Options Strategies for a Volatile Market (Part 4)

09/26/2008 12:00 am EST

Focus: OPTIONS

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

Short Calls

Like the short put example we worked through in the last section, shorting or selling a call has similar advantages and risks. In addition to the benefit of melting time value, a short option position is flexible. This flexibility allows you to place the call’s strike price and your trade’s break even points above resistance levels you might see in your technical analysis. This can increase the probability of a successful trade outcome.

Selling a call is a bearish trade because you are selling the call first, for a high price, and hoping to buy it back later for a cheaper price (or let it expire worthless) when the underlying stock drops.

You should note that most traders feel that selling calls is a higher risk strategy than selling puts. Most stocks and market indexes have a long-term tendency to trend up. That makes most bearish trades less likely to end profitably. This increases the importance of evaluating trends and finding the weakest stocks to trade.

In the chart below, you can see Merrill Lynch & Co (MER) in a significant downtrend. That is exactly the kind of trend you want to see as a call seller. Assume that you decided to sell the first out of the money call at the $40 strike for a premium of $220. As long as the stock’s price stays below the strike price, you will get to keep the entire premium, or the maximum profit of $220 per contract.

Pizz Chart

A closer look at this trade can help you visualize what I mean when I say that selling options gives you some flexibility. With a long stock or options position, prices have to move in your favor to experience a profit. Conversely, a short options position does not have to move at all to create a profit because you are collecting a premium.

In the example above, as long as the stock does not rise above $40 a share, you keep the entire premium; but, you have even further to go before experiencing a loss. In fact, the stock’s price will have to rise $2.20 a share above the strike price to $42.20 before you start to experience a loss at expiration.

Adding the option premium to the strike price gives you your break even when you sell a call. Similarly, subtracting the option premium from the strike price will give you your break even for a short put. Let’s look at two of the possible outcomes for this trade.

Possible outcome #1: Stock falls to $35 a share at expiration

1. Call expires out of the money and worthless. No action is necessary and you keep the entire premium of $220 per contract.
2. ROI: 5% (Assuming you kept a cash balance equal to the entire exercise price of $4,000)

Possible outcome #2: Stock rises to $42

1. Call is repurchased for $200 at expiration to avoid exercise. You will still have kept $20 of the original premium.
2. ROI: .5%

You should run through some scenarios on your favorite bearish stocks to see how a short call gives you the ability to profit if the market falls, remains flat, or even rises.

By John Jagerson, of PFXGlobal.com and LearningMarkets.com.

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