Using Option Strategies In A Volatile Market

Not sure if you should be using options in the current volatile market? Unsure of which option trading strategies might work well in today’s market? The following article does a great job of helping you sort it all out.

Options are often unjustly given a bad rap as being overly risky. It is true that a countless number of investors have lost hefty sums speculating on options. When used correctly, however, options can be a great instrument to hedge your risk and achieve certain returns that are not possible by simply buying and selling stock alone. The unfortunate truth is that many investors do not have a full understanding of the option strategies they are undertaking. This is what truly makes options risky.

Let’s suppose that an investor undertakes an option-based trading strategy that has unlimited downside risk (i.e. the covered straddle that will be discussed shortly). We’ll classify this one as a ‘riskier’ strategy. In fact, some might consider this strategy too risky to utilize. Is this position too risky though if the investor thoroughly understands both the payoff patterns and the downside risk, and uses them as a play on an educated market outlook? Given a rational and risk-tolerant investor and assuming the payoffs match his or her market outlook, it is definitely not too risky.

A call option is a contract on an underlying stock that can be purchased or sold, giving the buyer the right but not the obligation to enter into a position on the underlying at a predetermined (strike) price. Investors purchasing a call option are bullish towards the underlying stock. Those selling call options are bearish because if the stock increases, they are held accountable to pay the purchaser of the call option.

An investor who believes Apple (AAPL), currently priced at $400, will increase in the near future may purchase a call option with a strike of $405. If the price of Apple increases above $405 to $415, the investor will exercise the option. This means they can effectively purchase the share at $405 even though it is worth $415, a profit of $10 (less the premium paid for the option and brokerage expense). A put option, on the other hand, gives the buyer the right, but not the obligation to sell the underlying at a predetermined (strike) price. Purchasers of put options are bearish on the underlying; conversely, sellers of put options are bullish.

Now that we’ve covered the basics, time to get into the good stuff. I’m going to introduce some fairly straight forward option strategies and how/when they can be used. Please keep in mind that these strategies do not involve any wild speculation or get rich quick tactics. They are simply ways to control the risks you are taking and ensure that the risks you are exposed to match your expectations of the market.

A quick note regarding the notation below: So = underlying stock price at time of purchase; Xc = strike price of call; Xp = strike price of put; C = price of call; P = price of put; Comm = commission charges.

The Covered Straddle

The covered straddle, which is a combination of a covered call and a naked put, involves having a long position in the underlying stock and simultaneously writing at the money call and put options. The call option that is written is covered in the sense that if the stock price increases above the strike, the investor can deliver the underlying stock that he or she already owns. The ‘naked’ put option that is written is not covered because if the price of the underlying drops below the strike, the investor is forced to sell the stock at the lower price and sustain a loss on the position. Here is an example of the profit payoff from a covered straddle on Google (GOOG) as it hits various prices. It is based on October 4 prices, with the options expiring on October 22.

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By examining the profit trend, you can get a better idea of how this strategy can be used. The upside potential is limited due to the losses on the short call offsetting the gains of the underlying. The downside potential is unlimited because, as mentioned above, the put is not covered. I would, however, like to point out the fact that even when the stock dips from 497 to 472, you are still making a profit. Google would have to dip more about $25 before you would begin to lose money!

The reason for this is because the premiums received on the call and put options sold are greater than the losses on the underlying and the short put position. I believe this is the bread and butter of this strategy. Any strategy where you can turn a profit, even as the stock dips in price is worth some consideration.

The unlimited downside risk can be admittedly worrisome. Google was extremely volatile throughout a turbulent September. Its price moved from approximately 520 at the beginning of September, up to almost 560, before plummeting to its current (as of October 4) price of 497. If Google continues to plummet, this position could become unprofitable quickly. One way to manage this would be to put a stop loss on the stock at 470. You will still sustain the losses on the short put option, but at least it will not be doubled by the loss on the underlying. I would only recommend a covered straddle for investors who are very risk tolerant and are strongly confident that the stock won’t be too volatile, especially on the downside.

See Seeking Alpha for more strategies to use in today’s volatile market

Option Trading Secrets

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