Sell Insurance, Buy Insurance and keep the change?

This is an options strategy known as trading a ‘Credit Put Spread’ and is the first strategy I ever did.  As you know you can buy or sell a call or a put.  This strategy uses the art of selling a put (for income) and buying a put (for protection).  The structure of the deal means you would receive more income from selling the put that you would pay out for buying the put as protection. This strategy is placed on the premise your view of the stock is bullish (Stock is going up).

This strategy may seem complicated at first but once you can understanding the mechanics of options trading then eventually things will click.

I don’t want to go into detail with this post but merely want to highlight just another strategy that can take options to the next level.  The strategy is sometimes referred to as the ‘Bull Put Spread’ because the expectation is for the stock to go up but personally I think this can be a bit of a misnomer, and this is why:

A “Bull Put Spread’ is denoting the trade as bullish and more importantly a direction trade.  However the best thing about this strategy is that the stock can stay at the same level or even go down a bit and still have a successfully trade, and because of this the trade has an 80% chance of winning.  Selling a put ‘Out The Money’ will usually mean selling a put slightly below the current price.  Your obligation to provide stock to the market will only become a reality if the stock was to finish below the sold put strike price on expirey.  So really the stock can 1) go up a bit, 2) go up a lot, 3) stay the same, 4) go down a bit or 5) go down a lot.  It is only if the stock goes down a lot the trade will fail.  Which is where the 20% of the trade failing comes from.

Insure Your Shares

There are so many investors out there, especially the mum and dad type investers that have bucket loads of cash tied up in shares which is all good. But how many know that they can be insured just like a house. This is what option trading is all about and it is such an easy process to undertake.

If you recall, buy buying a put gives you the right to sell a parcel of shares for a specific price.

Anyone owning a home, or a car or anything else of great value 99 out of 100 would have insurance.  So why not unsure your stock portfolio as well.

If you own stock that cost you $10.00 per share, then buying a PUT option with a strike price of say $9.00 allows you sell your stock for that price no matter where the current price is.  So even if the stock dropped to $2.00 you have effectively locked in a maximum loss of only $1.00.  Ok you might be thinking you have spent extra of you capital to buy the Put (the insurance) but hey… that’s the cost of insurance, you’d do exactly the same when insuring you house.  But also consider this.  Remember if you have bought a PUT then as the stock decreased in value the price of the put increases which can also off set any losses.

So if you are really attached to your particular shares and the stock drops, then rather than exercising your option to sell the shares you could cash in your PUT option for profit and take out further insurance at a suitable strike price.  Remember the strike price is the stock price value that the option is related to.

Buying a PUT OPTION

To buy a PUT option means that as a buyer, you are buying the right but not the obligation to buy a particular stock at a particular price on or before a particular date know as the contract expiry date. The price of a call option will rise in price as the stock increases.

Selling a PUT OPTION

To sell a put  option means that as a seller you would be receiving premium in return for selling a promise that you will deliver a particular amount of a particular stock at a particular price to the market should the contract be exercised within the contract period. Should you be exercised you are obligated to deliver the stock as per the contract. If you don’t already own the stock then you have to buy the stock at market value and sell it back at the agreed price.

Selling options is usually transacted to take advantage of the premium in the hope the stock will close at a particular level meaning you would keep the premium as opposed to being exercised and having to provide the stock to the market.

If you own the underlying stock then this is called writing a ‘covered call’. If you don’t own the underplaying stock you are defined as trading a ‘naked call’

Weather you exercise your rights or are obligated to provide stock to the market; this is all dependant on what the stock price is at the time of purchase and what the stock price is at the time of selling.

Buying a CALL OPTION

To buy a CALL option means that as a buyer, you are buying the right but not the obligation to buy a particular stock at a particular price on or before a particular date know as the contract expiry date.  The price of a call option will rise in price as the stock increases.

Selling a CALL OPTION

To sell a call option means that as a seller you would be receiving premium in return for selling a promise that you will deliver a particular amount of a particular stock at a particular price to the market should the contract be exercised within the contract period. Should you be exercised you are obligated to deliver the stock as per the contract.  If you don’t already own the stock then you have to buy the stock at market value and sell it back at the agreed price.

Selling options is usually transacted to take advantage of the premium in the hope the stock will close at a particular level meaning you would keep the premium as opposed to being exercised and having to provide the stock.

If you own the underlying stock then this is called writing a ‘covered call’.  If you don’t own the underplaying stock you are defined as trading a ‘naked call’

Weather you exercise your rights or are obligated to provide stock to the market; this is all dependant on what the stock price is at the time of purchase and what the stock price is at the time of selling.

What Are Options

I love trading Options, and it’s one of those strategies that the un-educated and sometimes the well educated turn their nose up at.  Why… because the usual response when bringing up the topic results in “they are too risky”.  As I mentioned in previous posts, risk is just the fear of the unknown.  Once I could understand the concept of options, then I would more often than not prefer to deal options rather than the stock because they have much more advantages. Not to mentioned needing less capital.

I could talk about this subject until the cows come home so I will keep this really basic and separate the different topic areas into different blogs. Once the concept of options are understood there are a huge variety of ways that options can be used with literally dozens and dozens of different strategies, not just on stock but also fx, futures, indices and interest rates just to mention a few.  For the sake of all the posts I will assume the options discussed are based on stock options to keep it easy.

An option is a derivative meaning the price of an option is derived from it’s underlying instrument, in our case the stock. (Or share for those in the US)

Basically there are two types of option contracts.  A CALL option and a PUT option which can either bought or sold.  Each option contract is based on 1000 shares but can vary slightly for many complex reason that I don’t understand and to be honest it’s one of those areas that doesn’t need to be understood.  All that is required is to know how many equivalent shares the particular option contract is based upon.

Therefore to expand on that slightly 1 option contract (call or put) is based upon being in control or at risk to an equivalent base of 1000 shares and 1 contract is the minimal amount one can trade.  So if the cost to buy an option is say $0.50c then one option will cost $0.50 x 1000 = $500. Then if a stock rises, then so will that options price. (Assuming we are talking about a Call option here).  Say the option rises to $1.00 then you could sell the option back for $1.00 x 1000 = $1000 and therefore net $0.50c on the option making a total gain of $1000 – $500 = $500 profit on the trade.  Less a few fees of course, which incidentally are nowhere near the fees that would have been charged for trading the equivalent in shares.

I will continue to provide additional posts to carry on these discussions.