Boot Camp #3
The Option Pit Method
Stock and Options
Outline
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Why options exist
Basic Option Terminology and P&L
Calls, Puts, Stocks and their relationships
Putting options together
Create the synthetic relationships through risk
and P/L charts
• Use of Options and Stock together for directional
trading
• Use of options to replace stocks
• The Wheel
The Option
• If I were to describe options in 1 word, what
word would I use?
– Insurance
• Calls insure against the loss of dollars in a long
position
• Puts insure against the loss of dollars in a
short position
Long Stock vs Call
Short Stock vs Puts
Stocks, Calls, And Puts
• One thing that is important about options is
that they can be used to recreate the
underlying
• Additionally, with the use of the underlying
calls or puts can convert to one and other
• Here is how
Relating an option to the Stock
• Why combine calls and puts together with stock?
Simple Put/Call Parity
Call – Put = Stock – Strike + Carrying cost
or
C – P = S – X + (I –D)
• This Formula is like the duct tape: it holds the
whole option world together
Making a Long Call
• How do you make a synthetic call?
– For a long call, add together 1 long put and long
100 shares of stock.
– C-P = S - X => C= P + S -X
• Price it in the market:
– OPT is trading $21
– The OPT Nov 20 put is trading for $1
Adding Risk Graphs Together
The risk on the downside is fixed leaving
the long stock and long put on the upside.
Making a Short Call
• How do you make a synthetic short call?
– For a short call, add together 1 short put and short
100 shares of stock.
– C - P = S - X => -C = -P - S + X
• Price it in the market:
– OPT is trading $21
– The OPT Nov 20 put is trading for $1
Adding Risk Graphs Together
Short Calls
The profit on the downside is fixed leaving risk
of the short stock and short put on the upside.
Making a Long Put
• How do you make a synthetic put?
– For a long put, add together 1 long call and short
100 shares of stock for a synthetic put
• C – P = S – X => P = C – S + X
• Price it in the market:
– OPT is trading $21
– The OPT Nov 20 call is trading for $2
Adding Risk Graphs Together
The risk on the upside cancels out leaving
the short stock to control the downside.
Making a Short Put
• How do you make a synthetic short put?
– For a short put, add together 1 short call and long
100 shares of stock for a synthetic put
• C – P = S - X => -P= -C + S – X => P=C-S+X
• Price it in the market:
– OPT is trading $21
– The OPT Nov 20 call is trading for $2
Adding Risk Graphs Together:
Short Puts
The risk is on the downside with the upside
canceling out the long stock and short call.
Making Long Stock with a Call and Put
• How do you make synthetic stock?
– For a 100 shares of long synthetic stock add
together 1 long call and 1 short put.
– C-P = S - X
• Price it in the market:
– OPT is trading $21
– The OPT Nov 20 call is trading for $2
– The OPT Nov 20 put is trading for $1
Long Call and Short Put
Synthetic Short Stock
Note the Long Call and Short Put converge on the breakeven of stock
where the short put controls the downside and the long call the upside
Making Short Stock with a Call and Put
• How do you make synthetic stock?
– For a 100 shares of short synthetic stock add
together 1 short call and 1 long put.
– C-P = S => -C+P = -S
• Price it in the market:
– OPT is trading $21
– The OPT Nov 20 call is trading for $2
– The OPT Nov 20 put is trading for $1
Short call and Long Put
Synthetic Short Stock
Note the Short Call and Long Put converge on the breakeven of stock
where the long put controls the downside and the short call the upside.
Quick Review
• LONGS:
– Long Stock+Long Put=Long Call
– Long Call+Short Stock=Long Put
– Long Call+Short Put=Long Stock
• Shorts
– Short Put+Short Stock=Short Call
– Short Call+Long Stock=Short Put
– Short Call+Long Put=Short Stock
Insurance
• Do insurance policies last forever?
• If I cancel a policy to I get all of my money
back?
• Options, like all insurance decay in value over
time (this is sometimes called theta)
Decay and a Long Call
Premium Selling
This is a chart of option premium time decay:
30 Days
vs. 8 Days
Stock and Options
• There are several ways to use stock and
options together
• The 1st and most common is the covered call
• The 2nd most common is the short put for
income
• The way I would like to see traders trade is the
wheel trade
Making a Covered Call
• A covered call starts with a long stock position,
in this case we can use MMM for 97.29
Selling A Call
• When we sell a call, we get to collect ‘time
premium’. We sell a call at 1.63
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Combined
• By owning a stock and then selling a call the
combination creates a graph that looks like
this: Notice our break even is now below $95.66
What is the Net of the Trade
• We collected premium on the trade, which
lowers our cost basis on our stock
• We limited our upside, because if the stock
moves above our call’s strike price, our stock
will be ‘called away’
• It’s like taking the points on a football game
rather than playing the money line
• Our Break even is now 95.66, but the most we
can make on the stock/call combo is 99.13
The Low Down
• What is the yield of the trade on a takeout?
– Stock price is $97.29
– Strike price is 97.5
– Option price is $1.63
Total Return= (Strike + Option Price – Stock Price)/ Stock Price
(97.5 + 1.63 – 97.29)/97.29
Total Return $1.84 or 1.8%
My minimum is 1% per month on short puts, full margin.
Mechanics
• A covered call can be done with an existing
stock position, simply pick a call you want to
sell against stock you might own
• It can also be done as a package in a trade
called a buy-write
– The trader buys stock
– Sells a call
– As a package
• A buy-write can become a covered call trade
Management Mechanics
• If you do not get the stock called away, buy
the call back and sell another expiration
• If you can buy the call back for .05 or less, buy
it back and sell another expiration
• If the stock runs through the call
– let the stock get called away
– take a day or two
– THEN decide to enter the trade again
The Perfect Covered Call
• In a perfect world:
– The underlying stock would ‘creep’ higher every
month, but would not sky rocket higher
– The trader would be able to consistently sell calls
at a higher and higher strike price
• This helps build yield in the trade
– The stock is never ‘called away’
– The stock pays a dividend, further increasing yield
Short Put
• A short put is kind of like selling a slightly in
the money covered call every month
• The trader never really owns the stock,
because his calls are in the money
– If there is a dividend the stock will get called away,
but the trader would keep the premium
Short Put
The Low Down
• A trader sells a put a Sep 185 put at 2.51
• If the stock settles above 185, I keep all of the
premium
• I keep some of the premium if the underlying
settles less than 2.51 below 185 dollars
– My break even is 182.49
Mechanics
• A short put should be sold in a stock that one
wants to own
• The strike selection and premium selected
should be at a level that the trader would be
willing to take delivery even if its less than
that net price
• It is important to keep track of the total net
premium collected on each put sale. This is
the true underlying price if deliver is taken
Premium
• I have 6 sales in IBM
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Apr collected 2.20
May collected 2.15
June collected 1.55
July collected 1.85
Aug collected 2.50
• With If I took delivery on my Sep 185 put sale
at 2.51, what is my NET ownership price
– 185-12.76=172.24
– Not bad if the underlying is 180 (terrible if its 140)
The Perfect Short Put
• In a perfect world:
– The underlying stock would ‘creep’ higher every
month, but would not sky rocket higher
– The trader would be able to consistently sell puts
at a higher and higher strike price
• This helps build yield in the trade
– The stock is never ‘delivered’
– The stock pays a no dividend or the div is reduced
The Wheel
• Now that we have seen covered calls and
short puts, lets discuss the wheel trade
• The wheel is a combo of short puts in order to
take delivery on a stock
• Then a sale of covered calls to get out of a
stock
• Hopefully there is a collectible dividend too
Mechanics
• Sell a put in FB
• Can be done weekly or monthly
• Weekly is more active, will create income
– More flexible on strike selection
– More Dynamic
• Monthly is easier, collects a larger ‘bulk’
premium
– But less overall in a stable stock
Wheel
• If the trader takes delivery, the trader then
sells calls till the stock gets called away
• Hopefully there is a dividend and the trader
can collect that while he or she sells covered
calls
• Trader should ensure that he or she does not
get ‘called away’ at a loss
Keys
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Keep track of all premium collected
Wait for a dip before starting
Make sure one knows the net ownership price
Hopefully take delivery at a low in the stock
– When a stock is below the strike it MIGHT make sense
to buy the stock
• Do not sell calls at levels where the trader will
lose
– Might sell call spreads instead to insure ‘reentry’
• Hopefully sell at the top
Perfect Wheel
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Low Vol Stock
Delivery on the bottom
Slow rally back
Sells the top
PUT/BXY Study
• Russell Rhoads of CBOE and I have conducted
several studies involving the BXY and the Put
Write index
• Our most recent study that has not been
released (till tomorrow) involved a wheel
trade in SPX
The Study
• We began by selling an ATM Put in SPX
• We continue to sell a put until the SPX Total
Return index goes negative on the month
• We then ‘take delivery’ and then begin to run
BXY
• When SPXTR increases more than 2% in a
month switch back to PUT WRITE
• Done over and over again over 25 years
Results
• Unlevered the system trade delivered
• 10.49% return (300 BP better than the SPX TR)
• STD of 12.44% (25% less than the volatility of
the SPX TR)
The Retail Trade
• In an IRA, Roth IRA or 401-k, it might make sense
to do this using SPY:
– as a broad market exposure replacement
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Sell ATM SPY puts until they go into the money
Then take delivery
Begin selling 2% OTM Calls against stock on hand
Outside of an IRA the use of Futures and SPX
Options probably makes the most sense for
potential tax purposes (consult your accountant).
Equity Wheel Candidates
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XOM
GE
CSX
ORCL
AAPL
MSFT
F
Review
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Calls and Puts are insurance contracts
Put-Call Parity is super important
Covered Calls an Short Puts are pretty similar
The wheel enhances both
Boot Camp 3 Quiz
• Describe the components of a synthetic long
call.
• What is the Wheel Trade?
• Is Time Decay a factor in a buy write? If the
answer is yes, why?
• Describe the components of a synthetic short
put.