The Long Put Option

I said in my last posting that we’d move on from there to a discussion of two technical analysis tools that I and many others use in option trading.  We’ll do just that as soon as I finish up this and the following segment on puts.  

Owning a put, meaning you are long the put option, gives you the right, but not the obligation to sell 100 shares of the underlying for each option contract you own at the strike price before the option expires.  A long put gives its holder downside protection or profits with limited risk.  In fact, the only risk a put holder has is loss of the option premium paid when the put was acquired.

The strategy behind buying a put is straightforward.  You believe that the stock or underlying will decrease in value below the strike price by more than the premium paid before the option expires.  By analogy to owning a call option, that means you have to be correct on both the minimum decrease in the value of the underlying and the time in which the strike price level and below can be achieved.

Let’s look at an example based on yesterday’s close.  I think that FDS is overpriced at its Friday close of $37.79.   I am concerned that diminishing volume in the markets will put great pressure on brokerages and financial firms and that they will cut services, such as those provided by FDS in an attempt to shed expenses.  By the way, my use of FDS or any other stocks, as examples in this workshop, is for educational purposes only and is not a recommendation to buy, hold or sell these stocks. 

As noted, FDS closed at $37.79 yesterday and I think it is likely to go lower.  If I short the stock, I have considerable risk if the share price suddenly increases, for example if another company makes a tender offer at a significant jump over current levels to $50 a share or FDS makes a surprise announcement of a high, unexpected earnings increase.  A leap in share price to $50 would cost me more than $1200 not counting costs if I bought back the shares at the tender price or at the level reached after the overnight earnings announcement.  On the other hand, if I bought a put, my total risk is the cost of the put premium and nothing more permitting me to patiently wait until expiration for the stock to tank as I’ve predicted (my humility knows no bounds). 

As with call options, I like to submit limit orders and I am quite content to miss an opportunity, even if the difference is only a couple of cents, rather than buy an inflated put.  Again as with calls, I almost never buy or sell put options at the market.  Further, I don’t trade any type of option in the first hour or so after the open.  Things have not settled down much before 10:30 a.m., pricing is spotty and it’s likely you’ll do better later in the trading day when a consensus on the market is agreed on by traders.  If you think about it, this also means I don’t use good-til-cancelled option orders because I don’t want to be filled during the first hour or so, the so-called “amateur hour,”  after the open.  

The April 35 FDS put carries a $2.50 premium or $250 per contract.  That means I won’t profit on this option unless the stock drops below $32.50.  I’d be paying $250 plus costs for this put.  I think my chances are better if I buy more time, but the June premium for a 35 FDS put is $4.40.  If I was really convinced that FDS was likely to tank by the June expiration date, this would be my put option of choice to buy.  I think the balance between cost and additional time for my expectations to work out is worth the $1.90 premium difference.

Another use for a put is to buy insurance for downside protection when a stock is purchased.  I’ve never done this, but I know lots of folks who do this to limit risk.  This is known as a “married put,” a situation in which the put option is married to the underlying stock.  An investor who uses the married put strategy wants to own the underlying stock and protect his investment in that stock while limiting negative results.  Such an investor will usually buy sufficient put contracts to equal the number of 100 share lots owned.  Keep in mind that it’s nice to have the downside protection, but a married put, like normal insurance, isn’t free.  It’s your choice, your money and your degree of risk aversion at stake, but having something like a married put available is, pun intended, a nice option to have.

In the case of FDS I’ve completed a stock study in order to form my basis for buying the put I’ve described if I think that’s the appropriate strategy.  I also use other strategies, like technical analysis, to help me make option decisions. 

Next, selling put options.

Saul…

The Collar

Okay, so I lied a little.  I previously said that I wasn’t going to cover any exotic options (defined for our purposes as a trade having more than two option legs), but I think on reflection that you should know a little about the option strategy known as a collar as it may be useful to you even if you don’t want to play in the option sandbox on a regular basis. 

As you will recall, in the discussion on covered calls, I noted that the greatest risk in a covered call is the situation where the underlying stock takes a significant drop.  Well, some option traders who are content to limit their profits a little more than in a covered call position, establish that position and also buy a protective put so they also have downside protection.  For that reason, the collar is also known as the protected buy-write (buy the stock and write or sell the call, often done simultaneously). 

In certain cases, the trader can even enjoy a “riskless” trade or a trade close to that, which sounds great, but limits upside potential in the underlying in exchange for downside protection.  The potential returns from a collar aren’t likely to make you “Trader of the Year” although slow and steady ain’t bad as the hare learned from the tortoise. 

Finally, a collar can also be used in the situation where you already own a stock on which you have enjoyed an excellent return (not too many positions like this around in the current market although it’s possible), but for which you fear a possibly significant price drop.  Let’s say you want to hold the stock longer (1) for tax purposes (push the sale into next year), (2) because you think the stock will drop to form another base before going even higher, (3) you want to establish a covered call position and are willing to pay for downside protection or (4) there’s a big event on the horizon (like buying a house) and you want to hold the position until it’s nearly time for closing on the new home.  In any of these cases, you can simply hold on to the stock or write the covered call without establishing a collar, but if you’re wrong and the stock heads south and stays there, you’ll wish you had out a collar in place.

Conceptually, the collar isn’t difficult to understand.  Let’s say you already own a 300 shares of Factset Research, which closed yesterday at $37.79.  For any of the above reasons, you want to establish a collar that will protect you for three months (longer if it’s for tax purposes).  Here’s how it would work.   

The June 40 call premium for FDS closed on March 13th at $3.10 per contract.  Assume you own or will buy FDS at the above closing price, you can sell three calls and take in $930 less costs.  You can then buy three June 30 puts (I’ll be covering puts shortly) at a per contract premium cost of $2.80 or a total of $840.  Your net result on selling the calls and buying the puts nets you $90. 

In summary, you can profit on a rise in share price of FDS up to $40 per share and have protection against loss once FDS gets to $30 a share.  If FDS does drop below $30, you absorb the loss between current price ($37.79) and the put strike price ($30).

At expiration, if the stock stayed below 40, the calls expire worthless and you keep the stock and the call premium. If the stock price rose above 40, your 300 shares of FDS will be called and the puts will expire worthless.  You get paid $12,000 for your FDS stock and keep the call premiums. 

If FDS drops no further than to 30 at expiration, the calls expire worthless as will the puts.  However, if your worst fears are realized and FDS drops below 25, your put options will rise dramatically in value, sufficiently to offset the difference in share price between 30 and what the price at expiration will be, thereby saving you $5 or more per share.  In other words, you’ll be able to sell your FDS stock no matter what price it drops to before expiration.  You become a self-insurer for the drop in price from $37.79 to 30, less the net premium of $90 you received.

You may ask why I didn’t buy a higher strike price put to protect myself further.  Well, it’s that old factor of cost and the tradeoff between risk and reward.  The FDS June 35 put premium is $4.40 per contract.  Buying these puts instead of the June 30 puts will cost $390 or $1.30 per share more than the premium revenue from the call option, meaning your protection doesn’t effectively kick in at 35, but instead will only protect you from $$33.70 a share on down.  This is due to the net cost of the option premiums when buying a put having a higher premium cost.

Note that in either case, for the example collars, you have established a zone of protection with a top and bottom limit.  The collar, as previously noted, is primarily a defensive strategy although it is used by some option traders as a profit motivated, low risk option trading strategy using LEAPS (Long-term Equity AnticiPation Securities) on underlying stocks that have high volatility.  I have never been tempted to try the LEAPS implemented version of the collar.  By the way, LEAPS (also to be covered at a later point in the workshop) are long range options that expire more than a year away. 

I don’t often use collars because I am not overly concerned with downside protection based on my selection criteria for writing covered calls and a collar gives up revenue due to the cost of protective puts.  However, given what has happened in the market over the past year or so, I will admit to holding a couple of positions for which a collar would have been wonderful to have in place . 

I’ve only received a few questions so far and I suspect that at least a few of you have questions you may still be reluctant to ask.  Please don’t be shy, ask away because others may have the same questions and are probably shyer than you are .  School is taking its spring break for me next week so I’ll have a little bit of extra time, when I can break away from grading mid-terms, to answer your questions.  Now is the best time for that!

Next, we’ll take a look at LEAPS and ETFs and how they can be used by a conservative option investor.   

Saul…

Karen asked when speaking about the interest rate automatically filled in by the option calculator at TradeKing -

"Do you think it is looking for the long term risk free rate?"

Yes, I'm guessing this is the rate the calculator finds.  I can find out one of these days and let you know if it's of importance to you.  I don't pay a lot of attention to the interest rate since I don't trade options based on my own premium calculations.  It's one of the factors involved, but is probably the least important to the premium calculation.  Volatility is the main man in that respect!

Saul...

Hi Miriam,

We are away for the weekend and while I do have limited access to the Internet, it's not great.  I am also away from my desktop computer and my library so I don't have access to all the data and information I need to answer your questions.  However, I will send you a complete response once I get home on Sunday evening.

As far as technical analysis is concerned, I did a workshop about 18 or so months ago on Manifest Investing.  You are a member and so someone there can show you how to access this material if you can't find it.  I think it was in the Continuous Classroom.  I have a book in mind for you on TA, new edition just came out, and will forward that info to you once I get home.

As far as Point & Figure is concerned, the acknowledged leading expert in the US is a Virginia based analyst named Tom Dorsey.  His books on this subject are considered to be the best sources of information on the point and figure methodology.  Well, I was also involved in a review of Dorsey's point and figure book at the Investing for Growth forum, formerly the NAIC Growth Forum.  This is a free forum, but you do need to establish a user ID and password.  I'll send you further information on this once I get home.  I use point and figure charting a lot, but it's not in widespread use so it's hard to get someone to work along with.

Talk to you soon.  Have a great weekend and thanks for your questions.

Saul...

Sorry, but I got off track a little.  What follows this installment of the workshop will be material on the use of Bollinger Bands and RSI for option trading.  Then I'll cover LEAPS and move on to how record keeping for options, follwoed by an istallment on how option revenue is  treated for tax purposes.  Finally, I'll do a summary of the workshop and answer any questions you may have. 

Bollinger Bands

Trading bands or envelopes of various kinds have been around the technical analysis world for many years.  Trading bands are formed by plotting lines, based on a characteristic of an underlying, above and below price results, to define envelopes that offer clues to future developments and overbought/oversold levels.  Bands have been used to identify market or stock cycles, future price movements and volatility for many years.

In the late 70s, John Bollinger came up with an innovation in trading bands, while trading options and warrants.  Bollinger decided that volatility bands should be a key variable of a band based system and picked an upper and lower band limit of two standard deviations sandwiched around a 20 day moving average.  As data is added each day or tracking period, the changing standard deviations plot bands around the moving average. It is the bands that move with price changes, not price with band movement although it certainly looks that way.

Note that different moving averages can be used for shorter or longer moving averages, which necessitates slight changes in the standard deviation used.  I rarely change these metrics and use the two standard deviation and 20 day moving average pretty much all the time.

Bollinger Bands widen as prices become more volatile and narrow when prices consolidate or generally move sideways.  The narrowing of the bands suggests, but doesn’t guaranty, a fairly sharp breakout or expansion of the bands.  However, the direction of the breakout is undefined.  The longer the period of consolidation and that of the narrow bands, the more likely it is that the breakout will occur.

The 20 day moving average is representative of an intermediate term trend and has been vetted over almost 30 years of use as appropriate and effective.  The plus and minus two standard deviation Bollinger Band envelope captures about 95% of the price action.  Since volatility is a key, if not a critical component of option premium pricing and activity, I have found that standard Bollinger Bands have a natural rhythm that helps in trading options when used as further described in this and the next workshop installment on the RSI indicator. 

A StockChart.com candlestick chart for Pfizer (PFE) with an overlay of Bollinger Bands is shown at http://tinyurl.com/c7edo4.  Note the band undulations as price and volatility change over time.  This chart also shows a band narrowing in the middle of January (top, center portion of graph) which is followed by a widening of the bands with a breakout to the downside.  Lastly, please note for our purposes that once the price line, in this case it’s the candlesticks, touches or pierces the upper or lower band, it may hug the band being pierced or touched for a short time or for a longer duration. 

Here’s another example of Bollinger Bands using Johnson & Johnson (JNJ) as a stock of interest; see http://tinyurl.com/copthv.  The band narrowing in the JNJ chart that occurred in the middle of January was followed by a good sized downward move that may now have been reversed after a drop to the high 40s.  We’ll have to see if this scenario plays out as such after last week’s rally.  Bear market rallies are tough to decipher and it’s usually only after a couple of such grinding reverses, when very few willing sellers are left, that the market makes and holds an honest breakout.  

Bollinger teaches that moves outside the bands, these are the 5% price movements not captured within the bands, have the following meaning.  “A move outside the bands calls for a continuation of the trend, not an end to it.  Often, the first push of a major move will carry prices outside of the bands.  This is an indication of strength.”  On the other hand, “a sharp move outside the bands followed by an immediate retracement of that move is a sign of exhaustion” or a sign of weakness.   It takes but a moment to check for price movement within or outside the bands every day, and I try to do so for each of my established option positions.

Another characteristic of Bollinger Bands presumes that a move originating at one band tends to go to the other band. I have found that this doesn't happen as often as the literature suggests.   This band to band movement is useful for projecting price targets and yields revised targets over time that can be of help when contemplating repair tactics for an option trade that isn’t working out.

I now need to explain an important aspect of indicator use in technical analysis.  Most TA indicators rely on price.  Using several indicators, such as RSI and MACD, results in a multiple count of the same price information as used by these indicators.  This tendency to create investing forecasts based on the same criteria is called multicolinearity.  While many TA users think using several price based indicators makes good sense, any resulting confirmation isn’t reliable since the indicators all rely on the same metric, price.  Thus, the apparent confirmation in such a case will not help an investor and, in fact, may mislead him.  In short, it’s better to use indicators that use indicators that are not based on the same characteristic. Thus, selecting indicators based on price, volume and volatility is good, while selecting multiple indicators all based on a single characteristic, like price, is not too helpful. 

This slection of non-correlated criteria is what I do in my options forecasting efforts.  I use the relative strength index in conjunction with Bollinger Bands.  RSI is based on price while Bollinger Band results are based on volatility.  Since these indicators are based on different criteria, they work well together.

I have one last observation about technical analysis in general before moving on.  Technical analysis is not without its errors.  Neither is fundamental analysis.  There is no single analysis approach or TA indicator that works every time, all the time.  I’ve found over the years that it doesn’t pay to tweak or optimize indicators to make them work.  I try to keep the odds in my favor and I follow my method of trading options (or of performing stock studies) as rigorously as I can. I also honor my stops!

Next, we’ll take a look at the RSI indicator and see how it can be used in conjunction with Bollinger Bands to help an option trader make decisions.  

Saul…

Hi all,

I wanted to clarify a few points with respect to Bollinger Bands and RSI. I was so focused on options that I forgot to make the following points clear.

1.  Both Bollinger Bands and RSI can be used on individual stocks, ETFs, commodities, indexes and derivatives like options.  Their use is not limited to options.

2.  While Bollinger Bands can be used by themselves, conventional wisdom calls for and the overwhelming majority of BB users employ another indicator in tandem with the bands.  Three favorites in this respect are RSI, an indicator called MACD (pronounced Mac-D; Moving Average Convergence Divergence) and Stochastics.  I believe this is the order of their popularity based on my experience with technical analysis.  I much prefer using RSI in conjuntion with Bollinger Bands and have had my best results with this combination, but I have two friends who swear by MACD.

3.  If you tweak the moving average used in Bollinger Bands, you should make a commensurate tweak in the other indicator used in conjunction with the bands.

4.  If you change either or both indicators, make sure you write that change along with details of your trade so you have a record of the basis of the trade along with the TA parameters used.

Any questions, please let me know.

Saul...

Hi Karen,

I'm not clear on your point re. setting stops.  My question is that should I get stopped out of a posion, I'm not allowed to sell that position if it is a covered call and I don't understand how or even if its possible to set a stop on an option?. 

If your broker has cleared you to sell naked calls, that's Level 5 I believe, then you can sell the stock first and let your option position go naked since the call isn't going anywhere if the underlying stock has tanked.  I do try to sell the stock position first and then buy back the call a little more slowly in case there's a bounce.

As your time trading options expands, your broker may bump your level up if you ask.  I did this about every 6 weekes when I first started until I got to where I wanted to be.  On the other hand, you can have a high trading level in case you need it, but not use all the capabilities of your level.  For example, although I can, I have never sold a naked call.

Do you mean you set these stops on paper only, and then watch the position closely?

Yes, I do this in my trading notebook.  I remind myself about my stops each morning before the market opens just to make sure I'm in tune with my positions.  Note that these written stops are on the stock. You really don't have to worry too much about stops on option prices  unless you are trading some exotic combinations.

According to Investopedia, whether you set your stop on the stock or the option is a matter of personal preference. Most exchanges allow stop-loss orders in options; however, most brokerage firms do not allow them for various reasons. Check with your broker.

Saul...

LEAPS (2)

Because of the length ‘til expiration, LEAPS carry a significant time or extrinsic value.  Selling covered calls using LEAPS can bring in larger premiums although the rate of return will not be as good as it is for a near term option.  While a LEAP may not always be as profitable on an annualized basis as an ordinary option, it’s one straightforward way to  get a large premium now, especially if you don’t want to keep on selling more calls as time goes on or initially invest in more calls. 

For example, as of this morning, AFL is at $16.15 a share.  An April 09 $17.50 call on AFL, if sold, will fetch a premium of about $1.75.  That’s not too shabby by the way.  The same parameter LEAP call with a January 2010 expiration provides a call premium of $5.00 per contract.  That’s not bad considering that it’s a 9 month position. 

Excluding commissions and other fees, a covered call based on the April 09 call gives the call seller an annualized return of slightly more than 250% for the April call if it is exercised and an annualized return of approximately 140% if it expires.  These returns are on a cash basis and will be higher if the underlying stock is bought on margin since less money is used in the trade.

The covered call LEAP trade on the January 2010 call, excluding commissions and other fees, gives the seller an annualized return of slightly more than 67% for the January call if it is exercised and an annualized return of almost 53% if it expires.  These returns are on a cash basis and will be higher if the underlying stock is bought on margin since less money is used in the trade. 

Hopefully, I've used theWith a LEAP, however, the underlying has much more time in which to recover if it stubles for a month or two or even longer coming out of the gate.  On the other hand, a near term option, like the April call above will expire because of an initial stumble and depending on how far the underlying sinks in price, you may end up with a loss or a significantly reduced return.  The premium on a LEAP is determined on its sale and guaranteed for you.  The premiums on near term calls depend on how often you can resell calls through the period in which the LEAP exists.  There’s no clear answer here, near term or LEAP, so think about your outlook and risk tolerance and decide accordingly.

I’m sure many of you will be interested in that level of return on AFLAC, a company that most of us know as excellent based on its past performance.  Many of us have owned or still own AFL.  However, there are rumors about AFL’s investment portfolio and financial strength and this concern is reflected in higher volatility and higher than usual premiums.  The downside risk is that AFL can drop from here and while you’ll keep the premium on either call, you’ll have to be nimble to stay plus on either position to avoid being saddled with a poorly performing stock. 

Please note that the use of AFL in the example trades above, or trades on other options or underlyings discussed in this workshop, are cited for educational purposes only.  No investment advice is given, intended or implied.  In fact, this trade looks too good to be true so please exercise caution when trading options and always perform your own due diligence and consult with your own advisors to determine if a particular option trade is appropriate and safe for you. 

Hopefully, I've used the calculator correctly in which case the above results are as they should be.  However, I suggest you check my results just in case I did get something wrong.

You may be asking where the above return figures came from.  Actually, there’s another option tool that is simple to use and free which provided this information.  I haven’t mentioned it before as I was trying to cover all of the base material in the workshop before sending you off to play around with this very useful tool.

Go to http://www.optionseducation.org/resources/covered_call_calculator.jsp and meet the Option Council’s clever Covered Call Calculator.  Type in the stock or underlying symbol and click on “Go.”  Default values for some of the variables will be inserted for you.  Change the expiration date to what you want and click on “Calculate” to get return information like that above for the option of interest to you.  Note also the option symbol at the top of the right hand column which you should write down for use when you enter your covered call trade.  I usually print out the final page of what the Call Calculator shows once I’ve finished calculating returns and playing “what ifs” in the calculator.

Next, we’ll take a look at record keeping requirements and taxes and review some fundamental aspects of both.      

Saul…