Options for Rookies

Deep in the Money Calls as a Stock Substitute

2009-11-11T10:00:00-06:00

Hello Mark:

I am awaiting your book, but I have read other authors, and I want to use a "Deep ITM" option to buy and control a stock, XYZ, a blue-chip company. This to control the stock at less cost than buying outright, while taking advantage of a near 100% delta relation between shares and option.

My intention is to sell a Covered Call against the shares, just above ATM, with the intent of assigning my shares (those for which I do not yet own, but hold an option) if the holder of my sold option exercises his option. I want to collect the difference in my option strike price and present price of the shares for my account, rather than just exercise my option to close the Call I wrote. Another goal is to own the right to buy my shares at a future time, at today's price, when I will have more cash on hand.

If my Covered Call is assigned, I am delighted. I will wait for another dip in the share price to buy another "DITM" option as above, as I want to own XYZ stock when the price is right.

For the short time I "pass-on" my assignment I would prefer not to have cash on hand.

I am sure this can be done, can you help me with the mechanics. Thanks-Joel

***

Hello Joel,

Options for rookies is primarily an educational blog, so first let me correct some terminology for the benefit of other readers.

When you say: 'assigning my shares,' it should be: 'exercise my options.'

***

Next a discussion, then the mechanics.

1) Good use of a DITM call.

2) If you are assigned an exercise notice, it's a simple matter for you to exercise your DITM call. Even when it's prior to expiration.

3) But, if you want to collect any remaining time premium remaining in your call option, then you simply buy shares and sell your calls. Pay attention to just how much time premium remains and don't ignore the fact that you will have to pay two commissions when you buy shares and sell the call, rather than one exercise fee (not all brokers charge this fee).

Keep in mind that if you are assigned an exercise notice, it's most likely going to be at expiration (or very near), and it's virtually 100% guaranteed that there will be zero time premium in your deep in the money call to collect.

If that's the case, or if the premium is too little to justify any extra commissions, then simply exercise your call to offset the stock you sold when assigned.

4) You have the correct attitude. Being delighted when assigned is the winner's attitude.

***

The Mechanics

1) Enter an order to buy a call spread. The option you buy is (obviously) your DITM option and the one you sell is your slightly out of the money (what you refer to as 'above ATM') call.

Specify the debit for the spread. That means how much cash you are willing to pay. It's important to specify a debit because that makes the order a 'limit' order. DO NOT enter a market order. You can always (ok, at least 99% of the time) pay less for the spread than the price you see on your trader screen.

2) I assume the options both expire at the same time. If that's true, there is no problem.

If the option you buy expires later, that's also not a problem - but from your strategy description, I don't believe that would be advisable.

3) If you are NOT assigned an exercise notice, and the option you sold expires worthless, you must either sell your DITM option, or exercise it and become a stockholder.

There is another choice (buy the calendar spread, moving your long option out one month. If you do this, buy back the call you sold (at a very low price; $0.05) AND sell another covered call that expires in the same month as the new DITM call.

You cannot expect this strategy to work every time, and you will see the options expire worthless more often than prefer to see that happen.

I want to mention, but assume you are aware, that this is a bullish strategy with a limited reward. The potential loss is much larger.

Name that spread: 1 x 3 x 3 spread

2009-11-11T05:00:00-06:00

Covered call alternatives; part V.

I had intended the series that I named 'Covered Call Alternatives' to end with four posts, but received two excellent questions and am reproducing those comments and replies to share with all readers.

I'm looking for a good name for these 1 x 3 x 3 spreads, first described here. Suggestions welcome.

***

Mark,

Thanks for the excellent series! There is just one thing I don't understand. In my own paper plotting, using the example where you write 3 SPY 106/109 call spreads, it's pretty clear that profit decreases as you move through the 106 to 109 range at expiration. This makes intuitive sense, since in that range, you're losing 3 for every 1 you gain. If you instead write 1 call spread, that should result in the profit curve being flat as you move through spread at expiration. Profit is the same at 106 as it is at 109 and every point in between. It picks up again after clearing the upper strike.

So my question is why do your P/L charts show a monotonically increasing profit? I would expect the example using 1 call spread to show the profit curve go flat between the strikes of the spread, and anything with more than 1 call spread should show a decline as we move from lower to upper strike.

Thanks for clarifying,

Rob

The charts are drawn as of the day the trade is made.

As expiration nears, your idea of how the charts should look becomes reality. Thus, if SPY moves higher now, profits grow. Nearer to expiration that is no longer true in the 106 to 109 range.

Why?

NOW, the 106/109 spread does not approach it's full value of $300 until SPY is far past 109. In other words, the spread carries time premium. That's reasonable because the more time remaining, the greater the chance that SPY will again move lower. That's just another way of saying the spread isn't worth the maximum until time is very short or the options are deep ITM. Thus, the single long option has enough delta to overcome losses associated with the three spreads - at this point in time.

At expiration, the 106/109 spread reaches nearly $300 much sooner, and time decay has hurt the value of your long option. Thus, the longer you hold, the less profitable the bad range. But the spread is still good on the big move, never loses money (other than original cost) at any price, and affords excellent protection.

This is just an adjustment, not a cure-all. Thus, it is still necessary to be careful with original iron condor and not allow it to get anywhere near the maximum loss - unless your protection is so good that most of the loss is canceled by the adjustment.

***

Mark,

Thanks for writing these articles. I am new to the blog and really enjoying them.

You mention that this strategy may be a way to adjust an iron condor. Of course, I realize that you could not give specific advice, etc, but what would be the best way to utilize this strategy?

Would you wait until price moved to your short strike, then place the entire trade? Would you trade your original IC with an extra long at the wing, then place the additional credit spreads when price moved to the short strike at the wing?

Thanks again!

Jon

As I say repeatedly, there is no 'best' way because we each have our own needs and comfort zones.

1) I invest by buying insurance before it's needed. For many traders, that's a waste of money.

So I add these spreads when prices are favorable. I BUY the PUT version on rallies. I buy CALL version on dips. I prefer to buy only one or two of these at a time, adding more (only as needed) when prices get better.

Sometimes I go for a better strike price. For example, bought the RUT Jan 620; 640/650 spread earlier. Today I added the 610; 640/650. With RUT lower, I bought a position with better protection at an acceptable price. I cannot recommend prices. You will readily develop a feel for how much you want to spend on insuring your portfolio.

2) Something else I like, that may not appeal to you: adjusting in stages. That means I do an early adjustment before my position is in trouble. Thus, I would adjust a RUT IC when the short is 20 or 30 points OTM. I would buy the strike that is 10 to 20 points OTM and choose an appropriate spread to sell three (or four) times.

3) If you prefer to wait, then I suggest using your risk graph to help you choose which options to buy and sell. You want acceptable risk at a reasonable cost.

One rule that suits me: The option bought should be nearer to the money than your short option. The longer you wait as the stock moves against you, the more the adjustment costs.

4) Many people like owning extra longs at the wing. I do NOT. Repeat: I do not. But if you do, this is an option I suggest buying early - as a separate insurance play. I do not recommend making a 'wing' purchase as part of this 1 x 3 x 3 play.

I want an extra long that will always be good to own, and that includes the time when expiration nears (if you still own position). OTM option lose their power as time passes. They turn into insurance against a disaster only, instead of providing gains or reducing losses in the more common situations.

This isn't a strategy in which you add to wings. This play is to buy an option that affords REAL protection at all times and the cost is reduced by selling the extra spreads - with appropriate strike prices. If you are not sure which strikes work - or just how many to sell - use those risk graphs to give you a good idea of portfolio risk.

Exercising, trading, and investing with options

2009-11-10T05:00:00-06:00

This is Part II. (Part I)

Questions/comments from Scott:

One of the quotes I wrote down from the Options Clearing Corporation states “we usually see options exercised early if the option holder is able to buy below parity."

Years ago, when I was a market maker, whenever I sold stock short, I collected interest on the cash generated. One reason that was a wonderful benefit can be seen when I was able to buy a call option near parity. I would then sell stock short and have a put that was better than free. I would earn more in interest than I had to pay in time premium. Thus, I was guaranteed a profit - just from the interest.And, if the stock ever fell below the strike of the call, that would be even better. The stock drops in value and the calls moves to worthless. An opportunity for extra profit as the stock falls farther. This position, long call, short stock is equivalent to a put. And to get it for free was just great.

Thus, if I bought that call, I would never exercise before expiration. I'd keep the free put.

The world is different today. I don't know if anyone collects interest on short stock, but I doubt it. In fact, many have to pay interest when they borrow shares to sell short. No matter. The point is this: If a market maker can buy calls under parity and then sell stock, there is nothing to be gained by holding the position when it is deep ITM. The free put doesn't have much value and if paying interest to own the position, it's better to get rid of the position and take the profit.

Example: Stock is $80. Buy the Nov 60 call, paying $19.90. Sell stock short at $80, exercise the call and collect the free profit of $10, less commissions. It's these professional traders who occasionally get to buy puts and calls below parity. These are the traders who hedge with stock and then exercise.

This has nothing do to with you or any other individual investor. It's virtually impossible for you to buy options under parity and take advantage of this. But where this affects you is being certain that you do not misinterpret that line from the OCC as a suggestion that exercising such calls is beneficial to you.Unless there is a dividend you want to collect (and often it does not pay to collect it), do not exercise any call option prior to expiration. That's essentially true for puts also, but there is an exception (You own DITM puts and stock. By exercising you eliminate position and save the cost to carry. But you are giving up the upside profit opportunity if stock rallies above strike).

***

Do you have a plan to earn a profit when you buy out of the money calls? What are the details of that plan?

Of course I plan to earn a profit—as to the details of the plan, that is the purpose for reading books and asking questions.

I was referring to the details of the plan. Most, dare I say all?, traders in your shoes buy OTM options and sell them at some point. Holding to expiration kills all the time premium you paid, and that makes it even more difficult to earn a profit. If that's your plan (holding to the end and exercising) that's truly not a good plan. If you are a stock trader, why not be an options trader instead of becoming an options investor?

***

In hindsight, this was not a very good example. I’ll try again: In August I wrote down the options chain for AIB. The stock was selling for $5.25. The premium on the SEP 5 was $0.45. In mid-September AIB broke $9.50 and I could have sold the OCT 10 option for $1.15. Shortly after, AIB fell below $6.00.

Would it have been better to exercise the option or to sell it?

If I exercised the option and sold the shares I would have made ($9.50-$5.45 X 100) = $405 per contract.If I had resold the option I would have made ($1.15 X 100 – original premium of $45) = $70 per contract.

Is the math right?

It would have been better to sell it.Yes, the math is correct. But you were describing the sale of the Oct 10 call. You want to sell the Oct 5 call, which was obviously trading at a much higher price than $1.15. The price would have been at least $4.50 (parity), and perhaps a bit higher.

Suggestion: For clarity it's better to refer to the Oct 5 call, rather than the 'Oct 5 option.'

***

(Describing a put option that is in the money by $5 per share) ...But once again, just sell your option, collecting $5 for the same profit. Why exercise?

What if the option premium is less than $5?

That's one time to exercise the option and sell the shares. Although the bid for an option can be under parity, it only happens when the option is deep in the money.

***

Please, do yourself a big favor. Get a copy of The Rookie's Guide to Options. Read it. All the details are there to help you understand what you are doing when trading options.

I do plan to get a copy of your book.

***

Once again, thank you for the time and thought you put into your replies—it is greatly appreciated.

Scott,

Thanks Scott. When the questions are thoughtful, I'm very happy to do it. You clearly know what you are doing as a trader - but options are still new to you and learning the answers does not come from osmosis. You are making the effort, and that's what it takes.

Good trading.

Q & A. Exercising, trading, and investing with options

2009-11-09T05:00:00-06:00

Scott is continuing a conversation begun earlier.

Below, he has clarified some questions and raised new points that are worth discussing. Link to the above post to read the entire discussion from the beginning.

Mark,

I appreciate the time you took to respond to my questions - questions that after rereading the following day I realized were poorly written. And in reference to a few of your comments, no, I have not begun trading options with real money—thanks for your concern. I’ve done well trading stocks and thought it time to learn about options.

***

Below are pertinent excerpts and my replies. Scott's comments and questions are in bold.

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1) Is your understanding that you can always earn a profit when buying options?

No; I’ve read that more than 75% of options expire unexercised.

The figure about options going unexercised (expiring worthless) is false and misleading.

That 75% (I usually see a higher estimate) number refers ONLY to those options which are still open when expiration arrives. Many - dare I say most? - of the options that have value - have already been closed. That means the original option buyer may have taken a profit or loss, but he/she is unlikely to continue to own that option all the way to expiration. This applies to the sellers as well. Those closed option trades are ignored by those who publicize the statistic you quote. This results in too many people believing the incorrect numbers.

Example: If the open interest is 100, and 80 are closed prior to expiration, that leaves 20. If 15 expire worthless, the figure you see as expiring worthless is 75%, not 15%. The 75% is a statistical lie.

***

I have a question for you: Why are you mentioning the idea that you 'could exercise' the option? Did you 'learn' that exercising is a reasonable choice?

In each source that I’ve read they spend equal amounts of time discussing the two choices available if the underlying stock advances past the strike price: 1) resell the option for a slight profit, or 2) exercise the option and either sell or hold the stock. From what I understand, the second option seems to be more advantageous if my plan is to purchase and own the stock in the long run. With this choice, if I am right I may able to purchase the stock at a slight discount and if I’m wrong and the price plummets, I am only out the price I paid for the option.

Most call buyers do NOT want to exercise a call option and take possession of the shares for the longer term. They prefer to trade the options and earn a profit (or take a loss when necessary). That doesn't mean choosing to exercise is wrong for you, but think about the cost.

Consider this: You can buy stock today at 28. Or you can pay a premium to buy a 3-moth call option with a strike price of 30.

If you buy the call, your downside loss is very limited. And that's good. But, if you are considering exercising the option if it moves past the strike price (and remains there until it's time to exercise), It seems to me that your choice comes down to paying $28 today, or $30 (plus the option cost) later.

There has to be a very good reason why you would not want to pay the reduced price today. One such reason for taking this stance is that you are not going to be bullish on this stock unless it breaks out by trading above 30. You are buying the option because you expect it to rally very quickly once it breaks out. And if it never does that, you don't want to own the shares.

Most investors who plan to exercise a call take possession of stock would benefit by buying ITM, not OTM options. Yes, you can lose more if the stock declines, but if it's your intention to become a shareholder, the purchase price matters.

One more point. I don't consider buying an out of the money option and later exercising - to be buying the stock at a discount. It may be a discount to the price at the time you exercise, but you paid dearly by not buying stock today. This is paying more for the stock than you should be paying.

These are the major reasons that option buyers are not usually interested in buying (or shorting) the shares. Option buyers tend to trade for profits.

Bottom line: Decide why you are buying the options and the best way to achieve that goal, while paying attention to risk.

***

When you own an option, you have the 'right' to exercise. But more importantly, you have the right NOT TO EXERCISE. So once again, I ask, why are you considering exercising the option? Did you read that exercising is to your advantage?

Several sources mention that most options are exercised when they are in-the-money by $0.05 or greater, especially if the buyer believes the underlying stock will continue to rise.

Those sources are referring to what happens when expiration arrives. When discussing exercise choices, omitting that detail is criminal, in my opinion. Almost all options that are in the money (ITM) by one penny or more are exercised - at expiration. Not before. Occasionally an investor may elect not to exercise an option that is barely ITM.

But the point is: They are referring to expiration, and only expiration.

to be continued...

Recent Publications

2009-11-08T10:28:01-06:00

Recently I've published three articles for Investopedia and one for Futures and Options Magazine .

Here are the links:

Costless Collars: Because Asset Allocation is not Enough

Four Reasons to hold onto an option

Trade Smarter with equivalent positions

To Hedge or not to hedge.
Futures & OptionsTrader: Nov, 2009, Vol 3, #11, pp 16-19.