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Options Lab Part 3: Trading Hunches with Bullish Strategies

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November 1, 2013

As you “Lab” readers know by now, options are incredibly flexible, customizable instruments. Then again, if you’re bullish and you know how to buy stock, why would you want to complicate things with options? Because in some circumstances, options can provide a “better kind of bullish.”

For most traders, there’s more to the story than simply believing a stock will move up. For example, maybe you’re thinking about how much your stock might rise over just the next month. Depending on how much detail drives your trading goals and decision-making, there may be an option strategy that fits. We’ll start with a few basic strategies, saving bullish options spreads for later.

Kinda Bullish: Covered Call

Let’s say you buy a stock in the belief that it will head to the moon. The company has sound earnings, a good chart, and appears to be trading at an appealing price. You buy the stock, but soon after, you realize that it’s no longer the stock that you fell in love with. Some months it may not move. And in those months when it does, it tends to barely budge.

Just as one man’s junk is another man’s treasure, this stock may be a candidate for a covered call strategy. A call gives the owner the right, but not the obligation, to buy the stock at a set time and price. The seller of the call is obligated to deliver stock to the call owner at the strike price if assigned. 

To create a covered call, you sell one standard call option contract, which represents 100 shares of stock, against a corresponding stock position. For example, you could buy 100 shares of XYZ stock for $60 per share, and sell one XYZ May 65 call for $3.

If XYZ remains below the call strike of $65 per share, you will likely keep the option premium of $3, or $300 per contract. If, on the other hand, XYZ trades at or above $65 per share prior to expiration, you’ll likely be forced to sell your stock at $65 per share (yes, the same stock you bought for $60) and you get to keep the $3 from the sale of your option. But you would miss out on any additional appreciation on the stock above $65. Notice that in this second scenario, you’d keep both the money made from the appreciation and subsequent sale of the stock and the premium collected by selling the XYZ May 65 call. In both scenarios, you will also need to factor in commissions and other transaction costs, which should be considered when evaluating any options trade.

As a bonus, the covered call strategy can pack a small bit of downside protection (the premium you received). Had you simply bought XYZ stock for $60 per share, your breakeven price would be $60. However, by taking advantage of a covered call strategy and selling the 65 strike call at $3, you lower your breakeven on the stock purchase from $60 to $57 per share (not including transaction costs).

All in One: Cash-Secured Put

The covered call can be a great strategy to introduce a beginning options trader to the power and elegance of options. Of course, you have to pay a commission for the stock purchase, a commission for the sale of the call. And yes, if you decide to close out the position early or if you are assigned on your short call option, you’ll have commissions and fees there too. But what if you could create a trade with the same risk profile and only have to pay one commission?

Enter the cash-secured put strategy. A put option gives the owner the right, but not the obligation, to sell the stock at a set time and price. The seller is obligated to purchase shares at the strike price if assigned. Here’s how it works.

Rather than buying stock for $60 and selling the XYZ May 65 call at $3 against the stock, you sell the at-the-money XYZ May 60 put at $5 and put enough cash aside to buy the stock in case you need to. You don’t have as much upside potential—$8 on the covered call, $5 on the short put—but the beauty here is in a covered call, you have to buy the stock right away. With a cash-secured put, you don’t buy the stock, you save yourself a commission and the money you set aside to buy the stock may accrue a little interest.  

Ideally you want the price of the stock to stay above $60 per share. But of course, it’s already trading at $60. So, if XYZ falls below $60, then you risk early assignment, and will be forced to buy XYZ stock at $60 per share. If so, you’ll use the cash that you set aside when you initially placed the trade. That’s the “cash-secured” part of the name that some folks miss. In addition to that ready cash, you’ll have the $5 of premium from your initial sale of the 60-strike put (less transaction costs) to help soften some of the blow. Of course, it’s possible that the price could continue to fall, however, since your cost basis is actually $55, you have a little cushion before you start to lose on the trade.

Sell and Sell Again: Combining the Strategies

The beauty of this combo is that if you’re assigned on your short put position and forced to buy the stock, you might turn right back around and sell a call against your newly bought stock. With that, you’ve just created a covered call position. The difference is that you collect an option premium at trade initiation and grab more premium in the sale of a call option after assignment.

Today’s take-home: Betcha didn’t think you could get this excited about a stock slogging away in a ho-hum range? That’s the power of options. The covered call and the cash-secured put are basic strategies, but they can be used to generate some additional premiums in a trading account.