Options Pricing: It’s Like Buying in Bulk

Options Pricing: It’s Like Buying in Bulk
By Bill Johnson

One of the benefits of options is that we get lots of choices. We have lots of expiration dates, strikes, and strategies. Unfortunately, having so many choices also causes confusion among traders. Which expiration and which strike should you choose?

To answer that, it helps to understand some basics of options pricing. Most traders believe that at-the-money option prices follow a straight-line path. For instance, if a one- month option costs $1, you’d think a two-month option must cost $2 – twice the time, twice the money. It seems to make sense, but it’s wrong. Not understanding how options are priced leads traders to make bad strategy decisions.

It’s counterintuitive, but here’s the way it works: If a one-month option costs $1, it would take a four-month option before you’d see it trading for $2. In other words, it takes four times the amount of time to double an option’s price. The reason is that options prices are proportional to volatility, which is proportional to the square root of time.

If you increase time by a factor of four, the option’s price increases by the square root of four, or a factor of two. If you can increase in option’s time to expiration nine-fold, the option’s price triples.

The point to understand is that when you’re buying long-dated options, it’s like buying things in bulk. Yes, you’ll pay more for the option, but the price per day is greatly reduced. For instance, the four-month option trading for $2 costs about 1.7 cents per day, but the one-month option trading for $1 costs about 3.3 cents per day – twice as much. If you’re buying options, you should lean toward buying longer-dated options as the amount of time value you’re spending per day is greatly reduced.

On the other hand, option sellers should lean toward selling shorter-term options multiple times rather than selling one longer-dated option. For example, if you’re using a covered call strategy, you may decide to sell the four-month option for two dollars. It sounds like a better deal since you’re receiving $2 rather than $1. However, you must wait the entire four months before you’ll collect it all. On the other hand, if you sell the one-month option four times, you’ll collect $4 – twice as much money for the same length of time.

Unfortunately, many new traders think longer dated options are riskier because they cost more money in total. However, you must always ask yourself how much am I paying per day? When you look at options in this light, longer dated options are always far cheaper. For a live example, Apple Computer (AAPL) closed today at $187.63. If you decided to sell the January 2019 $190 call (242 days to expiration), you’d receive $12.30. However, if you sold the $190 weekly that expires in four days, you’d get 54 cents. Instead, if you sold the 4-day call, you could do that 60 times during the same 242 days, which would net a total of $32 – far greater than $12.30.

There are other considerations, such as the size of the hedge. If Apple takes a big hit, you may have been better off having sold the longer-dated option. But all things being equal, you should buy longer-dated options and sell shorter-dated ones. The square-root pricing relationship is the reason. All options strategies are always about tradeoffs, so there’s never a crystal-clear answer as to what the best strategy may be. Instead, you want to focus on which strategy is best for you. Once you understand how options are priced, it puts you one step closer to mastering the art and science of options trading.

Good Investing!

Bill Johnson, Steve Bigalow
and The Candlestick Forum Team

P.S. Bill Johnson’s Alpha Trader Options Course takes you from the very beginning, step-by-step, through an exciting journey into the world of options. At the end, you’ll have the necessary knowledge and confidence to start investing and hedging with options. In addition, you’ll have a rock-solid foundation from which to continue your options education.

Click here for more information about Bill’s Alpha Trader Options course, now with multi-pay options!

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The Hidden Dangers of Automatic Exercise

The Hidden Dangers of Automatic Exercise
By Bill Johnson

Options strategies are highly rewarding, but like any field, there are rules and procedures you must understand. One of the most misunderstood – and potentially dangerous – is automatic exercise.

When you buy an option – call or put – you have the right, not the obligation, to exercise the option. If you exercise a call option, you’ll buy 100 shares of stock and pay the strike price. On the other hand, if you exercise a put option, you’ll sell 100 shares of stock and receive the strike price. You’re not required to ever exercise a long option. It’s simply a right if you choose. Most the time, options traders just close their options in the open market and take their profits that way. Still, some traders may want to buy or sell shares of stock by exercising an option, and they’re certainly free to do that.

However, there is a procedure set by the Options Clearing Corporation (OCC) that can potentially change that decision. If any option is at least one cent in the money, it is automatically exercised unless you instruct the broker to not do so. For example, let’s say you own the $100 call, and the stock closes at $100.01 or higher at expiration. If you didn’t close at call out at expiration, it will automatically be exercised, and that means you’re going to own 100 shares of stock on Monday morning. On the other hand, if you own a $100 put and the stock closes at $99.99 or lower, you’ll end up selling 100 shares of stock from your account. If you don’t have the stock in the account, you’ll be short 100 shares of stock. What if you don’t have to cash in the account to maintain the long or short stock positions?

Most brokers will still exercise the options, and you’ll owe at least a 50% margin requirement to continue holding the position. Some brokers, however, will close the position if you don’t have the cash, so it’s important to understand your broker’s policies.

Losing More Than What You Paid

The main danger with automatic exercise is that it creates the potential for you to lose more on the option than the amount you paid. You often hear that the most you can lose on an option is the amount you paid, and that means the option itself cannot have negative value. However, because of this man-made rule of automatic exercise, it’s not totally true.

Here’s an example of how things can go wrong if you don’t understand option mechanics. Let’s say you bought a $100 call for $3, or a total of $300. On expiration Friday, the stock is trading for $99.50, and it looks like it’s going to expire worthless. Rather than paying the commission to close it out, you take off for the golf course. However, in the last few minutes of trading, news breaks out, and the stock closes above $100. Because you didn’t close out the option, you’re going to be long 100 shares of stock on Monday morning. Now let’s say the stock trades at $95 on the opening bell. You own shares at $100, but if you don’t want the shares in your account, you’re going to end up selling them for the current market price of $95. Therefore, you ended up with a $500 loss, even though you only spent $300 on the option. The reason this happens is the long $100 call has a limited downside risk of $3 – the amount you paid. It’s profit and loss diagram looks like a hockey stick as shown by the blue curve in the chart below:

However, if you end up exercising that call, whether intentionally or through automatic exercise, your profit and loss diagram is no longer represented by the blue curve. Instead, you’re now long shares of stock and have an unlimited downside risk as shown by the red line.

The lesson to learn is that if you have any long options that are even remotely close to becoming in the money at expiration, close them out. If your proceeds are not enough to cover commissions, most brokers will call it even. If your broker won’t, you can always place instructions to not exercise any long options that may end up going in the money. If you either close out the long positions or instruct the broker to not exercise them, now it’s safe to go to the golf course. Options aren’t risky if you understand all the rules. As Warren buffet said, risk comes from not knowing what you’re doing. If you understand the art and science of options trading, they’ll become invaluable tools for hedging risk and holding on for bigger gains.

Good Investing!

Bill Johnson, Steve Bigalow
and The Candlestick Forum Team

P.S. Bill Johnson’s Alpha Trader Options Course takes you from the very beginning, step-by-step, through an exciting journey into the world of options. At the end, you’ll have the necessary knowledge and confidence to start investing and hedging with options. In addition, you’ll have a rock-solid foundation from which to continue your options education.

Click here for more information about Bill’s Alpha Trader Options course, now with multi-pay options!

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Capturing Profits on After-Hours News

Capturing Profits on After-Hours News
By Bill Johnson

Options trading is quickly becoming a favorite tool for investors and traders alike – especially in today’s uncertain markets. The reason is simple: Options allow investors to profit in ways that cannot be done with stock alone. But there are tactics most options traders don’t know that can be used to profit when news is announced after the closing bel

Anyone who’s invested for a while knows that big news is often withheld until after the closing bell in order to not disrupt the markets while open. It’s why earnings are announced either prior to the opening bell or after the closing bell.

Sometimes, however, the stock can trade to exceptional high values after hours, and if you’re holding call options you’d like to sell, there’s nothing you can really do about it. No matter what the stock price may show in after-hours markets, you must wait for the opening bell before you can sell the call option. The risk is that prices may move against you during the night, and when the opening bell rings, your anticipated profits have evaporated.

A recent example occurred on April 26, when Amazon released stellar earnings by reporting $3.27 per share versus $1.26 per share analysts expected. The next morning, prior to the opening bell, the stock was trading up $140 at $1,658 – over 9%. Let’s say you bought the $1,550 call before earnings. With the stock trading at $1,650, you’re expecting to close the option for the 100-point difference, or $10,000 per contract. The problem is that sometimes the euphoria fades prior to the bell, and the stock may open at much lower levels. But again, there’s nothing you can do until the opening bell – or is there?

There’s a trick that experienced options traders will do. Rather than taking your chances and waiting for the market to open, you simply short 100 shares of stock in the after-hours market. Once the trade is filled, exercise your call option. For instance, if you short shares at $1,650, you collect $1,650 per share in cash, but you owe 100 shares of stock to the broker. By exercising the call, however, you’ll buy 100 shares, which clears the short position. The cash for the exercise is automatically created from the short sale. You collected $1,650 cash but use $1,550 of that cash to exercise the call, which leaves you with the $100 difference. The trade, therefore, requires no out-of-pocket expense. It’s self-financing.

Another problem can occur to for traders by waiting for the opening bell. Options go through an opening rotation, so most option strikes won’t open for trading for 10 minutes or so after the opening bell. During this time, however, the stock price is off to the races – and may be racing south. That’s exactly what happened to Amazon on this day, and it closed at $1,572 – a big difference from the $1,634 opening price. Even if you placed a market order to sell your contracts on the opening bell, your execution price would be significantly lower that what you were anticipating. Experienced options traders know the tactics, rolls, hedges, and morphs to make the most of any situation. It’s the art and science of options trading that makes the difference between trades that make you crazy – and ones that make you money.

Good Investing!

Bill Johnson, Steve Bigalow
and The Candlestick Forum Team

P.S. Bill Johnson’s Alpha Trader Options Course takes you from the very beginning, step-by-step, through an exciting journey into the world of options. At the end, you’ll have the necessary knowledge and confidence to start investing and hedging with options. In addition, you’ll have a rock-solid foundation from which to continue your options education.

Click here for more information about Bill’s Alpha Trader Options course, now with multi-pay options!


Trading in the Stock Market, Trading Options, Trading Futures, and Options on Futures, involves substantial risk of loss and is not suitable for all investors. Past Performance is not indicative of future results. CandlestickForum.com, Candlestick-Trading-Forum.com, StephenBigalow.com, and Candlestick Forum LLC do not recommend or endorse any specific trading system or method. We recommend that you research all trading systems, methods and market strategies thoroughly. Full Disclaimer here

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Why Credit Spreads are Debit Spreads in Disguise

Give Me Some Credit!
Why Credit Spreads are Debit Spreads in Disguise
By Bill Johnson

Everybody likes credits. We want credit for the work we do. We get credits for taking college classes. And, of course, we love our credit cards.

It only makes sense that when using vertical spreads, we should love the credit spread over the debit spread. A credit spread is simply the seller to the trader who bought the spread. The buyer pays a debit. The seller gets the credit. Well, you don’t need to know anything about options to figure out that the credit side is better, right?

Actually, you do need to not know anything about options to believe it’s true.

There’s always a debate among traders over debit and credit spreads, so let’s be sure you understand the art and science behind these two sides of the same trade.

As a refresher, a vertical spread is the purchase of one option and the simultaneous sale of another. Both must be the same type (calls or puts) and have the same expiration date. For instance, if you buy a Facebook May $160/$165 call spread, you’re buying the $160 call and selling the $165 call. Because lower strike calls must be worth more money for any expiration, this is a debit trade.

The most you can make from the trade is the difference in strikes, or $5 for this example. That’s because you have the right to buy shares at $160 and the potential obligations to sell them for $165. If you paid $3 for the spread, the most you can make is $2. As a check, the amount paid added to the maximum loss must equal the difference in strikes, or $3 + $2 = $5 difference in this example. By entering a spread, you have limited risk and limited reward:

However, you can get the identical risk profile by selling the same put spread – same strikes and expiration. If you sold the $160/$165 put spread, you’d have the same risk graph. And yes, it will be bullish too. It will be identical to the call debit spread. However, because you’re the seller, you’d receive a credit. And it’s at this point that most traders immediately jump to the conclusion that the credit trade must be better. After all, everybody loves credits.

Buyers Have Rights. Sellers Have Obligations

However, when you buy a spread, you have rights. You own something that might appreciate. But when you sell a spread, you have an obligation equal to the difference in strikes. You can think of debit spreads as assets and credit spreads as liabilities. Part of the misperception with credit spreads is that traders think they’re earning a credit to take on an asset. They’re not. They’re getting paid to accept a liability.

For example, by selling the $160/$165 put spread, you’re long the $160 put and short the $165 put. For puts, higher strikes are worth more money, as you have the right to sell shares for more money. Therefore, to receive a credit from this position, you must be selling the $165 put – that’s what’s providing the overall credit.

Now check your rights and obligations: If you sell the $165 put, you have the potential obligation to buy shares for $165. By purchasing the $160 put, you have the right to sell shares for $160. Buying shares at $165 and selling them at $160 is a five-dollar loss. There’s no asset anywhere in the equation. It’s a five-dollar liability. That’s why you’re getting paid to accept the trade. Spread sellers act like an insurance company. They’re collecting a smaller amount today, say $2, to insure a larger loss, say the $5 difference in strikes.

Here’s the important relationship you must understand to find which spread – the debit or credit – may be most effective: Buying the call spread is identical to selling the put spread. How is that possible?

Go back to the original $160/$165 call spread trading for $3. That’s an opportunity to pay $3 and potentially make $2. However, the if it’s trading for $3, the $160/$165 put spread must be selling for $2. By selling the spread for $2 that’s the most you can make, but you may lose $3. Wait a minute, that’s exactly the same as the call spread!

Exactly right. There is no difference.

To take it a step further, if you buy the call spread, your broker will debit your account $3, or $300 total, to buy the call spread since that’s the most you can lose. However, if you sell the put spread for $2, the broker will still debit your account for $3 since, again, it’s the maximum you can lose. Brokers don’t care how much you can make. They do care about how much you can lose, so the margin requirements are always pegged to the maximum loss. No matter how you cut it, a debit spread is a credit spread. There’s no reason to automatically prefer one over the other. Why bother learning both?

In the real world, you’ll get slight pricing discrepancies due to put-call skews. For instance, if you can buy the call spread for $3, you may be able to sell the put spread for $2.20. In that case, you’re better off with the put spread. You can make more ($2.20) and lose less ($2.80).

But many times, skews work the other way. If the call debit spread is trading for $3, the corresponding put spread may be selling for $1.80. Now you’re better off buying the call spread – even though it’s a debit trade.

Options trading is the most rewarding, but it’s even more rewarding when you understand the finer points – the art and science of options trading. Now that you understand, give yourself some credit.

Good Investing!

Bill Johnson, Steve Bigalow
and The Candlestick Forum Team

P.S. Bill Johnson’s Alpha Trader Options Course takes you from the very beginning, step-by-step, through an exciting journey into the world of options. At the end, you’ll have the necessary knowledge and confidence to start investing and hedging with options. In addition, you’ll have a rock-solid foundation from which to continue your options education.

Click here for more information about Bill’s Alpha Trader Options course, now with multi-pay options!


Trading in the Stock Market, Trading Options, Trading Futures, and Options on Futures, involves substantial risk of loss and is not suitable for all investors. Past Performance is not indicative of future results.CandlestickForum.com, Candlestick-Trading-Forum.com, StephenBigalow.com, and Candlestick Forum LLC do not recommend or endorse any specific trading system or method. We recommend that you research all trading systems, methods and market strategies thoroughly. Full Disclaimer here

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When to Sell: It’s No Longer  the Hardest Decision

When to Sell: It’s No Longer
the Hardest Decision
By Bill Johnson

It’s often said the hardest decision an investor must make is when to sell. Sell too soon, and you miss out on a potentially skyrocketing stock price. Sell too late, and you could sink with the ship. Buying is easy; selling is difficult. However, options can make the difficult challenge of selling a thing of the past. It’s done with a strategy called a stock swap.

Here’s how it works. Let’s say you purchased 500 shares of stock at $45 and it’s now trading for $56. You think the stock will continue higher, but at the same time, don’t want to see your gains turn to losses. The most common approach investors take when faced with this dilemma is to sell the stock and look for another opportunity.

The problem with this approach is that the new stock you pick is equally likely end up heading south as the one you currently own. If you always try to sell your stock at the top and look for another to buy at the bottom, you’ll end up generating a ton of commissions and probably be worse off than if you had just stuck with the original company in the first place. Trends last longer than people expect, and the better approach is to hedge your position and get your money back – plus a return – and maintain the position. That’s what hedging is all about.

Protecting Profits with Stock Swaps

The underlying stock is $56 and the following option quotes are available:

To enter the stock swap, sell your shares of stock and simultaneously replace them with a share-equivalent number of call options. In this example, you may sell 500 shares of stock at $56 and simultaneously buy five $55 calls for $3.38. The net credit is $52.62 per share:

Sell 500 shares at $56
Buy 5 $55 calls at $3.38
Net credit = $52.62

The effect of this hedge is that you’ve swapped your shares for a call option – and collected a net credit of $52.62, or $26,310 for 500 shares, which is sitting safely in cash. Your original purchase price was $45, or $22,500 for the 500 shares. The swap guarantees a return of $26,310 – $22,500, or $3,810. That’s a 17% guaranteed return on your money – but still leaves you with unlimited upside potential. However, you’re still effectively long 500 shares of stock if it should continue to rally. If it crashes, the worst that can happen is you made $3,810.

The strike you choose is a matter of preference. If you buy a lower strike call, such as the $45 or $50, the good news is that it’ll behave more like the stock and move closer to dollar for dollar with the underlying stock. The bad news is that lower strike calls won’t recoup as much of your original principal since lower strike calls are more expensive. Because the goal of the stock swap is the recoup your principal, or at least a good portion of it, most investors use at-the-money or slightly out-of-the-money call options.

Stock swaps prevent you from trying to time the market. When you sold the stock for $56, was that the very top? Probably not. At the same time, it’s not easy to hold a position when substantial profits start to build. The stock swap provides a solution to both problems. The following profit and loss diagram shows the effect of our stock swap hedge:

You can see that the original stock position (red line) assumes risk all the way down to a stock price of zero. The stock swap (blue line) not only removes all of that risk, but it also guarantees a minimum of $7.62 per share, or $3,810 in profits for the 500 shares.

The tradeoff is that the stock swap will not be as profitable as the shares alone if the stock should rise. The reason is you paid $3.38 for the call options, which is an unnecessary expense if the stock continues higher. But since we don’t know what will happen to the stock in the future, the hedged tradeoff provides a very comfortable and reasonable strategy for investors. You’re simply sacrificing the $3.38 time premium in exchange for a guaranteed $3,810 profit – but still have the potential to make more money if the stock continues to rise. Once you’re in a guaranteed position, the decision to hold the position is much easier. The difficult decision of when to sell is eliminated and you can now hold on for serious profits. Options give all investors – including stock owners – better choices. The stock swap ensures you’ll never have to worry about when to sell.

Good Investing!

Bill Johnson, Steve Bigalow
and The Candlestick Forum Team

P.S. Bill Johnson’s Alpha Trader Options Course takes you from the very beginning, step-by-step, through an exciting journey into the world of options. At the end, you’ll have the necessary knowledge and confidence to start investing and hedging with options. In addition, you’ll have a rock-solid foundation from which to continue your options education.

Click here for more information about Bill’s Alpha Trader Options course, now with multi-pay options!

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On a Roll? Then Roll Up!

On a Roll? Then Roll Up!
By Bill Johnson

Options traders have opportunities and choices that simply are not available to stock traders, and that’s what makes them the choice among professional traders. These advantages can be categorized as hedging, morphing, and rolling, and it’s the art and science of these three that makes options trading so rewarding. One of the easiest, most powerful strategies is a type of roll called the roll-up. If you’re an options trader, this one strategy will immediately improve your profitability. If you’re a stock trader, it’ll convince you to switch to options.

The roll-up is a strategy used for call options where the underlying stock price has risen, and there’s a related strategy called the roll-down that’s used for puts when the stock price falls. Conceptually, they’re the same strategy – just used in opposite directions. When you understand one, you’ll understand the other. For now, let’s just focus on the roll-up.

The Stock Trader Dilemma

To appreciate the roll-up, let’s first see the dilemma stock traders face. Let’s say you own ABC shares at $50, and the stock has run to $56.50 after a few weeks. Should you take the profit? Or hold on for bigger gains? That’s the big decision for stock traders. They have lots of money riding on the position and get tempted to take quick profits. After all, as the saying goes, “You can’t go broke taking a profit.” The truth is you can go broke taking profits. If you take quick, small profits, it’s a matter of time before you have one big loss, and those many small profits may not cover the loss. To succeed, you must let your profits run. Anyone whose been trading for a long time knows that regretful feeling all too well. You pick up a few pennies in profits, only to find you missed the serious money. Trends – up or down – always last longer than people expect.

One of the most dramatic examples occurred in the late 90s when Qualcom (QCOM) rose from $40 to $80 within three months in anticipation of a strong earnings report. It can’t go higher from here, right?

Wrong. It did and went straight to $600. Whoops.

Any stock trader has seen countless examples like this. Amazon.com, Apple, Nvidia, and Salesforce just to name a few recent ones. The real money in the markets is usually made from a handful of positions, but the problem is that you don’t which ones – or when.

The Option Solution

Rather than buying the shares, let’s say you purchased 10 of the 90-day $50 calls for $3. The stock has moved up to $56.50 after five weeks, and the following option quotes are now available:

With the $50 call trading for $7.10, it may be tempting to sell, but remember, trends last longer than people think. Further, even if you sell for a profit, what are you going to do with the money? You’ll plow it back into the market, so you haven’t really accomplished anything other than switching the risk of the option you sold with the one you bought. Instead, the stock is performing well. Stay on it, but let’s remove some of the risk – and fear.

To execute a roll-up, you’ll sell your current strike ($50 in this example) and simultaneously buy the next higher strike with the same expiration:

1) Sell 10 $50 calls for $7.20
2) Simultaneously buy 10 of the $55 strike for $3.20
3) Net credit = $4.00

Doing so, you’ve given up a long position in the $50 calls and replaced it with a long position in the $55 calls – you have rolled up in strikes. At the current prices, this will result in a net credit of $4 to your account, or a total of $4,000 for the 10 contracts.

The roll-up always produces a net credit since higher-strike calls of the same expiration will always be less expensive. This cash is sitting safely in the money market and will not vary based on the stock’s price. Therefore, you’ve reduced future price fluctuations – and reduced the amount you have in the position. Initially, you purchased the $50 calls for $3, but after collecting the $4 credit, you have a guaranteed $1 gain, or 33% — but still control 1,000 shares. By looking at the profit and loss diagram, you rolled up from the shaded line to the blue line:

Most importantly, notice that the blue line sits above the breakeven line shown in red. Again, that’s because you initially paid $3, but collected $4 from the roll-up. You can’t lose – but you might make more.

Some stock traders try to do a similar thing by selling a portion of their shares, say half, and then hold the remaining shares. The problem is that you’ll eventually run out of shares. You can only hold on for so long, but that doesn’t happen if you’re using options.

A roll-up won’t always shift you into guaranteed territory as in this example. However, each roll reduces the potential you can lose. You can also sell a few contracts and roll the remainder to get you into a guaranteed trade quicker. For instance, if the stock was only trading at $54 rather than $56.50, you might sell three contracts and roll seven to get you into a guaranteed position. The possibilities are endless once you see the power of options.

Roll-ups and roll-downs are two of the most powerful hedges that long call and put owners can use. They allow you to collect profits while still maintaining the same-sized position. If your stock’s on a roll, roll your options, and improve your profits.

Good Investing!

Bill Johnson, Steve Bigalow
and The Candlestick Forum Team

P.S. Bill Johnson’s Alpha Trader Options Course takes you from the very beginning, step-by-step, through an exciting journey into the world of options. At the end, you’ll have the necessary knowledge and confidence to start investing and hedging with options. In addition, you’ll have a rock-solid foundation from which to continue your options education.

Click here for more information about Bill’s Alpha Trader Options course, now with mult-pay options!

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If You Want Versatility, Go Vertical!

If You Want Versatility, Go Vertical!
By Bill Johnson

Options are powerful, flexible tools for all traders and investors, as they allow risk profiles that cannot be obtained using shares of stock alone. One of the most versatile options strategies is a vertical spread. With this strategy, traders can take a bullish or bearish outlook, but with limited risk.

In the option’s world, any type of “spread” strategy means you’re simultaneously buying and selling options. You’ll be long and short options at the same time.

With a vertical spread, you’ll buy and sell different strikes but with the same expiration. For instance, you could buy a May $50 call and simultaneously sell a May $55 call, which is called the 50/55 vertical spread. It’s called a vertical spread because, if you look at an option’s quote board, the expiration dates run horizontally across the top while the strikes run vertically along the side. With this strategy, you’re “spreading” the strikes vertically.

If you buy the 50/55 vertical, you have the right to buy shares at $50 but the obligation to sell them at $55, which represents a $5 maximum gain. Because lower strike calls must be worth more money than higher strikes, this trade would result in a debit. If you paid $3 for the spread, your maximum profit is the $2 difference. The following chart shows your resulting profit and loss diagram:

Interestingly, you can create the identical profile by using puts. If, instead, you bought the May $50 put and sold the May $55 put, you’ll still have a bullish spread. An easy way to remember is “buy low, sell high” or BLSH, which resembles the word bullish. Any time you buy a low strike option and sell a higher-strike option, whether using calls or puts, you’ll have a bull vertical spread. When using puts, however, the trade results in a credit.

If the 50/55 bull spread costs $3, the 50/55 put spread is theoretically worth $2. In other words, you could sell the spread for $2, which is the maximum gain, and would have a $3 maximum loss. You’ll get exactly the same profit and loss diagram as when using calls. Professional traders will always check the pricing relationships for small discrepancies that may arise. For example, if the 50/55 call spread costs $3, the 50/55 put spread is theoretically worth a $2 credit. However, if the put spread is selling for $2.20, you’re better off selling the put spread. You’ll end up with the same profile, just with a greater maximum gain – and a smaller maximum loss. It pays to understand these differences!

Vertical Bear Spreads

You can also create bearish positions by purchasing puts. Any time you buy a high strike option and sell a lower strike option, whether using calls or puts, you’ll get a bear spread. For instance, you could buy the $55 put and sell the $50 put. Because higher-strike puts must cost more money than lower-strike puts, this trade results in a debit. If you paid $3, the maximum gain is $2, and you’ll get the resulting profit and loss diagram. Of course, you could buy the $55 call and sell the $50 call, which would also result in the same bearish profit and loss diagram:

Why Use Spreads?

While there are many reasons for using vertical spreads, probably the main use is to reduce the cost of the long option. If the $50 call costs $10, for example, perhaps you can sell the $55 call for $7, which reduces your net cost to $3. The tradeoff is that you give up the unlimited upside potential you’d have with buying the $50 call by itself. The benefit is that your maximum loss is reduced from $10 to $3.

Vertical spreads create great risk-reward profiles. In this example, you can earn 66% on your money, but greatly limit the amount you can lose. However, vertical spreads are flexible. If you have the 50/55 vertical call spread and the stock begins to break out, you can buy back the $55 call to close and keep the $50 call free and clear to capture unlimited gains.

Changing Directions

What if you’re in a bull spread, but the stock’s heading down? Verticals are versatile, and you can easily change directions. If you have the 50/55 vertical call spread, you can buy the short call’s corresponding put (the put with the same strike). The long $55 put combined with the short $55 call creates what’s called a synthetic short stock position. Those two options behave exactly like short stock. However, when it’s combined with the long $50 call, the net result is a long $50 put. This is a good example of what professional traders call a “morph,” which is a single trade that allows us the change the profit and loss profile.

Vertical spreads allow traders to buy options that otherwise may have been too expensive. As you get more experienced, you can even use vertical spreads to trade volatility or even volatility skews. Depending on how the spread is constructed, you can make the position bullish, bearish, or even neutral. You can make them premium outlay – or premium collection. The possibilities are endless with options, but the versatility of verticals is hard to match.

Good Investing!

Bill Johnson, Steve Bigalow
and The Candlestick Forum Team

P.S. Bill Johnson’s Alpha Trader Options Course takes you from the very beginning, step-by-step, through an exciting journey into the world of options. At the end, you’ll have the necessary knowledge and confidence to start investing and hedging with options. In addition, you’ll have a rock-solid foundation from which to continue your options education.

Click here for more information about Bill’s Alpha Trader Options course, now with mult-pay options!


Trading in the Stock Market, Trading Options, Trading Futures, and Options on Futures, involves substantial risk of loss and is not suitable for all investors. Past Performance is not indicative of future results. CandlestickForum.com, Candlestick-Trading-Forum.com, StephenBigalow.com, and Candlestick Forum LLC do not recommend or endorse any specific trading system or method. We recommend that you research all trading systems, methods and market strategies thoroughly. Full Disclaimer here

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Eliminating Emotions

The psychology of investing not only affects individual investors but also affects the market as a whole. Many investors often underestimate or are unaware of the affects that our emotions have on our return on investment. Many well educated and competent traders lose money due to trading anxiety and trading emotions. In today’s article we will discuss various emotions felt everyday by online stock investors and how each emotion affects trading decisions and trading performance.

Eliminating Emotions:

Greed and Fear
Greed causes traders to buy at high prices or buy a large amount of the same share, therefore increasing risk. Fear causes investors to exit the markets too early causing a loss of otherwise attained profits. Traders suffering from fear are afraid that the price will decrease further so they get out before the timing is correct, instead of letting the trade play out.

Overconfidence
Traders who are overconfident tend to trade more rapidly and tend to over trade. These traders lose money in commissions, taxes in addition to simply losing out on trades themselves due to the illusion of control. Greater participation in trading stock makes some traders feel more in control even though they are not. These traders also tend to invest in smaller and riskier companies and lack portfolio diversification.

Herding 
The psychology of investing tells us that many investors tend to follow the crowd. They hear of hot stocks and they jump on the bandwagon only to lose money. What they fail to realize is that those stocks were hot until you and everyone else in “the herd” heard about them. Pass on these hot stock market picks. Even if they were money makers at some point, that time has passed. Find your own stocks to invest in based on your own proven research and analysis.

Confirmation Bias
Too often investors believe what they want to believe. We pay attention only to the information that supports what we believe, and ignore information that does not support what we “think we know.” Confirmation bias directly results in poor investment decisions and a loss of profits. An example of confirmation bias is when we become attached to a certain stock. Perhaps it performed very well in the past so we ignore all signs that it is currently not performing as well as it did and we invest anyway.

There are many factors to consider when studying the psychology of investing and how it affects stock traders every day. Successful investors understand investment psychology and all it entails, they have determined their strengths and their weaknesses, and they proactively practice and develop the skills necessary to controlling their trading emotions so that they are successful in the stock market.

Learn more about Eliminating Emotions. The most profitable skill that can’t be taught!

 

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Stock Options 101 T-W

Stock options 101 includes options trading terms below.

Terms
The collective name denoting the expiration date, striking price, and underlying stock of an option contract.

Theoretical Value
The price of an option, or a combination of options, as computed by a mathematical model.

Theta
A measure of the rate of change in an option’s theoretical value for a one-unit change in time to the option’s expiration date.

Time Decay
A term used to describe how the theoretical value of an option “erodes” or reduces with the passage of time.

Time Value
The portion of the option premium that is attributable to the amount of time remaining until the expiration of the option contract. Time value is whatever value the option has in addition to its intrinsic value.

Underlying Security
The security subject to being purchased or sold upon exercise of the option contract.

Undervalued
Describing a security that is trading at a lower price than it logically should. Usually determined by the use of a mathematical model.

Unit of Trading
The minimum quantity or amount allowed when trading a security. The normal minimum for common stock is 1 round lot or 100 shares. The normal minimum for options is one contract (which normally covers 100 shares of stock).

Vega
A measure of the rate of change in an option’s theoretical value for a one-unit change in the volatility assumption.

Vertical Spread
Most commonly used to describe the purchase of one option and sale of another where both are of the same type and same expiration, but have different strike prices. Also used to describe a delta-neutral spread in which more options are sold than are purchased.

Volatility
A measure of the fluctuation in the market price of the underlying security. Mathematically, volatility is the annualized standard deviation of returns.


Write
To sell an option. The investor who sells is called the writer.

Be sure to understand all basic definitions associated with trading stock options. Happy investing!

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Trading Stock Options R-S

Trading stock options is a great way to invest. Read the terms below as well as other options trading terms.

Ratio Calendar Spread
Selling more near-term options than longer-term ones purchased, all with the same strike; either puts or calls.

Ratio Spread
Constructed with either puts or calls, the strategy consists of buying a certain amount of options and then selling a larger quantity of more out-of-the-money options.

Ratio Strategy
A strategy in which one has an unequal number of long securities and short securities. Normally, it implies a preponderance of short options over either long options or long stock.

Ratio Write
Selling of call options in a ratio higher than 1 to 1 against the stock that is owned.

Return if Exercised
The return that a covered call writer would make if the underlying stock were called away

Series
All option contracts of the same class that also have the same unit of trade, expiration date and strike price.

Settlement Price
The official price at the end of a trading session. This price is established by The Options Clearing Corporation and is used to determine changes in account equity, margin requirements, and for other purposes.

Short Position
A position wherein a person’s interest in a particular series of options is as a net writer.

Spread Order
An order to simultaneously transact two or more option trades. Typically, one option would be bought while another would simultaneously be sold. Spread orders may be limit orders, not held orders, or orders with discretion

Spread Strategy
Any option position having both long options and short options of the same type on the same underlying security

Straddle
The purchase or sale of an equal number of puts and calls having the same terms.

Strike Price
The stated price per share for which the underlying security may be purchased (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract.

Synthetic Put
A strategy equivalent in risk to purchasing a put option where an investor sells stock short and buys a call.

Be sure to read more about how to trade options.

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