My last article was called The Level One Blues. It described how to construct option positions in more than one way. This is useful if the option approval level assigned to you by your stockbroker is a low level. You can read more about what option approval levels are and what they mean in the last article. I’ll expand on the idea of synthetic options further here.
Below is today’s chart of QQQ, the exchange-traded fund for the Nasdaq 100 index. With multiple tech stocks having recent bad news, and other issues, the ETF had fallen quickly to around $157. There was an apparent demand zone just below, with a low around $150. Because of recent market price volatility, options were quite expensive.
(Click on image to enlarge)
Let’s say you believed that QQQ was not likely to drop below $150 in the next few weeks, and that you wanted to benefit from the current highly inflated option prices. A common strategy would be to sell (short) a put option at the $150 strike price. The 150 puts expiring in 22 days at that strike could be sold for $2.12 per share, or $212 per contract.
Each put option sold would obligate you to buy 100 shares of QQQ at $150 each, for a total of $15,000. But this obligation is only a contingent one. You would not actually be required to buy the stock unless it was below $150 when the options expired.
If you were correct about the price direction, and QQQ were to recover and remain above $150, then the put would not be exercised and it would be worth nothing when it expired. The $212 that you had received for selling it would be clear profit. On your $15,000 of cash tied up, this would be a profit of 212/15,000 or 1.41% in 22 days. This would be an annualized rate of return of 23.45%.
On the other hand, if the price of QQQ dropped below $150, and remained there at expiration, then you would be obligated to buy the shares of QQQ at $150 each, or $15,000 for the 100 shares. Your net cost per share would then be $150 paid, less the $2.12 received initially for selling the puts. $150 – $2.12 = $147.88 per share. If QQQ were anywhere above that price at expiration, you would have a profit. If not, you would have a loss.
Let’s say you liked these possible returns and decided to place the trade.
But your broker informed you that your brokerage account was only “approved for level 1.” You would not be allowed to place the trade, which requires a higher approval level (level 4 in this case).
This is where the idea of synthetic options comes in. Any option position can be synthesized by substituting a different type of option position.
In last week’s article, I gave the basic equation used when creating synthetic options positions. Quoting from that article:
These are the notations we will be using:
- +S = Long 100 shares of the underlying Stock
- -S = Short 100 shares of the underlying Stock
- +C(x) = One long call option at strike X
- -C(x) = One short call option at strike X
- +P(x) = One long put option at strike X
- -P(x) = One short put option at strike X
Here is a basic equation: +S + P(x) = C(x)
This translates to: 100 shares of stock plus one put at strike x equals one call at strike x.
In the above translation, equals means yields the same profit or loss in all conditions.
This equivalence is the result of a property of options that is called Put-Call Parity, as explained in the earlier article.
In today’s QQQ example, we would like to sell a put at the $150 strike. Our desired position, using the above notation, would be:
-P(150)
But we are not allowed to sell short puts. How else can this position be constructed?
We just need to do a little rearranging of the basic equation.
If it is true that: +S + P(x) = C(x)
then: -S -P(x) = -C(x)
Adding +S to both sides of the equation yields: -S +S -P(x) = +S – C(x)
Which simplifies to: -P(x) = +S – C(x)
Fine, but what is the point of all that algebra?
Well, +S -C(x) is a position that is long 100 shares of stock (+S), and also short one call (-C(x)). A position with long stock and a short call is a covered call, which isallowed in a level 1 option account.
In other words, if we buy 100 shares of QQQ at its current market price, and also sell one 150 call, that covered call position would yield the same profit or loss as simply selling a 150 put. In either case, the plan would be to hold the position until the April 20 expiration. At that time the position would be closed for its market value
These were the per-share market prices at the time of the example:
QQQ stock: $157.71
QQQ April 150 put: $2.12
QQQ April 150 call: $9.76
Here is the comparison of the two positions:
Capital Required to enter the position
Covered call: $15,771 to buy stock, less $976 received for the call, a net of $14,795.
Short put: $15,000 security required against the put, less $212 received for the put, net outlay of $14,788.
So, the two positions would require almost exactly the same capital ($14,795 vs $14,788).
Profit/Loss on the position
1. If the stock is flat at $157.71
Covered call: the stock will be called away and you will be paid $15,000. This is a $771 loss from your original stock price. But adding back the $976 originally received for the call, you have a net profit of $976 – 771 = $205.
Short put: The put is worthless. You keep the $212, which is your profit. This is $7.00, or just $.07 per share more than the profit on the covered call.
2. If the stock falls to $150 (or any price between $150 and $157.71)
Covered Call: your shares are not called away. You keep them with a value of $15,000. This is a loss of $771. But adding back the $976 originally received for the call, you have a profit of $976 – 771 = $205. This is the same as if the stock were flat.
Short put: The put is worthless. Again, you keep the $212, which is your profit, same as if the stock were flat.
3. If the stock rises to $160 (or any price above $157.71)
Covered call: the stock will be called away and you will be paid $15,000. This is a $771 loss from your original stock price. Adding back the $976 originally received for the call, you have a profit of $976 – 771 = $205. Same result as if the stock were flat.
Short put: The put is worthless. You keep the $212, which is your profit. Same result as if the stock were flat.
4. If the stock drops to $145 (or any price below $150)
Covered call: the stock will not be called away and you will still own it. Since your original cost was $14,795 and it is now worth $14,500, you have a loss of $295. In any case where the stock is at a price below your $147.95 per share net cost, you will have a commensurate loss.
Short put: The stock will be put to you, meaning that you will have to buy it and pay the $15,000 for it. Subtracting its current value of $14,500, that is a $500 loss. Adding back the $212 you were paid for the put, your net loss is $288. In any case where the stock is at a price below your $147.88 per share net cost, you will have a commensurate loss.
Note that in every case above, the net result of the covered call trade is the same as for the short put trade (except for the insignificant $.07 per share difference). This would be true no matter what the stock does.
So, if your desired position is either a short put or a covered call, they can be freely substituted for each other.
In this example, we wanted to do a short put and substituted a covered call. In other situations, it might be the other way around. For example, we might want to do a covered call on an underlying asset that can’t be owned, like a stock index. In this case, substituting a short put accomplishes the same thing as the desired covered call.
In these two articles, I’ve introduced the idea of synthetic option positions as a way to create desired positions in alternative ways. I hope you find them useful.
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Disclosure: I understand that Online Trading Academy instruction will prepare me to actively trade securities and/or other financial instruments for my own account at an appropriate financial firm which utilizes the Electronic transmissions of securities and other financial instruments orders to execute trades for its customers. I understand that this course is not preparation to be a Licensed Broker in the financial industry and will not help me get a job.
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Understanding Trading Risks
Electronic active trading involves special risks and may not be suitable for everyone. Electronic active trading may also involve a high volume of trading activity. Each trade generates a commission and the total daily commission on such a high volume of trading can be considerable.
Electronic active trading accounts should be considered speculative in nature with the objective being to generate short-term profits. This activity may result in the loss of more than 100% of an investment, which is the sole responsibility of the customer. An electronic active trader should understand the operation of a margin account under various market conditions and review his or her investment objectives, financial resources and risk tolerances to determine whether margin trading is appropriate for them. The increased leverage which margin provides may heighten risk substantially, including the risk of loss in excess of 100% of an investment.
STATEMENT BY CHAIRMAN ARTHUR LEVITT SECURITIES AND EXCHANGE COMMISSION CONCERNING ON-LINE TRADING
JANUARY 27, 1999
Chairman Arthur Levitt today issued the following statement to investors:
The Internet and other new technologies are in many ways transforming how our capital markets operate. There are clear benefits to these changes including lower costs and faster access to the market for investors. I believe that investors need to remember the investment basics, and not allow the ease and speed with which they can trade to lull them either into a false sense of security or encourage them to trade too quickly or too often.
Over the last two years, particularly in recent months, the SEC has been hearing concerns about retail, on-line (Internet) investing. In fact, the number of complaints concerning on-line investing has increased 330 percent in the last year. Some of the issues raised specifically relate to on-line trading, others are generic to all investing. The majority of them can be addressed through better education and investors ensuring that they have done their homework.
Every day, more and more Americans are investing in the stock market, and many of them are doing so through the Internet. On-line brokerage accounts account for approximately 25 percent of all retail stock trades. And, the number of on-line brokerage accounts is expected to exceed 10 million by the end of the year.
While the manner in which orders are executed may be changing, the time-honored principles of evaluating a stock have not. An investor's consideration of the fundamentals of a company-net earnings, P/E ratios, the products or services offered by the company-should never lose their underlying importance.
Investing in the stock market-however you do it and however easy it may be-will always entail risk. I would be very concerned if investors allow the ease with which they can make trades to shortcut or bypass the three golden rules for all investors: (1) Know what you are buying; (2) Know the ground rules under which you buy and sell a stock or bond; and (3) Know the level of risk you are undertaking. On-line investors should remember that it is just as easy, if not more, to lose money through the click of a button as it is to make it.
In recent months, we have begun to identify a number of issues every on-line investor should be aware of. First, investors must understand the issues and limitations of on-line investing. You may occasionally experience delays on these new systems. Demand has grown so quickly that many firms are racing to keep pace with it. In the meantime, you may have trouble getting on-line or receiving timely confirmations of trade executions. You should not always expect "instantaneous" execution and reporting. There can and will be delays in electronic systems. You should investigate and understand options and alternatives to executing and confirming your orders if you encounter on-line problems.
Second, investors may sometimes be surprised at how quickly stock prices actually move. For example, many technology stocks have recently had dramatic and rapid price movements. When many investors attempt to purchase (or sell) the same stock at the same time, the price can move very quickly. Just because you see a price on your computer screen doesn't mean that you will always be able to get that price in a rapidly changing market. You should take precautions to ensure that you do not end up paying much more for a stock than you intended or can afford.
One way to do this is to use limit orders rather than market orders when submitting a trade in a "hot" stock. The result for investors that do not limit their risk can be quite surprising. Say an investor wanted to buy a stock in an IPO that was trading earlier at $9.00 and failed to specify the maximum they were willing to pay using a limit order. That investor could end up paying whatever price the stock has moved to at the time his order reaches the market -- $60, $90 or even more. If, on the other hand, the investor submitted a limit order to buy the stock at $11.00 or less, the order would only be executed if the market price had not moved past that level. Investors should understand the risk associated with trading in a rapidly moving market and make sure that they take all possible actions to control their risk.
Third, I am concerned that investors buying securities on margin may not fully understand the risks involved. In volatile markets, investors who have put up an initial margin payment for a stock may find themselves being required to provide additional cash (maintenance margin) if the price of the stock subsequently falls. If the funds are not paid in a timely manner, the brokerage firm has the right to sell the securities and charge any loss to the investor. When you buy stock on margin, you are borrowing money. And as the stock price changes, you may be required to increase the cash investment. Simply put, you should make sure that you do not over-extend.
Fourth, while new technology available to retail investors may resemble that of professional traders, retail investors should exercise caution before imitating the style of trading and risks undertaken by market professionals. For most individuals, the stock market should be used for investment not trading. Strategies such as day trading can be highly risky, and retail investors engaging in such activities should do so with funds they can afford to lose. I am very concerned when I hear of stories of student loan money, second mortgages or retirement funds being used to engage in this type of activity. Investment should be for the long-run, not for minutes or hours.
Millions of new investors have taken advantage of the unprecedented access and individual control the Internet provides. But, new opportunities present all of us with new responsibilities, challenges and risks. The SEC will do everything it can to protect and inform investors during this time of great innovation and change. But, investor protection-at its most basic and effective level-starts with the investor. I say to all investors-whether you invest on-line, on the phone, or in-person-know what you are buying, what the ground rules are, and what level of risk you are assuming.
Important Information about trading Foreign Exchange.
Trading foreign exchange is not for everyone. Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to trade foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts.
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