Hedging Archives - PeakProfit

Reversal

Posted on June 26, 2024June 27, 2024 by admin

Reversal overview

Reversals look to capitalize on arbitrage opportunities provided by skewed options pricing. Risk reversal strategies have defined risk and profit. A reversal consists of selling a call and buying a put for long stock positions or buying a call and selling a put for short stock positions. All options have the same expiration date.

Reversal market outlook

Risk reversals may be used on long or short stock positions and are entered for a guaranteed small credit. The credit received at entry is the guaranteed profit with no risk, as the shares of stock will be closed when the in-the-money option is exercised. While the profit is guaranteed, it is limited to the original credit received, and the investor will not experience additional profit if the stock continues higher or lower.

How to set up a Reversal

A reversal is created by purchasing and selling opposing at-the-money options contracts with the same expiration date. Reversals are similar to collars in their composition. If an investor is long a stock, a short reversal is created by selling a short call option at the price the stock was purchased, and buying a long put option at the same strike price, much like a collar strategy. If an investor is short stock, simply reverse the mechanics: a short put option is sold and a long call is purchased to create a long reversal.

The long leg components of the reversal provide protection if the stock moves against the investor. The short legs help offset the cost of buying the long options but limit profits if the stock moves in the desired direction.

Reversal payoff diagram

The payoff diagram for a reversal is a straight horizontal line based on the credit received to enter the position. The strategy takes advantage of skew in options pricing, when available, while protecting against downside risk.

For example, if a stock is owned at $100, a reversal may be created by buying-to-open (BTO) a $100 put and selling-to-open (STO) a $100 call with the same expiration date. This would only be advantageous if a credit is received. Therefore, the short call would have to collect more money than the long put. If $1.00 was earned for completing the transaction, a profit of $100 would be the trade outcome. If the stock is above the strike price of $100, the short call will be exercised and sell the 100 shares of stock. Conversely, if the stock price is below the strike price of $100, the long put will be exercised and sell the 100 shares of stock.

If a stock has increased since the position was initiated, a reversal could be created above the purchase price to secure a profit. The strike price of the options would guarantee the exit price.

For example, if a stock purchased at $100 is trading for $110, and a costless reversal could be entered at $105, a $500 profit would be guaranteed, because the long stock position would be sold at $105 regardless of where the underlying stock price is at expiration. The reversal would protect against future downside price movement. However, the profit would be capped at the $105 strike price.

Image of reversal payoff diagram showing guaranteed profit

Entering a Reversal

Entering a risk reversal involves buying and selling options with the same strike price and expiration date, typically at the price the stock was originally purchased or higher. If long shares of stock are owned, a buy-to-open (BTO) order is placed for a long put and a sell-to-open (STO) order is placed for s short call. If an investor is short shares of stock, the order is reversed: purchase a long call and sell a short put. The goal is to collect a credit at entry based on skew in the option’s pricing. This will guarantee a profit, as the options will automatically cancel out the stock position at expiration.

Exiting a Reversal

Reversal strategies are typically held until expiration. At expiration, one of the two options will expire in-the-money, and the other will expire worthless and out-of-the-money. Because the options are opened at the price of stock ownership, the in-the-money option will automatically be exercised and close the stock position. The reversal trade is opened for a credit, and that credit will remain as profit.

Time decay impact on a Reversal

Time decay does not impact a reversal strategy during the trade but may impact the pricing at entry. Because the strategy depends on a skew in options pricing to be profitable, an investor will want to identify a scenario where theta works in favor of the short option being sold.

Implied volatility impact on a Reversal

Implied volatility does not impact a reversal strategy during the trade but may impact the pricing at entry. Because the strategy depends on skew in options pricing to be profitable, an investor will want to identify a scenario where implied volatility works in favor of the short option being sold. This will typically occur when the market anticipates a move in one direction is more likely than the other, which will result in higher pricing for those options premiums.

For example, if a stock is owned at $100, the at-the-money options will be priced according to the market’s belief that the underlying asset is more likely to move up or down. The $100 call may be worth $3.00, while the $100 put is only worth $2.00. This is because implied volatility in the future tends to lead to a move up in the stock price. An investor would then enter a reversal by selling the call and buying the put, thereby guaranteeing a $100 profit whether the stock moves up or down.

Adjusting a Reversal

A reversal position may be adjusted if the trade can be extended for more credit. This may be possible as the options approach expiration if the original skew in pricing still exists. If the price of the underlying stock is unchanged, the same position could be opened for a later expiration date. If the underlying stock price has changed, and a new reversal can be opened at-the-money for credit, an investor may choose to extend the trade and continue receiving credit.

Rolling a Reversal

Reversals can be rolled to a later expiration date if the original position can be closed and reopened for more credit. The roll could occur at the same strike prices or adjusted up or down to reflect a change in the underlying stock price, but only if additional credit is collected. This may be accomplished by simply closing the existing position and opening a new position for a later expiration date.

Hedging a Reversal

Reversals are not typically hedged because the strategy is a hedge for an underlying stock position. A reversal is a tool to lock in profit and avoid downside risk, so further hedging is unnecessary. The position already has a strictly defined profit and loss outcome.

FAQs

What is the difference between a collar and a risk reversal strategy?

A reversal strategy is used to create a risk-free profit. Reversals secure a defined profit and limit risk when entered. Reversals use the credit from writing an option to help offset the cost of holding the long option. The short option will limit the profit potential, while the long option protects from an unfavorable move in the underlying stock.

A collar strategy is a multi-leg options strategy combining a covered call and protective put. Selling the covered call will result in a credit that can be used to offset the cost of purchasing the protective put.

What is an example of an options risk reversal?

If a stock is owned at $100, a reversal may be created by buying-to-open (BTO) a $100 put and selling-to-open (STO) a $100 call with the same expiration date. This would only be advantageous if a credit is received. Therefore, the short call would have to collect more money than the long put.

If you collect $1.00, a $100 profit is guaranteed if the position is held until expiration (less any brokerage fees + commissions). If the stock is above the strike price of $100, the short call will be exercised and sell the 100 shares of stock. Conversely, if the stock price is below the strike price of $100, the long put will be exercised and sell the 100 shares of stock.

What is an options reversal?

A reversal is a multi-leg options strategy with defined risk and limited profit potential. Reversals are used in conjunction with a long or short stock position. Risk reversals are hedging strategy that defends long or short positions against unfavorable price movements using calls and puts.

Stock Repair

Posted on June 26, 2024June 27, 2024 by admin

Stock Repair overview

Stock repairs have limited profit potential, and while they do not define risk to the downside, the ratio spread-like structure lowers the break-even price on a long stock position held at a loss. The income collected from selling the spread helps increase the probability of recovering from the loss of the long stock position. A stock repair may be entered at no cost or for a credit.

Stock Repair market outlook

The stock repair strategy is utilized when an investor has incurred losses on a long stock position and wants to reduce the necessary price increase required to break even. The strategy limits future upside potential but is an alternative to simply holding the shares and waiting for the stock price to recover and/or adding shares to lower the original trade’s cost basis, which requires risking more capital. However, the best the stock repair strategy will do is break even on the original trade, but this comes at no further downside risk than already owning the shares of stock.

How to set up a Stock Repair

Stock repair is essentially a call ratio spread combined with a long stock position and consists of buying an at-the-money call and selling two out-of-the-money calls at a higher price. The strategy is used if the stock price has decreased since ownership was initiated. Therefore, the at-the-money long call option will be below the cost basis of the long stock shares. The short options become the break-even price for the original stock position.

The ratio spread may be opened at no cost, or result in a credit, and will help to lower the cost of the initial trade.

Stock Repair payoff diagram

The payoff diagram for a stock repair strategy combines the profit and loss outcomes of long stock ownership and a call ratio spread. The maximum potential profit will now be limited to the strike price of the short call options. However, the break-even point will now be reduced.

For example, if 100 shares of stock were purchased at $50, and the stock is now trading for $40, a stock repair strategy could be used to help reduce the cost of the position. One buy-to-open (BTO) order for a long call option is entered at-the-money of the current stock price of $40. Two sell-to-open (STO) orders for short call options are entered out-of-the-money above the long options at $45. If the long call is purchased for $400 and the short calls are sold for $200 each, the net cost of the position is $0. If the stock stays below $40, all options expire worthless.

A similar strategy could be employed for the next expiration month. If the underlying stock closes above $40 but below $45 at expiration, the short calls expire worthless, and the long call can be sold for its intrinsic value, which would bring in more credit and reduce the break-even point of the original stock position. The investor could choose to close his long shares of stock or open a new position for a later expiration date. (For example, if the stock was at $42, the stock repair would have collected $200. Selling the stock would result in a -$600 loss, which is better than the -$800 it would have experienced without the strategy).

If the stock price closes above $45 at expiration, all options will be in-the-money. The long call and one short call will cancel out, and the remaining short call would sell shares of stock at $45. This would result in a break-even result for the stock repair as the $500 gain on the long call cancels out the $500 loss on the long stock position. The downside is that if the stock position closes above $50, the position will still only break even.

Image of stock repair payoff diagram showing max profit, max loss, and break-even points

Entering a Stock Repair

Stock repair is a call ratio spread and consists of buying an at-the-money call and selling two out-of-the-money calls at a higher price for every 100 shares of stock owned. All three options have the same expiration date. The strategy is used on a stock position that has an unrealized loss in an attempt to reduce cost basis and increase the chances of breaking even.

The stock repair strategy is opened with the at-the-money long call at a strike price lower than the stock’s original purchase price. The short options are sold at a higher price and must offset the cost, or collect more money, than the cost to purchase the long call for the strategy to be effective.

For example, if 100 shares of the stock were purchased at $50 and are now trading at $40, the stock repair may be entered with buying-to-open (BTO) one long $40 call and selling-to-open (STO) two short $45 call options, all with the same expiration date. If the long call is purchased for $400, the two short options should collect at least $400 of credit for the strategy to be successful.

Exiting a Stock Repair

The mechanics of exiting a stock repair strategy will depend on the underlying stock price at expiration. If the stock price is above the short calls, all options will expire in-the-money, and the shares of stock will be sold at the strike price of the short calls. If the stock closes between the long call and short calls, the short calls will expire worthless, and the long call will be in-the-money. The long call and the stock could be sold simultaneously, or the long call could be sold for its intrinsic value, and a new repair strategy could be opened with a later expiration date. If the stock closes below the long call, all options expire worthless. The credit, if any, from the strategy would remain, but the overall position would still show a net loss, and a new repair strategy could be opened with a later expiration date.

Time decay impact on a Stock Repair

The effects of time decay are minimal on the stock repair strategy. The short calls are positively impacted by theta decay, while the long call is negatively impacted. However, the strategy is not looking to capitalize on time decay to be profitable, so it is not a factor in whether the stock repair is successful. The longer the options are from expiration when the strategy is initiated, the more the options will be worth, but this will apply to all of the options.

Implied volatility impact on a Stock Repair

The effects of implied volatility are minimal on the stock repair strategy. Implied volatility values will impact the pricing of the options when the position is opened, but all options will be affected similarly.

Adjusting a Stock Repair

Stock repair strategies are not typically adjusted during the trade. The strategy’s goal is to reduce the original stock position’s cost basis and lower the break-even point to a more realistic price. If the price of the underlying stock continues to fall, the short calls may be purchased and resold at a lower price, which will bring in more credit but will force the investor to sell shares of stock at a lower price if the stock is called away. If the credit received did not cover the lower strike price, the adjustment will result in a loss.

A stock repair may be adjusted if the investor decides they no longer want to break-even on the trade and believe the stock will continue to rise. If the stock price increases, the short calls could be purchased and either resold at a higher price and/or later expiration date. The position could be exited completely, but buying back the calls will cost more money than the position was initially opened for, so the outlook for the stock would need to be very bullish to eventually exceed the additional cost added to the position.

Rolling a Stock Repair

The stock repair may be rolled if the underlying stock price is above the long call strike at expiration, and the investor wishes to extend the position. Any in-the-money options could be bought or sold and reopened at a later expiration date and different strike prices if the stock price has changed. The stock repair position may be rolled if the underlying stock price is below the long call strike at expiration, and the investor wishes to extend the position for additional time to break even on the long stock position. Any in-the-money options could be bought or sold and reopened at a later expiration date and different strike prices if the stock price has changed.

Hedging a Stock Repair

Stock repairs are not typically hedged because the option strategy is an attempt to lower the break-even point on a position trading at a paper loss. Downside protection is not considered with a stock repair. Other options strategies should be considered if downside protection is desired.

FAQs

How to recover losing stocks?

The stock repair strategy can be used if your stock position is losing money and you want to reduce the amount required to break even. The options strategy limits profit potential but does not add risk. It is an active investing alternative to holding shares waiting for a rebound and/or adding more shares to lower the cost basis. The best the stock repair strategy will do is break even on the original trade.

What is the long call repair strategy?

The stock repair strategy is a combines a long stock position with a call ratio spread. The ratio spread may be opened at no cost, or result in a credit, and will help to lower the cost of the initial trade.

Buy an at-the-money call and sell two out-of-the-money calls at a higher price. You can use this strategy if your stock position is losing money.

What is the optimal time frame to use a stock repair strategy?

You can use the stock repair strategy on any timeframe. The option’s days until expiration in the call ratio spread may impact the cost of the long option and credit of the short options. However, since the repair strategy is designed to breakeven, the holding period for the stock shares is not as important.

Protective Put

Posted on June 26, 2024June 27, 2024 by admin

Protective Put overview

Protective puts are similar to purchasing car insurance: a premium is paid to protect against future risk, but the hope is that it will never be needed. Like car owners, investors are willing to pay a relatively small amount on a recurring basis to guarantee defined risk.

Protective Put market outlook

A protective put is purchased when an investor owns an asset and wants to protect against future downside price movement. Owning the long put defines risk by allowing the investor to sell stock at the long put option’s strike price. A protective put can be entered below the price of the long stock position to limit loss. If the underlying asset has increased in price since its purchase, the protective put could be placed above the original purchase price of the stock to secure a profit.

How to set up a Protective Put

Put options are listed on the option chain at various strike prices and expiration dates. The closer to the money the put option is, the more expensive the options contract. The more time until expiration, the more expensive the options contract.

Purchasing a protective put will require paying a debit and will increase the cost basis of the original long stock position by the amount of the premium paid. An investor will need to consider these factors when deciding where he or she would like to protect their downside risk and for how long.

Protective Put payoff diagram

A protective put will have a payoff diagram similar in appearance to a single-leg long call option. The maximum profit potential is unlimited if the underlying stock moves up and stays above the protective put strike price. The downside risk will be limited to the long put option’s strike price plus the cost of the premium to own the long put.

For example, if stock is owned at $100 and a protective put is purchased for $5.00 with a strike price of $95, the maximum risk for the position is $1000 per contract ($95 – $100 – $5 = -$10 x 100 shares per contract = -$1,000).

Image of a protective put payoff diagram showing max profit, max loss, and break-even points

Entering a Protective Put

Entering a protective put position is very similar to opening a single long put option, but long stock is either already owned or purchased in conjunction with the protective put. Buying the long protective put will cost money and therefore increase the long stock position’s cost basis, but that is the compromise for protecting the underlying asset from downside risk.

For example, if stock is purchased at $100 and a protective put is purchased at the $95 strike price for $5.00, the long stock position’s cost basis becomes $105, meaning the stock will have to rally above $105 to realize a profit.

Exiting a Protective Put

Exiting a protective put will depend on where the price of the underlying asset is at expiration. If the stock price is above the protective put’s strike price, the put will expire worthless. If the stock price is below the protective put’s strike price, and the investor wishes to exercise the put option, 100 shares per contract will be sold at the strike price, and the position will be closed.

Time decay impact on a Protective Put

Protective puts have extrinsic value like all options. Time decay, or Theta, will slowly decrease the value of the contract’s premium. However, because protective puts are purchased for protection and not speculation, time decay is not as important. Ideally, since long stock is owned, the goal for a protective put is to see the price of the stock increase, and the protective put expire worthless.

Implied volatility impact on a Protective Put

Implied volatility will have an impact on the pricing of protective puts. The higher the value of implied volatility, the more expensive the cost of the put option. Generally speaking, put options are more expensive than call options because investors are willing to pay a higher premium to protect from downside risk. When markets experience large price movements, implied volatility increases, and the cost of put options typically increases.

Adjusting a Protective Put

Protective put options positions can be managed during a trade as the price of the underlying stock moves. If the stock price rises, an investor may choose to move up the protective put to secure selling shares at a higher price.

To do so, a sell-to-close (STC) order would be entered to exit the original long put option position. This would collect a credit, but typically at a lower price than the option was originally purchased. A buy-to-open (BTO) order would be entered for a new long put option with a higher strike price. This will cost more than the put option that was sold, and the total amount debited would be added to the original premium paid to create a new cost basis. However, if the stock price has rallied high enough, the protective put could still guarantee a profit, even with the debits.

For example, if stock is owned at $100 and a protective put is purchased for $5.00 with a strike price of $95, and the stock subsequently increases to $120, the original $95 put may be sold (for less credit than was initially paid) and a new put may be opened at $115. If the new protective put costs an additional $5.00, the position would still guarantee a profit of at least $500.

Rolling a Protective Put

Protective put options that expire out-of-the-money at expiration have no value. To initiate a new protective put contract, a long put can be purchased for a future expiration date at the same strike price or a different strike price depending on where the underlying stock is trading.

Suppose the put is in-the-money at expiration, and the investor does not want to exercise their right to sell at that price (perhaps believing the stock will continue to rally in the future). In that case, the options contract can be rolled out to a future date by selling the original position and purchasing a new long put.

Hedging a Protective Put

Protective puts may be hedged to reduce the overall cost of the position. A short call can be sold above the stock price to collect a credit. This will limit the upside potential of the underlying stock position, but the premium received can offset the cost of the protective put. This is called a collar strategy.

FAQs

What is a protective put?

A protective put is an options strategy combined with long stock that defines the underlying asset’s downside risk. Protective puts are also known as married puts because the stock position and long put are “married” together to protect against a potential decrease in the stock’s price.

Protective puts are purchased when an investor owns an asset and wants to protect against future downside price movement. Owning the long put defines risk by allowing the investor to sell stock at the long put option’s strike price.

Are protective puts bullish or bearish?

Investors use a protective put when they want to limit downside risk of a long equity position. The investor is bullish on the underlying stock and uses the long put to hedge potential losses.

Are protective puts worth it?

Protective puts limit a stock’s downside and hedge against downside risk. However, buying a protective put adds cost to the original stock position and increases the trade’s cost basis, so it is important to factor in those considerations when thinking of using a protective put.

What is a an example of a protective put?

If you own a stock at $100 per share, you could buy a protective put with a strike price of $95. If you pay $5.00 for the put option, the maximum risk for the position is $1000 per contract ($95 strike price – $100 cost basis – $5 option premium = -$10 (x 100 shares per contract) = -$1,000).

Collar

Posted on June 26, 2024June 27, 2024 by admin

Collar Strategy overview

A collar strategy is a multi-leg options strategy combining a covered call and protective put. Selling the covered call will result in a credit that can be used to offset the cost of purchasing the protective put.

Collar market outlook

Collar strategies are used by investors who hold long stock and want defined risk. The goal of the collar strategy is to fund the cost of the long put with the credit from the short call. A collar strategy combines the downside protection of a protective put with the earning potential of a covered call. The strategy can be entered for a credit, debit, or cost-free, depending on the width of the collar’s strike prices.

How to set up a Collar

The further from expiration the position is entered, the more money will be collected on the short call option, and the more expensive the cost of the long put option. Similarly, the closer the options are to the stock price, the more money will be collected on the call and paid for the put.

Collars may be costless or entered for a credit or debit, depending on the strike price of the short call and long put options. Investors typically try to enter a collar at no cost or for a credit, but a small debit is sometimes paid. Because of the put-call parity in options pricing, a put option with a strike price that is equidistant from the stock as a call option will typically be more expensive. Therefore, if an investor wishes to enter a costless position, they would generally need to have a slight skew in strike prices relative to the underlying stock, where the strike price of the call option is closer to the underlying stock than the strike price of the put option.

For example, a collar on a stock currently trading at $100 may be entered for a debit with a $105 call option and $95 put option, a credit with a $104 call option and $95 put option, or costless with a $105 call option and $94 put option.

Collar payoff diagram

The collar strategy payoff diagram has a defined maximum profit and loss. Shares of the underlying asset may be sold at the short call strike price or the long put strike price if the option is in-the-money at expiration. If the stock is between the two levels at expiration, both the call and put options will expire worthless. The credit received for selling the call will remain but will be offset by the price of buying the put.

Collars may be costless or entered for a credit or debit, depending on the strike price of the short call and long put options. Calls sold closer to the stock price will receive more credit and puts purchased closer to the stock price will be more expensive. Investors typically try to enter a collar at no cost or for a credit.

For example, an investor may choose to enter a collar position for a stock that was purchased for $100. A $105 call may be sold and a $95 put may be purchased. If the position had a debit of $1.00 at entry, the cost basis of the long stock position will increase by $1.00 to $101. The collar will limit the profit potential above $105, but the long stock will be protected from any price movement below $95. The maximum loss would be -$600 if the stock is below $95 at expiration ($100 – $5 – $1 debit), and the maximum profit would be $400 if the stock is above $105 at expiration ($100 + $5 – $1 debit).

Image of a collar payoff diagram showing max profit, max loss, and break-even points

Entering a Collar

A collar is built around stock ownership. The stock position can be owned before entering the covered call or purchased simultaneously with the short call and long put. The collar is essentially a covered call position combined with a protective put. To initiate the collar strategy, a call is sold above the stock price and a put is purchased below the stock price. Both options will have the same amount of contracts and expiration dates. Collars may be costless or entered for a credit or debit, depending on the strike price of the short call and long put options. Calls sold closer to the stock price will receive more credit, and puts purchased closer to the stock price will be more expensive. Investors typically try to enter a collar for no cost or for a credit, but a small debit is sometimes paid.

For example, an investor may choose to enter a collar position for a stock that was purchased for $100. A $105 call may be sold, and a $95 put may be purchased. Because of the put-call parity in options pricing, a put option with a strike price that is equidistant from the stock as a call option will typically be more expensive. Therefore, if an investor wishes to enter a costless position, they would generally need to have a slight skew in strike prices relative to the underlying stock where the call option’s strike price is closer than the strike price of the put option.

Exiting a Collar

The collar is exited if either the short call or long put is in-the-money at expiration. In this case, the options contract will be exercised, and the stock will be sold at the corresponding strike price. If neither option is in-the-money, both contracts will expire worthless, and the investor may choose to initiate a new collar strategy for a later expiration date.

Time decay impact on a Collar

Time decay will impact the long and short options differently in a collar strategy. Short option positions benefit from time decay, or Theta, while long options are negatively affected. However, with a collar strategy, the protective put is in place to control downside risk, not to generate profit. Ideally, it expires worthless. The short call option will decline in value as time progresses.

Implied volatility impact on a Collar

Implied volatility will impact the price of options premium when the collar strategy is entered. The higher the level of implied volatility, the more the options will cost. This will benefit the pricing of the short call contract but have a negative impact on the pricing of the long put contract. Because collar options are typically only exercised if they are in-the-money at expiration, implied volatility changes should not affect the strategy while in the trade.

Adjusting a Collar

Collar strategies can be adjusted during the trade if the investor chooses to not exercise the options at expiration. If he or she chooses to extend the trade because they are not ready to close out the long stock position, then the challenged options contracts can be adjusted up or down, or rolled out to a later expiration date. If the long put option is being challenged, the short call can be adjusted down by buying back the original call option and selling a new contract closer to the stock price.

For example, if a collar was entered with a $105 call and a $95 put, and the stock price has moved lower, the $105 call option may be purchased and a $100 strike call option may be sold. This will bring in more credit and lower the overall cost of the position. If the stock has moved down and the investor believes it will rally in the future or if the stock has moved up and the investor believes it will continue to climb, the collar can be rolled out to a later expiration.

Rolling a Collar

Rolling a collar position can extend the duration of the trade. Suppose an investor chooses to stay in the trade, as opposed to exercising their options contracts. In that case, he or she can exit the current position by buying-to-close (BTC) the covered call and selling-to-close (STC) the protective put and opening a new position for a later expiration date. The new collar position can be at the same strike prices, or they can be adjusted up or down to reflect the new stock price.

Hedging a Collar

Collars are typically not hedged because the strategy itself is in place to protect against downside risk in a long stock position. The protective put will act as security if the stock position declines in price, thereby creating a hedge against the initial bullish bias of owning the long stock position.

FAQs

What is an options collar strategy?

A collar strategy is a multi-leg options strategy that combines a long stock position, an out-of-the-money covered call, and an out-of-the-money protective put. The collar creates a risk-defined position with limited profit potential.

What is an example of a collar strategy?

The collar strategy requires owning or purchasing at least 100 shares of stock and combining the position with a covered call above the stock price and a protective put below the stock price. Upside profit potential is limited, but the long put provides defined downside risk protection. The put and call options can be set up at any expiration date and strike price the investor chooses, but the call and put sides of the collar must have the same expiration date and number of contracts.

For example, you could enter a collar on a stock you currently own. If the security is trading at $70, you could sell a $75 call option and buy a $65 put option. This obligates you to sell the stock at $75 if you’re assigned and gives you the right to sell the stock at $65 if you exercise the long put option.

Is collar strategy bullish or bearish?

Collar strategies can protect your long equity investment from downside risk. However, the potential upside is also limited.

Covered Call

Posted on June 26, 2024June 27, 2024 by admin

Covered Call overview

Covered calls are a natural bridge between stock investing and options. Because options are leveraged, each contract represents 100 shares of stock, so a covered call requires ownership of at least 100 shares of the underlying asset. The long shares of stock can be owned before selling the covered call, or the positions can be entered simultaneously by purchasing the shares and selling the covered call against the stock position.

Covered Call market outlook

A covered call strategy is used if an investor is moderately bullish and plans to hold shares of stock in an asset for an extended length of time. The covered call will help generate income during the holding period and lowers the original position’s cost basis.

How to set up a Covered Call

Covered calls do not eliminate downside risk if the asset drops in price, but every covered call sold adds credit to the account, thereby reducing the overall cost of holding the long stock position.

Covered Call payoff diagram

Selling a covered call limits the profit potential and does not eliminate the downside risk. However, it does help to reduce the risk by the price of the premium received.

For example, if stock is purchased at $100 and a call option is sold at the $105 strike price for $5.00, the original position’s cost is now reduced by $5.00. Therefore, the cost basis and break-even point of the long stock position is now $95.

If the stock drops below that price, the downside risk is unlimited until the stock reaches $0, minus the adjusted cost basis. If the short call option is in-the-money at expiration and assigned, the profit potential is limited to the option’s strike price plus the premium collected from selling the call option. The option seller is obligated to sell shares of stock at the short strike price if assigned, therefore closing the long stock position.

If the stock closes above $105 at expiration, a profit of $1,000 will be realized per contract because the stock gained $5.00 per share ($500), plus the credit received from selling the covered call option ($500). If the stock closes below the short call at expiration, the option will expire worthless, and the credit received will remain.

Covered call payoff diagram showing max profit, max loss, and break-even points

Entering a Covered Call

Exiting a Covered Call

There are two scenarios for exiting a covered call at expiration, depending on where the stock price is relative to the strike price of the call option sold. If the stock price is below the strike price at expiration, the call option will expire worthless, and the option premium collected is the amount profited from the trade. At this point, a new covered call position may be initiated for a future expiration date.

If the stock price is above the strike price of the short call option at expiration, the long stock is “called away” at the strike price. If the short call option is in-the-money at expiration, but the investor does not want to sell the position, the trade can be rolled out to a later expiration date by buying back the short call and selling a new contract.

Time decay impact on a Covered Call

Time remaining until expiration and implied volatility make up an option’s extrinsic value and impact the price of the premium. Short call options contracts with more time until expiration will have higher prices because there is more time for the underlying asset to experience price movement. As the time until expiration decreases, the price of the call option goes down.

Covered calls with longer-dated expirations will collect more premium when the trade is entered than those with shorter time duration. Time decay, or theta, works in favor of the covered call writer.

Implied volatility impact on a Covered Call

Implied volatility reflects the possibility of future price movements. Higher implied volatility results in a higher price of short call options because there is an expectation the price will move more in the future. Selling covered calls with higher implied volatility will receive more credit at trade entry, but the underlying asset is expected to have more price fluctuations.

Adjusting a Covered Call

There are multiple ways to adjust the position of a covered call if the underlying asset’s price moves up or down before expiration. A covered call is either in-the-money or out-of-the-money at expiration, and adjustments can be made to address each scenario.

If the stock is above the short call strike price at expiration, a decision will need to be made. If no action is taken, the short call will be exercised and the broker will automatically sell 100 shares of stock per options contract at the option’s strike price. The stockholder will participate in the gains of the move up in the underlying stock, and keep the credit from selling the short call. Any move above the strike price will not be included. If the covered call writer does not wish to exercise, the call option can be rolled out to the next expiration month.

If the underlying price has moved sideways or down before expiration and the stock price stayed below the short call, the original covered call will expire worthless. At this point, a new position may be opened for a future expiration date at the same strike price or a lower strike price. Any credit received from selling the call option will remain. The closer to the money the new call option is sold, the greater the credit received, but the more likely the long stock position may become in-the-money and subject to assignment at expiration.

Most assignments do not occur until the last week of expiration. One exception that needs to be accounted for is dividend payments. If the underlying asset is about to pay a monthly or quarterly dividend, the short call is at greater risk of assignment if it is in-the-money. This is because the holder of the long call option may wish to exercise their right to buy shares of stock and collect the dividend.

Rolling a Covered Call

Covered calls can be rolled up or down before expiration. The short call option can be rolled down to a lower strike price within the same expiration month if the underlying asset has traded sideways or dropped in price. A strike price closer to the stock price will result in more credit received but have a higher probability of being in-the-money at expiration.

If the stock has moved above the strike price and the investor wishes to continue to hold the underlying stock and does not want the position called away, the covered call can be purchased and a new position sold at a later date with the same strike price or a different strike price.

Hedging a Covered Call

Covered calls can be hedged by rolling down the short call option as price decreases. To roll down the option, repurchase the short call (for less money than it was sold) and resell a call option closer to the stock price. This will limit the upside potential but the credit received for the roll will help offset the downward movement of the stock.

Another strategy to consider is to purchase a long put option somewhere below the short call option. Long put options give the holder the right to sell shares of stock at the strike price. For example, if long stock is purchased at $100 and a covered call is sold at $105, a long put option could be purchased at $90 and guarantee the opportunity to sell stock at $90. Buying the put option will cost money and therefore offset some or all of the credit received for selling the covered call.

Synthetic Covered Call

A synthetic covered call, also known as a poor man’s covered call, is a cost-effective way to gain long exposure to an asset while still selling covered calls against the long call option position to lower the overall cost basis.

A synthetic covered call has two parts. The first part consists of buying a deep in-the-money call with a far-dated expiration (also known as LEAPS).This replicates owning shares of stock but at a much lower capital outlay than actually owning the stock.

The second part of the synthetic covered call is to sell short-term call options against the position. Selling short-term calls throughout the longer expiration period will continually receive credit and help offset the cost of the long call position.

The maximum risk on the trade is limited to the cost of the long call option, and the risk will decrease every month by the amount of the premium received of every call sold.

FAQs

What is a covered call?

A covered call is a popular options strategy used to generate income. To enter a covered call, you sell a call against shares of long stock. If an investor is moderately bullish and plans to hold shares of stock in an asset for an extended length of time, selling a covered call will bring in premium during the holding period to lower the original equity position’s cost basis.

How do covered calls work?

A covered call consists of selling a call against shares of long stock. Typically, covered calls are sold out-of-the-money above the current price of the underlying asset. Calls that are sold closer to the stock price will result in more credit received but have a higher probability of being in-the-money at expiration.

If you own at least 100 shares of stock, you can sell a covered call using the equity position as a collateral. Selling a short call brings in a credit. The credit received lowers the overall position’s cost basis.

If the covered call expires out-of-the-money, you’ll keep the full premium you received when you sold the call. In-the-money calls will automatically be assigned at expiration, and you’re required to sell the shares at the strike price.

What is an example of a covered call?

A covered call requires ownership of at least 100 shares of stock. If the stock is already owned, a call option may be sold at a higher strike price than the current stock price. A covered call can also be sold at the time the long stock is purchased.

For example, if you own 100 shares of AAPL stock at $150 a share, you could choose to sell a covered call with a $150 strike price.

What is the downside of covered calls?

While covered calls reduce the stock position’s cost basis, they do not eliminate downside risk.

If you’re call option expires in-the-money, you are obligated to accept assignment and sell your stock shares at the strike price.. You can always roll out an ITM covered call to a later expiration date if you do not wish to sell the shares.

What is the best strategy for selling covered calls?

There are many factors to consider when selling a covered call. Calls sold closer to the stock price will receive more credit but have a higher probability of being in-the-money at expiration.

Likewise, calls with longer days to expiration have higher premiums.
Download our free Mastering Covered Calls ebook for in-depth research.

Long Put

Posted on June 26, 2024June 27, 2024 by admin

Long Put overview

Short selling stock is not available for all investors as it requires borrowing stock and uses margin. Furthermore, as opposed to buying a long put, short selling has unlimited risk because the underlying asset has unlimited upside potential.

Long put options give the buyer the right, but no obligation, to sell shares of the underlying asset at the strike price on or before expiration. Because options are levered investments, each contract is equivalent to selling 100 shares of stock. An advantage of using a long put option is that less capital is required to own one contract than the cost of selling 100 shares of stock, and downside risk is limited to the option contract’s cost.

Long Put market outlook

A long put is purchased when the buyer believes the price of the underlying asset will decline by at least the cost of the premium on or before the expiration date. Further out-of-the-money strike prices will be less expensive but have a lower probability of success. The further out-of-the-money the strike price, the more bearish the sentiment for the outlook of the underlying asset.

How to set up a Long Put

A long put position is initiated when a buyer purchases a put option contract. Puts are listed in an option chain and provide relevant information for every strike price and expiration available, including the bid-ask price. The cost to enter the trade is called the premium. Market participants consider multiple factors to assess the value of an option’s premium, including the strike price relative to the stock price, time until expiration, and volatility.

Typically, put options are more expensive than their call option counterparts. This pricing skew exists because investors are willing to pay a higher premium to protect against downside risk when hedging positions.

Long Put payoff diagram

The payoff diagram for a long put is straightforward. The maximum risk is limited to the cost of the option. The profit potential is unlimited until the underlying asset reaches $0. To break even on the trade at expiration, the stock price must be below the strike price by the cost of the long put option.
For example, if a long put option with a $100 strike price is purchased for $5.00, the maximum loss is defined at $500, and the profit potential is unlimited until the stock reaches $0. However, the underlying stock must be below $95 at expiration to realize a profit.

Image of long put payoff diagram showing max profit, max loss, and break-even points

Entering a Long Put

To enter a long put position, a buy-to-open (BTO) order is sent to the broker. The order is either filled at the asking price (market order) or at a specific price an investor is willing to pay (limit order). The call option purchase results in cash debited from the trading account.

Buy-to-open: $100 put

Exiting a Long Put

There are multiple ways to exit a long put position. Anytime prior to expiration, a sell-to-close (STC) order can be entered, and the contract will be sold at the market or a limit price. The premium collected from the sale will be credited to the account.

If the contract is sold for more premium than originally paid, a profit is realized. If the contract is sold for less premium than originally paid, a loss is realized.

If the long put option is in-the-money (ITM) at expiration, the holder of the contract can choose to exercise the option and will sell 100 shares of stock at the strike price. If the long put option is out-of-the-money (OTM) at expiration, the contract will expire worthless and the full loss is realized.

Time decay impact on a Long Put

Time remaining until expiration and implied volatility make up an option’s extrinsic value and impact the premium price. All else being equal, options contracts with more time until expiration will have higher prices because there is more time for the underlying asset to experience price movement. As time until expiration decreases, the option price goes down. Therefore, time decay, or theta, works against options buyers.

Implied volatility impact on a Long Put

Implied volatility reflects the possibility of future price movements. Higher implied volatility results in higher priced options because there is an expectation the price may move more than expected in the future. As implied volatility decreases, the option price goes down. Options buyers benefit when implied volatility increases before expiration.

Adjusting a Long Put

Long put positions can be managed during a trade to minimize loss. A single-leg long put option can be converted into a bear put debit spread.

If the stock price increases, a put option can be sold at a lower strike price to reduce the trade’s risk. This decreases the overall cost of the original position and lowers the break-even price. However, the short put option limits the maximum profit potential to the spread width minus the debit paid.

For example, if a $100 put option was purchased for $5.00, a $95 put option could be sold. If the short put option collects $1.00 of credit, the maximum loss is reduced to $400. The max profit, however, is now capped at $100 if the stock reverses and closes below $95 at expiration. The break-even point is now $1.00 less than the original payoff diagram.

Sell-to-open: $95 put

Image of a long put option adjusted to a bear put debit spread

Rolling a Long Put

Long put positions can be adjusted to extend the time duration of the trade if the stock has not decreased before expiration. The ability to roll the position into the future allows the trade more time to become profitable, but will come at a cost because more time equates to higher options prices.

If an investor wants to extend the trade, the long put option can be rolled out by selling-to-close (STC) the current position and buying-to-open (BTO) an option at a future date. This will likely result in paying a debit and will add cost to the original position.

For example, a $100 put option with a November expiration date could be sold and a $100 put option could be purchased for December. If the original position cost $5.00, and was sold for $2.00, the net loss on the original position is $300 per contract. If the December option costs an additional $5.00, the overall debit of the position is now $8.00. Therefore, the max loss increases to $800 and the break-even point moves out to $92.

Payoff diagram of a long put roll out for a debit

Hedging a Long Put

To hedge a long put, an investor may purchase a call with the same strike price and expiration date, thereby creating a long straddle. If the underlying stock price increases above the strike price, the call will experience a gain in value and help offset the loss of the long put. However, this adds cost to the original trade and widens the break-even price.

For example, if the original long put had a $5.00 debit, and a long call is purchased for an additional $5.00, the risk increases to $1,000 and the break-even points are extended.

Buy-to-open: $100 call

Long put converted to a long straddle to hedge price action

Synthetic Long Put

A synthetic long put combines short stock with a long call option at the strike price of the original short stock position. This creates a synthetic long put because the payoff diagram is similar to a single long put option. The maximum downside risk is limited to the strike price of the long call option, and the profit potential is limited to the difference between the sale price of the short stock position and the call option premium paid.

FAQs

What is a put option?

A long put is a bearish options strategy with defined risk and unlimited profit potential. Buying a put option is an alternative to shorting stock. Unlike short selling a stock, which has unlimited risk, a put option’s maximum risk is limited to the its premium.

Long put options give the buyer the right to sell shares of the underlying stock at the strike price on or before expiration.

How do put options work?

Buying a put option contract gives you the right, but no obligation, to sell shares at the contract’s strike price. Writing a put option obligates you to buy shares at the cotract’s strike price. If you are long a put option, you are bearish on the underlying security.

How to calculate put option profit?

Long puts have unlimited profit potential. A long put option must be below its break even price at expiration to realize a profit. To calculate a long put’s break even price, subtract the contract’s premium from the option’s strike price. The option’s cost is the max loss for the position.

Long Call

Posted on June 25, 2024June 27, 2024 by admin

Long Call overview

Long call options give the buyer the right, but no obligation, to purchase shares of the underlying asset at the strike price on or before expiration. Because options are levered investments, each contract is equivalent to holding 100 shares of stock. An advantage of using a long call option is that less capital is required to own one contract compared to the cost of owning 100 shares of stock, and downside risk is limited to the option contract’s cost.

Long Call market outlook

A long call is purchased when the buyer believes the price of the underlying asset will increase by at least the cost of the premium on or before the expiration date. Further out-of-the-money strike prices will be less expensive but have a lower probability of success. The further out-of-the-money the strike price, the more bullish the sentiment for the outlook of the underlying asset.

How to set up a Long Call

A long call position is initiated when a buyer purchases a call option contract. Calls are listed in an option chain and provide relevant information for every strike price and expiration available, including the bid-ask price. The cost to enter the trade is called the premium. Market participants consider multiple factors to assess the value of an option’s premium, including the strike price relative to the stock price, time until expiration, and volatility.

Long Call payoff diagram

The payoff diagram for a long call is straightforward. The maximum risk is limited to the cost of the option. The profit potential is unlimited. To break even on the trade at expiration, the stock price must exceed the strike price by the cost of the long call option.

For example, if a long call option with a $100 strike price is purchased for $5.00, the maximum loss is defined at $500 and the profit potential is unlimited if the stock continues to rise. However, the underlying stock must be above $105 at expiration to realize a profit.

Entering a Long Call

To enter a long call position, a buy-to-open (BTO) order is sent to the broker. The order is either filled at the asking price (market order) or at a specific price an investor is willing to pay (limit order). The call option purchase results in cash debited from the trading account.

Buy-to-open: $100 call

Exiting a Long Call

There are multiple ways to exit a long call position. Anytime before expiration, a sell-to-close (STC) order can be entered, and the contract will be sold at the market or a limit price. The premium collected will be credited to the account.

If the contract is sold for more premium than originally paid, a profit is realized. If the contract is sold for less premium than originally paid, a loss is realized.

If the long call option is in-the-money (ITM) at expiration, the holder of the contract can choose to exercise the option and will receive 100 shares of stock at the strike price. If the long call option is out-of-the-money (OTM) at expiration, the contract will expire worthless and the full loss is realized.

Time decay impact on a Long Call

Implied volatility impact on a Long Call

Adjusting a Long Call

Long call positions can be managed during a trade to minimize loss. A single-leg long call option can converted into a bull call debit spread.

If the stock price declines, a call option can be sold at a higher strike price to reduce the trade’s risk. This decreases the overall cost of the original position and lowers the break-even price. However, the short call option limits the maximum profit potential to the spread width minus the debit paid.

For example, if a $100 call option was purchased for $5.00, a $105 call option could be sold. If the short call option collects $1.00 of credit, the maximum loss is reduced to -$400. The max profit, however, is now capped at $100 if the stock reverses and closes above $105 at expiration. The break-even point is now $1.00 less than the original payoff diagram.

Sell-to-open: $105 call

Rolling a Long Call

Long call positions can be adjusted to extend the time duration of the trade if the stock has not increased before expiration. The ability to roll the position into the future allows the trade more time to become profitable, but will come at a cost because more time equates to higher options prices.

If an investor wants to extend the trade, the long call option can be rolled out by selling-to-close (STC) the current position and buying-to-open (BTO) an option at a future date. This will likely result in paying a debit and will add cost to the original position.

For example, a $100 call option with a November expiration date could be sold and a $100 call option could be purchased for December. If the original position cost $5.00, and was sold for $2.00, the net loss on the original position is -$300 per contract. If the December option costs an additional $5.00, the overall debit of the position is now $8.00. Therefore, the max loss increases to -$800 and the break-even point moves out to $108.

Hedging a Long Call

To hedge a long call, an investor may purchase a put with the same strike price and expiration date, thereby creating a long straddle. If the underlying stock price falls below the strike price, the put will experience a gain in value and help offset the loss of the long call. However, this adds cost to the original trade and widens the break-even price.

For example, if the original long call had a $5.00 debit, and a long put is purchased for an additional $5.00, the risk increases to $1,000 and the break-even points are extended.

For example, a $100 call option with a November expiration date could be sold and a $100 call option could be purchased for December. If the original position cost $5.00, and was sold for $2.00, the net loss on the original position is -$300 per contract. If the December option costs an additional $5.00, the overall debit of the position is now $8.00. Therefore, the max loss increases to -$800 and the break-even point moves out to $108.

Sell-to-open: $105 call

Synthetic Long Call

A synthetic long call combines long stock with a long put option at the entry price of the original long stock position. This creates a synthetic long call because the payoff diagram is similar to a single long call option. The maximum downside risk is limited to the long put option’s strike price, and the profit potential is unlimited if the stock continues to rise.

FAQ

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PeakProfit utilizes advanced artificial intelligence to analyze market data, generate high-probability trading signals, and provide insights to traders. Our system is designed to streamline the trading process, offering signals for 0-1 days to expiration Iron Condor, Short Call spread, Short Put spread option strategies

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