Page 1 of 9 Basic Option Strategies This chapter considers trading strategies for profiting from our ability to conduct a fundamental and technical analysis of a stock by extending our MCD example. In the case of MCD, our fundamental and technical analyses gave mixed results. Our fundamental assessment was extremely strong: MCD scored 91.3% on its historical performance diffusion index, and modeled up as slightly undervalued, along with many other desirable fundamental characteristics. Technically, however, MCD's long-term uptrend appeared to be weakening, and in the short-term the stock has been trading in the low range of a consolidation channel. If MCD's stock declined another $1.50 (breaking below $96), it would suggest the start of a short-term downtrend that would contribute to further weakening of and perhaps a reversal of MCD's long-term uptrend. We are going to apply and discuss each of the 10 trading strategies depicted in the course spreadsheet "Basic Option Trading Strategies." This spreadsheet comes pre-loaded with MCD market data from 03.21.12. We will divide up the strategies into those appropriate for a bullish (positive) outlook, those appropriate for a bearish (negative) outlook, and include several strategies that pertain to an investor's outlook for MCD's future price volatility. BULLISH OPTION STRATEGIES. Our fundamental analysis concluded that, for an investor with a long time horizon, MCD was an attractive stock to acquire. We will consider several bullish strategies that go beyond merely placing a market or limit order to acquire shares (which would be the most appropriate, low-cost strategy for an investor who was highly-convicted that MCD's shares were about to begin a substantial new short-term uptrend that would further extend MCD's long-term uptrend). Buying Call Options. If an investor had a reasonably strong conviction that MCD was about to begin a new short-term uptrend above its recent price of $97.50, one good strategy for acquiring shares would be to buy some just out-of-the-money call options on MCD. A call option is a contract that allows the owner to buy shares of stock at a pre-set price (known as the strike, or exercise price) for a certain period of time (the options depicted in all the examples that follow expire in June, 2012). The table below shows that MCD traded at a price of $97.50 on 03.21.12. MCD also had call options with a June expiration and a strike price of $100 available at a price of $1.40 (although the prices are quoted per share, option contracts control 100 shares of stock, so the total cost of this contract would be $140 plus fees and commissions). One of the advantages of options is the leverage it provides an investor. Although 100 shares of MCD would cost $9,750, we can control 100 shares of MCD for as little as $140. If we bought this call option contract, we would have the right to buy 100 shares of MCD for $100 a share between March and mid-june. If MCD's price rises sharply, marking the start of a significant new
Page 2 of 9 short-term uptrend, we can exercise our option and buy 100 shares at $100, or simply sell the option contract at a profit (the call contract will have increasing intrinsic value as MCD's price rises above $100). The chart and payoff table below depicts our profit and loss from buying MCD call options: If MCD's price rises above $101.40 (the call option strike price plus the option premium), this long call position will be profitable. If MCD's price was, say, $105 in early June, we could take possession of 100 shares of MCD for $3.60 less than the market price, which gives us a considerable advantage for both short- and long-term strategies. Of course, if MCD's price stays well below $100, our option would expire worthless and we would forfeit the $140 investment (we lose $1.40 per share 100 shares). Further note that American options would allow you to sell out of the position before the June expiration, but European options can only be exercised or sold on the expiration day. Selling Put Options. Put options are the opposite of call options they grant the owner the right to sell shares at a predetermined price over the life of the contract (or at the end of the contract in the case of European options). When we sell put options to someone else, we are granting them the right to make us buy shares at a certain price. Let's consider how such a strategy might help us acquire shares in MCD. The table above shows that MCD had June put options available at a strike price of $95 for $1.80 per share ($180 to control 100 shares). These options grant the owner the right to "put" their shares onto someone else for $95 a share. The profit and loss from writing these put options is shown in the graph and table below. These put options acquire intrinsic value if MCD's price falls below $95. If we determine that we would like to acquire MCD shares, and a net cost of $93.20 per share is an acceptable entry point, we can sell these put options and know that we will face 2 distinct outcomes: either keep the $180 per contract (if MCD's shares stay above $95), or acquire MCD at a net cost of $93.20 per share.
Page 3 of 9 Bullish Call Spreads. Another advantage of options is that they allow us to construct synthetic payout positions without owning any underlying shares of stock at all. Moreover, we can predefine our potential profit and loss, so the risk/reward tradeoff from these positions is observable in advance. Let's consider how we can combine the purchase and sale of call options to take a bullish position in MCD with a known upside and downside. The next position we will consider is known as a bull call spread. To construct a bull call spread, we are going to buy call options with a strike price at or just below MCD's current price, and simultaneously sell call options with a strike price at or just above MCD's current price. (For a bull call spread, always buy a call option with a lower strike price and sell a call option with a higher strike price.) The call options we'll use are shown below: Buying the in-the-money calls and simultaneously selling the out-of-the-money calls creates the payout pattern depicted in the following chart and table: The "Net Profit" column is created by summing the profit/loss from the long and short call positions. Notice that the long call, which grants us the right to buy MCD at a strike price of $95/share, becomes profitable as MCD's price rises above $95. The short call, which grants another investor the right to make us buy shares at a strike price of $100, remains profitable as
Page 4 of 9 long as MCD's price is less than or equal to $100. The final column shows that the offsetting result of these two positions provides us with maximum losses of $2.60 per option and maximum gains of $2.40 per option, which is a well-balanced risk/return tradeoff. OPTION STRATEGIES FOR A MIXED OUTLOOK. Sometimes an investor's outlook will depend on his/her time horizon. In the case of MCD, we can see that the stock remains in a long-term uptrend, but in the near term the outlook is more neutral, and possibly bearish. The next two strategies are appropriate for investors who are long-term bullish and either already own MCD or are about to acquire it, but are uncertain regarding MCD's short-term outlook. Writing Covered Calls. For an investor just acquiring MCD, or owning it as part of a long-term buy-and-hold strategy, one way to hedge against a short-term price decline is to write "covered calls." This strategy involves owning MCD and simultaneously writing (selling) call options on the stock to generate short-term income. For this strategy it's usually best to write just out-of-themoney calls (the June $100 contracts, shown below, which sold for $1.40 on 03.21.12): The payoff from writing MCD call options with a June expiration and strike price of $100 is shown in the graph and table below: The chart shows that the strategy offers additional downside protection equal to the price of the call option ($1.40 in this case). The cost of this protection is the risk that the stock price will soar and the investor will have his/her MCD shares "called away" at the $100 strike price. Thus, the maximum profit from this position equals the difference between the strike price and the current stock price ($100 $97.50, or $2.50) plus the option premium ($1.40), which in this case equals $3.90. Protective Puts. Another strategy appropriate for an investor who either owns or is just buying the stock, but is even more uncertain and/or bearish over the short-term, is to buy "protective puts." Protective puts involve buying put options (the right to make someone buy your shares) at a price slightly below the current stock price. (When puts are purchased for an entire portfolio,
Page 5 of 9 this strategy is sometimes called portfolio insurance.) The payoff from writing put options with a $95 strike price against a long position in MCD is shown in the graph and table below: In this case the potential downside from the long position is offset by the increasing value of the put options as the stock price declines. Whether to write covered calls or buy protective puts depends on how bearish the investor is in the short term, and how much they really want to own the stock in the long term. For example, covered calls generate up-front income, but only provide limited downside protection, and also come with the risk that the stock can increase abruptly and be called away. On the other hand, protective puts come with an up-front cost, but provide significantly more downside protection. The protective put buyer also has more upside potential if the stock price breaks out to the upside. BEARISH OPTION STRATEGIES. Sometimes investors are outright bearish over both the shortand long-term. Several strategies appropriate for strong bearish sentiment are shown below.
Page 6 of 9 Buying Put Options. Investors with a strong bearish outlook on a stock can simply buy put options, which grant the owner the right to make another investor buy shares at a predetermined price over the life of the option contract. The table below shows that on 03.21.12 there were MCD put options available with a June expiration that had a strike price of $95 selling for a premium of $1.80. The payoff from MCD's June 2012 $95 puts is shown in the graph and table below. This strategy is relatively safe, as the maximum potential loss equals the put premium. The position is increasingly profitable the further the stock price falls. Bearish Put Spreads. Investors with bearish inclinations can also construct a bearish put spread. This strategy involves buying an in-the-money put option (with a strike price slightly above the current price) and simultaneously selling an out-of-the-money put option (with a strike price slightly below the current price). Prices of representative put options on MCD with a June expiration are shown in the tables below: The payoff from the bearish put spread is shown in the graph and table below. The first thing you might notice is that the maximum potential profit and loss is a mirror image of the expected profit and loss from the bull call spread. This is not a coincidence the general "efficiency" (or accuracy) of financial market prices causes this to happen. Another thing to notice is that the bear put spread starts becoming profitable if MCD's stock price falls by as little as 10 cents (below $97.40). When we bought the out-of-the-money put options alone (in the previous example), we did not earn a profit until the price fell below $93.20. The additional cost of making the position more responsive to declines in MCD's price was only $0.80 (the $4.40 cost of the in-the-money put minus the $1.80 premium we collect on the out-of-the-
Page 7 of 9 money put = $2.60, which is $.80 more than buying the out-of-the-money put option alone). As was the case with the bull call spread, the bear put spread depicted below offers a reasonable balance between the maximum potential profit ($2.40) and the maximum potential loss ($2.60). OPTION STRATEGIES BASED ON EXPECTED VOLATILITY. It is also possible to construct synthetic investment positions based on an investor's expectations of a stock's future price volatility, whether up or down. For example, let's say that our fundamental and technical analysis led you to believe that MCD's price would remain in its tight consolidation channel for an extended period of time. As shown in the "short straddle" example below, we could simultaneously sell 1 call and 1 put option to create a position that profits from a stagnant price. On the other hand, if we thought a stock's price was due for a big move up or down (resulting from a final announcement regarding a takeover, or litigation, or regulatory approval, etc.), we could simultaneously buy 1 call and 1 put to create a "long straddle" that profits from large price movements to the upside or downside. These strategies are elaborated on in the following two examples. Short Straddle. A short straddle is designed to profit from expectations of a stagnant price (low volatility). To create a short straddle, we would simultaneously sell 1 call and 1 put option. We'll start with an example that sells an in-the-money call and an out-of-the-money put this will create a synthetic payout that is most profitable if a stock's price remains at the lower end of its expected trading range. Representative calls and puts with a June expiration are shown below: The payoff from constructing the short straddle is shown in the graph and table below:
Page 8 of 9 The short straddle is profitable if MCD's price remains between $89.20 and $100.80. The maximum profit is achieved if the price stagnates around $95 (a slight decline) between March and June 2012. We can fine-tune the break-even prices by selling different options. If we were to sell the calls with the $100 strike price instead, we could change the break-even price range to $96.80-$103.20. This position, known as a "short strangle," is shown in the graph below: If we sold both calls and puts with strike prices of $100 (shown in the table below), we could shift the short straddle payout range higher. The payoff from the short straddle based on selling calls and puts with strike prices of $100 is shown in the graph below. Now the range of MCD prices over which this position is profitable extends from $94.20 to $105.80, with the maximum potential profit at a closing price of $100:
Page 9 of 9 Long Straddle. We can also create a synthetic position that will pay off if MCD's price breaks out of the $89.20-$100.80 range. This strategy, known as a "long straddle," involves buying 1 call and 1 put with the same strike price (we'll use the June $95s; prices for the calls and puts are $4.00 and $1.80, respectively, as shown on page 35): As was the case with the short straddle, we can shift the payout range higher by buying the June calls and puts with $100 strike prices instead. As shown below, now the long straddle is profitable if MCD's price breaks out of the $94.20 to $105.80 range: