OptioNewton

Stock & Option Strategies

Selling calls and puts require the backing of capital, ie it requires stock or cash in the amount to cover the obligation of the sold options contracts. Since, as illustrated in the previous tab, options can provide protection of an existing stock position and the opportunities for success for selling options (if sold properly) are 2 in 3, the logical question might be - can we use this to the trader's advantage? Is there a stock & option combination strategy where the risk of loss is removed or minimized while still maintaining a relatively large upside potential? The answer is yes with a properly selected strategy.

First, since the profitability of trading options is largely a function of the cost of the options premium and they are decaying assets, the goal should be to reduce the cost of the options. We can wait for the time value to decay or we can leg in positions to try to catch the options at their lowest price as the stock gyrates up and down, but these can take time to complete a position. If we want to establish a position immediately and capitalize on time value decay, it seems logical that an element of a stock and option strategy would be selling an option or at worst a combination or spread. We can also lose money if the stock price falls, so another element of the stock and option strategy should be protection for a stock price decline. We don't want to be so protected that we miss a move that would have generated a large profit if we had just held the stock alone. So the strategy needs a long call or a short put to provide some upside if the stock goes up. Let's see if we can start assembling the pieces.

First, we know we have a long stock position (although a strategy could be built around a short stock position as well). Next we want some down side protection. We could write a call or buy a put. The written call would be a credit to the account, would provide an immediate profit, it is a decaying asset (to our advantage) and has a 2 successful events out  of 3 possible outcomes. The put is a debit to the account, is a decaying asset (not to our benefit) and has 1 successful event out of 3 possible outcomes. The written call seems to be the better choice. So now we have a long stock and a written call otherwise known as the buy write (discussed before) which by itself limits the profit on a large move up and although it minimizes the downside over owning the stock alone, the downside protection is limited to the written call premium. So we still might want some more downside protection and of course we want upside profit potential as well. Since we already have a credit for the call write, we could possibly look at buying options which would still provide a net premium much less than buying the options alone. Alternatively, we could short more options enhancing the credit while providing both downside protection and upside potential. However when short options, the profit is limited to the premium and the loss is generally unlimited. The strategies that allow us to profit on down side or up side are straddles and strangles, either long or short. But since the selling of additional options requires more capital, let's check a long straddle.

So we have a buy write and a long straddle. We have a long stock, a written call that provides a credit to the account. A long straddle would be a debit, but is offset by the credit from the written call. The put portion of the straddle provides the additional downside protection to supplement the written call and the call portion of the straddle provides the upside profit along with the long stock. Now we need to know a couple of things - which call to sell and which straddle to buy. We'd like the net premium to be close to zero as possible for a free trade that provide upside profit and ownside protection. The current Call Put chart can help. Using the previous example -

Let's say we buy 100 shares of stock at about the current price of $180. Then starting with which call to write, we'd want one with a most time value that will decay as it approaches options expiration and the least intrinsic value. Also if it goes ITM and is exercised, we don't want our stock to have to be sold for less than we paid for the stock, so an ATM or OTM call should be sold. But further, the goal in the sell of the call is to reduce the price of the purchased long options leg. OTM calls are much cheaper than ATM calls, so let's select the 180 (ATM) call to be sold or written. The time value is high and it has zero intrinsic value at this point so potential profit is all of the time value.

Now for the straddle. (Note the straddle curve shown as the yellow line in the graph.) Since it will be a debit to the account, we want the cheapest straddle. According to the chart, the ATM straddle would be the cheapest, but the purchase of the ATM call portion of the ATM straddle would nullify the written call. The next cheapest straddle would be the lower strike or the higher strike. Since we want protection, the put of the lower strike would give us the right to sell at the lower strike which is not desirable. So let's choose the upper strike straddle at 185.

Summarizing, we have the stock purchased at $180, an ATM written call with a premium of $9.95 and the 185 strike straddle with a premium of about $21.05. The net debit premium is  $21.05 - $9.95 or $11.10. Or another way to look at it is a buy write of $180 - $9.95 or $170.05. Before we run off and execute the trade we should see what the results migth be with various movements in the stock price. For simplification, again the stopping point should be option expiration day when all time values are zero. We'll check the stock price for about a 10% movement in either direction.