Delta, the positive and negative

I came across a misconception about the deltas for puts and calls.  Someone put forth that a Sept. expiry Bull Call Spread on AAPL was the same as a Sept. expiry Bull Put Spread with similar strike prices.  In fact, the two strategies are diametric opposites.  That is because calls and puts do NOT have the same deltas, even when accounting for the fact that put deltas are represented by a negative number.  So, the AAPL Sept. 710 call has a delta of .0159 and the Sept. 730 call has a delta of .0000.  Since a Bull Call Spread is a debit spread, the cost for this spread is tiny, $.10 x .02=$.08 per contract, or $8.  The same strikes for the AAPL Sept. puts are 710 delta of -.9786 and the 730 put delta is -.9942.  Since a Bull Put Spread is a credit spread, the credit received would be $18.50 on a $20 spread, i.e., $1850 credit for every $2000 margin (but the "real" or effective margin is only $150=2000-1850). 

But, and this is a HUGE but -- with September expiry, you are giving no time at all for the stock to move.  Sept. expiry has an enormous theta influence (meaning time erosion).  If you buy the Bull Call Spread, it would cost you nearly nothing ($0.08 or $8 per contract), but the likelihood of that spread rising are almost nil, zero, zilch.  You know why?  Because the delta is 0.  The delta determines how much the option will move for every $1 move in the underlying stock.  With a delta of 0 and only 3 weeks to expiry, you would need a miracle for your $8 to go anywhere.  Of course, $8 is not a lot of money, so you may want to play with it.  But that would represent the true analogy to a lottery.

As for the Bull Put Spread, even though the credit is enormous, the Sept. expiry still poses a problem because of its short nature.  Yes, the deltas are huge (and are represented with a negative sign), which imply just about a 1:1 move of the options for every $1 move in the stock, but again, you are giving a very short time for the stock to do anything.  Very risky.

I am in the process of writing a book on this.  Stay tuned, if you're at all interested

Deep In The Money Bull Put Spreads

Someone compared a Deep ITM Bull Put Spread strategy to a lottery.  Indeed, it is anything but.  Rather, it is a very sound, safe strategy.  Consider that Bull Put Spreads are credit spreads, and the deeper ITM you go, the bigger the credit (i.e., money in your pocket).  Also, the farther out you go in time to expiry, the greater the chance that the stock will make a big move.  For example, let's take AAPL.  At its current market price, $676 or so, a Deep ITM Bull Put Spread might be something like a 2014 expiry 770/780 Bull Put Spread, which will fetch approximately $700 per margin of $1000 per contract ($770-$780=$10 x100 per contract=$1000), or 70% return, with a risk of 30%.  How do I figure the risk?  Simple: You receive $700 credit for each contract, and while the margin requirement is $1000 per contract, the $700 mitigates against that, thus reducing your out of pocket, and putting you at risk for only $300 IF the stock does not make the expected move, and IF you choose to keep it open until expiry.  In this case, you are about $100 ITM (AAPL $676; strike price $780), but your risk is only 30% if AAPL fails to reach $780 by Jan. 2014.  Moreover, you are not obliged to hold on to this spread until expiry.  If AAPL comes out with new products or wins another legal case, or declares a split, or whatever, it could surge, thereby lowering the spread amount, in which case you can buy it back to close.  Even if AAPL does not surge, but simply meanders slowly through the months, at $780, you are assuming a $104 rise in the stock price, which represents a 15.3% rise in 18 months, certainly within the realm of possibility for this stock.  Again, the credit (money in your pocket) is 70% on a risk of 30%.  In my book, that is not a lottery ticket at all, but a very sound strategy.

A Bull Put Spread is a strategy where the underlying stock can stay the same (you profit by the erosion of time), rise (you profit by the decrease in the puts) and even decline a little (by the amount of the credit received).

Is there a risk to this strategy? Yes, and here it is: If AAPL falls precipitously in price, the Bull Put Spread INCREASES in value.  Thus, it may trigger a margin call, unless you are very well funded.  The operative word here is may.  There are many situations where the market takes a tumble, even a severe correction, yet nothing happens to your long-term positions.  On the other hand, you may be called upon to reduce your margin, in which case, you simply buy the spread to close.

Remember: A PUT increases in value as the underlying stock price decreases.  A CALL increases in value as the underlying stock price increasees.

Suggestive Lexicon - Even More Interesting Tactics

I'm talking here about being naked and legging in and out.  Don't get carried away - I didn't make these up, I swear!

I love to sell naked puts.  That is, in fact, my favorite strategy.  But I also love Bull Put Spreads.  Let's see what I did with AAPL.

When AAPL was trading around $500, I sold to open (STO, in the jargon) a 2014 LEAP put at a strike of $450.  When AAPL rallied after earnings, I bought back that put to close (BTC) for a profit, and rolled out to 2014 $500 strike.  When AAPL again rallied, I "covered" this naked put with a long put by creating a Bull Put Spread - I bought to open (BTO) a 2014 $450 put.  In time, AAPL has continued to defy gravity, rising ever more, and I have been keeping a keen eye on my short puts.  With the imminent launch of the iPad 5 in September 2012, my $500 expiring in 2014 put had before very profitable.  I therefore placed a trailing stop of $2 to buy it back to close, in order to secure my profits.  I kept my long $450 put intact, in case the stock rallies, and then takes a tumble as other traders also take profits.  In that event, my long put would increase in value.

Here is what I love about Bull Put Spreads: As the name implies, you put those on with a bullish expectation on the underlying stock.  But with Bull Put Spreads, you needn't be all that bullish - just bullish enough.  One of the benefits of doing Bull Put Spreads is that you are getting money into your account immediately, because these spreads are credit spreads.  Another benefit is that, if the underlying stock tumbles significantly, your long put becomes profitable, and when that happens, I like to sell it for a profit, thus "legging out" of the spread.  I took a credit to begin with; I'm now selling the long put at a profit, thereby taking in more money; and I'm leaving the naked put in place with the expectation that the stock will recover.  Such was the case with CMG.  It had gone from about $340 down to $285, and then stabilized.  At that point, I wrote a Bull Put Spread expecting the stock to find its legs again.

Adjusting the Legs

Yesterday, I set up a Strangle With a Twist on Netflix (NFLX) right before earnings.  NFLX came out with earnings which were very positive, but "guided" lower.  The stock dropped in after-hour trading, and is trading considerably lower this morning, down about $16.75 at this writing.

Recall that I had two spreads on the stock: May 2011 $260-$265 Bull Call Spread and the May 2011 $235-$240 Bull Put Spread.  Both spreads are bullish; both spreads were set to expire May 2011.

With the stock currently down about $16.75, the call options are trading lower (the call options are currently out of the money - OTM), while the put options are trading higher (the put options are currently in the money - ITM), I have executed a few adjustments, as follows:

I bought to close (BTC) the May 2011 $265 call options for $2.90 ($290 per contract).  I sold them yesterday at $9.75 ($975 per contract), so my profit on this leg is $6.85 ($685 per contract).  That leaves a Long Call at the $260 strike expiring May 2011.  This is a Long Call (Long means that I own this position), therefore, there is no Margin Requirement.

I sold to close (STC) the May 2011 $235 put options for $10.35 ($1,035 per contract).  I bought them yesterday at $8.25 (of $825 per contract), so my profit on this leg is $2.10 ($210 per contract).  That leaves a Naked Put at the $240 strike expiring May 2011.  This is a naked position, therefore, there is a Margin Requirement of $5,977. 00.

Why did I adjust these legs?  From past experience, it seems that there is a knee-jerk reaction to negative news, and I am betting that the selling action is overdone, and the stock will recover.  So far, by removing those two legs (the short call* and the long put*), I have put $895 back into my account.  I opened both spreads yesterday at almost no cost to me.  My risk here is that the stock will not recover to the $240 strike naked put, in which case the stock will be put to me, and I will be obligated to buy it at the strike of $240 (refer to the lexicon for definitions).  As expiration approaches, I can reevaluate my position to see if the fundamentals of the stock are still interesting enough to wish to hold the stock, and if not, I can simply buy back to close that naked put, thereby relieving myself of that obligation.  In the event I do wish to allow the stock to be put to me, my break-even cost would be $240 (the strike price) less the profit of $895 I just realized, or $231.05.  Looking out to some long-term call options, selling a covered call would bring down the price even more.

With the stock currently trading at around $236, the $240 strike naked put is trading at around $12, which is $4 in the money (ITM) - $240-$236 - and a full $8 out of the money (OTM), or time value.  With May expiration being just 3 weeks away, the Theta of the option erodes extremely fast.  The Theta refers to how much value an option price will lose with every day that passes.  The closer to expiration, the faster an option loses value.

On May 11, 2011, the market started to jiggle (to the downside) a bit more than I like.  NFLX was trading up to $241, but then regressed down to $238, so I decided to roll out my naked puts to June 2011.  By rolling out, I closed (BTC) my May 2011 open position $240 Naked Put at $6.31 and opened (STO) a new June 2011 $240 Naked Put for $12.61, thus pocketing a profit on the May position of $3.74 ($374), and taking in a premium of $12.61 per contract ($1261) for the new June 2011 naked put.

Strangle - With a Twist

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Recently, when Netflix (NFLX) reported earnings, the stock fell out of bed.  It dropped like a stone, shaving about $50 off its then price.   That was about a 20% drop in just a few days.  Tonight NFLX is reporting earnings again, and I would like to position myself to profit in any direction the stock might go.  The way to accomplish that is traditionally through what is known as a "Straddle," where one buys and sells a put and a call option with the same strike price and the same expiration date.  With the stock currently at $250 (+/-), a straddle would be buying a $250 strike call and buying a $250 strike put.  The greatest volatility and movement comes from the nearest expiration month, in this case, May 2011.  With earnings coming out tonight, a May 20, 2011 expiration feels right.  But buying a $250 call would cost $16.95, and a $250 put would cost $14.25, for a grand total of $31.20 per share, or $3120.00 for 1 contract of each (each contract controls 100 shares). 

The idea is that by positioning yourself at the same strike price, if the stock falls, the put you bought will increase in price, while the call would decrease in price; while if the stock rallies, the call you bought would increase in price, while your put would decrease in price.  You are looking for a sufficient increase in price to compensate for the entire position cost.

The Strangle is a variation on the straddle.  Whereas the straddle encompasses a call and a put at the same strike price, the strangle is a position with prices that are not the same.  Those prices can be either in the money (ITM) or out of the money (OTM).  The expiration date is the same.

Here is what I did:

Bull Put Spread

I bought to open (BTO) a May $235 put = $8.25

I sold to open (STO) a May $240 put = $10.05

CREDIT $1.80

-and-

Bull Call Spread

I bought to open (BTO) a May $260 call = $11.63

I sold to open (STO) a May $265 call = $9.75

DEBIT $1.88

NET DEBIT $.08 plus commissions

Notice that both are bullish positions: The Bull Call Spread from $260-$265, and the Bull Put Spread from $235-$240.  Both of these spreads are said to be out of the money (OTM) (refer to previous blogs for definition).  If NFLX rallies, the Bull Put Spread will expire worthless, and I will pocket $1.80, and will be able to sell to close (STC) my Bull Call Spread at $5 less my debit of $1.88 for a total gain of $3.12. 

But the main reason I put on those positions is because it costs me very little, and I can modify the legs of either spread should there be a dramatic movement in the stock.

Time Value vs. Intrinsic Value

Recall that options come in two varieties: Calls and Puts.  Both calls and puts can be bought or sold.  That's a total of four possible moves, but within those four moves are innumerable possible permutations.  For the sake of this very simple explanation, let's focus on what is meant to Time Value and Intrinsic Value.

First, Intrinsic Value.  As the term suggests, intrinsic means inherent, built-in, real value.  Let's consider a call option on Apple Computer (AAPL).  The stock is currently trading at about $350.  If you buy a call option at a $320 strike price expiring in May 2011, that means you are buying the right to buy AAPL at $320 on or before May 20, 2011.  For that right, you would pay $33.60 on the ask (you buy at the ask and sell at the bid).  For 1 contract, the total cost would be $3360.  With the stock currently around $350, that means that a full $30 of the cost of the $320 call is intrinsic value, or in the money (ITM).  You are therefore buying some "real meat," if you will.  You are buying some portion of the stock itself.  The remaining cost of the option ($33.60-$30.00=$3.60) is Time Value. 

All options, both calls and puts, have what is known as intrinsic value and time value.  Time value is that portion of the option that erodes over time.  It is much cheaper, dollar-wise, to purchase only time value (out of the money OTM) call options, but the risk is greater.  More on that later.  In the case of AAPL, as above, by spending $3360, you are actually positioning yourself to profit very closely to the movement of the stock itself; if AAPL rises by $1, your call option is likely to appreciate by a similar amount (called the delta - more later).  The delta of ITM call options is significantly higher than deltas for time value call options.

Covered Calls

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Selling covered calls is a way to enhance returns on stock you already own.  You are in effect using your stock as rental property, collecting monthly or semi-annual royalties on that stock.  In return, you are agreeing to part with that stock should it come up to a certain price level.  Selling covered calls generates income that also reduces your cost basis on the stock.  Let's say you have own Altria (MO) for years.  It has paid regular dividends, and periodically, you have purchased more shares.  You now have about 500 shares, and would be happy to generate more money out of that stock than mere dividends.  Why not collect some (rental) money while waiting for your money to grow or waiting for the dividends?  It is just sitting in a brokerage account; why not "use" it to enhance your returns.  MO closing price on April 21, 2011 was $26.06.  The December 2011 $27 strike calls are bidding $.75.  If you sell 5 contracts to cover your 500 shares, you will receive $.75 x 500=$375.00 into your account immediately.  The sale of a covered call means that should MO rise to $27.00 by the December expiration, you agree to part with your 500 shares at the strike price of $27.00. 

What could go wrong?  MO could crash.  In this example, you received $.75 per share for agreeing to sell your stock at $27.  That brings the break-even price down to $25.31 ($26.06 - $.75).  But if MO crashes down to, say, $20.00, clearly that $.75 does very little to mitigate that loss.  Then again, with or without selling the covered call, MO could still crash.

Covered calls are a terrific strategy to generate income from range-bound to slightly bullish stocks.

Covered Calls With a Twist

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First, a definition: Covered Calls are Call options sold on stock that one owns.  One does that in order to generate income.

Say you own some shares of QQQ (an ETF of Nasdaq 100 shares).  The closing price on April 21, 2011 was $58.34.  You need a minimum of 100 shares of stock in order to be able to sell covered calls on those shares, therefore, your out-of-pocket outlay to buy those shares is $5834.00.  Assuming you own at least 100 shares, and you wish to generate some income, rather than simply waiting for continued increase in the stock itself, you search the option tables and various expiration dates, and determine that you would be happy to part with your shares at $59.  The May 2011 $59 strike call options are trading at $.55 bid x $.57 ask.  If you sell 1 contract per 100 shares of the May 2011 $59 strike calls, you will receive $55.00 into your account.  By doing so, you have committed yourself to part with the underlying stock at $59 by Friday, May 20, 2011.  Since the stock is currently at $58.34, selling it at $59 means an additional amount of $.66, or $66.00.  Add that to the $55 premium received for selling the calls, and your total gain is $121.00.  If you bought the QQQ at $58.34 and sold those calls, your return would be 2.07% for less than 4 weeks.  That translates to a return of 26.96% per year. 

What's the twist? You can buy call options on the QQQ and sell call options against the ones you own.  Remember from prior entries that you can buy Call options with any expiration date, and at any strike price.  Let's assume you are long-term bullish on the direction of the Nasdaq, and are willing to buy the basket ETF, the QQQ.  You do not want to monitor your position every day, so you buy the 2013 expiration $60 strike price, currently listed as $5.32 bid x $5.49 ask.  You buy at the ask.  Ten contracts which control 1000 shares cost $5490.00, essentially the same as buying 100 shares of the ETF itself.  In order to create a spread, and thereby mitigating your cost, you now sell calls against this position.  If you decide to sell the May 2011 $60 strike calls, you will receive $220 ($.22 bid x $.23 ask).  Assuming the QQQ closes at less than $60 by May 20, 2011, your total cost for the position will be mitigated down to $5268.00.  You can then sell the June 2011 $60 strike calls (or any strike, or any expiration).  If the QQQ does rise above $60, your total cost of $5268 will be recovered, PLUS any amount up to $60, in this hypothetical case, $6000-$5268, for a very decent return.

In the Money (ITM)/Out of the Money (OTM)

Have you heard these terms and wondered what they mean?

Options are financial instruments designed to take advantage of price movements of stocks.  This is a very simplistic definition, because options actually involve many more financial maneuvers than just stocks.  Let's stick with stocks for now.  Options come in two types: Calls and Puts.  Both Calls and Puts can be bought or sold.  Although that represents four directions, in reality, options can be "played" in an infinite variety of moves, directions, expectations and techniques.  There are "Greeks" which refer to Green terminology to identify forces that affect the movement of options; there are expiration dates; and there are strike prices. 

Some people think of Call options as ways to buy a position, but that is erroneous, as Calls can also be sold.  So it is with Put options.  Even though there is a common misconception that Put options are used to sell a stock, Puts can also be bought, or, as is the mainstay of this blog, can be sold "naked" to generate income.

For both Calls and Puts, the strike price determines if the option is In the Money (ITM) or Out of the Money (OTM).  In a previous entry, I discussed BTU (Peabody Energy Corporation).  The closing price as of Thursday, April 21, 2011 was $66.02.  I sold a Naked Put expiring January 2013 at the $65.00 strike price and received a premium of $1120 immediately into my account.  That means that between now and January of 2013, if BTU remains above $65, I will get to keep the entire $1120 that I received.  Based on a Margin Requirement of $2340, my return on investment (ROI) is 47.86%.  Since BTU closed at $66.02, and the strike price is $65, my Naked Put is said to be $1.02 out of the money (OTM). 

In the case of Puts, if the market price of the stock is HIGHER than the strike price, it is said to be OTM.  Conversely, if the stock price is LOWER than the strike price, it is said to be ITM.

In the case of Calls, if the stock market price is HIGHER than the strike price, it is said to be ITM.  Conversely, if the stock price is LOWER than the strike price, it is said to be OTM.

Lexicon

ATM - at the money

Bearish - Having a downward (price decline) bias

bCS - Bear Call Spreads

Bullish - Having an upward (price increase) bias

BCS - Bull Call Spreads

bPS - Bear Put Spreads

BPS - Bull Put Spreads

BTC - buy to close

BTO - buy to open

Covered Call = Call option sold against underlying long stock

ITM - in the money

Long - Buy or own

Long stock - stock that is owned

Margin - collateral needed as securitization for certain stock and option trades

Naked Put - Put option sold without covering position

OTM - out of the money

Q's - shorthand for QQQQ - a proxy for the NASDAQ

Short - Sell

STC - sell to close

STO - sell to open