at the quotes again -- we see both
spreads are prices at $2.

How? The bull spread consists of the long $95 and short $100 for a net debit of $2. The bear
spread consists of the short $100 and long $105 for a net credit of $2.
With the stock at $101, the market maker knows the bull spread should be more valuable relative
to the bear spread, so he'll buy the bull spread and sell the bear spread -- a butterfly spread.

Notice that this does not guarantee a profit -- the stock could fall below $95 or rise above $105 --
so is not an arbitrage play. It does, however, allow the market maker to take an unfair advantage
of a mispricing and put the odds on his side that the trade will, in fact, be profitable. This is one of
many trading situations known as a pseudo-arbitrage because it does not guarantee a profit, but
is traded solely from a theoretical mispricing viewpoint; it is an arbitrage on theoretical odds.

What does a butterfly spread look like?

The profit and loss diagram for the above butterfly looks like this:

Notice how there is no loss area; the lowest this spread can go, in this example, is zero. This is
because it was constructed with the bull and bear spread priced the same, so there was no cash
outlay -- the market maker paid $2 for the bull spread and received $2 for the bear
spread. Realistically, there may be a slight debit, especially after commissions, so it may actually
look like this:
The point is that with a butterfly (assuming a very low debit or low commissions), you have very
little loss area but a high profit area albeit over a small range of stock prices. In a lot of ways, it's
like playing the lottery. The market makers are thinking they have little to lose but much to
gain. The maximum profit will be achieved at the strike price of the short, in this case, $100.

If you use your imagination, the profit and loss diagram looks like the wings of a butterfly (I told
you to use your imagination!) -- hence the name butterfly spread.

Iron butterfly
Another way to view the spread is that it's the combination of a short straddle and long strangle
(please see our section on "Straddles and Strangles" for more information on these strategies). If
a trader executes a short straddle and long strangle, it is a special variation of the butterfly known
as an iron butterfly. The trader of an iron butterfly wants the stock to fall, so the above profit and
loss diagram is actually a short iron butterfly or long butterfly. The short straddle is easy to see; it
is the part that forms the upside down "V" in the diagram. The long strangle just provides
protection from further losses if the stock falls below $95 or rises above $105. It is the long
strangle that forms the protective "wings" to the left and right of the diagram. If a butterfly spread
is constructed in this manner, there will be four commissions to open and four to close.

If you can ever execute a butterfly for a very low debit, you may want to consider it. If you can
ever execute it for a credit, do not pass it up, as this would be an arbitrage situation -- you cannot
lose!

Let's look at some real numbers and see why retail investors should think twice before entering a
butterfly spread.

Example:
MSFT is currently trading for $68-3/4 with the following option quotes available:
Dec $65 call = $6-1/2 ask
Dec $70 call = $3-3/8 bid
Dec $75 call = $1-3/4 ask

Let's trade the $65/$70/$75 butterfly and see what happens:

Long 1 $65 = -$6-1/2

Short 2 $70 = +$6-3/4
Long 1 $75 = -$1-3/4
Net debit $1-1/2

Now, to make it more realistic, let's say you pay a commission of $100 for the three contracts,
which may be a conservative number. Now you must add $100 to the cost. Remember that we
are dealing with three different strikes, so there will be three separate commissions -- and that's
just to buy it.

Now our net debit is $2-1/2 and the maximum we can make is $5. Here's our profit and loss
diagram so far:

It already looks much different from the market maker's above. Notice just how much more "loss"
area there is in this diagram.

Now, our break-even points are $67-1/2 and $72-1/2. If the stock closes below $67-1/2 or above
$72-1/2, the trade will incur losses, and we haven't even considered the commissions to get out.

Already it's a pretty narrow range in order to be profitable -- a five-point range between break-
even points. Let's assume the stock closes at exactly $70, which is the point of maximum
gain. We make $250 but have to pay another $100 in commissions for a total of $150.

Now, it still may not seem like such a bad deal, after all, $150 bucks is $150 bucks. But this was
assuming the stock closed at exactly $70. Just how much room do we have to work?
Taking the sell commissions into account, here's how the trade looks now:

The stock must close above $68-1/2 or below $71-1/2 in order to get anything. In order to get the
full $150, we need the stock at exactly $70. If you can call the stock closing prices within this
close of a range, you're probably better off selling naked calls, puts, or straddles.

The butterfly spread is an interesting combination strategy, which you will no doubt hear about as
you continue with your options trading. Over the past seven years, I have seen many retail
investors attempt butterfly spreads and did not see one -- not a single one -- make a dime.

If you decide to try one, you may want to check with your broker regarding commissions and
break-even points.

My guess is that you will decide against it.

 Condor
Condor, albatross, pterodactyl spreads
Once again, the traders have given some creative names to another class of wingspreads --
strategies with profit and loss diagrams resembling wings. The condor, albatross and pterodactyl
spreads are all similar to the butterfly spread (please see "Butterfly Spreads" for more
information) except each of these strategies sells multiple strikes.

It should be noted that, like the butterfly, these spreads are really meant to be used as floor trader
tools for hedging and taking advantage of small pricing discrepancies that periodically appear in
the market. Because of the large number of strikes involved, the commissions usually make
these losing strategies for retail investors.

This does not mean that you should not take the time to understand them. They will increase
your knowledge of options and give insights into the versatility of options by showing how
strategies can be stacked on one another.

Condor spread
The condor spread is a strategy involving four strikes and can be made up of calls, puts or a
combination of both. The basic condor spreads are usually constructed with either calls or puts.

To execute a basic condor spread, a trader needs four strikes, which we will call S1, S2, S3 and
S4 with each strike being successively higher and having the same expiration. The trader will be
long S1, short S2, short S3, and long S4. For example, the trader may be long the $100 call,
short the $105 call, short the $110 call and long the $115 call. Notice how each strike is
successively higher. It is not necessary to have them separated by five points, though. You
could construct one with a long $100 call, short $110 call, short $120 call and long $130 call -- as
long as the strikes are evenly spaced. From a profit and loss standpoint, the condor spread looks
like this:
The trader will maximize profit between the two short strikes, $105 and $110 in this example. For
stock prices below $105 or above $110, the trader will start to lose profits and eventually end up
negative if the stock falls below $101 (low break-even point) or rises above $114 (the high break-
even point). Any stock price below $100 or above $115 produces the maximum loss of $1 -- the
cost of the spread.

Notice how the condor is similar to a butterfly where the trader buys a low strike, sells two
medium strikes, and buys one high strike. The condor is the same basic pattern except the trader
is splitting the two medium strikes of the butterfly into two separate strikes. This action creates a
wider profit area relative to the butterfly. The trader is hoping for a relatively stable stock
price. The following chart shows a comparison between the condor and butterfly:
Notice how the butterfly (blue) has a higher profit but, in return, gets into loss territory
quicker. The condor (red) has a lower, but wider, profit area and takes longer to head into
losses. The markets realize the condor is therefore more desirable and will bid its price up.

Again, market makers are probably the biggest users of condors as they pay very little in
commissions and can make it worth their while to pay four commissions to enter the condor and
four to exit.

Why do market makers use them?

To understand them, we need a refresher on butterflies. If you read our section on butterfly
spreads, you will recall that market makers are actually spreading spreads -- they buy the bull
spread and sell the bear spread. For example a basic call butterfly has this pattern:

Strike 100 105 110 115 120 125

Call butterfly +1 -2 +1

In other words, the long butterfly trader is long the $100 call, short 2 $105 calls and long the $110
call. If the stock is at $105-1/2, the $100/$105 bull spread (long $100, short $105) should be
more valuable than the $105/$110 bear spread (short $105 and long $110). If, for some reason,
the markets are pricing them equally, market makers will buy the bull spread and sell the bear
spread making them long the butterfly. For the same reasons traders buy spreads (buy one call
and sell another), traders will spread spreads, which is a butterfly.

With condors, market makers are actually laddering butterfly spreads; that is, they buy one set of
butterflies and buy a successively higher set of butterflies.

Strike 100 105 110 115 120 125

Call butterfly #1 +1 -2 +1
Call butterfly #2 +1 -2 +1
Net position +1 -1 -1 +1 = condor spread

A trader may see a theoretical discrepancy between the $100/$105 bull and $105/$110 bear
spread and want to buy butterfly #1 above. In addition, there may be another discrepancy
between the $105/$110 bull and $110/$115 bear, so they may desire to purchase that one as
well. With one condor, all pricing discrepancies between the two butterflies are captured!

A short condor will be the mirror image of the long position and, consequently, have opposing
profits and losses. Using the same example above, to execute a short condor, the trader will be
short $100 call, long $105 call, long the $110 call, and short the $115 call. The short condor
looks like this:
With the short condor, the trader will make maximum profit if the stock makes a large move in
either direction. In this example, if the stock is below $109 or above $114, the break-even points,
the trader will keep the initial $1 credit. If the stock is between $100 and $115, the position will
start to lose profits, and eventually end up at a maximum loss of $4 if the stock is between $105
and $110 -- the strikes of the two long positions.

Albatross spread
The basic long albatross is a strategy utilizing four strikes just as the condor. However, the trader
skips a strike in the middle. Using the earlier notation, a long condor trader will be long S1, short
S2, short S3, long S4, but skip a strike between S2 and S3. For example, a trader who is long
the $100 call, short $105, short $115, long $120 is long an albatross spread.

From a profit and loss standpoint, the long albatross looks like this:
It has a wider but lower profit zone relative to the condor. This reflects the relative risks of the two
strategies. All else equal, traders would prefer to have wider ranges of profit so will bid this
strategy higher relative to the condor. This can be seen if we overlay the two profit and loss
diagrams:

The trader will profit for any stock price above $102 and below $118, the break-even
points. Maximum profit will be realized for stock prices between $105 and $115. Similar to the
condor trader, a long albatross position is betting on a fairly stable stock price; however, the
albatross trader has more room for error.
As with the condor, the albatross is a continuation of the laddering of butterfly spreads. For
example, the following chart shows the trader who is long an albatross spread is effectively long
the $105, $110 and $115 butterflies.

Strike 100 105 110 115 120 125

Call butterfly #1 +1 -2 +1
Call butterfly #2 +1 -2 +1
Call butterfly #3 +1 -2 +1
Net position +1 -1 0 -1 +1 = albatross spread

The short albatross, of course, will be the opposite of the long position. Here, the trader is betting
on a very large move, either up or down, in the underlying.

Pterodactyl spread
As you probably guessed, the pterodactyl spread is just a continuation of the albatross. It still
involves four strike prices but, this time, two strikes are skipped in the middle. A trader who is
long $100 call, short $105 call, short $120 call, and long $125 call is long a pterodactyl. The profit
and loss diagram looks like this:
The albatross trader has an even lower, but wider, range of profits compared to the
albatross. The trader, in this example, will be profitable for any stock price above $102 3/4 or
below $117-1/4, the break-even points. Maximum profit will be realized for stock prices between
$105 and $120.

As shown in the following chart, the pterodactyl spread is a laddering of four butterfly spreads:

Strike 100 105 110 115 120 125

Call butterfly #1 +1 -2 +1
Call butterfly #2 +1 -2 +1
Call butterfly #3 +1 -2 +1
Call butterfly #4 +1 -2 +1
Net position +1 -1 0 0 -1 +1 = pterodactyl spread

Notice in the following chart how each spread -- the condor, albatross, and pterodactyl -- reflects
the relative risks of each position. The strategy with the highest profit potential will be the
cheapest one to purchase. Sometimes new traders find this confusing and think the highest profit
strategies should be the most expensive, as those are the ones everybody wants and will bid the
price higher. This is incorrect, as the highest profit strategies are also the riskiest. In order to
make them worth the risk, the market must reduce the price.
Think of it this way: if all spreads were priced equally, which would you prefer? Obviously, the
pterodactyl as it has the widest area for profit. So traders will bid up the price of the pterodactyl
relative to the others. The same process will occur for the albatross and the condor. No matter
how sophisticated you become with option trading, you will never be able to avoid the risk-reward
relationships.

Spreads are great trading tools and you should take the time to become familiar with these
advanced combinations. In most cases, these are better suited for market makers but that
doesn't mean they cannot be used at the retail level. If you plan to use one, be sure to evaluate
your break-even points and maximum gains and losses taking commissions into account.
 Option Exam 9 - Week 9

1) Assume you are looking at $50, $55 and $60 strike call options. How would you construct a
butterfly spread?

a) Buy a $50, sell a $55, buy a $60

b) Buy a $50, buy 2 $55, sell a $60
c) Sell a $50, sell a $55, buy a $60
d) Buy a $50, sell 2 $55, buy a $60

2) The butterfly can be viewed as the combination of a(n):

a) Bull spread and condor spread

b) Bull spread and bear spread
c) Bear spread and condor spread
d) None of the above

3) The owner of an at-the-money butterfly spread (middle strike equal to the stock price) wants
the underlying stock to:

a) Move sharply upward

b) Move slowly upward
c) Fall sharply
d) Sit still

4) A trader enters a $50/$55/$60 butterfly. The maximum value this spread can ever be worth is:

a) $5
b) $10
c) $60
d) None of the above

5) If you can ever enter a butterfly spread for a net credit you should:

a) Never do it as it is a sure loser

b) Always do it as you can never lose
c) Not enough information as butterfly spreads are always executed for credits

6) The butterfly spread is generally a great strategy for retail customers.

 a) True
b) False

7) Compared to the butterfly spread, the condor is a higher risk, higher reward spread.

a) True
b) False

8) The owner of a calendar spread wants the spread to:

a) Narrow
b) Widen
c) Stay the same

9) The owner of a calendar spread wants the underlying stock to:

a) Stay the same

b) Rise
c) Fall

10) Which of the following is a calendar spread?

a) Buy the March $50 and sell the January $40

b) Buy the March $50 and sell the January $50
c) Buy the March $50 and sell the April $55
d) Buy the March $50 and buy the April $50

Week 10 : Advanced Strategies & Topics

Backspread
The backspread is similar to a ratio spread, except that it has unlimited profit instead of unlimited
loss on the profit and loss diagram. It is the mirror image of the ratio spread. In fact, the
backspread is often called a long ratio spread.

Call backspread
A call backspread involves the sale of a low strike price call and the purchase of a higher number
of contracts at a higher price. For example, a trader may sell 10 $50 calls and buy 20 $60 calls,
also known as a $50/$60 backspread.

The profit and loss diagram for a call backspread looks like this:

Assume the trader sells 10 $50 calls for $10 and buys 20 $60 calls for $3. This trade can be
broken down to 10 (-1/2) spreads (please see our section on "Ratio Spreads" for more
information). In other words, the trader sold one call and bought two calls, but did this ten
times. For every call sold at $10, two were purchased at $3 for a total of $6. Therefore, the
above trade was executed for a net credit of $4 (received $10 but paid $6). Depending upon
prices and ratios used, backspreads may be entered for either debits or credits.

For any stock price below $50, the trader will keep the net credit of $4, as both calls will expire
worthless. If the stock moves above $50, the trader will head into loss territory because he is
short these calls. However, if the stock continues upward, the $60 calls will come to the rescue
and stop the losses. The maximum loss will occur at $60 where the trader will lose ten points
(the difference in strikes) less the credit of $4, for a maximum loss of $6. Because there are two
$60 calls for every short $50, the trader will start to make gains above $60. In order to make up
for the $6 loss, the stock must rise to $66 to reach break-even. The downside break-even can be
found in two ways: One, the trader must make up the $6 loss from the low point of $60; Or, he
can sustain a loss of $4 (the initial credit) above $50. Either way you choose, you will see the
downside break-even is $54.

Notice that if the trader had purchased the 10 $50 calls and sold 20 $60 calls, he would have a
ratio spread. Ratio spreads and backspreads are opposites. The following is a profit and loss
diagram comparing the two spreads:
Why enter a call backspread?
If a trader is bullish on a stock yet fears a market turndown, then both sides of the market can be
played with a backspread. The trader will capture all upside profits yet have a credit (or less of a
loss if entered as a debit) if the stock should fall. Typically, novice traders will enter long
straddles to play the upside and downside. However, with long straddles, the break-even points
become very wide due to the fact that premiums are paid for both the call and put and must be
made up. With the backspread, a trader can custom-tailor his bias in the stock and create better
risk-reward ratios. The trader using a call backspread is more bullish, but fears a downturn. He
will not profit as much as a long straddle trader, but does not have as much at risk either.

Backspreads are another great example of just how versatile options can be.

Put backspread
Backspreads can be used with put options too. To enter a put backspread, the trader will sell a
high strike put and buy a higher number of a lower strike put. For example, a trader may sell 10
$60 puts and buy 20 $50 puts.

The profit and loss diagram for a put backspread looks like this:
Assume the trader sells the $60 puts for $10 and buys the $50 puts for $3. As above, this spread
can be broken down into 10 (-1/2) spreads. This means that for every one put that was sold, two
were purchased. The trader receives $10 from the sale of the $60, but pays $6 for the two $50
puts for a net credit of $4. If the stock should rise, the trader is left with a credit, as both puts will
expire worthless. If the stock falls below $60, the trader heads into loss territory, as he is short
these puts. If the stock continues to fall to $50, the losses stop and gains will start, as he is long
two of the $50 puts for every one of the $60 puts that are short.

So for any stock price below $50, the trader starts to gain. At $50, the trader is down $10 (the
difference in strikes), but received $4 from the initial trade for a net loss of $6. Because this $6
must be made up, the break-even will be $6 points below the $50 strike or $44. If the stock falls
below $44, the trader will start to show profits. Where is the upside break-even? The trader will
need to make up the $6 from the max loss point at $50 to the upside; equally, he can sustain a $4
loss (the initial credit) below $60. Either way of looking at it will yield an upside break-even of
$56.

With puts, traders are betting more on the downside, but they fear the upside risk. A put
backspread allows them to capture both possibilities while favoring the position to the downside.

Intel backspread example

Let's run through an actual example using Intel (INTC), which is currently trading around
$41. The option quotes are as follows:

Dec $40 Call = Bid:$3-1/2 Ask: $3-3/4

Dec $45 Call = Bid:$1-3/8 Ask: $1-3/4

Assume a trader wants to place a $40/$45 backspread and sells the $40 call for $3-1/2 and buys
2 $45 calls for $1-3/4 each or $3-1/2 for a net debit of zero shown by:

Short 1 $40 call = -$3 1/2

long 2 $45 calls at $1 3/4 each = +$3 1/2
Net debit $0
Here is what the profit and loss diagram will look like for the above trade:

The trader will make nothing if the stock falls, and lose $5 if the stock closes at $45. If the stock
is above $45, the trader will start to recover losses and eventually break even at $50. Any stock
price above $50 will yield a profit. Note the break-even points of $40 and $50. If the stock closes
between these two points, the trader ends up with a loss.

Remember we said the trade opposite the backspread is the ratio spread? Well, the floor trader
who executes the above backspread will have the ratio spread (assuming the trades are not
matched with other orders or positions). The floor trader's profit and loss diagram looks like this:
Backspreads are great tools; especially for active traders. They generally require level 2 option
approval (ratio spreads require level 3). Many traders shy away from ratio and backspreads
because of the initial complexity in understanding them. However, with a little work, you can
quickly find the maximum gain and loss points as well as the break-evens. They are a wonderful
tool for option traders, so you should take the time to understand them if you want advance to a
higher level of trading!
 Box Spread
There are many tools that market-makers use to hedge risks, either partially or fully. One of the
most powerful tools is called a box spread. While this particular strategy is not widely used by
retail investors, it is very useful in determining if your vertical spread is priced fairly.

Another important use of the box spread is for investors who place spread orders (please see our
section on spreads if you are not familiar with these.) They often ask, "Do you think I can get
filled at such-and-such a price?" If you understand the box spread, you will be able to
immediately determine if there is any room for the market makers to work with your order.

If you are a user of spread orders, understanding box spreads will be a very helpful tool!

The box spread

A box spread is a relatively simple strategy. To enter into a long box position, all you need to do
is buy the bull spread and buy the bear spread with the same strikes and all other factors the
same (if you are unsure about bull and bear spreads, please see our section on "Basic Spreads.")

For example, say a stock is trading at $50. A trader could buy the Jan $50 call and sell the Jan
$55 call (bull spread), and also buy the Jan $55 put and sell the Jan $50 put (bear spread.)

This trade will result in a debit for both spreads. What is interesting about this position is that it is
now guaranteed to be worth $5 (the difference in strikes) at expiration (keep in mind this is a
theoretical price, and in the real world of trading, the bid-ask spreads will probably make the value
slightly less than $5 at expiration).

How? Think about this: No matter where the stock closes, either the $50 call or the $55 put
will be in-the-money. Because these are the two long positions of the box spread, the trader
who buys the box spread is guaranteed to have a position worth $5 at expiration.

Let's run through some examples if you are still not sure:

If the stock closes at $53, the long $50 call will be worth $3 and the long $55 put will be worth $2
for a total of $5. The short $55 call and short $50 put will expire worthless (if you are not sure
why these prices must hold, please see our section under "Basic Option Pricing").

If the stock closes at $51, the $50 call will be worth $1, and the $55 put will be worth $4 for a total
of $5. Again, the two short positions expire worthless.

What if the stock closes outside the ranges of $50 and $55?

If the stock closes at, say, $30, the $55 put will be worth $25 and both calls will expire
worthless. However, the short $50 put now has value. In fact, it will be worth $20, which is an
obligation because the trader is short. So the total value of the position is +$25 - $20 = $5.

You can't get around it. No matter where the stock closes, the position will be worth the
difference in strikes, in this case, $5.
Question:
Okay, here's one for you to try. What will be the value of the above box spread is the stock is
trading for $100 at expiration? How would you show it? (Answers at the end.)

Pricing a box spread

Now that we know the mechanics of the box spread, how can we use it to help with our trading?

It is now October 31 and say you are interested in SCMR, which is currently $58-3/8, with the
following quotes available for options:

BID ASK
Dec $55 Call $12-7/8 $13-7/8
Dec $65 Call $8-7/8 $9-5/8

Dec $55 Put $8-3/4 $9-1/2

Dec $65 Put $14-3/4 $15-3/4

Let's say you are bullish on SCMR and want to place a $55/$65 bull spread:

Buy Dec $55 Calls = $13-7/8

Sell Dec $65 Calls = $ 8-7/8
Net debit $ 5

Is this being priced fairly? Is it likely we will get filled if we put a net debit of $4-3/4?

In order to answer these questions, let's look at the other side of the box spread:

Buy Dec $65 Puts = $15-3/4

Sell Dec $55 Puts = $ 8-3/4
Net debit $ 7

Now, you will pay $5 for the bull spread and $7 for the bear spread for a total debit of $12, which
is guaranteed to fall to a value of $10 at expiration! So with the current bid/ask spreads, this box
is not being priced fairly. In fact, this is most often the case and the primary reason the box
spread is not a popular tool for retail investors.

Let's see what the market makers are trying to do. Remember, the bid represents what they are
willing to pay, and the ask what they are willing to sell. So, from the market-makers perspective,
here is how the box spread looks:

Buy Dec $55 Calls = $12-7/8

Sell Dec $65 Calls = $ 9-5/8
Net debit $ 3-1/4

Buy Dec $65 Puts = $14-3/4

Sell Dec $55 Puts = $ 9-1/2
Net debit $ 5-1/4
The market makers want to complete the box spread for a total of $8 1/2 points, which is
guaranteed to grow to a value of $10.

On the surface, it appears to be a pretty good deal. Let's see just how good it is.

Remember, it is October 31 and we are looking at December options, which will expire in 45
days. That actually works out to be 17.6% simple interest, or a whopping 267% annualized rate
of return -- which certainly beats the guaranteed rates on T-bills.

So to answer the second question: yes there is certainly a lot of room to work with on the bull
spread.

Let's go a step further. Just how much room is there? One useful method is to start with what
the spread "should" cost. If the spread is guaranteed, it should earn the risk-free rate (roughly
6%). So the value of $10 guaranteed in 45 days is about $9.93, which is roughly $1.17 above the
$8-3/4 price the market makers are trying to pay.

In a case like this, it is very feasible to get 1/2 point or maybe more off of this spread.

Please remember, any limit order, no matter how close to the market, is not guaranteed to fill, so,
if you really need to get into or out of a trade, use caution in applying this method. This pricing
method is a great tool for analyzing the potential for all traders who like to use limit orders.

Uses of the box spread

Why would a market maker enter into a box spread? The box spread is effectively a way for
market makers to borrow or lend money. If a market maker sells a box spread, they are
effectively borrowing money. They receive a credit and must pay back the value of the box at
expiration. Similarly, if they buy a box spread, they are loaning money. They will pay money but
receive a guaranteed return at expiration.

Of course, the market makers will price the boxes in their favor and either buy it below or sell it
above the theoretical fair value.

For example, say a $90/$100 box is priced at $9. If the $90/$100 put spread is priced at $4, the
$90/$100 call spread should be worth $5. However, the market maker may bid $4-3/4 and ask
$5-1/4 for the call spread. This way, regardless of whether he buys or sells the call spread, he is
either borrowing at less than (or loaning for a higher rate of) current risk-free rates by completing
the box. For instance, if he buys the call spread for $4-3/4, he will buy the put spread for $4 and
thus pay only $8-3/4 for a box position worth $9, and effectively loan money for higher than the
risk-free rate. Likewise, if he sells the bull spread for $5-1/4, he will sell the bear spread for $4
thereby completing the box for $9-1/4. Now the market maker has sold a box worth $9 for $9-1/4
and effectively borrowed money for less than the risk-free rate.

Other views of the box spread

We said earlier that a long box spread could be viewed as a long bull spread matched with a long
bear spread. There are two other ways to view boxes, and depending on your situation, one or
the other may be more helpful.
One way to see it as a conversion at one strike and a reversal at another. For example, if a
trader is short stock at $50, long $50 calls and short the $50 puts, he has a reversal at $50. If he
subsequently buys stock at $60 with long $60 puts and short $60 calls, he has a $60 conversion.

Notice that the long and short stock positions cancel out, leaving the trader with long $50 calls
and short $50 puts (synthetic long position) with long $60 puts and short $60 calls (synthetic short
position).

$50 reversal $60 conversion

Short 1,000 shares at $50 Long 1,000 shares at $60

Long 10 $50 calls Long 10 $60 puts

Short 10 $50 puts Short 10 $60 calls

The long and short stock positions cancel each other out (shown in red). The remaining positions
are a synthetic long position (blue) at $50 and a synthetic short position (black) at $60. Notice the
embedded bull and bear spreads (long $50 call and short $60 call, long $60 put and short $50
put).

Of course, a long position matched with a short position cancels each other. This holds true
whether it's actual stock or synthetic versions. The trader who is synthetic long at $50 and
synthetic short at $60 has effectively purchased stock at $50 and sold at $60. Bear in mind this is
not as good as it seems, as the trader was also short stock at $50 and long at $60. The profits or
losses come for the total reversal and conversion prices.

If you trade spreads, take the time to really understand box positions, as it will make all the
difference in the world in your understanding of spread pricing. Once you have a handle on that,
you will be able to make more knowledgeable decisions as to which limits to use with your orders.

Answers:
What will be the value of the above box spread if the stock is trading for $100 at expiration? How
would you show it?

The question was referring to the $50/$55 box spread. The value of the box spread must be
worth $5 -- the difference in strikes -- at expiration. To prove it, if the stock is trading at $100, the
long $50 call will be worth $50 and the short $55 call (which is an obligation) will be worth
$45. Both puts, the $50 and $55, will expire worthless because they are out-of-the-money. So
the total value to the trader will be +$50 - $45 = $5
 Option Exam 10 - Week 10

1) Call backspreads exhibit unlimited profit potential for the holder.

a) True
b) False

2) Call backspreads have unlimited downside risk if the stock falls.

a) True
b) False

3) Which of the following is a call backspread?

a) Sell $50 call, buy 2 $55 calls

b) Sell $50 call, sell $55 call
c) Buy $50 call, sell 2 $55 calls
d) Buy $50 call, sell $55 call

4) Put backspreads have unlimited risk if the stock rises.

a) True
b) False

5) A call ratio spread has unlimited risk if the stock rises.

a) True
b) False

6) A put ratio spread has unlimited risk if the stock rises.

a) True
b) False
7) Consider these two ratio spreads:
(1) Buy $50 call and sell 2 $55 calls
(2) Buy $50 call, sell 3 $55 calls

a) The first ratio spread is riskier than the second

b) The second ratio spread is riskier than the first
c) Both are equally risky
d) Neither have any risk

8) A trader places a ratio-spread order to buy 10 $50 calls and sell 20 $55 calls as a limit order.
Can the market maker fill the order as buy 8 $50 calls and sell 14 $55 calls?

a) Yes
b) No

9) Box spreads are a way for market makers to borrow and lend money.

a) True
b) False

10) Box spreads can be used by retail investors to see if vertical spreads are priced fairly.

a) True
b) False

Week 11 : Advanced Strategies & Topics

 Synthetic Options
The name sure sounds intimidating, but synthetic options are fairly easy to understand and are
truly a fascinating and useful part of options trading. Understanding synthetic positions will allow
you to effectively do things many traders will tell you cannot be done, such as shorting stock on a
downtick (or even when no stock is available), buying calls or selling naked puts in an IRA, buying
stock for virtually no money, and a host of other imaginative strategies. Further, understanding
synthetics will give you great insights into option pricing. You will understand how options are
created, and why the market makers are quoting the puts and calls the way they are.

In order to understand these mysterious sounding options, you need to understand one of the
most fundamental concepts of option pricing known as put-call parity.

Put-call parity
Put-call parity is a relationship showing that call and put prices are very dependent on one
another, and not just arbitrarily chosen. In order to understand the put-call parity equation better,
it's best to show how orders are filled on the floor of the exchange. Here's an example of how it
works:

Say you want to buy 10 calls to open of the ABC $50 strike (with 1 year to expiration) at
market. ABC stock is also trading at $50.

When this buy order is received on the floor, the market maker must become the seller so that the
transaction can be completed. This means the market maker must be willing to be short a
call. Now, while you may be totally comfortable in speculating by buying 10 calls, the market
maker may not be so eager to be on the short side. The reason is this: Market makers are in the
business to take 1/8th's or 1/4th's of a point on a large number of trades; they are not really too
interested in holding open speculative positions over long periods of time -- especially short calls
that have unlimited upside risk!

How does the market maker create a short call?

If the market maker is to be short a one-year call, his risk will be that the stock goes higher. So,
in order to protect himself from this risk, he will purchase 1,000 shares. No matter how high the
stock moves, he will always be able to deliver 1,000 shares of stock (represented by the 10 calls)
at expiration.

However, now there is a new risk; the stock may fall. So to protect himself from this, he will buy a
$50 put with one year to expiration.

Now our market maker is now long 1,000 shares of stock, long 10 $50 put options and short 10
$50 call options. Because he is short 10 calls, he can now fill your order to be long 10 calls. But
what price should he charge?

Here is what's interesting about this position: The market maker is now fully hedged (protected)
against any stock price movement at expiration. This means he cannot lose on the
position! How? Well, the stock price can do one of three things between now and expiration of
the call:It can stay the same, go up or go down. If the stock stays exactly at $50, the call and put
expire worthless and the market maker's position is worth exactly $50,000, which is the amount
he originally paid for the stock. If the stock closes above $50, the long put will expire worthless
and the market maker will get assigned on the short call and lose the stock; however, he will be
paid the $50 strike and receive exactly $50,000. Likewise, if the stock closes below $50 at
expiration, the short call will expire worthless and the market maker will exercise his put and
receive $50,000.

With the long stock at $50, long $50 put and short $50 call, the market maker is now guaranteed
to receive $50,000 in one year. It is kind of ironic by using these speculative derivatives of puts
and calls we can actually create a risk-free portfolio!

Now, if any financial asset is guaranteed to be worth a certain amount in the future, then its value
today must be worth the present value discounted at the risk-free rate of interest.

PRESENT VALUE/FUTURE VALUE are "time value of money" concepts used throughout the
financial industry to describe the value of assets at different points in time. The concept of time
value says that a dollar today is worth more than a dollar tomorrow because the dollar today can
be invested and earn interest. For example, if you deposit $100 into an account that pays 5%
interest, you will have $100 (1+5%) = $105 in the future. So the future value of $100 today is
$105 if interest rates are 5%.

Similarly, if someone owes you $105 one year from now and interest rates are 5%, then you
should be willing to accept $105/(1+5%) = $100 today. In other words, it should make no
difference to you by waiting one year and receiving $105 or collecting $100 today. The reason is
that you can take the $100 today, invest it at 5% for one year, and still have your $105 a year
from now. So the present value of $105 one year from now is $100 (if rates are 5%). To
calculate the present value, we simply take the future value of the asset and divide it by 1 + risk-
free interest rate.

The market maker is guaranteed to receive $50,000 in one year regardless of the stock price. So
the present value of $50,000 in one year is $50,000 / (1.05) = $47,619 today. The market maker
should pay $47,619 today for these three assets -- the stock, long put and short call
positions. Why? If he pays $47,619 and receives $50,000 in one year, his return on investment
will be 5%, which is exactly the interest rate he should receive for a risk-free investment.

The market maker will spend $50,000 for the 1,000 shares of stock trading at $50. Let's also
assume he pays $5 for the put. Now he will spend an additional $5,000 for the put for a total
cash outlay of $55,000. We already figured that the fair price for this package of three assets
should be worth $47,619 yet he's paying $55,000 for it.

The market maker has overpaid by $55,000 - $47,619 = $7,381, so he will need to bring in a
credit for this amount. How can the market maker receive a credit of $7,381? Easy -- he will fill
your order on the 10 $50 calls for roughly $7-3/8. Doing so, he will receive the necessary credit
to make his -$55,000 cash outlay equal to -$47,619. Of course, the market maker will try to make
an 1/8 or 1/4 point profit, so the order would probably be filled around $7-1/2.

To summarize, the market maker's initial position looks like this:

Buy 1000 shares at $50 = -$50,000

Buy 10 $50 puts at $5 = -$5,000
Sells 10 $50 calls at $7 3/8 = +$7,375
Equals -$47,625 cash outlay by market maker.
This is guaranteed to grow to a value of $50,000 in one year ($47,625 * 1.05 = $50,000) because
of the full hedge provided by the 3-sided position.

This three-sided position (long stock + long put + short call) established by the market maker is
called a conversion. If he does the reverse (i.e. short stock + short puts + long calls) then it is
called a reversal or reverse conversion.

The put-call parity equation

We have shown that the market maker's three-sided position (conversion) is guaranteed to be
worth the present value of the exercise price. Remember, he was short $50 calls and long $50
puts; the stock must either be above or below this price at expiration, resulting in a cash inflow of
$50 -- the exercise price. Because he's guaranteed this strike price, the long stock + long put +
short call position must be worth the present value of the exercise price. We can rewrite this
using S for stock price, P for put price, C for call price, and E for exercise price as follows:

S + P - C = Present Value E
And therein lies the magic of synthetic options!

Notice the notation with the plus and minus signs. The long put position is denoted by a "+" sign
and the short call is denoted by "-". This will be important to remember later.

To make things a little easier to understand, we know the present value of E (the right side of the
equation) is guaranteed to grow to E so it behaves like a risk-free investment -- a T-bill (or
Treasury bill, treasury note or treasury bond). We can therefore rewrite the above equation as:

S + P - C = T-bill
With some very basic algebra, we can create many interesting positions. We will take it slow with
lots of examples, so hang in there!

This equation is known as put-call parity. If you know the value of a call option, you can
immediately figure out the value of the put.

One small adjustment

Before we can continue with some examples, there is one note we need to make with an
example. Let's say we are interested in seeing what a long stock + long put position are equal
to. Using the equation, S + P - C = T-bill, how can we get the S + P (the pieces we are interested
in) by themselves? Algebraically, we need to get the C to the other side of the equal sign; we
need to add C to both sides. Now we have S + P = C + T-bill.

What does this mean? It means that someone holding long stock and a long put in a portfolio
(the left side of the equation) will have exactly the same portfolio balance at option expiration as
another person holding a call plus a T-bill (the right side of the equation).

Let's see if it holds true:

Assume we are interested in 1-year options and interest rates are 5%:
Investor A holds stock at $50 and a $50 put (left side of the equation)

Investor B holds a $50 call and a T-bill (right side of equation)

Investor B will pay $50,000/(1.05) = $47,619 for the T-bill.

At expiration:

Portfolio A Portfolio B
Total Total
Stock price Stock $50 put Value At T-bill $50 Call Value At
Expiration Expiration
35 35 15 50 50 0 50
40 40 10 50 50 0 50
45 45 5 50 50 0 50
50 50 0 50 50 0 50
55 55 0 55 50 5 55
60 60 0 60 50 10 60
65 65 0 65 50 15 65
70 70 0 70 50 20 70
75 75 0 75 50 25 75
80 80 0 80 50 30 80
85 85 0 85 50 35 85

Regardless of where the stock closes, investor A will be worth exactly the same as investor B;
there are no differences in the two portfolios. Why does this happen? Portfolio A can never fall
below $50 -- the strike of the put. However, if the stock rises, investor A will participate
fully. Portfolio B must grow to a value of $50 because that is the T-bill portion and is
guaranteed. Portfolio B, like A, can never have a value below $50. If the stock rises, investor B's
call will start to increase in value by the same amount as the increase in stock in A's portfolio so
both A and B receive all of the upside potential in the stock.

Portfolio B is said to be the synthetic equivalent of portfolio A. Also A can be said to be

the synthetic equivalent of B.

So, a synthetic equivalent -- or synthetic -- is any position that has exactly the same profit and
loss, at expiration, as another position using different instruments.

Now here's the one small adjustment I was referring to at the beginning of this section. By
definition, synthetic positions only track the changes in portfolios and not the total value. For
example, in the above example with investor A and B, the total value of B's portfolio is the same
as A's. To have the synthetic equivalent, we only need to look at the changes. If B just held the
$50 call option and not the T-bill, he would exactly reflect the changes in A's portfolio.

For example, if A buys the stock for $50 and it falls to $40, A can exercise the put and receive
$50 -- so A starts with a value of $50 and ends with $50 and therefore has no change. Portfolio B
would also reflect no change as well. The $50 call will expire with a value of zero. If the stock is
trading at $60 at expiration, portfolio A will be worth $60, from $50, reflecting a change of
$10. Portfolio B will also change by $10, as the $50 call will now be worth $10.
The whole point of all this is that, with the original equation S + P - C = T-bill, we can ignore the T-
bill on the right hand side; it accounts for total value and not the changes in portfolio value.

Now our equation is even easier! All you need to know is:

S+P-C=?
And you can figure out any synthetic position!

Synthetic positions
Now that you have the necessary equation, let's work through lots of examples to get the hang of
synthetic options.

For starters, remember that we said the above is equal to a T-bill? Well, if you are long stock +
long put + short call you are said to be holding a synthetic T-bill; the positions will behave exactly
the same at expiration.

Synthetic long call

Using the equation, S + P - C = ?, we are in a position to find out. We are trying to find out the
synthetic value of a long call, so we need to get a +C (remember, we are using "+" to denote a
long position) on one side of the equation. If we add C to both sides and we get: S + P = C, and
there's the answer; long stock and long put (left side of the equation) will behave just like a long
call (right side). Therefore, if you hold long stock and a long put, you have a synthetic call
position.

Let's check the profit and loss diagrams to see if we're correct:
We can easily see there is no difference between long stock + long $50 put purchased at $5 (left
chart) and long $50 call purchased at $5. The person holding the long stock and long put raised
the cost basis of their stock from $50 to $55, that's why their break-even point is now
$55. However, they still participate in all of the upside movement of the stock. What if the stock
falls? The investor is protected for all prices below $50, which is the strike of the put. The worst
that can happen is for the stock to fall to zero. This investor will exercise the put and receive $50
effectively only losing on the $5 they paid for the put; therefore the maximum loss is $5.

For the call holder (right chart), they paid $5 so their maximum loss is also $5 but they too
participate in all of the upside of the stock. The stock will have to be $55 at expiration in order for
the call holder to break even.

It should now be apparent that call owners get downside protection as well as a put holders; the
call keeps you from losing value in the stock because you are not holding the stock!

So how do you own calls in an IRA? Now you should know. Use the synthetic equivalent and
buy the stock and put. Your return on investment will be much lower than the person who buys
the call because of the difference in capital required to purchase the stock, but the two positions
will behave the same way at expiration.

Synthetic long stock

Without looking ahead, see if you can use the equation S + P - C = ? and solve it for long stock.

Because we have +S on the left side already, let's move the C and P to the other side. To do this
we need to add C and subtract P from both sides. If you did it correctly you should find that S = C
- P. Now you know that a trader holding a long call and short put (right side of equation) are
actually holding synthetic stock (left side).

Looking at the profit and loss diagrams for each:

We see there is no difference in the two positions. The long stock purchased at $50 (left chart)
will gain and lose point-for-point to the upside as well as the downside. The same holds true for
the long $50 call and short $50 put (right chart). The $50 call will gain point-for-point at expiration
while the short put will become a liability (loss) point-for-point if the stock should fall.

So synthetic stock is long call plus a short put. What would synthetic short stock be? Just the
opposite, long put and short calls. This is great to know for all traders involved in short
selling. Now you know how it is possible to short stock without an uptick or when stock is not
even available for shorting -- use synthetics and buy the put and sell the call.

How much will it cost to short synthetic stock? Theoretically you should receive a credit. This
can be shown by the original equation S + P - C = Present value of E. If we rearrange so that C -
P = S - Present value E we see that, if S and E are equal (in other words, at-the-money), then S -
Present value E must be a positive number. In order for C - P to be positive, C must be more
expensive than P. Because you are buying puts and shorting calls, you should get a slight
credit. Realistically though, because of bid-ask spreads and commissions, it will probably cost
you a slight debit.

Synthetic covered call

Hopefully you are getting the hang of this, but we'll do one more to be sure. What is a synthetic
covered call? We know a covered call is long stock plus a short call, so it would be represented
by S - C in our equation. Looking at the equation S + P - C = ?, we need to get S and -C on one
side. In order to do that, we can just subtract P from both sides and get S - C = -P. A covered
call position is synthetically equivalent to a short put.

As expected, the profit and loss diagrams are the same. For the covered call position (left chart),
the investor buys stock at $50 and sells a $50 call for $5, effectively giving the stock a cost basis
of $45, which is the break-even point. If the stock rallies, the investor will be forced to sell it for
$50 regardless of how high the stock moves. The short put (right chart) is at risk for all stock
prices below $50, which is offset by the $5 premium received, which gives a break-even point of
$45.

How can an investor sell puts in an IRA? Using synthetics, one can buy stock and sell calls,
which is exactly the same thing from a profit and loss standpoint.

It is a little ironic that most brokerage firms require level 3 option approval to short puts yet require
only level 0 to enter covered call positions. Synthetically, they are exactly the same thing. If you
wouldn't short a put on a particular stock, you shouldn't enter into the covered call either.

Incidentally, if you do enter a into a covered call position, you should see the benefit of entering
the order as a buy-write (please see our section under "Buy-writes" for more information). Doing
so gives the market maker two of the three sides necessary to complete a reversal. This gives
the market maker a guaranteed trade so they are very eager to get them filled. Most of the time,
you will receive a better fill than the natural at the time the trade is placed.

Practicing with synthetics

It is a good idea to practice with the synthetic relationships of any trade you are thinking of
entering. Doing so will help you understand synthetics as well as give you additional insights into
the way the trade will behave at expiration.

As a guide, remember that there are three pieces to the puzzle: Stock, calls and puts. The
synthetic of any one of the pieces will always be some combination, either long or short, of the
remaining two. For example, a synthetic call will be some combination of stock and
puts. Synthetic stock will be a combination of calls and puts.

Once you become proficient with synthetics, you will certainly become a better options trader!
 Synthetic Short
If you read the section on synthetics, you should have a handle on how they work. Now we'll
show you how powerful they can be.

Shorting stock
Before we talk about synthetic short stock, let's go through the basic short sale.

A popular strategy among bearish investors is shorting stock. When you short stock, you are
selling it first and then buying it back later at hopefully a lower price. Short sellers are attempting
to sell high and buy low -- just in the reverse order of bullish investors.

In order to sell stock you don't own, you must borrow it from another investor. While this may
sound complicated, it is a seamless transaction and usually takes a matter of seconds to execute.

Notice how the short stock position is exactly opposite the long position:

This means the investor who is short stock has unlimited upside liability. As the stock moves
higher, the short position increases its losses.

Uptick
There is one catch with selling stock short; the sale must be done on an uptick or a zero-plus
tick. What is an uptick? Say a stock is quoted bid $25 and offered at $25-1/2 with the last trade
at $25. If the next trade is higher than the last trade of $25, that new trade is an uptick. If the
trade is lower, it is a downtick.
When you look at the last trade of a stock, you will usually see a "+" or "-" sign to the side (or on
some systems, an up or down arrow). The "+" indicates and uptick and the "-" a downtick. Using
the above example, if the next trade is $25-1/4, you will see the last trade reported as +$25-
1/4. If the following trade is back to $25, you will see -$25.

If the next trade is $25-1/4, again, you will see +$25. What if the following trade is also $25-
1/4? That is called a zero-plus tick indicating that the last change was an uptick but the recent
prices are unchanged.

The uptick rule was created to prevent investors from selling into a sharp downtrend, thereby
nearly guaranteeing a profit. The rule is of little significance to the investor other than it must be
met. There is nothing the trader needs to do other than place the order -- either it will fill or it
won't.

Because of the uptick rule, it is possible for a short sale to not execute even if it is a
market order!

We've seen there are two main obstacles to overcome when shorting stock: shares must be
located to be borrowed and the sale must occur on an uptick.

Locating shares
Although it is fairly uncommon, it is possible for shares to not be available for shorting. Around
April of 1999, there was a four-month period where Amazon.com (AMZN) was starting to fall after
being on a record climb to the upside (shown in red circle below). Prior to that, investors saw it
fall from nearly $100 to just above $40 (blue circle). So once it started falling again in late April,
investors were eager to sell it short hoping it would fall back to $40.

But many investors were unable to capitalize on the situation, as there was a two-week period or
so where no shares were available to short!
Most investors would let the situation pass as an unfortunate market technicality, and miss out on
a potentially terrific trading opportunity.

But if these same investors understood synthetic options, they would have participated fully on
the short side. Better yet, they would avoid the uptick rule.

Synthetic short stock

If you read our section on synthetics, you will recall the equation for synthetic options is Stock +
Put - Call = ? Because we want to find out the synthetic equivalent of short stock, we need to get
short stock (minus stock) by itself in the equation. If we subtract stock from both sides, we get
Put - Call = - Stock and there's the answer: Long put + short call = short stock.

Basically what investors are doing with synthetic short sales is buying puts, and that gives them
the right to sell the stock so, will appreciate as the stock falls -- just like a short stock
position. However, puts can be very expensive especially under the conditions in the chart
above. So in order to pay for the puts, investors will sell calls and use the proceeds to buy the
puts. If the stock is trading for $100, the trader should theoretically receive a credit from the
trade. But due to bid-ask spread and commissions, the synthetic short sale will usually result in a
slight debit.

From a profit and loss standpoint, the synthetic short position looks like this:

We can see that is looks exactly like our short stock position shown earlier; at expiration, the
investor gains point-for-point if the stock falls, and loses point-for-point if it rises. The synthetic
position, at expiration, is behaving exactly like short stock.

It is important to remember that options do not behave like stock until expiration unless they are
very deep-in-the-money. So if a trader executes a synthetic short at a strike of $100, the profit
and loss diagram will not have the above shape until expiration. If a trader wishes to have the
options behave more like stock, he should consider buying an in-the-money put and selling and
in-the-money call.
What's great about the synthetic short is that it does not need an uptick to execute. You simply
place your order to buy the put and sell the call. Of course, it is usually suggested these two
trades be placed simultaneously to prevent execution or risk -- the risk of an unfavorable market
move while you are executing two separate orders.

Bear in mind that the short call position is naked. This means you will generally need level-3
option approval and, in addition, will have an option requirement in order to hold the naked call
position. Be sure to check with your broker if you are unsure as to how that works. The
requirement is not a huge offset for the synthetic position compared to short stock; the short stock
position will be charged with a 50% Reg T requirement, which is not applicable to the synthetic.

Bullet strategy
There is an interesting strategy known as a "bullet" where investors can actually intensify the fall
of a stock and increase the odds that they will make money. Here's how it works, Say a stock is
in a rapid decline. You'd like to short it, but you're concerned there may not be an
uptick. However, if you buy a put, the market maker will be forced to short the stock and buy a
call to create the long put position for you. Market makers are not subject to the uptick rule; they
can just hit the bid and execute a short sale.

One strategy is to buy deep-in-the-money puts, which force market makers to hedge nearly
dollar-for-dollar and short an equal number of shares. For example, say a stock is trading for
$100 and falling sharply. If you buy a deep-in-the-money put such as a $130 (or wherever delta
is near 1), the market maker will sell nearly 100 shares for each put, thereby putting more
downward pressure on the underlying. Because you hold a deep-in-the-money put, it will
appreciate nearly dollar-for-dollar with each point fall in the underlying.

To exacerbate the fall further, you can enter the deep-in-the-money synthetic short position by
selling the calls, too. Now the market maker will be forced to short the stock again nearly point-
for-point. So if you buy 10 puts and sell 10 calls (both deep-in-the-money), the market maker will
be forced to short nearly 2,000 shares without an uptick.

Semifutures
There is a related strategy that has a little less risk called a semifuture. The strategy can be used
as a long or short position. If you want a synthetic short position with a little less risk, you can
split the strike prices, such as buy the $50 put and sell the $55 call. The more distance you put
between the strikes the less upside risk there is. From a profit and loss standpoint, the short
semifuture position looks like this:
You can see that the flat area between $50 and $55 creates less risk to the upside. In other
words, with synthetic stock at $50, the trader is exposed to losses for any stock price above
$50. With the semifuture, the trader is not exposed to losses until the stock is above $55.

The semifuture strategy can be split further. For example, the trader may buy the $45 put and
sell the $55 call. Now there will be less risk to the upside, but also less profit to the downside as
shown in the following chart:

Market downturns can be fast and furious, which is what attracts speculators to short
sales. Many investors recognize potential situations, but are unable to capitalize on them due to
market restrictions. If you understand synthetics, you can overcome many restrictions and profit
from your outlook on the market.
 Systematic Writing
The strategy called "systematic put writing" or sometimes just "systematic writing" is a hedged
variation of naked, or uncovered, put writing. This strategy will be appealing to investors ranging
from conservative to speculative. If you like writing naked puts, this strategy will be of great
interest to you. If you think you would never attempt it, you may change your mind!

Before we start, we should clarify some misconceptions about naked put writing. When you sell a
put, you are effectively acting as an insurance company by entering into an agreement to
potentially buy stock at a fixed price over a given amount of time. For this protection, the buyer
will pay you a premium. It's a mutually beneficial relationship; you are willing to insure their stock
and they are willing to pay for the peace of mind.

Many investors shy away from naked puts because of the large downside risk, to a stock price of
zero, if the stock should fall. But these same investors are usually willing to buy stock and hold
it. Let's see what the real risk is.

Example:
Say we have two investors, A and B. A only buys stock and B only sells naked puts. In the eyes
of many investors, A is conservative, and B is a loose cannon that speculates with options.

A and B each have $50,000 in their accounts.

XYZ stock is selling for $50 per share. A buys 1,000 shares but B sells 10 $50 puts, with 3
months of time, for $8. Investor A now has $50,000 worth of stock and no cash while B has
$58,000 cash ($50,000 cash + $8,000 from sale of put) and no stock. What happens at
expiration?

If the stock is down, say $30, A's account will be worth $30,000 but B's will be worth
$38,000. Why? Because B started with $58,000 but is forced to buy stock 3 months later for
$50,000 due to the option assignment. He will pay $50,000 but receive stock worth $30,000. His
transactions are:

Portfolio value at start: +$58,000

Pays for option assignment: -$50,000
Receives stock: +$30,000
Net account value: +$38,000

In fact, B's total account value will always dominate A's for all stock prices at $58 ($50 strike price
plus $8 premium for the put) or below. Any stock price above $58 at expiration, B's account will
be worth $58,000 and no more. From a profit and loss standpoint, the two accounts look like this
at expiration:
Investor B's account dominates A's for all prices below $58. His tradeoff for this privilege is that
he does not participate in any upside potential of the stock if it moves above $50. Investor B is
giving up upside potential in exchange for a downside hedge. In addition, B has deferred his
payment for buying the stock by three months in exchange for the premium. So, B actually
appears conservative compared to A, the long stock position!

If you read our sections on "Profit and Loss Diagrams" and "Synthetic Options," you will
understand that a naked put is really nothing more than a covered call in disguise. They are
synthetic equivalents.

So, the point of all this is to understand that naked put writing really isn't as speculative or
dangerous as some would think. This is assuming you are writing puts on stock you would
buy regardless, not because the premiums are high!

Hopefully you are now not as reluctant to write naked puts. If so, continue reading about how
systematic writing may benefit you.

The systematic writing strategy

This strategy is appealing in a number of ways. It allows investors to sell naked puts but adds a
couple of new dimensions. First, it allows the investor to dollar cost average into the
stock. Second, it allows for the sale of a covered straddle thereby giving the investor one more
additional option premium to further reduce the downside risk.

The systematic writing recipe:

Step 1:Start by writing puts on half the amount of shares in which you are willing to buy (for
example, if you are willing to buy 1,000 shares, write 5 puts).

Note: Repeat step 1 until you are assigned. Again, it is very important to use this strategy only
for stocks you would be willing to buy at the strike price regardless.
Step 2:Once you are assigned in step 1, write covered straddles (sell a call and sell a put). In
this example, the investor will write 5 calls and 5 puts. The position is considered covered,
because the investor can always deliver the shares if assigned on the short calls.

Step 3:If the investor gets assigned from the calls in step 2, start with step 1 again. If assigned
on the puts again, write covered calls against the entire position.

Example:
Let's use our two investors above, A and B, and see how they would fare using naked puts
versus systematic writing.

Investor A is now convinced that naked put writing may not be so bad. He likes the stock and
would be willing to buy 1,000 shares so he sells 10 $50 puts for $8. The time to expiration is a
matter of preference, but all else equal, investors are usually better selling shorter-term options.

Step 1 for systematic writing

Investor B uses the systematic strategy. He will write puts on one-half of the position, to
represent the 500 shares he's willing to purchase. So he writes only 5 of the contracts for $8.

At expiration, the stock is trading for $35. While A is at least hedged by the amount of the original
premium, he's not willing to buy any more stock because he is now long 1,000 shares -- his
original limit -- from the assignment. His cost basis is $42 per share ($50 for the stock less $8 for
put premium). He must sit and be patient for the stock to rally. While it is possible for A to write
calls at this point, if the stock is down far enough, this strategy may not be sufficient, as there may
be no premium in a $45 strike that would be necessary to bring him to a profit if called away.

Step 2 for systematic writing

Because B is using the systematic principle, he bought only 500 shares from the put
assignment. Now he enters the second step of the strategy: writing covered straddles. Investor
B will now write 5 $35 puts (assume they are $5) and 5 $35 calls (assume they are $6).

Investor B will bring in an additional $2,500 for the puts and $3,000 for the calls.

At this point, two only two things can happen for the stock: It will either be above or below $35 at
expiration. If the stock is above $35 (the strike price) at expiration, B will have his shares called
away due to the short call option. But that's okay, as we will see shortly that his average cost is
only $33, and he will make 2 points profit. But, let's assume the stock is down again to
$30. Investor B will buy his second lot of 500 shares at a price of $35, the strike of the short put.

Investor A's cost basis is $50 for the stock, less $8 for the put, for a total of $42. Investor B's cost
basis is effectively $42-1/2 for the purchase of stock alone (500 shares at $50 and 500 shares at
$35). But in addition, B took in $4,000 for the original put sale, and $5,500 for the covered
straddle (500 * $5 for the puts and 500 * $6 for the calls). The total proceeds from the options is
$9,500, for a total cost basis of $33,000 or $33 per share for investor B.

Now, investor A has a cost basis of $42, and B has one of $33 with the stock trading at $30.
Notice the large difference in cost basis between the two investors. The majority of the difference
in costs is due to B being able to average into the stock. He bought 500 shares at $50 and 500 at
$35 with 3 option premiums along the way to boot.

Step 3 for systematic writing

The third step for the systematic writing would require B to write 10 calls (covered call position)
against his 1,000 shares. The market is at $30 and his average cost is $33. Say he can sell 10
$30 calls trading at $5 to bring his cost basis to $28 per share. If he gets assigned, he will sell
1,000 shares at $30. If not, he will continue to write calls against the entire position until called
out. At that point, he will look to start with step 1 again in the strategy.

Notice too that, although a two-point profit may not seem like such a big deal, the stock has fallen
34% from $50 to $33. There is not much an investor who paid $50 for the stock can do at this
point. But our systematic writer is able to potentially capture a two-point profit despite the fall.

Using the strategy

This is an outstanding strategy for naked put writers; especially for stocks you expect to be
volatile. The average cost basis on your stock will be greatly reduced if you are assigned on the
short put written at the time of the covered straddle.

The strategy is very versatile. Investor B, in the above example, could have written calls and puts
with different strike prices (called a strangle or combo) for step 2 instead of the covered
straddle. Investors can select different time frames or strikes to meet their needs. You can even
mix and match some of the steps. For example, if you are very bullish on the stock, you may
elect to enter step 2 initially. This way you own half the shares you are willing to purchase and
have a short put to provide a small hedge. Now, if the stock runs to the upside, at least you have
some shares to fully participate in the rally unlike the investor who starts with step 1 and only
writes puts on half the position.

Again, it should be emphasized that naked put writing can actually be viewed as a conservative
strategy if you are writing puts on stock you would be willing to buy at the strike price
regardless. If, however, you are writing puts on stocks solely for a high premium that is present
and would rather not own the stock, be aware that this is an extremely speculative position and
you should invest accordingly.

Hopefully this strategy adds some interesting insights as to how valuable options can be for
conservative and speculative investors alike.
 Jelly Rolls
Breakfast menu? No, it's an actual options strategy. There doesn't appear to be any particular
reason for the name, although rumor has it that market makers on the floor of the Chicago Board
Options Exchange (CBOE) created it.

Jelly rolls are primarily used by market makers, but are a great tool for retail investors to evaluate
the fair price between calendar spreads in the same way that box spreads can be used to
evaluate vertical spreads.

While you may never enter a jelly roll, they are crucial to understand if you are placing calendar
spreads -- spreads where you buy and sell calls or puts of the same strike, but at different
expiration months.

Jelly rolls
There are many ways to view and understand the jelly roll strategy, but it is probably easiest to
view from the market makers perspective. If you read our section on synthetics, you will recall
that market makers like to enter conversions and reversals -- three sided positions -- involving
stock, calls and puts.

Conversions (long stock, long puts and short calls) and reversals (short stock, short puts and long
calls) are ways for market makers to lock in profits, so they are always looking for orders that
allow them to create these positions.

Say a market maker has the following reversal for January expiration:

Short 1,000 shares at $50

Long 10 $50 calls
Short 10 $50 puts

And also has the following conversion for March expiration:

Long 1,000 shares at $50

Long 10 $50 puts
Short 10 $50 calls

This is a jelly roll -- a conversion in one month and a reversal in another.

Notice the market maker is short 1,000 shares in the reversal and long 1,000 shares in the
conversion -- a net zero position. This leaves him with long calls and short puts (synthetic long
position) in January, and long puts and short calls (synthetic short position) in March as follows:

January reversal March conversion

Short 1,000 shares at $50 Long 1,000 shares at $50

Long 10 $50 calls Long 10 $50 puts

Short 10 $50 puts Short 10 $50 calls
The long and short stock positions cancel each other (shown in red). The remaining positions are
a synthetic long position (blue) in January and a synthetic short position (black) in March.

One way to interpret the January synthetic is that the market maker will buy stock for $50 at
expiration. How? If the stock is above $50, he can exercise the call and pay $50; if it's below
$50, he will be assigned on the puts and be forced to buy stock at $50. Similarly in March he
must sell stock for $50. If the stock is above $50, he will be assigned on the short calls and be
forced to sell stock at $50; if the stock is below $50, will exercise the $50 puts and receive that
amount for the sale.

The market maker is therefore left with a position that forces him to buy stock for $50 in January
and sell it for $50 in March. What is the cost? It should be evident that the market maker is not
losing any principal as he's buying and selling at $50; however, he is missing out on the interest
he could have earned during the three months had he not been forced to purchase the stock in
January. Assuming the risk-free rate of interest is 6% and exactly three months to expiration, the
cost is $50 * 3/12 months * 6% = $3/4.

Therefore, the difference in cost between the synthetic long position in January and synthetic
short position in March should be about $3/4. If the January synthetic costs $10, the March
synthetic should cost $10-3/4.

If the stock pays a dividend, this must be subtracted from the position as well, because it
represents a cash inflow. If the above stock pays a 1/4-point dividend in March, the spread value
would be reduced by 1/4 point from $10-3/4 to $10-1/2.

Calendar spreads
We can also view the synthetic long and short positions as calendar spreads:

January March
Short 10 $50 puts + Long 10 $50 puts = Long calendar spread
Long 10 $50 call + Short 10 $50 calls = Short calendar spread
= Long synthetic stock =Short synthetic stock

If we view the positions vertically, we see the market maker has a long synthetic stock position in
January and short synthetic stock position in March. This is the way we were viewing the
positions earlier. However, we can also view them horizontally and say he is long a put calendar
spread (long Mar $50 puts and short Jan $50 puts) and short a call calendar spread (short Mar
$50 calls and long Jan $50 calls).

An equally valid way, then, to view the jelly roll is the difference between two calendar spreads
(also called time or horizontal spreads).

If you trade calendar spreads, here's where the jelly roll can help!

Example:
Intel (INTC) is currently trading for $36-7/8 with the following quotes:
 Calls Puts
Month/Strike Bid Ask Bid Ask
Jan $35 5-3/8 5-3/4 3-1/8 3-1/4
Apr $35 7-1/4 7-5/8 4-1/4 4-5/8

Say you are interested in the following long calendar spread: Long April $35 calls and short
January $35 calls. The natural quote is currently $2-1/4 debit:

Buy Apr $35 calls = $7-5/8

Sell Jan $35 calls = $5-3/8
Net debit $2-1/4

Because there is a net payment (debit), this is a long calendar spread.

Traders often ask if this is a fair price. Is there room to negotiate? If so, how much?

To answer these questions, let's look at the value of the synthetic long and short stock positions
from the retail investor's side. An investor buying a synthetic long position will pay the asking
price and sell at the bid price. As a guide, these numbers are highlighted below: red is a debit
and blue is a credit.

Calls Puts
Month/Strike Bid Ask Bid Ask
Jan $35 5-3/8 5-3/4 3-1/8 3-1/4
Apr $35 7-1/4 7-5/8 4-1/4 4-5/8

The retail investor can create the January synthetic long and April synthetic short for: +7 1/4 - $5
3/4 + $3 1/8 - $4 5/8 = $0. So a retail investor will receive zero credit for the trade. How much
should it be worth theoretically? There are approximately 135 days to expiration, so the cost of
carry is roughly $35 * 135/360 * 6% = 0.79 cents.

In addition, any dividends received must be subtracted. Intel is currently paying 2 cents per
share. The dividend is expected during the life of the jelly roll, so the cost is reduced from 79
cents to about 77 cents[*]. Most of the time dividends are not a big concern, especially for tech
companies. But in cases where the dividends are sizeable, be sure to factor it into the cost.

[*]Technically, the credit will be reduced by the present value of the dividend. This is because the investor must wait to receive
the dividend. However, since most dividends are small as well as the time between buying and selling the stock, most traders will
just subtract off the full amount of the dividend as a very close estimate.

The trade should be worth a credit of 77 cents, but the retail investor receives zero. The spread
is clearly not priced fairly at the bid and ask prices for the retail investor.

How about from the market makers' perspective? Using the same color coded notation as
before, the market maker can create the synthetic January $35 long position by buying the Jan
$35 call at the bid and selling the Jan $35 put at the ask. He can also create the synthetic short
April position by purchasing the Apr $35 put on the bid and selling the Apr $35 call at the ask as
shown in the chart below:

Calls Puts
Month/Strike Bid Ask Bid Ask
Jan $35 5-3/8 5-3/4 3-1/8 3-1/4
 Apr $35 7-1/4 7-5/8 4-1/4 4-5/8

The synthetic positions will create a net credit of: -$5-3/8 + $7-5/8 - $4-1/4 + $3-1/4 = + $1-1/4.

We said earlier the fair price of the package should be about 77 cents; however, the retail
investor receives nothing, and the market maker wants $1-1/4.

Notice a key point here. The market maker is able to construct the synthetic long and short
positions with the color coded trades above. If you recall from the beginning, we were assuming
you were interested in the calendar spread consisting of long April $35 calls, and short January
$35 calls. You would pay the asking price on the April $35 calls and sell for the bid price on the
January $35 calls -- exactly two of the pieces the market maker needs to construct his synthetic
positions!

The market maker can offset your trade by buying an April $35 put at $4-1/4 and selling the
January $35 put at $3-1/4 (remember, market makers buy at the bid and sell at the ask). In other
words, because you want to be long the calendar spread, the market maker must be short the
same spread in order to fill the order. To offset the short call calendar spread, he will execute a
long put calendar spread.

Because neither party -- neither you nor the market maker -- wants to execute the trade for less
than 77 cents, it appears you have about 48 cents with which to work. The market maker wants
$1-1/4, but theoretically should only receive 77 cents for a difference of 48 cents. You probably
won't be able to shave the full 48 cents off the price, but 1/4 point certainly looks reasonable. So
the calendar spread we described earlier:

Buy Apr $35 calls = $7-5/8

Sell Jan $35 calls = $5-3/8

could probably be filled for a net debit of $2 instead of the $2-1/4 natural.

Now, 1/4 point may not seem like much, but on a relative basis, it's about 11% better than the $2-
1/4 debit most traders would be tempted to place.

This is the essence of great options trading -- becoming a little bit better on each trade. It's the
little changes that make big differences on profits.
 STRATEGIES
Wrangles
The wrangle is a complex position usually used by market makers for reasons we will see later. It
consists of a long ratio spread with calls and a long ratio spread with puts. Long ratio spreads are
also known as backspreads. A long call ratio spread is established by selling a lower strike call
and purchasing two (or more) higher strike calls. Likewise, a long put ratio spread entails selling
a higher strike put and then purchasing two (or more) lower strike puts.

Let's look at the individual pieces and then put them together. The profit and loss diagram for a
long call ratio spread looks like this:

The profit and loss for the long put ratio spread looks like this:
If we put these two profit and loss diagrams together we get the wrangle:

If you read our section on the strategy of "strangles," you may recognize the above profit and loss
diagram as identical. However, the wrangle, unlike the strangle, will not be exposed to the same
time decay if the stock stands still. It's my guess that the wrangle gets its name from the fact that
it is a ratioed strangle (which sounds like wrangle).

It may be difficult to see why the above profit and loss diagram results from two long ratio spreads
but let's break down the two component positions using $50 and $55 strikes and see if we can
make sense of it.
The basic long call ratio spread is:

Sell 1 $50 call

Buy 2 $60 calls

The basic long put ratio spread is:

Sell 1 $60 put

Buy 2 $50 puts

There are many ways to dissect this position but probably the easiest is to look at just the short
positions: sell 1 $50 call and sell 1 $60 put. These two options, by themselves, are a short in-the-
money strangle also called a "guts." The reason it is an in-the-money strangle is because the put
has a higher strike thereby guaranteeing this position to be down at least $10 (the difference in
strikes) at expiration. Don't let the guaranteed value bother you because we haven't even talked
about price yet; the markets will have to pay you more than $10 for it. We will use the proceeds
from this short strangle to purchase two $50 puts and two $60 calls, which is a long out-of-the-
money strangle. Because we are long more contracts than short, this position must become
profitable as the market moves either up or down. In other words, we are net long calls and puts
so must make money if the market explodes to either the upside or downside.

Another way to look at this net long contract position is to look at just the calls. If we are long two
$60 calls and short 1 $50 call, the effectively we are net long one $60 call. The sale of the one
$50 call reduced our purchase price a bit and lessens the risk if the stock should fall. That's why
the chart goes up on the right "wing" (showing profit) if the stock should move beyond $60; we
are net long 1 $60 call.

A similar argument can be made for the puts.

Is this position better than a strangle? It depends on your outlook on the stock and tolerances for
risk. Remember, there are no superior strategies as they all come with their own unique sets of
risks and rewards (Please see course "Best Strategy" under week 1). The wrangle has less risk if
the stock stands still but will also take longer to become profitable if the stock does move. That's
because the short positions are competing with the deltas of the long positions -- something
known as gamma risk.

The benefit of the short strangle is offset by its sluggish responsiveness to moves in the
underlying stock. Which is better depends on you and the circumstances at the time of the trade.

While wrangles are generally used by market makers (after all, there are four commissions just to
establish the long position!), this doesn't mean it's not useful for retail investors to
understand. One scenario is that you enter into a backspread (long ratio spread) at one time and
hedge at a later time by legging into a wrangle.

But probably more important is the wrangle shows, once again, the versatility that options provide
and why they are so necessary to understand if you want to compete in today's markets. By
finding different combinations of calls and puts, you can completely change the risk-reward
characteristics to match your needs and that is something that cannot be done with stocks alone.
 Option Exam 11 - Week 11

1) A position of long stock plus long put is synthetically the same as a:

a) Long put
b) Long call
c) Short call
d) Short put

2) Synthetic equivalents have the same ____ as the asset being replicated:

a) Profit and loss shape

b) Cost
c) Profit
d) Return on investment

3) Short stock plus a long call is synthetically the same as:

a) Short put
b) Short call
c) Long put
d) Long call

4) A trader wants to execute a short sale in a rapidly falling market. There have been no upticks
so he cannot get the trade executed. However, he can get it executed by entering a synthetic
short by:
 a) Buying a call and selling a put
b) Buying a put and selling a call
c) Buying a call and buying a put
d) Selling a call and selling a put

5) A jelly roll is a(n):

a) Synthetic long in one month and a synthetic short in another

b) Synthetic short and synthetic long in the same month
c) Synthetic short in one month and a long position in another
d) Synthetic short in one month and a short position in another

6) Synthetic short stock positions have:

a) Limited upside risk

b) Unlimited downside risk
c) Unlimited upside and downside risk
d) Unlimited upside risk

7) Jelly rolls can be used to determine if _____ are being priced fairly.

a) Box spreads
b) Vertical spreads
c) Calendar spreads
d) Synthetic calls

8) Systematic writing is a three-step method of writing naked puts over time. Once you are
assigned on puts written in the first step, the next step is to sell:

a) Covered straddles
b) Naked straddles
c) Spreads
d) Box spreads

9) If you are interested in purchasing 400 shares of a stock and want to use a systematic writing
strategy, what is the first step?

a) Sell 4 straddles
b) Sell 4 puts
c) Sell 2 puts
d) Buy 200 shares
10) What is the last step in a systematic writing strategy?

a) Selling puts
b) Selling calls
c) Buying puts
d) Selling straddles

Final Exam
Options Final Exam
1) A stock is trading for $100 and the $95 call is trading for $8. The $8 premium is composed of:

a) only intrinsic value

b) only time value
c) only extrinsic value
d) time value and intrinsic value

2) A stock is trading for $50 and the $55 call is trading for $3. The option premium is:

a) only time value

b) $3 intrinsic value and no time premium
c) $5 intrinsic value and no time premium
d) $3 time value and $3 intrinsic value

3) An option's time value plus intrinsic value will equal its price.

a) True
b) False

4) An option's price must have intrinsic value.

a) True
b) False

5) A stock is trading for $75 and the $80 put is trading for $6. How much intrinsic value is there?

a) $3
b) $5
c) $0
d) Put options will never have intrinsic value
6) A stock is trading for $100 and the $90 put is trading for $7. Which of the following correctly
identifies the time and intrinsic values?

a) There is $7 intrinsic value and $10 time value

b) There is $10 intrinsic value and $7 time value
c) There is $7 intrinsic value and no time value
d) There is no intrinsic value and $7 time value

7) a trader wishes to buy an option and must get it filled. The trader should enter a:

a) market order
b) limit order
c) all or none order (AON)
d) good until cancelled (GTC) order

8) a trader sees an option trading for $6 but doesn't want to pay more than $5 1/2 for it. He
should enter a:

a) market order
b) all or none order (AON)
c) limit order
d) Day order

9) A trader has purchased a stock at $100. It is now trading for $125. He thinks it will continue
higher, but also does not want to lose all of his unrealized profits. If he enters an order to sell his
shares at a stop price of $122, which of the following are true?

a) The order will be filled for $122 if the stock falls below that price
b) The order will become a limit order to sell at $122 if the stock trades for that price
c) The order will become a market order if the stock trades at $122 or lower
d) You cannot place sell stops on stocks

10) A trader is entering an order to buy 50 contracts. However, he does not want to be filled
unless all 50 contracts can be purchased. Which of the following types of orders should he use?

a) All-or-none (AON)
b) Immediate or cancel
c) Good until cancelled (GTC)
d) Or-better

11) A trader is trying to buy option contracts at a limit price. However, every time he enters the
order, the price immediately jumps above his limit because it is in a fast market. He is afraid to
use a market order. Which of the following orders would help him best?
 a) All-or-none (AON)
b) Or-better
c) Immediate or cancel
d) Day order

12) A trader is trying to purchase stock in a fast market, which is currently trading for $100. He
wishes to use an "or-better" order to avoid the risk with a market order. Which of the following
would be an "or-better" order?

a) Buy 100 shares at a limit of $100

b) Buy 100 shares at a limit of $102
c) Buy 100 shares at a limit of $100, good-until-cancelled
d) Buy 100 shares at a $99-3/4

13) An option trader wants to purchase call options to initiate a new position. Her order would be:

a) buy calls to close

b) buy calls to open
c) sell calls to open
d) sell calls to close

14) A trader has 300 shares of stock and 3 short calls against it (covered call position). He now
wants to back out of the call options. He would:

a) sell calls to open

b) sell calls to close
c) buy calls to open
d) buy calls to close

15) A trader owns 700 shares of stock and wishes to write 3 call options against it. She would:

a) buy calls to open

b) buy calls to close
c) sell calls to close
d) sell calls to open

16) A trader owns 10 put options and wishes to sell them. He would:

a) sell puts to close

b) sell puts to open
 c) buy puts to open
d) buy puts to close

17) Put-call ratio is:

a) the total CBOE put volume / the total CBOE call volume
b) the total CBOE call volume / the total CBOE put volume
c) the S&P 500 put volume / the S&P 500 call volume
d) the S&P 500 call volume / the S&P 500 put volume

18) If the put-call ratio gets sufficiently high, then this is viewed as a:

a) bullish signal
b) bearish signal
c) neutral signal

19) How many option expiration cycles are there?

a) 3
b) 4
c) 6
d) 12

20) It is now February and a certain stock has options traded on a March cycle. Which months
will be available for options trading?

a) Feb, Mar, Jun, Sep

b) Feb, Mar, May, Aug
c) Feb, Mar, Apr, Oct
d) Jan, Feb, Jun, Sep

21) There are always at least ____ option expiration months for equity options.

a) 2
b) 3
c) 4
d) 6

22) It is now March and a certain stock has options traded on a February cycle. When will the
November options start trading?
 a) When April options expire
b) When May options expire
c) When October options expire
d) When March options expire

23) Not counting dividends, how many factors are in the Black-Scholes Option Pricing Model?

a) 3
b) 4
c) 5
d) 6

24) According to the Black-Scholes Option Pricing Model, if the risk-free interest rate rises, put
prices will ______ (assuming all other factors stay the same).

a) stay the same

b) rise
c) fall

25) According to the Black-Scholes Option Pricing Model, if the strike price is reduced, call prices
will ______ (assuming all other factors stay the same).

a) fall
b) stay the same
c) rise

26) According to the Black-Scholes Option Pricing Model, if volatility is increased, call prices will
_____ and put prices will _____ (assuming all other factors stay the same).

a) fall, fall
b) fall, rise
c) rise, rise
d) rise, fall

27) With the Black-Scholes Option Pricing Model, if you enter the factors, the pricing model will
give you the theoretical value of a:

a) put option
b) call and put option
c) call option
d) synthetic long position
28) The single most important factor in the Black-Scholes Model is:

a) risk-free interest rate

b) exercise price
c) volatility of the underlying
d) stock price

29) The price of a call option can never exceed:

a) the price of a put

b) its own strike price
c) the delta
d) the price of the underlying stock

30) For any two call options, the difference in their prices cannot exceed the difference in their
strikes.

a) True
b) False

31) What two conditions must be met in order for an arbitrage to occur?

a) Guaranteed profit without waiting

b) Guaranteed profit for no cash outlay
c) Guaranteed profit with limited risk
d) Limited risk with large profit potential

32) At expiration, a call option must be worth either:

a) zero or the stock price plus the risk-free rate

b) zero or the exercise price
c) zero or the stock price minus the exercise price
d) zero or the stock price

33) A stock is trading for $100 and the $90 call is trading for $9. Is arbitrage possible in this
situation?

a) Yes
b) No

34) A buy-write can be executed for a net credit.

 a) True
b) False

35) A stock is trading for $75 and the $70 put is trading for $3. Is arbitrage possible in this
situation?

a) Yes
b) No

36) Basically speaking, the delta of an option is:

a) the price of the option

b) the price change of the option for a $1 change in the stock
c) the price change of the put for a $1 change in the call
d) the change in the stock price for a $1 change in the call

37) If a May $50 call has a delta of 0.60, what will be the delta of the May $50 put?

a) -0.60
b) -0.40
c) 0.60
d) No way to determine

38) A stock is trading for $100 and the $90 call has a delta of 0.70. If the stock moves to $101
immediately, the price of the call should increase by approximately (assuming all else stays the
same):

a) 30 cents
b) 70 cents
c) $1
d) $1.70

39) One way to define delta (ignoring the negative sign for put deltas) is that it is:

a) the probability of a profit

b) the probability of the option having intrinsic value
c) the probability of a loss
d) the probability of an automatic exercise

40) Gamma can be thought of as the:

 a) time decay
b) risk-free rate
c) delta of the delta
d) increase in an option's price for a $1 move in the stock price

41) Long calls have _____ delta and long puts have _____ delta.

a) negative, negative
b) positive, positive
c) negative, positive
d) positive, negative

42) Long calls have _____ gamma and long puts have _____ gamma.

a) negative, negative
b) positive, positive
c) negative, positive
d) positive, negative

43) An option is trading for $5. However, according to the Black-Scholes Model, it "should be"
trading for $4. How do you account for the difference?

a) There is a decrease in the implied volatility

b) The implied volatility is the same as the historic volatility
c) There is an increase in the implied volatility
d) The option could never trade for more than the theoretical value

44) You purchased a call option yesterday for $7. Today the stock is trading up $1, but the call
option is trading for $6-1/2. How do you account for this?

a) There is an increase in the implied volatility

b) The delta is 1/2
c) The gamma is 1/2
d) There is a decrease in the implied volatility

45) You purchased a $50 call for $3. What is your breakeven point at expiration?

a) $53
b) $50
c) $47
d) There is no way to tell
46) A long call gives the owner:

a) the right, but not the obligation to buy stock

b) the obligation to buy stock
c) the right, but not the obligation to sell stock
d) the possible obligation to sell stock

47) You have been watching a stock move sharply upward from $30 to $100 over the past couple
of weeks. You think the stock will continue upward but are afraid to purchase it at these levels. In
order to profit from further increases but greatly limit your losses you could:

a) buy puts
b) sell puts
c) sell calls
d) buy calls

48) You purchased a $100 put for $6. What is your breakeven point at expiration?

a) $100
b) $106
c) $94
d) No way to determine

49) You have sold 10 $50 put options. You have:

a) the right to purchase 1,000 shares for $50

b) the possible obligation to buy 1,000 shares for $50
c) the right to buy 100 shares for $50
d) the possible obligation to buy 100 shares for $50

50) You have purchased a June $50 call and a June $50 put on the same underlying stock or
index. This position is called a:

a) straddle
b) strangle
c) combo
d) horseshoe

51) You bought a $70 put for $5 and a $75 call for $6. Your breakeven points at expiration are:

a) $59, $86
b) $75, $81
 c) $5, $6
d) $70, $75

52) You own 500 shares of stock at $100 and would like to buy some puts to protect the shares
from a downward fall. However the puts are expensive, so you elect to sell the $105 call for $8
and use those proceeds to purchase the $95 puts. This position is called:

a) reversal
b) strangle
c) butterfly spread
d) equity collar

53) Equity collars expose the investor to:

a) unlimited losses, unlimited gains

b) limited losses, unlimited gains
c) limited losses, limited gains
d) unlimited losses, limited gains

54) You have purchased a $50 call and sold a $55 call for a net debit of $3. Which of the
following are true?

I. This is a bear spread

II. This is a bull spread
III. Maximum profit is $2
IV. Maximum loss is $5

a) I only
b) I, III
c) II, III
d) II, III, IV

55) You place a spread order to buy 5 $100 calls and sell 5 $105 calls for a net credit of $2. This
order will be:

a) filled only for $2 or lower

b) filled only for $2 or higher
c) rejected
d) filled regardless of price

56) An investor buys a $100 put and sells a $90 put. This is a:
 a) horizontal spread
b) vertical spread
c) diagonal spread
d) condor spread

57) An investor buys a March $50 call and sells a January $60 call. This is a:

a) diagonal spread
b) horizontal spread
c) vertical spread
d) box spread

58) You sell a $100 call for $7 and buy a $105 call for $5. Your maximum profit is _____ and your
maximum loss is _____.

a) $2, $5
b) $7, $5
c) $5, $2
d) $2, $3

59) A trader enters a Christmas tree by buying one $50 call, selling one $55 call and selling one
$60 call. The investor is exposed to which of the following risks?

a) Unlimited downside risk

b) Limited upside risk
c) Unlimited upside risk
d) Unlimited upside and downside risk

60) A Christmas tree is most similar to which strategy?

a) Condor spread
b) Ratio spread
c) Box spread
d) Vertical spread

61) Which of the following is a butterfly spread?

a) Buy 1 $50 call, sell 1 $55 call, buy 1 $60 call

b) Buy 1 $50 call, sell 2 $55 calls, buy 1 $60 call
c) Buy 1 $50 call, sell 2 $55 calls, buy 2 $60 calls
d) Buy 2 $50 calls, sell 1 $55 calls, buy 1 $60 call
62) The owner of a butterfly spread wants the stock to close:

a) at the highest strike

b) at the lowest strike
c) above the highest strike
d) at the middle strike

63) You have an opportunity to establish a butterfly spread for a net credit after commissions.
You should:

a) not enter it, because you are exposed to unlimited risk if the stock sits still
b) enter as many spreads as you can, because you cannot lose
c) not enter it, because you are exposed to unlimited risk if the stock rises
d) not enter it, because you are exposed to unlimited risk if the stock falls

64) Butterfly spreads are generally a great trading strategy for retail investors.

a) True
b) False

65) The condor spread is most similar to the:

a) butterfly spread
b) vertical spread
c) ratio spread
d) time spread

66) An investor owns a $50 call and a $65 call on the same underlying stock. She wishes to
hedge by creating a condor spread. She should:

a) sell the $55 call and sell the $60 call

b) buy the $55 call and sell the $60 call
c) buy the $55 call and buy the $60 call
d) sell the $55 call and buy the $60 call

67) You purchased a $100 call for $7, and the stock is now trading for $120 with three weeks
remaining until expiration. You are afraid the stock will start to fall, so you should:

a) exercise the call early

b) buy the call and short the stock
c) sell the call to close in the open market
d) sell the put
68) The risk of a covered call is:

a) the stock rises, and you are forced to sell your shares below market
b) the stock closes at the strike price of the short call
c) the stock falls
d) the covered call is a riskless transaction

69) An option is quoting bid $7 and asking $7-1/2. You place an order to sell 1 contract at a limit
of $7-1/4. If the exchange does not fill your order, what will be the new quote?

a) Bid $7, asking $7-1/4

b) Bid $7-1/4, asking $7
c) The quote will remain unchanged
d) Bid $7-1/4, asking $7-1/2

70) An option is quoting bid $10 and asking $10-1/4. You place an order to buy 1 contract at a
limit of $9-3/4. Your order is not filled, but you also notice that the quote did not change. Did the
exchange make a mistake?

a) Yes. the exchange should have made the new bid $9-3/4
b) No. The exchange will only show the lowest bid and highest offer
c) No. The exchange will only show the highest bid and lowest offer
d) Yes. you should contact your broker and they will get the order filled

Answer questions 71 - 73 using this information:

An investor buys 12 $50 calls for $5 and sells 20 $55 calls for $3-1/2.

71) How many spreads is this?

a) 12
b) 20
c) 4
d) 2

72) Is this trade entered as a net debit or credit?

a) Debit
b) Credit
c) Cannot be determined

73) What is the amount of the net debit or credit?

 a) $5
b) $3-1/2
c) $1-1/2
d) $2-1/2

74) An investor holds a long calendar spread. They want the stock to:

a) move higher
b) sit still
c) move lower
d) make a large move either higher or lower

Answer questions 75 - 77 using this information:

An investor sells a $50 call for $5 and buys 2 $55 calls for a total of $7 ($3-1/2 each).

75) This investor has placed a:

a) bull spread
b) bear spread
c) backspread
d) condor spread

76) The trade is placed for a net:

a) credit of $2
b) debit of $2
c) credit of $5
d) debit of $7

77) The maximum this investor can make is:

a) theoretically unlimited
b) $2
c) $5
d) $7

Answer questions 78 - 79 using this information:

An investor buys a $50 call and sells a $60 call. Then he buys a $60 put and sells a $50 put.

78) This investor has entered a:

 a) condor spread
b) bull spread
c) butterfly spread
d) box spread

79) Assume the investor pays a total of $9 for the four positions. Which of the following best
describes the profit at expiration?

a) Possible $1
b) Possible $5
c) Guaranteed $5
d) Guaranteed $1

80) A jelly roll is defined as a:

a) conversion and reversal in the same month

b) conversion in one month and a reversal in another
c) reversal in one month and reversal in another
d) conversion at one strike and a reversal at another strike in the same month

81) Jelly rolls are important for retail investors to understand because they can help determine:

a) fair prices for vertical spreads

b) fair prices for calendar spreads
c) fair prices for box spreads
d) fair prices for bull spreads

Answer questions 82 - 83 using this information:

An investor is holding a position of long stock and a long put.

82) These two positions together are a:

a) synthetic short position

b) synthetic call
c) synthetic put
d) synthetic bull spread

83) The most this investor could make is:

 a) theoretically unlimited
b) the strike price of the put
c) the strike price of the put less the premium paid
d) the stock price minus the exercise price of the put

84) Synthetic positions have the same _____ as the position they are synthetically creating.

a) rate of return
b) return on investment
c) profit and loss diagram
d) sets of risks

85) Short stock plus a short put is synthetically the same as:

a) short put
b) long put
c) long call
d) short call

86) You want to short a stock in a rapidly falling market but are unable to get an execution
because there are no upticks. You can short the stock synthetically by:

a) buying the call, and shorting the put

b) buying the put, and selling the call
c) buying the put, and buying the call
d) selling the put, and selling the call

87) A position of long stock and short call (covered call) is synthetically the same as:

a) long put
b) short put
c) short stock
d) long call

88) A position of short stock and long call is synthetically the same as:

a) long put
b) short put
c) long call
d) short call
89) You think a stock will rise slowly over the next two months. If you're using options, your
position should have:

a) positive delta, positive gamma

b) positive delta, negative gamma
c) negative delta, negative gamma
d) negative delta, positive gamma

90) The owner of a straddle wants the stock to:

a) sit still
b) move slowly either up or down
c) decrease in volatility
d) make a quick, large move in either direction

91) The following profit and loss diagram represents a:

a) Backspread
b) Straddle
c) Ratio spread
d) Condor spread

92) The following profit and loss diagram represents a:

 a) covered call
b) naked put
c) naked call
d) either a or b

93) The following profit and loss diagram represents a:

a) short straddle
b) condor spread
c) short call
d) ratio spread

94) A stock is trading for $100. The $95 put is:

a) in-the-money
b) out-of-the-money
c) at-the-money
d) none of the above

95) On expiration day, all options expire worthless.

a) True
b) False

96) Option approvals for IRA accounts generally only allow:

a) naked put writing

b) long straddles
c) spreads
d) covered calls and protective puts

97) Which of the following option positions expose the trader to the greatest risk?
 a) Long put
b) Long condor spread
c) Backspread
d) Naked call

98) The strategy of systematic writing involves which steps (in order)?

a) Naked put, covered straddles, covered calls

b) Naked put, condor spreads, naked calls
c) Covered puts, long stock, covered calls
d) Covered puts, covered calls, long stock

99) As an option trader, you are better off being the seller of options since most buyers lose
money.

a) True
b) False

100) If the stock or option has moved in your favor, stop orders are a great trading tool, as they
prevent losses.

a) True
b) False
c) True for stop limits, but not regular stop orders
d) True for regular stop orders, but not stop limits