KnowHow® News

June 2014: In the Know

Expand Your Horizon: Build Upon the Basics

Option contracts give traders a variety of ways to play market forecasts. However, it's easy for some traders to get stuck using only a limited number of strategies. These basic strategies may be used as building blocks to more sophisticated strategies. Keep in mind that Scottrade charges $7 per online trade, plus $1.25 per option contract, and remember options involve risks are not suitable for all investors.

Let's look at a couple strategy combinations that may work for directional plays.

Call Spread Risk Reversal

The call spread risk reversal is a combination of selling a put along with the purchase of a call debit spread. The thinking behind this trade starts with a simple long call. You may want to purchase a call because you think the stock is going higher over a certain time frame. This call by itself can be an expense, so you sell a higher strike call to form the call debit spread. By selling this call, the amount of money you may make on the long call is capped, but the cost of the trade is reduced.

The risk reversal takes this logic one step further. It has you sell a put to help offset the cost of the call by even more. The put that is sold is typically at lower or same strike price as the long call you purchased. By selling the put, you have taken on an obligation to buy shares of stock at the strike price of the put. This will result in losses if the stock price were to drop.

Let's look at an example using the following option data.

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Below is the graph of the risk reversal if you sell the 95 put, buy the 105 call and sell the 110 call.

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The big drawback to this strategy is the large potential loss and limit profit potential. The short put position opens you up to potentially large losses if the stock were to move against you. Because of this potential, the margin requirement for the position could be significant.

To alleviate these concerns, you could forgo selling the topside call (to keep an unlimited profit potential), and purchase a lower strike price put (to reduce the downside risk). This alternative to the risk reversal is a combination of a long call and put credit spread.

To demonstrate this strategy we sell the 95 put, buy the 90 put, and buy the 105 call.

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In this strategy, you offset the cost of the long call with the proceeds from a put credit spread. When compared to the risk reversal, the cost to purchase the strategy is higher, but the potential loss (and margin requirement) is less, and the profit potential is unlimited.

If this new spread is too expensive, you may think of selling a topside call option, forming a call spread like you did in the original risk reversal spread. This new strategy is now a combination of a put credit spread and a call debit spread.

This combination of strategies limits your potential losses and reduces the cost of the trade. The trade off of this strategy is that your profits are again limited.

To demonstrate this strategy, let's assume you sell the 95 put, buy the 90 put, buy the 105 call, and sell the 110 call.

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These three complex strategies are simply combinations of other more basic strategies that you may already be familiar with. To take it a step further, all option strategies are combinations of simple calls and puts. If you have a firm understanding of these basic concepts, then these more complex strategies may have a place in your trading plan.

There are special risks associated with uncovered option writing that may expose investors to significant losses. Therefore, this type of strategy may not be suitable for all customers approved for options transactions. Consult with your tax advisor for information on how taxes may affect the outcome of these strategies, and remember profit will be reduced or loss worsened, as applicable, by the deduction of commissions and fees.

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