GDP Growth, Inflation, and the Yield Curve

Current information about the most important variables effecting the stock market. The article discusses GDP Growth, Inflation and the Yield Curve environment and how these variables are effecting the TSX stock market, the Canadian US dollar exchange rate, and bond yields.

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GDP Growth, Inflation, and the Yield Curve

GDP Growth: Statistics Canada reported a rise of 2.8% in GDP annualized over 2006. The latest report available indicates an increase in GDP of 0.3% in May, 2007 after remaining nearly unchanged through April. Strong increases in retail and wholesale trade were present while a drop in oil and gas exploration constrained overall growth. GDP Growth is expected to remain strong through 2007 at an estimated 2.6% and subsequent 2.7 % in 2008.

Higher interest rates combined with an ease in housing starts and slowing profit growth will slow economic growth; however, a number of external factors, mainly a resurgence of the US economy, will keep the overall growth in the Canadian economy near 2.6% in 2007.

As a result of the anticipated growth remaining strong but constrained, the Bank of Canada is likely to hold off on interest rate hikes in the near term. As interest rates remain stable so too will consumption of capital investments as no higher rates will force consumers out of the market and no lower rates will attract new consumers. This policy will continue unless inflation increases, which would result in an increase in interest rates from the Bank of Canada to decrease consumption, or inflation decreases, which would result in a decrease in interest rates to revitalize consumption. Further, as a result of the continued moderate growth in GDP the yield curve has remained stable with a positive long term trend, the stock market although experiencing volatility has held gains through the year and the Canadian dollar has strengthened substantial against the green back and other major currencies throughout the year..

Inflation: Statistics Canada reported in July, 2007 a rise of 2.2% year over year in total CPI, which was identical to increases over the past 3 months. The Cost associated with owned accommodation was attributed for the fourth straight month to represent the most significant portion of the CPI rise. These price increases were offset by falling prices for gasoline, computer equipment and supplies, and natural gas.

Rising inflation due to a world wide economic expansion has caused many Nations to raise rates over the past few quarters in an attempt to ease inflation concerns. With the latest data placing inflation within the Bank of Canada’s target rate of between 1% and 3%, the case for a pause in interest rate policy remains strong. However, caution should be taken as a result of the latest interest rate movement in the US, a half percentage point decrease.

A pause in interest rates generally will not fane or dampen GDP growth and yield curves will remain stable. However, the market will normally predict a rate cut or increase before it is implemented by the Bank.

If the Bank of Canada decides GDP growth will decelerate too much without action, they will decrease interest rates at their September press release and many effects will ensue: the yield curve would steepen in a positive direction, increased consumer spending, yields on fixed income investments become less attractive than stock market gains, debt service costs decline, new equity becomes easier to place, equities rise on justified higher price/earning multiples, the expansion of the economy increases pace, unemployment falls, while inflation would likely increase pace.

Yield Curve: Long term yields on Government of Canada benchmark bonds have decreased recently as a result of market concerns of a pending rate cut in the future. As of August 22, 2007 the current yield was 4.49%. Yields on 3 month Treasury bills have also recently decreased but at a faster rate to 4.01% as of 21 August, 2007. This amounts to spread of 0.48% and implies a normal sloped yield curve that has recently steepened. This positive slope reflects investors expectations for GDP and inflation to grown in the future.

The TSX has experienced substantial gains over the past year while volatility has also been substantial. Under the current yield curve conditions the stock market still remains more attractive to investors than fixed income instruments and the outlook for the Canadian dollar is for further strengthening against the US dollar over the coming years.

Top 10 Option Investment Strategies

Top 10 Option Investment Strategies:

Neutral to Bullish Strategies

1) Long Call: Simply buy a call option on a stock. This provides unlimited upside potential and caps the associated risk at the amount paid for the stock option. For Example, say you have $1600 and think Google (GOOG) will increase in value: say it is currently trading at $500 a share but you only have enough money to buy 3 shares. Instead of buying the shares you decide to buy call options on Google (GOOG). Let’s say you want to be conservative and only buy options trading write at the money (strike of $500). Now you just need to choose the expiration month (do you think the stock will increase in value soon or will it take a while?) Say you believe Google (GOOG) will increase in value within 1 month. You buy September 500 Calls for $16 (you have $1000 so you can afford 1 contract (sold in 100 board lots). As long as Google (GOOG) Trades at $516 at expiration in September you have made a profit.

Say GOOG is trading at $550 at expiration of the call options:

If you had bough 3 shares your profit would be ($550-500)*3 = $150.

If you bought the Call Options your profit would be {(550-500)-16}*100 = $3400.

2) Put Writing (Short Put): Simply sell put options on a stock. This provides you with the option premium while your maximum risk is strike price of the option minus the premium received. Your max risk scenario would only occur if the price of the stock went to $0. For this strategy an investor will normally have a neutral to bullish market forecast. Say you are interested in Apple (AAPL) and think it will appreciate in value or remain the same. You can sell Puts on Apple (AAPL) and received the option premium in exchange for the risk that the stock may decrease in value up to the expiration of the stock options you sell. Say Apple (AAPL) is trading at $120. To be conservative you write put options with a strike price at the money ($120) for $6 each and an expiry in 1 month. Say you only write 1 contract, you will receive $600. While you are waiting for the option to expire you can invest that $600 elsewhere say in Google. At expiry, as long as the Apple (AAPL) is trading above (120 – 6 = $114) you have made a profit.

3) Married Put: This strategy is implemented by buying the stock and buying a put on the stock. This provides you with protection against a price decline while you can still participate in all upside in the stock price. The risk/reward profile is very similar to the Long Call; that’s why this strategy is also referred to as a ‘synthetic call.’ Lets go with Starbucks (SBUX). You buy 100 shares at $25 a piece for $2500 and want to protect yourself against a decline in Starbuck’s (SBUX) stock price so you buy puts right at the money because you are being very conservative. Say you only want to protect your stock from a decline for 1 month. You buy puts with a strike of $25 1 month to expiration for say $1. Now, the most money you can loose over the month is the $1 you paid for the put while you still can participate in any upside so as long as the Starbucks (SBUX) is trading above $26 at expiration you have made a profit.

Neutral to Bearish Strategies

4) Long Put: Simply buy Put Options on a stock. This strategy is implemented when an investor has a bearish forecast for a stock. Say you think Google (GOOG) will decrease in price over the next month. Instead of shorting Google (GOOG) you decide to buy put options on Google (GOOG) because you don’t want to put so much money at risk. Say Google (GOOG) is trading at $500. If you were to short the stock you need to be able to cover you position. Say you have $1500, you would be able to cover shorting 3 shares. If you buy puts and are conservative you could write at the money $500 puts for one month out for say $15. You could afford 1 contract (100 shares). If you had just shorted the stock you would profit as long as the stock declines in value, but you have unlimited up side risk. With the put options on google (GOOG) your risk is limited to you initial investment while your rewards could be substantial.

Say Google (GOOG) in one month is now trading at $450:

If you shorted the stock your profit would be ($500 - $450) * 3 = $150

If you purchased the puts your profit would be ($500 + $15 - $450) * 100 = $6500

5) Call Writing: Simply Write (Sell) call options on a stock. This provides you with the option premium while your maximum risk is infinite (the stock can potential increase to infinity, ha). For this strategy an investor will normally have a neutral to bearish market forecast. Say you are interested in Apple (AAPL) and think that it will depreciate in value over the next month or remain the same. You can sell Call options on Apple (AAPL) and receive the option premium in exchange for the risk that the stock may increase in value over the month. Say Apple (AAPL) is trading at $120 and you are going to be conservative and write put options with a strike price at the money ($120). You receive $5 in premium. As long as the price of Apple (AAPL) is less than (120 + 5 = $125) at expiration, you have made a profit.

6) Protected Short Sale: This strategy is implemented by shorting the stock and buying a call option on the stock. This provides you with protection against an increase in the price of the stock while you can still participate in the decline in the stocks price. The risk/reward profile is very similar to the Long Put; that’s why it is also know as a ‘synthetic Put.’ Let’s go with Starbucks (SBUX) again. You can short 100 shares at $25 a piece for $2500 and want to protect yourself against a rise in the stocks price so you buy calls on Starbucks (SBUX) right at the money because you are conservative. Say you only want to protect your stock from a decline for 1 month. You buy calls on Starbucks (SBUX) with a strike of $25 and 1 month to expiration for $1. Now, the most you can loose over the month is the $1 you paid for the put while can still participate in any decrease in the stock price. As long as Starbucks (SBUX) is trading for less than $24 at expiration you have made a profit.

Neutral Option Strategies:

7) Short Straddle: This strategy is implemented by simultaneously writing a put and a call option on the same stock with the same strike price and the same expiration date. This way, as long as the stock price remains somewhat stable you will profit. For example, say Google (GOOG) is trading at $500 and you think it will remain near that price over the next month: sell google (GOOG) $500 Calls for $16 and sell google (GOOG) $500 Puts for $15, both with expirations of about 1 month. As long as the price of Google (GOOG) at expiration in one month is trading above ($500 – (15 + 16) = $469) and below ($500 + (15 + 16) = $531) you have made a profit.

8) Short Combination (Short Strangle): This strategy is similar to the Short Straddle as you write a call and a put option; however, the difference is that with a short combination you use different strike prices. This way you can increase your window of profit opportunity just incase there is a price move. For example, say Apple (AAPL) is trading at $120/share and you think the price will remain somewhat stable over the next month but are a bit more causes than the Short Straddle Investor: sell Apple (AAPL) $130 Calls for $2 and sell Apple 110 (AAPL) Puts for $3; both with one month to expiration. As long as the Apple Shares remain above (110 – 3 – 2 = $105) and below (130 + 3 + 2 = $135) you have made a profit. This way you will receive less option premium but are more likely to make a profit.

9) Long Straddle: This strategy is the opposite of the Short Straddle; an investor will simultaneously buy a call option and a put option on the same stock with the same strike price and same expiration date. Investors use this strategy when they think a large price more will occur in a stock but are unsure of which direction the stock will move. This strategy can work well when a major anticipated decision is about to be made for the stock: buy-back program, law suite, new technology, earnings reports, presidential election. For example, say the United States Presidential Election will occur in the next month and you want to find a way to profit. Some stocks will move depending on which candidate wins and you decide to focus on Starbucks (SBUX). Say one candidate wants to increase taxes on milk and the other wants to decrease them. You know this will effect Starbucks (SBUX) bottom line so you decide to implement a long straddle because you are not sure which candidate will win. You buy calls and puts with the same strike price on Starbucks (SBUX) and same expiration month. When the decision is announce the stock will most likely move dramatically in one direction. As long as the stock moves in one direction more than the amount that you paid in option premium you will profit.

10) Time Spreads (Calendar Spreads): This strategy is implemented by buying and writing an equal number puts or calls on the same stock with different expiration dates but the same strike prices. Normally time spreads have a neutral basis but they can also be designed for a bullish or bearish basis. For example, sell $500 Calls on Google (GOOG) with 1 month to expiration and buy $500 Calls on Google (GOOG) with 6 months to expiration. You can make a profit if the Calls with a shorter time to expiration erode in value faster than the longer term calls. This tends to work as the time value component of an options value usually erodes faster the shorter the term to expiration. However, you need to consider other aspects of the options price like volatility.

Neutral Market Stock Option Strategies

Neutral Market Option Strategies

There are 5 common Neutral Market Option Strategies implemented by investors: Short Straddle, Short Combination, Long Straddle, Long Combination, and Time Spread.

1) Short Straddle: This strategy is implemented by simultaneously writing a put and a call option on the same stock with the same strike price and the same expiration date.

When to use a Short Straddle:

• An investor feels the stock will remain at or very near to the strike price

• An investor is willing to accept a large amount of risk in exchange for the stock option premium received.

For example: write the XYZ June 30 Put and also write the XYZ June 30 call.

2) Short Combination (Short Strangle): This strategy is similar to the Short Straddle as you write a call and a put option; however, the difference is that with a short combination you use different strike prices.

When to use a Short Combination:

• An investor feels a stock will remain between the two strike prices

• An investor is willing to accept a larger risk in exchange for the option premiums received.
For example: write XYZ June 20 Puts and Write XYZ June 30 Calls.


3) Long Straddle: This strategy is the opposite of the Short Straddle; an investor will simultaneously buy a call option and a put option on the same stock with the same strike price and same expiration date.

When to use a Short Combination:

• An investor feels a stock will experience a large price move but is not sure in which direction it will occur.

For example: Buy XYZ June 30 Puts and buy XYZ June 30 Calls.

4) Long Combination (Long Strangle): This strategy is similar to the Long Straddle as it involves buying a put option and a call option on the same stock; however, you use different strike prices.

When to use a Long Combination:

• An investor feels a stock will make a large price move but is unsure of the direction.
For example: buy XYZ June 20 Puts and buy XYZ June 30 Calls.

5) Time Spreads (Calendar Spreads): This strategy is implemented by buying and writing an equal number puts or calls on the same stock with different expiration dates but the same strike prices. Normally time spreads have a neutral basis but they can also be designed for a bullish or bearish basis.

When to use a Short Combination:

• An investor feels the stock will remain around the strike price.
For example, the investor writes a near term option with a strike price near the stocks current market price and buy’s a long term option and hopes the time value of the near term option will erode in value faster than that of the long term option.

Neutral Option Strategies Chart

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Option Strategy	Market Volatility Forecast	Maximum Reward	Maximum Risk	Break Even Price
Short Straddle	Declining	Premiums Received	Infinite	Strike Price +/- Premiums Received
Short Combination (Call Strike > Put Strike)	Declining	Premiums Received	Infinite	1. Call Strike Price + Premiums Received, 2. Put Strike Price – Premiums Received
Short Combination (Call Strike < Put Strike)	Declining	Premiums Received – (put strike price – call strike price)	Infinite	1. Call Strike Price + Premiums Received, 2. Put Strike Price – Premiums Received
Long Straddle	Increasing	Infinite	Premiums Paid	Strike Price +/- Premiums Paid
Long Combination (Call Strike>Put Strike)	Increasing	Infinite	Premiums Paid	1. Call Strike Price + Premiums Paid, 2. Put Strike Price – Premiums Paid
Long Combination (Call Strike < Put Strike)	Increasing	Infinite	Premiums Paid – (Put Strike Price – Call Strike Price)	1. Call Strike Price + Premiums Paid, 2. Put Strike Price – Premiums Paid
Time Spread	Declining	Market Price of Long Option – Net Premium Paid

Bearish Option Strategies

Bearish Option Strategies

There are 6 common Bearish Option Strategies implemented by investors: Long Put, Protected Short Sale, Covered Put Sale, Short Call, Bear Put Spread, and Bear Call Spread.

1) Long Put: This strategy is implemented by simply buying a put option on a stock that an investor feels will decline in value. The Long Put is a popular strategy because of its simplicity and is used by investors who want a leveraged and limited risk method to participating in an expected decline in a stocks price.

The success of this strategy will depend on 3 conditions:


· Picking a stock that will decrease in price


· Picking an expiration month with a long enough duration for the stock price decrease to occur.


· Picking a strike price that will maximize the profit earned when the stock price decreases.

How to select an Expiration Month


Buy a near-term Put Option: The advantage is Leverage with fewer dollars at risk; however, the option will experience rapid time decay.


Buy a long-term Put Option: The advantage is getting more time for the stock to decrease in price; however, there is more money at risk since you must pay a higher premium for Options with longer durations to expiration.

How to select a Strike Price


Buy out of the money put options: This affords lower cost and more leverage; however, a larger move in the stock price will be required to exercise.
Buy in the money put options: This provides a better chance of making a profit but more dollars will be at risk since you must pay a greater premium.

2) Protected Short Sale: This strategy is implemented by purchasing a call option on a stock while shorting the stock. If a stocks price rises above the strike price of the call option the investor will exercise the right to buy the stock. In essence, the call acts as insurance against an increase in the price of the stock. Further, this strategy is often referred to as a “synthetic put” as it has a similar risk/reward payoff as buying a put option.

When is it used?

This strategy is used when an investor is bearish on an underlying stock but concerned about near term price risk. Usually this strategy is used when an investor has profited from a decrease in the value of a stock and wants to lock in their profit.

How Do You Choose a Strike Price?

Normally, the investor will choose an out of the money option. The closer the call options strike price to the current market price of the stock the greater the level of protection against a price increase, but the greater protection comes at a higher cost.

3) Covered Put Sale: This strategy is implemented by short selling a stock and writing (selling) an equivalent number of put options on that stock. Writing the put options obligates the investor to buy the stock from the option buyer if the stock price decreases below the strike price and the option buyer decides to exercise the option. Essentially, the covered put writer is foregoing the right to participate in the depreciation of the stock below the strike price in exchange for receiving the put option premium.

When is it used?

The Covered Put Sale is used by investors for 2 reasons:


a. The investor feels there is limited downside potential for the stock and as a result is willing to forego decreases in the stock price below the options strike price in exchange for receiving the options premium.


b. The investor wants some limited upside protection from shorting the stock which comes from receiving the put premium. The net cost of short selling the stock is lowered by the put premium amount received.

How do you choose the Strike Price?

The more bearish the investor is the further out of the money the put should be. By writing a deep out of the money put option the investor is able to participate in a larger decrease in the stock’s value; however, a further out of the money put option will provide a smaller amount of option premium.

4) Call Writing: This strategy is implemented by simply selling call options on a stock. The investor implementing this strategy will be expecting the underlying stock chosen to stay at or decrease below the strike price. Fundamentally, the call writer will profit when the stock price remains at or below the strike price as the call will expire worthless while the investor keeps the premium.

When is it used?

Call option writing is used by investors to generate additional income.

How do you choose the Strike Price?

Choosing a strike price will depend on the investors market forecast:


a. If the investor is bearish, writing call options at the money or in the money would be best as there will be more option premium offered for writing the call options.


b. If the investor is neutral to slightly bearish, writing an out of the money call option would be best as it is less risky. These will contain less option premium for writing the options but it is much less risky because the stock price will have to increase considerable for the option to be exercisable.

5) Bear Put Spread: This strategy is used when an investor is moderately bearish on a stock (the bearish equivalent of the Bull Call Spread). The Bear Call Spread is implemented by buying a put option while simultaneously writing a put option with a lower strike price. The options will be identical except for the strike price (use same expiration, same stock).

When is it used?

Bear Put Spreads are used when:


a. An investor feels a stock will decrease only slightly and is willing to forgo any depreciation in the stock below the strike price of the written put in exchange for the premium received for writing the lower strike price put.


b. An investor wants some limited upside protection from purchasing the higher strike price put option. This protection comes from the premium gained by writing the lower strike price put, which lowers the net cost of purchasing the higher strike price put option.

How to choose the Strike Price?

The strike prices used will depend on how bearish an investor is. The greater the bearishness of an investors forecast, the further out of the money and further apart the strike prices should be. When an investor is less bearish the strike prices used should be closer to the current market price of the stock and the strike prices should be closer together.

6) Bear Call Spread: This strategy is implemented by writing a call option while simultaneously buying a call option with a lower strike price. The options used will be identical except for the strike price (use same expiration, same stock).

When is it used?

Bear Call Spreads are used when:


a. An investor feels there is some limited downside for a stock but is not as confident as an outright call writer and as a result buys the higher strike price call to cap upside risk.


b. An investor wants additional income.

How to choose the Strike Price?

The strike prices used will depend on how bearish an investor is. The greater the bearishness of an investors forecast, the deeper in the money and further apart the strike prices should be. When an investor is less bearish, the strike prices used should be closer to the current market price of the stock and the strikes should be closer together.

Bearish Option Strategies Chart

Option Strategy	Market Forecast	Maximum Reward	Maximum Risk	Break Even Price
Long Put	Outright Bear	Strike Price – Premium Paid	Premium Paid	Strike Price – Premium Paid
Protected Short Sale	Outright Bear with near term concerns	Stock Price Received – Premium Paid	Premium Paid + (Strike Price – Stock Price Received)	Stock Price Received – Premium Paid
Covered Put Sale	Neutral to Bearish	Premium Received + (Stock Price Received – Strike Price)	Infinite	Stock Price Received + Premium Received
Short Call	Neutral to Bearish	Premium Received	Infinite	Strike Price + Premium Received
Bear Put Spread	Moderately Bearish	(Strike Price of L. Put – Strike Price of S. Put) – Net Premium Paid	Net Premium Paid	Strike Price of Long Put – Net Premium Paid
Bear Call Spread	Neutral to slightly Bearish	Net Premium Received	(Strike Price of L. Call – Strike Price of S. Call) – Net Premium Received	Strike Price of Short Call + Net Premium Received

Bullish Option Strategies

Bullish Option Strategies

There are 6 common Bullish Option Strategies implemented by investors: Long Call, Married Put, Covered Call, Short Put, Bull Call Spread, and Bull Put Spread.

1) Long Call: This strategy is implemented by simply buying a call option on a stock that an investor feels will appreciated in value. The Long Call is a popular strategy because of its simplicity and it is used for two main reasons:

a. The investor wants a leveraged and limited risk method to participate in an anticipated increase in a stocks price.

b. The investor wants to lock in a price for a stock they anticipate buying at a future date.

The success of this strategy will depend on 3 conditions:

· Picking a stock that will increase in price
· Picking an expiration month with a long enough duration for the stock price increase to occur.
· Picking a strike price that will maximize the profit earned when the stock price increases.

How to select an Expiration Month

Buy a near-term Call Option: The advantage is Leverage with fewer dollars at risk; however, the option will experience rapid time decay.

Buy a long-term Call Option: The advantage is getting more time for the stock to increase in price; however, there is more money at risk since you must pay a higher premium for Options with longer durations to expiration.

How to select a Strike Price

Buy out of the money call options: This affords lower cost and more leverage; however, a larger move in the stock price will be required to exercise.

Buy in the money call options: This provides a better change of making a profit but more dollars will be at risk since you must pay a greater premium.

2) Married Put: This strategy is implemented by purchasing a put on a stock while owning the stock. If a stocks price declines under the strike price of the put the investor will exercise the right to sell the stock. In essence, the put acts as insurance against a decline the price of the stock. Further, this strategy is often referred to as a “synthetic call” as it has a similar risk/reward payoff as buying a call option.

When is it used?

This strategy is used when an investor is bullish on an underlying stock but concerned about near term price risk. Usually this strategy is used when a stock has appreciated in value and the investor wants to lock in their profit.

How Do You Choose a Strike Price?

Normally, the investor will choose an out of the money option. The closer the put options strike price to the current market price of the stock the greater the level of protection against a price decline, but the greater protection generally comes at a higher cost.

3) Covered Call (or Covered Write): This strategy is implemented by purchasing a stock and writing (selling) an equivalent number of call options of that stock. Writing the call options obligates the investor to sell the stock to the option buyer if the stock price increases above the strike price and the option buyer decides to exercise the option. Essentially, the covered call writer is foregoing the right to participate in the appreciation of the stock above the strike price in exchange for receiving the call option premium.

When is it used?

Covered Call writing is used by investors for 2 reasons:

a. The investor feels there is limited upside potential for the stock and as a result is willing to forego increases in the stock price above the options strike price in exchange for receiving the options premium.

b. The investor wants some limited downside protection from holding the stock which comes from receiving the call premium. The net cost of buying the stock is lowered by the call premium amount received.

How do you choose the Strike Price?

The more bullish the investor is the further out of the money the call should be. By writing a deep out of the money call the investor is able to participate in a larger rise in the stock’s value; however, a further out of the money call option will provide a smaller amount of call premium.

4) Put Writing: This strategy is implemented by simply selling put options on a stock. The investor implementing this strategy will be expecting the underlying stock chosen to stay at or remain above the strike price. Fundamentally, the put writer will profit when the stock price remains at or above the strike price as the put will expire worthless while the investor keeps the premium.

When is it used?

Put option writing is used by investors for two reasons:

a. The investor wants additional income

b. The investor wants to acquire the stock at a net price cheaper than the current market price of the stock. (If the option is in the money slightly and exercised, the put writer will be force to purchase the stock at the strike price but the net purchase price will be the strike price less the premium received from writing the put initially).
For example: you believe a stock will either remain at or increase in value so you write put options on the stock. (XYZ is currently trading at $40 in June so you write the July 40 Put for $1). As long as the stock is trading above $39 at the July expiration you have made a profit. The maximum profit you can make from this strategy is the $1 premium that you initially received however.

5) Bull Call Spread: This strategy is used when an investor is moderately bullish on a stock. The Bull Call Spread is implemented by buying a call option while simultaneously writing a call option with a higher strike price. The options will be identical except for the strike price (use same expiration, same stock).

When is it used?

Bull Call Spreads are used when:

a. An investor feels a stock will increase only slightly and is willing to forgo any appreciation in the stock above the strike price of the written call in exchange for the premium received for writing the call.

b. An investor wants some limited downside protection from purchasing the lower strike price call option. This protection comes from the premium gained by writing the higher strike price call, which lowers the net cost of purchasing the lower strike price call option. This is similar to the covered call/covered write except instead of owning the underlying stock the investor owns call options on the stock.

How to choose the Strike Price?

The strike prices used will depend on how bullish an investor is. The greater the bullishness of an investors forecast, the further out of the money and further apart the strike prices should be. When an investor is less bullish the strike prices used should be closer to the current market price of the stock and the strike prices should be closer together.

6) Bull Put Spread: This strategy is implemented by writing a put option while simultaneously buying a put option with a lower strike price. The options used will be identical except for the strike price (use same expiration, same stock).

When is it used?

Bull Put Spreads are used when:

a. An investor feels there is some limited upside for a stock but is not as confident as an outright put writer and as a result buys the lower strike price put to cap downside risk.

b. An investor wants additional income.

How to choose the Strike Price?

The strike prices used will depend on how bullish an investor is. The greater the bullishness of an investors forecast, the deeper in the money and further apart the strike prices should be. When an investor is less bullish, the strike prices used should be closer to the current market price of the stock and the strikes should be closer together.

Bullish Option Strategies Chart

Option Strategy	Market Forecast	Maximum Reward	Maximum Risk	Break Even Price
Long Call	Outright Bull	Infinite	Premium Paid	Premium Paid + Strike Price
Married Put	Outright Bull with near term concerns	Infinite	Premium Paid + (Stock Price Paid – Strike Price)	Premium Paid + Stock Price Paid
Covered Call	Neutral to Bullish	Strike Price – (Stock Price – Premium Received)	Stock Price Paid – Premium Received	Stock Price Paid – Premium Received
Short Put	Neutral to Bullish	Premium Received	Strike Price – Premium Received	Strike Price – Premium Received
Bull Call Spread	Moderately Bullish	(Strike Price of S. Call – Strike Price of L. Call) – Net Premium Paid	Net Premium Paid	Strike Price of Long Call – Net Premium Paid
Bull Put Spread	Neutral to slightly Bullish	Net Premium Received	(Strike Price of S. Put – Strike Price of L. Put) – Net Premium Received	Strike Price of Short Put – Net Premium Received

Option Investment Strategies

Option Investment Strategies

Background

Option trading is a relatively new investment opportunity for investors. Prior to the implementation of exchange-traded options, most investors were limited to only a few investment strategies: buy stock when the market was expected to increase, and short/sell stock when the market was expected to decrease.

As exchange traded options were introduced new investment strategies became available to the majority of investors which allow investors to profit in an up, down, or sideways market place. As a result, option trading has grown steadily and now the average investor can employ a broad range of investment strategies from conservative investment strategies to high risk investment strategies. This allows the average Joe to construct an investment strategy that will either increase expected returns while keeping the same risk levels or decrease risk levels while keeping the same expected returns.

Common Option Strategies

Before presenting the most common option strategies implemented, definitions of some key option terms, a description of option language and the most common market forecasts are necessary:

Key Option Terms:

1) Strike Price: the price the option must reach to be exercised.

2) Expiration month: the month the option expires in (expiration occurs on the 3rd Friday of the month)

3) Call: an option to buy stock in the future.

4) Put: an option to sell stock in the future.

5) Premium: value you pay for the option.

6) Exercise: implementing your right to buy (for a call option) or sell (for a put option)

7) American Option: Options that can be exercised at any point up to expiration.

8) European Option: Options that can be exercised only at expiration.

9) In The Money: the stock is trading at a point where the option can be exercised.

10) Out Of The Money: the stock is trading outside of the range where the option can be exercised.

Option Language Examples:

1) Buy the XYZ July 50 Call at $3.00
2) Sell the XYZ July 50 Call at $2.00
3) Buy the ZYX September 20 Put at $5.25
4) Sell the ZYX September 20 Put at $0.50

Here, you issue your order to buy/sell, (XYZ/ZYX) which is the stock ticker symbol, select the expiration month, select the strike price, select the type of option (Call/Put), and finally select the option premium which you bid when buying and offer when selling.

You will have one of the following stock market outlooks/forecasts:

1) Bullish: you believe that a stocks price will increase
a. An “Outright Bull”: you feel the price of a stock has the potential to increase substantially
b. A “Moderate Bull”: you feel there is limited opportunity for a stocks price appreciation.

2) Bearish: you believe that a stocks price will decrease
a. An “Outright Bear”: you feel the price of a stock has the potential to decrease substantially
b. A “Moderate Bear”: you feel there is limited opportunity for a stock decline.

3) Neutral: you believe the price of a stock will remain within a certain range.

Once you digest all these terms your ready to explore the three most common types of Option Strategies: Bullish Option Strategies, Bearish Option Strategies, and Neutral Market Strategies.