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Review options premiums with various expiration dates and strikeLong Put Road Map In order to place a long put, the following 13 guidelines should be observed: 1. Look for a low-volatility market where a steady decrease in price is anticipated. 2. Check to see if this stock has liquid options available. 3. Review options premiums with various expiration dates and strike prices. Use options with more than 90 days to expiration. 4. Investigate implied volatility values to see if the options are over priced or undervalued. Look for options with low implied volatility. 5. Review price and volume charts over the past year to explore past price trends and liquidity. 6. Choose a long put option with the best profit-making probability. De termine which option to buy by calculating: Limited Risk: Limited to the initial premium required to purchase the put option. Limited Reward: Limited to the downside as the underlying stock can only fall to zero. Breakeven: Put strike - put premium. 7. Create a risk profile for the trade to graphically determine the trades feasibility. The profit/loss line slopes up from right to left. 8. Write down the trade in your traders journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade. 9. Make an exit plan before you place the trade. Determine a profit and loss percentage that will trigger an exit of the position. Close out the entire trade by 30 days to expiration. 10.Contact your broker to buy the chosen put option. A margin deposit isnot required. 11. Watch the market closely as it fluctuates. If the market continues to fall, hold onto the put option until you have hit your target profit or a reversal seems imminent. 12. If the underlying market gives a dividend to its stockholders, this will have a positive effect on the price of a put option because a dividend usually results in a slight decline in the price of a stock. 13. Choose an exit strategy based on the price movement of the underly ing stock and the effects of changes in the implied volatility of the put option: The underlying stock falls below the breakeven: Either offset the long put by selling a put option with the same strike and expiration at an acceptable profit or exercise the put option to go short the underlying market. You can hold this short position or cover the short by buying the shares back at the current lower price for a profit. The underlying stock rises above the breakeven: You can wait for a reversal or offset the long put by selling an identical put option and using the credit received to mitigate the loss. The most you can lose is the initial premium paid for the put. 2. Check to see if this stock has liquid options available. 3. Review options premiums with various expiration dates and strike prices. Options with less than 45 days to expiration are best. 4. Investigate implied volatility values to see if the options are over priced or undervalued. Look for options with high implied volatility, and thus a higher premium. 5.Review price and volume charts over the past year to explore pastprice trends and liquidity. 6. Choose a short put option with the best profit-making probability. Determine which put option to sell by calculating: Limited Risk: Limited to the downside below the breakeven as the underlying stock can only fall to zero. Limited Reward: Limited to the initial put premium received as a credit. Breakeven: Put strike - put premium. 7. Create a risk profile for the trade to graphically determine the trades feasibility. The risk graph slopes down from right to left, showing a limited profit. 8. Write down the trade in your traders journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade. 9. Make an exit plan before you place the trade. Determine a profit and loss percentage that will trigger an exit of the position. 10. Contact your broker to sell the chosen put option. This strategy requires a margin deposit; the amount depends on your brokers discretion. 11. Watch the market closely as it fluctuates. If the price of the underly ing stock falls below the short strike price, it will most likely be assigned. If exercised, the option writer is obligated to purchase 100 shares of the underlying asset at the short strike price (regardless of the decrease in the price of the underlying stock) from the option holder. 12. If the underlying market gives a dividend to its stockholders, this will have a negative effect on the price of a short put because a dividend usually results in a slight decline in the price of a stock. 13. Choose an exit strategy based on the price movement of the underly ing stock and the effects of changes in the implied volatility of the put option: The underlying stock continues to rise or remains stable: Wait for the option to expire worthless and keep the credit received from the premium. The underlying stock reverses and starts to fall: Exit the position by offsetting it through the purchase of an identical put option (same strike price and expiration date) to avoid assignment. Covered Put Road Map In order to place a covered put, the following 13 guidelines should be observed: 1. Look for a range-bound market or bearish market where you antici pate a slow decrease in the price of the underlying stock. 2. Check to see if this stock has options. 3. Review put option premiums and strike prices no more than 45 days out. 4. Explore past price trends and liquidity by reviewing price and volume charts over the past year. 5. Investigate implied volatility values to see if the options are over priced or undervalued. 6. Choose a lower strike put no more than 45 days out to sell against short shares of the underlying stock. 7. Determine which trade to place by calculating: Unlimited Risk: The maximum risk is unlimited to the upside above the breakeven. Requires margin to place. Limited Reward: The maximum profit is limited to the credit re ceived from the sale of the short put option plus the profit made from the difference between the stocks price at initiation and the short put strike price. Breakeven: Calculated by adding the short put premium to the price of the underlying stock at initiation. 8. Risk is unlimited to the upside as the underlying asset rises above the breakeven. Create a risk profile for the trade to graphically determine the trades feasibility. 9. Write down the trade in your traders journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade. 10. Choose your exit strategy in advance. How much money is the maxi mum amount you are willing to lose? How much profit do you want to make on the trade? 11. Contact your broker to sell the stock and sell the chosen put option against it. Choose the most appropriate type of order (market order, limit order, etc.). This strategy will require a large margin to place, depending on your brokerages requirements. 12. Watch the market closely as it fluctuates. The profit on this strategy is limited. Keep in mind that an unlimited loss occurs if and when the underlying stock rises above the breakeven point. 13. Choose an exit strategy: The price of the stock falls below the short put strike price: The short put is assigned to an option holder. You can then use the 100 shares you are obligated to buy at the short put strike price to cover the original short stock position. This scenario allows you to take in the maximum profit. The price of the stock rises above the short strike, but stays below the initial stock price: The short put expires worthless and you get to keep the premium received. No losses have occurred on the short stock position and you are ready to place another short put position to bring in additional profit on the short stock position if you wish. The price of the stock rises above the initial stock price, but stays below the breakeven: The short stock position starts to lose money, but this loss is offset by the credit received from the short put. As long as the stock doesnt rise above the breakeven, the position will break even or make a small profit. The price of the stock rises above the breakeven: Let the short put expire worthless and use the credit received to partially hedge the increasing loss on the short stock position. CONCLUSION Having been involved in teaching options strategies for more than a decade, Im still amazed by the lack of knowledge pertaining to what I believe is the most flexible investment vehicle available: the option. The number one question I receive from publications, individual investors, and almost everyone I meet is: Why should anyone trade options? After all, options are so risky. This line of reasoning makes me cringe. Its obvious that educators, brokers, and the overall investment community simply havent done a good enough job informing investors of the benefits of trading options. Yes, there are risks if you havent taken the time to learn how to trade options. But that goes for stocks, too! Knowledge is power. In my opinion, every trader should attain enough knowledge to be able to make informed decisions about whether to include options as part of their investment arsenals. The initial eight strategies covered in this chapterlong stock, short stock, long call, short call, covered call, long put, short put, and covered putare the fundamental building blocks of intermediate and advanced trading techniques. It is absolutely essential to your success as an options trader to develop a solid understanding of these basic strategies. Your knowledge level is what will ultimately determine how successful you will be. The primary reason that beginning traders do not last is because they do not educate themselves enough. The more knowledge you have in your field, the more confidence you have, and that will inevitably enhance your trading results. I am still learning and trying to increase my trading savvy on a daily basis. This is the type of hunger for knowledge that you need to havenot only to thrive, but also to survive in the volatile markets of the twenty-first century. Covered calls are the most popular option strategy used in todays markets. If you want to gain additional income on a long stock position, you can sell a slightly OTM call every month. The risk lies in the strategys limited ability to protect the underlying stock from major moves down and the potential loss of future profits on the stock above the strike price. Covered calls, however, can be combined with a number of bearish options strategies to create additional downside protection. While covered calls are a very popular strategy, covered puts enable traders to bring in some extra premium on short positions, but with high risk involved. Once again, you can keep selling a put against the short shares every month to increase your profit. However, shorting stock is a risky trade no matter how you look at it because there is no limit to how much you can lose if the price of the stock rises above the breakeven. There are many other ways to take advantage of a stocks bearish movement, using options to limit the trades risk and maximize the leveraging ability of your trading account. In fact, we will cover 19 additional strategies in this book. Covered writes also enable traders to weather moderate price fluctuations without accumulating losses. This should help reduce stress; any technique that helps to reduce stress is a worthwhile addition to a traders arsenal. To gain added protection, try buying a long put against a covered call or a long call against a covered put. The extra outlay of premium acts as an insurance policy, and that could mean the difference between losing a little on the premium versus taking a heavy loss in a volatile market. |
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