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Chapter 1. Option Trading Strategies Uncovered

Closing Out a Contract for Partial Recovery

Looking at option trading strategies, the preceding example of a Call contract for speculation showed a handsome profit. Suppose that when a Call option at 50 was about to expire the stock was selling at 52. While the holder of the Call contract could not recover all of his premium of $350, he could, nevertheless, Call for his stock at 50 and sell it in the market at 52, so instead of losing the $350 premium, he would recover $200 of it.

His account would read:

  Bought Call XYZ at 50-cost  $ 350
  Bought 100 shares a/c Call 5,000
    $5,350
  Sold 100 shares in market 52 $5,200
  Loss $ 150

(For simplification Stock Exchange commissions have been omitted.)

Selling Stock and Buying a Call to Maintain a Position

Continuing to look at option trading strategies, a man is "long" 100 shares of XYZ now selling at 50. The stock is owned outright or is held on margin, but the man needs the money in his business. However, he does not like to lose his stock position. He might consider the following: He sells his stock at 50, releasing his funds, and at the same time buys a Call option at 50 good for 90 days at a cost of $350.00. If the stock advances, he exercises his Call and thereby re-acquires his stock. He may then sell the stock that he acquired through the Call and take his profit, or he may care to carry the stock at 50 which is now selling in the market at 60. If, on the other hand, the stock declines to 40, he lets the Call option expire and now he can, if it suits him, re-acquire at 40 the stock that he sold in the market at 50. Through the Call contract, he accomplished two things—he released the $5,000 that he had invested and also had control over the same number of shares for the duration of his option, and at the same price that he sold them.

The Use of a Call Contract for Trading Purposes

If one is an astute trader and the market offers the opportunities, Call options can be used quite profitably and at all times with a limited risk. This means that they should definitely be considered when looking at option trading stategies.

Suppose a trader bought a 90-day Call option at the current market price of 50, for which he paid $350, and that the contract was to expire on December 31. Let us also suppose that some time in October the stock rose to 55, at which point the trader sold short 100 shares. This short-sale—and it must be sold as "short" stock—must be margined with his stock-exchange broker, but at this point the trade is risk less. The trader has a 5-point profit less the cost of the Call at any time that he cares to exercise his option. But he doesn't care to exercise his option because it has about 2 months to run and the fluctuations in the market price of the stock in that 2-month period may give him additional opportunities to trade. Let us say that after having made the short-sale at 55, the market declines in another week or so to 50, where Mr. Trader sees fit to buy in or cover his short-sale. His account now looks like this:

  Sold 100 shares at 55 $5,500
  Bought 100 shares at 50 $5,000
  Cost of Call Option      350
  Total Cost....    $5,350
  Profit   $ 150

But the Call runs until December 31, and the trade which was made does not nullify the option. In another week or so, because of some news, the stock rallies to 56, where Mr. Trader again sees fit to sell short. Again he has a riskless, profitable transaction, and in a week or so the stock again declines to 50, at which point the short-sale is covered. On this trade another profit of $600 is added to the $150 already made.

  Sold 100 shares at 56  $5,600
  Bought 100 shares at 50 5,000
  Profit   $ 600

Past performances of many stocks show that such opportunities are far from rare and there have been instances of as many as twelve full trades made against a Call before its expiration. This is important when considering option trading strategies. Without owning the Call, Mr. Trader might have been fearful of making a short-sale but, knowing that he could always cover the short-sale at 50 through the terms of his Call contract, he does not hesitate to trade. Suppose, for argument's sake, that after having made the short-sale at 56, the stock advances to 70 and stays at about that price. The trader merely exercises his call, thereby covering at 50, through the terms of his contract, the short-sale that he made at 56. Without the Call option he would have a 14-point loss, and even though the short-sale would prove to be a bad trade, his guaranteed trade would show a profit. Just as a Call can be used to protect a trade for trading purpose, Call options can also be used to:

Protect a Short-Sale at Time of Commitment

Consider another of the available option trading strategies: a man feels that a stock now selling at 50 will decline and sells 100 shares short in the market. Not willing to risk an unlimited loss if the stock advances, he buys a Call option at 50, good for 90 days, for which he pays $350. He is now guaranteed through the terms of his Call that he can buy 100 shares at 50 at his option before the contract expires, so if he is wrong, his loss will be limited to the cost of his Call option.

Now let's look at the operation both ways: Let's see what happens if the man is right and the stock declines and if he is wrong and the stock goes up instead of down. If the stock should go down to 30, as the man expects, he covers his stock in the market at 30 and takes his 20-point profit. Naturally, he won't want to exercise his Call option to buy stock at 50 because he can buy it better in the market, so he allows his Call option to lapse. He:

  Sold 100 shares at 50    $5,000
  Bought 100 shares at 30     $3,000
  Bought Call at 50   350
      $3,350
  Profit        $1,650

One might say that he could have made the short-sale without having spent $350 for the protection. Certainly— but suppose that instead of the stock going down to 30, it had gone to 55, 60, 65, and then 70. What then? How far do you let your loss run? Well, some would say, why not sell the stock short and put a "stop loss" order in at 53½?

If the stock declined to 30, he would have saved the $350 and his profit would have been $2,000 instead of $1,650. That's fine, but suppose the stock rose to 54 first, stopped out the man's short-sale with a loss of $350 or $400, and then declined to 30. His original idea was correct—the stock did decline to 30—but the stop-loss order for protection was more costly than the Call option. If he had had the Call option, the rally to 54 would not have worried him because he would have been guaranteed through his contract that he could cover at 50, but the stop-loss order caused him a quick and definite loss. This must be anticipated when dealing with this choice of option trading stategies.

The Use of a Call Option to Average

Those who remember the market decline in late 1957 and the middle of 1962 recall that people who had bought stocks at high prices before the decline did not have much desire for or even spare funds, for that matter, to try to average their costs by buying additional shares. This choice of option trading strategies will now be considered. If a man had bought a stock at 40 and found it selling at 20 a few months later (many stocks did that), he didn't have much incentive to buy additional shares. Had he known the technique of averaging through the purchase of Call options, he might have done well.

Suppose that, after the fall from 40 to 20, the man inquired and learned that he could buy Call options at 20 good for 90 days for $225 per 100-share Call. Now it doesn't take as much nerve—or as much money—to buy a Call for $225 as it would to buy another hundred shares of stock for $2,000. If Mr. Trader (or call him Mr. Investor) had bought such a Call at 20, and before the expiration the stock had advanced to 35, and at that point he sold both the stock that had cost him 40 and the stock that had cost him 20, which he had on Call, his account would look like this:

  Bought 100 shares at 40      $4,000
  Bought Call 100 shares at 20     225
  Bought 100 shares at 20 a/c Call          2,000
    $6,225
  Sold 200 shares at 35  $7,000
  Profit  $ 775

On the other hand—and we like to look at both sides-had he not bought the Call, a rise of 35 in the stock would have left him with a 5-point loss on his original stock. Instead, by the additional risk of $225, the rise to 35 gave him the opportunity to come out with a profit.

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