Basic Option Strategies for Income

Enhancing Profits for Building Wealth

Walnut Creek – November 18, 2009

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Tonight’s Topics

Market Stance, Dow, S&P, Nasdaq Basic Income Strategies

• Short Vertical Spreads

Assumptions

You know what an option is and the basics of how they work

Time Value Intrinsic Value ITM, ATM, OTM

Basic Points

If you buy a stock you must be right about direction to profit but time does not work against you.

If you buy an option you not only have to be right about the direction of movement but it’s also a race against the clock

If you sell an option you can be wrong about direction and profit - the clock is your friend

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Critical Concept

Time value is like an ice cube on a hot day, it melts away

Option Selling strategies put time decay in your favor!!!

Vertical spreads are a selling strategy which makes use of time decay

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Time Decay of an option

Time

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General Rules for Selling Strategies

Buying options – Buy more time than you need Selling options – Sell front month – don’t want

buyer to have time to be right Buy back the short options when most of the

premium has eroded Example: lets say you sold an option for 1.00

and the premium has decayed to .20 with two weeks till expiration – Buy it back!!!!! Don’t be greedy!!!!!!!!!!!!

Vertical Credit Spreads

Income producing strategy Can be bullish or bearish Don’t need to own the stock Short term plays – generally 20 to 40

days to expiration – Remember the basic rule don’t; give the option buyer more time than necessary to be right

Vertical Spreads – How they work

Vertical spreads involve the purchase of one option and the sale of another option• The purchased option is for insurance – limits the risk

the trade – for a short vertical the long option must be less expensive than the sold option

• The short option is for what brings in the income and for a short vertical spread must be more expensive than the long option

• The short and long options are within the same expiration month

Short Vertical Spreads

Short vertical Spreads are Credit Spreads!!! The money is deposited into your account immediately.

They are “Defined Risk” trades Risk is the difference between the two strike

prices minus the credit received The risk is the margin requirement your broker

will require you to maintain in your account to cover your potential loss

Entering Vertical Spreads

Most brokers permit entry of the spread as a single trade (long and short trade are entered simultaneously)

If your broker does not permit simultaneous entry always execute the long side before the short side (and get a new broker).

Determining Max Potential ROI

Potential ROI = credit / risk * 100

= credit received / (difference between strikes – credit received) * 100

Difference between strikes = 2

Credit = .42

Risk = 2 - .42 = 1.58

ROI = .42 / 1.58 * 100 = 27%

Bullish Vertical Credit Spread

Bull Put Spread• Buy a put at a strike price lower than the put

you intend to sell

• Sell a put with a higher strike price than the one you purchased which will bring a net credit into your account

• May enter both trades simultaneously as a vertical spread

Bull Put Spread

Short Strike can be ITM, ATM or OTM Sell ITM if you are extremely bullish ITM trades carry lower risk but have

lower probability of success OTM trades have lower rewards but

higher probability of success

CTRP Bull Put Spread

CTRP has been in a strong upward trend since March

On 10/22 it bounced off strong horizontal support closing above the high of the low day – This is my entry signal for a trade on 10/23

Strong horizontal support identified at about 55 Next strong level of support below 55 is at

about 47.50 Good chance if stock price breaches 55 on

high volume it will continue down to about 47.50

CTRP Bull Put Spread

10/23 – Enter 55/50 Bull put Spread for a credit of .82 credit ($82 per contract)

Calculate Break Even Price, Risk and ROI on this trade (at expiration)

Look at exit strategies• If correct

• If you’re wrong (and, how will you know when you’re wrong) (Fixing Trades will be a topic for another meeting)

CTRP Trade

BE = Short Strike Price – Credit Received• Note for a Bear Call Spread the BE stock

price is the short strike + the credit received

BE = 55 - .82 = 54.18 Maximum Risk = 55 – 50 -.82 = 4.18 Potential ROI = .82 / 4.18 * 100 = 19.6%

CTRP Exit Strategy Close trade at a profit at .10 (GTC order placed when

entry order filled) Buy back the short strike on breach of 55 support level

with confirmation (very high selling volume or follow through the next day) – This is an indication the stock is no longer in favor with institutions and the downtrend is likely to continue. Allow the long strike to gain value but the intent is no longer to make a big profit but to get out with your hide.

Note: You can be wrong on the repair so you need to remain nimble – may have to repair the repair. The desire of repairs is to make a small profit or incur minimal loss

CTRP – So how did this trade end – Lets take a look

As you’ll soon see the trade was profitable

But not before a few moments of concern

Don’t panic!!!

CTRP Trade - ROI

Trade entered 10/23 for .82 Credit Trade closed 11/12 for .06 Profit Realized on trade .76 ROI = .76 / 4.18 *100 = 18.2% Annualized ROI = 18.2 / 20 *365 = 332%

Not to bad for a 20 day trade

Bearish Vertical Credit Spread Bear Call Spread Works just like a Bull Put Spread but just the

opposite Instead of utilizing puts the Bear Call Spread

uses call options Hence the name – Bear Call Spread

• “Bear” designates our stance on the market or direction on the underlying

• “Call” designates we will be using calls to bring money into our account

• “Spread” indicates that this is a defined risk trade

Bearish Vertical Credit Spread

Bear Call Spread• Buy a call at a strike price higher than the call you

intend to sell – This is your insurance

• Sell a call with a lower strike price than the one you purchased which will bring a net credit into your account

• May enter both trades simultaneously as a vertical spread

• This transaction results in a net credit in your account

Bear Call Spread

Short Strike can be ITM, ATM or OTM Sell ITM if you are extremely bullish ITM trades carry lower risk but have

lower probability of success OTM trades have lower rewards (higher

risk) but higher probability of success

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Possible Future Topics

Repair Strategies Technical Analysis Iron Condors Butterflies Diagonal Spreads Calendar Spreads