Section 1 - Overview; trading and leverage defined

Transcription

1 Section 1 - Overview; trading and leverage defined Download this in PDF format. In this lesson I am going to shift the focus from an investment orientation to trading. Although "option traders" receive quite a bit of publicity, let me say that trading options is not as easy as the media may sometimes make it sound. In fact, I want define trading first, so that we know exactly what we are talking about. Second, I will discuss leverage, because it frequently determines the risk of a strategy. For those of you who are not familiar with leverage, you should pay particular attention to this important topic. Beginning with Section 2, I will show you some stock-oriented trading strategies that use options. -oriented trading strategies are a good place to begin, because the performance of the stock, ultimately, determines the results of any option strategy. Options-only trading strategies are the last topic of this lesson. In analyzing these strategies, you will see how important an understanding of option price behavior is. That knowledge is used to select the "best" strategy from a number of alternatives that, conceptually at least, are appropriate for a particular forecast. As you will see, it is not enough to "buy a call" or "buy a put." Only by analyzing several strategies can the "best" one be selected. Trading Defined "Trading" means different things to different people, but the definition I would like to use for this Lesson is the following: trading means buying and selling securities in the hopes of profiting from predicted short-term price movements. Investing, on the other hand, involves buying and holding for the long term. One reason that trading means different things to different people is that "short-term" has no precise definition. For some, "short-term" means one to two days; for others it means two to three months. For day traders, those who regularly buy and sell on the same day, short-term may mean only a few minutes. Regardless of the time horizon, trading is difficult to learn. It involves intuition, an ability to act on that intuition, and an ability to close positions at either a profit or loss when market conditions dictate such action. Trading then requires you to do it all over again, i.e., to make another trade. Generally, the only way one can learn to trade is by trying it. So, if you are inclined to try, then, when you think you are ready, take some of your hard-earned savings, open an account with a brokerage firm and start making buy and sell decisions. Only then will you learn if you like trading and if you are good at it. In some sense, trading is not much different than a regular job. If you like a job, and if you are good at it, then you are likely to get positive reinforcements such as aboveaverage pay raises and promotions. If you are not good at job, then you are likely to get negative reinforcements, and you are likely to change jobs. In trading, the only positive reinforcement is making money. If you enjoy trading and if you make money at it, then you are likely to continue. Trading is Different than Investing Traders and investors differ in a number of ways. First, as mentioned above, traders attempt to profit from short-term price fluctuations and investors focus on owning stocks and accruing dividends and capital gains over the long-term. Traders also tend to use leverage which will be explained next, but investors typically do not use leverage. The variety of strategies used is also a distinction between traders and investors. Traders attempt to profit from both market rallies and market declines, whichever they predict. In contrast, investors use only neutral or bullish strategies, and they "go to cash" when they are bearish. Another difference is the method of trade selection. Investors tend to rely more on fundamental information about the underlying company, and traders tend to emphasize the tools of technical analysis such as charts showing price trends, volume and moving averages. One more difference between traders and investors is the need for

2 detailed option price analysis. Traders, in attempting to profit from smaller price changes, need to know, fairly accurately, an option's delta and it's implied volatility. Investors, however, need less exactness, because, when longer time periods are involved, the performance of the underlying stock usually outweighs factors that are more important in the short term. The differences between traders and investors are summarized below: Method of Profiting Time Horizon Use of Leverage Strategies Employed Traders Predict Short-Term Changes Min: Few Hours Max: Few Weeks Yes Bullish, Bearish, Neutral Basic to Advanced Investors Hold for the Long-Term Min: Several Months Max: Many Years No Bullish, Neutral Basic Type of Analysis Nature of Forecast Greater Emphasis on Technical Analysis Specific Forecast for Time, Period and of Underlying Instrument Greater Emphasis on Fundamental Analysis General Forecast of Long-term Business Fundamentals Leverage Another distinction between investing and trading is management of capital. Traders frequently use leverage while investors typically do not. Leverage means that the capital at risk can fluctuate by a greater percentage than the price of the security. Buying stock "on margin" is a strategy involving leverage that is commonly used by aggressive stock traders. When the purchase of stock is partially financed with loans, these borrowings are known as margin loans. A margin loan must be repaid in full with interest regardless of the profit or loss outcome, all of which accrues to the trader. Consider an example in which Joe, a stock trader, purchases 100 shares of XYZ stock at $40 per share, or $4,000 not including commissions. If Joe uses $2,000 of his own capital and a $2,000 margin loan to finance this purchase, then he has made a "leveraged" trade. If XYZ stock rises to $50, a 25% increase from $40, then the value of 100 shares rises to $5,000. If Joe sells at $50, his profit is $1,000 (not including commissions or interest expense), and $1,000 is 50% of Joe's $2,000 investment. In this case, his percentage profits (50%) were greater than the percentage price change in XYZ stock (25%) that's leverage! But leverage works two ways. If XYZ stock declines in price from $40 to $30, a 25% decline, then the value of 100 shares declines to $3,000. If he sells at $30, then Joe will have a $1,000 loss. That would be a 50% loss of Joe's $2,000 initial investment, even though XYZ stock declined by only 25%. That is leverage too! The concept of leverage is important to option traders, because options are leveraged instruments. Consider an example in which Sally buys an XYZ 40 for 2, or $200. If XYZ stock rises in price to

3 $50 at option expiration, then Sally's call will have an intrinsic value of 10, or $1,000. If she sells her call at 10, her profit will be 8, or $800, a 400% profit when the stock's price rise was only 25%. Of course, if XYZ declines to $30 at option expiration, then the XYZ 40 will expire worthless. In this case, Sally will lose 100% of her investment in the call while the price of XYZ stock declined by only 25%. Capital management Leverage, Risk & Options Since it is possible to lose 100% of the cost of an option if it expires worthless, option traders must plan in advance how much of their total trading capital they will commit to any one trade. Although there are no "scientific answers" for such a question, one common guideline is to never invest more than 10% of trading capital in any one trade. By following such a guideline, a trader is assured of not losing 100% of trading capital after a series of 3 or 4 losing trades, even if the options expire worthless in all 3 or 4 cases. Another guideline many traders follow is that "trading capital" is not 100% of total capital. Trading capital is "risk capital," i.e., money that you can live without if losses occur. This means that savings for emergencies, savings for a home and retirement savings are separate from trading capital. Getting started Predicting stock prices is an art. My goal is to show you options strategies you can use to attempt to profit from your market predictions. Section 2 - -oriented strategy #1 - Covered Straddle traders sometimes find themselves in this situation: they own shares of a stock they like and, if the price rises, they would sell the shares and realize a profit. If, however, the price declined, then they would purchase more shares. In such a situation, a trader can always wait for the stock price to rise or fall and then take the appropriate action, sell on a rally or buy on a dip. But here is an alternative to waiting that involves options: sell a "covered straddle." First, I will review the mechanics, and then I will discuss when you might use this strategy. If you recall from Lesson 2, Profit and Loss Diagrams, a straddle is a position involving a call and a put with the same strike price and same expiration date. A "long straddle" is established by purchasing both the call and put. If the underlying stock moves enough, then, depending on the direction of the move, either the call will make more than the put loses, or the put will make more than the call loses. A "short straddle" involves writing both options initially. When selling a straddle, the hope is that the underlying stock does not move and both options decline in price from time erosion. If, however, the stock price declines, then the short put involves an obligation to buy the underlying stock. If the stock price rises, then the short call involves an obligation to sell the stock. A " covered straddle " is a combination of long (or owned) stock, cash and a short straddle. The calls in the short straddle are written on a share-for-share basis with the owned stock, and cash is available to purchase stock on a share-for-share basis with the short (or written) puts. The short options are "covered," because the obligations they involve can be easily fulfilled. The short calls are covered, because the underlying stock is owned. The short puts are covered, because cash is available to purchase the underlying stock. That is the overview of how a short straddle works, let's look at a specific example. Assume that John owns 100 shares of Neutral stock (NEUT) which is currently trading at $30 per share. Assume also that the 60-day 30 is trading for 1.60 and that the 60-day 30 Put is trading at If John also has cash available to buy an additional 100 shares, then he can establish a covered straddle by selling both of these options for a total of 3, or $300 not including commissions. The following profit and loss table and profit and loss diagram will help you review how this strategy

4 works. Covered Straddle Described Long $30 Short 1 NEUT 1.60 Short 1 NEUT $3,000 Cash available Profit/Loss Table for Covered Straddle a At $30 Profit/Loss Short 1.60 Profit/Loss Short Profit/Loss Covered Straddle Total Profit/Loss The profit and loss diagram below is created by plotting the profit or loss numbers from the right-most column in the profit and loss table.

5 Covered Straddle - Continued Mechanics at The profit/loss diagram for the covered straddle shows that, if NEUT stock is above $30 at expiration, then the short 30 calls will be assigned, and the stock will be sold. If the price is below $30, then the puts will be assigned, and additional shares of NEUT will be purchased. The profit and loss diagram raises two questions. First, is either outcome, above or below $30, too risky? And, second, why does the line below $30 have a steeper slope than the long stock line? Is either outcome "too risky?" Above $30 at option expiration, the currently owned shares are sold. Below $30, additional share are purchased. To determine whether either (or both) is too risky, recall John's original objectives. Initially, John owned 100 shares and was willing to sell at a higher price and was willing to buy more at a lower price. On the surface, it seems that neither outcome is too risky. Let's do a little further investigation. If the price rises, then the puts will expire worthless at expiration, and the calls will be assigned. If this happens, John will want to know what "effective price" is received for selling the stock. An effective price is the price of a stock transaction that takes into account the option premiums paid or received. In the case of the covered straddle, the "effective selling price" is the strike price of the call plus the two option premiums received, and it is calculated as follows: Effective Selling if Short is Assigned Strike of + Premium + Put Premium = 33 If the stock price is below $30 at expiration, then the calls will expire worthless and the puts will be assigned. The effective purchase price in this case will be $27 per share which is calculated as follows: Effective Selling if Short Put is Assigned

6 Strike of Put - Premium - Put Premium = 27 It should be clear than neither outcome is "too risky," because John was willing to either sell the stock he owns or buy more. John has only to think about the price. Are the prices of $27 and $33 satisfactory? If they are, then the covered straddle has given John a viable alternative to waiting for the stock price to change. Steep slope of line below $30 There are two lines in the profit and loss diagram. The covered straddle strategy is represented by the darker, solid line that is horizontal above $30 and downward sloping below $30. The long stock strategy is represented by the lighter, hyphenated diagonal line. The downward sloping portion of the covered straddle line has a steeper slope than the long stock line, because, below $30, the covered straddle strategy is long 200 shares - the original 100 shares plus a second 100 shares from the assignment of the 30 Put. Again, this is not "too risky," because John is willing to purchase the additional shares. Watch out for hindsight The prices of $33 and $27 may seem attractive when John initiates his covered straddle. When option expiration arrives, however, the price of NEUT could be substantially above $33, or substantially below $27. At that point, John might think that "waiting and doing nothing" would have been a better strategy. Hindsight always works that way! And hindsight is something that traders must learn to live with. If the stock price is substantially above $33 or below $27 at expiration, then it is not the fault of the strategy, but rather of the forecast. The options will have achieved the original objective of selling at $33 or buying more at $27. Short s vs. Short Puts Covered Straddle: Take this position apart Section 3: -oriented strategy #2 - stock repair Buying stock, unfortunately, sometimes causes one of the most basic trading problems: the stock goes down, and the trader is living with an unrealized loss. As a result, the initial goal of making a profitable trade has changed to not losing money. At this point, the trader may just want to get back to break even! First, as always, the trader can simply hold the stock and wait. No action is required to implement this strategy. The trader simply maintains the existing stock position and prays for the stock to rise back to the initial purchase price. If this occurs, then the shares can be sold, and the loss will be recovered. A second alternative, "doubling up" or "lower-cost averaging," involves the purchase of an equal number of shares at the current, lower price. If this action is taken, the stock needs to rise only half way back to the initial purchase price for the loss to be recovered. While the prospect of reaching the break-even point sooner sounds attractive, there is a negative. Doubling up requires additional capital to purchase the additional shares. It also increases risk, because, if the stock continues to decline in price, then

7 losses mount on two shares for every one share that was originally owned. The third alternative involves options. Consider the following example. Assume that Dione purchased 100 shares of DWN stock at $70 expecting it to rise after an earnings announcement. Instead, it declined to its current price of $60. Assume also that Dione is forecasting a price rise to $65 in approximately 60 days which coincides with an option expiration. Finally, assume that the DWN 60-day 60 s are trading at 4 and that the DWN 60-day 65 s are trading at 2. Assume also that Dione is reluctant to double up (buy more shares), because she does not want to invest additional capital in this losing trade, and because she does not want to assume additional risk. Dione can initiate a two-part option strategy known as "the stock repair" by doing the following: Buy 1 60-day 4 and Sell 2 60-day 65 2 each Before looking at how this strategy works and what is accomplishes, we will discuss Dione's concerns. First, Dione is not willing to invest additional capital in DWN stock, and this strategy does not require an additional investment other than commissions. Buying 1 60-day 60 at 4 costs $400 not including commissions. Selling two 60-day 65 s at 2 each, however, generates $400 which fully pays for the purchased calls, not including commissions. The result is that no additional investment is required. Dione's second concern was increased downside risk. Since the option position contains only calls, they all will expire worthless if the stock price is below 60 at expiration. If this happens, then the net result would be breaking-even on the options: no initial cost, no ending value. Now let's see what this strategy might accomplish for Dione. The following profit and loss table and profit and loss diagram illustrate the strategy components and the overall position at various stock prices at expiration. Long (own) 70 Long 1 4 Short each at Long $70 Profit / Loss Long 1 4 Profit / Loss Short each Profit / Loss Total Profit/Loss

8 Now consider the profit and loss diagram: The table and diagram show that, with the stock price at or below $60 at expiration, all options expire worthless, and Dione is left holding her original stock position. Between $60 and $65 at expiration, the option strategy reduces her loss at a faster rate than simply holding the stock. At $65, the loss is recovered, and above $65, performance is capped. Above $65 at expiration, the long 60 s are exercised, and the short 65 s are assigned. The net result is that the entire position is liquidated. If this happens to Dione, she will be left with cash equal to her original investment. This is an excellent outcome if the stock price is between $65 and $70 at expiration, but the negative aspect is that it is impossible to benefit from a price rise above $65. But is this outcome so bad? After all, Dione's goal, when she initiated the option strategy was just to get her money back, i.e., to simply break even. Repair: Take this Position Apart Repair Alternatives Section 4 - -oriented strategy #3 - An alternative to buying stock on margin Buying stock on margin is a common strategy among aggressive traders. As described in Section 1 of this lesson, when stock is purchased on margin, borrowed funds pay part of the purchase price. Such borrowed funds add leverage, and, if the stock rises, then the percentage profits on the invested capital are greater than the percentage rise in the stock price. But leverage works both ways. If the stock declines in price, then the percentages losses are

9 higher than the percentage decline in the stock price. Whether the stock price rises or falls, however, the trader must repay the loan with interest. An alternative to buying stock on margin is buying in-the-money LEAPS call options. LEAPS is the name given to "long-term options," those with expiration dates more than 9 months away. LEAPS have their own unique root ticker symbols, and, at any given time, there are two LEAPS expirations available (e.g. January 2002 and January 2003). Also, LEAPS have fewer strike prices than shorter-term options. Why should a stock trader consider the use of LEAPS calls? Let's see. Assume that AGG stock is trading at $40 and that 18-month LEAP 30 s on AGG are trading at 15. Also assume that Marty is an aggressive trader, accustomed to buying stock on margin, who predicts that AGG stock will rise significantly in one month. If Marty buys 500 shares of AGG on maximum margin, he will be required to pay 50% of the purchase price, or $10,000, plus transactions costs plus interest on the borrowed funds. His maximum theoretical risk is $20,000, the full value of the 500 shares, plus interest. While this amount of loss may be unlikely, Marty does face the risk of a "margin call" if AGG declines sharply in price. Margin loans are secured by stock, and brokers make margin loans based on pre-determined stock value-to-loan ratios. If the stock price declines below a pre-determined level, then the broker will require additional collateral, i.e., the broker will "call for more margin." If the broker fails to receive the collateral, then the broker has the right to sell the stock without the approval or knowledge of the stock owner. From Marty's point of view, he is paying 50% of the purchase price, or $10,000, and he is getting 500 shares of AGG stock and the risk of a margin call. He will also receive dividends, if any, and have the right to vote in corporate affairs. Most aggressive traders do not care about voting in corporate affairs, and dividends, generally, are inconsequential relative to stock price fluctuations. So Marty is essentially getting 500 shares of risk for $10,000. The question for us to discuss is, what is different about buying 5 AGG LEAPS 30 s? The answer is there are three differences: the cost, the risk and delta. At $15 per share, 5 AGG 18-month 30 s would cost Marty only $7,500 not including commissions, or 25% less than the minimum requirement of $10,000 to purchase 500 shares of AGG stock on margin. $7,500 is also Marty's maximum theoretical risk, and there is no risk of a margin call. So far, the LEAPS call seems to be the better choice for Marty. LEAPS calls, however, do have a disadvantage relative to stock, their delta. To review briefly, delta is the amount by which an option changes in price when the underlying stock price changes by one dollar. It is reasonable to estimate that an AGG 18-month LEAPS 30 would have a delta of approximately 0.92, or 92%. 5 of these calls, therefore, would have a combined delta of 460. This means that, if AGG stock rises $1, then 5 LEAPS calls would make $ shares of AGG stock, of course, would make $500. So let's summarize Marty's alternatives: Purchase Purchase 5 LEAPS 500 Shares 30 CALLS Initial Funds Invested $10,000 $7,500 Borrowed Funds $10,000 0 Maximum Theoretical Risk $20,000 $7,500 Delta Receive Dividends Yes No Vote in Corporate Affairs Yes No

10 Which is better? Unfortunately, there is no absolute "better." Marty must make a personal decision. But, if dividends are minimal and if voting in corporate affairs is unimportant, then the choice is a trade-off between a higher up-front cost, a higher maximum risk and a higher delta for the stock versus a lower up-front cost, a substantially lower maximum risk and a slightly lower delta for the LEAPS calls. When stated this way, you can see why more and more traders have been choosing the LEAPS alternative. Section 5 - Buying calls and puts Buying options seems simple enough. It is generally low in cost, the risk is limited to the premium paid, the commissions are not much different than buying stock, and profits are leveraged if the forecast is correct. Is it really that simple? Unfortunately, no. Trading options involves a different thought process than trading stocks. An option trader has to analyze several alternatives to determine which is "best." The issue of measuring results must be addressed, and there has to be a plan for management of trading capital. Warning! The next example is the most difficult in this course, so prepare yourself for some detailed analysis. Also, transaction costs are not included in the following example, but they should be considered when analyzing actual trading decisions. I will present you with a typical trading problem, and then I will show you how it might be analyzed. The analysis will involve the use of the option pricing calculator introduced in Lesson 4, so you might want to turn it on if you want to perform the calculations yourself as we proceed. Setting the stage for a trading decision Meet Terry, an aggressive trader, who forecasts that GUES stock, currently $60, will rally to $65 in 10 days. Although there are many possible strategies Terry might employ to attempt to profit from his forecast, for this problem Terry is looking at two options, the 60 and the 65 which are trading at 3.40 and 1.50 respectively. Let's see how Terry analyzes these options and then chooses a trading strategy. For this example, assume that today is 42 days before option expiration, interest rates are 4% and GUES stock pays no dividends. There are six steps in selecting an option strategy. First, state the forecast clearly. Second, calculate the implied volatility of each option under consideration. Third, estimate the price of each option assuming the forecast is correct. Fourth, estimate the price of each option assuming the forecast is wrong. Fifth, measure results alternative on a percentage basis and analyze the risk/reward of each option. Sixth, and finally, using the option chosen from your analysis, determine the number of options to purchase. Now let's see how Terry handles each step. Step 1: State the forecast This is easy, because we were given Terry's forecast. Note, however, that an option trader's forecast contains a specific forecast for both stock price and time. traders, in contrast, frequently have forecasts that are much more vague. traders might be "bullish" or "bearish" without stating price targets or time horizons. It is essential that option traders recognize the need for specificity and practice making forecasts that include it. To restate Terry's forecast, he predicts that the price of GUES stock will rise from $60 to $65 in 10 days. Today is 42 days to expiration, so 10 days from now will be 32 days to expiration. Step 2: Calculating Implied Volatility

11 As explained in Option Behavior, implied volatility is the volatility percentage which, if used in an option pricing formula with the known inputs of stock price, time to expiration, interest rates, etc., will produce the current market price of an option as the theoretical value. The current level of implied volatility is used to estimate strategy results. To estimate the implied volatility of the 60, Terry uses the Options Calculator feature of the Options Toolbox software. The current inputs, stock price of $60, strike price of 60, days to expiration of 42, interest rates of 4% and dividends of zero are entered along with the market price of the 60 of As illustrated below, the Options Calculator calculates an implied volatility of 40%. Calculating the implied volatility of the GUES 60 : $60 Option as an Input: Volatility as an Output: Strike $60 Dividends 0% 60 Value Interest Rates Days to 4.0% 42 Outputs Volatility 39.98% Repeating this process for the 65, Terry finds that the implied volatility of the 65 is 40%. Calculating the implied Volatility of the GUES 65 $60 Option as an Input: Volatility as an Output: Strike $65 Dividends 0% 65 Value 1.50 Interest Rates Days to 4.0% 42 Outputs Volatility 39.63% Buying s and Puts - Continued Step 3: Estimating option prices if the forecast is correct

12 The next step is estimating the price of each call if the forecast is correct. To do this, Terry simply inserts the assumptions of his forecast. First, the stock price is changed from $60 to $65. Second, the Days are changed from 42 to 32. Note that the figure for volatility is 40% which is the implied volatility calculated above. Estimate of 60 (If forecast is correct): Change in Change in Days Estimate of New Strike New $60 $65 $60 $60 Dividends 0% 0% Volatility 40.0% 40.0% Interest Rates Days to 60 Value 4.0% 4.0% Outputs New Output Repeating the process for the 65, only the strike price has to be changed. Estimate of 65 (If forecast is correct): Estimate of New Strike New $60 $65 $65 $65 Dividends 0% 0% Volatility 40.0% 40.0% Interest Rates Days to Outputs 65 Value 4.0% 4.0% New Output Step 4: Estimating option prices if the forecast is wrong It is only realistic to consider what the loss might be is Terrys forecast does not materialize, but what is a "wrong" outcome? The maximum risk of either strategy is the total purchase price of the options plus commissions, and such an outcome is possible. But experienced traders usually close a position at a loss when the market goes against them.

13 Deciding what is a "wrong" forecast is subjective, but Terry decides to estimate his loss if the stock price is unchanged in 10 days. Under those conditions, both options will have a loss, and that is when Terry might expect to close out his trade. Estimate of 60 ( price unchanged in 10 days): Unchanged Change in Days Estimate of New Strike New $60 $60 $60 $60 Dividends 0% 0% Volatility 40.0% 40.0% Interest Rates Days to Outputs 60 Value 4.0% 4.0% New Output Estimate of 65 ( price unchanged in 10 days): Unchanged Change in Days Estimate of New Strike New $60 $60 $65 $65 Dividends 0% 0% Volatility 40.0% 40.0% Interest Rates Days to Outputs 65 Value 4.0% 4.0% New Output Buying s and Puts: Next Steps Results in Absolute Terms - A Brief Digression Terry now has both profitable scenario and loss scenario estimates of the option prices. We will first consider the results in absolute terms and then in percentage terms. As you will see, this is an important step in understanding how option strategy alternatives are chosen.

14 To analyze the results in absolute terms, we look at the change in option value as follows: Results in Absolute Terms $60 $65 in 10 days Purchase Selling Profit/Loss Profit of Profit of 1.63 Unchanged in 10 Days Purchase Selling Profit/Loss Loss of Loss of.38 To summarize the above analysis, buying 1 60 requires an investment of 3.40, will make 2.90 if Terry's forecast is realized and lose.50 if the stock price is unchanged in 10 days. Buying 1 65, however, requires an investment of only 1.50, will make 1.60 if Terry's forecast is realized and lose.38 if the stock price is unchanged in 10 days. Is it possible to choose between these two strategies? No! The two strategies are not equal, because one requires a larger investment and has both a larger absolute profit potential and a larger absolute risk potential. If results are measured in percentage terms, however, there is a different conclusion. Step 5: Measuring results in percentage terms and analyzing risk/reward The table below summarizes, in percentage terms, the results of Terry's analysis. Results in Percentage Terms $60 65 in 10 days Purchase Selling Profit/Loss Profit = 2.88 = % Profit = 1.63 = % Unchanged in 10 Days Purchase Selling Profit/Loss Loss =.5 = -14.8% Loss =.38 = -25.0% By focusing on percentage results, the choice between the 60 and 65 s becomes more clear. Using only the two scenarios described above, purchasing the 60 s has a potential profit of 85.2% and a potential risk of 14.7% while purchasing the 65 has a potential profit of 108.3% and a potential risk of 26.6%.

15 The 65 has both a higher potential percentage profit and a higher potential percentage risk, so there is still not a perfectly clear choice. The difference in potential percentage losses, however, is 10.2%, while the difference in potential percentage profits is 23.1%. Therefore, to Terry, purchasing the 65 is more appealing. The question becomes: how does Terry find trading alternatives that implement this percentage analysis? Step 6: Determining the number of options to purchase What makes two limited-risk strategies equal? The amount of the risk is certainly one factor. If the maximum theoretical risk is equal, then, at least in some basic sense, the two strategies are comparable. There may still be some trade-offs, i.e., relative advantages and disadvantages, but at least they have the same maximum theoretical risk. Terry can make alternative strategies equal from a risk standpoint by deciding on the amount of capital he is willing to invest and risk. From that figure, he can then determine the number of options of each strike that can be purchased. He will then be comparing alternatives that do not exceed his risk limit. If Terry is willing to invest and risk approximately $1,800 not including commissions, for example, then he can purchase either 5 of the 60 s at 3.60 each (5 x $360= $1,800) or 12 of the 65 s at 1.50 each (12 x $150 = $1,800.00). These strategies require investments that are approximately equal, so analysis of profits and losses in percentage terms is appropriate. Since Terry's analysis indicated that the 65 has the preferred risk/reward ratio, Terry decides to purchase s for 1.50 each. Purchasing calls has a profit potential of $1,950 (12 x $162.50) and a loss potential of $450 (12 x $37.50). In contrast, purchasing 5 60 s has a profit potential of $1, (5 x $287.50) and a loss potential of $ (5 x $50.00). Terry's decision is partly subjective. He believes that purchasing s is justified, because the $ of extra profit potential is worth the risk of $ in extra loss potential. There is no guaranty that this choice will earn a profit, but it appears to Terry to have a better risk/reward ratio. If he believes in his forecast, and if he is willing to assume the risk of being wrong, then Terry will purchase 12 of the 65 s. Section 6 - A trading problem for you Are you ready for another involved problem? Here goes... Jay wants your advice. He has $2,250 not including commissions to invest and risk on his prediction that WDO stock will rise from $86 to $91 in the next four weeks. WDO call options are available as follows: WDO Options 42-day day day Assuming Jay is looking to purchase call options to profit from his forecast, he would like to know which alternative and what specific strategy -- you prefer. For this trading problem, assume WDO stock is trading at $86, it pays no dividends in the next month, it is 42 days before option expiration, and interest rates are 4%.

16 Feel free to use the Options Calculator and to write down your answers. After thinking through the problem for yourself, continue reading to see how Jay might analyze his choices. Step 1: State the forecast Jay predicts that WDO will rise from $86 today, which is 42 days prior to expiration, to $91 in four weeks, or 28 days, when it will be 14 days prior to expiration. Step 2: Calculating Implied Volatility The Options Calculator helps us calculate the implied volatility of the 80, 85 and 90 s as follows: Calculating the implied volatility of the WDO calls $86 $86 $86 Strike Dividends 0% 0% 0% Option as Value an Input: Interest Rates 4.0% 4.0% 4.0% Days to Outputs Outputs Outputs Volatility as an Output: Volatility All three calls are trading at an implied volatility of approximately 30% which Jay will use in his forecast. Step 3: Estimate option prices if the forecast is correct By changing the stock price to $91 (from $86) and the days to expiration to 14 (from 42), we get the results below. Note that there are three columns next to "Strike " which correspond to the three columns next to "Estimates of New s." Estimate of s (If forecast is correct) Change in : New $86 $91 Strike 80 / 85 / / 85 / 90 Dividends 0% 0% Volatility 30.0% 30.0% Interest Rates 4.0% 4.0%

17 Change in Days: Estimates of New s: Days to Values Outputs 7.50 / 4.25 / New Outputs / / Step 4: Estimate option prices if the forecast is wrong Determining what constitutes a "wrong forecast" is subjective. Although the total investment could be lost if the calls expire worthless, Jay might estimate the option prices if the stock price is unchanged in 4 weeks. These are prices where Jay might choose to close his position at a loss regardless of when the options trade at these prices. Estimate of s ( price unchanged in 4 weeks) Unchanged: Change in Days: Estimates of New s: New $86 $86 Strike 80 / 85 / / 85 / 90 Dividends 0% 0% Volatility 30.0% 30.0% Interest Rates Days to Values 4.0% 4.0% Outputs 7.50 / 4.25 / New Outputs / / Step 5: Measuring results in percentage terms and analyzing risk/reward The table below summarizes, in percentage terms, the results of Jay's analysis. Estimated percentage changes in option prices $86 $91 in 4 weeks Profit = 3.60 = % Profit = 2.10 =+ 50.0% Profit =.60 = % Unchanged in 4 weeks

18 Loss = 1.10 = -16.2% Loss = 1.60 = -38.2% Loss = 1.40 = -67.6% Using only the two scenarios described above, purchasing the 80 s appears to have the better risk/reward ratio: 48.3% estimated profit if Jay's forecast is realized and a 16.2% estimated loss if the stock price is unchanged in 28 days. The 85 has a slightly higher estimated profit potential, but its estimated loss is substantially higher. The 90 has both the lowest estimated profit potential and the highest estimated loss potential, so it is clearly the least desirable choice. Step 6: Determining the number of options to purchase Given $2,250 not including commissions of available capital, Jay could purchase 3 of the 80 s ($750 x 3 = $2,250), 5 of the 85 s ( $425 x 5 = $2,125) or 10 of the 90 s ($ x 10 = $2,125). Each of these alternatives would require approximately the same investment and risk. Jay's analysis, however, leads his to the 80 s. If he purchases 3 of the 80 s at 7.50 and his forecast is realized, then he can expect to make approximately $1, not including commissions. If, however, the stock price is unchanged, then he can expect to lose approximately $ This analysis does not guarantee Jay a profit, but it has lead him to a strategy that has, in his opinion, the preferred risk/reward ratio. Summary of Lesson 5 Trading options requires a different thought process than trading stocks. Option traders should start with a forecast that includes a specific price target for the underlying stock and a specific forecast for the time period. One stock-oriented option strategy, the covered straddle, combines long stock, a covered call and a cash-secured put. This strategy enables a trader to either buy more stock at a price below the current market price or to sell the existing stock position above the current price. Another stock-oriented option strategy, the stock repair strategy, is an alternative to "doubling up" on an unprofitable stock position. The goal of the stock repair strategy is to lower the break-even point on an unprofitable stock position without increasing risk which doubling up does. Long-term call options, or LEAPS, can be used as an alternative to purchasing stock on margin. Although a LEAPS call has a lower delta than stock, there is generally less total risk than buying stock on margin. There are six steps in selecting an option trading strategy. 1. First, the forecast must include a specific forecast for the price of the underlying stock and the time period. 2. Second, the implied volatility of each option under consideration is calculated, and this figure is used when estimating option prices. 3. Third, an estimate of the price of each option under consideration is made assuming the forecast is correct. 4. Fourth, an estimate of the price of each option is made assuming the forecast is wrong.

19 6. 5. Fifth, the risk/reward of each option is analyzed on a percentage basis. Sixth, and finally, after an amount of capital is chosen, a strategy is formulated by dividing the capital by the cost of the favored option. Trading is not easy. It takes time to learn and it involves acting on intuition and closing positions at either a profit or a loss when market conditions dictate. "Trading capital" should only be a small portion of total capital, and it should be money that you can live without if losses occur.