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Calculating option risks
Both call and put options have risk that is limited to the initial investment.
This initial investment can vary in size, but is less than the investment required to control the same number of shares of the underlying stock.
Although the risk is relatively smaller in terms of dollars, it’s important to recognize the likelihood that an option will go to zero is much higher than the underlying stock going to zero.
The chance that an option will go to zero is 100%. Remember an option is a limited life security that eventually expires. At expiration, the option value goes to zero.
Call option
A call option provides the buyer with rights to purchase the underlying stock at the contract’s strike price by its expiration date. When the strike price for the call option is below the price for the underlying stock, it will lose time value as expiration nears. Assuming the stock remains at the same price level, this time decay can result in losses for the trader. The losses will be limited because the option retains its intrinsic value.
However, when the stock is trading below the strike price the option’s value is all time value. Assuming the stock remains at the same price level, time value diminishes as you get closer to expiration. Continuing in this manner will result in a total loss of the initial investment.
Most of the time a stock doesn’t stand still, it does that vacillation thing. That means that although there’s a chance the underlying stock will increase in value rising above a call strike price, the stock may also decline in value and fall below the strike price. Once again that puts you in a situation where you can lose your entire investment as expiration nears.
Put option
A put option provides the buyer with rights to sell the underlying stock at the contract’s strike price by its expiration date. The option will lose time value as expiration nears, which can result in losses for the trader when the stock is trading above the option strike price. When trading below the strike price, the losses will be limited because the option retains intrinsic value.
However, when the stock is trading above the strike price the option’s value is all time value. Assuming the stock remains at the same price level, time value diminishes as you get closer to expiration. Continuing in this manner will result in a total loss of the initial investment.
Because the stock has the same chance of rising as falling, there’s a chance the underlying stock will increase in value rising above a put strike price. As a result, you can lose your entire investment as expiration nears.
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Reaping Your Rewards
So with all this stock and option risk, just why do you do it? Because the interest you receive on a regular money market account can often be below the rate of inflation, the only way for your savings to keep up or outpace your expenses in the future is by assuming this risk. You should expect rewards that are better than a money market rate. Both stocks and options provide this potential.
Benefiting from stocks
As a stock holder you can benefit by receiving dividends and/or gains in the price of the stock. This often results when a company’s sales or profits increase, when new products or technologies are introduced, and other countless reasons. There are also approaches that allow you to benefit from downward moves in the stock.
Long stock
A long stock position by purchasing shares of stock in the market. Because stock can continue to exist indefinitely, it can continue to rise without limit.
What ultimately happens is a function of the company prospects and general market conditions. So your potential reward with stock is unlimited.
Not all companies distribute profits in the form of dividends to stock holders.
Many growth stocks retain profits to fuel continued growth.
Short stock
You create a short stock position by reversing the standard stock transac- tion; you sell first with the expectations that the price of the stock will go down. In this situation you profit when you buy the shares back. You com- plete such transactions in a brokerage account that allows margin trading.
The rewards you reap for a short stock position is similar to the risks assumed for a long stock position — it is high, but limited. A stock can con- tinue to decline, but only until it reaches zero. This is the downside limit that caps your rewards.
Call options increase in value when the underlying stock rises while put options increase in value when the underlying stock falls.
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Breaking even with options
A call option provides you with similar profits as long stock while a put option provides you with similar profits as short stock. This makes sense given your rights as an option holder it allows you to buy or sell stock at a set level. There is one slight difference between stock rewards and option rewards; options require an initial premium payment that you must consider when identifying potential gains.
Calculating potential option rewards requires you to add option premiums to call strike prices and subtract option premiums from put strike prices to come up with a price known as the position’s breakevenlevel. A stock must:
Rise above the breakeven for call option profits to kick in Fall below the breakeven for put option profits to kick in
In each case, this results in profits that are slightly less than your stock profits.
A stock’s breakeven point is your purchase price when buying stock or your sell price when shorting a stock. As soon as the stock moves away from this price, you have gains or losses.
Call option
Purchasing a call option gives you rights to buy stock at a certain level. As a result, the option increases in value when the stock moves upward. After a stock moves above your call option’s strike price, the option has intrinsic value which increases as the stock continues to rise. Calls with strike prices below the price of the stock are referred to as in-the-money (ITM).
For a call position you own to be profitable at expiration, it must remain above the strike price plus your initial investment. At this level option premi- ums will minimally equal your cost when you bought the call.
The breakeven for a call option is:
Call Breakeven = Call Strike Price + Call Purchase Premium
After a stock is at the option’s breakeven level, it can continue to rise indefi- nitely. Your call option can similarly rise indefinitely until expiration. As a result, call option profits are considered to be unlimited, just like stock.
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An option’s moneyness is determined by the option type and the price of the underlying stock relative to the option strike price. Call option’s with a strike price that is below the stock price is out-of-the-money (OTM) and its pre- mium is all time value. After the stock moves above the strike price, it is referred to as in-the-money (ITM) and has intrinsic value along with the time value.
Put option
Purchasing a put option gives you rights to sell stock at a certain level. As a result, the option increases in value when the stock moves downward. When a stock moves below your put option’s strike price, the option has intrinsic value which increases as the stock continues to fall. Puts with strike prices above the price of the stock are referred to as in-the-money (ITM).
For a put position you own to be profitable at expiration, it must remain below the strike price minus your initial investment. At this level option pre- miums will minimally equal your cost when you bought the put.
The breakeven for a put option is:
Put Breakeven = Put Strike Price – Put Purchase Premium
When a stock is at the option’s breakeven level, it can continue to fall until it reaches zero. Your put option can continue to increase in value until this level is reached, all the way to its expiration. As a result, put option profits are considered to be high, but limited, just like a short stock.
Call options have risks and rewards similar to long stock while put options have rewards that are similar to short stock. Put option risk is limited to the initial investment. The reason your rewards are similar rather than the same is because you need to account for the premium amount when you pur- chased the option.
Profiling Risk and Reward
Profiling risk and reward means you’re using a visual to get a feel for potential gains and losses for the trade. By doing this you can quickly assess strategies you already trade as well as new ones. Risk graphs orrisk profilesare graphi- cal views of potential risks and rewards in option trading. You can create a generic graph that excludes prices to identify the risks and rewards for any asset type. In addition, you can also create a more specific risk graph that includes stock price levels, with breakeven levels, profits, and losses for a particular position.
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Profiling stock trades with risk graphs
Although risk graphs are more commonly used in option trading, it’s impor- tant for you to get a good picture of stock risk graphs. Such basic profiles simply look at maximum potential risks and maximum potential rewards.
Long stock
The maximum potential risk for long stock is high, but limited to the down- side. This is because a stock can only decline to zero. The maximum poten- tial rewards for a stock position is unlimited because a stock can technically rise without limit.
The long stock risk graph displayed in Figure 4-1 reflects this risk-reward profile.
By profiling the risks and rewards this way for long stock, you quickly see that losses (which are limited to the initial investment amount) accumulate as the stock price declines while profits continue to rise as the stock price rises.
Short stock
The maximum potential risk for short stock is unlimited because a stock can technically rise without limit. The maximum potential reward for a short stock position is high, but limited to the downside. This is because a stock can only decline to zero.
The short stock risk graph displayed in Figure 4-2 reflects this risk-reward profile.
Figure 4-1:
Risk graph for a long stock position.
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The short stock risk graph quickly displays losses that rise without limit as the stock rises and profits that are high, but limited as the stock declines.
Profiling option trades with risk graphs
Basic call and put option risk graphs incorporate the risk and reward for the security, along with the breakeven level. Position specific profiles will include stock prices on the x-axis and profits/losses on the y-axis. The profile also identifies the following:
The option strike price The position breakeven
Although it’s less obvious when you’re viewing generic risk profiles, the main benefit of using options to limit losses can be viewed in these risk graphs.
Call option
A basic call option risk graph is similar to a long stock risk graph with two distinctions:
You need to account for the call option premium in the breakeven level.
Your losses are capped to the downside before a stock declines to zero.
The potential risk for a call option is limited while the potential rewards are unlimited. This is displayed by a generic call option risk graph displayed in Figure 4-3.
Figure 4-2:
Risk graph for a short stock position.
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The call option risk graph provides you a visual of losses that are limited to the initial investment as the stock declines. This amount is much smaller than those for a long stock position. It allows unlimited profits that are simi- lar to a long stock position, but must also account for the call option breakeven level.
Put option
A basic put option risk graph is similar to a short stock risk graph with a couple of distinctions. The second one is extremely valuable if you’re bearish on a stock:
You need to account for the put option premium in the breakeven level.
Your losses are capped with an upside move and are therefore limited.
The potential risk for a put option is limited while the potential rewards are limited, but high. This is displayed by a generic put option risk graph dis- played in Figure 4-4.
Figure 4-4:
Risk graph for a put option position.
Figure 4-3:
Risk graph for a call option position.
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The put option risk graph provides you a visual of losses that are limited to the initial investment as the stock rises. As a trader, you have to prefer this graph to the short stock profile. It also provides profits that are similar to a short stock position which are high, but limited. The put risk graph also accounts for the put option breakeven level.
When you buy a put option, the most you can lose is this initial investment.
Although that’s pretty undesirable, you need to remember that this initial investment is much smaller than a short stock position which is also used when you have a bearish outlook for the stock.
Combining option positions
Many investors use put options as a form of insurance for existing stock posi- tions. You can buy puts for stocks you own, as well as for those you don’t own because holding the underlying asset is not a requirement in the listed option markets.
A combined positionis one that is made up of one of two things:
Stock and options for a single underlying stock Multiple options for a single underlying stock
In addition to creating a risk graph for a single stock or option position, you can also create ones for combined positions. This definitely helps you easily access the reward profile for the position and more importantly, its risk profile.
Trading options with stock
Three basic combination positions for long stock and options include the following:
A married put position A covered call position A collar position
In each case long stock is paired with a long put, a short call, or both to improve the risk and/or reward potential. Similar combination positions can be applied to a short stock position.
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You can hold a stock position and purchase options on that same stock to change the risk or reward profile for the stock or you can hold option posi- tions without holding a position in the underlying.
Trading options with options
There are many combination positions that use multiple options to capitalize on market conditions or improve the risk and/or reward potential. Different market conditions include:
High relative volatility Low relative volatility Sideways stock movement
Directional stock movement (up or down)
After a market outlook is identified, different strike prices and options can be combined to vary risk and reward.
Profiling a combined position
You can draw risk graphs for combination positions by drawing the risk graph for each individual position and overlaying them. You then check to see if the risks or rewards for any one position provide a cap for the unlim- ited or limited, but high risks or rewards for the other position.
This is better understood through example. Figure 4-5 displays the risk graph for a married put position, one that combines long stock and a long put for the same stock.
Figure 4-5:
Risk graph for a married put position.
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In this figure, you create a risk-reward profile that is similar to a long call. By adding the put, you minimize losses for the stock. At the same time, your potential rewards remain unlimited after accounting for the new breakeven point.
Considering the worst-case scenario
Before looking at your potential gains, you must look at the downside if you want to continue trading for any extended period of time. By managing your risk, you stay in the game long enough to master different strategies that are appropriate for changing market conditions. That’s why considering the worst-case scenario is so important — these worst-case scenarios can and will happen during your trading career.
All new traders assume they’ll do the right thing when the time comes — exit a position when their predetermined exit level is reached. But after you’ve been trading awhile you know how hard this seemingly simple action can be.
Never assume you will completely control the emotions you experience when trading. The best traders know that all they can do is manage them.
Start with single position risk graphs
Looking at the worst-case scenario means looking at the lower portion of the risk graph; the one that profiles your losses. After you have a certain stock or market outlook, you can select the position or strategy (i.e. long stock or long call option) that has the most desirable risk graph.
Look to trade strategies that do the following:
Limit losses
Allow unlimited profits
In Chapter 10 I discuss more specific position risk graphs that will make this more intuitive for you.
Improve existing risk graphs
There’s a lot more to cover before exploring advanced strategies using com- bination positions with just options. Throughout the strategy review process, consider those option additions that improve the risk profile first. This can be done by:
Capping losses that are limited but high and even better, Capping losses that are unlimited.
By managing your risk first, you get the opportunity to realize gains.
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Part II:
Evaluating
Markets, Sectors, and Strategies
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In this part . . .
Trading options doesn’t begin by running out to buy a call or put. It’s the culmination of your analysis on the markets, sectors, and the underlying security for your trade. This part provides market assessment methods using breadth and sentiment analysis then moves on to technical analysis of sectors. It also incorporates the options market in this analysis. Because you may be exploring new strategies, you also want to evaluate those strategies in a systematic way to reinforce your under- standing of them while also addressing the unique
characteristics of options, such as trading costs and order placement methods, which I provide in this part.
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