Bear Call Spread: Bear Call Spread vs. Sold Call

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A number of advantages are evident when trading bear call spreads compared to selling calls (naked calls). A bear call spread has considerable lower risk than just selling a call which technically has unlimited risk. The bear call spread has a much better risk vs. reward ration then a sold call option. Selling calls have a number of benefits when combined with shares or portfolios that can help produce income. This strategy is called covered calls and will be in another e-book.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bear Call Spread: Strategy Risks

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It is important to always be aware of the strategy risks. The primary risk when placing a bear call spread is when the share price increases past the sold call option and an ever greater concern is if the share price increases above the bought call option (protection). Since you receive a premium to enter this trade there is a required margin. This margin can increase to as much as 1.2 times your maximum loss. For example if you were risk $5,000 the cash margin required in the account can increase to $6,000 (5000 *1.2) which includes the premium received. So it is important to know your maximum risk and make sure there are enough funds to cover the worst case scenario.

Another risk inherent with selling options is volatility. When you open the bear call spread you want the volatility to be high so you can sell the call options for as much value as possible. Once the trade is placed you want the volatility to drop off and time decay to kick in. So even if the share price stays still but volatility increases the position may not profit in the short-term. Increased levels in volatility mean to close out it will cost more to buy back the sold call option. If the share price increase above the sold put option prior to expiry there is potentially a risk of exercise.

Exercise

The main risk of credit spreads is the risk of being exercised. If the sold call option is exercised it means that you are obligated to sell shares at the exercise price of the sold call option. This can have a negative impact in terms of you have sold shares you do not own which means you need to buy them back at the higher level and therefore locking in a loss on that position. If the share price is above the bought call option (protection) when exercised then you can sell the call option which will reduce the loss from being exercised. It is still not possible to lose more than the maximum risk before entering the trade. Another disadvantage of being exercised is the brokerage on the share sale and purchase so it is a good idea to try an avoid exercise. To avoid being exercised you need to monitor your position and more importantly the delta of the sold call option. If the share price is above the sold call option an indication of the likelihood of being exercised can be identified by the delta. If the delta on the sold call option is above 0.95 there is a chance being exercised. If the delta is above 0.98 then it is necessary to implement one of your exit strategies.

To avoid exercise there are two options. If you think the share price will keep increasing you can close the trade for a loss. If you think you view is correct and the share price will fall from this level and want to keep the position you can roll out to the next month. What this means is you can close the positions you have an open the same position for the next month and do this for no cost or a small credit. Therefore if the share price then decreases below the sold call by the next month you can still make maximum profit. This options is normally recommended unless your analysis, technical or fundamentals, indicate a change is trend or market conditions.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bull Call Spread: Identifying Trades – The Greeks

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Delta

When identifying trades it is essential to look at the delta of the option legs. In particular it is important to calculate the net delta of the bull call spread. The net delta is calculated by the delta of the bought option minus the delta of the sold option. The net delta of a bull call spread will always be positive. The net delta indicates if the share price increases quickly what the value of the bull call spread will be worth. For example, if a bull call spread had a net delta of 0.35, and the share price increased by $1.00, the bull call spread would have increased approximately by 35 cents.

Vega

The volatility affect on a bull call spread is varied. When looking to enter a bull call spread you look to buy an at-the-money call option. The idea is to buy a call which has a relatively low volatility and therefore trading at its theoretical value. The sold call which you are selling out-of-the-money you are looking for as much volatility as possible. So you are selecting an option that is trading a lot higher than theoretical value. This means you receive greater premium for that option and it makes the bull call spread cheaper to enter. A bought call is best purchased when volatility is low but when volatility is high and the call is too expensive a bull call spread is an alternative strategy. This is because the higher volatility on the bought option is offset by the high volatility on the sold option.

Theta

The effect of time decay on this strategy varies with the underlying stock’s price level in relation to the strike prices of the long and short options. If the stock price is midway between the strike prices, the effect can be minimal. If the stock price is closer to the lower strike price of the bought call, losses generally increase at a faster rate as time passes. Alternatively, if the underlying stock price is closer to the higher strike price of the sold call, profits generally increase at a faster rate as time passes.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bull Call Spread: Options Pay-Off Diagrams

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It is essential to understand the option pay-off diagram for the option strategy you are trading. It allows you to know to determine at what share price you achieve maximum profit, maximum loss and break even level at expiry. The bull call spread is made up of a bought call option and a sold call option at a higher strike. When combined it creates a bull call spread. See below for how the bull call option pay-off diagram is constructed. The dotted green line is the sold call and the dashed green line represents the bought call

Bought Call

 

 

 

Sold Call

 

 

 

Bull Call Spread

 

To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 07 5504 2244 or info@totaloptions.com.au

Selection Criteria – Selling Options

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When selling options, there are a number of variables to take into consideration. When you enter a sold call option your outlook needs to be that the share price will stay still or fall. Conversely, when you enter a sold put option your outlook needs to be that the share price will stay still or increase. Your objective is to sell time and you profit from your positions time decay. Also you can sell options when the volatility is high and expected to decrease throughout the trade. Your risk profile will determine whether you sell out-of-the-money calls for lower returns and lower risk at-the-money calls to receive more premiums with higher risk of exercise. Before placing any trade you must make sure there is enough open interest and volume through the options so liquidity is not an issue.


To receive ASX Option Recommendations or to learn more about trading options please request the complete Introduction to Options Trading eBook by contacting us on 07 5504 2244 or info@totaloptions.com.au

Why Trade Options?

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Why Trade Options?

Leverage

Options are an investment product used for its leveraged nature. Many traders turn to options because they can start investing with just a fraction of the money that would be required to trade the underlying asset. Trading in options can allow you to benefit from a change in the price of the share without having to pay the full price of the share. The option premium you initially pay is your maximum risk. A bought call option also has potential unlimited returns. The risk vs. reward characteristic of buying options is the primary reason traders use options.

Flexibility

Options can be used for a number of different objectives. Portfolio managers use options to insure or hedge their portfolios. Traders use options to take advantage of market conditions that can not be traded with just the underlying share. If you can accurately analyse the direction of the underlying share, there is an option strategy that you can use to make a profit. These strategies can profit whether the underlying shares goes up, down or sideways. This is exactly what this seminar series will teach and is the reason I trade options.

Share Portfolio Management

Options can allow you to build and manage a diversified share portfolio. You can use options to either buy or sell shares. If a sold put is exercised you are obligated to buy shares. Additional income can be generated by selling calls. If a sold call is exercised you are obligated to sell the shares at the exercise price. Options can also be used as a form of risk management. Bought put options allow you to hedge against a possible fall in the value of shares you hold. This can be considered similar to taking out insurance against a fall in the share price.


To receive ASX Option Recommendations or to learn more about trading options please request the complete Introduction to Options Trading eBook by contacting us on 07 5504 2244 or info@totaloptions.com.au

Covered Calls – Monitoring Trades

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The share price increases this is great for your trade and there are three things you can do:

1. Do Nothing

2. Roll out sold call for a small credit to avoid unwanted option exercise

3. Wait to be exercised and lock in profit

The share price falls there are a number of different things you can do with the covered call position:

1. Do Nothing

2. Close out of entire position sell shares and buy back sold call

3. Buy back sold call

  • This will be bought back at a lower price and therefore locking in a profit.

4. Protect Capital

  • Buy a put option to if you think the share price will continue to fall
  • This will reduce the risk of the trade significantly
  • More information on protecting shares from a fall can be requested.


To receive ASX Option Recommendations or to learn more about The Covered Call or The Buy – Write Option Strategies please request the Covered Calls eBook by contacting us on 07 5504 2244 or info@totaloptions.com.au

Covered Call – BHP Covered Call Recommendation

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Covered Call Example:

In January bought 1000 BHP at $30.00 currently held in the portfolio

Current BHP Share Price at 9/02/2009 is $33.50

Trade:

Sell 1 BHP Feb 3400 Calls @ 150

Option Premium Received: $1.50

Total Premium = $1.50 *1 *1000 (1000 shares per contracts)

= $1,500

That is (1500/3350) 4.4% return for the month

Maximum Profit

Option Premium received = $1500

Profit on shares = $34.00 – $30.00

= 4,000

Total profit = sold call premium + profit on shares

= $4,000 + $1,500

= $5,500

Maximum Loss

The maximum loss is the same as purchased shares which is unlimited.

Breakeven

The breaks even on the share purchase have decreased by $1.50. Therefore they have decrease from $30.00 to $28.50.

Technical Analysis

The BHP share price was overbought with the stochastic crossing over. This is shown in the green circle below. The share price was also above its upper Bollinger Band indicating volatility in the call options would have been high. BHP also has heavy resistance due to its trading range at $33.00. For these reasons I am comfortable selling a call on BHP.

Scenario 1 – BHP above $34.00 at expiry

Result:

This would mean the option is exercised at expiry.

  • 1000 shares would be sold at $34.00
  • Total Return of $1500 or 4.4% for the month.
  • Return on trade of $5,500.
  • Equivalent to selling shares at $35.50 (exercise price + premium received)

Scenario 2 – BHP below $34.00 at expiry

Result:

This would mean the options expire worthless.

  • Total Return of $1500 or 4.4% for the month.
  • Would look at selling another call for March to generate income
  • Lower breakeven to $28.50 so sell a call above that level
  • If your view on BHP is negative either exit trade by selling shares or buy a put option as protection.

To receive our ASX Option Recommendations or to learn more about The Covered Call or The Buy – Write Option Strategies please request the Covered Calls eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Options Greeks: Finding Option Trades

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Options Greeks

Delta

The delta of the covered call strategy is always positive. This is because the delta of the shares is 1 and therefore if the share price increases by $1.00 so does the profit. The sold call has a negative delta between 0 and 1. The further out of the money the option is sold the more positive the delta is and the more bullish the strategy is. It is also important to watch the delta of the sold call to avoid exercise.

Vega

The aim when selling calls is to sell volatility and time. The covered call strategy is best implemented when the implied volatility is high. You can then sell calls and receive a premium. Once the call has been sold you want the volatility to decrease. This means that if you close out the sold call it will be cheaper to buy back and lock in a profit on the sold call. To identify high volatility there is more information in the Technical Analysis section which can be requested.

Theta

The covered call strategy is designed to profit from selling time. In Topic 1 – Introduction to Options Trading eBook I outlined how time decay affects the option price. This strategy profits from the rapid decay of an options in the last month. Therefore with this strategy the aim is to continually sell one month options to take advantage of time decay.


To learn more about The Covered Call or The Buy – Write Option Strategies please request the Covered Calls eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

The Psychology behind Covered Calls

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The share price outlook when selling a call over existing shares is neutral to slightly bullish. The aim is the sell call options when volatility it high and expected the volatility to decrease. At the same time, the investor enjoys the benefits of underlying share ownership, such as dividends and voting rights, unless they are assigned an exercise notice on the sold call and are obligated to sell the shares.

In theory, if the investor believes the share price has reached a temporary peak (resistance level), selling covered calls gives them some protection against a pullback in the share price. The premium received compensates for the temporary fall in the price of the share.


To learn more about The Covered Call or The Buy – Write Option Strategies please request the Covered Calls eBook by contacting us on 1300 368 316 or info@totaloptions.com.au