OPTION STRATEGIES PART - 2

OPTION STRATEGIES PART - 2

We will examine four market outlooks with trading strategies corresponding to each:

Bullish -  The expectation of an increase in price. This category has two subcategories:

* Moderately bullish-Although the outlook is for higher prices, the increase is not likely to be dramatic.

* Extremely bullish  - Expecting a dramatic, explosive increase in price (generally anticipated to occur in the short term)

Bearish -  The expectation of a decrease in price. This category has two subcategories :

* Moderately bearish - Although the outlook is for lower prices, the decrease is not likely to be dramatic.

* Extremely bearish - Expecting a dramatic sell-off in the stock (generally anticipated to occur in the short term)

* Neutral (front spread) - Expecting little price movement over a given time period. Neutral strategies enable the trader to make money in a market where prices remain the same or move little.

* Volatile (back spread) - The anticipation that prices will move dramatically, but the direction of that move is not clear.

Our goal in separating our discussion of strategies into the four general categories of bullish, bearish, neutral, and volatile is to provide our readers (after determining your market outlook) with a reference for the potential strategies. This chapter will also discuss risk-reduction strategies for managing an existing stock portfolio.

Spreads

A number of these strategies involve option spreads. You construct a spread by being long an option(s) and being short an option(s) of the same type in the same underlying asset. For example, buying a call and selling another call with a different strike or a different expiration is a spread. Buying a put and selling another put with either a different strike or a different expiration is also a spread. In contrast, buying a call and either buying or selling a put is not a spread. 

Spreads offer the investor an array of strategies for attempting to benefit from almost any anticipated market condition while reducing risk. For example, you can use a spread to take a bull position or a bear position, for selling high volatility and buying low volatility, or to finance the purchase of other options. The degree of risk reduction varies among the different types of spreads. While some spreads have limited risk, others have risks that are comparable to buying the underlying security outright. There are several different types of spreads:

1. Calendar spread (in other words, a time or horizontal spread)-With this type of spread, all options are of the same type and have the same strike price and underlying asset, yet they have different expiration dates. The purchase (sale) of one option has a different expiration date from the sale (purchase) of another. Buying one XYZ March 85 call, for example, and selling one XYZ February 85 call would be a calendar spread.

2. Diagonal spreads-This kind of spread is similar to the time spread in that the options are of the same type and underlying asset; however, the expiration date and the strike prices are different. This time spread uses different strike prices. Buying one XYZ March 90 call and selling one XYZ February 85 call is an example of a diagonal spread.

3. Vertical spread-A vertical spread consists of options of the same type, on the same underlying asset, and with the same expiration date, but these options have different strike prices. Buying one XYZ May 90 put and selling one XYZ May 85 put is an example of a vertical spread.

4. Ratio spreads-A ratio spread is any of these types of spreads in which the number of options purchased differs from the number of options sold. Buying one XYZ July 90 call and selling two XYZ July 95 calls is an example of a ratio spread.

Legging

Several strategies involve three or more options strikes. As a practical matter, you cannot put on these positions simultaneously at reasonable prices. In order to achieve these positions at prices that produce an acceptable risk/reward profile, you must put on the positions in a series of separate trades. This process is called legging. Although the analysis of these specific positions includes a discussion of how to approach legging, we should give you some general comments concerning legging at this point. Until a position is fully legged into, your ability to complete the position at an acceptable price is subject to the risk of changing prices in the positions that you have not yet executed. The key to legging is knowing which order to execute the trades in order to minimize that risk.

To minimize this risk, we look at the supply and demand factor of each building block in the options strategy. Once we determine the supply and demand for each building block, the trader can leg into the position first from the building block that has the most demand and finish the implementation with the building block that has the most supply. This procedure is called legging the hard side first. The hard side is the trade that is the most difficult to put on. If the stock is rising rapidly in price and the trader wishes to purchase the stock, because the stock is rising, this side is considered the demand side.

The demand side refers to what the majority of traders are doing, whether buying or selling. If a stock is rising quickly, we would say that there is demand for the stock-hence, there would be more buyers than sellers. Selling the stock would be easy; because there are many buyers. We would then call this side the supply side. Because buying the stock in a rising market situation is difficult (getting a good price is difficult because of the high demand), we call this side the hard side.Consider the following example of legging the hard side

first. Assume that you are legging into a covered call in which the stock price is rising. Realizing that it will be harder to purchase the stock at a good price than it will be to sell the call, you should buy stock as the first part of the leg. Selling the call would be the easier of the two sides to fill, because the rising price of the stock should increase the demand for the call. If the trader decides to sell the call first in a rising market, he or she is taking the chance that he or she might not be filled on the stock at his or her price.

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When a trader puts on a leg and cannot complete the rest of the position because the price for remaining legs has become unacceptable, the trader is said to be legged out. He or she now has a position that has gone against him or her, and it will be hard to close it without incurring a loss. Some of the option positions that we cover in this book can only be legged into. Do not even bother calling your broker with any fancy spread terminology such as a butterfly or iron butterfly: The market makers on the trading floor will just laugh your broker right out of the trading pit. There is no market maker in the world who will hand over free money, especially to a customer.

Bullish Strategies

Bullish strategies are among the most common strategies that individual investors use, probably resulting from the general view of the market that we acquire through the media and elsewhere is that rising stock prices are good, and falling stock prices are bad. In actuality, your position relative to that market movement-not the movement itself-is either good or bad for you. For example, if you position benefits from a declining market and the market does decline, that is good, while if instead it rallied, that would be bad. Most investors, then, are programmed to buy low and sell high. 

These are bullish investors who want to gain a profit from a rise in value or stock price. In fact, when investors tend to think of bullish strategies, the only thing that typically pops into their head is to purchase stock. To be sure, this strategy is great when the stock rises in price, but when a hefty sum of the investor's capital is committed to the position, this endeavor can be risky: In other words, while long stock purchase is not necessarily the wrong idea, it can be capital intensive and can create risk parameters that the individual investor might not totally understand. 

In this topic, we will show alternatives to purchasing stock, learn how to reduce market directional risk and capital exposure, and discuss the relevance of leverage. The first bullish strategy we will consider is long stock. Because long stock is the most commonly employed strategy and the one with which most traders are familiar, it will offer a good comparison study against the other bullish strategies described in this topic.