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Friday September 05, 2008 |
Advanced Strategies for Options
Now
we are finally hitting full stride. By now you should have a good understanding of options. We know that there are many versatile strategies involving
simply buying and selling puts and calls so you can imagine the
possibilities available to investors if they begin to combine sets
of option contracts. Why
would an investor want to do such a thing? Since all markets have the potential to fluctuate beyond
their normal trend, it is essential to learn how to use strategies
to limit potential losses to manageable levels. There are a
variety of option strategies that can be employed to hedge risk
and leverage capital.
In
this lesson we will examine the development and application of the
more advanced option strategies.
Before we get started on the advanced strategies it is going to be
helpful to lay out some simple ground rules. If you ask any veteran option trader he is likely to make
your head spin with phrases like butterfly, iron butterfly and
condor. All of these
are types of option strategies but don't fret.
As
we know, there are just two types of options; puts and calls –
and if you really break it down, there are just three things you
can do can do with these contracts; spreads, straddles and
combinations. Every advanced strategy is merely a variation of one of these
basic constructs.
Spreads, Three Types
When
an investor uses a spread strategy he is typically trying to do
two things, first, take advantage of the difference in option
premium values between strike prices, expiration dates or both and
second, reduce the cost of purchasing the first option contract by
gaining the proceeds for the sale of a second option contract. Thus, to establish a spread position the investor
simultaneously buys one option and sells another of the same class
with different terms.
Different
terms? Just as there
are three basic constructs for all advanced option strategies,
there are three basic categories for spreads; vertical, horizontal
and diagonal.
Vertical
spreads are those in which the strike prices are different but the
expiration date is the same, in effect, the investor is spreading
the strike price. For
example Jane is moderately bullish for Dell Computer and she
decides to buy the Dell Computer January 45 call and
simultaneously sell the Dell Computer January 55 call. By doing so she limits the amount of profit she can earn
because she has effectively capped Dell Computer at $55 but she also
reduces the cost of the January 45 calls by the amount of the
premium received for the January 55 calls.
Horizontal
spreads are those in which the strike prices are the same but the
expiration dates are different, in effect, the investor is
spreading time. These
spreads, often called time or calendar spreads are effective when
the investor feels the price of the underlying security common
stock will remain relatively unchanged over the life of the
written contract. For
example Bill likes the prospects for Dell Computer longer-term but
feels the stock will remain in a narrow range for the next month. He buys the Dell Computer February 45 calls and he
simultaneously sells the Dell Computer December 45 calls. By selling the December 45 calls he reduces the cost of
purchasing the February 45 calls by the amount of premium received
by the sale of the December 45 calls.
Diagonal
spreads are any combination of the vertical and horizontal spread. Investors may spread price, time or both. For example, Mike is also bullish for Dell Computer. He believes the stock is likely to move modestly higher in
the short-term but the real gains will come over the next two
months. He decides to
buy the Dell Computer February 45 calls and simultaneously sell
the Dell Computer December 50 calls. By doing so he effectively caps his profit potential in the
month of December but he also reduces his cost for February 45
calls by the amount of premium received from the sale of the
December 50 calls.
In
each of these examples it is important to note that both the long
and short options are of the same class (calls). Spreads always involve the same class of options. In fact, this option strategy takes its name from the
difference between the two premiums involved in the transaction.
In
review, a spread is an option strategy where the investor buys and
sells an option of the same class. Price or Vertical Spreads are those where the options in a
spread have different strike prices. Time, Calendar or Horizontal Spreads are those where the
options in a spread have different expiration dates. Finally, Diagonal Spreads are those where the options in
the spread have different expiration dates and different strike
prices.
Now that we understand the ground rules for
spreads let's take a look at some of the specific strategies.
selling
calls 
bull call spread
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