Using Options to Limit Risk—But Not Gains

03/26/2009 12:59 pm EST

Focus: OPTIONS

Nick Atkeson

Partner, Delta Investment Management, LLC

Nick Atkeson and Andrew Houghton of ChangeWave Options Trader discuss a strategy that can give options buyers cash while they wait for big gains.

The strategy we've followed [recently] is selling out-of-the-money puts to pay for upside calls that we purchase. Buying call options and selling puts are both bullish strategies, but they have different risk-versus-reward setups, so we evaluate very carefully before deciding which strategy to use.

Essentially, the idea behind selling puts is to get paid to enter a trade—that is, we collect our premium at the moment we initiate the trade, and we wait for the option value to drop to (or near) zero. If the underlying stock, index, or Exchange Traded Fund trades up when we've got a bullish bet on the table, there are no limits on how much you can make.

With the price of options today, you get paid well to sell puts and, if you end up being "put" the stock (which is always a risk when selling puts to open), it should be at an attractive entry price.

Let's look at an example.

In February, we recommended you sell the Yahoo (Nasdaq: YHOO) March 2009 $10 Puts (YHQOB) for 16 cents and buy the YHOO March $16 Calls (YHQCQ) for 14 cents.
When you put this trade on, you received a small credit of two cents per contract.

Microsoft and YHOO have publicly discussed an interest in renewing talks about a partnership now that YHOO has a new chief executive officer. The last time these companies considered a partnership, YHOO was valued at $30 per share. If an announcement occurs before expiration that involves YHOO selling above $16 per share, your upside will be measured in the thousands of percent and your dollar gain will be substantial.

As it stands today, if you had executed ten contracts per each side of this trade, you would have collected $20 upfront and an additional $110 if you sold [recently].

The key point is you get paid to put the trade on and your potential upside has no limit.

We [recently] recommended closing the March 10-16 spread and recommended opening an April 11-17 spread in its place.

Specifically, we recommended you sell to open the YHOO April $11 Puts (YHQPK) for 32 cents or better and buy the YHOO April $17 Calls (YHQDR) for 22 cents or better to collect a net credit and leave yourself open to making big money profits if a deal is consummated.

This strategy helps us to buy more time for the trade to work out in our favor (by rolling "out" to a later expiration month) and gives us more leverage (by rolling "up" to a higher strike price). (Yahoo closed at around $13.50 Wednesday, its April $11 puts changed hands at 12 cents and its April $17 calls traded at 13 cents—Editor.)

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