Easy option trade

[iceman5]

First a short lesson on options. A very basic lesson in laymens terms.

Option prices consist of intrinsic value and time value. Forget about intrinsic value for now. The main point of this post concerns time value. When you buy and sell options you are buying and selling time. The time value of an option is always decaying and the decay picks up steam the closer the option gets to expiration.

Ex: If an option is priced at 4 and the stock is at 50.....a week later if the stock is still at 50, the option can fall to 3. The stock hasnt moved but the time value has decayed. This is why selling options is a much easier strategy to perfect than buying options.

Heres how it works in real life.

Today I sold some put options on the SP500 index. They expire on Friday.

The SP500 tracking stock was trading at 136.13 when I made this trade. I sold the Jun 136 puts for 1.6 (thats $160 each and the contracts are for 100 shares each).

If the stock closes on Fri above 136, the option expires worthless and what I sold for $160 is now worth nothing. Whoever bought it from me for $160 now has an option worth $0.

As you can see, the stock was already above the 136 price. So the stock can move nowhere or even drop a bit and I still make the $160 per contract. That is the time value that will decay away in one weeks time.

One of 3 things will happen this week.

1) SPY will go up and obv be above $136. I keep the $160 per contract
2) SPY will go nowhere...I keep the $160 per
3) SPY will go down. It can go down 1.6 plus the .13 its above 136 for a total of 1.73 and put me at break even. If it drops more than that I lose money.

Nobody knows where the stock will move in one week. Its equally likely to go up as go down in any one week. I have 1.25% downside protection before I lose money.

So if you figure its 50/50 to go up or down, you can say i have a 1.25% overlay.

[iceman5]

OK, so this trade went to hell. It was still a good trade and I will do this most every month, but it just didnt work out this time as the stock market s really hurting right now. The past month has been the worst month in the last 7 years and this particular week waas the worst week of the month. UGH! Great timing huh?

Anyway, if anyone is interested in any of this stuff......

As of Fri which was the day of options expirations for the month the stock was well below the stike price of the puts I sold so i have a few options.

Strike price was 136. Stock was at about 131.60

1) I couldve bought back the puts for about 4.4 each (thats $440) I had sold them for 1.6 each so i would taken a 2.8 loss on each.

2) I couldve allowed the options to be assigned which means I have to buy 100 shares of the stock for each put option. Thats $13600 for each contract. This option has 3 sub options

a) I could hold the stock either short term or long term and wait for a recovery in the stock. My break even price was 134.4 so i would need a 2.1% increase to break even. This turns the option trade into a whole different animal and isnt normally advisable since I didnt enter this option trade for the purposes of holding the stock long term and if it sinks further I could be stuck with it longer than i want and / or i could lose more money

b) I could let the stock be assigned to me and sell it immediately. This results in the same as option #1. I loss a bit of money but Im out of the trade entirely. Commisions would normally determine which is better between this option and option #1

c) I could let the stock be assigned to me and then immediately sell a "covered call" against it. In this case I couldve sold a July 132 Call option for 3. This means I get $300 per contract but I have to sell the stock for 132 no matter what the price is in one month when the call option expires. The benefit of this is that although I bought the stock for 136 when it was assigned to me, I already recieved 1.6 from the1st trade and now I recieve 3 more for a total of 4.6. This makes my break even point 136 - 4.6 or 131.4. If the stock is above 132 I have to sell it for 132 but still make $60 per contract for the overall trade which is pretty damned good considering that the market totally tanked as soon as I started this trade. Market tanks..I still make money...not bad.

If the stock is below 132 at expiration, I keep the stock and still keep the 3 premium (plus the 1.6 already collected) as well. Worst case scenrario is that the stock keeps dropping and is at lets say 129. I do have a paper loss but no real loss yet. I would have these same options next month as I have now and could sell another call option to further lower my break even price. Eventually the market will recover and I can get out without losing any money. Profit potential with very limited risk of loss is my goal with these trades.

3) I couldve bought back the Jun 136 put for 4.4 and sold a July 132 put for 3. This would mean I have a slight profit (1.6 +3 - 4.4 = 0.2 or $20 per contract) as long as the stock is above 132 on the 3rd Fri of July. So although the stock dropped over 3% during very short week long holdng period of the orignal trade, as long as it recovers less than 1/3 of a percent in the next month, I still espcape the trade with a tiny profit. This is very simlar to option 2c

Having said all of that, for this particular trade I have so far decided to just hold the stock for a few days and see what happens. Im hoping for a bounce in the market but this is by far the riskiest option.