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Chapter 1. Steps To Explain Option Trading Further Explored

Protect Profit in a Call by Buying a Put

To further explain option trading, here's a tricky one but very useful. A man bought a 90-day Call at 50 (stock was selling at 50) for $350. In 60 days the stock rose to 70. At this price of 70 he has a 20-point profit, less the cost of his option, and he buys a 60-day Put at 70 for about $400. Let us see what happens. Say that in the 60-day life of his Put the stock declines again to 50. He has lost the profit that he had on his Call, but he has a 20-point profit on his Put, less 2 premiums totaling $750-a net gain of $1,250.

Or, say that in the remaining 30 days of his Call, the stock continues to rise and goes to 80. He then has a profit of $3,000 less the two premiums of $750, or a net profit of $2,250. This treatment can be varied by the purchase of two Puts instead of one.

The uses of options are limited only by ones ability and ingenuity.

Buying Stock and Call at the Same Time

Something to be watchful for when desiring to explain option trading, there is a theory among some traders that, if they are bullish enough on a stock to buy a Call, they should be bullish enough to buy stock at the same time with the idea that, if the stock advances to a point where the profit will pay the cost of the Call contract, they can sell the stock and have the Call for nothing.

A stock is selling at 50. and the man buys a Call at 50 on 100 shares for 90 days for $350. At the same time, he buys 100 shares in the market at 50 (which he must margin). If the stock advances to 55 in a few weeks and he sells his stock, he has made $500, less commission, which will about pay for the Call option. Now he has his Call option at 50 the stock is selling at 55 and the Call cost him nothing, with some time for the Call still to run. From here until the time the contract expires, he may trade to his heart's content above the Call price for he has his Call as protection. He may sell short at 60, cover at a lower price, then sell again and cover again as long as there is a profit. If the stock goes up after a short sale, he can always use his Call to cover his short sale.

Trading in Odd Lots Against a Call

While I explain option trading, I have to say that I don't approve of trading like this—I believe in going whole hog—but there are some who like to scale their orders to sell against an option which they hold. For instance, take a man who owns a Call option on 100 shares at 50, good for 90 days, for which he paid $350; his idea of trading is to sell 50 shares short at 60, and maybe 50 shares short at 65. Of course, he must deposit margin with his stockbroker to take such a position, and he may be able to trade back and forth before the expiration of the option and complete many trades. If, after selling 50 shares short at 60 and 50 shares short at 65, the market continues to rise to 70 or 75, he just exercises his option at expiration and his account will look like this:

  Bought Call 100 shares at 50        $ 350
  Bought 100 shares at 50 through Call....    5,000  $5,350
  Sold 50 shares at 60  $3,000
  Sold 50 shares at 65     3,250
  Total proceeds      $6,250
  Profit       $ 900

Explanation of Chart
Chrysler

As I explain option trading, take, for example, a man who bought 100 Chrysler on August 20, 1957, at 80. By November 20 (or in 90 days) he would have had a loss of $1,400, and in 6 months his loss would have been $3,000. Compare his position with that of a man who bought a 90-day Call contract on 100 Chrysler at 80 on August 20, at the market for $500. Let us suppose also that this last man bought a 6-month Call at 80 on August 20 for which he paid $750. Neither the 90-day Call nor the 6-month Call would have shown a profit. The man who bought the Call options was as wrong in his market judgment as the first man, and he lost the money that he paid for the Calls—but that money was the limit of his risk. Now, after Chrysler declined, the man who had bought the Calls instead of the stock and had drawn from the equity in his account only the cost of the Call contract, was in a position to buy the actual stock at a much lower price than when he first became bullish on it. Even though the purchase of the Calls was unprofitable, it saved him from buying the stock at the original high price.

As another example, suppose a man was bullish on Chrysler in the third week in July, 1958. The stock, according to the chart, sold at 46½. At that time he could have bought a 90-day Call contract at 46½ (the price at which it was selling) for $350. During the life of the Call the stock advanced, and in the third week in October, when his Call expired, the stock sold at 58. He could have exercised his Call at 46½ and at the same time sold the stock at 58, thereby making approximately 11½ points, less the cost of his option and commission for buying and selling the stock.

The records show also that 6-month-and-10-day Calls were bought on October 24, 1958, at 53½ for $600 per 100-share Call, when the stock was selling at that price. On May 4, 1959, when the Call expired, the stock was selling at 68, showing a profit of $1,450, less the cost of the Call and stock-exchange commissions for buying and selling the stock.

option trading strategies

Notice the profit against the cost of the option (notice the leverage) and the percentage gain; at no time was the risk greater than the cost of the option contract.

Suppose - while I finish this aspect of my attempt to explain option trading - that before the Call expires and after selling 50 shares short at 60 and 50 shares short at 65, the stock declines to 45. At this point it would be more advantageous to the trader to buy the stock in the market to cover his short-sale than to exercise his Call option. He buys 100 shares at 45 to cover his short-sale and allows his Call to lapse. His account then looks like this:

  Sold 50 shares at 65 $3,250  
  Sold 50 shares at 60 3,000  
  Bought Call at 50   $ 350
  Bought 100 shares at 45   4,500
    $6,250 $4,850
  Profit $1,400

 

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