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.

A simple way to create stock and option combination strategies is to replace the long calls of any of
the strategies with long calls in them in the previous section with 100 shares of stock for every call.
This will reduce the overall premium of the trade, because there is no time value in buying stocks,
but it will also increase the risk, because with stocks you can lose the entire principal. However, this
can be limited if there is a protective element for the stock in the strategy. We can also reason our
way through to build a stock and option strategy from scratch and see what we come up with. It could
quite easily turn out to be one of the above.

First, since the profitability of trading options is mostly 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.

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 -

(Click on the images to enlarge, click on the back arrow to return to this page.)

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.
Copyright 2010 OptioNewton. All rights reserved.
Web Hosting by Yahoo!
Custom Search