WORRY-FREE OPTION

TRADING

Sergey Perminov

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WORRY-FREE OPTION TRADING
by Dr.Sergey Perminov

ISBN 978-0-557-02562-6

Copyright © 2008 by Stock Markets Institute

All rights reserved

Printed in the United States of America

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 CONTENT

PREFACE ..................................................................................... 1
Chapter 1. COMMON MISTAKES MADE BY TRADERS........ 3
Chapter 2. STRONG TECHNICAL SIGNALS, IDENTIFIED .... 7
Chapter 3. HOW STOCK OPTIONS WORK, AND WHICH ONE
TO CHOOSE................................................................................. 9
Chapter 4. KEY OPTION STRATEGIES................................... 13
BUY CALL ............................................................................ 15
SELL NAKED PUT ............................................................... 20
BULL CALL SPREAD .......................................................... 34
BUY PUT ............................................................................... 39
BEAR CALL SPREAD.......................................................... 41
BEAR PUT SPREAD............................................................. 43
BUY STRADDLE .................................................................. 45
BUY STRANGLE .................................................................. 47
Chapter 5. HOW TO USE PROBABILITY ESTIMATES IN
OPTION TRADING ................................................................... 49

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 PREFACE

H ow would you feel if after reading a 60-page book you’d be

able to predict the market’s up and down movements?

No, this book is not about traveling in time. And it’s not about
fortune-telling. It is about a trading system we developed on the
basis of sound statistical and probability theories – a system which
has proved to be the most certain and consistent tactic to make
profit in any market.

We call it the Worry-Free Option Trading System, and we are

happy to share it with you. This system will help you to identify
tops and bottoms in any market, thereby maximizing profits and
minimizing risks, no matter whether the market is going up or
down.

Simple to learn and easy to understand, the System is the product

of about 20 years of research and in-depth analysis of hundreds of
trading systems, indicators and methods used by professionals. It
this book we give a brief overview of the System, provide a short
reference section about option trading in general, and focus on the
key option trading strategies. At the end, we provide a comparison
of these strategies.
We believe this book will help you to enhance the effectiveness of
your trading.

PREFACE 1
 Chapter 1
_________________

COMMON MISTAKES MADE BY TRADERS

W hat is the main thing that worries you in stock or option

trading? A simple answer would be: risk. However, such
answer would be incomplete. Only the investments in government
securities are risk-free, and you know it. You enter the stock
market ready to take a risk and expecting to be fairly compensated
– that’s how it works. Therefore, to define it more precisely, your
worries are concentrated around the key question: “Are the risks
worth the rewards?”

What kind of market play would fit your requirements and keep
you worry-free? Let us consider a hypothetical situation: you toss
a coin and see what you get. If heads, you lose $1. If tails, you get
$1,000. Would you agree to play this game? Of course, you would
- the answer is obvious. Unfortunately, situations of that simple
kind do not exist in reality.

Real market situations are much more complicated. Non-

professionals usually don’t feel 100% comfortable about the
decisions they make. Solutions to complicated problems are rarely
obvious and often lead to stress.

When you don’t have the fundamental knowledge about

something and can’t estimate risks and rewards, you turn to your
intuition and emotions. Hope, fear and greed are popular emotions
but by no means can they be strategies. Decisions should never
be based on emotions: positive emotions can strip you off the risk
precautions, while negative emotions can trigger hesitation. The
‘big boys’ of the stock market can easily leverage your decision-
making by spreading rumors and, for example, ‘shaking stocks off
weak hands’: you get emotional and do exactly what they need
you to do. Do you like being manipulated? Probably, not. Then
isn’t it better to have your own trading system, which is based on
facts, not on emotions?

COMMON MISTAKES MADE BY TRADERS 3

Trading is a psychological game. Most people think they're
playing against the market, but the truth is: the market doesn't
care. You're really playing against yourself, against your
emotions that paint a simplified picture of the actual market. But
the reality is that complicated situations cannot be resolved with
simple intuitive decisions.

Another popular mistake is to underestimate the fact that losses

are merely the cost of doing business. Each decision can have a
different outcome, but the only right way to assess the quality of
your decisions or your trading technique is to consider a flow of
decisions. Statistical regularities can only be revealed through a
series of observations. For example, a tossed coin can land on
either of its two sides. The frequencies of getting heads or tails
will be approximately equal if a series of trials is made. Such
experiment tells us the following: if you want to place a one-time
bet, then stock trading is not for you. You can be a successful
trader only if you follow a certain methodology in a rather long
sequence of trades.

View the stock market is an ocean, where one wave comes after
another. Take the losses easy. Don't try to convince yourself that a
bad trade will turn soon into a good trade. The stock market offers
endless and overflowing possibilities. Prices keep changing and
create opportunities: missed opportunities exist only in your mind.
Winning traders are able to ride through the downturn periods.
The purpose of trading is to make a net profit in a sequence of
trades.

Perhaps, the only way to keep the worries away is to learn to

think in terms of probabilities and to perform upon
them. There is a lot of uncertainty in trading – that’s why you
should learn to operate with approximate predictions and
interpretations. In this respect, stock options are a unique tool:
they reflect the collective opinion of the market players and
estimate the probability of stock price going up or down.

Last but not least, we should all be thankful to the technical

progress, which provides us with online access to the amazing
world of modern financial instruments. Such privilege has become
available not only to the small professional community, but also to
the individual investors. It opens up the door to the precise

4 COMMON MISTAKES MADE BY TRADERS

assessment of the risk you are willing to take for the return you
will get.

COMMON MISTAKES MADE BY TRADERS 5

 Chapter 2
_________________

STRONG TECHNICAL SIGNALS, IDENTIFIED

O ur findings show that reliable forecasts based on technical

signals can be made for a period of up to two weeks. Beyond
this time horizon the statistical reliability fades very quickly. Of
course, you can continue to believe that the trend would last, but
the numerous back tests show that it becomes too questionable to
bet on.
We have analyzed all 33,691 bullish signals generated by the
stochastic oscillator indicator1 for all US optionable stocks in 1999
(priced above $10) and found that:

• An upward skew takes place soon after the occurrence,

since the probability distribution is right-skewed. Over
time the skew fades away.

• Probability of the stock price dropping more than 10%

over the next 5 days averages only 8%.

1
You can find more about the stochastic oscillator and other technical indicators at
http://www.equis.com

STRONG TECHNICAL SIGNALS, IDENTIFIED 7

This is a fact you can bet on. For example, you can sell an out-of-
the money put option (in other words, sell an insurance against the
price drop below the stated level). Indeed, doing it may make
sense because we already know that such a dramatic price drop of
this particular stock is highly unlikely. Are the risks worth the
rewards? The next chapter will give a detailed answer to this
question; however, it is already obvious that the answer depends,
among other factors, on the put option price you can sell at. The
market price of the put option can be too low compared to the risk
you take, and the transaction will not be a good one. To make the
right decision we need to have factual information about the
potential price movements after one or another technical signal
takes place.

This is where our approach is unique: we scan the market data and
select the stocks with strong technical signals. Then we determine
the best suitable trading vehicles – option strategies with better
risk/reward ratio.

Our numerous back tests have allowed us to discover the

predictive accuracy of the most popular technical indicators -
Stochastic Oscillator and MACD.
MACD Vs. Stochastic Oscillator in Terms of Predictive Accuracy

Stochastic Oscillator MACD

Daily charts:
Bullish Pattern 61.3% 68.0%
Bearish Pattern 59.7% 62.2%
Weekly charts:
Bullish Pattern 62,3% 75,1%
Bearish Pattern 65,9% 81,0%
Predictive accuracy is measured in terms of probabilities to move higher/lower.
(5 days for daily charts and 10 days for weekly charts).

We have found that MACD significantly dominated Stochastic

Oscillator in all back tests. Therefore, we can conclude that
technical indicators provide a good foundation for the selection of
tradable market situation, and now we can move on to the next
subject of our analysis – what trading vehicle (i.e. option) is the
best one to use in a given situation.

8 STRONG TECHNICAL SIGNALS, IDENTIFIED

 Chapter 3
_________________

HOW STOCK OPTIONS WORK, AND WHICH

ONE TO CHOOSE

T he choice of a trading vehicle depends on a trader’s risk

tolerance and personal preferences.

A call (put) option is the right to buy (sell) an underlying stock at

a specified price (called “the strike”) before some specified
expiration date2.

Option holders have rights, not obligations. For example, a

September call option on Intel Corp. with a strike of $40 entitles
you to purchase Intel stock for a price of $40 at any time up until
the expiration date in September. On the other side, the option
sellers take an obligation to sell this stock at the striking price.
This call option may be exercised at any time if its market price
exceeds the strike. If the market price stays below the strike, the
option will have no value and will not be exercised.

The same holds for a put option. Since the buyer (holder) of a put
option has a right to sell stock at the striking price, the seller
(writer) of a put has no choice but to buy that stock if the market
price drops below the strike and the buyer decides to exercise the
option.

The following two parameters play a key role in option pricing:

time until the expiration date, and the current market price.
Intrinsic value is the value of an option if it were to expire
immediately. For call options, this is the difference between the

2
An exchange traded option contract provides for the right to buy or sell 100
shares of stock and has four specifications: option type (put or call), name of the
underlying stock, expiration date and strike.

HOW STOCK OPTIONS WORK… 9

stock price and the strike if that difference is a positive number, or
zero otherwise. For put options, it is the difference between the
strike and the stock price if that difference is positive, and zero
otherwise.
Intrinsic value depends on the current stock price and the strike.
The following definitions are widely used:

Is There Any
Intrinsic Call Option Put Option
Value?

In-the-
Strike < stock Strike > stock
Money Yes
price price
option

At-the-
Strike = stock Strike = stock
Money No
price price
Option

Near-the-
Strike is close Strike is close
Money -
to stock price to stock price
Option

Out-of-the-
Strike > stock Strike < stock
Money Yes
price price
Option

A deep-in-the-money call (put) option has a strike well below

(above) the current price of the stock. Both call and put options
primarily consist of intrinsic value.
Time value is the amount by which the current market price of an
option exceeds its intrinsic value. This additional value of an
option is due to the volatility of the market and the time remaining
until expiration. In fact, this is the premium, which the option
buyer is ready to pay and the option seller wants to get as
compensation for the potential stock price and related option price
changes before expiration.

It is important to note that:

• near-the-money options have the maximum time value,

HOW STOCK OPTIONS WORK… 10

 • time value decay speeds up substantially as expiration
date approaches.

Let’s say the price of Stock ABC is $40 one week before the
expiration. Option with a $40 strike would cost $2. Option with
the same strike but for the next expiration month would cost more:
$4. The option always costs more than the differential between
the strike and the current stock price. The difference exists
because the future underlying stock price may move higher than
$40. If the underlying stock rises, let’s say, to $45, the call
premium rises above $8.

Option prices for any stock depend on its current price and the
market opinion about its movements in the future. The “public”
opinion of market players is reflected in the so-called volatility,
which measures how much the underlying stock is expected to
fluctuate in a given period of time.

Generally speaking, higher volatility means higher option price.

But volatility is not the only factor. It would be too simple to
ignore the expected stock price skew, but this oversimplification
does take place in many theoretical option pricing models. The
most widely known is the Black-Scholes model, which computes
the "fair value" of an option by taking into account stock
volatility, risk-free interest rate, current stock price and time to
expiration.

Option pricing models are used to calculate implied volatility,

which is different from historic volatility. Historic volatility
reflects how much a stock price has fluctuated in the past. It is
calculated by taking a standard deviation of price changes.
Implied volatility is based on actual option prices. Option pricing
models define the level of volatility at which theoretical prices are
equal to the actual ones. The comparison of historic and implied
volatilities shows what the market thinks about the future stock
price fluctuations. When the market players anticipate a
significant price move (a surge or a drop), the implied volatility
exceeds the historic volatility. The mechanism of this
phenomenon is very simple: the demand for call or put options
increases and their prices (like for any other commodity) rise.

Theoretical models quantify the potential future stock prices. No

one can forecast the future price of a stock with certainty.
Theoretical models usually assume a standard normalized

HOW STOCK OPTIONS WORK… 11

distribution curve for the future stock prices. The height or the
width of the standard curve depends on the historical stock data.
The more volatile a stock has been, the more likely it is to be
priced far from today's price on the expiration date. To be
compensated for this, the seller needs to receive more for the
option, and the buyer needs to pay more for the possibility.

The OptionSmart state-of-the-art trading system differs from

conventional option-pricing models by taking into account the
technical signals, or, in other words, the current market opinion
about the direction of stock price movement. As a matter of fact, it
is the ability to incorporate directional technical signals into the
option trading process that distinguishes highly professional
traders from amateurs who rely on volatility alone.

Below we provide a brief list of the risk measurements, which are

associated with options and are labeled by Greek letters.

Delta. The rate of option price change relative to one unit change
of the price of underlying stock or index. Call options have
positive deltas, while put options have negative deltas.

Gamma. The rate by which the delta changes with respect to

changes in the stock price.

Rho. The measure of how much an option changes in price for an

incremental move in short-term interest rates; more significant for
longer-term or in-the-money options.

Theta. A measure of the rate of time value decay that shows how
much an option loses per day.

Vega. It reflects how much an option loses (or gains) due to a

change of volatility.

All these parameters can be computed on any option calculator

and can be extremely useful when choosing the option

HOW STOCK OPTIONS WORK… 12

 Chapter 4
_________________

KEY OPTION STRATEGIES

W hen you open a new option trading position, you probably

have a certain idea about the future stock price movement.
You bet that your idea is right and prefer to minimize your loss if
it turns out to be wrong. The most common bets are related to the
stock price changes (upwards or downwards with many grades–
very, modestly, etc.). The bet on volatility change is also very
popular.

Options as financial instruments offer absolutely unique

possibilities of “fine tuning” risks and rewards. First of all, you
can always select the most suitable option strategy that better fits
your opinion about the expected stock price move. Second, you
can choose the strike, the expiration date and, finally, the
underlying stock, to find the most suitable risk/reward ratio. If you
want to play the risky game, you should be fairly compensated.

According to the game theory, any complex situation of decision

making in uncertainty can be simplified and considered as a
simple lottery, defined by a set of possible outcomes (wins or
losses) per one dollar invested and their probabilities. State-of-the-
art computer systems allow to scan more than 200,000+ various
options (for 2,000+ optionable US stocks), multiplied by a dozen
of option strategies (2+ million of different trading possibilities)
and compare all of them from the point of view what return per $1
invested you can expect and how much risk you have to take.

Regardless of your personal preferences, no matter what option

strategy, industry or time horizon you might prefer, the
OptionSmart Trading System provides you with an exceptional
tool. Being able to compare over two million trading possibilities
and to single out a handful of high quality (in risk/reward terms)
option picks for further matching with your individual

KEY OPTION STRATEGIES 13

preferences, is a truly new way of trading, which has not been
seen before.
Let’s look at the most common option strategies in more detail
YOUR EXPECTATIONS & SUGGESTED STRATEGIES

You ‘re very bullish >> buy call

You ‘re moderately bullish and you are sure the price will not fall >>
bull call spread or bull put spread
You ‘re moderately bullish and you think the price will not fall >> sell
naked put or sell covered call

You ‘re very bearish >> buy put

You ‘re moderately bearish and you are sure the price will not rise >>
bear put spread or bear call spread

You expect prices to be very volatile >> buy straddle

You expect prices to be volatile >> buy strangle
You think the price will not fluctuate much >> buy butterfly
You expect prices to be moderately volatile >> sell butterfly

14 KEY OPTION STRATEGIES

“BUY CALL” STRATEGY

Strategy in brief: Buy a call option and benefit from the stock
price upturn.
When to use this strategy: you are very bullish on the stock. The
more bullish you are, the higher strike you should choose.
Comments:
‰ No other strategy gives you so much leveraged advantage
with a limited downside risk.
‰ You can participate in the upward price movements by
paying just the option price (a fraction of a stock price) –
that’s all your investment at risk.
‰ This strategy provides a great advantage over the outright
stock purchase when you risk ten times more capital.

Let’s consider the following example (assume current price of

IBM at $114 here and in all further examples).
Figure 1: Buy Call Strategy Example

Buy Call Strategy Example

15
Profit on Expiration

10

0
110 115 120
-5

-10
Stock Price

Outlook Strike Price Paid Time Value

Less Bullish 110 7.65 3.65
Moderate Bullish 115 4.4 4.4
Very Bullish 120 2.45 2.45

Profit: increases as the stock rises. At expiration, break-even

point will be option strike plus option price paid. For each point
above break-even, profit increases by an additional point.
Loss: limited to the option price paid. Maximum loss is realized if
the stock ends below the strike. For each point above the strike,
the loss decreases by an additional point.
Risk: limited.

“BUY CALL” STRATEGY 15

Reward: unlimited.
Margin: not required.
Time value decay: this position is a wasting asset. As time
passes, the value of position erodes toward expiration. If volatility
increases, decay slows; if volatility decreases, decay speeds up.
Near-the-money option with a 115 strike has a maximum time
value.

Research Findings and Trading Tips:

1. The higher the strike, the less you pay for participating in
the upward stock price movement. Many call option
buyers intuitively prefer out-of-the-money options. This
is a very common mistake. Absolute price really doesn’t
matter! However, keep in mind that the stock might not
swing up that high and your option can stay out-of-the-
money on expiration. You must be very bullish to select
this strike. Besides, prices of options with higher strikes
contain no intrinsic value: all they have is time value (and
not so much of it, compared to other strikes), which
erodes over time.
2. Options with lower strikes contain less time value (which
you overpay for) and are less risky. At the same time,
these options require a higher investment, thus making
you risk more money.
3. Options with more distant expiration dates are less prone
to time value decay. This is a good thing for option
buyers. At the same time, they are less sensitive to the
underlying stock price changes (by having lower deltas),
thus being not so good for short-term speculations.
4. Some option traders bet on a difference between the
actual and theoretical, “fair” prices. Assuming that a call
option is “underpriced”, they expect its price to rise soon.
Needless to say, this play can be very risky because the
option price depends on too many factors. The most
important of these factors is the underlying stock price: if
it drops, the option price would fall substantially.
5. When the underlying stock moves higher and option
holder gets an unrealized profit, the following “roll-up”
tactic has become popular: you sell the call option, return
the initial investment and use the remaining proceeds to
buy as many calls with higher strikes as possible. If the
stock continues to surge, you enhance your return

16 “BUY CALL” STRATEGY

 substantially. Consider this trick using the example
presented above. Suppose you have bought 10 contacts of
Oct 110 Call at $4.80 and spent $480. If the stock price
goes up from $114 to $120, this option will be priced at
around $10.80. At the same time, the Oct 120 Call also
becomes more expensive - around $2.00. If you sell all
10 contracts of Oct 110 Call, you get $10,800. It is
enough to repay the initial investment of $4800 and to
buy 30 contracts of Oct 120 Call to participate in the
further upward movement.
6. Another way to repay your initial investment is to sell an
option with a higher strike against the option you already
have. Although it would limit your potential profit, it
would also eliminate the risk of losing the initial
investment. This new position is called “Bull Call
Spread” and is reviewed further below.

Call Option Buying vs. Stock Buying

There is an opinion that "Buy Call" strategies have much more

risk and return than "Buy Stock" strategy. It's like a sharp knife: if
you know how to use it, you will work very efficiently. However,
if you are not experienced, you can hurt yourself. Two conclusions
can be drawn from this illustration. First, it is better to use a sharp
knife - in our language it is the "Buy Call" strategy - because it
will help you to be more efficient, namely to control the risk and
reward. Second, it is essential to know how to use it.

Let's consider the following example:

Figure 2: Call Option Buying vs. Stock Buying Example

Current Stock Price $99.95

Expected Upward Bias 8.70%
Interest Rate 4%
Implied Volatility 56%
Days to Expiration 20

“BUY CALL” STRATEGY 17

 Figure 3: Call Option Buying vs. Stock Buying Example – Results at
Expiration

Stock Price Profit Potential (per one dollar invested)

at "Buy Call" Strategies Buy Stock
Expiration, $ Less Bullish Moderate Bullish Very Bullish
70 -100% -100% -100% -26%
75 -100% -100% -100% -21%
80 -100% -100% -100% -16%
85 -100% -100% -100% -11%
90 -100% -100% -100% -5%
95 -44% -100% -100% 0%
100 11% -17% -100% 5%
105 67% 67% 25% 11%
110 122% 150% 150% 16%
115 178% 233% 275% 21%
120 233% 317% 400% 26%
125 289% 400% 525% 32%

"Buy Call" strategies have much more risk and return than the
"Buy Stock" strategy. Your choice of a strategy is influenced by
two factors: first, your forecasted stock price for the period before
the call option expires; and second, your risk averseness, or how
much extra risk you are willing to take for each additional unit of
profit.

You can see below four price intervals: $99 (break-even for ‘less
bullish’ strategy) to $105 (intersection of ‘moderate bullish’ and
‘very bullish’), $105 to $108 (intersection of ‘less bullish’ and
‘very bullish’), $108 to $110 (intersection of ‘moderate bullish’
and ‘very bullish’), and $110 and up.

Figure 4 also shows that when the price is between $95 (current
stock price) and $99 (break-even for ‘less bullish’ strategy), the
‘buy stock’ strategy is preferred over all ‘buy call’ strategies. To
summarize, the choice of strategies is defined by two things: your
contemplation about the future stock price and your attitude to
risk.

18 “BUY CALL” STRATEGY

 Figure 4: Call Option Buying vs. Stock Buying Example

400%
300%
200%
Less Bullish
100%
Moderate Bullish
0%
-100% 105 110 Very Bullish
-200% Buy Stock
-300%
-400% Stock Price on Expiration

“BUY CALL” STRATEGY 19

“SELL NAKED PUT” STRATEGY

Strategy in brief: Sell a put option with a certain collateral

(normally equal to 30-35% of the current stock price). This
strategy like no other resembles selling an insurance against stock
price drop.
When to use this strategy: you are moderately bullish and
confident that the price will not fall.
Comments:
‰ Sell lower strike options if you are only somewhat
convinced the stock will stagnate or rise.
‰ Sell higher strike options if you are very confident the
stock will stagnate or rise.

Figure 5: Sell Naked Put Strategy Example

10

0
110 115 120
-5

-10
Stock Price on Expiration

Premium Break- Max Collateral Max Time

Outlook Strike
Earned even Profit Required Return Value
Less Bullish 110 3.15 106.85 3.15 39 8.10% 3.15
Moderate
Bullish 115 5.3 109.7 5.3 45.23 11.70% 4.38
Very Bullish 120 8.25 111.75 8.25 48.18 17.10% 2.33

Profit: limited to the premium received from sale. At expiration,

the break-even point is the strike less the premium received.
Maximum profit is realized if the stock settles at or above the
strike, and it is equal to the put option premium you initially
received if the put expires worthless.
Loss: increases as the stock falls. At expiration, losses increase by
one point for each point stock is below break-even.
Risk: Unlimited.

20 “SELL NAKED PUT” STRATEGY

Reward: Limited.
Margin (collateral): Always required. Collateral is the loan
value of marginable securities used to finance the writing of
uncovered options. It varies depending on brokerages and equals
to approximately 30% of the underlying stock’s market price.
Time value decay: a growing asset. As time passes, the value of
position increases because the option loses its time value.
Maximum rate of increasing profits occurs if the option is at-the-
money.

Advantages of this strategy:

1. Higher return. Since you have to keep a collateral on

the margin account, the return on the short puts will be
higher compared to the outright buying of stocks.
2. Get the stock you like at a discount price. If you want
to own a stock, but don't want to pay today's price, sell
puts. You win whatever happens. If the stock drops, you
get to buy it at the exercise price, less the premium you
received. If the stock goes up, you get the premium.
Moreover, if the stock does not move, you still keep the
premium.
3. Price pullbacks are less impressive. Psychologically
investors will take price fluctuations a lot easier if they
know that fluctuations within a certain range do not hurt
the principal.
4. Better downside protection. Even if a stock price goes
down, there is an opportunity to minimize losses by
rolling down (replacing the option with another one that
has a lower strike or a later expiration date).

Research Findings and Trading Tips:

1. Unlike some other bullish strategies, such as “Buy Call”,

the “Sell Naked Put” strategy gives you two kinds of
downside protection. The first one you get automatically
when you sell naked put. The second one is the rolling
down, explained below in Tip 3.

Let’s look again at the example presented above. When you sell
one contract of IBM Oct 115 Put at $5.30, your maximum profit is
$530. The loss is the difference between the strike and stock price
at expiration. However, no net loss will be realized if the stock

“SELL NAKED PUT” STRATEGY 21

price goes down to $109.7, because the premium of $5.30 had
been received upfront.

Stock Price Put Option Price

Profit
on Expiration on Expiration
104 5.7 -$570
106 3.7 -$370
108 1.7 -$170
110 0 30
112 2 230
114 1 430
116 0 530

2. Near-the-money put options (i.e. those with a strike close

to the current price of the underlying stock) have the
greatest time value. Such put, other conditions being
equal, is the most profitable put to sell. In this respect, the
put writer is a seller of time value. Time value decreases
as the expiration day approaches. That is why this
position is a growing asset.
3. “Rolling down” is when you buy back the put option you
previously sold and sell another one with a lower strike.
It provides an additional downside protection that can
save up to 70% of losses caused by a stock price drop.
4. In this option strategy, the critical importance of
technical signals is especially obvious. According to our
back tests, around 80% of the bottoming up stocks don't
fall below break-even points for their one month at-the-
money put options. Put options are very often overvalued
as many of them expire worthless. Why does it happen?
Let us consider an example (seeFigure 6).

22 “SELL NAKED PUT” STRATEGY

Figure 6: Critical Importance of Technical Signals, Illustrated

The above chart illustrates why selling puts is so profitable. Most

market players use standardized theoretical option pricing models
to calculate option prices. These models, as a rule, employ
volatility regardless of direction (up or down). Therefore, from
point A on the chart the price can either move to D or to E, and the
probabilities of both outcomes are equal. Note that there is a 95%
probability that the price will fall inside the DAE curve.

Looking at the stock price historical data, it is important not only

to see the volatility, but also to see the trading range. In this
particular case, there is an obvious trading range, and there is also
a 95% probability that the price will stay within this range, above
the support line BC.

Thus, considering both volatility and trend, we find out that the
buyer of the put is paying extra because of the overestimated risk
(in fact, the price is unlikely to drop to the CAE area). In this
particular case, the price indeed went up and allowed the writer to
either buy the put back and make money, or to wait for the put to
expire worthless.

Naked Put Selling vs. Stock Buying

Let's compare three "sell naked put" strategies and stock buying.

“SELL NAKED PUT” STRATEGY 23

 Figure 7: Naked Put Selling Vs. Stock Buying Example

Current Stock Price $99.95

Expected Upward Bias 8.70%

Interest Rate 4%
Implied Volatility 56%
Days to Expiration 20

Figure 8: Three Sell Naked Put Strategies Vs. Stock Buying

Buy Sell Naked Put

Moderate Very
Stock Less Bullish Bullish Bullish
Current Stock Price $99.95 $99.95 $99.95 $99.95
Option Strike $95 $100 $105
Actual Option Price $3.25 $5.15 $7.75
Break-even $99.95 $91.75 $94.85 $97.25
"No losses" Probability 75% 89% 84% 79%
Expected Profit $10.04 $2.25 $3.06 $3.95
Downside (Regret) $1.86 $0.57 $0.98 $1.42
Upside $11.90 $2.82 $4.04 $5.37
Max Profit Potential unlimited $3.25 $5.15 $7.75
Max Loss Potential unlimited unlimited unlimited unlimited
"Max Profit" Probability 84% 72% 59%
Collateral Required $99.95 $30.03 $34.98 $34.98

Figure 9: Estimates per one dollar invested

Buy Sell Naked Put

Moderate
Stock Less Bullish Bullish Very Bullish
Expected Profit $0.10 $0.07 $0.09 $0.11
Downside (Regret) $0.09 $0.02 $0.03 $0.04
Upside $0.119 $0.09 $0.12 $0.15
Max Profit Potential unlimited $0.11 $0..15 $0,22
Expected Annualized Return 183.% 136% 159% 206%

24 “SELL NAKED PUT” STRATEGY

 Figure 10: Risk Vs. Return

Strategy “No Losses” Expected

Probability Annualized Return
Buy Stock 75% 183.25%
Less Bullish 89% 136.40%
Sell Moderate 84% 159.80%
Naked Put Bullish
Very Bullish 79% 206.00%

You can see that "efficient frontier" includes only "sell naked put"
(the black points on the chart) strategies. They clearly dominate
the "Buy stock" strategy (the red point), which is more risky and
less profitable than "very bullish" "naked put" strategy. These
conclusions are based on technical analysis and forecasted
volatility.
Figure 11: Sell Naked Put Strategies Vs. Stock Buying Example – Conclusion

250
Expected Ann. Return (%)

200

150

100

50

0
70 75 80 85 90 95
"No losses" Probability (%)

“SELL NAKED PUT” STRATEGY 25

“SELL COVERED CALL” STRATEGY

Strategy in brief: Sell call option against the underlying stock

you hold.
When to use this strategy: you are moderately bullish and
sure that the price will not fall.
Comments:
‰ Sell lower strike options if you are only somewhat
convinced the stock will stagnate or rise.
‰ Sell higher strike options if you are very confident the
stock will stagnate or rise.

Figure 12: Sell Covered Call Strategy Example

10.0
8.0
6.0
4.0
2.0
0.0
-2.0 110 115 120
-4.0
-6.0
-8.0 Stock Price

Premium Break- Max Return if Return if Downside Time

Outlook Strike
Earned even Profit Exercised Unchanged Protection Value
Less
Bullish 110 7.65 106.43 3.57 2.90% 6.30% 6.70% 3.57

Moderate
Bullish 115 4.4 109.68 5.32 4.50% 3.70% 3.90% 4.40
Very
Bullish 120 2.45 111.63 8.37 7.20% 2.10% 2.10% 2.45

Profit: limited to the premium received from sale. At expiration,

the break-even point is the strike less the premium received.
Maximum profit is realized if the stock settles at or above this
strike. It is equal to the put option premium you initially received
if the put expires worthless.
Loss: increases as the stock falls. At expiration, losses increase by
one point for each point stock is below break-even.
Risk: Unlimited.
Reward: Limited.

26 “SELL COVERED CALL” STRATEGY

Collateral: Always required.
Research Findings and Trading Tips:

This strategy is virtually equivalent to “Sell Naked Put”. Covered

calls appear to be based on personal psychological preferences as
they involve actual stock ownership. Many investors prefer to own
a stock; however, selling a covered call may be considered as an
additional possibility to enhance return of existing portfolio. Both
strategies have nearly equivalent risk/reward parameters.

NAKED PUTS COVERED CALLS

Outlook Bullish Bullish
from 50% (if covered call
Collateral required 20-30% of the stock written
price plus the put on margin) to 100% of the
premium stock price

Type of collateral any present portfolio underlying stock

Earn income from an

existing portfolio Yes No
Receive dividends on the
underlying stock No Yes

By using the “Sell Naked Put” strategy instead of "Sell Covered

Call" you can earn risk-free interest on the principal capital
invested, for example, in government bonds. Naked puts might
well be the top choice of option traders because they require
smaller investments, thus providing higher returns.

Sell Covered Call Strategies Vs. Stock Buying

In covered call writing you sell a call option while simultaneously
owning the obligated number of shares of underlying stock. As a
writer, you should de mildly bullish, or at least neutral, about the
underlying stock. By writing a call option against the stock, you
always decrease the risk of owning the stock. It may even be
possible to profit from a covered write if the stock declines.
However, the covered call writer does limit his profit potential and
therefore may not fully participate in a strong upward move in the
price of the underlying stock.
Let's consider the following example:

“SELL COVERED CALL” STRATEGY 27

 Figure 13: Sell Covered Call Strategies Vs. Stock Buying Example

"Sell Covered Call" Strategies

"Buy Stock"
Less Bullish Moderate Bullish Very Bullish
Current Stock Price $90 $90 $90 $90
Option Strike $85 $90 $95
Actual Option
Price $9 $6 $4
Break-even $81 $84 $86 $90
Investment
required $81 $84 $86 $90

The table below summarizes the results at expiration.

Figure 14: Sell Covered Call Strategies Vs. Stock Buying Example –
Summarized Results

Stock Price Profit Potential (per one dollar invested), %

at "Sell Covered Call" strategies Buy Stock
Expiration, $ Less Bullish Moderate Bullish Very Bullish
70 -14% -17% -19% -22%
75 -7% -11% -13% -17%
80 -1% -5% -7% -11%
85 5% 1% -1% -6%
90 5% 7% 5% 0%
95 5% 7% 10% 6%
100 5% 7% 10% 11%
105 5% 7% 10% 17%
110 5% 7% 10% 22%
115 5% 7% 10% 28%
120 5% 7% 10% 33%
125 5% 7% 10% 39%

“Sell covered call” strategies are less risky and less profitable
compared to ‘buy stock’ strategy. In our example, such strategies
can be used when the stock price is between $81 (break-even for
‘less bullish’) and $100 (intersection of ‘buy stock’ and ‘very
bullish’ strategies). Depending on the amount risk you are willing
to take for more profit, you can chose between options with
different strikes. ‘Buy call’ strategy is preferable when the stock
price goes above $100. ‘Sell covered call’ strategy is a good
profit-making instrument when you anticipate slight changes in
the stock price either up or down.

28 “SELL COVERED CALL” STRATEGY

Figure 15: Sell Covered Call Strategies Vs. Stock Buying Example –
Profitability

Less Bullish
Moderate Bullish
Very Bullish
Buy Stock

“SELL COVERED CALL” STRATEGY 29

“BULL PUT SPREAD” STRATEGY

Strategy in brief: Buy put option with a lower strike and sell
another put with a higher strike producing a net credit.
When to use this strategy: you expect the stock to go up, or at
least you believe it is a bit more likely to rise than to fall.
Comments:
‰ Both options should have the same expiration date.
‰ This is a good position if you want to be in the stock but
are unsure of bullish expectations.
‰ This is the most popular bullish strategy, along with the
“Bull Call Spread”.

Figure 16: Bull Put Strategy Example

0
110 115 120
-2

-4

Stock Price

Buy Sell Max Break- Max Profit Time

Outlook Credit
Strike Strike Profit even Risk Loss Value
Less Bullish 110 115 2.15 2.15 112.85 2.75 0.78 0.09
More Bullish 115 120 2.95 2.95 117.05 2.05 1.44 6.95

Profit: potential is limited, reaching its maximum if the stock

ends at or above the higher strike at expiration.
Loss: limited because you buy a protective put. Loss reaches its
maximum if the stock at expiration is at or below the lower strike.
This maximum is equal to the difference between strikes minus
initial credit.
Risk: Limited.
Reward: Limited.
Time value decay: If the stock is midway between the strikes,
there is no time effect. When the stock price is close to higher

30 “BULL PUT SPREAD” STRATEGY

strike, profits increase at the fastest rate. When the stock price is
close to lower strike, losses increase at a maximum rate.

Research Findings and Trading Tips:

1. A spread with short near-the-money put contains more

time value and is more preferable. For example, you
establish a put option spread by buying one contract of
IBM October 110 Put and simultaneously selling one
contract of IBM October 115 Put. The credit is $2.15 or
$215 for one contract. The maximum profit (net credit)
for this bull spread is $215, and you already got
it. Nevertheless, if the stock moves down, your loss is
limited by the difference between the strike prices minus
net credit received.

October 110 October 115

IBM Stock
Put Put
Price Total
Price Profit Price Profit
on Profit
on on
Expiration
Expiration Expiration
109 1 100 6 -600 -285
110 0 0 5 -500 -285
111 0 0 4 -400 -185
112 0 0 3 -300 -85
113 0 0 2 -200 25
114 0 0 1 -100 125
115 0 0 0 0 225
116 0 0 0 0 225

Profit/loss ratio is 0.78 = $215/$275. Is

it reasonable? This ratio for a more bullish spread in our
example is 1.44. The degree of reasonableness depends
on how bullish you are on the stock. If the stock is
unlikely to go up, neither high credit nor high profit/loss
ratio would look attractive. On the contrary, if you are
very bullish on the stock, a certain risk level appears
quite acceptable.

“BULL PUT SPREAD” STRATEGY 31

 Collateral requirement for options spread is usually equal
to $2000 for one contract. You have to keep that much
equity on your margin account to establish a spread.

With this strategy you have a unique possibility to

participate in the upward stock price movements with a
little investment. Additionally, you get a downside
protection. Just compare to outright purchase of a stock -
no downside protection and no leverage!

2. If the stock goes substantially up, it is reasonable to roll

the spread up (to buy back the short put at a lower price
and to sell another one at a higher price). If the
underlying stock drops, you can also undertake a
protective action: buy back your short put at a loss and
sell another one at a lower strike. It is better to sell the at-
the-money put which contains more time value.
Remember that the price of the protective put you bought
goes up. Therefore, rolling your spread down you can
reduce your losses even more.

Bullish Put Spreads Vs. Stock Buying

Let's consider the following example:

Figure 17: Bull Put Spread Vs. Stock Buying Example

"Bullish Put Spread" Strategies "Buy

Moderate Very Stock"
Less Bullish Bullish Bullish
Current Stock Price $115 $115 $115 $115
Lower Strike $105 $110 $115
Actual Option Price $3 $4 $6
Higher Strike $110 $115 $120
Actual Option Price $4 $6 $9
Net Credit $1 $2 $3
Break-even $109 $113 $117 $115
Max Loss Potential $4 $3 $2
Max Profit Potential $1 $2 $3
Investment required $4 $3 $2 $115

32 “BULL PUT SPREAD” STRATEGY

The table below summarizes the results at expiration.

Figure 18: Bull Put Spread Vs. Stock Buying Example – Results at Expiration

Stock Price Profit Potential (per one dollar invested) , %

at "Bullish Put Spread" strategies Buy
Expiration, $Less Bullish Moderate Bullish Very Bullish Stock
90 -100% -100% -100% -22%
95 -100% -100% -100% -17%
100 -100% -100% -100% -13%
105 -100% -100% -100% -9%
110 25% -100% -100% -4%
115 25% 67% -100% 0%
120 25% 67% 150% 4%
125 25% 67% 150% 9%
130 25% 67% 150% 13%
135 25% 67% 150% 17%
140 25% 67% 150% 22%
145 25% 67% 150% 28%
As
Figure 19 illustrates, the ‘bullish spread’ strategies have a clear
advantage over the ‘buy stock ’strategy in terms of profit
potential. Depending on the strike (the more ’bullish’ the strategy,
the larger its maximum profitability), “bullish spread’ strategies
can be several times more profitable than a simple ‘buy stock’
strategy. The special feature of a ‘bullish spread’ strategy is its
sensitivity around the break-even point. Slight changes in the
stock price around the break-even figure cause significant changes
in the profitability of ‘bullish spread’ strategies. The more bullish
your strategy is, the more sensitive it is around the break-even
point.
Figure 19: Bull Put Spread Vs. Stock Buying Example – Profit Potential

Less Bullish
200%
Moderate
100% Bullish
0% Very Bullish
-100% 110 115 120
Buy Stock
-200%
-300%
-400%
-500% Stock P rice

“BULL PUT SPREAD” STRATEGY 33

“BULL CALL SPREAD” STRATEGY

Strategy in brief: Buy call option with a lower strike and sell
another call with a higher strike producing a net debit
When to use this strategy: you expect the stock to go up or at
least to be a bit more likely to rise than to fall.
Comments:
‰ Both options should have the same expiration date.
‰ This is a good position if you want to be in the stock but
are unsure of bullish expectations.
‰ This is the most popular bullish strategy, along with the
“Bull Put Spread”.

Figure 20: Bull Call Spread Strategy Example

10
8
6
4
2
0
110 115 120
Stock Price

Buy Sell Max Break- Max Profit Time

Outlook Debit
Strike Strike Profit even Risk Loss Value
Less Bullish 110 115 3.25 1.75 113.25 3.25 0.54 0.09
More Bullish 115 120 1.95 3.05 116.95 1.95 1.56 1.21

Profit: potential is limited, reaching its maximum if the stock

ends at or above the higher strike at expiration.
Loss: limited. Loss reaches its maximum if the stock at expiration
is at or below the lower strike. This maximum is equal to the
initial debit.
Risk: Limited.
Reward: Limited.
Time value decay: If the stock is midway between the strikes,
there is no time effect. When the stock price is close to higher
strike, profits increase at the fastest rate. When the stock price is
close to lower strike, losses increase at a maximum rate.

34 “BULL CALL SPREAD” STRATEGY

Research Findings and Trading Tips:

1. Many beginning option traders prefer bull put credit spreads

over bull сall debit spreads. They prefer to get money than to
pay. However, both kinds have almost equivalent parameters.

2. My stock dropped! What should I do? If you are facing

unrealized losses on a collapsed stock, you can get better
chances to save your money using call spreads. Imagine your
ABC stock drops from $58 to $52. At the same time, you see
that the chances of the stock bouncing back up are very slim
(e.g. the stock has just been downgraded, it looks like the
worst times are left behind but there is no hope for the stock
to come back up any time soon). The instruction below will
help you to bring down the break-even point, i.e. to recover
unrealized losses if the stock goes slightly up, say to $54,
even if the upward move is insignificant. You will not
need additional funds to do this.
Say, you own 100 shares of ABC, currently traded at 52. The
idea is that you keep the stock and also open the following
position:

Position Price
Buy One Nov
3.00
50 Call
Sell Two Nov
1.50
55 Call

Both options that you sold are covered: one by the stock itself,
another one by another "leg" of the bull spread. Note that you
haven't spent any extra money yet.

The new position has two advantages. First, it is as risky as the

initial position: if the price drops below 52, the losses remain the
same as they were initially. Second, if the price goes up a little -
up to 54 - you cut all the losses (see the table below):

“BULL CALL SPREAD” STRATEGY 35

 Profit on
Profit on Profit on
ABC Price at 100
One Two Total Profit
Option Shares of
Contract Contracts of (New
Expiration ABC
of Nov 50 Nov 55 Call Position)
(November) (Initial
Call Bought Held Sold
Position)
49 -900 -300 +300 -900
50 -800 -300 +300 -900
51 -700 -200 +300 -600
52 -600 -100 +300 -400
53 -500 0 +300 -200
54 -400 +100 +300 0
55 -300 +200 +300 +200
56 -200 +300 +100 +200
57 -100 +400 -100 +200
58 0 +500 -300 +200

We should note that although opening and maintaining the new

position does not cost you a dime, you will still have to pay a
small commission and to have $2000 worth of equity as a
collateral on the margin account per one contract, as required by
most brokers.

Bullish Call Spreads Vs. Stock Buying

The bull spread is one of the most popular forms of spreading. In

this type of spread you buy a call at a certain striking price and sell
a call at a higher striking price. Generally, both options have the
same expiration date. This is a vertical spread. A bull spread tends
to be profitable if the underlying stock moves up in price - hence it
is a bullish position. The spread has both limited profit potential
and limited risk. Although both can be substantial percentage-
wise, the risk can never exceed the net investment. In fact, a bull
spread requires a smaller dollar investment and therefore has a
smaller maximum dollar loss potential than does an outright call
purchase of a similar call. A call bull spread is always a debit
transaction, since a call with a lower striking price must always
trade for more than a call with a higher price, if both have the
same expiration date.

Let's consider the following example:

36 “BULL CALL SPREAD” STRATEGY

 Figure 21: Bullish Call Spreads Vs. Stock Buying Example

"Bullish Call Spread" Strategies

Moderate Very "Buy Stock"
Less Bullish
Bullish Bullish
Current Stock Price $115 $115 $115 $115
Lower Strike $105 $110 $115
Actual Option Price $11 $7,5 $5
Higher Strike $110 $115 $120
Actual Option Price $7,5 $5 $3
Net Credit $3,5 $2,5 $2
Break-even $108,5 $112,5 $117 $115
Max Loss Potential $3,5 $2,5 $2
Max Profit Potential $1,5 $2,5 $3
Investment required $3,5 $2,5 $2 $115

Figure 22 summarizes results at expiration.

Figure 22: Bullish Call Spreads Vs. Stock Buying Example – Results at
Expiration

Stock Price Profit Potential (per one dollar invested), %

at "Bullish Call Spread" strategies
Buy Stock
Expiration, $ Less Bullish Moderate Bullish Very Bullish
90 -100% -100% -100% -22%
95 -100% -100% -100% -17%
100 -100% -100% -100% -13%
105 -100% -100% -100% -9%
110 43% -100% -100% -4%
115 43% 100% -100% 0%
120 43% 100% 150% 4%
125 43% 100% 150% 9%
130 43% 100% 150% 13%
135 43% 100% 150% 17%
140 43% 100% 150% 22%
145 43% 100% 150% 28%

As illustrated below, the ‘bullish spread’ strategies have a clear

advantage over the ‘buy stock’ strategy in terms of profit

“BULL CALL SPREAD” STRATEGY 37

potential. Depending on the strike (the more ’bullish’ the strategy,
the larger its maximum profitability), “bullish spread’ strategies
can be several times more profitable that a simple ‘buy stock’
strategy. The special feature of a ‘bullish spread’ strategy is its
sensitivity around the break-even point. Slight changes in the
stock price around the break-even point cause significant changes
in the profitability of ‘bullish spread’ strategies. The more bullish
your strategy is, the more sensitive it is around the break-even
point.

Figure 23: Bullish Call Spreads Vs. Stock Buying Example – Profit Potential

Less Bullish
200% Moderate Bullish
0% Very Bullish
-200% 110 115 120 Buy Stock

-400%
-600%
Stock Price

38 “BULL CALL SPREAD” STRATEGY

“BUY PUT” STRATEGY

Strategy in brief: Buy a put option and benefit from the stock
price downturn.
When to use this strategy: you are very bearish on the stock.
Comments:
‰ The more bearish you are, the more out-of-the-money
(lower strike) your option should be.
‰ No other position gives you as much leveraged advantage
in a falling stock (with a limited upside risk).

Figure 24: Buy Put Strategy Example

10

0
110 115 120
-5

-10
Stock Price

Outlook Strike Price Paid Time Value

Less Bullish 110 3.15 3.15
Moderate Bullish 115 5.3 4.38
Very Bullish 120 8.25 2.33

Profit: increases as the stock falls. At expiration, break-even point

will be the strike less the premium paid. For each point below
break-even, profit increases by an additional point.
Loss: limited to the premium paid for the option. Maximum loss is
realized if the stock ends above the strike. For each point below
the strike, loss decreases by an additional point.
Risk: Limited.
Reward: Limited.
Margin: Not required.
Time decay: This position is a wasting asset. As time passes,
value of position erodes towards the expiration value. If volatility
increases, decay slows; if volatility decreases, decay speeds up.

“BUY PUT” STRATEGY 39

Research Findings and Trading Tips:

1. In comparison with a short sale of the underlying stock,

this strategy offers much higher return with a limited risk.
However, these advantages are balanced by a couple of
shortcomings. First, it is a wasting asset because of time
value decay, which stocks do not have. Second, if the
stock doesn’t fall substantially before expiration date,
you risk to not return your initial investment (premium
paid). That is why the “Buy Put” strategies are widely
used for short-term speculative purposes.

2. Out-the-money puts are cheaper and offer higher returns

and risks than in-the-money puts. However, they contain
only time value. That is why in-the-money puts are
considered a better choice for momentum players.

3. When the underlying stock moves much lower and the

option holder gets an unrealized profit, the following
“roll down” tactic has become popular: you sell the put
option, return the initial investment and use the
remaining proceeds to buy as many puts with lower
strikes as possible. If the stock continues to drop, you
enhance your return substantially. This is the mirror
image of the “roll-up” tactic in the “Buy Call” strategy
described earlier.

40 “BUY PUT” STRATEGY

“BEAR CALL SPREAD” STRATEGY

Strategy in brief: Call option is bought with a higher strike and

another call sold with a lower strike, thus producing a net credit.
When to use this strategy: you think the stock will go somewhat
down or at least is a bit more likely to fall than to rise.
Comments:
‰ Good position if you want to be in the stock but are
unsure of bearish expectations.

Figure 25: Bear Call Spread Strategy Example

4
2
0
-2 110 115 120

-4
Stock Price

Buy Sell Max Break- Max Profit Time

Outlook Credit
Strike Strike Profit even Risk Loss Value
Less Bullish 120 115 1.95 1.95 166.95 3.05 0.64 3.05
More Bullish 115 110 3.25 3.25 113.25 1.75 1.86 0.09

Profit: limited, reaching its maximum if the stock ends at or

below the lower strike at expiration; equal to the net initial credit.
At expiration, the break-even point will be lower strike plus initial
credit.
Loss: reaches its maximum if the stock at expiration is at or above
a higher strike. It is equal to the difference between strikes minus
initial credit.
Risk: limited.
Reward: limited.
Time decay: if the stock is midway between the strikes, there is
no time effect. At a higher strike, profits increase at the fastest rate
with time. At lower strike, losses increase at a maximum rate with
time.

“BEAR CALL SPREAD” STRATEGY 41

Research Findings and Trading Tips:

1. The more bearish you are, the lower strikes you should
select. It gives you more credit and requires more
substantial stock price downward movement to realize
the profit potential.
2. This strategy doesn’t require any investment because this
is a credit spread. It only reduces the buying power of
trader’s margin account.

42 “BEAR CALL SPREAD” STRATEGY

“BEAR PUT SPREAD” STRATEGY

Strategy in brief: Buy put option with a higher strike and sell
another put option with a lower strike, producing a net debit.
When to use this strategy: you think the stock will go down
somewhat or at least is a bit more likely to fall than to rise.
Comments:
‰ Good position if you want to be in the stock but are
unsure of bearish expectations.
‰ This is the most popular bearish strategy.

Figure 26: Bear Put Spread Strategy Example

4
2
0
-2 110 115 120

-4
Stock Price

Buy Sell Max Break- Max Profit Time

Outlook Debit
Strike Strike Profit even Risk Loss Value
Less Bullish 120 115 2.95 2.05 177.05 2.95 0.69 6.95
More Bullish 115 110 2.15 2.85 112.85 2.15 1.33 3.25

Profit: limited, reaching maximum if stock ends at or below the

lower strike at expiration. It is equal to difference between strikes
minus initial debit. At expiration, break-even point will be higher
strike minus initial debit.
Loss: reaches its maximum, if stock at expiration is at or above a
higher strike. It is equal to net initial debit.
Risk: limited.
Reward: limited.
Time decay: if the stock is midway between strikes, no time
effect. At higher strike, profits increase at the fastest rate with
time. At lower strike, losses increase at the maximum rate with
time.

“BEAR PUT SPREAD” STRATEGY 43

Research Findings and Trading Tips:

Bear put spreads have the following advantages over bear call
spreads:
a. You are not risking early exercise of short
option.
b. Bear put spreads perform much better if the
underlying stock drops quickly.

44 “BEAR PUT SPREAD” STRATEGY

“BUY STRADDLE” STRATEGY

Strategy in brief: Call option and put option are bought with the
same usually at-the-money strike.
When to use this strategy: you strongly believe that the stock
moves far enough in either direction in the short run.
Comments:
‰ Buy higher/lower strike options if the position can
encounter different probabilities of bullish/ bearish
movements of the stock.
‰ Buy at-the-money options if those probabilities are
almost equal.

Figure 27: Buy Straddle Strategy Example

10
5
0
-5 110 115 120

-10
-15
Stock Price

Put Call Downside

Max Upside
Skew Strike Premium Premium Break-
Risk Break-even
Paid Paid even
Bearish 110 3.15 7.65 10.8 99.2 120.8
Neutral 115 0.3 4.4 9.7 105.3 124.7
Bullish 120 8.25 2.45 10.7 109.3 130.7

Profit: increases as the stock rises or falls. At expiration, break-

even points will be the strike +/- prices paid for options. For each
point above upside break-even or below downside break-even,
profit increases by an additional point.
Loss: limited to the amount paid for options.
Risk: limited.
Reward: unlimited.
Margin: not required.

“BUY STRADDLE” STRATEGY 45

Time decay: This position is a wasting asset. As time passes, the
value of position erodes towards the expiration value. If volatility
increases, decay slows. If volatility decreases, decay speeds up.

Research Findings and Trading Tips:

1. This strategy makes you bet on an increase in the stock’s

volatility. It is reasonable to count on such development
if the volatility is currently low, or, in other words, the
stock price has been stable for a while and is expected to
move in either direction. We strongly recommend that
you analyze the volatility chart if you decide to go with
this strategy.
2. Lower and higher break-even points must be compared
with the support and resistance levels on the stock chart.
Such comparison will allow you to estimate the real
chances of yielding profit.

46 “BUY STRADDLE” STRATEGY

 “BUY STRANGLE” STRATEGY

Strategy in brief: Put option is bought with a lower strike and a

call option is bought with a higher strike.
When to use this strategy: you strongly believe the stock will
move far enough from the predefined range.
Comments:
‰ This strategy is similar to the buy straddle, but the
premium paid here is less.
‰ Buy higher/lower strike options if the position can
encounter different probabilities of bullish or bearish
movements of the stock; buy at-the-money options if
those probabilities are equal.

Figure 28: Buy Strangle Strategy Example

5
0
-5 110 115 120

-10
-15

Stock Price

Put Call Downside Upside

Call Max
Skew Put Strike Premium Premium Break- Break-
Strike Risk
Paid Paid even even
Bearish 110 115 3.15 7.65 99.2 125.8 10.8
Bullish 115 120 5.3 4.4 105.3 129.7 9.7

Profit: unlimited. It increases as the stock rises above a higher

strike or falls below a lower strike. At expiration, break-even
points will be:
• lower strike - premiums paid for options,
• higher strike + prices paid for options.
For each point above the upside break-even or below the downside
break-even, profit increases by an additional point.
Loss: limited to the amount paid for the options. Maximum loss is
realized if the stock ends between the strikes. For each point above

“BUY STRANGLE” STRATEGY 47

a higher strike or below a lower strike, loss decreases by an
additional point.
Risk: limited.
Reward: unlimited.
Margin: not required.
Time decay: This position is a wasting asset. As time passes,
value of position erodes towards the expiration value. If volatility
increases, decay slows. If volatility decreases, decay speeds up.

Research Findings and Trading Tips:

1. This strategy requires less initial investment than the

straddle, but you should anticipate much more substantial
stock movement in either direction.
2. You need to compare stock volatility with its average
levels and the entire market volatility trends.

48 “BUY STRANGLE” STRATEGY

 Chapter 5
_________________

HOW TO USE PROBABILITY ESTIMATES IN

OPTION TRADING

E xperienced traders think in terms of probabilities. They don’t

simply compare the deterministic parameters such as potential
profit/loss, but also look at the probability estimates.
Why is it so important? Let's consider two strategies.

Potential Potential
Profit Loss
Strategy
$1,000 $100
1
Strategy
$50 $100
2

Which one is better? Most people would say the first strategy is
far better. Experienced traders would ask: What are the
probabilities?

Figure 29: Strategy 1

Potential Potential
Profit Loss
Amount $1,000 $100
Probability 5% 95%

Expected Profit (Loss) = -$45

HOW TO USE PROBABILITY ESTIMATES… 49

 Figure 30: Strategy 2

Potential Potential
Profit Loss
Amount $50 $100
Probability 90% 10%

Expected Profit (Loss) = $35

The choice is obvious, isn’t it? However, the advantage of strategy

2 is not visible without probability estimates.

Probabilities of profit/loss outcomes should be based on stock

price short-term skew, which can be forecasted based on the
technical signals.
Probability estimates make us drift from the traditional theoretical
approaches towards the factual technical signals. Indeed, in the
presence of a clear and strong bullish signal, it would be
unreasonable to presume that the stock price movements up or
down are almost equally possible, as the traditional option pricing
theory states.

Let us illustrate the role of probabilistic parameters with the

following example.
Figure 31: Role of Probabilistic Parameters – Example

Position Symbol Expiration Strike Type Entry Price

Buy JCPBE Feb 25 Call 1.05

The following parameters are computed to be used in option

strategies comparison and selection:

1. Expected Profit: 0.96 Probability-weighted

average of the possible
profit outcomes. Although
the goal should be to
maximize the expected
profit, it is necessary to
remember about the risk of
loss, which is measured by
the next parameter.
2. Upside: 3.37 Probability-weighted
average of possible positive
HOW TO USE PROBABILITY ESTIMATES… 50
 profit outcomes.
3. Downside: 2.41 Probability-weighted
average of possible loss
outcomes.
4. "In-the-money" Probability of the fact that
probability: 0.55 the option will have any
value on the expiration
date, i.e. the actual stock
price goes above the option
strike.
5. "No losses" Once you set a certain
Probability: 0.44 minimum level for this
parameter, you can reject
the picks that go beyond
your desired risk level.
6. Expected Stock Price: Calculations for this
25.79 parameter account for the
anticipated price
movements based on the
observed technical signals.
7. 95% Confidence The interval (range) within
Interval: Upper Limit which the stock price will
34.87, Lower Limit fall on expiration date, with
18.6 a probability of .95.
8. The interval (range) within
68% Confidence
which the stock price will
Interval: Upper Limit
fall on expiration date, with
29.8, Lower Limit
a probability of .68.
21.77
9. Per $1 invested: These parameters,
Expected Profit 0.92, calculated per $1 invested,
Upside: 3.21, allow you to compare
Downside: 2.29 profitability and risk of
various picks, which can
have different strike,
expiration date and
underlying stock.

These parameters are usually calculated by professional option

traders and used in option picks comparison depending on a
personal risk tolerance.

HOW TO USE PROBABILITY ESTIMATES… 51

We can show the individual trade-off between risk and return on
the graph with axes measuring the expected profit per $1 and risk
which is quantified with the “No Losses” probability. This
probability points to your chances at least to repay initial
investments. These parameters help compare all option picks
across the board, i.e. with various strategies, strikes, expiration
dates and underlying stocks.

Analysis here should be performed in two steps. First, you pre-

select the picks situated on the “efficient frontier”. After that, you
can select the picks that better fit your individual risk tolerance
and investment style.
Figure 32: No Losses Probability Vs. Expected Profit per $1

"No Losses" probability Vs. Expected Profit per $1

80%

70%
"No Losses" Probability

60%

50%

40%

30%

20%

10%

0%
$0.00 $1.00 $2.00 $3.00 $4.00
Expected Profit per $1

The use of probability estimates makes option trading

almost "mechanical" - no emotions whatsoever, only strong
mathematical computations. Nevertheless, it is important to
keep in mind that there is always room for risk.

HOW TO USE PROBABILITY ESTIMATES… 52