The first post in this series “Follow Up Options Tactics” is here. This is the follow up example from Options as a Strategic Investment.

A call buyer bought an XYZ October 50 call for 3 points when the stock was at 48. The stock has since risen to 58 and the October 50 is now worth 9 points with plenty of time remaining to expiration.

We presented four tactical choices for the call buyer:

1. Liquidate - take the $600 in profits and close out this trade.
2. Roll-Up - Sell the October 50. Pocket the $300 initial investment and use the $600 to buy out of the money XYZ calls that have a reasonable chance, according to the volatility, to be in the money at expiration.
3. Spread - Create a bull spread by selling a same expiration out of the money call against the profitable October 50 long call, preferably getting at least as much as the $300 cost of the October 50 and going into a zero risk situation.
4. Do Nothing - Hold the October 50 until sale or expiration. This is the only tactic that can result in total loss of the initial investment.

What are the alternatives to Tactic 1 - liquidating and pocketing the 6 points, and Tactic 4 - doing nothing, that would allow the call buyer to reduce some of the risk of staying in the position without giving up on the possibility of greater profits?

The XYZ October 60 call is selling at 3 points. The call buyer could liquidate his October 50 call for 9, buy two October 60 calls, and put $300 in his pocket. One of the attractions of this roll-up tactic is that the vanilla options trader is now playing with house money. He owns two calls for free, doubling his position, and every penny of appreciation in the October 60 call is pure profit.

If XYZ stock continued to rise substantially above the 60 strike price then Tactic 2, the roll-up, would provide the greatest reward. If ZYX stayed the same or fell backwards before expiration, however, the roll-up becomes one of the worst choices.

The final alternative, Tactic 3, has the distinct advantage of never being the worst choice.

The call buyer initiates this tactic by holding onto his October 50 call, for which he paid 3 points, and selling the October 60 call for 3 points. Because the sale of the October 60 call (the short side of the spread) matched the cost of his October 50 call (the long side of the spread), the call buyer is in the position for zero risk no matter what XYZ stock does between now and expiration.

Tactic 3 is called a bull spread.

(ed. You need a margin account and must meet minimum equity requirements to create option spreads.)

The maximum potential profit in the bull spread is 10 points, the difference between the higher short strike and lower long strike. The maximum profit can be realized only if XYZ is at or higher than 60 at expiration because the October 50 call would always be worth exactly 10 points more than the October 60 call no matter how much above 60 XYZ stock ended up.

Tactic 3 is the best choice if XYZ remains above the lower strike price but relatively unchanged at expiration. If XYZ drops below 50 then it is a better choice than doing nothing because the call buyer does not experience a loss. If XYZ rises above 60 then the 10 points profit from Tactic 3 is a better outcome than the 6 points the call buyer would have received from liquidating. And again, Tactic 3 is never the worst performer of the four choices.

You can quickly set up a matrix with real numbers to get a handle on the possible outcomes for each of the four choices.

The best or “right” choice at any given time is not going to jump out and bite you. Successful options trading is about cooly managing the probabilities. Part of that is setting a range of realistic outcomes for the future price of the underlying stock. Implied Volatility is the tool of the options professionals. You can see our Vanilla Options Toolbox video here. It’s a freebie with any of our ebooks.

In the next post in the series we will cover some defensive options strategies you can use to salvage a position when the stock moves against you.

If you are a call buyer, and you’ve been fortunate enough to have the underlying stock rise rapidly in price, you have an unrealized profit. But now you’re torn between taking the profit or holding onto the option in an attempt to generate even more profits with an expectation that the stock will continue to rise. So the question is that once you have an unrealized profit with some time remaining to expiration, what are the tactical choices you can make to protect a profit, and what are the different risks involved?

If you’re in this situation you have four choices about what to do now.

1. You can liquidate the position by selling your long call and pocketing the profits.

2. You can sell the call you own, pocket some of the cash, and use the remaining part of the proceeds to buy as many contracts of an out of the money call as you can.

3. You can create a bull spread by keeping your long call and selling a higher strike price call in the same expiration month.

4. You can do nothing and continue to hold current option contract until expiration.

From this point forward in time each of these choices presents a different level of risk and reward.

If you liquidate your current position and take the profit, Tactic 1, that ends the possibility that you can get any further appreciation from it. By the same token you cannot lose any money on the position either. This is the least aggressive tactic. If the underlying stock continues to rise, say to more than 10 points from its current level, all of the other choices would outperform the complete liquidation. However, if the underlying stock would decline below your strike price then liquidating your position now would have been the most profitable of the four strategies we listed above.

In Tactic 4 you do nothing but hold the option until expiration. This is the riskiest tactic because it’s the only one that would create a complete loss in the event that the stock price fell below your contract strike price at expiration. However if the stock price continued to rise to expiration then Tactic 4 would have proven to have been the most profitable.

Tactic 1 and Tactic 4 are easy to figure out and are probably what most vanilla option traders do all the time. In the next post we will set up a real world scenario and see how Tactic 2 and Tactic 3 would turn out with different stock prices at expiration and then compare them to the outcomes of Tactic 1 and Tactic 2.

Options as a Strategic Investment

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Book Description

Reflecting today’s market realities and the new innovative options products available, this fourth edition features an in-depth analysis of volatility and volatility trading; updated information on all stock option strategies, reflecting recent market conditions; buy and sell strategies for Long Term Equity Anticipation Securities (LEAPs); detailed guidance for investing in the growing field of structured products; the latest developments in futures and futures options; and the market impact of the most recent changes in the margin rules.

Packed with graphs and charts to clarify profit and loss potential, margin requirements, and criteria for selection of a position, this classic remains an indispensable resource for investors determined to master the world of options–and profit.

Tough Stuff But Worth The Effort November 24, 2007

This is a review for the non-professional investor or for the new full time investor who is considering a possible 2nd career or full time activity with their personal funds.

As an individual investor for over 30 years, I thought I knew the ropes about Options and Stocks. The first 94 pages opened my eyes to what I did not know! These pages alone have changed my investment strategy profoundly and for the better.

This is a best of breed book. It’s pithy and precise. It’s not a breezy read. But the good news is that it’s comprehendable to the non-professional. I was delighted with excellent concept presentations, examples, and well defined terminology.

In exchange for the effort of reading and re-reading - yes plowing through it — you are rewarded with the techniques of the pros. You’ll see options investing in a very different and profitable way.

You might consider investing your time an money in this book before plunging thousands of dollars into “investor education” which is marketed so aggressively today. Once you know the fundamentals that this book provides, you’ll be in a better position to assess the value of these other alternatives.

I can’t give this book enough praise.

In the Vanilla Options Toolbox video, we talked about volatility as a moving target. The chart above is the CBOE NASDAQ Volatility Index, called the VXN. The chart is one year of daily data, and you can see that indeed volatility is a moving target that ranged from around 15 all the way up to about 34.

Using the Black-Scholes option pricing formula, that extreme range of values would produce a rather huge range in stock prices and option prices, possibly wreaking havoc on your call or put buying strategy. Anybody who bought long, out-of-the-money options at the apex of volatility almost certainly got killed when volatility dropped and their out-of-the-money options went immediately to pennies.

In the Options Toolbox, we have a screen that does implied volatility calculations, but perhaps another way to handle the volatility calculation is to use an index like the VXN. If not for assigning voaltility then to try to get a handle on the direction in which volatility is heading. One thing that we did with this chart was that we put the VXN data into Excel and ran a trendline through the data, and then projected the data ahead 30 days. It looks like a fairly good estimation that volatility will creep higher into the February expiration period.

Book Description

One of the most widely read books among active option traders around the world, Option Volatility & Pricing has been completely updated to reflect the most current developments and trends in option products and trading strategies.

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Written in a clear, easy-to-understand fashion, Option Volatility & Pricing points out the key concepts essential to successful trading. Drawing on his experience as a professional trader, author Sheldon Natenberg examines both the theory and reality of option trading. He presents the foundations of option theory explaining how this theory can be used to identify and exploit trading opportunities. Option Volatility & Pricing teaches you to use a wide variety of trading strategies and shows you how to select the strategy that best fits your view of market conditions and individual risk tolerance.

New sections include:

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* A broader, more in-depth discussion volatility
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A Beginner’s Guide to Day Trading Online (2nd edition)
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Customer Review: I bought this book based on all the high review ratings of so many other readers. Unfortunately I found this book to be disappointing. The author clearly knows what he is talking about but I feel does a poor job conveying the concepts to the reader. The basics of placing orders, commission structure,etc get glossed over and the author frequently mentions concepts and then states the will be discussed later in the book. This just needlessly muddies the waters. The presentation of numerical data is also poorly handled. The author describes in long-winded paragraphs concepts that could be more clearly illustrated in tables or graphs. At any rate I found the book disappointing and feel I have learned little about option investing. The book seems to be more of an academic study in options, not an investment oriented, “real world” way to profit from trading options. Someone with advanced knowledge can probably appreciate this but beginners and intermediates I think will find this book lacking.


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Hot Commodities: How Anyone Can Invest Profitably in the World’s Best Market
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Customer Review: I almost gave this book 5 stars for the mere fact that Rogers’ predictions have come true since the time the book was published. For example, gas and gold prices have increased dramatically, as predicted, since 2004. S&P has been mostly going sideways and Rogers’ prediction of the housing meltdown was right on. From an investment standpoint, the book would have been more helpful 4 years ago than today. Nevertheless there is still a lot of value here. First, Rogers’ writing is engaging and interesting. Second, he offers readers a different way of looking at the world which is valuable regardless of your investments. Finally, he claims that his ideas and predictions of rising commodity prices will continue at least to 2015, so there is plenty of time left to profit from his wisdom.

This book is an introduction and individual investors will have to do a lot more research and thinking before they can actually implement Rogers’ ideas. The author admits that point, himself. Furthermore he does not really tell readers a logical way of even trying to profit from rising commodities. He claims the best way is to buy commodities directly, but after reading the book I have little idea how to go about buying commodities for the long term. Futures allow investors to profit in the short term but if you believe that lead prices will peak in 2015 or so, how can you profit from that prediction? After all, prices are not predictable in the short term and an investor can get burned badly speculating in the …


Mastering the Trade (McGraw-Hill Trader’s Edge)
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If you ever wondered what trading software W.D. Gann would have used if he were born a few decades later, I suspect it might be Wave 59. What other trading software has a menu with Geometric Patterns, Neural Nets, Fibonacci Vortex, and astrological cycles? I suggest not doing the free 30 day trial until you know that you’ll have some time to spend with Wave 59.

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Person also fully discloses some of his proprietary setups, such as the high close doji, the low close doji, and the jack hammer pattern, complete with rules on the entries and exits to help you identify high probability trades.

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Software and hardware for the active trader

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A thorough trading guide from a professional trader

The Complete Guide to Technical Trading Tactics can help the new individual investor understand the mechanics of the markets. Filled with in-depth insights and practical advice, this book details what it takes to trade and shows readers how they can broaden their horizons by investing in the futures and options markets. The Complete Guide to Technical Trading Tactics outlines a variety of proven methodologies-pivot points, candlesticks, and other top indicators-so readers may use those that work best for them as well as make their own trading decisions without a second thought. Author John Person also shares his insights on a variety of trading technologies that will allow readers to gain a competitive edge in the market.

John L. Person (Palm Beach, FL) publishes The Bottom-Line Financial and Futures Newsletter, a weekly commodity publication that incorporates fundamental new developments as well as technical analysis using his trading system.

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