Chapter 18 - Bullish Option Strategies Flashcards
What is a bull call spread?
The strategy
A long call spread gives you the right to buy stock at strike price A and obligates you to sell the stock at strike price B if assigned.
This strategy is an alternative to buying a long call. Selling a cheaper call with higher-strike B helps to offset the cost of the call you buy at strike A. That ultimately limits your risk. The bad news is, to get the reduction in risk, you’re going to have to sacrifice some potential profit.
Options guys tips
Because you’re both buying and selling a call, the potential effect of a decrease in implied volatility will be somewhat neutralized.
The maximum value of a long call spread is usually achieved when it’s close to expiration. If you choose to close your position prior to expiration, you’ll want as little time value as possible remaining on the call you sold. You may wish to consider buying a shorter-term long call spread, e.g. 30-45 days from expiration.
The setup
Buy a call, strike price A Sell a call, strike price B Generally, the stock will be at or above strike A and below strike B
Who should run it
Veterans and higher
When to run it
Options Playbook image 1
You’re bullish, but you have an upside target.
Break-even at expiration
Strike A plus net debit paid.
The sweet spot
You want the stock to be at or above strike B at expiration, but not so far that you’re disappointed you didn’t simply buy a call on the underlying stock. But look on the bright side if that does happen — you played it smart and made a profit, and that’s always a good thing.
Maximum potential profit
Potential profit is limited to the difference between strike A and strike B minus the net debit paid.
Maximum potential loss
Risk is limited to the net debit paid.
Margin requirement
After the trade is paid for, no additional margin is required.
As time goes by
For this strategy, the net effect of time decay is somewhat neutral. It’s eroding the value of the option you purchased (bad) and the option you sold (good).
Implied volatility
After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.
If your forecast was correct and the stock price is approaching or above strike B, you want implied volatility to decrease. That’s because it will decrease the value of the near-the-money option you sold faster than the in-the-money option you bought, thereby increasing the overall value of the spread.
If your forecast was incorrect and the stock price is approaching or below strike A, you want implied volatility to increase for two reasons. First, it will increase the value of the option you bought faster than the out-of-the-money option you sold, thereby increasing the overall value of the spread. Second, it reflects an increased probability of a price swing (which will hopefully be to the upside).
What is a bull put spread?
The strategy
A short put spread obligates you to buy the stock at strike price B if the option is assigned but gives you the right to sell stock at strike price A.
A short put spread is an alternative to the short put . In addition to selling a put with strike B, you’re buying the cheaper put with strike A to limit your risk if the stock goes down. But there’s a tradeoff — buying the put also reduces the net credit received when running the strategy.
Options guys tips
One advantage of this strategy is that you want both options to expire worthless. If that happens, you won’t have to pay any commissions to get out of your position.
You may wish to consider ensuring that strike B is around one standard deviation out-of-the-money at initiation. That will increase your probability of success. However, the further out-of-the-money the strike price is, the lower the net credit received will be from this spread.
As a general rule of thumb, you may wish to consider running this strategy approximately30-45 days from expiration to take advantage of accelerating time decay as expiration approaches. Of course, this depends on the underlying stock and market conditions such as implied volatility.
The setup
Buy a put, strike price A Sell a put, strike price B Generally, the stock will be above strike B
Who should run it
Seasoned Veterans and higher
When to run it
Options Playbook image 1Options Playbook image 4
You’re bullish. You may also be anticipating neutral activity if strike B is out-of-the-money.
Break-even at expiration
Strike B minus the net credit received when selling thespread.
The sweet spot
You want the stock to be at or above strike B at expiration, so both options will expire worthless.
Maximum potential profit
Potential profit is limited to the net credit you receive when you set up the strategy.
Maximum potential loss
Risk is limited to the difference between strike A andstrike B, minus the net credit received.
Margin requirement
Margin requirement is the difference between the strikeprices.
NOTE: The net credit received when establishing the shortput spread may be applied to the initial margin requirement.
Keep in mind this requirement is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.
As time goes by
For this strategy, the net effect of time decay is somewhat positive. It will erode the value of the option you sold (good) but it will also erode the value of the option you bought (bad).
Implied volatility
After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.
If your forecast was correct and the stock price is approaching or above strike B, you want implied volatility to decrease. That’s because it will decrease the value of both options, and ideally you want them to expire worthless.
If your forecast was incorrect and the stock price is approaching or below strike A, you want implied volatility to increase for two reasons. First, it will increase the value of the near-the-money option you bought faster than the in-the-money option you sold, thereby decreasing the overall value of the spread. Second, it reflects an increased probability of a price swing (which will hopefully be to the upside).
What is a bullish strategy?
Bullish options strategies are simply policies that are adopted by several traders when they expect to see a rise in asset price. It is essential to determine how much the underlying price will move upwards and the timeframe in which the rally will take place in order to choose the best options strategy.
What is a covered call?
The strategy
Selling the call obligates you to sell stock you already own at strike price A if the option is assigned.
Some investors will run this strategy after they’ve already seen nice gains on the stock. Often, they will sell out-of-the-money calls, so if the stock price goes up, they’re willing to part with the stock and take the profit.
Covered calls can also be used to achieve income on the stock above and beyond any dividends. The goal in that case is for the options to expire worthless.
If you buy the stock and sell the calls all at the same time, it’s called a ”Buy / Write.” Some investors use a Buy / Write as a way to lower the cost basis of a stock they’ve just purchased.
Options guys tips
As a general rule of thumb, you may wish to consider running this strategy approximately 30-45 days from expiration to take advantage of accelerating time decay as expiration approaches. Of course, this depends on the underlying stock and market conditions such as implied volatility .
You may wish to consider selling the call with a premium that represents at least 2% of the current stock price (premium ÷ stock price). But ultimately, it’s up to you what premium will make running this strategy worth your while.
Beware of receiving too much time value. If the premium seems abnormally high, there’s usually a reason for it. Check for news in the marketplace that may affect the price of the stock. Remember, if something seems too good to be true, it usually is.
The setup
You own the stock Sell a call, strike price A Generally, the stock price will be below strike A
Who should run it
Rookies and higher
NOTE: Covered calls can be executed by investors at any level. See the Rookie’s Corner for a more in-depth explanation of this strategy.
When to run it
Options Playbook image 1Options Playbook image 4
You’re neutral to bullish, and you’re willing to sell stock if it reaches a specific price.
Break-even at expiration
Current stock price minus the premium received for selling the call.
The sweet spot
The sweet spot for this strategy depends on your objective. If you are selling covered calls to earn income on your stock, then you want the stock to remain as close to the strike price as possible without going above it.
If you want to sell the stock while making additional profit by selling the calls, then you want the stock to rise above the strike price and stay there at expiration. That way, the calls will be assigned.
However, you probably don’t want the stock to shoot too high, or you might be a bit disappointed that you parted with it. But don’t fret if that happens. You still made out all right on the stock. Do yourself a favor and stop getting quotes on it.
Maximum potential profit
When the call is first sold, potential profit is limited to the strike price minus the current stock price plus the premium received for selling the call.
Maximum potential loss
You receive a premium for selling the option, but most downside risk comes from owning the stock, which may potentially lose its value. However, selling the option does create an “opportunity risk.” That is, if the stock price skyrockets, the calls might be assigned and you’ll miss out on those gains.
Margin requirement
Because you own the stock, no additional margin is required.
As time goes by
For this strategy, time decay is your friend. You want the price of the option you sold to approach zero. That means if you choose to close your position prior to expiration, it will be less expensive to buy it back.
Implied volatility
After the strategy is established, you want implied volatility to decrease. That will decrease the price of the option you sold, so if you choose to close your position prior to expiration it will be less expensive to do so.
What is a combination?
In options trading, a combination is a blanket term for any options trade that is constructed with more than one option type, strike price, or expiration date on the same underlying asset.
What is a diagonal spread?
A diagonal spread is an options trading strategy that combines long and short positions with different strike prices and expirations dates.
What is a long call?
The strategy
A long call gives you the right to buy the underlying stock at strike price A.
Calls may be used as an alternative to buying stock outright. You can profit if the stock rises, without taking on all of the downside risk that would result from owning the stock. It is also possible to gain leverage over a greater number of shares than you could afford to buy outright because calls are always less expensive than the stock itself.
But be careful, especially with short-term out-of-the-money calls. If you buy too many option contracts, you are actually increasing your risk. Options may expire worthless and you can lose your entire investment, whereas if you own the stock it will usually still be worth something. (Except for certain banking stocks that shall remain nameless.)
Options guys tips
Don’t go overboard with the leverage you can get when buying calls. A general rule of thumb is this: If you’re used to buying 100 shares of stock per trade, buy one option contract (1 contract = 100 shares). If you’re comfortable buying 200 shares, buy two option contracts, and so on.
If you do purchase a call, you may wish to consider buying the contract in-the-money, since it’s likely to have a larger delta (that is, changes in the option’s value will correspond more closely with any change in the stock price). You can learn more about delta in Meet the Greeks . Try looking for a delta of .80 or greater if possible. In-the-money options are more expensive because they have intrinsic value, but you get what you pay for.
The setup
Buy a call, strike price A Generally, the stock price will be at or above strike A
Who should run it
Veterans and higher
NOTE: Many rookies begin trading options by purchasing out-of-the-money short-term calls. That’s because they tend to be cheap, and you can buy a lot of them. However, they’re probably not the best way to get your feet wet. The Rookie’s Corner suggests other plays more suited to beginning options traders.
When to run it
Options Playbook image 1
You’re bullish as a matador.
Break-even at expiration
Strike A plus the cost of the call.
The sweet spot
The stock goes through the roof.
Maximum potential profit
There’s a theoretically unlimited profit potential, if the stock goes to infinity. (Please note: We’ve never seen a stock go to infinity. Sorry.)
Maximum potential loss
Risk is limited to the premium paid for the call option.
Margin requirement
After the trade is paid for, no additional margin is required.
As time goes by
For this strategy, time decay is the enemy. It will negatively affect the value of the option you bought.
Implied volatility
After the strategy is established, you want implied volatility to increase. It will increase the value of the option you bought, and also reflects an increased possibility of a price swing without regard for direction(but you’ll hope the direction is up).
What is a married put?
The strategy
Purchasing a protective put gives you the right to sell stock you already own at strike price A. Protective puts are handy when your outlook is bullish but you want to protect the value of stocks in your portfolio in the event of a down turn. They can also help you cut back on your antacid intake in times of market uncertainty.
Protective puts are often used as an alternative to stop orders. The problem with stop orders is they sometimes work when you don’t want them to work, and when you really need them they don’t work at all. For example, if a stock’s price is fluctuating but not really tanking, a stop order might get you out prematurely.
If that happens, you probably won’t be too happy if the stock bounces back. Or, if a major news event happens overnight and the stock gaps down significantly on the open, you might not get out at your stop price. Instead, you’ll get out at the next available market price, which could be much lower.
If you buy a protective put, you have complete control over when you exercise your option, and the price you’re going to receive for yours tock is predetermined. However, these benefits do come at a cost. Whereas a stop order is free, you’ll have to pay to buy a put. So it would be nice if the stock goes up at least enough to cover the premium paid for the put.
If you buy stock and a protective put at the same time, this is commonly referred to as a “married put.” For added enjoyment, feel free to play a wedding march and throw rice while making this trade.
Options guys tips
Many investors will buy a protective put when they’ve seen a nice run-up on the stock price, and they want to protect their unrealized profits against a downturn. It’s sometimes easier to part with the money to pay for the put when you’ve already seen decent gains on the stock.
The setup
You own the stock Buy a put, strike price A Generally, the stock price will be above strike A
Who should run it
Rookies and higher
When to run it
Options Playbook image 1
You’re bullish but nervous.
Break-even at expiration
From the point the protective put is established, the break-even point is the current stock price plus the premium paid for the put.
The sweet spot
You want the stock to go to infinity and the puts to expire worthless.
Maximum potential profit
Potential profit is theoretically unlimited, because you’ll still own the stock and you have not capped the upside.
Maximum potential loss
Risk is limited to the “deductible” (current stock price minus the strike price) plus the premium paid for the put.
Margin requirement
After the trade is paid for, no additional margin is required.
As time goes by
For this strategy, time decay is the enemy. It will negatively affect the value of the option you bought.
Implied volatility
After the strategy is established, you want implied volatility to increase. That will increase the price of the option you bought.
What is a price spread?
An options strategy that involves buying and selling two options on the same security with the same expiration month, but with different exercise prices.
What is a spread?
An options spread is a trading strategy that involves buying and selling two or more options on the same asset, with different strike prices or expiration dates. This strategy aims to limit risk and maximize potential profit by using a combination of options contracts. Common types of spreads include bull spreads, bear spreads, and calendar spreads.
What is a straddle?
An options straddle is a strategy where an investor buys a call option and a put option with the same strike price and expiration date on the same underlying asset. This strategy profits if the asset’s price makes a significant move in either direction.
What is a strangle?
An options strangle is a strategy where an investor buys a call option and a put option with different strike prices but the same expiration date on the same underlying asset. This strategy profits if the asset’s price makes a significant move outside the range defined by the two strike prices.
What is a synthetic call?
A synthetic call option is a trading strategy that mimics the payoff of a call option by combining a long position in the underlying asset and a long position in a put option on the same asset. This setup allows the investor to benefit from potential price increases while limiting downside risk.
The strategies that are available when one is bullish and how to pick strike prices
- The different option strategies available to bullish investors are: long call, married put, covered call, short put,
bull call spread and bull put spread. - The choice of strike prices depends on the extent of an investor’s bullishness
The risk and reward profiles of bullish strategies
- The following table summarizes the risk and reward profile and the break-even price of the underlying stock
(at expiration) of the bullish strategies covered in this chapter.
