by Helmut Schmidhofer
In the previous lesson we discussed short straddles, butterflies and condors as profitable strategies when the market is drifting. Here we deal with trending markets.
If you are bullish, you could write put options. If your prediction is correct, you collect the premium. If your prediction is wrong, you protect yourself by buying back the option or shorting the underlying stock.
Vice versa, if you are bearish, you could write call options. Collect the premium if right, hedge with long stock if wrong. The problem is that the market could turn your way as soon as you are hedged, in which case you would remove the hedge to stay in profit.
This whipsawing costs commissions, BAD (bid-ask discrepancy), and slippage, which erodes your potential profit. Worse, the market could gap past your break-even point, as happened on 3 July 2007 to the writer of 5,000 calls (500,000 shares) on Hilton Hotels Corp., when a takeover offer was announced.
Safer solutions are the bullish put spread and the bearish call spread:
By giving up part of the premium, from $3.10 to $1.85 (bull spread) and $3.76 to $2.00 (bear spread), you are protected against disaster.
You will have noticed that I prefer strategies where the initial position results in a credit. Gamblers prefer to buy way-out-of-the-money options where a dramatic move can return 1000% (9:1). I am happy to accommodate them because for every one time they win, they lose the small premium fifteen times.
However, if you are an investor, options give you better choices. Say you are bearish on a stock. If you go short, you have unlimited risk on the upside. Better to buy a deep-in-the-money put option. Its price moves almost the same as the stock, its time value is negligible, and the upside risk is limited to the premium paid.
Or, if you are a speculator, how often were you stopped out of a position, only to find that the market turned around and proved you right? With options, the cost may be less than your stop-loss, and you would still be in the market when it turns your way.
Another situation. Say you are long in a stock with paper profit after a good run. You suspect it may retrace substantially but you don't want to sell. An option strategy called “equity collar” is a way to hedge your position.
By selling a call option and buying a put option, both out of the money, your stock's downside is limited to -4.49 at the price of limiting your upside to +5.51.
If you expect a major move, the ratio spread lets you profit from it at minimum cost. Sell one high-priced and buy two low-priced options, puts if bearish or calls if bullish.
With a ratio spread, you want a healthy move of more than 10%. Which brings us to the last spread in this series of risk-free speculation, the M-spread (it looks like an M for 'money' and you won't find it in any textbook):
This spread is highly profitable in erratic markets. You are long one call and one put near the money, long three calls and three puts furthest from the money, and short 4 calls and 4 puts between the long strikes. After thirty days, the market could be up or down for a maximum profit of 5.34. If it stays unchanged, you make 0.34. If it goes berserk (moves more than 15%), you risk -9.66.
IMPORTANT WARNING: Never be naked short, even for one second! This means that you open your longs before the shorts, and you close your shorts before the longs. Make sure your broker heeds your conditional order. Of course, some spreads are traded as spreads so that both legs are opened simultaneously.
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