How Bullish Traders Can Use Probabilities to Maximize Return

Do you ever find yourself in the situation where, you have a lot of conviction that the stock market, or at least a particular industry or sector, will make a notable move to the upside?

Timing these moves can be difficult and even when traders are able to do so, buying the physical stock may still only result in a small return once commissions and fees are taken into the mix. However, using options allows a trader the potential to see a higher return, even if they don’t perfectly time the rally.

Assuming that a trader is relatively accurate on the timing and has chosen the correct direction, the next input they need to figure out is strategy. Should they sell puts, a neutral to slightly bullish position? Should they buy call spreads, a clearly bullish play on an underlying move?

Each situation is different and will call for a specific strategy.

However, there’s one final step that too many investors simply ignore or don’t consider: Probability.

What exactly are they odds that the trade will be profitable? How likely is it that the trade will turn out to be a complete bust? When those answers are question marks rather than percentage points, traders are equipping themselves with a dull edge rather than a sharp one.

That’s why at OptionParty we use three different probabilities, including the probability of profit, probability of target return and probability of total loss. To learn more about these three probabilities, read about it here.

How Bullish Traders Can Use Probabilities to Maximize Return

In our first example, let’s say we’re expecting a notable rally in the broader market, but would prefer to play it via the tech sector. It’s early October and we expect the move to happen by the end of the month.

The first trade that we see is a long bull call spread, which says we should buy the Netflix (NFLX) regular October expiration $85 calls and sell the $96 calls. The minimum return we’re looking for is 10%.

The odds that our target return is hit is 72.6%, while there is a 75.6% chance the trade generates a profit of a penny or more. Pretty good numbers, but with an 8.9% chance – almost 1-in-10 odds – that we experience a total loss is somewhat concerning.

While the return on risk is attractive, standing at 14.5%, we feel that there are lower risk alternatives out there. Instead we find:

Buy the Apple (AAPL) October 28th $101 calls and sell the $109 calls to create a bull call spread. While the return on risk of 10.3% is less than the 14.5% return in the first trade, the probability of total loss is lower, at 5.4%.

Along with a lower risk profile, the odds of hitting our target return and probability of profit are both higher than the first trade, standing at 73.4% and 76.3%, respectively.

In this example, both trades have their merits. It merely comes down to risk vs. reward and different traders will view them differently. However, because we used a tight set of parameters, the scan resulted in just 12 potential trades; however, it resulted in the types of trades we wanted.

How Bullish Traders Can Use Probabilities to Maximize Return

What About Unsure Bullishness?

Sometimes a trader finds him or herself in a situation where they’re bullish, but don’t have a whole lot of conviction. Perhaps they feel the market may or may not go up, but it seems unlikely it will fall – and at least if it does pull back, it won’t be by much.

In a situation like this – where any movement seems likely to be muted and if there is movement, it’s most likely to come in the form of a small rally – options strategies can still be deployed.

Instead of playing for just a rally or a decline, traders can incorporate neutral movement into their bias. The summer of 2016 has been a great example of this. Since mid-July, the market has gone on a period of incredibly low-range trading. Meaning, the market hasn’t moved much one way or the other.

Selling options in this environment is one way to take advantage of this type of movement. Rather than selling calls and puts, traders can incorporate their bias (either bullish or bearish) by selecting either calls or puts. Let’s look at an example:

Because we are neutral to slightly bullish on the overall market, we will consider selling cash-secured put options and bull put spreads. By selling puts, we are looking for the market to continue on its current path, which is just small moves in either direction. If the market rallies, our position will benefit. If the market falls considerably, that’s where we’ll have problems.

Basically, we are just looking for the market to go sideways to higher over the next few weeks.

Using the same timeframe parameters as the first trade, we could consider selling the Caterpillar (CAT) $84.50 puts and buying the $80.50 puts with an expiration date of October 28th, just a few weeks away.

While the 21.7% return on risk is far about the 6% minimum return we were seeking, there are some other probabilities to take note of. For instance, there is 72.6% chance of this trade hitting its target return and a more than 76% likelihood that it profits by at least a penny. However, the 11.4% risk of total loss is somewhat of a turn-off.

How Bullish Traders Can Use Probabilities to Maximize Return

Instead, how about looking for a trade with a bit lower risk, despite the hefty potential payout? By sorting the Option Profit results by risk, we find that selling the VMWare (VMW) Oct. 28th $69.50 puts and buying the Oct. 28th $60 puts is the lowest risk play.

Despite the lowered risk, there’s still a 71.3% probability that it will hit our minimum return of 6% and a 75.9% chance the trade will result in a profit. It should also be noted that despite its lower risk – with a total loss probability of 4% – the reward isn’t diminished too much. There’s still a return on risk potential of 13.4%.

How Bullish Traders Can Use Probabilities to Maximize Return

While the 13.4% return on VMW is lower than the 21.7% return possibility from CAT, the lowered risk profile on the second trade may be more suitable for certain traders.

If one is bullish, they will look for way to take advantage of a rally. That’s where conviction comes into play. Are you positive that a move higher is on the way, or does it just seem possible? Depending on how strong one”s conviction is, that could compel them not only to choose different strategies – for instance, buying a call spread vs. selling a put spread – but also, how aggressive or conservative to be with those strategies. The different examples above help demonstrate how factoring in probabilities can aid in those decisions.

Looking for Income? Boost Your Payout With Probabilities

Everyone wants and needs income, whether it’s from working, in retirement or from trading. It’s a sought after source that provides us with not only what we need, but also with what we want.

In today’s world of low – and in some instances negative – interest rates, finding that income is becoming harder and harder. Making it even more difficult is the risk associated with finding that yield. No longer can we receive sizable income from what many consider “risk-free” Treasury bonds, nor can we count on the banks to provide us with a stable of income on even high-balance accounts.

Many in the industry call it reaching for yield, meaning investors are forced to buy riskier assets in order to get a similar yield to its previously less-risky counterpart, or they are forced to buy assets at a higher valuation in order to get the same yield they used to get at a lower valuation.

This reach for yield has left many investors less certain and has caused them more worry as a result. I certainly don’t like having to buy more bonds to generate the same income, nor do I like to buy stocks with a far higher valuation in order to get the same dividend yield.

But income goes beyond stocks, bonds and the interest generated in banking products. Thankfully, there are also options.

Like the reach for yield issue, lower volatility has also crimped the returns one can generate in the options market. Traders can repeatedly generate income via the options market on a weekly, monthly or quarterly basis. However, when volatility is low (like the current environment), option premiums are also low. While lower premiums do lead to lower income, that doesn’t mean it’s a worthless endeavor.

One problem investors face on a daily basis, but particularly in regards to the reputation of options, is risk. Many investors shy away from selling options because they are perceived as risky, despite a vast majority of options positions expiring worthless to the buyer, entitling the seller to a full profit.

Before we get into all the buying and selling, let’s backpedal a bit. Blindly selling options leaves investors exposed to risk should the underlying security move against their position. Indeed, selling options blindly is risky.

But when an investor combines options selling for income with the three probabilities system developed by OptionParty, the odds tilt heavily in their favor. The three probabilities include probability of profit, probability of target return and probability of total loss. To learn more about these three probabilities, read about it here.

Looking for Income? Boost Your Payout With Probabilities

Investors generate income by selling options – they can sell cash-secured puts or naked calls, but less risky strategies come in the form of covered calls, bear call spreads and bull put spreads.

Investors will sell these options for a net credit, money that goes into the investor’s account, and will remain there until the trade either expires or is closed. The goal is for the value of the options to decrease leading into expiration, allowing the investor to pocket a profit

Let’s use an example:

We’ve been following shares of Western Digital (WDC) and want to establish a neutral to slightly bullish strategy. We will do this by selling put options, in what is known as a bull put spread. Our desired minimum return is 5% with an expiration sometime within the next four to five weeks.

The trade requires us to sell the October 14th $46 put and buy the October 14th $44.50 put for a net credit of $0.09. Given that it is mid-September, investors will have roughly four weeks to wait out the trade, and should Western Digital fail to close below $46, the investor will realize their full profit potential.

Currently, there is roughly an 89.4% chance the stock will do just that – close above $46. Should it do so, our trade will hit our minimum target return of 5%. Further, this trade has an 89.6% probability of profit, meaning the trade will generate a profit of $0.01 or more.

Looking for Income? Boost Your Payout With Probabilities

Pretty good odds, right? For every ten trades we perform in this manner, roughly nine of them will generate a 5.3% return. Too good to be true? Yes and no.

While the odds do appear quite favorable, the risk of maximum loss, meaning the trade results in a full loss for the investor, is somewhat high at 6.4%. If you were to go to the bank and the manager said they will pay you a 5% return on your money this month, but there’s a 6.4% chance you’ll lose it all, would you still make the deposit?

Some investors might, but they don’t have to take on that much risk.

That’s why probabilities are so important. In the scenario above, we have a nine-in-ten chance of generating our specified return, but a 6.4% chance of total loss is a bit startling. So how about this one instead:

By selling the October $72/$67 bull put spread on the iShares Real Estate ETF (IYR) for a net credit of $0.27, we not only have slightly better odds of hitting our minimum return, but also have a higher probability of profit.

Looking for Income? Boost Your Payout With Probabilities

In this case, the trade will generate the same 5.3% return as the first one should the stock close above our short put strike price of $72. However, rather than absorbing the 6.4% probability of maximum loss, this trade carries a maximum loss risk of just 1%.

Despite the lower odds of total financial failure, our odds for profitability did not diminish. Instead we have a 91.6% chance of hitting our minimum return of 5%, as well as a 92.4% probability for generating some form of profit.

By using probabilities, we can take what many would consider a good trade and turn it into a great trade. Too often, investors act on emotion, rather than relying on the odds. But it’s when one tilt the odds in their favor, rather than in the market’s favor, that profitability really has a chance to shine.

Ways to Play the Election Year with Options

Election time is approaching. And after a nice calm summer where most investors are out on vacation, it’s time to get back to reality and get ready for a busy next few months in the investing world.

There have been many financial surprises in the markets this year, including one of the worst January bear surprises in recent history and the Brexit vote a couple of months ago. These types of events increase investor uncertainties, which ultimately raises volatility. Another important event is coming; the presidential election. And this means investors need to stay alert and be prepared for some volatility to come.

Historical Facts

It is a given that presidential election years affect the market. Based on an MFS Investment Management research report on political control and market statistics from 1901 to 2016, the S&P 500 Index, on average, returned a total of 8.6% per year under Democratic presidents and Republican-led Congresses. Also, the S&P 500 Index gained about 7% per year when both the White House and Congress were run by the same political party.

Ways to Play the Election Year with Options

After 1976, the worst S&P 500 Index returns we saw were in the 2000 election year with -9.1%, and in the 2008 election year with -37%.

Ways to Play the Election Year with Options

Another thing to observe is that since 1928, the S&P 500 has dropped an average of 2.8% when the presidential election years do not have an incumbent president seeking reelection. On the other hand, when the president is seeking reelection, the S&P 500 had a 12.6% average return. One of the reasons why the markets returns are favorable when an incumbent is seeking reelection is the benefits of continuity, and perhaps more certainty, that come with it.

While these facts hold true, the performance of previous elections – whether they involve new candidates or incumbents seeking reelection – do not necessarily mean that same scenarios will happen this year or in future election periods. Since we all know that past returns do not equal future performance.

Take note that the market responds better to election developments with more predictable outcomes. We can expect that the markets will be uncertain all the way through November 2016. The very fact that we have a candidate with no political experience but business expertise, and another one with the political experience and less business authority – makes this election year one with few clues on how each of them may either help or hurt the stock market.

Election Candidate Influence on Different Sectors

Investors look at political parties to help them steer their investment decisions. Investors seem to look into party affiliations to get clues into which candidate can have a better impact on the market.

Economic proposals by the candidates can have an impact on how investors will build their portfolio this year. The effects of candidate’s values and proposals may not have an equal effect on all sectors, however. For example, we do know that the infrastructure industry is likely to thrive under both candidates given their expansion plans, especially Donald Trump given his real estate investing background. He is also likely to increase the budget for defense. This will be welcomed by aerospace and defense companies. However, Trump may be seen as more of a wild card given that a lot of uncertainty may be poured on Wall Street due to his previous lack of involvement in politics.

Hillary Clinton, on the other hand, has been in politics for a large chunk of her career and has ties with Wall Street, which could suggest that she will maintain the status quo for the financial sector. Even though she supports the idea of implementing stricter rules on hedge funds, it’s very unlikely she will completely change things around. So that’s a plus for financials.

She’s also in support of alternative and green energy. This suggests more subsidies for solar, wind and other renewable energy companies. This will drive that industry higher. Whereas, coal and all the major fossil fuels could experience downward pressure.

Ways to Play the Election Year with Options

Making Decisions in a Volatile Election Year

When people sell stocks, fear rises. Volatility increases as well.

Too many domestic and international factors surprised us since the end of 2015. These include terrorist attacks, wars, decreasing oil prices, the Fed increasing interest rates last December and potentially doing it again soon, the Brexit vote, Yuan devaluation and other market catalysts have been affecting the markets recently.

If we are to look into the VIX (the volatility index), the figure has been hovering around 11 or 12 during the summer, with not much action. We had a spike in volatility during the China fallout in August of 2015, as well as in June 2016 following the Brexit vote. We also hit high on the VIX at the beginning of 2016, a couple of weeks after the Fed raised rates by 25 basis points. And now we see that volatility is at 2-year lows. Given this, volatility is likely to rise above its current level as we get closer to November – when investors will be more fearful and uncertain on how the change in government will affect the markets and their investment portfolios.

These are some examples of market volatility that affects investing decisions, which may be rational or not. After all, your success in investing will largely depend on you blend of financial goals, your time horizon, and risk appetite among other factors. It is not time for emotional investing.

One thing to keep in mind is that major lows in the stock market seemed to be more likely to occur in the midyear between congressional elections. That is two years before or after the presidential elections. Most of the time, bear markets are likely to happen during the first to second years of presidential terms.

Having said that, the main focus for investors should be to get ready for these uncertainties and then develop effective strategies that will provide the best benefits. Analyzing charts to see probable price levels is one way. Another would be to look into the different option trading strategies.

But before diving into that, you must understand the risks and ways to mitigate them investing in options. Some things you have to be well-informed of are time spreads, vertical spreads, and options Greeks, among many others, so you have the best possible knowledge and education to achieve your desired outcomes when trading and investing with options this election year. Smart option trading is one of the keys to investment success.

How Should We Trade Options Going into the Election Period Then?

To reiterate again, investors should always invest in accordance to their financial objectives, risk tolerance, and investment policy statement. However, if you’d like some ideas on how to protect your portfolio during uncertain times such as elections, we’ll talk about a couple here.

If we assume that volatility will increase in the next few months, we can conclude that option prices will increase. This is the case for both calls and puts because volatility is a major component of option pricing..

  1. Investors can take advantage of low option prices now given the current low volatility in the markets. For example,you can choose to buy protective puts to hedge some of your portfolio holdings for fairly cheap. The benefit is that your portfolio will be more protected and when/if volatility rises, the price of that put will increase in value.
  2. Another strategy investors can implement is waiting for volatility to begin rising, which in turn pushes option prices up. In this case, investors can take advantage by selling options at high prices. For example, you could sell some naked or cash-secured puts where the underlying is a stock that you wanted to earn, but it has been too expensive in the past. This way, you’re taking advantage of high put prices and earning premium, as well as potentially owning the stock you wanted at a cheaper price should it drop below the strike price by the expiry date.
  3. If you wait for the rise in volatility, you could also sell calls. Ideally, implementing the covered call strategy. This involves selling a call option where the underlying is a stock you currently own. This way you’re selling the call at an inflated premium given the high volatility and providing a lower breakeven price for your stock should the price tumble.

Final Words

We always say that trading in options is a risky process, and without the right knowledge you might be making the wrong decisions that may lead you to losing some instead of gaining some. While historical facts can provide us a vision of how the markets may go given particular scenarios, we will always be in for a surprise as unforeseen events unfold.

No matter what your options investment strategies are, keep in mind that your decisions should be a cohesive process of your financial goals, risk appetite, time horizon, and other constraints. There is no better way to do it than to have a plan, which is your investment policy statement (IPS). You may be reading all there is to read about how you should behave this election year with respect to your portfolio, but if you don’t have a clear understanding of your IPS, you might just be making wrong decisions you won’t be able to take back.

Want to Profit With Options? Use Three Probabilities

When surfing the web, it’s easy to find several different sites that will generate a very common probability found in the options world: Probability of profit.

Has a nice ring to it, right? The only problem is, the probability of profit doesn’t give you as much to work with as you think. At least when you use it as your sole calculation.

Simply put, the probability of profit measures the likelihood that your trade will become profitable. This is a literal measurement; it calculates the odds that a specific trade will yield at least one penny in profits, including commissions. However, that reading doesn’t do serious traders much good without other probabilities to compliment it.

It’s like having a computer without a keyboard or a house without doors. It may look nice and all, but how practical is it without other features?

Want to Profit With Options? Use Three Probabilities, Not Just One

That’s why at OptionParty we use three probabilities, one of which is the probability of profit that we just discussed. The others include probability of total loss and probability of target return. What are these?

The probability of total loss is exactly what it sounds like: The likelihood that the trade will result in the worst possible loss. While many traders use stop-loss orders to limit their losses, this probability’s responsibility is not to account for such potential orders. Its job is to calculate the worst-case scenario.

In order to calculate the probability of target return, traders first need to identify their return objective. Is it 2%? 8%? Somewhere in between perhaps? Either way, once the target return is entered, the probability or likelihood that that return will be reached can be calculated. It could be argued that this measurement is more beneficial to traders than the ever-so-common probability of profit.

So let’s take a look at some examples to see how this pans out. In our scenario, it’s late-August and we’re looking for a 6% return on our trade using an expiration of no more than 8 weeks.

Want to Profit With Options? Use Three Probabilities, Not Just One Left: A “Story Mode” snapshot of the results Option Party members will find when using the screening options to find the best trades.

Here we can see what calls to sell, which to buy and at what price. We can also see the probability of target return, probability of profit and probability of total loss.

 

How about this trade: Selling the October $49/$50 bear call spread on Halliburton (HAL) – a bearish strategy that traders enter when they believe the underlying security will trade flat to slightly lower by expiration.

The probability of profit shows an 85.9% chance that we’ll make a gain on our trade – and that includes commissions! So what’s to lose? We already know there’s a good chance of profit. After all, for every 100 trades we perform like this, a whopping 85 of them will result in a profit of a penny or more. Better than a loss, right?

This is exactly the problem with only using one probability, the most readily available one at that. The probability of profit simply leaves out too many other important considerations.

For example, in this trade there’s a 10.3% chance of experiencing a total loss. 10.3%! While there is an 85.6% chance we’ll hit our target return of 6%, the more than one-in-ten deadly odds that we’ll experience our max pain – in this case a HAL close above $50 – should be enough to turn off many traders.

Now let’s look at a trade with the same 6% return, but with a lower risk profile. Remember, it’s late-August in our example.

Right: Now in “Data Mode” we can see that although the probability of profit is lower than in the first trade, the total loss probability is greatly reduced, making this a better overall trade.

The “Quantity” column in the bottom box can be adjusted by Option Party members, as they can alter the dollar amount for each trade.

Want to Profit With Options? Use Three Probabilities, Not Just One

 

Here’s a better one: Sell the October $82.50/$77.50 bull put spread on Exxon Mobil (XOM). That means we are neutral to bullish on Exxon, at least to the point where we don’t think the stock will advance that much over the next six weeks.

There’s an 82.7% chance that we’ll hit our target return of 6% and an 84.4% chance we’ll generate a profit of a penny or more. However, instead of finding a trade with a remarkably high total-loss probability, this trade has just a 2.9% chance of experiencing a total loss.

Even though our probability of profit is lower than in the first trade, we still have a very good chance of hitting our target return and doing so with a lot less risk. These are the types of trades that traders prefer to enter and that’s exactly why using three probabilities rather than one is the smart and rational choice.

In both examples, each trade has a more than 80% likelihood of generating a profit. But without other key inputs – such as profit target, probability of profit target and total loss probability – we could have taken on a trade that had a much higher risk than the other. Another problem? The increased risk didn’t even result in an increased reward.

And that’s the whole goal in trading: finding a balance between maximum reward and minimal risk. Using probabilities will greatly help in that endeavor.

Cash-Secured Puts Vs. Covered Calls

Let us discuss two options strategies a lot of investors may think are similar. Investors are correct to assume these strategies are similar in many aspects, but they are not exactly the same. This article focuses on Cash-Secured Puts and Covered Calls. We define each strategy individually, and then how they are different from each other.

Cash-secured puts

Cash-secured puts is an options strategy where a seller enters a short put position for which he receives cash (or premium). In exchange for that premium however, the seller is obligated to buy the underlying stock should the buyer of the put option (long position) wish to exercise it. Exercising a put option basically means the long put position will sell the stock to the short put position at a predetermined price (strike price). Exercising the put option usually only happens when the underlying stock price drops below the strike price. The short put position can be risky, therefore the strategy should only be implemented by advanced options traders. Cash-securing your position means you set aside enough cash to make sure that you can fulfill this obligation should the option exercise at the strike price. This makes a cash secured put strategy safer than a naked put strategy, where the seller of the put does not set aside enough cash to buy the underlying.

Go back our previous article on stock options or the difference between stocks and stock options for a quick refresher.

Covered Calls

Covered call writing on the other hand, is when you sell a call against a long stock you already own, allowing you to earn premium income in exchange for temporarily forfeiting much of the stock’s upside potential. It means you are willing to sell your long stock at the call’s strike price when “called upon” by an exercise notice. This strategy is best for stockowners that are not hesitant to sell the shares if the stock rises and the calls are assigned.

SIMILARITIES OF CASH-SECURED PUTS & COVERED CALL WRITING

  1. Some of the similarities between the two include the fact that they have similar profit and loss graphs. You can accomplish similar returns by employing both strategies, with similar risks.
  2. Secondly, the process for selecting stocks or ETFs for consideration in implementing these strategies is precisely the same on both.
  3. Lastly, they both require investors to have mastered the skills in selecting stocks as well as selecting options, and managing their position well.

Let’s look at an example where the two strategies can accomplish the same thing.

You believe a stock will decline in value in the short term, but will increase in the long term. You consider both option strategies to protect yourself against a short-term decline.

  • The stock’s price is $48.
  • The put or call option you consider is at the strike price of $50.
  • The put premium is $3.50.
  • The call premium is $1.50.

Because of the call-put parity it won’t matter if you implement the secured put strategy or a covered call strategy. In other words, if you short the put while having enough cash to buy the stock at the $50 exercise price, your exposure is the same as if you were to long the stock and short the call option at the same strike price. The P/L graph will look like this:

Cash-secured Puts Vs. Covered Calls

You must keep in mind that whether you prefer one over the other, there are options with different strike prices that do better in bull markets and there are others that do well in bear markets. Consequently, you must also have an exit plan and know when to rebalance your portfolio so you do not go out of line of your intended risk and exposure. Investors should know ahead of time what they will do under different underlying stock price scenarios.

Do not ever make the mistake of trying to figure it out when the scenario occurs. It pays to plan ahead of time. Some scenarios to think about are what you should do when the stock price turns out much better than you expected. Another one would be what will your course of action be if the strike is in the money as the expiration approaches. What would you do for each scenario? Will you keep holding the option, or sell before the expiry and “roll” the position for next month’s expiry?

Now let’s look at the differences between the two.

Cash-secured Puts Vs. Covered Calls

DIFFERENCES OF CASH-SECURED PUTS & COVERED CALL WRITING

Primary Motives

  1. A cash-secured put writer typically wants to acquire, via assignment, the underlying stock. The downside here is that a put assignment is not guaranteed. Any investor will miss out on purchasing the stock if the price remains above the strike price throughout the option’s life. The investor will lose out on any upside potential.
  2. Covered call writers want to earn premium income without taking on additional risk. This also provides an extra cash cushion, equal to the premium income, should the stock price drop. Regardless of the outcome, the premium an investor receives boosts the overall returns of his position. Although, here again the investor may lose out on any upside if the call option gets exercised when the underlying stock’s price is significantly higher than the strike price.

On Dividends

  1. Put sellers do not collect dividends. They generally receive higher premiums for their short put position when an ex-dividend date comes prior to expiration.
  2. Covered call writers own the underlying shares. They collect the dividend distribution as long as the shares are owned on the ex-dividend date.

Maximum profit

  1. Put sellers can only generate the premium (one income stream). Compared to selling cash-secured puts, covered call writing is a somewhat more bullish strategy. But this is only the case because of the primary motives for each option strategy discussed above. In terms of the exposure and profit taking potential, both strategies can accomplish similar risk/return objectives.
  2. Covered call writers make a premium on the option plus the stock’s appreciation if and when an out of the money strike call option is sold. Recap the example discussed earlier: let’s say you bought a stock at $48 and sell the out-of-the money $50-strike call option for $1.50. Let’s say the stock’s price by the time the contract expires, moves up beyond the $50 strike.

You will earn $1.50 per share plus $2 per share due to the price appreciation from $48 to $50. You gain $3.50 per contract, which includes two income streams in the same month with the same stock.

Cash-Secured Puts Vs. Covered Calls

Initial Step

  1. Cash-secured puts’ first step is to place the appropriate amount of cash into the brokerage account for a possible future stock transaction with a put buyer. Then sell the put option. There’s one transaction (short put).
  2. The first step for covered call writers is to place money into the brokerage account and buy the underlying stock. This is what makes the strategy covered or protected. You own the shares before selling the call option. There’s two transactions (long stock, short call).

Market Outlook

  1. A price-sensitive investor usually sells cash-secured puts. He is slightly bearish to neutral on the market especially when it becomes volatile. If the expectations go well, this strategy allows investors to buy the stock at a price below its current market value.
  2. Covered call writers generally look for a steady or slightly rising stock price. The type of stock they select also dictates what they do based on overall market assessment and personal risk tolerance. So if we are bullish on the overall market, we are more likely to sell an out-of- the-money call option.

Use in Self Directed IRAs

  1. Selling cash-secured puts is allowed only by some brokers.
  2. Covered call writing is allowed and regulated by FINRA.

Cost to Close when Stock Declines

  1. The costs involved in closing out the cash-secured put position are higher than the original premium generated if the price declines beyond the breakeven point.
  2. In covered call writing, the price of the option declines when the price of the stock declines. So you earn money on the call option but lose on the declining stock price.

Profit Expectations

  1. The potential profit is limited to the premium received with cash-secured puts. The potential loss on the other hand is limited to the strike price minus the premium received. However, the profit you gain is attractive with a cash-secured put if an assignment occurs and the stock’s price begins rising.
  2. As for covered call writing, you gain more when you have a good exit strategy for a stock. Your profit or loss will largely depend on whether you prefer to keep the stock longer or not. Your profit is limited to the strike price less the purchasing price, plus the premium you receive for selling the call. Your potential loss is biggest on the long stock position.

FINAL WORDS

Although covered call and cash-secured puts may have the same risk-reward profile, each strategy boasts of various advantages to investors with different risk appetites.

With cash-secured puts, usually the main intent for the investor is to acquire the underlying stock at a cheaper price. Even if it may hit near-term lows, as long as the put writers expect an assignment and are comfortable with the stock’s risks, their investment is in great shape. The only time that it may largely affect the investor is when the underlying stock becomes too volatile and falls lower than initially anticipated price levels, or in extreme cases, drops to zero.

As for the covered call strategy, take into account that you are still exposed to the downside of the stock’s potential decline and you may have restrictions on selling the stock when you have a short call position. All covered call investors need to monitor the stock for possible early assignment.

Overall, all else being equal, it may be more advantageous to implement the cash-secured put position given that you will decrease your brokerage commissions since there’s only one transaction involved, instead of two in the covered call strategy. However, if you already own the underlying stock and wish to generate premium income, a covered call position may be more appropriate.

Use Implied Volatility to Discover Stock Price Expectations

In the previous article, What is Implied Volatility in Options?, we introduced implied volatility and how it is calculated. Implied volatility is one of the most important factors used to assess the affordability or the luxury of an option. The judgment of option traders and investors in determining their best buying and selling strategies for a particular option depends on their analysis of that option’s implied volatility. Below are the key takeaways on the dynamics behind implied volatility (IV):

  1. Option prices are dependent on implied volatility.
  2. A higher IV means higher option prices.
  3. When big moves occur in implied volatility in just a short period of time, there are big changes in option prices as well.
  4. Buyers must aim to buy options with a low implied volatility to pay less.
  5. Sellers must aim to sell options with a high implied volatility to gain more.

We said that understanding implied volatility, as well as the basic knowledge on how it is computed, can help traders and investors avoid committing poor investment decisions when options are involved. Accounting for it is extremely necessary to ensure that you are not overpaying or underpaying. When one does not consider this seriously, he is up for a huge error. Both new and experienced traders should not fall into this trap.

Aside from that, we introduced you to the Implied Volatility Rank (in percentage terms). It is used by many financial institutions to measure a stock’s implied volatility. As an example, when a stock has an IV Rank as high as 90%, this means that it has a lower implied volatility than the current one 90% of the time over the past year. This means that the current implied volatility is high, since it sits at least at the 90th percentile over the past year. Many financial advisors can help you with looking into implied volatility charts through their online screening systems, so you may see the expected range for an underlying asset in a particular period of time.

This brings us to another question.

If the implied volatility of an underlying asset helps investors evaluate the affordability or luxury of an option, how then can they assess the possibility of a stock’s price moving up or down? How do we calculate stock price expectations using the implied volatility of an underlying asset?

Implied volatility gives us the expected price movement of an underlying asset (we’ll dive into this shortly). That’s one of the factors that scare or excite us when it comes to options trading.

Let us go deeper again with implied volatility for a minute.

Of course, we have markets where options are trading. Variables such as the stock price, strike price, time to maturity, and the risk free rate (usually the 10 year treasury yield is the benchmark) are widely available in these public markets. Stock market prices fluctuate based on various factors: big market events; employee strikes; entrepreneurial errors; unfavorable litigations; political and legal policy changes that affect the business; bad management; changes in business location or succession; and other company or industry specific events. Prices fluctuate based on supply and demand. The change in stock prices directly affects implied volatility.

You can use a pricing model to come up with a theoretical option price. In the previous article, we used the Black-Scholes pricing model. One of the inputs in this pricing model’s formula is volatility (or implied volatility). Implied volatility can be calculated as a plug in the Black-Scholes formula. We can use Excel’s Goal Seek Function to calculate the correct implied volatility number given all the other variables in the formula are widely available using the market data. We won’t go into too much details on this again since this was already introduced in the previous article. If you haven’t read it, please read “What is Implied Volatility in Options and How is it Calculated?”

What is Implied Volatility in Options and How is it Calculated?

Standard Deviation Vs. Volatility

Standard deviation is one way to measure volatility and for our purposes, standard deviation and volatility are essentially two ways of saying the same thing. It’s the probability for a stock to move up or down by certain amounts in a given time of period.

However, there are certain differences that you should be aware of.

Volatility is a percentage that tells us how much something (not just a stock) tends to move. It is not always standard deviation since there are other measurements of volatility. For example, average true range, which is a measure of volatility that has nothing to do with standard deviation.

Whereas, standard deviation is a statistic that describes variability in a data set. It’s the square root of variance. Variance is the average of all squared deviations away from the mean in a data set.

Therefore, these standard deviation and volatility go beyond finance and investing. But if we were to focus on our topic of stock and option trading, standard deviation is the measure of volatility we’ll be using. Therefore, these two terms will be used interchangeably in this article.

Let’s dive into calculating a stock’s price range below.

Calculating a Stock’s Estimated Price Range Using Implied Volatility

Let us now take a look at how we can calculate stock price expectations. The expected move of an underlying asset can be determined in three steps:

  1. Standard Deviation. As discussed above, for our purposes, implied volatility derived from the Black-Scholes formula is the same as standard deviation. So the first step is finding implied volatility, which we’ll substitute for standard deviation.Here’s how the generic bell curve graph, the most common type of distribution for a variable, looks like. This graph is often used by financial analysts and investors when looking into the possible returns of a security.Use Implied Volatility to Discover Stock Price ExpectationsSource: http://www.optionstradingsignals.com/understanding-implied-volatility-when-trading-options-part-1/You should be aware that in a normal distribution, roughly 68% of observations (potential stock price movements) fall within one standard deviation away from the mean (in our case, current stock price). 95% of potential stock price movements fall within two standard deviations. 99.7% of potential stock price movements fall within three standard deviations.
  2. Next, we need to multiply the standard deviation by the current stock price. You’d also want to take into account the number of days for which you’re estimating the stock price movement for. This will give you the increase and decrease of the stock price you can expect in a given time period. Here’s the formula:Use Implied Volatility to Discover Stock Price ExpectationsWhere:
    • S is the stock price.
    • σ is the annual volatility of the stock (also referred to as standard deviation).
    • n is the number of days for which you’d like to find out the expected stock price move for.

    Let’s say that the stock price of an underlying asset is $62.25, and the implied volatility (standard deviation) is 20%. The number of days for which you’d want to know the range of stock price movements is 45 days. By using the formula you get:

    Use Implied Volatility to Discover Stock Price Expectations

    What this says is that the stock price is likely to move $4.37 up or down in the next 45 days, given a 68% probability (we’re only looking at one standard deviation for now).

  3. Add the increase and decrease of the stock price you can expect in a given time period to the current stock price.Use Implied Volatility to Discover Stock Price ExpectationsThe resulting stock range is between $57.88 and $66.62 in the next 45 days. By default, this is given a 68% probability, since we only used one standard deviation. What this means is that the stock price will be between that range in the next 45 days with a 68% probability.If we were to use two or three standard deviations, the formula would look like this:Two standard deviations:Use Implied Volatility to Discover Stock Price ExpectationsThree standard deviations:Use Implied Volatility to Discover Stock Price ExpectationsThis would increase the range of potential future stock prices. For instance, with two standard deviations, the range increases in the next 45 days to between $53.51 and $70.99 with a 95% probability. And with three standard deviations, the expected range is between $49.14 and $75.36 in the next 45 days with a 99.7% probability.Here’s the work done in an Excel file:Use Implied Volatility to Discover Stock Price Expectations

Advantages of Getting a Stock’s Estimated Price Range Using Implied Volatility

Why do investors use this formula to get the stock’s estimated price range? The bottom line is that any investor would like to make investing portfolio decisions that will earn returns. With the help of this formula, forming our assumptions on a stock’s price potential can largely benefit investors when making buy and sell decisions.

By looking into the +4.37 value from the example earlier, investors can assess whether or not that estimate is large or small. If your belief is that this value is too small and you expect greater potential for stock movement, then you’ll definitely that the option is a great buy. Whereas, if that value seems large, then you may be inclined to sell the option of that stock.

If your assumptions are correct and you utilized the formula, then you ultimately benefit from your return on investment.

Lastly, while it is important that we know about IV Rank which we can easily access from online screeners or through the assistance of your financial advisor (if you have one), it is equally important to understand what actually went into that IV Rank, by understanding the above formula.

Making Decisions between Price Trends and Volatility

We have covered the importance of implied volatility in a pricing model when making wise investment decisions. But, how about looking into price trends?

Trends change when there are events that affect investors’ minds about the stock. Some of the factors that constitute these events could be supply and demand; earnings of a company’s stock; an industry’s trend; investors’ sentiments of certain breaking news within or outside of the country; company changes; and many more.

Stock charts show us that there is no one single stock with prices that go up continuously or in a straight line. They zigzag in a general upward direction in a bull market and down in a bear market. The general direction of a stock’s price is the trend. In essence, you need to be able to properly distinguish normal volatility in the context of a trend so that you can make effective investment decisions.

Volatility Indices

Today, investors have more means to stay updated with the current and expected volatilities of their chosen portfolios implied by options prices. Some benchmarks are the Volatility Indexes provided by the Chicago Board Options Exchange (CBOE). The Board calculates and updates the prices of several volatility indexes which are designed to measure the volatility expectations by the market, implicit in the option prices. The indexes are leading measurements of investor sentiment and market volatility related to listed options.

As you can see, most investors don’t really have to make all the calculations themselves when it comes to figuring the expected volatility of a security. With various stock charts and volatility indexes available today, investors don’t have to spend a lot of time manually calculating Implied Volatilities, Call or Put Options prices, and Expected Stock Range, unless they don’t have tools that allow them to do this effectively and provide an edge over the market. We here at OptionParty go one step further by calculating probabilities on the entire market so individual investors don’t have to. Try it for yourself using our free 14 day trial here.

The most popular Volatility Index is the CBOE Volatility Index ($VIX). It measures the implied volatility for a group of out-of-the-money put and call options for S&P 500 stocks.

There is generally an inverse relationship between the VIX and the stock market. This is because markets go down a lot faster than they go up, which means volatility is higher during down markets. Also, investors are more cautious during uncertain times when prices drop, which increases price fluctuations, and therefore volatility.

Let’s look at an example of the VIX chart.

Use Implied Volatility to Discover Stock Price Expectations

In this chart, as of Aug. 11 2016, we see that the implied volatility as measured by the VIX was 11.55%. By just looking at the chart, how are our investment decisions driven? When we see that there is a decline in the implied volatility, there is a decrease in option prices. It’s one of many good indicators to help investors decide when to buy or sell options. If you believe the VIX is overstated or overvalued, you should be selling options. If you believe the VIX is undervalued and that more implied volatility can be expected, this is one indicator to suggest that it’s a good option buying opportunity time.

FINAL WORDS

Implied volatility is an important aspect for determining a stock’s potential future price movement, especially for short-term option sellers. While it may have its limitations, many investors rely on factors other than implied volatility, such as Implied Volatility Rank (IVR), expected stock price ranges, and Volatility Indexes as well.

While trends and indicators in the stock market help you achieve investment returns in the stock market and options trading, remember not to neglect your financial goals, risk appetite, and investment constraints.

What is Implied Volatility in Options?

In our article on the Black-Scholes formula, we explained that before the popularity of the Black-Scholes model, it was difficult for investors to evaluate whether an option was fairly priced. When the formula was developed, people became more confident with the idea that it is indeed possible to enter a perfectly hedged position. This is achieved by combining option contracts and their underlying securities when the contracts are priced accurately. Again, the Black-Scholes model only applies to European options that may only be exercised upon expiration day.

In that article, we also explained that one of the most important factors for pricing options is the volatility (implied volatility) of the underlying.

As a review, here is the modern Black-Scholes Formula for calls:

What is Implied Volatility in Options and How is it Calculated?

And here it is for puts:

What is Implied Volatility in Options and How is it Calculated?

  • C stands for Call Premium.
  • S is the stock price.
  • K is the option strike price.
  • T – t is the time remaining until expiration (or maturity).
  • r is the risk free interest rate.
  • e represents the irrational number that’s often called Euler’s number.
  • N is cumulative standard normal distribution.

The first part in the equation represents the expected returns of purchasing the underlying asset. SN(d1) multiplies the stock price by the sensitivity in the call premium of the change in the underlying price. The second part, N(d2)Ke-r(T-t) represents the current value of paying the exercise price of the option on expiration day. Getting the difference between the two parts gives investors the value of the option, or the call/put premium.

Below are the formulas for getting the values of d1 and d2:

What is Implied Volatility in Options and How is it Calculated?

Where:

  • S is the stock price.
  • K is the option strike price.
  • T – t is the time remaining until expiration (or maturity).
  • r is the risk free interest rate.
  • In is the natural logarithm.
  • σ is the annual volatility of the stock (also referred to as standard deviation).

To refresh your memory, we explained that the option price is easily affected by volatility (σ) changes. However, since volatility is not easily determined, most of the time it is estimated from historical underlying security values or is derived from the Black Scholes formula. Stock price volatility is among the necessary factors that investors look into when calculating the premium of an option. And remember, volatility is simply the amount that the stock price fluctuates.

What is the Difference Between Historical and Implied Volatility?

By definition, historical volatility is the annualized standard deviation of a stock’s price movements in the past. So, if a stock has large price swings on a day-to-day basis over the past year, it is historically a volatile stock with a high standard deviation.

On the other hand, implied volatility (IV) is not based on historical pricing. Instead, implied volatility is forward-looking. It is what the marketplace is “implying” a stock price’s volatility is right now, with current data. Implied volatility is an annualized figure.

Where then can implied volatility be derived? Simple: it is derived from the currently available cost of the option, where implied volatility will be calculated as a plug in the Black Scholes formula.

Since we know what the current option price (option premium) is, implied volatility is often what the formula actually calculates, not the premium price. If there were no options traded on a given stock, it will be difficult to calculate implied volatility.

Which brings us to the next question: how do we compute implied volatility?

Calculating Implied Volatility

Would you buy an Apple stock without knowing the price? Naturally of course, you wouldn’t! But here’s the thing; many option traders buy and sell options without any serious regard for understanding implied volatility.

When you have the components for calculating the Call Premium (using the Black-Scholes formula), it actually becomes easy to compute a security’s implied volatility. Implied volatility is, arguably, the most important factor used to assess the affordability or the luxury of an option. You should not trade when you haven’t done your due diligence. It is extremely important for you to understand whether or not you are overpaying for an option. You need to get your money’s worth.

Let’s look at an example with the following data:

What is Implied Volatility in Options and How is it Calculated?

In this example, let’s say the last call option trade price was at $3.61. That value, versus the $3.13 call price which we calculated using the Black Scholes formula, means that we are way off. With the help of the Excel’s Goal Seek function (or you could try trial and error with different values using the Black Scholes formula) you can get the correct volatility which matches the last options trade price of $3.61.

What is Implied Volatility in Options and How is it Calculated?

This Goal Seek function requires three readily available variables. You just need to select your calculated call price as the “Set cell” (C9). Then input the $3.61 market value under the “To value” window. Then, set the “By changing cell” to your assigned cell (C6) for volatility on the Excel sheet. When you hit OK, the Goal Seek function figures out that the volatility for this particular stock is at 20%.

Here are the results. As you can see cell C6 changed to 20% as the correct volatility.

What is Implied Volatility in Options and How is it Calculated?

Today, investors and traders are luckier than ever because everything in the securities markets is transparent. With the World Wide Web, we see various market data – even a security’s highest implied volatility rates on a daily basis. When traders see that a security’s implied volatility is high, they become aggressive in selling that option. A lot of online market data also shows the percentage of the increase or decrease in volatility.

What is Implied Volatility in Options and How is it Calculated?

When is High Implied Volatility Too High?

We now know that Implied Volatility plays a huge role in our analysis when it comes to buying or selling an option. Volatility of a security changes over time. When the Implied Volatility is low, buyers get the options for cheaper. When the Implied Volatility is high, buyers will pay more for the option. The opposite occurs for option sellers. They get more premium when the Implied Volatility is high and lower premium when Implied Volatility is low.

Now the question becomes when is implied volatility high enough to get our desired results? How do we know that the odds are in our favor? Well, we introduce you to the Implied Volatility Rank, or IV Rank.

Implied Volatility Rank (percentage) is used by many financial institutions to measure a stock’s Implied Volatility. To illustrate, when a stock has an IV Rank as high as 90%, this means that it has a lower implied volatility than the current one over the past year 90% of the time. This means that the current Implied Volatility is high, since it sits at least at the 90th percentile over the past year.

For example, if Microsoft has an IV Rank of 90% or higher today, then this means that we can expect it to go down over the next five days. When we assume that the IV Rank is mean-reverting (meaning we can always expect it to go down), then the IV Rank can help us in our trading decisions. We profit from an increase in IV for selling options.

We profit from a decrease in IV for buying options. IV Rank’s values run from 1 to 10, as we can see under column “Volatility” in the image below.

What is Implied Volatility in Options and How is it Calculated?

Image via Barchart.com

Taking Advantage of Online Screeners

If you have an investment or financial advisor, who can walk you through the whole process because you simply don’t have the time – they can actually tell you the IV Rank of your chosen fund. Volatility charting are widely available online and the resources are just enormous.

There are actually three indicators (or charts) that you may opt to take advantage of when looking into your buying or selling opportunities.

One key thing to remember is that when the historical volatility is higher than the current implied volatility, the options might be undervalued. Meanwhile, the options become overvalued when there is higher implied volatility compared to historical. This is where Volatility Forecast Scans become a necessity. This online analyzer, available in various institutions, assists you in finding securities with volatilities that increase or decrease over the short- or long-term.

Another online analyzer that can help you gauge your opportunities is one that evaluates the Implied Volatility Moves. Securities with the largest moves in daily and monthly implied volatilities are observed with this type of scan. Analyzing the figures in this type of chart can help you assess, in advance, whether an upcoming event may have a large impact on the price of your fund’s options.

Lastly, take advantage of charts that show results of Implied Volatility Scans. These scans help you find securities that are either high or low risk, which is obviously necessary in your investment decision-making process.

To conclude, while our own knowledge and understanding, as well as manual calculations, help us make informed decisions when buying or selling European call options – there is absolutely nothing wrong with taking advantage of online trading tools. This can also be a perfect opportunity for you to get all your money’s worth with your investment advisor, if you have one.

Why Implied Volatility is Important to Investors

The decision of option traders and investors in determining their best buying and selling strategies for a particular option depends on their analysis of that option’s implied volatility. An option’s premium price component changes where there are expectations of volatility changes over time. These volatility changes occur with supply and demand conditions affecting the underlying asset of an option as well as the expectations of the market with regard to its price direction. When an option’s underlying asset demand increases and the price goes up, implied volatility generally decreases. This will also result in a decrease in the premium price component. On the contrary, when an option’s underlying asset’s demand decreases and the stock price decreases, the implied volatility generally goes up, and options become more expensive.

To illustrate the idea behind Implied Volatility realistically, a security’s implied volatility increases during bearish markets when investors assume that the asset’s prices will reduce over time. On the other hand, a security’s implied volatility decreases in bullish markets when investors believe that the asset’s price will increase over time. This is generally the case since prices go down faster in a bear market than when they go up in a bullish market. Therefore, stock price fluctuations are greater in bearish markets when demand for equities is low.

For most option traders, implied volatility is more important than historical volatility because IV takes into account all market expectations. Various factors such as employee strikes, entrepreneurial errors, unfavorable litigations, political and legal policy changes that affect the business, bad management, changes in business location or succession, and other company or industry specific events are all factored in when implied volatility is seriously considered by traders and when buy and sell decisions are made. Business, market, and economic risk factors are always considered.

These are the things options traders must remember:

  1. Option prices are dependent on implied volatility.
  2. A higher IV means higher option prices.
  3. When big moves occur in implied volatility in just a short period of time, there will be big changes in option prices as well.
  4. Buyers must aim to buy options with a low implied volatility to pay less.
  5. Sellers must aim to sell options with a high implied volatility to gain more.

Final Words

Understanding implied volatility, as well as the basic knowledge on how it is computed, can help traders and investors avoid committing poor investment decisions. Accounting for it is extremely necessary to ensure that you are not overpaying or underpaying. When one does not consider this seriously, he is up for a huge error. Both new and experienced traders should not fall into this trap.

There are various strategies that can be utilized so you can enjoy maximum results should you decide to buy or sell options. It is best to regularly conduct one-on-one meetings with your options and/or financial advisor (if you have one) to get a clear picture of how your investment portfolio is performing.

Remember that options, just like any investment vehicle, come with many risks. Many investors have different goals in mind when making investment decisions. Regardless of the decisions that you make, whether you buy or sell an option, steady your ground as to what your financial goals are. Being a successful investor is about looking into the amount of money that you have, how much you want to earn by a given point in time, and how much risk you can handle given all your financial constraints.

What is Return on Risk?

In business ventures or investment planning, two things are always calculated by the capital holder: risk of the return and return on investment. The relationship between risk and return is inevitable. Let us define the two.

What are Returns?

Returns are usually quoted in percentage terms. They represent the gains or losses of a security in a particular time period. The basic premise is that an investor has a higher potential for larger gains or losses if he undertakes more risk on an investment. In finance, returns can be a Return on:

  1. Investment/Capital
  2. Equity, or
  3. Assets.

We arrive at a Return on Investment in percentage terms by first calculating what the gain was and then divide it by the initial investment amount (or cost) of the investment. As an example, if you pay $50,000 for a number of stocks and then sell them later for $60,000, you receive a gain (or capital appreciation) of $10,000. Now, you divide the gain of $10,000 by the initial principal investment of $50,000. Therefore:

$10,000 / $50,000 = 0.2 = 20%

In this scenario, the return after selling your stocks is 20%.

On the other hand, when we compute the Return on Equity to analyze a company’s performance, we take into account its net income and equity. So let’s say, Company A makes a profit of $20,000 this year and its equity capital is $200,000. We divide $20,000 by $200,000, and we arrive at a ROE of 10%.

As for Return on Assets which is relevant in analyzing financial stocks, the gain (or loss) that we consider in the computation is also the company’s net income. However, we divide the net income by the total company assets. If its net income for the year is $20,000 and total assets in the same year is $300,000, then we divide $20,000 by $300,000 and get an ROA of 6.67%.

What is considered a good ROI?

By now, you may be asking, if I am to start or am currently investing in the stock market, what’s a good return on investment? Is it 4%? How about 10%? Is 15% more than enough?

There are three things you must remember:

  1. Times and markets change. Wars start and end. Markets crash and recover. A government’s policy change also affects the economy and equity markets. There really is no one single figure that any investor will be satisfied with. It is all a matter of understanding your financial goals, objectives, constraints, as well as willingness and ability to take risk. You really don’t have to be overwhelmed by all the various market figures.
  2. Rates of return are dependent on market conditions. However, most experts suggest that you keep updated with the current performance figures of key stock market indexes. For example, if the S&P 500 index is up 7% for the one year period, then you might have to make sure that your portfolio of securities with similar exposure and risks are performing similarly.
  3. Be realistic in terms of your expectations. Expecting a 20% rate of return without research or plainly depending on what other investors say (or “hearsay”) will only disappoint you. Again, we go back to your financial goals. How long do you intend to keep your investment before enjoying the benefits? Do you intend to sell them straight away as soon as you enjoy a 30 to 50% gain? Are you aware of the fees of your pension funds, bonds, stocks and other types of money market instruments? By analyzing these things, among others, you will have a more clear understanding of what to expect regarding your investments.

Next, we’ll discuss another very important factor in stock investing; Risk.

Risk Defined

Risk is simply the possibility of losing some or all of your original investment in any form of security. The more an asset fluctuates in value in a shorter period of time, the more volatile it is, and the more risky it’s considered to be. Again, in most cases the higher the risk of an investment, the higher the potential return. The lower the risk of an investment, the lower your potential returns.

Basic example: bonds have lower risks than equities (or stocks) because they’re generally less volatile, very often have periodic coupon payments, and get paid out first in case of company bankruptcy. Thus, bonds generally have lower potential for returns, while equities have higher potential for returns.

Risk Categories

There are two main categories of risk: systematic and unsystematic.

Systematic risk affects the overall market instead of a specific industry or stock. It’s also referred to as “market risk”, “undiversifiable risk”, and “aggregate risk”. It pertains to an entire market or entire market segment’s vulnerability to events that affect a security’s price fluctuations. Some of these market events include:

  • recessions,
  • wars,
  • central bank’s decision to increase or decrease interest rates,
  • aggregate income and GDP,
  • worsening business production and customer orders in an industry,
  • inflation,
  • debt crisis, and
  • many others.

Systematic risk is measured in terms of Beta in the capital asset pricing model (CAPM). Beta is the sensitivity of a security to market fluctuations. And CAPM computes the estimated return of an asset based on its beta and expected market returns.

While systematic risk pertains to the market as a segment or as a whole, unsystematic risk comes with a company or an industry that you invest in. It is also known as “specific risk”, “diversifiable risk” and “residual risk”. Some events that pertain to unsystematic risk are:

  • employee strike,
  • entrepreneurial error,
  • unfavorable litigation,
  • political and legal policy changes that affect the business,
  • bad management,
  • changes in business location or succession, and
  • other company or industry specific events.

At this point, you should be aware that investment risk can either be inherent to an entire market, or is company or industry specific. Below, we’ll take a look at four types of risks that derive from the two categories discussed above. You need to be mindful of these risks in order to protect your investment portfolio.

  1. Business Risk – The value of a company’s stock is dependent on internal operational activities and external threats (competitors’ activities). Strategies, expansions, bankruptcies, mergers, regulatory environment changes and many other factors pose risks to investor portfolios.
  2. Liquidity Risk – Liquidity refers to how easy it is to buy or sell a security. The more liquid a security is, the more fair the price will be when trying to buy or sell it and the easier it is to get in and out of a trade. Illiquid securities have high bid-ask spreads. For instance, some illiquid securities may be trading at a premium (referred to as liquidity premium) from its fair market value. Therefore, if you’d want to buy that security, you’d have to pay more for it. Whereas, if you wanted to sell an illiquid security you may have to accept a lower price than its fair market value.
  3. Economic Risk – This refers to anything related to economic events and indicators. Some examples include production PMI, GDP, employment, inflation, monetary policy, currency valuations, etc. For example, at the end of 2015, the Federal Reserve increased interest rates. What did it mean to investors and regular consumers? It meant that borrowing money became more expensive. Companies received lower valuations (because of higher discount rates), bond prices declined (because of increased yields), and the US dollar surged.
  4. Concentration Risk – We have discussed so many areas relating to investment risks that by now you should have realized the importance of diversifying your investments. This fourth type of risk becomes present when you put all your investments in, say, only one type of security, such as equities. It is also not advisable to put all of your capital in only one type of market sector or industry. You will have a safer and more balanced portfolio if you diversify into different types of equities, bonds, commodities, and various other asset classes.

 

What is Return on Risk?

Risk/Return Trade-off

As discussed previously, higher levels of risk mean higher potential returns. Lower levels of risk will result in smaller potential returns. This is basically what the risk/reward (or return) trade-off is and what every investor needs to face when making their investment decisions.

Now that we have defined both returns and risks, why do we look into return on risk rather than return on investment? Why do we put more emphasis on the return on risk when considering how to develop your portfolio for wealth management?

Remember how we calculated return on investment? It was a simplistic calculation based on invested values without any risks taken into account. There is no point in focusing your attention to the return on investment only without looking at the risk. This is because the increase or decrease in the value of your investment depend largely on what is going on in the entire market, a market segment, a company, or industry.

How Risks Instead of Returns Affects an Investor’s Behavior

Below, we’ll look at some examples of risks and how these affect investor decisions.

Interest Rates – Let us take a look at how interest rates affect the stock market and investment decisions.

Before 2015 ended the Fed increased interest rates due to the belief that the US is on a good path to recovery after the financial crisis in 2008. How does that decision impact the stock market?

Simple: when the Fed increases interest rates it simply means that financial institutions have to borrow money from the Fed at higher costs (or rates), and when a consumer borrows from the bank, interest rates are consequently high as well. It becomes more expensive for a business to borrow money to expand. People have to pay higher rates for home mortgages, credit cards, auto loans and more.

Naturally, an increase in the federal funds rate (interest rate risk) will affect decision-making among businesses and individuals. Furthermore, as an investor, you will take into account, for example, the future cash flows of the company you will be investing in. If you see that Company A might have an undesirable outcome on their future cash flows as a result of increased interest rates due to their high debt, you will opt out from investing in their shares.

Now, if the market declines and there is a large possibility for Company A’s stock prices or remain stagnant or decline further, then of course you wouldn’t buy its stocks today. Not too many people will be interested in stocks ownership in a company that’s expected to lose value.

Here you can see how a major market event (increase in interest rates) triggered risk in a certain investment, which in turn affected an investor’s decisions. This just shows how closely investors look at risk in the market and very often base their decisions from that perspective.

Currency Fluctuations – Do currency exchange rates also affect behavior of investors? Of course! Otherwise, we wouldn’t even see those figures at banking institutions or when opening the business section of a newspaper.

Foreign exchange risk (also called FX risk or currency risk) is simply the risk of currency exchange rate movements. For example, exchange rates matter for companies who deal with more than one currency. If a company exports and imports goods and services to and from other countries it will exchange currencies. There are pros and cons for a US company with suppliers outside the country if dollar either strengthens or weakens. A company’s cash flow and earnings will depend on exchange rates, which will ultimately affects the company’s stock price. This then affects investor decisions.

Credit RiskCredit risk is another example of an area of consideration in investments. When a company raises money by selling bonds, they are simply asking bond buyers for a loan. One way for investors to check the financial stability of the company they invest in is by looking at its bond ratings. If their credit risk is low and the bonds are rated as single, double or triple A’s, then they are in good standing. A company’s credit risk is calculated by checking into its collateral assets, their ability to generate revenues and their taxing authority, among other factors. If the overall ability of the borrower to repay is good, then chances are you would be more willing to invest part of your hard-earned money in this company’s corporate bonds.

Political Risk – What makes every election period exciting? The confidence by the people in the new government will affect market returns. Political risk is the risk that the returns on your investments may either be good or bad depending on current political changes and other governmental events. If part of your portfolio is invested in countries with instability threats and reforms, there is a higher risk that you will lose money in that exposure. Local labor laws, tax regulations, trade policies, legal and regulatory constraints, and other federal, state and local laws are just some of the events associated with political risks.

Here again, we see that as new political events occur, risks may rise or fall and investors act accordingly.

Key Difference between Return on Investment and Return on Risk

Again, for a given level of risk, you should be investing in the highest returning asset possible. For example, if a risk-free asset is offering 5% annual return, whereas an equity investment is also expected to generate 5% but at a higher risk, it’s much better to accept the risk free asset.

If you were to just see the 5% return on investment in a year’s time without knowing what risks were taken, would that be considered a good return or a poor one? The answer is unknown because if it was invested in a stock that fluctuates 10% every day that return is extremely poor due to how unsafe an investment like that is. But if it was invested in a risk-free asset such as treasuries, then the investment may very well be a good one (especially given the extremely low interest rate environment over the last several years).

Return on risk (ROR) takes this into account and provides an annual return figure that provides more than just a simple return on investment (ROI). ROI doesn’t tell you anything relating to the asset’s risk, whereas ROR (return on risk) does. Return on risk tells you how much you will earn for a given level of volatility or other risk measures.

Final Note

As you can see, investing in securities comes with many risks. Your expected gains or losses will depend on your risk appetite. First, you need to know whether you are a conservative, moderate or aggressive investor, as well as your financial goals, in order to decide on the level of risk you are willing to take in order to arrive at your stated objectives.

You might be putting so much of your attention on what you should be doing to increase the value your capital through bonds, stocks, and other forms of securities. However, this kind of behavior will prove to be futile if you don’t have more than ample knowledge about the risks that come with your investment portfolio.

Are the companies you are planning to invest in affected by currency changes? Does the company perform many transactions outside the country? If so, how is the political situation there? Does this company have a double A bond rating? How do the prices of this company’s stocks perform in the last week? These are just some of the questions you need to ask in order to better understand the risks associated with the securities you choose for your portfolio. This is obviously more important than just knowing how much you expect to earn in a specified number of years. Our measure of return on risk is more helpful and can assist in understanding returns in the context of risk.

That is what we call understanding your investment’s high earning potential while still considering the possibility of incurring losses. And that, my friends, is the application of knowledge, which then leads to power.

Black Scholes Formula Explained

Black Scholes Explained: In this article we will explain how Black Scholes is the Theoretical Value of an Option. In financial markets, the Black-Scholes formula was derived from the mathematical Black-Scholes-Merton model. This formula was created by three economists and is widely used by traders and investors globally to calculate the theoretical price of one type of financial security.

European Options Defined

Just like American options, European options have two types, calls and puts. With European options however, investor’s right to buy or sell may only be exercised on the option’s expiration date. For example, a European call option is a contract where the seller gives the buyer the right to sell – within a time period – a number of shares at a predetermined price. While it is a right of a seller, it is not an obligation.

Where are European options traded? They are traded among individual and institutional investors, as well as professional traders. The trades may be for single or multiple contracts.

Options are referred to as derivatives for a reason; their price is the result of an underlying investment’s value. The most common underlying investments on which option prices are based on are publicly listed company equity shares. Other underlying investments (or “securities”) include:

  1. ETF’s (Exchange Traded Funds)
  2. Stock indexes
  3. Government securities
  4. Foreign currencies
  5. Commodities

Now, there are five features in an option contract:

  1. Type of the option – puts and calls
  2. Underlying security
  3. Number of shares
  4. Strike price
  5. Expiration Date

Let’s get a quick refresher on what put and call options are.

A put option is a contract that gives the buyer the right, but not the obligation, to “sell” a number of units of a security at a specified price (or the strike price) within a fixed period of time (in the case of European options, the buyer can only exercise the option on the expiry date).

A call option on the other hand gives the seller the right, but not the obligation, to “buy” a number of units of a security at a strike price within a fixed period of time (again, in the case of European options, the buyer can only exercise the option on the expiry date).

There are various differences between an American and a European option in terms of the underlying investments, exercise rights, settlement price, and trading of index options. To keep our focus on the Black-Scholes formula, a European call option’s underlying investments mostly involve major broad-based indices. Secondly, as mentioned previously the owners of European-style options exercise their right only at expiration. Lastly, European trading index options stop one day earlier, unlike an American option where trading ceases on the third Friday of the expiration month.

Now, why do European options matter? This type of option is usually traded at a discount because there is only one single opportunity to exercise the option. Unlike an American option where the holder can exercise his right at any time before expiry, a European option requires the holder to wait until maturity. For example, when you, an investor, buy a European call option on June 1, which expires on the third Friday of June – you cannot exercise your right to buy the underlying asset when its value goes higher than the strike price by the second week. You cannot take the opportunity to buy the underlying security at the strike price that’s supposedly cheaper than current market value because you can only exercise your right to buy on the expiration date. The one advantage a European option holder still possesses is his ability to sell his option without waiting for the expiration date.

Now Back To The Black-Scholes Formula

Three economists developed the formula in the 1970’s based on the principle that a stock either rises or falls in price in the same predictably unpredictable manner. This idea is still popular today, and the formula is widely used in global financial markets. The introduction of this formula paved the way for a rapid increase in options trading. Its main goal: get a theoretical price estimate of European-style options.

American economist Fischer Black studied monetary policy around 1970. He concluded that basing on the capital asset pricing model, discretionary monetary policy will not provide any good that the Keynesians (who believe there is a natural tendency of the credit markets to be unstable) expected it to do.

Canadian-American financial economist Myron Scholes was as a professor at the MIT Sloan School of Management. That’s where he met Fischer Black and began a research on asset pricing. Scholes also worked with Chicago’s Center for Research in Security Prices where he helped and analyzed their high frequency stock market’s popular database.

The third economist involved in this formula is Robert C. Merton. This American economist is also recognized for translating the science of finance into practice. He was also known for his development of a pension-management solution system and for first publishing a paper that expands the mathematical understanding of the options pricing model for which he coined the term “Black-Scholes options pricing model”.

Back then the Black-Scholes equation enabled pricing when an explicit formula wasn’t available. With the many available financial calculators online today, using the formula has been easier. Investors only have to input the needed figures to arrive at the theoretical estimated price of a European option. In essence, the formula helps investors calculate the theoretical price of European put and call options.

Purpose Of The Black-Scholes Model

Prior to the popularity of the model, investors found it difficult to assess (1) whether an option contract was priced accurately or not, and (2) whether it represented a good value or not. Naturally, investors would love to enjoy the benefits of an underpriced or overpriced underlying asset in order to take advantage of arbitrage opportunities. Because it was too risky to be in the market with unpredictable prices, there weren’t too many investors and traders that were interested in options. However, when the Black-Scholes formula was developed, there was a rise to the idea that it is possible to make a perfect hedging condition by combining option contracts and the underlying security when the contracts are priced correctly. In conclusion, the theory of the formula is that the trading price of an option can be calculated mathematically and that there is only one accurate price for an option. With the formula, the trader or investor can determine if the market price is higher or lower than its theoretical value.

Option Party Black Scholes Explanation

The Black-Scholes Formula Illustrated

The Black-Scholes Model calculates the theoretical price of an option using six factors:

  1. Whether the option is a call or a put.
  2. Current stock price.
  3. Strike price.
  4. Volatility of the underlying security.
  5. Time remaining until maturity.
  6. Risk free interest rate.

The modern formula looks like this for calls:

Black Scholes Call Formula

And like this for puts:

Black Scholes Put Formula

  • C stands for Call Premium.
  • P stands for Put Premium.
  • S is the stock price.
  • K is the option strike price.
  • T – t is the time remaining until expiration (or maturity).
  • r is the risk free interest rate.
  • e represents the irrational number that’s often called Euler’s number.
  • N is cumulative standard normal distribution.

As you can see, the formula is composed of two parts.

  1. Black Scholes Formula Part 1
    • Multiplies the stock price by the sensitivity in the call premium of the change in the underlying price.
  2. Black Scholes Formula Part 2
    • Represents the current value of paying the exercise price of the option on expiration day.

Subtracting the two parts of the equation provides us the value of the option.

Now, how do we get the values of d1 and d2?

Black Scholes Put Formula

Where:

  • S is the stock price.
  • K is the option strike price.
  • T – t is the time remaining until expiration (or maturity).
  • r is the risk free interest rate.
  • In is the natural logarithm.
  • σ is the annual volatility of the stock.

The volatility of the stock price is one of the most important factors for option pricing. The reason for that is because the option price is easily affected by volatility changes. Since volatility is not easy to determine, it is often estimated. However, there are online tools you can utilize; like volatility calculators that automatically retrieve historical or implied volatility data.

Investors should note that very often the formula is used to derive the implied volatility (σ). Since investors already see the market price of the option and all other variables, they can input all variable into the formula except the implied volatility. Then the unknown variable plug becomes implied volatility. And the way investors check if the price is fairly valued is if their estimate of volatility equals to the implied volatility which the formula provides.

The formula is obviously intimidating and looks complex. Luckily, we don’t have to go through the arduous process of calculating the option price manually because we are now equipped with numerous calculator tools on the Web that do the job for us. As long as you have the figures for the variables that the formula requires, you can quickly get the price of your put or call option.

Applying The Black-Scholes Pricing Model Into Practice

The Black-Scholes model has indeed played a crucial role in the way we interact with the financial markets. Like we said earlier, option trading became more alive after the model was introduced by the three economists. If it did not make any difference, then you wouldn’t even bother reading this post. Nowadays, option trading is fully established. The model is still widely used by traders today.

We are not expected to be fully dependent on it. Just like any financial model, it has advantages as well as limitations. A good advice for investors is to do their own research. Weigh both pros and cons of any financial model that you contemplate on using as you trade or invest in the market. Use the model to assist you in assessing whether or not a possible trade is worth it and if you agree with the implied volatility the formula calculates.

What are the things that you should know before using this model?

  1. You don’t really have to memorize the formula, or even understand it in great detail. Besides, who has the time to dig deeper into the model? Rather than manually calculating the values yourself, you can find a Black-Scholes model calculating tool online to save time. It’s easier and quicker.
  2. The model has underlying assumptions and implications you should know about.
    • Again, the option can only be exercised upon expiration.
    • The price of the underlying security may unpredictably go up or down, while the model assumes returns are normally distributed.
    • The underlying security pays no dividends.
    • The current market interest rate during the period of the contract remains constant.
    • Another thing is that “immediate benefits” are neither gained by the buyer nor the seller.
  3. Looking at the formula, we see that there are a few relationships involved.
    • First, the time left until the expiration date to the value of the call or put option. Simply put, the value of the option will be higher (in most cases) when you have more time before the expiration date. That’s a time value element. However, since the option can only be exercised on the expiry date, there are rare cases when longer term European options may be cheaper than shorter term ones. This is because investors would be happy to exercise the option sooner.
    • Second, the higher the volatility, the more expensive the option price will be.
    • The more that the option is in-the-money the more expensive it is (i.e. the higher S – K is for calls or K – S for puts).
    • Higher market interest rates translate to more expensive option prices.

Final Words:

The Black-Scholes Model is just one of the many models you can use to calculate the theoretical value of an option. You can use it anytime as you practice your strategies in the financial markets both as a trader and an investor.

Some advantages of this model include:

  1. Perhaps the best advantage this model provides investors is speed, because it allows you to calculate various prices of European put and call options in a short time span.
  2. It lets investors make better informed investment decisions when it comes to investing in European options.
  3. Another advantage is historical; this model, effectively, brought options trading to life.

The limitations of this model include:

  1. That assumptions are not always realistic (example: interest rates may not stay the same throughout the option period).
  2. A lot of stocks pay dividends, so the formula cannot be used for those.
  3. Can only be used for European options.
  4. The underlying stock’s returns are assumed to be normally distributed, which is not always the case.

We wish you the best with your strategies should you decide to use the Black-Scholes Model in your wealth management practices.

What Is a Covered Call Strategy?

Risk management is everywhere. When you’re climbing stairs, you face the risk of falling off. But when you hold a railing while climbing, you basically mitigate that risk. That’s risk management for you in the simplest of forms. Let’s get a bit more technical.

Risk management is a process where the risk related to a transaction are assessed with the objective of controlling the probability of its occurrence or minimizing its impact. If you’re looking for making extra-ordinary gains in the world of finance then you have to take risks. However, there are ways to mitigate risk. Derivatives are one of the financial instruments used by financial experts and investors in formulating an effective risk management strategy. The two most basic options strategies used by many investors are:

  • Covered Call: This involves holding a long position in a stock and selling a call option of the underlying. This strategy is the focus of the article.
  • Protective Put: This involves purchasing and holding a stock and the underlying put option. We’ll focus on this strategy another time.

This article will give you an in-depth knowledge on how the “Covered Call” strategy works. But before going into that, we need to make sure that some of the basics have been covered.

Options – Quick Refresher

As explained in a previous article titled “The Difference Between Stocks and Stock Options”, a derivative has three main features:

  • It is a legal contract.
  • It derives its value from an underlying. The underlying can be an asset, e.g stock or it can be an interest rate.
  • There is a long party, who will buy the underlying, and a short party, who will sell the underlying.

Options, a derivative instrument, are used by many financial experts for hedging risk. Options give the holder the right, but not the obligation, to buy or sell the underlying at a specified price, on or before a specified date. There are two types of options which are as follows:

  • Call Options: This gives its holder the right, but not the obligation to buy the underlying at a specified price on or before a fixed date.
  • Put Options: This gives its holder the right, but not the obligation to sell the underlying at a specified price on or before a fixed date.

Before moving on, it is highly recommended to read the article “The Difference Between Stocks and Stock Options”, and get yourself familiar with the basics on how options work.

Benefits of a Covered Call Options Strategy

As previously mentioned, a covered call options strategy is the combination of holding a stock along with writing (selling) a call option. The benefits include:

  1. The covered call position earns a premium from selling the call option. The premium amount is the price of the call option and depends on several factors. These include:
    1. The time horizon of the call option; the further away the exercise date of the option, the more expensive the option is. For example, an exercise date that is three months from now is more expensive than an exercise date that is only one month away.
    2. The price of the underlying and exercise price (also known as strike price) of the call option. The lower the exercise price, the more expensive the call option price. For example, if a stock is trading at $45 and the exercise price is “in-the-money” (lower than current stock price) at $43, the call option will be more expensive than one with an “out-of-the-money” (exercise price is above the stock price) strike price of $48.
    3. The volatility of the underlying asset. The more volatile a stock is (more rapid up and down movement with a higher standard deviation), the more expensive any option will be. This is because there’s a higher probability of the stock increasing and decreasing in value, thus options can increase in value faster.
    4. Market risk-free rate; higher rates translate into higher call premiums.
    5. Dividends of the underlying; during dividend payouts, stocks generally fall by the amount of the cash dividends on the ex-dividend date. By extension, this affects call prices as well. The higher the dividend payouts of the underlying, the cheaper the call option.
    6. Liquidity; the lower the liquidity of the underlying and the options, the more expensive option prices are.
  2. There is also some downside protection to the seller of the call option (i.e. the one with the covered call position). Because the covered call strategy receives a premium, that amount mitigates the potential downside. For example, if the premium received for the option is $1.50, then the investor will have that amount as a cushion in the case that the underlying decreases in value before the exercise date. The strategy is considered as a conservative one since it minimizes the downside risk of holding a stock.
  3. The investor not only gets to earn a premium by selling the option but will also be exposed to stock ownership benefits (e.g. dividends and voting rights).

Downside of a Covered Call Options Strategy

  1. Limited upside; there’s essentially a maximum gain from the covered call position. This is because as the seller of a call option, you enter into a contract to sell the underlying at a predetermined price. And the buyer of the call option has the right to buy the underlying at the exercise price until the expiry date. Therefore, if the exercise price is $43 and the market price of the underlying is $45, it makes sense that the investor with the long call position will exercise the option to obtain the underlying for cheaper; $43. Which means the short call position will lose that $2 gain from the stock appreciation. Although this loss balances out because the covered call position also has the underlying as a hedge against this $2 loss. Therefore, the covered call position will not gain any profits past the exercise price of $43. To sum-up, the short call option position won’t be able to fully benefit from capital appreciation in excess of the exercise price, thus limiting the benefit to the strike price of the option. When the stock price is above the exercise price, this is known as “in the money”.
  2. Risk of losing ownership of the underlying asset; if the counterparty (long call position) decides to exercise their call option, the stock ownership gets transferred to that option holder.
  3. Commission costs; all buyers and sellers of option transactions incur commission expenses.

 

What is a covered call?

In-the-Money vs. Out-of-the-Money Covered Call

The covered call strategy can be divided into two:

  • In-the-money (ITM) covered Call
  • Out-of- the-money (OTM) covered call

ITM Covered Call: If you’re looking to earn a normal return on your investment, adopting in-the-money covered call strategy is the way to go. The strike price is lower than the underlying stock and thus the option is in-the-money. The writer of the call option will not benefit from any upside movements in the stock price and his return will only consist of premium received at the start of the contract.

The maximum profit, or target return, is generated by this strategy when the price of the underlying is greater or equal to the strike price of the short call option. Therefore the deeper the short call is in-the-money, the more likely you are to earn the target return. This is called the probability of target return. Additionally, the downside risk of a falling price is minimized due to the decline needed to reach the at-the-money level and the cushion provided by the premium income.

Break-even point is achieved when the price of the underlying is below the strike price by the premium amount. I know this all may be going over your head, but this process will become much easier to understand through a simple example.

You buy 100 stocks for $45 and want to simply make a fixed return on the stock. You believe the stock won’t fall below $43, so you sell (write) a call option with that strike price. This is an ITM covered call strategy because the strike price is below current market price. The exercise date is in a month and the premium of the call option is $3. You net investment is $45 x 100 – $3 x 100 = $4,200. Let’s examine what happens if the price falls or increases.

Scenario 1: Fall in price

Let’s say the stock price falls to between $43 and $45 by the expiry date (example $44), which is above the strike price of $43. The option gets exercised at the $43 strike price, and you are left with no position. Your profit is the premium you received minus the loss on the underlying stock ($3 x 100 – [$45 – $43] x 100 = $100). The reason we use $43 in the equation and not $44 is because when the option gets exercised you effectively sell the stock at the exercise price, which is $43. The $100 profit also happens to be your target return you can make on this investment.

If the price of the stock falls between $43 and $42 by the date of expiry (example $42.30), your profit again equals the premium you received minus the loss on the underlying ($3 x 100 – [$45 – $42.30] x 100= $30). The reason we subtract $45 minus $42.30 this time is because you were left with the stock since it didn’t get exercised.

If the price of the stock falls below $42 at the time of expiry, your position losses money. For every dollar the stock falls below $42 you lose $100. For example, if the stock declines to $40, your loss equals [$42 – $40] x 100 = $200.

The total loss ($42 x 100 = $4,200) occurs when the stock price declines to $0. As you would expect, the probability of total loss with a covered call is almost always zero, but anything can happen, especially with extremely volatile stocks.

Scenario 2: Rise in price

Basically, any stock price above the $43 strike price makes you the max profit, or target return, of $100. The reason for this is because your option gets exercised at $43, you bought the 100 stocks at $45, and you have the $3 premium per stock you received from selling the call. Therefore, the equation becomes: 100 x $3 – 100 x [$45 – $43] = $100.

What is a covered call?

OTM Covered Call: An out of the money covered call strategy involves holding an underlying stock or asset while writing (selling) an out of the money call option. An out of the money call option is that which has a strike price higher than the current market price of the underlying.

The writer of the OTM call option has the advantage over the ITM call option because of the exposure to some price appreciation. Since the call option is out of the money, the value of the option would be lower and so the premium paid will be lower than the premium paid related to the ITM call option.

The OTM covered call strategy is generally adopted by bullish investors who are expecting price appreciations and are looking to profit from this expectation. The downside of this strategy compared to an ITM covered call is that since the premiums are lower, the scheme will not provide as much protection as the ITM covered call from losses due to fall in price of the underlying. Again, don’t get worried if this is a bitter pill to swallow, since you will have a better grip over the above by reading our simple example below.

You buy 100 stocks for $45. You believe the stock will increase to $47, so you sell (write) a call option with that strike price. This is an ATM covered call strategy because the strike price is above current market price. The exercise date is in a month and the premium of the call option is $0.50. You net investment is $45 x 100 – $.50 x 100 = $4,450. Let’s examine what happens if the price falls or increases.

Scenario 1: Fall in price

Let’s say the stock price falls to between $44.50 and $45 by the expiry date (example $44.60), which is below the strike price of $47. The option does not get exercised. Your profit is the premium you received minus the loss on the underlying stock ($0.50 x 100 – [$45 – $44.60] x 100 = $10).

If the price of the stock falls below $44.50 at the time of expiry, your position losses money. For every dollar the stock falls below $44.50 you lose $100. For example, if the stock declines to $42.40, your loss equals [$44.50 – $42.50] x 100 = $200.

The total loss ($44.50 x 100 = $4,450) occurs when the stock price declines to $0.

Scenario 2: Rise in price

If the price of the stock rises between $45 and $47 by the date of expiry (example $46.30), your profit equals the premium you received plus the gain on the underlying ($0.50 x 100 + [$46.30 – $45] x 100 = $180).

And any stock price above the $47 strike price makes you the target return of $250. The reason for this is because your option gets exercised at $47, you bought the 100 stocks at $45, and you have the $0.50 premium per stock you received from selling the call. Therefore, the equation becomes: 100 x $0.50 – 100 x [$47 – $45] = $250.

What is a covered call?

Concluding Remarks

Comparing the two different ways to play the covered call strategy, the ITM way will protect the investor more from losses as compared to OTM covered call strategy. On the other hand, the ITM strategy puts a ceiling on the upside potential of the position for the investor as compared to the OTM covered call strategy. Whichever strategy is selected by you, it will entirely depend on your expectations of the price movement of the underlying. If you expect an increase in the price, an OTM covered call strategy will be more suitable. Whereas, if you expect the price of the underlying to decrease or stay flat, an ITM strategy might be more appropriate. The decision also depends on your risk tolerance and what you wish to accomplish from your investing activities.