Learn About...

• Option basics: Puts and Calls and what they are

• A variety of option strategies

• Combining option approaches with the Triple Screen Method

• Incorporating option Greeks to embolden option approaches

• Utilizing Implied Volatility to choose between buying or selling strategies

• Low risk spread trades

• Using option straddles to profit from and earnings announcement

• Calculating tomorrows likely trading range from historical volatility

• When to use bull call spread versus bull put spread

• How to repair a stock position gone bad

• Option watch outs for the various strategies

• And much more

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Options: What Are They and How Can the Average
Investor/Trader Profit From Their Use?

by

 Richard W. Miller, Ph.D.

Worden TC2000’s “Sir Technofundamentalist”

- Table of Contents & Excerpt -

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- Table of Contents -

Part I:  The Characteristics of Options

   What are Options?
   Option Premium
   Time Value and Intrinsic Value
   What One Needs to Know About the Greeks
   Implied Volatility and Option Pricing
   A Simple Question about Option Trading

     Part II: Option Strategies

The Option Calculator The Long Call: Speculation or Stock Surrogate
Watch Outs Using the Long-Call Strategy The Long Put: Insurance or Speculation
Watch Outs Using the Long-Put Strategy
The Covered Call: Income and Risk Cushion
Watch Outs Using the Covered Call Strategy
The Deep In-the-Money Covered Call: Income and Risk Control
The Short Put: Buying Stock at Bargain Prices
Watch Outs Using the Short-Put Strategy
Stock Positional Repair Strategy: a Strategy for Large Losses
Watch Outs Using the Positional-Repair Strategy
Spreading for Profits: Income Strategy Modified for Risk Control
Watch Outs Using Spread Strategies

     Part III: More Option Strategies and the TSM Approach with Options

Straddles and Strangles: Expecting Strong Price Move Up or Down?
Watch Outs Using the Straddle and Strangle Strategies
Option Equivalence: Controlling Stock Movement with the Combination of the Short Put and
     Long Call Instead of Owning the Stock Outright
Option Watch Outs: Commissions, 1987 Naked Puts, Liquidity, Deltas, and Bid/Ask
    Spreads
Stop Loss Points for Option Trades
Using Option Approaches in the Triple Screen Method
Using Implied and Historical Volatilities
Calculating Historical Volatility
Using Implied or Historical Volatility to Calculate Price Ranges
Historical Volatility Ration Over Two Time Frames (10-d HS / 100-HS)

 

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- An Excerpt -

       Let me draw two analogies for those of you encountering options for the first time. A call contract is similar to a lease with option to buy in the real estate business. For example, you might lease a home for a year (expiration date) then pay some additional premium up front for an option to buy the house at any time during that year at an agreed upon price (strike price). You, the call option buyer, are betting that the home will appreciate over the next year to be worth more than the strike price. In effect, you are buying tomorrow at today’s price. The call option seller, on the other hand, is receiving a premium today to give up any appreciation beyond the strike price because, to him, it’s extra income today and still a profitable sale tomorrow. Call option contracts for stock work exactly the same way on its underlying stock. Think of the stock as the house.

       A put, on the other hand, acts like an insurance policy for the buyer in much the same way as an insurance policy acts to protect your home. You, the homeowner (put buyer) buy the insurance from the insurance writer (put writer). While you want to protect against a catastrophic loss, the insurance writer (like State Farm) wants to collect the premium for insuring that loss. Back to put options, the seller of the put (the writer of the put) is paid the option’s premium and, for doing so, guarantees the put buyer that he will buy the underling stock at an agreed upon price (the strike price) at any time up to the option’s expiration date. The seller of the put writes the insurance policy for the buyer of the put; the first gets the premium (income), and the second, the guarantee that his stock’s price will not fall below the option’s strike price.

        Typically, people buy puts for two reasons: (1) they believe that the stocks price will fall, and want to bet that way, or (2) they own positions in stocks that they want to protect from the fall (they want to hedge their bet)—a kind of insurance if you will. Others sell puts for income or as a method to buy stocks tomorrow at cheaper prices than would be available today. Calls, on the other hand, give buyers the right, but again not the obligation, to buy your stock up to some specified point in the future at a specified price. Call buyers are most often betting on a price rise in the underlying stock and are leveraging their cost. Sellers again are looking to generate income. If the seller already owns the stock on which he is writing calls, the options are commonly referred to as “covered” calls—perhaps the most conservative of all option plays, and one available in most IRA accounts.

- A Recent TSM Daily Report Example (7/21/05): GOOG "Straddle" -

We currently hold an option position in GOOG that's becoming profitable as the underlying stock takes off to new highs.  With its earning report due on Thursday, GOOG options are becoming more expensive for another reason: because of the uncertainty of its report, option sellers require more to provide insurance for that uncertainty.  In option parlance, its implied volatility (IV) climbs.  GOOG's volatility, for example, stands at 45 percent today, but it was 33 percent one month ago. Over the last 52 weeks it's IV has fluctuated between a high of 71 percent (11/04) and a low of 27 percent (4/05).  The interesting thing is that after GOOG reports on Thursday its volatility will drop with the uncertainty, and its options will become cheaper.  The strangle takes advantage of that roller coaster ride.  Let me emphasize, though, this position isn't for the feint of heart.  I will put on this trade 1/2 hour after tomorrow's open. 

At today's close with GOOG trading at $309.90, one could have sold both the $300 Put for $10.40 a share ($10,400 a contract) and the $320 Call for $11.60 a share ($11,600 a contract).  After the report Thursday, two things will happen:  (1) volatility (price) will drop, and (2) price will move in one direction or the other depending on how GOOG's report matches its expectations.  Today, analysts' expect $1.20 for the quarter, while two services providing so-called "whisper" numbers expect $1.28 and $1.30, respectively. 

The dual option position is called "writing" a strangle because each option leg encircles price.  The following chart shows how one might expect the option position to change after two days and the reporting of GOOG's earnings, i.e., with IV dropping to 35% and time to expiration dropping two days.  Using the Black-Scholes model for option pricing, the benefit of writing the strangle is obvious:  before the report, I'm holding $23,380 per contract and after I can expect to unwind the position at a cost of from $15,680 to $17,480--assumming volatility drops--depending on whether price stays the same ($309.90), goes down ($300), or goes up ($320).  Let's see how it plays out over the next few days.

Trade Comments:  [7/22/05] GOOG reported great earnings last night (7/21] then blew their conference call so its stock tanked in the after hours session.  As expected and forecasted in the above discussion, GOOG's option's implied volatility dropped from 45 percent to 33 percent, while its stock's price dropped to $305.78.  The value of the "strangle" [short the August $290 Put and the $320 Call on 7/20/05 for a Premium of $17.30] fell to $9.70 as a consequence of the volatility change where the position was closed at a profit of +$7.60.  This 3-day trade worked as planned!

Comments or Questions (TSM Service, Methodology, Performance or Your Success Stories)   Here

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