Understanding Options – Puts and Calls, Iron Condors and Other Strategies.

The concept of options is very simple. It’s the pricing of options that can be complicated, if you let it!

First – there are ONLY 2 types of options, a CALL and a PUT. You buy a Call when you expect the market to go higher; you buy a Put when you expect the market to go lower. All options have an expiration date, whether it is a week, month, 3 months or longer. Options are highly leveraged, one option contract controls 100 shares of stock.

Let’s compare buying Puts and Calls options to betting on a horse at racetrack. When you go to a racetrack, you pick a horse and hopefully it will win. If it wins you make money. If it loses, you only lose what you paid for the ticket.
When you buy a Call option, you must decide the price (called the strike price) the market will move past (this is the same as picking a horse). The price of the bet you will pay is called the premium. The end of the option ‘race’ is when the option expires!

Example: IBM is trading at $100/share. You expect within one month the price per share will exceed $115. So you buy 1 IBM option contract at a strike price of $110 that expires in 1 month. If the share price of IBM does not exceed $110, you lose the bet (your premium). If it does exceed $110, you win. But unlike betting on a horse, the value of the option keep rising the higher the share price of IBM stock goes. This is because one option contract is the equivalent of 100 shares of stock. So for every dollar the price of IBM stock exceeds $110, the value of your option contract increases roughly $100.

When you buy a Put it works the same way except you expect the market or stock price to move lower!
Because of the huge leverage most option buyers let their greed emotion make their decisions and they lose money most of the time!

The price (premium) that you pay for an option is mainly controlled by
1. The time left until the option expires,
2. Where the stock price is relative to the strike price of the option, and
3. The volatility of the stock price.

Now, for every buyer of Puts and Calls option contracts there MUST be a seller. While the risk for the option buyer is low – limited to what was paid for the option, the risk for the seller can be high. The seller has the obligation to deliver the buyer 100 shares of a stock if indeed the market moves past the strike price.

One would initially think that since there are only 2 types of option contracts, using them would be rather simple. BUT that is not true. Most option strategies are shown and explained in the chart below. The charts below show where your options are relative to the price of the stock at EXPIRATION of the option. However, most options are NOT held until expiration. So if your options are in a losing or winning position, you can close out your position any time before expiration of the option.

In the risk profile graphs below, red denotes where you would lose money and green where you would make money.

 

Option Strategy
Buy/Sell Risk Profile Graph Risk/Reward
Call
Buy (Long) Buy Call Option Graph This only involves buying a call option.  From the graph, you can see that the risk is low - you can only lose the premium that you paid.  But the reward can be very high if the stock price exceeds the strike price of the option because one options contract can convert to 100 shares of stock. 
Call
Sell(Short) Call Option Risk Graph This only involves selling a call option.  From the graph, you can see that the reward is low  - you can only make the premium that you were paid.  But the risk is very high because one options contract can convert to 100 shares of stock that you must deliver if the stock price closes higher than the strike price of the option. And the higher the stock price goes, the more it will cost you.
Put
Buy (Long)
This only involves buying a put option.  From the graph, you can see that the risk is low - you can only lose the premium that you paid.  But the reward can be very high if the stock price closes below the strike price of the option, because one options contract  converts to 100 shares of stock. 
Put
Sell (Short)
This only involves selling a put option.  From the graph, you can see that the reward is low  - you can only make the premium that you were paid.  But the risk is very high because one options contract converts to 100 shares of stock that you must deliver if the stock price closes lower than the strike price of the option.  And the lower the stock price the more it will cost you!
A Call Credit Spread is when you sell a Call at one strike price and buy a Call for the same month at a higher strike price.  Your reward (premium) is limited and your risk is also limited to the difference between the strike prices.  This is used when the market is expected to move lower.  But if the market instead goes higher, you can lose money depending on where your strike price is relative to the underlying stock price.
Straddle
Buy (Long)
Straddle
Sell (Short)
Strangle
Buy (Long)
Strangles have many of the same characteristics as straddles, but with a larger margin of error.  For a long strangle you buy both an out-of-the-money call and an out-of-the-money put of the same expiration.  Thus the premium paid or received is  lower than a straddle.  You might put on a long strangle if you think there is a chance stock might make a big move, but your conviction isn’t high enough to pay the premium for a straddle.
Strangle
Sell (Short)
Strangles have many of the same characteristics as straddles, but with a larger margin of error.  For a short strangle you sell both an out-of-the-money call and an out-of-the-money put of the same expiration. The risks of short straddles and strangles are obvious, but a slow death by decay can be extremely tortuous as well.
Butterfly
Buy (Long)
For a long butterfly, you sell two of the middle strike options and buy one of each of the outside strikes — buy the wings.  The maximum return on a long butterfly is the distance between the two strikes.  You want the stock price to not move much.  Any movement away from the options that you sold will reduce your gain.
Butterfly
Sell (Short)
For a short butterfly, you buy two of the middle strike options and sell one of each of the outside strikes — buy the wings.  The maximum return on a long butterfly is the distance between the two strikes.  You want the stock price to  move a lot - past the strike price of the wing options.  Any movement away from the options that you sold will reduce your gain.

 

 

From the information above you can see there are plenty of option strategies that you can use. BUT the question is – which one is best for you!!! Because options have high leverage, one options controls 100 shares of stock, most traders let their greed emotion control their decision. That is why most traders consistently lose. They see ads talking about making 100%, 150%, etc. in a few days, weeks or a month and they start salivating for these unrealistic returns. Sure they do happen once in a while, but that is not the norm.

Most option adviser’s talk about the reward to risk ratio and it should be at least 2:1. BUT what they fail to mention is “what is the probability of success”. For options, the higher the reward to risk ratio, the LOWER the probability of success. This is because in order to increase the reward you must move the option strike prices closer to the present market value. This will decrease your probability of success!!!

Let’s say following the option adviser’s suggestion that you choose options with a reward/risk ratio of 2. This sounds great right – you can see the money rapidly piling up!!! BUT, let’s say the probability of success is 20%. This means that out of 10 trades you would win twice and lose eight times. So if your risk was $1,000 then two times you would make $1,000 profit, but eight times you would lose the $1,000 premium that you paid for a net loss of $6,000. Not so appealing is it.

In most of the above strategies you are trying to predict the future movement of the market. But
NOBODY knows which way the market will move, NOBODY!!! Sure there are many so-called gurus that claim that they can, but they NEVER give you a history of all their previous predictions, only the ones when they were right. They are only interested in getting your money.
So based on the above info what can you do to make a consistent income from options? Well there are 2 things you need to do:

1. Keep your greed and fear emotions under control, and
2. Sell options to those who erroneously think they know which way and how far the market will move in the future.


From my research and experience, I found the iron condor to be the best strategy for safely generating a consistent monthly income without trying to predict the market movement. Since an iron condor is composed of a Call Credit Spread and a Put Credit Spread, you get a premium from BOTH Credit Spreads. The key is to not let your greed emotion control where you pick the option strike prices. Remember you want your probability of success to be high, at least 90%. This way you can consistently earn around 3% to 8% per months on your money. Note: just 3%/month compounded is 42% a year; 5% monthly compounded is 80% per year; 6%/month you double your money each year!

The next question is what stock or index to use for selling the iron condor. I don’t use stocks because they can be extremely volatile due to surprises in earning or rating changes, etc. I prefer to use an overall stock market index, like the DJI, SPX, OEX or RUT. Of these I use the RUT (Russell 2000) because it generally has the most volatility which means it has the highest premiums. Also the question of the length of the option to use. I use the options that will expire the next month. For example: option expiration Friday for April 2013 was on 19 April. So on Monday, 22 April 2013, I would be looking at purchasing RUT options that expire 17 May 2013. I prefer to be in the market for a month or less.

To select the best strike prices for your iron condor you will need to analyze weekly market data for at least 10 years. Remember what Will Rogers said: “I am more interested in the return OF my money than the return ON my money”. When trading, if you want to consistently win, you MUST be concerned about the safety of your trade!!!

 

Iron Condor - Puts and Calls

Most people get lured into options because of the huge POTENTIAL gain. But what they do NOT realize is the large gains seldom materialize. The average investor only wins 30% of the time. What they fail to do is to consider the probability of success of getting a high gain. They are told to make sure they have a reward to risk ratio of at least 2:1. BUT they are never told to consider the probability of success!!! What good does it do to have a high reward to risk ratio if the probability of success is only 10% or less.

The trading strategy below insures a monthly gain of 3 to 8% with a success rate of 99+%.

After spending hundreds of hours analyzing how the market moved weekly for 25 years, I’ve developed what I call the Remarkable Iron Condor Strategy.

It has the following characteristics: