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Option Trading - Part 2

Options trading can become very complicated very quickly. There are LEAPS (long-term contracts), choosers, barriers, compounds (exotics) and a host of technical parameters to measure volatility and predict price movements.

Thankfully, some of these complications can be simplified into a number of simpler trading strategies. Most revolve around using the fact that options have a contractually specified expiration date and strike price. This makes trading in them subject to some techniques not available in regular stock investing.

Calendar

The 'calendar spread' or 'time spread' strategy involves simultaneously buying and selling two options of the same type, with the same strike price, but different expiration dates.

For example, purchase two calls of MSFT (Microsoft) at a strike price of $27, but one set to expire on April 15, the other on June 17. The idea is to attempt to gain from the difference in price as each contract advances closer to maturity.

Straddle

In a 'straddle' strategy the investor holds both a call and a put (on the same underlying asset, of course) with the same strike price and expiration date.

At first blush, this seems like betting against oneself. No matter which way the price goes, the investor loses. But, it's also true that no matter which way the price goes the investor gains.

It's this feature that makes a straddle a kind of hedging strategy. Since price direction and amount can only be predicted to some degree of probability, the investor is 'hedging his bets'.

While risky, the strategy can produce profits when price movements are large. Offsetting those potential profits is the fact that, where others are also betting on a large price movement, these options contracts tend to be priced higher.

Strangle

Yet another variation is the 'strangle'. The investor holds both call and put options with the same maturity, but with different strike prices.

These contracts are purchased 'out of the money' and therefore cost less to buy. ('Out of the money' means the strike price of the underlying asset is – higher (for a call) or lower (for a put) – than the market price.) Their purchase price (premium) is lower since if the option were exercised immediately the investor would experience an immediate loss.

Suppose Microsoft (MSFT) is currently trading at $30 per share. Buy one call at $3 and one put at $2 with the call having a strike price of $35, the put $25. (Total Investment = ($3 x 100) + ($2 x 100) = $500.)

If the price over the length of the contracts stays between $25 and $35 the total possible loss = $500, the cost of the options.

Suppose the price drops, though, to $15. The call is worthless, but the put is worth ($25-$15) x 100 = $1000 - ($2 x 100) = $800. Subtract the cost of the call, $800 - $300 = $500. This represents the net profit (ignoring commissions and taxes) on the trades.

Definitely do try this at home, but wear a safety helmet... in the form of following carefully the movements of both the options and the underlying assets.



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