Sunday, August 19, 2012

Calls, Puts & Covered Writes

Long Call
Long 1 XYZ Sep 50 call @ $2.00
Total CostOption premium paid, $200
Maximum LossOption premium paid, $200
Maximum ProfitUnlimited
Short Call
Short 1 XYZ Sep 50 call @ $2.00
Total Credit ReceivedOption premium received, $200
Maximum LossUnlimited
Maximum ProfitOption premium received, $200
Long Put
Long 1 XYZ Sep 40 put @ $1.00
Total CostOption premium paid, $100
Maximum LossOption premium paid, $100
Maximum ProfitUnlimited
Short Put
Short 1 XYZ Sep 40 put @ $1.00
Total Credit ReceivedOption premium received, $100
Maximum LossUnlimited
Maximum ProfitOption Premium Received, $100

Explanation and Application

Before you can trade the more complicated option positions, it would be wise to understand their building blocks: calls and puts. Critics of option trading always point out how risky, speculative, and unnecessary options are. But what they either don't understand or point out is that options are designed to be a tool for transferring risk from one trader to another. It is imperative to understand that when buying calls or puts, the potential loss is limited to the amount paid for the calls or puts. When selling calls or puts, the potential loss is unlimited (short puts really have risk limited to their strike price, but are considered unlimited for all intents and purposes). Therefore, when you buy an option, you are limiting your risk by transferring it to whomever sold the option. When you sell an option short, you are accepting the risk from whoever bought the option. Options can offer a great deal of leverage, meaning that you can have the risk/reward exposure of a large position in stock for a relatively small amount of money.
It's important to understand that there are trade-offs in options. There are good points and bad points about every option strategy. You must isolate your speculation, i.e. precisely what do you think is going to happen to a stock and when is it going to happen? You must balance potential risk versus potential reward. Always keep in mind that in option trading, you never get anything for free.
To outline the basics, we'll focus first on a long call. Much of what is learned about long calls can be applied elsewhere. Buying a call is perhaps the most common and straightforward option position there is. It's a strategy that's used if you think a stock's price will rise and can be seen as a substitute for buying stock. Buying a call does offer leverage and limited risk. It usually costs less to buy an option than it does to buy the underlying stock, and is generally considered less risky than a position in stock. But you have to be confident that the stock price will rise sufficiently before the expiration date of the option. Options expire, stock does not. You can "sit" on a stock and hope that eventually it will rise in price. You can't do that with a call option. If the stock price doesn't rise enough by a certain date, the call option may expire worthless or with a lower price than you originally paid. So, it's not enough to be bullish on a stock in order to figure out which call to buy.
The key is that there are trade-offs between potential risk, the probability of profit, and the potential profit. Generally, the lower the risk or the higher the probability of profit of a trade, the smaller the potential percentage profit. It's highly unlikely that, in a lifetime of trading, there will be massive potential percentage profits that are all but guaranteed to happen with little or no risk. You're more likely to be hit by lightning, twice, after living out your fantasies at the Playboy mansion.
You have to balance these trade-offs. For example, an option's value is continuously whittled down by the passage of time. There is a constant battle between the erosion of your option's value as time passes and waiting for a favorable move in the stock price or an increase in implied volatility that will push the value of the option back up. Therefore, you need to consider the timing and the magnitude of the anticipated rise in the stock's price. Each one of these is a speculation that you are accepting when you trade options.
You also have to decide whether to buy a call with more or fewer days to expiration. An option with fewer days to expiration has a couple things going for it. First, all other things being equal, it's cheaper than an option with more days to expiration. That means you'll have a smaller absolute loss if your speculations are incorrect. Second, all other things being equal, if the stock price moves up, it will probably have a greater percentage increase in value than an option with more days to expiration. So why ever consider an option with more days to expiration?
Well, options with more days to expiration have their advantages. First, there's more time for the stock to make a favorable move. For a given level of volatility, a stock will have a chance to make a much greater up or down move if there is more time. There will be a greater opportunity for the stock to rise sufficiently and/or recover from any price declines in order for the call to be profitable. You don't want the stock to make its big move the day after your options expire. Second, an option with more days to expiration will experience less price erosion as time passes, and have a smaller percentage loss if the price of the stock remains unchanged or falls.
Changes in implied volatility affect options with more or fewer days to expiration differently. Calls with more days to expiration are more sensitive to changes in implied volatility than are calls with fewer days to expiration. You have to remember that implied volatility can move up and down, and can hurt badly if it moves against you.
Remember, you never get anything for free.
Whether to buy an ITM, ATM, or OTM call is another decision you have to make because each of them responds differently to changing conditions. An ITM option acts the most like a stock position. Depending on how deeply it is ITM, it will act more and more like stock. It will be affected less by time and changes in volatility, and more by the stock price moving up and down. An ITM call may require a smaller rise in the stock price to be profitable, but its percentage gains won't be as great as those of an ATM or OTM call.
An ATM option has the greatest uncertainty. It is the most sensitive to changes in the stock price and volatility, and time passing. This can be good or bad. If all your speculations are wrong, the ATM option can hurt you the most.
An OTM option begs for a very large rise in the price of the stock. If you get a big enough move in the stock, an OTM call can deliver a much higher percentage profit than an ITM or ATM call. And if the stock price falls dramatically, the loss on the OTM call will be smaller than on an ATM or ITM call. But remember that a big move in the stock price is less likely than a smaller move, and OTM options will expire worthless if the move in the stock isn't big enough.
Selling a call short is the mirror image of buying a call. It's a speculation that the price of the stock will fall, stay the same, or rise only very little. You have to consider the same things as when buying a call, except in reverse. It's a zero-sum game: where a long call loses money, a short call makes money. Just remember, a short call has limited profit potential in exchange for unlimited risk if the stock decides to skyrocket. When thinking about selling a call short, you should probably consider another option strategy that more effectively expresses your market opinion with less risk.
Buying puts is a strategy that profits from a drop in a stock's price. The only practical difference between buying puts and buying calls is that you want the stock price to go down if you buy a put, and up if you buy a call. The decisions about days to expiration, volatility, ITM, ATM, and OTM are all basically the same for a call and put.
Buying a put is an effective alternative to selling stock short. Short stock can have high margin requirements, and (unlike thinkorswim) some brokers restrict their clients from shorting stock. Unlike short stock, buying puts has limited risk. No matter how high the stock goes, you can only lose the premium you paid. The max potential profit on a long put is the dollar value of the strike price of the put minus the premium of the put, and would be achieved if the stock goes to $0 at expiration
Selling a put short is the mirror image of buying a put. Like a short call, a short put requires you to assume unlimited risk. Like the potential profit on a long put, the risk of a short put is the dollar value of the strike price of the put minus the premium of the put. Because a stock can never have a value less than zero, the potential loss on a short put can be very, very large, but it is not infinite. When thinking about selling a put, consider other trades that would take advantage of your market opinions with less risk.
When trading options, you have to refine your speculation to incorporate how much you think the stock may move, how much time it will take for the stock to move, and how implied volatility might change. Not accounting for these factors is a major reason why novice option traders lose money. Understanding the trade-offs in options will help you understand how and why your option position is acting the way it is.


Buying an option, whether it's a call or put, is known as buying premium; selling or shorting an option, whether it's a call or put, is known as selling premium. This terminology implies a certain equivalency between calls and put. Indeed, calls and puts share many characteristics.
The greeks of calls and puts are calculated from the price of the stock, the strike price of the option, the estimate of volatility of the stock, the time to expiration of the option, the current interest rate and any dividends payable on the stock before the expiration date of the option. You can read more about the greeks in their own article.
The delta of a long call is positive; the delta of a long put is negative. The delta is reversed for short calls and puts. This can be understood by knowing that, all things being equal, a long call makes money if the stock price goes up, and a long put makes money if the stock price goes down. One of the things you will probably watch the most when trading is the delta of your position. The delta of a position is simply the sum of the quantity of each option times each option's delta. Thinkorswim presents position deltas in terms of shares of stock, i.e. long 1 call option representing 100 shares of stock and with a delta of +.75 with shows a position delta of +75. Therefore, if you are long 5 calls, each with a delta of +.75, your position delta would be +375. Keep in mind that some options represent something other than 100 shares of stock. This occurs when there are stock splits, takeovers, or mergers. The delta of your position is affected accordingly.
And just what does make delta as "watchable" as the girl from Ipanema? It's that it changes. The main factor in the delta of an option is where the stock price is relative to the strike price of the option. So, a call that starts out with very little delta can have very large delta if the stock price rises sufficiently. Your exposure in the stock increases as the stock price rises. Now isn't that long and lovely.
Time passing and changes in volatility also affect delta. Time and turmoil ravage more than the looks of Brazilian hotties. Use the thinkorswim Analysis Page to see how time passing or a drop in volatility will push the delta of an ITM option closer to 1.00, and the delta of an OTM option closer to 0.0.
Remember that delta is only a theoretical approximation of your exposure in the stock. So, don't be surprised if your options don't have prices that match what your delta predicted. With the stock price, time, and volatility changing, you may have to monitor the delta of your position vigilantly to make sure you have the exposure you want.
Gamma is the greek that gets your delta going. If you look at delta as the "speed" of your option position, gamma is the "acceleration". The gamma of long options, calls or puts, is always positive; of short options, always negative. Gamma is highest for the ATM strike, and slopes off toward the ITM and OTM strikes. One good way of interpreting gamma is that long gamma "manufactures" deltas in the direction the stock is moving. That is, positive gamma is why long calls get more positive delta when the stock price rises, and why long puts get more negative deltas when the stock price falls. That's why short gamma can be so dangerous. When your speculation on stock price is wrong, short gamma makes it hurt really bad. With a small gamma, your position delta probably won't change much. The more gamma your position has, your position delta can change a great deal and probably needs close monitoring.
But if you think the price of a stock is going to move a great deal very quickly, you want to buy an option with relatively high gamma. The high positive gamma will get you more deltas if the stock price moves the way you want it to, and reduce your deltas if the stock price moves against you.
Theta measures the daily whittling down of an option's value. It's inescapable. Long calls and puts have negative theta and, all other things being equal, lose money as time passes. Short calls and puts have positive theta and, all other things being equal, make money as time passes. The theta of options is indirectly proportional to gamma. When gamma is big and positive, theta tends to be big and negative. That's the trade-off. A position that has a lot of gamma (good for fast changing stocks) also has lots of theta that is continuously eroding its value.
It's highest for the ATM strike, and slopes off to the ITM and OTM options, and responds to the passage of time and changes in volatility the same way that gamma does.
Don't let anyone tell you different: vega is not a Greek letter. So why does it get to be a greek, and not the lost-but-not-forgotten "digamma"? Sounds like a conspiracy to me. Vega measures how much the value of an option changes when the implied volatility of that option changes. Long calls and puts both have positive vega and, all things being equal, make money when implied volatility rises. Short calls and puts both have negative vega and, all things being equal, make money when implied volatility falls. Implied volatilities move up and down, sometimes in frighteningly large amounts. When markets are sluggish, implied volatilities often drop, combining with theta to make long option positions cry out for mercy.
The more time there is until expiration, the higher the vega is for an option. Vega also depends on where the price of the stock is relative to the strike price of the option. Like gamma and theta, vega is highest for the ATM options, and drops for the OTM and ITM options. So, ATM options with lots of time to expiration are the most sensitive to changes in implied volatility.
The theoretical assumptions made here are only as good as the data input. Stress testing with changes in overall implied volatility and at each individual strike will help you understand this concept.
From a purely theoretical standpoint calls and puts would be perfectly opposite were it not for the probability assumption, which implies that calls can theoretically go further in the money than puts and therefore have bigger deltas than puts when they are both at-the-money or equidistant from the money.
Some readers will cite minuscule differences between the greeks of puts and calls at the same strike. For all intents and purposes, gamma, theta, and vega are the same for long calls and long puts. A fair wager would be that there is no way to make or save money by playing for any differences.


Calls, puts, and stock are the building blocks of all trading strategies. Buying or selling any one of these is a strategy unto itself. The discussion of structure is really about how any two of the three – calls, puts, and stock – can be combined to make the third. Synthetics are most useful to arbitrageurs who look for opportunities to purchase one instrument cheaper than they sell its synthetic, a process that can at times be somewhat complicated.
When referring to options, synthetics are positions that are made up of two things to act like a third. That is, you can create a "synthetic" long call by buying stock and buying a put. You can sell "synthetic" stock by selling a call and buying a put with the same strike price. The basic synthetic equivalents are:
  • Long Stock = Long Call and Short Put
  • Short Stock = Short Call and Long Put
  • Long Call = Long Stock and Long Put
  • Short Call = Short Stock and Short Put
  • Long Put = Short Stock and Long Call
  • Short Put = Long Stock and Short Call
It can be seen that a short put is equal to the popular covered write, which is long stock and short a call.
To show you a simple way to prove that synthetics "work" we use a conversion, which is short a synthetic put and long an actual put, or long a synthetic call and short an actual call, or short stock and long synthetic stock. (N.B. being able to see an option position in different ways can be a useful skill in managing risk and taking advantage of market conditions.) The idea is that if you buy something at a certain price, and sell its synthetic equivalent at the same price, you shouldn't make or lose any money.
Let's consider the ABC Nov 50 call price priced at $4.00, the ABC Nov 50 put priced at $2.00, and ABC stock at $52.00 (the options prices are ignoring interest rates). The conversion is long 100 shares of ABC stock, long 1 ABC Nov 50 put, and short 1 ABC Nov 50 call. By performing "what–if" analyses, it can be determined that the conversion breaks even (that is, neither makes nor loses money) at all stock prices at the expiration of the options. We'll test scenarios where the price of ABC stock is $52.00, $100.00, and $25.00 at expiration.

Stock @ $52.00Stock @ $100.00Stock @ $25.00
Value at ExpirationProfit/
Value at ExpirationProfit/
Value at ExpirationProfit/
Sold 50 Call @ $4.00$2.00$2.00$50.00($46.00)$0.00$4.00
Bought 50 Put @ $2.00$0.00($2.00)$0.00($2.00)$25.00$23.00
Bought Stock @ $52.00$52.00$0.00$100.00$48.00$25.00($27.00)
So, a conversion is a flat position, that is, it has virtually no exposure to the risk of the stock price moving up and down. That's because you bought a synthetic call, and sold an actual call.
It is important to understand the nature of risk and the synthetic properties that are inherent in options. People too often look at how much they can win and not often enough at what they can lose. This approach has made many people rich, but it is unfortunately only a matter of time before the market eventually ruins those who carry positions that they were ill–prepared to deal with. Traders often suffer from tunnel vision and lose sight of the fact that they hold a position on a security that they never wanted. It is usually too late to act by the time they realize this.


At expiration, an option is worth any intrinsic value or 0. Option values depend on the price of the stock, the strike price, the implied volatility of the stock price, the time to expiration, interest rates, and any dividends payable before the expiration of the option. We won't go into a discussion of theoretical pricing models at this time. Suffice it to say that theoretical values really give you a good guess as to what the real value of an option is. They don't guarantee that you'll make money. Read the article on "The Matrix of Options", and get an insight on option pricing without theoretical models.
As a ruleTemplate of thumb, the higher the volatility, the more expensive the option, and the more days until expiration, the more expensive the option. Dividends reduce the value of calls and increase the value of puts. An increase in interest rates increases the value of calls and decreases the value of puts.
Remember, whenever an option trade occurs, the buyer thinks the option is too cheap and the seller thinks the option is too expensive. The fact that people disagree on value is why any trading occurs at all. Rather than worrying about the value of an option, you should concentrate on the risk/reward of an option trade. thinkorswim provides you with professional-level risk management tools to help you make sense of all this.

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