Stock Option BasicsDefinition: A stock option is a contract between two parties in which the stock option buyer (holder) purchases the right (but not the obligation) to buy/sell 100 shares of an underlying stock at a predetermined price from/to the option seller (writer) within a fixed period of time. Option Contract Specifications The following terms are specified in an option contract. Option Class The two classes of stock options are puts and calls. Call options confers the buyer the right to buy the underlying stock while put options give him the rights to sell them. Strike Price The strike price is the price at which the underlying asset is to be bought or sold when the option is exercised. It's relation to the market value of the underlying asset affects the moneyness of the option and is a major determinant of the option's premium. Premium In exchange for the rights conferred by the option, the option buyer have to pay the option seller a premium for carrying on the risk that comes with the obligation. The option premium depends on the strike price, volatility of the underlying, as well as the time remaining to expiration. Expiration Date Option contracts are wasting assets and all options expire after a period of time. Once the stock option expires, the right to exercise no longer exists and the stock option becomes worthless. The expiration month is specified for each option contract. The specific date on which expiration occurs depends on the type of option. For instance, stock options listed in the United States expire on the third Friday of the expiration month. Option Style An option contract can be either american style or european style. The manner in which options can be exercised also depends on the style of the option. American style options can be exercised anytime before expiration while european style options can only be exercise on expiration date itself. All of the stock options currently traded in the marketplaces are american-style options. Underlying Asset The underlying asset is the security which the option seller has the obligation to deliver to or purchase from the option holder in the event the option is exercised. In

the case of stock options, the underlying asset refers to the shares of a specific company. Options are also available for other types of securities such as currencies, indices and commodities. Contract Multiplier The contract multiplier states the quantity of the underlying asset that needs to be delivered in the event the option is exercised. For stock options, each contract covers 100 shares. The Options Market Participants in the options market buy and sell call and put options. Those who buy options are called holders. Sellers of options are called writers. Option holders are said to have long positions, and writers are said to have short positions.

Call OptionDefinition: A call option is an option contract in which the holder (buyer) has the right (but not the obligation) to buy a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration). For the writer (seller) of a call option, it represents an obligation to sell the underlying security at the strike price if the option is exercised. The call option writer is paid a premium for taking on the risk associated with the obligation. For stock options, each contract covers 100 shares. Buying Call Options Call buying is the simplest way of trading call options. Novice traders often start off trading options by buying calls, not only because of its simplicity but also due to the large ROI generated from successful trades. A Simplified Example Suppose the stock of XYZ company is trading at $40. A call option contract with a strike price of $40 expiring in a month's time is being priced at $2. You strongly believe that XYZ stock will rise sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ call option covering 100 shares.

Say you were spot on and the price of XYZ stock rallies to $50 after the company

reported strong earnings and raised its earnings guidance for the next quarter. With this sharp rise in the underlying stock price, your call buying strategy will net you a profit of $800. Let us take a look at how we obtain this figure. If you were to exercise your call option after the earnings report, you invoke your right to buy 100 shares of XYZ stock at $40 each and can sell them immediately in the open market for $50 a share. This gives you a profit of $10 per share. As each call option contract covers 100 shares, the total amount you will receive from the exercise is $1000. Since you had paid $200 to purchase the call option, your net profit for the entire trade is $800. It is also interesting to note that in this scenario, the call buying strategy's ROI of 400% is very much higher than the 25% ROI achieved if you were to purchase the stock itself. This strategy of trading call options is known as the long call strategy. See our long call strategy article for a more detailed explanation as well as formulae for calculating maximum profit, maximum loss and breakeven points.

Selling Call OptionsInstead of purchasing call options, one can also sell (write) them for a profit. Call option writers, also known as sellers, sell call options with the hope that they expire worthless so that they can pocket the premiums. Selling calls, or short call, involves more risk but can also be very profitable when done properly. One can sell covered calls or naked (uncovered) calls. Covered Calls The short call is covered if the call option writer owns the obligated quantity of the underlying security. The covered call is a popular option strategy that enables the stockowner to generate additional income from their stock holdings thru periodic selling of call options. See our covered call strategy article for more details. Naked (Uncovered) Calls When the option trader write calls without owning the obligated holding of the underlying security, he is shorting the calls naked. Naked short selling of calls is a highly risky option strategy and is not recommended for the novice trader. See our naked call article to learn more about this strategy. Call Spreads A call spread is an options strategy in which equal number of call option contracts are bought and sold simultaneously on the same underlying security but with different strike prices and/or expiration dates. Call spreads limit the option trader's maximum loss at the expense of capping his potential profit at the same time.

Put Option

Definition: A put option is an option contract in which the holder (buyer) has the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration). For the writer (seller) of a put option, it represents an obligation to buy the underlying security at the strike price if the option is exercised. The put option writer is paid a premium for taking on the risk associated with the obligation. For stock options, each contract covers 100 shares. Buying Put Options Put buying is the simplest way to trade put options. When the options trader is bearish on particular security, he can purchase put options to profit from a slide in asset price. The price of the asset must move significantly below the strike price of the put options before the option expiration date for this strategy to be profitable. A Simplified Example Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price of $40 expiring in a month's time is being priced at $2. You strongly believe that XYZ stock will drop sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ put option covering 100 shares.

Say you were spot on and the price of XYZ stock plunges to $30 after the company reported weak earnings and lowered its earnings guidance for the next quarter. With this crash in the underlying stock price, your put buying strategy will result in a profit of $800. Let's take a look at how we obtain this figure. If you were to exercise your put option after earnings, you invoke your right to sell 100 shares of XYZ stock at $40 each. Although you don't own any share of XYZ

company at this time, you can easily go to the open market to buy 100 shares at only $30 a share and sell them immediately for $40 per share. This gives you a profit of $10 per share. Since each put option contract covers 100 shares, the total amount you will receive from the exercise is $1000. As you had paid $200 to purchase this put option, your net profit for the entire trade is $800. This strategy of trading put option is known as the long put strategy. See our long put strategy article for a more detailed explanation as well as formulae for calculating maximum profit, maximum loss and breakeven points. Protective Puts Investors also buy put options when they wish to protect an existing long stock position. Put options employed in this manner are also known as protective puts. Entire portfolio of stocks can also be protected using index puts. Selling Put Options Instead of purchasing put options, one can also sell (write) them for a profit. Put option writers, also known as sellers, sell put options with the hope that they expire worthless so that they can pocket the premiums. Selling puts, or put writing, involves more risk but can be profitable if done properly. Covered Puts The written put option is covered if the put option writer is also short the obligated quantity of the underlying security. The covered put writing strategy is employed when the investor is bearish on the underlying. Naked Puts The short put is naked if the put option writer did not short the obligated quantity of the underlying security when the put option is sold. The naked put writing strategy is used when the investor is bullish on the underlying. For the patient investor who is bullish on a particular company for the long haul, writing naked puts can also be a great strategy to acquire stocks at a discount. Put Spreads A put spread is an options strategy in which equal number of put option contracts are bought and sold simultaneously on the same underlying security but with different strike prices and/or expiration dates. Put spreads limit the option trader's maximum loss at the expense of capping his potential profit at the same time.

Strike PriceDefinition: The strike price is defined as the price at which the holder of an options can buy (in the case of a call option) or sell (in the case of a put option) the underlying security when the option is exercised. Hence, strike price is also known as exercise price.

Strike Price, Option Premium & Moneyness When selecting options to buy or sell, for options expiring on the same month, the option's price (aka premium) and moneyness depends on the option's strike price. Relationship between Strike Price & Call Option Price For call options, the higher the strike price, the cheaper the option. The following table lists option premiums typical for near term call options at various strike prices when the underlying stock is trading at $50Strike Price Moneyness Call Option Premium Intrinsic Value Time Value

35 40 45 50 55 60 65

ITM ITM ITM ATM OTM OTM OTM

$15.50 $11.25 $7 $4.50 $2.50 $1.50 $0.75

$15 $10 $5 $0 $0 $0 $0

$0.50 $1.25 $2 $4.50 $2.50 $1.50 $0.75

Relationship between Strike Price & Put Option Price Conversely, for put options, the higher the strike price, the more expensive the option. The following table lists option premiums typical for near term put options at various strike prices when the underlying stock is trading at $50Strike Price Moneyness Put Option Premium Intrinsic Value Time Value

35 40 45 50 55 60 65

OTM OTM OTM ATM ITM ITM ITM

$0.75 $1.50 $2.50 $4.50 $7 $11.25 $15.50

$0 $0 $0 $0 $5 $10 $15

$0.75 $1.50 $2.50 $4.50 $2 $1.25 $0.50

Strike Price Intervals The strike price intervals vary depending on the market price and asset type of the underlying. For lower priced stocks (usually $25 or less), intervals are at 2.5 points. Higher priced stocks have strike price intervals of 5 point (or 10 points for very expensive stocks priced at $200 or more). Index options typically have strike price

intervals of 5 or 10 points while futures options generally have strike intervals of around one or two points.

Options PremiumThe price paid to acquire the option. Also known simply as option price. Not to be confused with the strike price. Market price, volatility and time remaining are the primary forces determining the premium. There are two components to the options premium and they are intrinsic value and time value. Intrinsic Value The intrinsic value is determined by the difference between the current trading price and the strike price. Only in-the-money options have intrinsic value. Intrinsic value can be computed for in-the-money options by taking the difference between the strike price and the current trading price. Out-of-the-money options have no intrinsic value. Time Value An option's time value is dependent upon the length of time remaining to exercise the option, the moneyness of the option, as well as the volatility of the underlying security's market price. The time value of an option decreases as its expiration date approaches and becomes worthless after that date. This phenomenon is known as time decay. As such, options are also wasting assets. For in-the-money options, time value can be calculated by subtracting the intrinsic value from the option price. Time value decreases as the option goes deeper into the money. For out-of-the-money options, since there is zero intrinsic value, time value = option price. Typically, higher volatility give rise to higher time value. In general, time value increases as the uncertainty of the option's value at expiry increases. Effect of Dividends on Time Value Time value of call options on high cash dividend stocks can get discounted while similarly, time value of put options can get inflated. For more details on the effect of dividends on option pricing, read this article.

MoneynessMoneyness is a term describing the relationship between the strike price of an option and the current trading price of its underlying security. In options trading, terms such as in-the-money, out-of-the-money and at-the-money describe the moneyness of options. In-the-Money (ITM)

A call option is in-the-money when its strike price is below the current trading price of the underlying asset. A put option is in-the-money when its strike price is above the current trading price of the underlying asset. In-the-money options are generally more expensive as their premiums consist of significant intrinsic value on top of their time value. Out-of-the-Money (OTM) Calls are out-of-the-money when their strike price is above the market price of the underlying asset. Puts are out-of-the-money when their strike price is below the market price of the underlying asset. Out-of-the-money options have zero intrinsic value. Their entire premium is composed of only time value. Out-of-the-money options are cheaper than in-the-money options as they possess greater likelihood of expiring worthless. At-the-Money (ATM) An at-the-money option is a call or put option that has a strike price that is equal to the market price of the underlying asset. Like OTM options, ATM options possess no intrinsic value and contain only time value which is greatly influenced by the volatility of the underlying security and the passage of time. Often, it is not easy to find an option with a strike price that is exactly equal to the market price of the underlying. Hence, close-to-the-money or near-the-money options are bought or sold instead.

Options Expiration:All options have a limited useful lifespan and every option contract is defined by an expiration month. The option expiration date is the date on which an options contract becomes invalid and the right to exercise it no longer exists. When do Options Expire? For all stock options listed in the United States, the expiration date falls on the third Friday of the expiration month (except when that Friday is also a holiday, in which case it will be brought forward by one day to Thursday). Expiration Cycles Stock options can belong to one of three expiration cycles. In the first cycle, the JAJO cycle, the expiration months are the first month of each quarter - January, April, July, October. The second cycle, the FMAN cycle, consists of expiration months Febuary, May, August and November. The expiration months for the third cycle, the MJSD cycle, are March, June, September and December.

At any given time, a minimum of four different expiration months are available for every optionable stock. When stock options first started trading in 1973, the only expiration months available are the months in the expiration cycle assigned to the particular stock. Later on, as options trading became more popular, this system was modified to cater to investors' demand to use options for shorter term hedging. The modified system ensures that two near-month expiration months will always be available for trading. The next two expiration months further out will still depend on the expiration cycle that was assigned to the stock. Determining the Expiration Cycle As there is no set pattern as to which expiration cycle a particular optionable stock is assigned to, the only way to find out is to deduce from the expiration months that are currently available for trading. To do that, just look at the third available expiration month and see which cycle it belongs to. If the third expiration month happens to be January, then use the fourth expiration month to check. The reason we need to double check January is because LEAPS expire in January and if the stock has LEAPS listed for trading, then that January expiration month is the additional expiration month added for the LEAPS options. Options Expiration Calendar 2008 Options Expiration Calendar 2009 Options Expiration Calendar

Option Exercise & AssignmentExercise To exercise an option is to execute the right of the holder of an option to buy (for call options) or sell (for put options) the underlying security at the striking price. American Style vs European Style American style options can be exercised anytime before the expiration date. European style options on the other hand can only be exercised on the expiration date itself. Currently, all of the stock options traded in the marketplaces are American-Style options. When an option is exercised by the option holder, the option writer will be assigned the obligation to deliver the terms of the options contract. Assignment Assignment takes place when the written option is exercised by the options holder. The options writer is said to be assigned the obligation to deliver the terms of the options contract.

If a call option is assigned, the options writer will have to sell the obligated quantity of the underlying security at the strike price. If a put option is assigned, the options writer will have to buy the obligated quantity of the underlying securty at the strike price. Once an option is sold, there exist a possibility for the option writer to be assigned to fulfil his or her obligation to buy or sell shares of the underlying stock on any business day. One can never tell when an assignment will take place. To ensure a fair distribution of assignments, the Options Clearing Corporation uses a random procedure to assign exercise notices to the accounts maintained with OCC by each Clearing Member. In turn, the assigned firm must use an exchange approved way to allocate those notices to individual accounts which have the short positions on those options. Options are usually exercised when they get closer to expiration. The reason is that it does not make much sense to exercise an option when there is still time value left. Its more profitable to sell the option instead. Over the years, only about 17% of options have been exercised. However, it does not mean that only 17% of your short options will be exercised. Many of those options that were not exercised were probably out-of-the-money to begin with and had expired worthless. In any case, at any point in time, the deeper into-the-money the short options, the more likely they will be exercised.

Getting Started in Options TradingTo start trading options, you will need to have a trading account with an options brokerage. Once you have setup your account, you can then place options trades with your broker who will execute it on your behalf. Opening a Trading Account When opening a trading account with a brokerage firm, you will be asked whether you wish to open a cash account or a margin account. Cash Account vs. Margin Account The difference between a cash account and a margin account is that a margin account allows you to use your existing holdings (eg. stocks or long-term options) as collaterals to borrow funds from the brokerage to finance additional purchases. With cash accounts, you can only use the available cash in your account to pay for all your stock and options trades. Minimum Deposit There is usually a minimum deposit required to open a trading account. The amount required depends on the type of account that you are opening as well as the brokerage firm. Little or no deposit is required to open a cash account while federal regulations require a deposit of at least $2000 to open a margin-enabled account. Online Brokerage vs. Offline Brokerage

To trade options effectively, I find it necessary to trade via an online brokerage account as there are simply too many variables in a typical options trade, as compared to a stock trade. Having to communicate too many details in one trade to your broker over the phone also increases the chance of miscommunication which can prove very costly. With technology so advanced these days, online brokerages for options now offer highly intuitive user interfaces where it is far easier to place option trades online than having to do it over the phone. Moreover, while a human broker can only handle one client at a time, online brokerages can handle thousands of orders simultaneously. Thus, it is no coincidence that the rise of option trading also coincide with the rapid advancement of internet technologies.

Finding the Best Options Broker OnlineWhen opening an option brokerage account, don't just go with the cheapest broker. You will find it worthwhile to spend some time evaluating their quality of service first. Read on for tips on how to find the best online options brokerage for your trading needs. Full-Service Broker vs. Discount Broker There are two main types of options brokerage firms in the market - the full service brokerage and the self-directed discount brokerage. Full service or traditional brokerages provide a wide range of services at extra charges. Their services include advice to their clients on where to place their investment money. Discount brokers are geared towards the self-directed trader. They do not provide any investment advice, leaving their clients to make their own financial decisions. Discount brokerages merely execute your orders and consequently their charges are much less than their full-service counterparts. There are also brokerage companies that offer both services to their customers, letting them to choose the level of service they require. Most option traders that I know opt to go with the discount brokerages since anyone who is confident enough to trade complex instruments such as options are usually financially savvy enough not to require trading advice from their brokers, especially when the broker's renumeration is based upon the frequency of trades rather than the quality of their recommendations. Quality of Service When determining which is the best options brokerage, commission charges should not be the only consideration. When it comes to online brokers, site availability, speed of execution and ease of use are just as important, if not more so, than price. Availability & Speed of Execution Site availability and responsiveness are perhaps the most crucial aspects to look out for when selecting an online brokerage. No matter how low the commission charges,

if the trade does not get through because the brokerage site is overwhelmed by ultra high load and becomes unavailable, the amount of transaction fees you save is not going to be worth it. Responsiveness of the site affects the timeliness of the real-time price quotes you get. Remember, we are living in the information age. News travel fast, round the globe, 24 hours a day. Markets react to breaking news events faster than ever before. You don't want to be lagging, even if its just seconds behind, especially when the trading action is fast and furious. Note: Your own internet connection should also be up to speed. You should upgrade to a broadband connection if you are still using dial-up. If you are using wireless, check that your connectivity is good before connecting to the brokerage site. Quality of Execution The National Best Bid or Offer (NBBO) is an SEC requirement that brokers must guarantee customers the best available ask price when they buy securities and the best available bid price when they sell securities. Look for brokers that guarantee trade execution prices that meet or exceed the NBBO. Ease of Use With option trades already complicated enough on their own, it sure doesn't help when you still have to puzzle over how to use the order placement form. An easy to understand user interface helps minimize errors, which can be extremely costly when thousands of dollars are changing hands every trade. Look for option trading brokerages that offer single-screen order entry forms for covered calls, condors, butterflies and other multi-legged option strategies. Commissions and Fees To differentiate themselves from their competition, options trading brokerages are very creative when charging commissions. For options trades, if you take a look at their commission and fees page, you should see two charges: 1) a per trade fee and 2) a per contract fee. Per Trade Fee (or Ticket Charge) - There is usually a minimum fee per transaction, regardless of how many (or rather, how few) contracts are involved in each trade. Per Contract Fee - This fee is charged for every option contract involved in each trade. It is important to know how they are used to calculate the total commission costs per transaction. Usually, the following method is used: Total Commission = $X per Trade + $Y Per Contract But some brokerages use the following formula: Total Commission = $X per Trade or $Y per Contract, whichever is higher Market or Limit Order

Some companies charges different brokerage fees for different types of orders. You should note the fee for limit orders since you almost never place market orders. Internet or Broker-assisted Trade Broker assisted trades can cost as much as several times more than internet trades. The only reason to place a broker-assisted trade is when you are cut off from the internet and a very good trading opportunity happen to arise. Volume Discount There are options brokerage houses which charge a lower rate if your trading frequency exceeds a certain threshold. So, if you are an active trader making dozens of trades a month, it makes sense to look out for a brokerage firm that offers such a discount scheme. Hidden Fees To offset their low commission charges, some discount brokerage firms charges a slew of hidden fees. So if an option brokerage charges an unusually low fee compared to the industry norms, make sure you find out whether there are other fees that you should be aware of. Some common hidden fees include: Account Inactivity Fee - Some brokerages charges a fee if you did not make any trade after a certain period of time. Annual Maintenance Fee - This is a fee levied every year as long as you have an account with the brokerage firm, whether or not you have made any trade. Minimum Balance Fee - This is a fee that is levied peroidically (say monthly or quarterly) when your account balance is below a certain threshold. Commissions can have a significant impact to an option trader's overall profit or loss, especially if your trading capital limits you to prudently buy/sell only 1 or 2 contracts per trade or if you are just starting out and your win/loss ratio is 6:4 or lower. Finding a low-commissions options broker can boost trading profits by as much as 50%. Recommended Options Brokerage If you are new to option trading, we recommend you sign up with optionshouse . They provide quality trade execution, intuitive, user-friendly interface while maintaining low commission charges. optionshouse also provides a Virtual Trading Tool where beginners can try out options trading in real market conditions without risking real money.

Options ChainNot all stocks have options listed for trading. There are some criterias that the public company will need to meet before their stock options can be listed for trading. To find out whether options are available for trading, the simplest way is to enter the stock ticker symbol to retrieve the stock quote information and find out if there is a corresponding options chain available. The availability of an options chain will mean that there are options being traded for that stock.

The options chain shows the available call and put strike prices for a specific underlying security and expiration month. Depending on the online brokerage service that you use, the interface may be slightly different but in general, the layout and available information should be very similar. Below is the options chain interface from OptionsXpress. The most important information is shown right at the top and they are usually the underlying security, along with its latest market price, and the expiration month. This is common sense as you don't want to purchase an option only to realise that its for the wrong underlier or the wrong expiration month!

Options ChainNot all stocks have options listed for trading. There are some criterias that the public company will need to meet before their stock options can be listed for trading. To find out whether options are available for trading, the simplest way is to enter the stock ticker symbol to retrieve the stock quote information and find out if there is a corresponding options chain available. The availability of an options chain will mean that there are options being traded for that stock. The options chain shows the available call and put strike prices for a specific underlying security and expiration month. Depending on the online brokerage service that you use, the interface may be slightly different but in general, the layout and available information should be very similar. Below is the options chain interface from OptionsXpress. The most important information is shown right at the top and they are usually the underlying security, along with its latest market price, and the expiration month. This is common sense as you don't want to purchase an option only to realise that its for the wrong underlier or the wrong expiration month!

Calls and Puts

Calls are usually listed on the left hand side while puts are typically displayed on the right hand side. In-the-money options are usually highlighted to differentiate them from out-of-the-money options. If you wish to trade at-the-money or near-the-money options, they are positioned on either side of the horizontal 'border' created by the highlighting. The Strike Price Down the middle is the range of strike prices available for trading for the selected expiration month. The strike price intervals vary and depends on the price of the underlying. For lower priced stocks (usually $25 or less), intervals are at 2.5 points. Higher priced stocks have strike price intervals of 5 point (or 10 points for very expensive stocks priced at $200 or more). Options Symbol Option symbols are unique to every option contract and they denote the type of option, the underlying asset and the expiration month, provided you have a good understanding of options symbology. However, they are seldom used nowadays since with modern computer technology, these information are often presented to the trader in a user friendly interface - the options chain! While you can enter the symbol directly when placing an order, it is advisable to select the desired options using the options chain interface to minimize human error. Last Done Price The last done price reflects the latest transacted price for the specific option. As the most recent transaction may be hours or days ago, especially for thinly traded contracts, you should check the bid-ask price rather than the last done price to get a better picture of the current market value of the option you wish to trade. Bid-Ask Spread The bid and ask shows the price at which buyers are willing to pay and sellers are looking to receive for the particular option. The bid-ask spread is the difference between the bid and the ask and the size of the spread depends on the liquidity of the option. As a general rule, the lower the open interest, the wider the bid-ask spread. Furthermore, near the money options usually have higher open interest and hence better liquidity and narrower bid-ask spreads.

Order EntrySince this is a basic introduction to options trading, we will be focusing on executing simple orders that just involve buying options. From the options chain screen, you will have selected the option you wish to purchase by clicking on the options symbol. A separate order entry screen will be displayed and here, you have several things to specify to complete your order.

Quantity After confirming the underlying security, expiration month and the strike price, the first thing you need to specify is the quantity. For options, this is the number of contracts you wish to buy. Remember, for stock options, each contract covers 100 shares. Commissions are charged for every contract but many brokerages offer discounts for larger orders. Sometimes, depending on your broker, there is also a mimimum commission charge for every order. All or None This option is available for limit orders. If you select this option, your broker will try to fill all of the quantity you specified. If he is unable to do that, then none of your orders will be filled.

Options TransactionsUnlike stock trading, the contractual nature of options offer four different ways for entering and exiting positions. There is an options seller (writer) and an options buyer (holder). The option seller can enter or exit a transaction, and so can an option buyer.

Opening TransactionsBuy-to-Open This is the transaction the options buyer make to enter a long position on an option. For example, if you want to buy a call option, you would enter a "buy-to-open" transaction. Sell-to-Open

This is the transaction the options seller make when he wish to enter a short position on an option. For example, if you are writing call options to earn premiums, you would enter a "sell-to-open" transaction.

Closing TransactionsBuy-to-Close This is the transaction the options writer make when he wish to exit a short position on an option. For example, if you wish to buy back the calls you had previously sold, you would enter a "buy-to-close" transaction. Sell-to-Close This is the transaction the options holder make to exit a long position on an option. For example, if you want to sell a previously purchased call option, you would enter a "sell-to-close" transaction.

Types of OrdersOnline brokerages provide many types of orders to cater to the various needs of the investors. The common types of orders available are market orders, limit orders and stop orders. Market Order With market orders, you are instructing your broker to buy or sell the options at the current market price. If you are buying, you will be paying the asking price. If selling, you will be selling at the bid price. The advantage of using market orders is that you will fill your order fast (often instantly) but the disadvantage is that you will usually end up paying slightly more, especially when the order is large and the trading volume thin. Limit Order With limit orders, you will specify the price you wish to transact. If you are buying, you are instructing your broker to buy at no higher than the specified price. If selling, you are telling him to sell at no less than your stated price. The advantage of using limit orders is that you are in full control of the price at which you buy or sell your options. The disadvantage is that filling the order will take some time, or the entire order may not get filled at all because the underlying stock price has moved way beyond your desired price. Stop Loss Order Stop loss orders are orders that only gets executed when the market price of the underlying stock reaches a specified price. They are used to reduce losses when the underlying asset price moves sharply against the investor. Stop Market Order A stop market order, or simply stop order, is a market order that only executes when the underlying stock price trades at or through a designated price. Buy stops,

designed to limit losses on short positions, are placed above current market price. Sell stops are used to protect long positions and are placed below current market price. While the stop market order guarantees execution, the actual transacted price maybe slightly lower or higher than desired, especially when the underlying price movement is very volatile. Stop Limit Order A stop limit order is a limit order that gets activated only when the underlying stock price trades at or through a specifed price. While a stop limit order provides complete control over the transaction price, it may not get executed if the underlying price moves too quickly and the limit price is never reached.

Margin RequirementsIn options trading, "margin" also refers to the cash or securities required to be deposited by an option writer with his brokerage firm as collateral for the writer's obligation to buy or sell the underlying security, or in the case of cash-settled options to pay the cash settlement amount, in the event that the option gets assigned. Margin requirements for option writers are complicated and not the same for each type of underlying security. They are subject to change and can vary from brokerage firm to brokerage firm. As they have significant impact to the risk/reward profiles of each trade, writers of options (whether they be calls or puts alone or as part of multiple position strategies such as spreads, straddles or strangles) should determine the applicable margin requirements from their brokerage firms and be sure that they are able to meet those requirements in case the market turns against them. Margin Requirements Manual A reference manual to the margins requirements of various options strategies has been published by CBOE and is available here. Margin Calculator Also provided by CBOE is this useful online tool that calculates the exact margin requirements for a particular trade.

Options Strategies:Buying OptionsThe most basic of options strategies is to simply buy call or put options. When you buy options, you are said to have a long position in that option. You have a long call position when you buy calls or a long put position if you buy puts. Generally, when you are bullish on the underlying asset, you can buy call options to implement the long call strategy and when bearish, you buy put options to implement the long put strategy.

In both cases, you hope that the underlying stock price move far enough to cover the premiums paid for the options and land you a profit. Cost Considerations When Buying Options The price you pay to own the option is called the premium which is affected by many factors such as moneyness, time to expiration and underlying volatility. Moneyness Out-of-the-money options are cheaper to buy than in-the-money options but they are also more likely to expire worthless. For call options, this means that the higher the strike price, the cheaper the option. Similarly, put options with lower strike prices are therefore less expensive to purchase. However, the size of the premium alone does not tell us the whole story. In fact, atthe-money options can be considered the most expensive even though their premiums are lower than in-the-money options. This is because their time value is highest and time value is the part of the premium that will waste away as the expiration date approaches. Time to Expiration Obviously, the longer the time to expiration, the more chance the option buyer have for the underlying price to move in the right direction and therefore the more expensive the option. Implied Volatility (IV) Watch out for the implied volatility (IV) when buying options. Options are more expensive when the IV is high and less expensive when it is low. Selecting the Right Option to Buy Which strike price and expiration you choose all depends on your outlook of the underlying. For instance, if you believe that the underlying will make an explosive move upwards very soon, then it makes sense to buy an at-the-money call option expiring in the nearest expiration month. Buying Options for the Purpose of Hedging Other than speculation, options can also be bought as a means to insure potential losses for an existing position in the underlying. To hedge a long underlying position, a protective put can be purchased. Similarly, to protect a short underlying position, a protective call strategy can be used.

Selling OptionsSelling options is another way to profit from option trading. The basic idea behind the option selling strategy is to hope that the options you sold expire worthless so that you can pocket the premiums as profits.

Things to Consider When Selling OptionsCovered or Uncovered (Naked) When it comes to selling options, one can be covered or naked. You are covered when selling options if you have a corresponding position in the underlying asset. Being covered or naked can have a big impact on the risk/reward profile of the strategy you wish to implement. Implied Volatility When selling options, one should take note of the implied volatility (IV) of the underlying asset. Generally, when the IV is high, premiums go up and when implied volatility is low, premiums go down. So you would want to sell options when IV is high.

Selling Call OptionsWriting Covered Calls The covered call is probably the most well-known option selling strategy. A call is covered when you also own a long position in the underlying. If you are mildly bullish on the underlying, you will sell an out-of-the-money covered call. Otherwise, if you are neutral to mildly bearish on the underlying, then the in-the-money covered call strategy will be more appropriate. Writing Naked Calls Selling naked calls is a high risk strategy that can be used when the option trader is very bearish on the underlying. Note that your broker will not permit you to start selling naked calls until you have been deemed to possess sufficient knowledge, trading experience and financial resources. Ratio Call Write Using a combination of covered calls and naked calls, one can also implement what is known as the ratio call write. The trader implementing the ratio call write is neither bullish nor bearish on the underlying.

Selling Put OptionsWriting Covered Puts A written put is covered when you also have a short position in the underlying. The covered put has the same payoff as the naked call and is seldom employed because the naked call write is a much better strategy for a number of reasons. Firstly, if the underlying asset is a stock, the covered put writer has to pay dividends on the short stock while the naked call writer need not. Secondly, call options generally sell for higher premiums than put options. Lastly, having to short the underlying and the option at the same time also increases the commission costs for the covered put writing strategy. Selling Naked Puts

Writing uncovered puts is a high risk strategy that can be used when the option trader is very bullish on the underlying. Selling naked puts can also be a great way to purchase stocks at a discount. Again, like all naked option writing strategies, your trading account must be assigned a sufficiently high trading level by your broker before you are allowed to trade naked puts. Ratio Put Write Using a combination of covered and uncovered puts, one can also implement what is known as the ratio put write. This strategy has the same risk/reward profile as the ratio call write but for the same reasons that the naked call strategy is preferred over the covered put write, the ratio put write is considered inferior and rarely used. Options Spreads By simultaneously buying and selling options of the same class, a wide range of strategies known as spreads can be created. Spreads are characterized by having limited profit potential coupled with limited risk.

Option SpreadsIn options trading, an option spread is created by the simultaneous purchase and sale of options of the same class on the same underlying security but with different strike prices and/or expiration dates. Any spread that is constructed using calls can be refered to as a call spread. Similarly, put spreads are spreads created using put options. Option buyers can consider using spreads to reduce the net cost of entering a trade. Naked option sellers can use spreads instead to lower margin requirements so as to free up buying power while simultaneously putting a cap on the maximum loss potential. Vertical, Horizontal & Diagonal Spreads The three basic classes of spreads are the vertical spread, the horizontal spread and the diagonal spread. They are categorized by the relationships between the strike price and expiration dates of the options involved. Vertical spreads are constructed using options of the same class, same underlying security, same expiration month, but at different strike prices. Horizontal or calendar spreads are constructed using options of the same underlying security, same strike prices but with different expiration dates. Diagonal spreads are created using options of the same underlying security but different strike prices and expiration dates. Bull & Bear Spreads If an option spread is designed to profit from a rise in the price of the underlying security, it is a bull spread. Conversely, a bear spread is a spread where favorable outcome is attained when the price of the underlying security goes down.

Credit & Debit Spreads Option spreads can be entered on a net credit or a net debit. If the premiums of the options sold is higher than the premiums of the options purchased, then a net credit is received when entering the spread. If the opposite is true, then a debit is taken. Spreads that are entered on a debit are known as debit spreads while those entered on a credit are known as credit spreads. More Options Strategies Altogether, there are quite a number of options trading strategies available to the investor and many of them come with exotic names. Here in this website, we have tutorials covering all known strategies and we have classified them under bullish strategies, bearish strategies and neutral (non-directional) strategies.

Options CombinationsA combination is an option trading strategy that involves the purchase and/or sale of both call and put options on the same underlying asset. Call & Put Buying Combinations Straddle The straddle is an unlimited profit, limited risk option trading strategy that is employed when the options trader believes that the price of the underlying asset will make a strong move in either direction in the near future. It can be constructed by buying an equal number of at-the-money call and put options with the same expiration date. Strangle Like the straddle, the strangle is also a strategy that has limited risk and unlimited profit potential. The difference between the two strategies is that out-of-the-money options are purchased to construct the strangle, lowering the cost to establish the position but at the same time, a much larger move in the price of the underlying is required for the strategy to be profitable. Strip The strip is a modified, more bearish version of the common straddle. Construction is similar to the straddle except that the ratio of puts to calls purchased is 2 to 1. Strap The strap is a more bullish variant of the straddle. Twice the number of call options are purchased to modify the straddle into a strap. Synthetic Underlying Combinations can be used to create options positions that have the same payoff pattern as the underlying. These positions are known as synthetic underlying positions. Using equity options as an example, a synthetic long stock position can be

created by buying at-the-money call and selling an equal number of at-the-money put options.

Bullish Trading StrategiesBullish strategies in options trading are employed when the options trader expects the underlying stock price to move upwards. It is necessary to assess how high the stock price can go and the timeframe in which the rally will occur in order to select the optimum trading strategy. Very Bullish The most bullish of options trading strategies is the simple call buying strategy used by most novice options traders. Moderately Bullish In most cases, stocks seldom go up by leaps and bounds. Moderately bullish options trader usually set a target price for the bull run and utilize bull spreads to reduce risk. While maximum profit is capped for these strategies, they usually cost less to employ. Mildly Bullish Mildly bullish trading strategies are options strategies that make money as long as the underlying stock price do not go down on options expiration date. These strategies usually provide a small downside protection as well. Writing out-of-themoney covered calls is one example of such a strategy.

Bearish Trading StrategiesBearish strategies in options trading are employed when the options trader expects the underlying stock price to move downwards. It is necessary to assess how low the stock price can go and the timeframe in which the decline will happen in order to select the optimum trading strategy. Very Bearish The most bearish of options trading strategies is the simple put buying strategy utilized by most novice options traders. Moderately Bearish In most cases, stock price seldom make steep downward moves. Moderately bearish options traders usually set a target price for the expected decline and utilise bear spreads to reduce risk. While maximum profit is capped for these strategies, they usually cost less to employ. Mildly Bearish Mildly bearish trading strategies are options strategies that make money as long as the underlying stock price do not go up on options expiration date. These strategies usually provide a small upside protection as well. A good example of such a strategy is to write of out-of-the-money naked calls.

Neutral Trading StrategiesNeutral options trading strategies are employed when the options trader does not know whether the underlying stock price will rise or fall. Also known as non-directional strategies, they are so named because the potential to profit does not depend on whether the underlying stock price will go upwards or downwards. Rather, the correct neutral strategy to employ depends on the expected volatility of the underlying stock price. Bullish on Volatility Neutral trading strategies that profit when the underlying stock price experience big moves upwards or downwards include the long straddle, long strangle, short condors and short butterflies. Bearish on Volatility Neutral trading strategies that profit when the underlying stock price experience little or no movement include the short straddle, short strangle, ratio spreads, long condors and long butterflies.

Synthetic PositionThere is a synthetic equivalent for all of the basic positions in an underlying security and its corresponding options. In other words, the risk/reward profile of any position can be simulated using a complex combination of the other basic positions. These equivalents are known as synthetic underlying and synthetic options respectively for the underlying security (e.g. stock or futures) and options positions. Options Arbitrage Synthetic positions are often used to perform arbitrage trades in options trading. When prices are right, the arbitrager can make a risk-free profit by going long/short on one position while simultaneously selling/buying the equivalent synthetic position.

Options ArbitrageIn the options market, arbitrage trades are often performed by firm or floor traders to earn small profits with little or no risk. To setup an arbitrage, the options trader would go long on an underpriced position and sell the equivalent overpriced position. If puts are overpriced relative to calls, the arbitrager would sell a naked put and offset it by buying a synthetic put. Similarly, when calls are overpriced in relation to puts, one would sell a naked call and buy a synthetic call. The use of synthetic positions are common in options arbitrage strategies. The opportunity for arbitrage in options trading rarely exist for individual investors as price discrepancies often appear only for a few moments. However, an important lesson to learn from here is that the actions by floor traders doing reversals and conversions quickly restore the market to equilibrium, keeping the price of calls and puts in line, establishing what is known as the put-call parity.

Conversion and Reversal Floor traders perform conversions when options are overpriced relative to the underlying asset. When the options are relatively underpriced, traders will do reverse conversions, otherwise known as reversals. Box Spread Another common arbitrage strategy in options trading is the box spread where equivalent vertical spread positions are bought and sold for a riskless profit. Dividend Arbitrage Besides conversions, reversals and boxes, there is also the dividend arbitrage strategy which attempts to capture a stock's dividend payout with no risk.

Option Strategy FinderA large number of options trading strategies are available to the options trader. Use the search facility below to quickly locate the best options strategies based upon your view of the underlying and desired risk/reward characteristics.Outlook on Underlying: Profit Potential: Loss Potential: Credit/Debit: No. Legs:

Bull Call Spread

Bull Put Spread

Buying Index Calls

Call Backspread

Costless Collar (Zero-Cost Collar)

Covered Calls

Covered Combination

Covered Straddle

In-The-Money Covered Call

Long Call

Married Put

Protective Put

Selling Index Puts

Stock Repair Strategy

Synthetic Long Call

Synthetic Long Stock

Synthetic Long Stock (Split Strikes)

Synthetic Short Put

The Collar Strategy

Uncovered Put Write

Bull Call SpreadThe bull call spread option trading strategy is employed when the options trader thinks that the price of the underlying asset will go up moderately in the near term. Bull call spreads can be implemented by buying an at-the-money call option while simultaneously writing a higher striking out-of-the-money call option of the same underlying security and the same expiration month.Bull Call Spread Construction

Buy 1 ITM Call Sell 1 OTM Call

By shorting the out-of-the-money call, the options trader reduces the cost of establishing the bullish position but forgoes the chance of making a large profit in the event that the underlying asset price skyrockets. The bull call spread option strategy is also known as the bull call debit spread as a debit is taken upon entering the trade.

Bull Call Spread Payoff Diagram

Limited Upside profits Maximum gain is reached for the bull call spread options strategy when the stock price move above the higher strike price of the two calls and it is equal to the difference between the strike price of the two call options minus the initial debit taken to enter the position. The formula for calculating maximum profit is given below: Max Profit = Strike Price of Short Call - Strike Price of Long Call - Net Premium Paid - Commissions Paid Max Profit Achieved When Price of Underlying >= Strike Price of Short Call

Limited Downside risk The bull call spread strategy will result in a loss if the stock price declines at expiration. Maximum loss cannot be more than the initial debit taken to enter the spread position. The formula for calculating maximum loss is given below: Max Loss = Net Premium Paid + Commissions Paid Max Loss Occurs When Price of Underlying = Strike Price of Short Put

Bull Put Spread Payoff Diagram Limited Downside Risk If the stock price drops below the lower strike price on expiration date, then the bull put spread strategy incurs a maximum loss equal to the difference between the strike prices of the two puts minus the net credit received when putting on the trade. The formula for calculating maximum loss is given below: Max Loss = Strike Price of Short Put - Strike Price of Long Put Net Premium Received + Commissions Paid Max Loss Occurs When Price of Underlying = 2 x Strike Price of Long Call Strike Price of Short Call +/- Net Premium Paid/Received Profit = Price of Underlying - Strike Price of Long Call - Max Loss

Limited Risk Maximum loss for the call back spread is limited and is taken when the underlying stock price at expiration is at the strike price of the long calls purchased. At this price, both the long calls expire worthless while the short call expires in the money. Maximum loss is equal to the intrinsic value of the short call plus or minus any debit or credit taken when putting on the spread. The formula for calculating maximum loss is given below:

Max Loss = Strike Price of Long Call - Strike Price of Short Call +/- Net Premium Paid/Received + Commissions Paid Max Loss Occurs When Strike Price of Long Call

Breakeven Point(s) There are 2 break-even points for the call backspread position. The breakeven points can be calculated using the following formulae. Upper Breakeven Point = Strike Price of Long Call + Points of Maximum Loss Lower Breakeven Point = Strike Price of Short Call

Example Suppose XYZ stock is trading at $43 in June. An options trader executes a 2:1 call backspread by selling a JUL 40 call for $400 and buying two JUL 45 calls for $200 each. The net debit/credit taken to enter the trade is zero. On expiration in July, if XYZ stock is trading at $45, both the JUL 45 calls expire worthless while the short JUL 40 call expires in the money with $500 in intrinsic value. Buying back this call to close the position will result in the maximum loss of $500 for the options trader. If XYZ stock rallies and is trading at $50 on expiration in July, all the options will expire in the money. The short JUL 40 call is worth $1000 and needs to be bought back to close the position. Since the two JUL 45 call bought is now worth $500 each, their combined value of $1000 is just enough to offset the losses from the written call. Therefore, he achieves breakeven at $50. Beyond $50 though, there will be no limit to the gains possible. For example, at $60, each long JUL 45 call will be worth $1500 while his single short JUL 40 call is only worth $2000, resulting in a profit of $1000. If the stock price had dropped to $40 or below at expiration, all the options involved will expire worthless. Since the net debit to put on this trade is zero, there is no resulting loss. Note: While we have covered the use of this strategy with reference to stock options, the call backspread is equally applicable using ETF options, index options as well as options on futures. Commissions For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages. However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out

OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$8.95 per trade). Similar Strategies The following strategies are similar to the call backspread in that they are also bullish strategies that have unlimited profit potential and limited risk.

Protective Put

Married Put

Long Call

Ratio Spread The converse strategy to the backspread is the ratio spread. Ratio spreads are used when little movement is expected of the underlying stock price. Put Backspread The backspread can also be constructed using puts. Unlike the call backspread, the put backspread is a bearish strategy.

The Collar StrategyA collar is an options trading strategy that is constructed by holding shares of the underlying stock while simultaneously buying protective puts and selling call options against that holding. The puts and the calls are both out-of-the-money options having the same expiration month and must be equal in number of contracts.Collar Strategy Construction

Long 100 Shares Sell 1 OTM Call Buy 1 OTM Put

Technically, the collar strategy is the equivalent of a out-of-the-money covered call strategy with the purchase of an additional protective put. The collar is a good strategy to use if the options trader is writing covered calls to earn premiums but wish to protect himself from an unexpected sharp drop in the price of the underlying security.

Collar Strategy Payoff Diagram Limited Profit Potential The formula for calculating maximum profit is given below: Max Profit = Strike Price of Short Call - Purchase Price of Underlying + Net Premium Received - Commissions Paid Max Profit Achieved When Price of Underlying >= Strike Price of Short Call

Limited Risk The formula for calculating maximum loss is given below: Max Loss = Purchase Price of Underlying - Strike Price of Long Put - Net Premium Received + Commissions Paid Max Loss Occurs When Price of Underlying = Strike Price of Short Call

Greater downside protection As the premiums received upon writing in-the-money calls is higher than writing outof-the-money calls, downside protection is greater as the higher premium can better offset the paper loss should the stock price go down. The formula for calculating loss is given below: Maximum Loss = Unlimited

Loss Occurs When Price of Underlying < Purchase Price of Underlying Premium Received Loss = Purchase Price of Underlying - Price of Underlying - Max Profit + Commissions Paid Breakeven Point(s) The underlier price at which break-even is achieved for the covered call (itm) position can be calculated using the following formula. Breakeven Point = Purchase Price of Underlying - Premium Received

Example

Suppose the stock XYZ is currently trading at $50 in June. An options trader decides to write a JUL 45 covered call for $7. He pays $5000 for the 100 shares of XYZ and receives $700 in premium giving a net investment of $4300. The stock then rallies to $55 at expiration and the call gets assigned. As per the options contract, the trader has to sell the 100 shares of XYZ at the striking price of $45 and so he receives $4500 for the shares sold. Since his original investment is $4300, his net profit for the entire trade is only $200. However, should the stock price go down to $45 instead, he still makes a profit since the $700 in premiums received more than offset the $500 in paper loss of the 100 shares he held which has lost $5 a share in value. At $45, the call most likely will not get assigned since there is no intrinsic value left in the option. Since the shares did not get called away, the call writer can either sell the shares for $4500 giving him a net profit of $200 for the entire trade or write another call against the shares held. Note: While we have covered the use of this strategy with reference to stock options, the covered call (itm) is equally applicable using ETF options, index options as well as options on futures. Commissions For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages. However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$8.95 per trade). Similar Strategies The following strategies are similar to the covered call (itm) in that they are also bullish strategies that have limited profit potential and unlimited risk.

Uncovered Put Write

Stock Repair Strategy

Covered Straddle

Covered Straddle

The covered straddle is a bullish strategy in options trading that involves the simultaneous selling of equal number of puts and calls of the same underlying stock, striking price and expiration date while owning the underlying stock. Note that only the call options are covered.Covered Straddle Construction

Long 100 Shares Sell 1 ATM Call Sell 1 ATM Put

Covered straddles are limited profit, unlimited risk options strategies similar to the writing of covered calls. Another way to describe a covered straddle is that it is simply a combination of a covered call write and a naked put write. Since the naked put write has a risk/reward profile of a covered call, a covered straddle can also be thought of as the equivalent of two covered calls.

Covered Straddle Payoff Diagram

Covered Straddle Payoff Diagram Limited Profit Potential Maximum gain for the covered straddle is reached when the underlying stock price on expiration date is trading at or above the strike price of the options sold. The formula for calculating maximum profit is given below: Max Profit = Strike Price of Short Call - Purchase Price of Underlying + Net Premium Received - Commissions Paid Max Profit Achieved When Price of Underlying >= Strike Price of Short Call

Unlimited Risk

Large losses can be experienced when writing a covered straddle when the underlying stock price makes a strong move downwards below the breakeven point at expiration. This is when the covered straddle writer loses not only on the long stock position but also on the naked put. The formula for calculating loss is given below: Maximum Loss = Unlimited

Loss Occurs When Price of Underlying < (Purchase Price of Underlying + Strike Price of Short Put - Net Premium Received) / 2 Loss = Purchase Price of Underlying + Strike Price of Short Put - (2 x Price of Underlying) - Max Profit + Commissions Paid Breakeven Point(s) The underlier price at which break-even is achieved for the covered straddle position can be calculated using the following formula. Breakeven Point = (Purchase Price of Underlying + Strike Price of Short Put Net Premium Received) / 2 Example Suppose XYZ stock is trading at $54 in June. An options trader executes a covered straddle strategy by selling a JUL 55 put for $300 and a JUL 55 call for $400 while purchasing 100 shares of XYZ for $5400. The total premiums received for selling the options is $700. On expiration in July, if XYZ stock rallies above the strike price to $57, the JUL 55 put expires worthless while the JUL 55 call expires in the money and the 100 shares get called away for $5500, producing a gain of $100. Including the $700 in premiums received upon entering the trade, the total profit comes to $800 which is also the maximum profit attainable. However, if the stock price drops below the breakeven to $45, the JUL 55 call expires worthless but the naked JUL 55 put and long stock position suffer large losses. The short JUL 55 put is now worth $1000 and needs to be bought back while the long stock position has lost $900 in value. Factoring in the $700 premiums received earlier, the total loss comes to $1200. Note: While we have covered the use of this strategy with reference to stock options, the covered straddle is equally applicable using ETF options, index options as well as options on futures. Commissions For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$8.95 per trade). Similar Strategies The following strategies are similar to the covered straddle in that they are also bullish strategies that have limited profit potential and unlimited risk.

Uncovered Put Write View More Similar Strategies

Stock Repair Strategy

In-The-Money Covered Call

Uncovered Straddle Despite its name, the uncovered straddle is not a converse strategy to the covered straddle. Rather, it is the reverse strategy of the long straddle and is also known as the short straddle. Both the long and the short straddles are neutral strategies, which is very different in outlook from the covered straddle which is a bullish strategy.

Diagonal Bull Call SpreadThe diagonal bull call spread strategy involves buying long term calls and simultaneously writing an equal number of near-month calls of the same underlying stock with a higher strike. This strategy is typically employed when the options trader is bullish on the underlying stock over the longer term but is neutral to mildly bullish in the near term.Diagonal Bull Call Spread Construction

Buy 1 Long-Term ITM Call Sell 1 Near-Term OTM Call

Limited Upside Profit The ideal situation for the diagonal bull call spread buyer is when the underlying stock price remains unchanged and only goes up and beyond the strike price of the call sold when the long term call expires. In this scenario, as soon as the near month call expires worthless, the options trader can write another call and repeat this process every month until expiration of the longer term call to reduce the cost of the trade. It may even be possible at some point in time to own the long term call "for free".

Under this ideal situation, maximum profit for the diagonal bull call spread is obtained and is equal to all the premiums collected for writing the near-month calls plus the difference in strike price of the two call options minus the initial debit taken to put on the trade. Limited Downside Risk The maximum possible loss for the diagonal bull call spread is limited to the initial debit taken to put on the spread. This happens when the stock price goes down and stays down until expiration of the longer term call. Example In June, an options trader believes that XYZ stock trading at $40 is going to rise gradually for the next four months. He enters a diagonal bull call spread by buying a OCT 40 call for $300 and writing a JUL 45 call for $100. The net investment required to put on the spread is a debit of $200. The stock price of XYZ goes up by $1 a month and closes at $44 on expiration date of the long term call. As each near-month call expires, the options trader writes another call of the same strike for $100. In total, another $300 was collected for writing 3 more near month calls. Additionally, with the stock price at $44, the OCT 40 call expires in the money with $400 in intrinsic value. Thus, in total, his profit is $400 (intrinsic value of the OCT 40 call) + $300 (additional call premiums collected) - $200 (initial debit) = $500. If the price of XYZ had declined to $38 and stayed at $38 until October instead, both options expire worthless. The trader will also be unable to write additional calls since they are too far out-of-the-money to bring in significant premiums. Hence, he will lose his entire investment of $200, which is also his maximum possible loss. Suppose the price of XYZ did not move and remains at $40 until expiration of the long term call, the trader will still profit as the total amount of premium collected is $400 while the OCT 40 call cost $300, resulting in a $100 profit. Note: While we have covered the use of this strategy with reference to stock options, the diagonal bull call spread is equally applicable using ETF options, index options as well as options on futures. Commissions For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages. However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$8.95 per trade). Similar Strategies

The following strategies are similar to the diagonal bull call spread in that they are also bullish strategies that have limited profit potential and limited risk.

The Collar Strategy

Costless Collar (Zero-Cost Collar)

Bull Put Spread

Long CallThe long call option strategy is the most basic option trading strategy whereby the options trader buy call options with the belief that the price of the underlying security will rise significantly beyond the strike price before the option expiration date.Long Call Construction

Buy 1 ATM Call

Compared to buying the underlying shares outright, the call option buyer is able to gain leverage since the lower priced calls appreciate in value faster percentagewise for every point rise in the price of the underlying stock However, call options have a limited lifespan. If the underlying stock price does not move above the strike price before the option expiration date, the call option will expire worthless.

Long Call Payoff Diagram

Since they can be no limit as to how high the stock price can be at expiration date, there is no limit to the maximum profit possible when implementing the long call option strategy. The formula for calculating profit is given below: Maximum Profit = Unlimited

Profit Achieved When Price of Underlying >= Strike Price of Long Call + Premium Paid Profit = Price of Underlying - Strike Price of Long Call - Premium Paid

Limited Risk Risk for the long call options strategy is limited to the price paid for the call option no matter how low the stock price is trading on expiration date. The formula for calculating maximum loss is given below: Max Loss = Premium Paid + Commissions Paid Max Loss Occurs When Price of Underlying Purchase Price of Underlying + Premium Paid Profit = Price of Underlying - Purchase Price of Underlying - Premium Paid

Protective Put Payoff Diagram

Limited Risk Maximum loss for this strategy is limited and is equal to the premium paid for buying the put option. The formula for calculating maximum loss is given below: Max Loss = Premium Paid + Purchase Price of Underlying - Put Strike + Commissions Paid

Max Loss Occurs When Price of Underlying = Strike Price of Short Call

Covered Combination Payoff Diagram

Unlimited Risk Large losses can be experienced when writing a covered combination when the underlying stock price makes a strong move downwards below the breakeven point at expiration. This strategy loses money twice as fast as a regular covered call write as the covered combination loses not only on the long stock position but also on the short put. The formula for calculating loss is given below: Maximum Loss = Unlimited

Loss Occurs When Price of Underlying < (Purchase Price of Underlying + Strike Price of Short Put - Net Premium Received) / 2 Loss = Purchase Price of Underlying + Strike Price of Short Put - (2 x Price of Underlying) - Max Profit + Commissions Paid Breakeven Point(s)

The underlier price at which break-even is achieved for the covered combination position can be calculated using the following formula. Breakeven Point = (Purchase Price of Underlying + Strike Price of Short Put Net Premium Received) / 2 Example Suppose XYZ stock is trading at $52 in June. An options trader executes a covered combination strategy by selling a JUL 50 out-of-the-money put for $100 and a JUL 55 out-of-the-money call for $100 while purchasing 100 shares of XYZ for $5200. The total premiums received for selling the options is $200. On expiration in July, if XYZ stock rallies above the strike price to $57, the JUL 50 put expires worthless while the JUL 55 call expires in the money and the 100 shares get called away for $5500, producing a gain of $300 on the long stock position. Including the $200 in premiums received upon entering the trade, the total profit comes to $500 which is also the maximum profit attainable. However, if the stock price drops below the breakeven to $45, the JUL 55 call expires worthless but the naked JUL 50 put and long stock position suffer large losses. The short JUL 50 put is now worth $500 and needs to be bought back while the long stock position has lost $700 in value. Factoring in the $200 premiums received earlier, the total loss comes to $1000. Note: While we have covered the use of this strategy with reference to stock options, the covered combination is equally applicable using ETF options, index options as well as options on futures. Commissions For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages. However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$8.95 per trade). Similar Strategies The following strategies are similar to the covered combination in that they are also bullish strategies that have limited profit potential and unlimited risk.

Uncovered Put Write

Stock Repair Strategy

In-The-Money Covered Call

Stock Repair StrategyThe stock repair strategy is used as an alternative strategy to recover from a loss after a long stock position has suffered from a drop in the stock price. It involves the implementation of a call ratio spread to reduce the break-even price of a losing long stock position, thereby increasing the chance of fully recovering from the loss.Stock Repair Strategy Construction

Buy 1 ATM Call Sell 2 OTM Calls

The most straightforward way to try to rescue a losing long stock position is to hold on to the shares and hope that the stock price return to the original purchase price. However, this approach may take a long time (if ever).

To increase the likelihood of achieving breakeven, another common strategy is to double down and reduce the average purchase price. This method reduces the breakeven price but there is a need to pump in additional funds, hence increasing downside risk. The stock repair strategy, on the other hand, is able to reduce the breakeven at virtually no cost and with no additional downside risk. The only downside to this

strategy is that the best it can do is to breakeven. This means that in the event that the stock rebounds sharply, the trader does not stand to make any additional profit. Example Suppose a trader had bought 100 shares of XYZ stock at $50 a share in May but the price of the stock had since declined to $40 a month later, leaving him with a paper loss of $1000. The trader decides to employ a stock repair strategy by implementing a 2:1 ratio call spread, buying a JUL 40 call for $200 and selling two JUL 45 calls for $100 each. The net debit/credit taken to enter the spread is zero. On expiration in July, if XYZ stock is trading at $45, both the JUL 45 calls expire worthless while the long JUL 40 call expires in the money with $500 in intrinsic value. Selling or exercising this long call will give the options trader a profit of $500. As his long stock position has also regained $500 in value, his total gain comes to $1000 which is equal to his initial loss from the long stock position. Hence, he have achieved breakeven at the reduced price of $45 and 'repaired' his stock. If XYZ stock rebounded strongly and is trading at $60 on expiration in July, all the call options will expire in the money but as the trader has sold more call options than he has purchased, he will need to buy back the written calls at a loss. Each JUL 45 call written is now worth $1500 but his long JUL 40 call is only worth $2000 and is not enough to offset the losses from the written calls. This means that the trader has suffered a loss of $1000 from the call ratio spread but this loss is offset by the $2000 gain from his long stock position, resulting in a net 'profit' of $1000 - the amount of his initial loss before the stock repair move. Hence, with the stock price at $60, the trader still only achieved breakeven. However, there is no additional downside risk to this repair strategy and losses from a further drop in stock price will be no different from the losses suffered if the trader had simply held on to the shares. If the stock price had dropped to $30 or below at expiration, then all the options involved will expire worthless and so there will be no additional loss from the call ratio spread. However, the long stock position will still take on a further loss of $1000. Note: While we have covered the use of this strategy with reference to stock options, the stock repair strategy is equally applicable using ETF options, index options as well as options on futures. Commissions For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages. However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$8.95 per trade).