FM JWBKSmith May 8, Char Count= 0 Option Strategies Profit- Making Techniques for Stock DOWNLOAD PDF Option strategies: profit- making techniques for stock, stock index, and commodity options / Courtney D. Smith. Protocols pdf baptist. For household water reuse home binary option range strategy, Rights reserved worldwide the complete guide by courtney. In this revised and expandededition, top options expert Courtney Smith details the ins and outsof this lucrative, yet complex, financial instrument.
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Updated and revised to include a decade of growth in the scope and complexity of options, Options Strategies: Profit-Making Techniques for Stock, Stock Index. Option Strategies: Profit-Making Techniques for Stock, St and millions of other books are available for Amazon Kindle. From the working fundamentals to the most innovative pricing models, Option Strategies gives you the information you need to make a wise and successful. OPTIONS UNIVERSITY - STRATEGY GUIDE. Page 2 of 24 Foreign Exchange, Courtney D. Smith provides a concrete and comprehensive approach to.
ADX Filter. Margin, in this context, is the amount of money you are allowed to borrow using your new position as collateral. The option price is based on the expected volatility from the time of purchase to the time of expiration. Click here. A vega of 0. An opening sale, or write, is followed by a closing buy, or exercise—a closing exercise following an opening sale, or write, means that sellers must meet their obligation. This is not technically true but is close enough for even the most picky of arbitrageurs.
Added to Your Shopping Cart. Learn to maximize your trading power with In this revised and expandededition, top options expert Courtney Smith details the ins and outsof this lucrative, yet complex, financial instrument. From theworking fundamentals to the most innovative pricing models, OptionStrategies gives you the information you need to make a wise andsuccessful investment. Whether you want to bull up or bear down,buy puts or sell calls, here's where you'll find: For traders andhedgers--both novice and professional--this is the only book tohave for getting to the bottom of options, and staying on top ofthe latest strategies.
With their high-profit yields and the flexibility they offer inbuying and selling, options are a preferred trading vehicle forinvestors. Trading options, however, is as complex as it can belucrative. Even for experts in the field, getting a firm grasp onthis high-risk activity can be difficult.
Option Strategies makesit easier, offering all the tools you need to invest safely andprofitably, using the latest trading techniques. Now revised and updated, this comprehensive guide by one of theindustry's top experts covers all the essentials, from thefundamentals of options to the intricacies of options valuation andtrading. You'll find details on everything from carrying chargesand strike prices to commissions, interest rates, and break-evenpoints.
Beyond the basics, you'll also learn about the bull andbear strategies needed to buy and sell calls, puts, spreads,straddles and combinations, synthetic positions, arbitrage, andmuch more. Additionally, major strategies are highlighted and accompanied by aunique "Decision Structure" that gives you a clear picture of howeach strategy works, and advice on how to plan your investmentbetter. Consisting of a series of questions and answers, thesedecision structures assist you in analyzing potential trades,determining your objectives and the amount of risk you're preparedto take, and deciding what follow-up action to take once you'veentered a trade.
To help you tune in to current trading trends andpractices, this newest edition has been expanded to cover thelatest practical and innovative trading strategies, and advancedoptions techniques such as implied volatility.
Filled with examples, charts, and graphs, this concise, accessiblebook is the only guide you'll need to stay on top of the high-risk,high-profit game of options. Trend Following Michael W. One Good Trade Mike Bellafiore. Encyclopedia of Chart Patterns Thomas N. Naked Forex Alex Nekritin. Trading Psychology 2. Following the Trend Andreas F. Quantitative Trading Ernie Chan. Flap copy Foreign exchange is the most traded instrument in the world.
It's not hard to understand why. Nobody needs to buy stocks, but because of today's extensive global trade we must all deal directly or indirectly with the forex world. Yet, while trading foreign exchange is one of the most exciting and potentially lucrative activities in the world, about 90 percent of traders lose money.
Smith provides a concrete and comprehensive approach to becoming a profitable forex trader. Smith first explains all the basic information you need to know to get started in trading forex.
He then introduces the tested, profitable techniques that will help you make money in the forex market, offering a variety of different methods to use over different time horizons--from those that look at the market from the perspective of days and weeks to those that hold positions for less than one day. Smith describes, for instance, a system that monitors the market from three different time perspectives and doesn't enter the market until all three are calling for an entry into the market.
He also details a new way to filter trades that eliminates about half of all losing transactions. And he tells how to sidestep the usual traps that drain money from your account using his method to identify short-term turning points and, more important, to identify major turning points. Smith concludes by showing you how all the techniques in the book fit together into a coordinated program for creating profits.
Throughout the book, the author stresses the two most important aspects of trading: How to Make a Living Trading Foreign Exchange shows how to take risk management one step beyond and use it as an offensive weapon for enhancing profits. And perhaps, most important, it tells how to overcome the biggest block against making money in the markets: Whether you're a novice or a pro, says Smith, following the techniques in this book will turn forex trading into your ticket to financial freedom.
Back cover copy Foreign exchange is the most traded instrument in the world. Table of contents Preface. Sell a Yard of Cable. Don't Want To Trade! Transaction Costs. It Never Stops. My Biggest Losing Trade. The Bottom Line. Chapter 2 Trend Analysis. What Is a Trend? How to Trade the Trend.
Megaphones and Pennants. Average Directional Index. The Bishop. Chapter 3 Channel Breakouts.
The Beginnings of Channel Breakouts. What Is A Channel Breakout? Better Channel Breakouts. The Pros and Cons of Channel Breakouts. ADX Filter. The Principle of Instant Gratification. Rejection Rule. The Last Bar Technique. Taking Profits. Chapter 4 The Conqueror. They are most common in the currency futures.
For example, the November option in currency futures will be exercised for the December futures contract because that is the next futures contract that exists. This means that the September option will be exercised into a September futures contract. The October, November, and December options turn into December futures contracts. In-the-Money, Out-of-the-Money, and At-the-Money Other terms to qualify options are in-the-money, out-of-the-money, and atthe-money.
They describe the relationship between option prices and the UI price. In-the-money r Call option: UI price is higher than the strike price.
UI price is lower than the strike price. Out-of-the-money r Call option: UI price is equivalent to the strike price. Most people use at-the-money to also describe the strike price that is closest to the price of the underlying instrument. Buying and selling, as discussed earlier, are the most common methods of liquidation. Abandonment and exercise are discussed here. Exercising Options An option gives the right to buy or sell a UI at a set price. Call option owners can exercise their right to buy the UI, and put option owners can exercise their right to sell the UI.
The call option owner is calling away the UI when exercising the option. Only holders of options can exercise. They may do so from any time after purchase of the option through to a specified time on the last trading day if it is an American option.
For example, stock options can be exercised up until 8: EST on the last day of trading. Option owners exercise by notifying the exchange, usually through their broker. The writer of the option is then assigned the obligation to fulfill the obligations of the options. Clearinghouses handle the exercising of options and act as the focal point for the process. If you want to exercise an option, you typically tell your brokerage house, which then notifies the clearinghouse.
The clearinghouse assigns the obligation to a brokerage house that has a client that is short that particular option. However, another method can be used if it is approved by the relevant exchange. It is, therefore, important for option writers to know their brokerage house rules on option assignment.
Once assigned, call option writers must deliver the UI or the equivalent in cash, if the contract specifications call for cash delivery. They may not buy back the option. They may honor the assignment of a call option by delivering the UI from their portfolio, by buying it in the market and then delivering it, or by going short. The assignment of a put option may be honored by delivering a short instrument from their portfolio, by selling short in the market and then delivering it, or by going long.
If you exercise an option, you will be holding a new position. You will then be liable for the cost and margin rules of the new position. Margin, in this context, is the amount of money you are allowed to borrow using your new position as collateral. For example, if you exercise a long stock call and want to keep the shares, you will either have to pay the full value of the stock or margin it according to the rules of the Federal Reserve Board.
Alternately, you could sell it right away and not post any money if done through a margin account. If you had tried to sell it through a cash account, you would have had to post the full value of the stock before you could sell.
In general, exercising an option is considered the equivalent of buying or selling the UI for margin and costing considerations. When an option is exercised, the brokerage house charges a commission for executing an order on the UI for both the long and the short of the option. For example, if you exercise a call option on American Widget stock, you will have to pay the commission to buy shares of American Widget. This makes sense because, when you exercise an option, you are trading in the UI.
The true cost of exercise includes the transaction costs and the time premium, if any, remaining on the option. Time premium is defined in the next chapter.
The costs make it expensive for most people to exercise options, so it is generally done only by exchange members prior to expiration. You will not want to exercise an option unless it is bid at less than its intrinsic value.
Intrinsic value is discussed in the next chapter. This will occur only if the option is very deep in-the-money or very near expiration. An option can be abandoned if the premium left is less than the transaction costs of liquidating it. Options that are in-the-money are almost certain to be exercised at expiration. The only exceptions are those options that are less in-the-money than the transaction costs to exercise them at expiration.
In all other cases, in-themoney options should be exercised. Otherwise, you will lose the premium and gain nothing. Most option exercises occur within a few days of expiration because the time premium has dropped to a negligible or nonexistent level. Most exchanges have automatic exercise of options that are in-themoney by a specified amount. Prior to expiration, any option trading for less than the intrinsic value could also be exercised.
This premature exercise can also occur if the price is far enough below the carrying costs relative to the UI. This discount is extremely rare because arbitrageurs keep values in line. Even if it occurred, it is likely that only exchange members could capitalize on it because of their lower transaction costs.
A discount might occur when the UI is about to pay a dividend or interest payment. Following the payment, the price of the UI will typically drop the equivalent of the dividend or interest payment.
The option might have enough sellers before the dividend or interest payment to create the discount. There are typically a large number of sellers just before a dividend or interest payment because holders of calls do not receive the dividend or interest and, therefore, do not want to hold the option through the period when the payment causes the option price to dip.
In the final analysis, there are few exercises before the final few days of trading because it is not economically rational to exercise if there is any time premium remaining on the option. This is very infrequent and happens only in stock options when the stock splits or pays a stock dividend. The result is a change in the strike prices and the number of shares that are deliverable.
A stock split will increase the number of options contracts outstanding and reduce the strike price. For example, suppose that Exxon declares a two-for-one split. You will be credited with having twice as many contracts, but the strike price will be halved. Note that the new strike prices can be fractional.
A stock dividend has the same effect on the number of options and the strike price. The exchange will adjust the number of shares in a contract up to from and reduce the strike price by 5 percent. Exchanges will list new strikes at round numbers following the split or stock dividend. The fractional strikes disappear as time passes. It shows the profit or loss of an option strategy at various prices of the UI at expiration.
Figure 2. The scale on the left shows the profit or loss of the option. The bottom scale shows the price of the underlying instrument at expiration. The chart illustrates the key fact that the price of an option generally rises and falls when the price of the UI rises and falls.
Thus, a call option buyer is bullish expecting prices to rise , and the seller is bearish expecting prices to fall or stay stable. A put option buyer is bearish, and the seller is bullish. Option charts usually do not consider the effects of carrying charges. They exist to give a quick overview of the effect of changes in price, time, and volatility on the price of an option. However, some charts will show the profit or loss characteristics of a strategy before expiration.
At expiration, the profit-and-loss line of an option will bend at the exercise price and cross the zero-profit line at the point that equals the exercise price plus the premium, for a call, or that equals the exercise price minus the premium, for a put.
The following shows typical option price quotes found in a newspaper: High Low Price Net Chg. Close With few exceptions, the units of price are the same as the UI. For example, because each option is for shares, a price of 4.
Quotations for options on Treasury-bond and Treasury-note futures are quoted in 64ths, whereas the underlying futures are quoted in 32nds. Many people make trading mistakes when trading these options due to this difference.
Price quotes on quotation services will be priced the same, but each quotation service has a different code for each option. Consult with your quotation service for the quote symbol of the option in which you are interested.
Quotes are available on all the major quotations services. They are also available on the Internet or you can call your broker for quotes. There are, however, two main styles of calculation. The first and simplest method is the flat rate in which the broker makes a single charge for each option. The other common method is to charge a percentage of the value of the premium.
For example, the broker could charge 5 percent of the premium. Some brokers will combine the two styles. The advent of online brokers has reduced commissions to dimes per options on most instruments. It is important to keep commission costs to a minimum no matter what strategy your broker uses.
A reduction in trading costs can have a big impact on your bottom line at the end of the year. The increase in return in percentage terms is particularly important for hedged options strategies, like covered writes, because they have two or more commissions for each trade.
I use a strategy that theoretically should consistently make me 65 percent per year but transaction costs reduce that to about 45 percent per year. However, the cheapest commissions might be a false economy. Be sure to look at the total package from the brokerage house. You might pay fewer commissions but receive no support or perhaps poor order execution. The cheapest brokerage house could turn out to be the most expensive! In general, the accepted orders for options are the same as those accepted for the UI.
Special considerations about orders will be mentioned when necessary in the rest of the book. It is important to note that options prices are nonlinear: They do not change go up and down in exact correlation with the price of the underlying instrument UI. This chapter and the two chapters following will explain the complexities of what moves options prices.
This chapter outlines, from a nontechnical and intuitive basis, the main factors that move options prices. The more advanced concepts will be left to Chapters 4 and 5, which introduce some math and the more technical aspects of the greeks, as well as showing how to use the greeks to identify the characteristics of an option strategy. This may get a little dense but it is worth it for your bottom line. The intrinsic value of an option is a function of its price and the strike price.
The intrinsic value equals the in-the-money amount of the options. This is simply the difference between the strike price and the current price of the stock. The intrinsic value of an at- or out-of-the-money option is zero. Thus, an out-of-the-money option is an option with only time value. The time value of an option is the amount that the premium exceeds the intrinsic value.
Alternately, the time value for in-the-money calls and puts is: Only in-themoney options can trade at parity. This usually occurs very close to expiration when the time value can easily be zero. It also typically occurs when the option is very deep in-the-money.
For example, an option with a strike price of 50 will be considered very deep in-the-money if the UI is trading at 70 and there is only one day left until expiration.
Time Value There are two ways to look at time value: Table 3. They are: Price of the underlying instrument 2. Strike price 3. Time remaining until expiration 4. The risk-free rate 5. Expected volatility 6. Dividend or interest payments, if any Fair Value An option has a fair value.
The fair value is the price at which the option should trade, given the six listed factors. The concept of fair value has far-reaching implications. A common use of fair value is to calculate the expected price of an option when given various combinations of these six factors. For example, you might be considering buying an option, and you calculate its fair value from these factors: Another person might use different assumptions and have a different fair value.
Calculations of this type are important for deciding if the price of the option is a good deal. You can compare your assumptions with those of the market to determine strategies. The difference between your estimate of the fair value of an option and its current market price is sometimes called the theoretical edge this concept is discussed in detail in Chapter 4 and is used extensively in describing option strategies. Price of the Underlying Instrument The price of the UI is the most important influence on an option price.
In combination with the strike price, it determines if the option is in-themoney or out-of-the-money. The relationship between the option and the UI changes as the factors outlined here change, but the delta measures only the sensitivity of the option price to changes in the price of the UI. The delta is calculated using option evaluation formulas.
A delta of 0. The delta can range between 0. The delta is the percent change of a single point move in the option when the UI moves one point. The delta changes as the price of the UI changes.
A deep in-the-money option will have a delta approaching 1. Figure 3. It shows the price of the option at various prices of the UI and breaks the option price into intrinsic value the shaded area and time value. The delta is the slope of a line tangent to the price curve. As the price moves up the curve, the slope increases, hence the delta increases. This also means that the delta changes with every change in price of the UI. However, the delta represents the relationship of the option price and the UI price for only an instant.
It is only a snapshot Everything is dynamic. As soon as the price of the UI or the option moves, the delta changes.
However, if the price of the UI moves higher, the delta of a call option will increase and the price of the option will move more than half as much. For example, presume a delta of 0. Put another way, it is the rate of change of the delta for each one-point move in the UI.
It is expressed as points of delta for every point change in the UI. The delta is important for both traders and hedgers. Traders can use the delta to help identify the options with the most responsiveness to the UI. Hedgers need to know the delta to have the proper number of contracts to hedge their particular instrument. Strike Price The strike price has a major impact on the option price because it determines whether the option is in-the-money or out-of-the-money.
This illustrates the same principle as Table 3. In addition, Figure 3. For example, say you bought a 65 call when the price was The components of the option price change from all time value to increasing intrinsic value. Notice also how the profits accelerate as prices approach and pass the strike price. The time remaining until the exercise date increases in importance as the exercise date nears.
When you buy an option, you are paying for the right to buy or sell something. The option has a time limit. The value will naturally decline as time progresses, all other things being equal. This illustrates that the time value of the option declines as the expiration day approaches. In addition, it demonstrates that far options will always be priced higher than near options. The difference is greatest when the UI price is at the strike price, but it declines as the UI price moves more inthe-money or out-of-the-money.
Time value does not decline in a straight line. Instead, it declines very little in the early days of its life and declines more sharply the closer it is to expiration.
The rate of decay is roughly a function of the square root of the time remaining. You can estimate the relationship of the rate of decay of two different options by taking the square root of the months remaining on the longest option. For example, the rate of decay of a two-month option is twice that of a fourmonth option because the square root of four is two. This is the loss in theoretical value that will occur if another day passes, all other things being equal.
Theta measures the time decay of an option, usually in points per day. A theta of 0. For example, an option with a theta of 0. Sometimes the theta of a complex position is given in dollars per day for the portfolio as a whole. This is particularly true if the portfolio contains different instruments. It would not make sense to mix the thetas of two different instruments, particularly if they are different commodities.
As a result, most options traders use the dollar value of the various thetas in their portfolios when they have mixed UIs. Interest Rates The level of interest rates also affects the price of options.
The higher interest rates are, the higher the premium will be for options. The reason is that options premiums are competing investments with debt instruments. Part of the pricing of an option premium is the so-called risk-free rate, which is usually considered to be the short-term Treasury-bill rate.
This will be discussed in more detail in the next chapter and in the sections of the book dealing with option pricing models. Few traders take rho into account when trading options because the changes in interest rates have little effect on option prices. Typically, option strategists just plug in the current interest rate and forget it. Assume a strike price of 50 with the UI trading at 50 with 90 days to expiration and an implied volatility see next section of 20 percent. This option will have a value of 1.
The value of the option is still worth 1. Interest rates would have to move all the way up to 8 percent before the value of the option moves down to 1.
As you can see, interest rates have little effect on option prices unless you live in a country with hyperinflation or where interest rates are moving rapidly and sharply.
Phi has even less of an effect on option prices than rho does. Typically, the only traders who pay attention to rho and phi are arbitrageurs who are looking to make microscopic profits on their positions.
Interest rates are typically looked at for such strategies as: Their effect will be mentioned in those strategies where they will have an impact. Expected Volatility The price of the option will be influenced by the expected and recent volatility of the UI. The more volatile an instrument is, the more valuable the option usually considered will be because increased volatility means there is a greater chance for the option to make money. Suppose you buy an out-of-the-money option with a strike of 60 and a price of 2 when the UI is The price range of the UI for the past year has been 48 to Unless something dramatic occurs, it will be unlikely that the call will expire with any intrinsic value.
On the other hand, a recent range of 25 to 75 suggests a much greater chance that the option will expire in-the-money. The option price is based on the expected volatility from the time of purchase to the time of expiration. Volatility might have been very low prior to initiating the position, but the market might expect the volatility to increase because, for example, earnings estimates are due to be issued or there is a series of economic reports about to be released.
Volatility can play a large role in selecting option strategies because of its powerful effect. The following chart shows the price of an at-the-money call with the price of the UI at 65 with 23 days remaining until expiration. Volatility Option Price 10 11 12 13 14 15 0. Models for determining the fair value of options can be turned on their heads and used to compute the components of the current price. Implied volatility is often calculated because of its importance.
The implied volatility of an option price is the expected volatility that is implied in the current option price. The responsiveness of the option price to changes in the volatility is called vega.
Vega measures how much the price of the option will change, given a 1 percent change in implied volatility. A vega of 0. For example, an option worth 3. Vega is used in the remainder of the book because it is the most common term used by traders and strategists. The concepts surrounding volatility are so important to option strategists that an entire chapter, Chapter 5, is devoted to volatility.
Dividend or Interest Payments If a stock pays dividends and many do , the dividends affect the price of an option on that stock particularly at the time that the payment is made. The value of the underlying stock will rise each day, all other things being equal, until the day the dividend or interest is paid. This is because the value of the stock is increased by the impending payment.
The ex-dividend day is the last day that you can own a stock and receive the dividend. The day after the dividend payment is made, the price of the stock will drop approximately the same as the value of the payment.
This affects the option as well. The option price will drop following the payment, even though the option owner does not receive the payment. This also has the effect of reducing the value of options that pay high dividends relative to those that pay low or no dividends. The dividend also has the microscopic effect on options of having the dividend receiver earn interest on the dividend.
The same sort of situation exists for options on interest-bearing instruments, such as bonds. The price of the option rises slightly each day until the interest payment is made. The price of the option then declines.
The daily rise in value is essentially imperceptible though the decline related to the payment is often easy to note. Once again, there is the additional microscopic effect on the value of the option of being able to earn interest on the interest. This compounding effect is virtually unnoticed unless you are holding multiyear options or the total value of your portfolio is huge enough to see the effect.
The main option traders who pay attention to the compounding of dividend or interest payments are the professional market makers in such instruments as interest rate caps and long-term over-the-counter equity options.
Just about everybody else ignores the effect of compounding. What is the most amount of money I can make? What is the worst that could happen to me? Size of Position The size of the position can make a significant difference in your return. Commission costs and, to a lesser extent, financing costs are reduced per unit the more shares, stock index contracts, or futures contracts are written against.
For example, a covered write program using GM stock will cost less per trade in commissions using , shares than using shares. Offsetting this may be an increased amount of slippage due to a lack of liquidity because of the size of position being initiated.
Trying to buy , options contracts at the market will move the market significantly. You might start buying the options when they are trading at 2. Your slippage will be about 0. Your commission bill will be small because you will have negotiated a good rate because of your size, but the slippage will be much greater than the commission savings. Importance of Price The returns of any option strategy are affected by the price paid or received.
This is particularly true with hedged strategies, such as covered writes, spreads, combos, and straddles. The gain or loss of a tick can have a profound impact on the return of the investment. This means that you should be alert to not giving up that last dime when entering a stock order. On the other hand, it is also important to be alert to false economies. You might be trading an option and looking for a huge move in the UI to drive the value of the option to atmospheric heights.
Then it would be smart to give up ten cents to the market or specialist to get the order filled and capitalize on the whole move. You, therefore, need to be looking at the kind of strategy you are using to determine the importance of price to that strategy.
The discussion about liquidity in Chapter 2 is relevant in this context as well. Break-Even Point The break-even point is the price point where you neither make nor lose money on your investment. Each option strategy has a different break-even point. At 55, the gain in the price of the widget is equal to the cost of the call. The break-even described here refers only to the break-even at the expiration of the option.
You can lose money before the expiration of the contract if the price of the instrument declines. This is because the value of the call is composed mainly of time value rather than intrinsic value. The decline in the UI price causes a decline in the option price but not to the same extent as if the option were in-the-money and had more intrinsic value.
The simple break-even point describes the situation only at the expiration of the option. Eventually, the position loses all its time value. The valuation curve illustrates the classic options curve. The actual break-even point at expiration is the same as the simple break-even point, but you must take into account transaction costs and 70 60 50 40 Profit c03 30 20 Break-even point 10 0 —10 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 Price of Underlying Instrument FIGURE 3.
Thus, the formula is: For example, a trade using stocks can take place using cash or margin. The carrying charge for a cash transaction will only be the opportunity cost. The carrying charge for stock bought on margin includes the cost of financing for the additional stock. Also note that carrying charges can be positive or negative. Some strategies, particularly those with lots of options that are sold, create positive carrying costs.
This means that you will earn money each day on the carrying charges.
Other strategies will cost you money to hold every day. The formula for the actual break-even point shows that you will add the carrying charges to the rest of the equation. Of course, if the carrying charges are negative, then you will be adding a negative number, which is the same as subtracting.
Net Investment Required The net investment required is the dollar amount necessary to initiate the trade.
Each option strategy requires a different investment. A major determinant of the amount is the type of trade. Are you buying or writing the option? Is it a mixed transaction that involves options and other instruments? Is the trade going to use cash, or will margin be used? The net investment required is detailed later in the discussion of each specific strategy.
The Investment Return It is just as important to know the return on your investment as it is to know the break-even point. There are several major ways to calculate the return on your investment.
Each way presents a different perspective on the proposed trade. A key way to make comparisons between various strategies is to annualize the return.
For example, you might expect to make 13 percent on one option strategy for two months but 9 percent on another strategy that you will hold for one month. For example, you make 9 percent for a one-month investment, but you do not know what your return will be for the remaining 11 months of the year. You might be able to reinvest at only 5 percent and would have been better off investing in a certificate of deposit at 8 percent for a year.
All discussions of return should also be tempered with the risk. One strategy might make 10 percent while another strategy makes 9 percent. It might be that the second strategy is still the best strategy because the risk is significantly lower. Think in terms of the amount of risk you are taking for each unit of profit. Return-if-Exercised The return-if-exercised is the return that the strategy will earn if one or all of the short or written options are exercised.
The return-if-exercised is not used if you have not sold short or written any options. The return is calculated by making the assumptions that the option is exercised and no other factor changes. The return is also affected by the type of transaction and account, which affect the carrying costs and the final position that the investor owns after the option is exercised.
For example, in a covered call position, the return-if-exercised is the return on the investment if the underlying stock was called away. The option expires in three months. The return-if-exercised would be significantly different if the stock had been bought on margin. The cost of borrowing the money would then have to be taken into account. Also note that dividends or interest payments, if any, should be taken into account, as well as the interest earned, if any, on the proceeds of the short option.
All of these carrying-charge-type factors will affect the return-if-exercised. Look at the same General Widget example but with these changes: The second General Widget example given assumed that you sold short an in-the-money option and that the price of the UI did not decline to below the strike price—in other words, the price of the option did not change and the stock was called away by the exercise.
But what if the price dropped below the strike price?
The option would not have been exercised, and the preceding calculation would not occur. This shows the main problem with calculating the return-if-exercised. It assumes that the option is exercised, which requires that you make an assumption on the price of the UI.
Also note that there is a greater chance that the return-if-exercised will be an accurate description of the eventual return to you the deeper in-the-money the option is. Return-if-Unchanged The return-if-unchanged is the return on your investment if there is no change in the price of the UI.
This calculation can be done on any option strategy. It also assumes that the option price does not change and so describes the most neutral future event.
For this reason, it is a popular return to calculate. It is often the starting point for the option strategist for identifying a possible investment. Of course, the chances of the UI price being exactly unchanged are very low. As a result, this is just the starting point for analysis of the strategy, not the final analysis. The calculation is done in much the same manner as the returnif-exercised, except that the strategy can include multiple legs, or options.
There can be different strikes and types in the calculation.