Investing In Canada

has been moved to a new address

http://www.investingincanada.info

Sorry for the inconvenience...

Bullish Option Strategies

Wednesday, August 15, 2007

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 StrategyMarket ForecastMaximum RewardMaximum RiskBreak Even Price
Long CallOutright BullInfinitePremium PaidPremium Paid + Strike Price
Married PutOutright Bull with near term concernsInfinitePremium Paid + (Stock Price Paid – Strike Price)Premium Paid + Stock Price Paid
Covered CallNeutral to BullishStrike Price – (Stock Price – Premium Received)Stock Price Paid – Premium ReceivedStock Price Paid – Premium Received
Short PutNeutral to BullishPremium ReceivedStrike Price – Premium ReceivedStrike Price – Premium Received
Bull Call SpreadModerately Bullish(Strike Price of S. Call – Strike Price of L. Call) – Net Premium PaidNet Premium PaidStrike Price of Long Call – Net Premium Paid
Bull Put SpreadNeutral to slightly BullishNet Premium Received(Strike Price of S. Put – Strike Price of L. Put) – Net Premium ReceivedStrike Price of Short Put – Net Premium Received

No comments: