TOOLS OF THE TRADE
THE NAKED SHORT PUT
This week we are going to explore the “Naked Short Put”. It is called “Naked” because the position is not hedged. This is a bullish strategy and the potential gain is limited to the credit received. You will notice that the “Naked Short Put” is synthetically equivalent to the “Covered Call”. When placing this trade, your broker will require margin in order to assure that you have the ability to take assignment of stock if necessary. The “Covered Call” with long stock does not require the broker to hold margin because they are covered. If the stock is called away, the stock is available in the account to fulfill the obligation to deliver.
The “Naked Short Put” position possesses the same risk profile as the “Covered Call”. The risk of the position is the short put strike price all the way down to zero. It may be prudent to consider a hedge on the position in the form of a long put below and in the same month as the short put. That position is known as a “Bull Put Vertical Credit Spread”. We will discuss that position at another time.
Please review the “Naked Short Put” and become familiar with its’ risk and reward. Best, Robin
TOOLS OF THE TRADE
THE SYNTHETIC LONG PUT
The inverse of the married put, which was covered last week, is the synthetic long put. The position comprises two trading instruments, 1) short stock and 2) a long call. As you may recall from our discussion of short stock, the trader borrows stock from his/her broker and sells those shares into the market hoping that the share value will decrease. When and if that happens, the trader will buy back (cover) the shares and return them to the broker and in the process will register a profitable trade. As we know from our prior understanding of the short stock position, it is accompanied by substantial risk in that the stock has unlimited upside potential which represents the risk in the position. In order to mitigate that risk, the trader can merely add a long call ‘at the money’ and hedge the upside risk. The resulting position is the synthetic equivalent to that of the long put.
Review the risk graph and you will gain an understanding of the risk and reward of the position. Best, Robin
TOOLS OF THE TRADE
THE MARRIED PUT
The ‘Married Put’ sometimes characterized as the ‘Protective Put’ is a combination strategy that comprises two trading instruments. 1) long stock and 2) the long put. The position is the synthetic equivalent to the ‘Long Call’. In fact, you will notice that the risk graph of the ‘Married Put’ is identical to the ‘Long Call’.
The risk in the trade is equal to the cost of the put and the difference between the stock value and the put strike price. Example- XYZ stock trading at $26.25 with a 25 strike put costing $1.75. The risk in the position is $3.00. ($26.25 stock minus the 25 strike put = $1.25 plus the put cost of $1.75 = $3.00.) In effect, the trader could purchase a long call at a value of $3.00 or less with the expectation of the stock rising and establishing a position that carries a risk/reward that is equivalent to a married put. The risk control in the long call is that the trader is limited to losing only the cost of the long call which is in this example limited to $3.00 or less.
The advantage of the ‘Married Put’ is that stock does not come with an expiration date and if the stock pays a dividend, it can create and additional income. On the other hand, the long call allows the trader to leverage the position because the trader can control shares of stock for less money.
The ‘Married Put’ strategy is a wonderful way to protect the downside risk and reduce the cost basis of the stock when and if the stock should fall. In a way, one could view the ‘Married Put’ as portfolio insurance. If the stock falls for any number of reasons, the trader is guaranteed to be able to sell shares at the long put strike price for as long a period of time as the long put is in effect.
Study the risk graph of the ‘Married Put’ and you will gain insight into the risk/reward of the position. Happy Holidays!! Best, Robin
TOOLS OF THE TRADE
COVERED CALL
This is a combination strategy that is very popular amongst traders and is represented by many to be an ultra conservative strategy. The position has risk and in fact, its’ synthetic equivalent is a naked put. You will see from the risk graph, that the covered call is identical to the short put.
The covered call can be a marvelous strategy if the trader realizes the risk involved in the position. If the trade is left unmanaged, it can be dangerous. The informed trader can do well by following some rules and managing the position from entry to exit. Consider the following suggestions when initiating the covered call:
· Stock selection is critical. Select a stock with enough volatility to offer a decent premium but be skeptical of those stocks offering extraordinarily high short call returns. There is a reason for the high premium and it may foretell a volatile move.
· Initiate the covered call in a neutral to bullish market on a neutral to bullish stock.
· Examine the stock chart and stay away from stocks that have a tendency to gap.
· Only trade stocks that have high liquidity.
· Do not initiate covered calls around earnings or other fixed news events.
· Research the message board for the stock you are considering. You will learn about issues surrounding the stock that are not necessarily in the general news releases.
· Learn to adjust the position if the stock moves bearish and don’t be afraid to close early for a profit.
Study the graph of the covered call and you will gain a strong understanding of the risk/reward of the position. Best, Robin
TOOLS OF THE TRADE
THE SHORT PUT
As discussed last week, short options come with obligations. It is the traders’ obligation if assigned, to purchase the underlying stock at the designated strike price of the short put. The risk in “selling to open” a short put is the strike price down to zero. It isn’t likely that a stock would go to zero within the time frame that most traders typically sell short puts, however, it is possible. The strategy takes advantage of “Theta” (time decay) of the option, so the preferred application of the trade is to sell the put with 30 days or less to expiration. Time decay is very rapid within the last 30 day of the options’ life and it is only necessary for the underlying stock to remain above the strike price of the short put for the trader to profit. Therefore, it is prudent to choose a strike price that is unlikely to be assigned.
The following criteria should be considered when selling puts:
· Sell puts only with 30 days or less to expiration.
· Conduct your due diligence to determine if this is a stock that you would want to own, should you be assigned.
· Do your chart analysis to determine the trading range and support levels of the stock. Select a strike price that is at or below support.
· Do a probability analysis using a probability calculator (which is readily available on the internet) to determine that the position has a high probability of expiring out of the money.
· Consider buying a long put beneath the strike price of the short put as a hedge. Not only will that provide a downside limit to your loss, it will also decrease your margin requirements to initiate the trade.
Examine and study the risk graph and develop an understanding of the risk/reward associated with this trade. Next week, we will begin to explore combination and spread positions. Best, Robin
THE TOOLS OF THE TRADE
THE SHORT CALL
A short option position comes with obligations. When the trader initiates a “sell to open” order he/she is obligated if the option is assigned, to sell shares at the strike price of the short option. When selling calls, it is generally not wise to sell “naked” or uncovered positions because the obligation leaves the seller of the option with a theoretically unlimited risk.
The short call is most commonly used in conjunction with another investment instrument such as a long call in a spread position or in association with a long stock to form what is known as a “covered call”. The short call when used with another trading instrument, be it a long stock or a long call, can reduce the cost basis of the aforementioned stock or call. Many use the short call to create monthly cash flow in a long stock portfolio.
However, it is important to realize that the short call creates some limitations in that its’ presence in tandem with a long stock will limit the upside potential of the stock position. It does, however, provide a limited hedge to the downside.
When selling an option, the premium for that option will appear immediately in the trader’s account and may be used for other investments. It is important to know that even though the premium for selling the option is in the trader’s account, the premium is not necessarily earned. If the trader closes the position prior to expiration, that transaction may either result in a profit or loss depending upon the value of the option at that time.
If the underlying moves swiftly toward the short call option strike yet does not breach the short call strike, the option will likely have increased in value and would cost more to “buy to close” than the premium that was received for the option initially. If the option expires out of the money, the trader will keep the entire premium initially received when it was “sold to open.”
Study the graph and fully understand the risk and reward characteristics of the short call position. We will review the short put next week. Best Robin
TOOLS OF THE TRADE
THE LONG PUT
Graph courtesy of the options industry council
The long put optimizes a bearish trend. You can use this bearish instrument as a standalone strategy to take advantage of a falling stock or you can add it to a stock that you currently own to protect the value of that stock. The aforementioned application of the put is known as a “Protective Put”. The same position but with a bullish expectation is called a “Married Put”. The “Married Put” is used when the trader is primarily bullish on the stock yet wants to hedge the downside in case of an unexpected drop.
There are also a number of spreads and combination plays using the long put which we will cover in future articles. As is so with the long call from last week, the trader’s risk is limited to the cost of the option. In the case of the long put, its’ value increases as the value of the underlying decreases. The amount of the movement of the option in relation to the stock movement is represented by the ”Delta”, which in part is related to the positioning of the long put either ITM, ATM or OTM. The proximity to expiration as opposed to long dated options also has an effect on the delta. We will get into more details on the Delta as well as other “Greeks” in future sessions.
Study the graph to get a firm grasp on the risk/reward of the position. This tool would have saved many accounts this year had the strategy been used to hedge the recent bear market. Next week, we will investigate the “Short Call”. Best, Robin
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