Options Trading

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The Motley Fool "Options Edge" Handbook

By Jeff Fischer
From Motley Fool President,
Scott Schedler
Dear Fellow Investor,
You're in a very fortunate position...
The market of the last year or two is creating some unique opportunities. That's why I've arranged for Jeff Fischer (the expert
behind our two premium trading services, Motley Fool Options and Motley Fool Pro) to reveal to you some of his most powerful,
and widely useful, options trading strategies in this special "Options Edge" handbook.
Jeff Fischer is a long-time Fool who co-managed the original Rule Breaker
portfolio from 1994 to 2003 with Motley Fool co-Founder David Gardner. Motley Fool options wiz, Jeff Fischer -- an
extraordinary trader with a documented 93%
Together they helped investors earn more than 20% per year. More
success rate -- leads two exclusive groups
recently, Jeff began focusing on options to take advantage of moments of committed to achieving bigger returns in up,
unprecedented volatility. And of his last 42 trades -- 39 have generated down, and sideways-moving markets:
serious profits. That's a staggering 93% rate of success.
Motley Fool Options, our
And what's truly exciting are the profits that are still to come! dedicated options service, has
been piling up profits and
With access to all of The Motley Fool's resources -- all the research and
dazzling members...
coverage from our newsletter team, and all the community intelligence of
CAPS -- Jeff is prepared to zero in on short-term price moves and Motley Fool Pro, our slightly
leverage his considerable trading expertise. more sophisticated trading
service, employs options, ETFs,
And this special "Options Edge" handbook is a perfect primer if you, too,
and other advanced hedging
are interested in building wealth in up, down, and even flat markets. Inside
strategies to help members
you'll discover the tools to profit more substantially, and more assuredly,
achieve their financial dreams...
than at any point in recent history!
And because we're committed to maximizing
It's all part of The Motley Fool's ongoing commitment to empowering you, the profit potential and experience for our
the individual investor. premium members -- Motley Fool
Options and Motley Fool Pro are by
Kindest regards, invitation only...
So if you're interested in learning more

about Motley Fool Options, or slightly
more advanced Motley Fool Pro, simply
click the button below. We will notify you
Scott Schedler the moment either service begins
accepting new members.
President, The Motley Fool
Click Here
It's Free!
1 of 23 2009/12/13 12:06
Why Options?
Options are ideal for generating income, protecting profits, and most importantly, earning outsized gains! They can generate
returns in flat markets, cushion the blow of down markets, and be outstanding performers in decent markets. So basically,
whatever your investment goals, options can be a powerful addition to your portfolio.
And it's important for you to know that I advocate trading options as an investor, not as a speculator. In other words, every option
trade we make should be based on thorough analysis of the underlying stock and its value. That way, the option is simply a way
to leverage what we know about a stock.
What Are Options?
Stock options formally debuted on the Chicago Board Options Exchange

in 1973, although option contracts (the right to buy or sell something in the Motley Fool options wiz, Jeff Fischer -- an
future) have been around for thousands of years.
committed to achieving bigger returns in up,
Applied to stocks, an option gives the holder the right, but not the
down, and sideways-moving markets:
obligation, to buy or sell an underlying stock at a set price (the strike
price) by a set date (the expiration date). The option contract allows you Motley Fool Options, our
to profit if a stock moves in your favor before the contract expires. Not all dedicated options service, has
stocks have options -- only those with enough interest and volume.
There are only two types of options: calls and puts. A call appreciates dazzling members...
when the underlying stock rises, so you buy a call if you are bullish on that
"84% gain in 3 weeks..." I closed my
company. A put appreciates when a stock declines. You buy a put if you NVDA covered call option at a 84% gain in
believe a stock will fall or to hedge a stock that you already own. One way 3 weeks!!! I would never ever thought
to remember this is: "call up" and "put down"... about using options in my years of
investing if it wasn't for Jeff and Jim.
Thanks guys. -- S.S. Melrose Park, IL
By the way, there's an Options Glossary in the back of this handbook for
you to use at any point! "Add to my education and wealth
building...." "I've been able to add options
Next, let's walk through the most common options trades: buying calls, to my toolbox. I have seen the potential
options can add to your portfolio and know
buying puts, selling covered calls, and selling puts.
this service will add to my education and
wealth building. -- D. Heredia, Keller, TX
Strategy Why
Motley Fool Pro, our slightly
more sophisticated trading
When you believe a stock will rise significantly service, employs options,
Buy Calls over time and you want to leverage your returns or ETFs, and other advanced
minimize capital at risk hedging strategies to help
members achieve their
To short a position or to hedge or protect a current
financial dreams...
Buy Puts
long holding
"Incredible" "My average investment
return per month is 11%, which will bring
my annual to 132%. Wow! That is
Sell Covered incredible! Am I missing something or can
To earn income on shares you already own while this be true?"
Calls
waiting for your desired sell price -- A. Ward in Brighton, Michigan
(sell to open)
"In for the long haul..." "I will be in for the
long haul with this philosophy!!!! I wish I
To get paid while waiting for a lower share price had been 'playing the FOOL' since 1995,
Sell Puts but just since February 2009 it has been
(your desired buy price) on a stock you would be
(sell to open) extra fine. Rock on!" -- G. Seibert, Marietta,
happy to buy Georgia

the profit potential and experience for our
Buying Calls premium members -- Motley Fool
Options is by invitation only...
Investors often buy call options rather than buying a stock outright to
2 of 23 2009/12/13 12:06
obtain leverage and potentially increase returns several-fold. Call options

So if you're interested in learning more
work as "controlled" leverage, enhancing your possible returns while
limiting your potential losses to only what you invest (which is usually a more advanced Motley Fool Pro, simply
much smaller amount than a stock purchase would be). Because each click the button below. We will notify you
the moment either service begins
option contract represents 100 shares of stock, an investor can control --
and benefit from -- many shares of stock without putting a lot of capital at
risk. When you make the right call, you'll enjoy higher returns than you
would have if you had used that money to buy the actual shares.
Click Here
It's Free!
Let's look at an example. Imagine that a stock that you know well has
been hit hard and now trades at $27 per share. You believe the shares
will rebound in the coming months or year. The market offers $30 call
options on the stock that expire in 18 months for $1.50 per share. Therefore, 10 contracts, representing 1,000 shares of the
stock, will cost you $1,500 plus commissions. This option contract gives you, its owner, the right to buy 1,000 shares of the stock
at $30 any time before expiration.
If your stock starts to rise again, your options will increase in value, too. Suppose the stock recovers all the way to $32 after a
few months. Your option's value would likely at least double to $3 or higher per contract. You've made 100% in a few months. If
you had simply bought the stock, you'd only be up 18.5%.
Of course, there is a flip side. Suppose your stock continues its decline to the abyss. Even 18 months later, it's below $20, so
your options expire worthless -- though hopefully you sold them at some point along the way to recoup part of your investment.
I like to buy longer-term call options on well-valued stocks that I believe will pay off handsomely over the coming months or
years. It's a way to take more meaningful positions in stocks I believe in -- without risking mounds of capital. This is useful if you
lack capital or just don't feel like risking it all in a stock.
As with any investment, you should only invest what you can afford to lose, since a stock can easily work against you in a set
amount of time and make your call worthless. Where real opportunity can be lost is when your timing is wrong. Your options
might expire before the stock rebounds, causing you to lose your option money and miss the stock's eventual rebound. Thus, we
aim to buy longer-term calls in positions in which we have high confidence and that have near-term catalysts.
Buying Puts
Next up, the antithesis to call options: puts.
Buy put options when you believe that the underlying stock will decline in value. Buying puts is an excellent tool for betting
against highly priced or troubled stocks, or even entire sectors! With put buying, your risk is again limited to the amount that you
invest in stark comparison to traditional short selling, where your potential losses are unlimited. Ouch!
Aside from betting against a position with puts, you can also buy puts to protect an important position in our portfolio, one that
you don't want to sell yet for any number of reasons. When a stock being protected -- or hedged -- in this way declines for a
while, the puts will increase in value, smoothing out returns.
I tend to buy puts on stocks that I believe are due to decline over the coming months or even years. You may also use puts to
hedge long positions that you own, or to short sectors and indexes in a small portion of your portfolio. I almost always buy puts
rather than short something outright to limit my risk.
Selling Covered Calls
Now our overview moves from the act of buying options to, instead, selling them to others.
Any qualified investor can "sell to open" an option contract. When you do so, you don't pay the premium; instead, as the contract
writer, you get paid. All cash generated from your option selling is paid immediately and is yours to keep.
"Covered" simply means that we own the underlying stock at the same time. Writing covered calls is one of the most
conservative options strategies available. In fact, most retirement accounts allow you to write covered calls. They're generally
used to generate income on stock positions while waiting for a higher share price at which to sell the stock.
3 of 23 2009/12/13 12:06
Here's an example of a covered call. Suppose you own 1,000 shares of a stable, blue-chip stock. It's trading at $56, but you think
it is fairly valued around $60 and you would be happy to sell at that price. So you write $60 call options on the stock expiring a
few months ahead, and you get paid up front to do so.
If the stock does not exceed $60 by your option's expiration, you keep your shares and you've made money on the call options.
You could then write more calls if you wanted to. If the stock is above $60 by expiration and you haven't closed out your call
option contract, you'd sell your stock at $60 via the options. Your actual proceeds on the sale would include the option premium
you were paid. So you sold your shares at the price you wanted to and received some extra cash for doing so. That's pretty
sweet.
So, write covered calls when:
You would sell a stock that you own at a higher price, and
you're not worried about it declining too much in the meantime. When to write Covered calls
Write calls at your desired sell price, collect the dough, and
then kick back and wait. Rinse and repeat, month after month, You would sell a stock that you own at a
when you can. higher price, and you're not worried
about it declining too much in the
You believe a stock you own is going to stagnate for a while,
meantime. Write calls at your desired sell
but you don't want to sell it right now. Write calls to make the
price, collect the dough, and then kick
stagnation more profitable.
back and wait. Rinse and repeat, month
You want to cushion a stock that is in decline, but that you're after month, when you can.
not ready to sell yet. Tread carefully here so you don't get sold
You believe a stock you own is going to
out at too low a price.
stagnate for a while, but you don't want
When you write covered calls, you must be prepared to give up your to sell it right now. Write calls to make
shares at the strike price. Approximately 80% to 90% of options are the stagnation more profitable.
not exercised until expiration, but they can be exercised early, so the You want to cushion a stock that is in
call writer has to be prepared to deliver the shares at any moment. decline, but that you're not ready to sell
yet. Tread carefully here so you don't get
That means that if the $56 stock in the example above suddenly
sold out at too low a price.
soars to $70, you'd still have to sell at $60. This is the biggest
downside to covered calls -- lost potential if a stock price rises. The
other risk is that a stock may fall sharply after hovering around your
desired sell price for a while, forcing you to wait longer for your sell price.
Even though covered calls are low risk, you should use them only on stocks you know well. You could even set up some
covered call-only positions -- buying a stock just to write calls on it.
4 of 23 2009/12/13 12:06
Selling Puts
Note: to sell puts, you must have a margin account. You won't actually need to use margin -- which entails high risk -- but you
must be margin-approved, have ample buying power (cash, in our margin-free strategy), and have full options permission from
your broker.
Selling puts -- also referred to as selling naked puts -- is a favorite strategy of mine to seed a portfolio. There may be plenty of
stocks that I'd like to buy at the start, but I'd prefer to snag them at lower prices. Put options are an excellent way to potentially
buy a stock at your desired, lower share price and get paid an option premium while waiting for that price, whether it arrives or
not.
Let's turn to an example: A top-rated stock we found on Motley Fool CAPS and researched thoroughly is trading at $39, but our
analysis suggests that we shouldn't buy it above $35. The $35 put options expiring four months out are paying $3 per share. We
"sell to open" the put contracts and get paid $3 per share to make the trade, giving us a potential net purchase price of $32
before commissions. A few things could happen here.
Scenario 1: The stock could stay above our $35 strike price; the options we sold would expire. We didn't get to buy the
stock at the price we wanted, but at least we made money on the options we sold.
Scenario 2: The stock could fall below $35 by expiration. In this situation, our broker would automatically buy the stock for
our account, giving us a start price of $32 before commissions -- even lower than our $35 desired buy price!
Scenario 3: The stock may tank to $29 soon after we sell the puts, but then climb back above $35 by expiration. In this
case, we most likely would not have had the shares sold to us during this brief decline because about 80% of options are
exercised only at expiration, not before. So we won't own the shares, and we'll have missed our buy price and the stock's
rebound -- but we did get paid the premium, at least, and can try again.
Scenario 4: The company's CEO flees to Bermuda and the stock is only at $16 by our option's expiration. We didn't
have the heart to close our losing option position, and we still have hope, so we wait and the shares are "put" to our account at
$35 (minus our option premium) upon expiration. This is the worst-case scenario -- we're down 50% to start. But we own the
stock now and can hope it rebounds. Of course, assuming that we would have bought the stock outright when it hit our $35 buy
price, as we had considered, we would be down even more than we would be with this strategy.
You should most often sell puts when a stock you follow closely and want to own is, alas, above your desired buy price. You
should sell puts on it at lower strike prices, prices that you believe are great levels at which to buy. Either you eventually get to
buy the stock at your desired price via the puts, or you keep writing puts if the situation merits it. You may also sell puts when a
stock you already hold a partial position in is above the price where you'd like to buy more. You can write puts as you wait to
average in at lower prices. This is a great tool for allocation and averaging into a position.
Writing puts on stocks you know well and want to own at lower prices can be an excellent tool for income and for securing lower
buy prices, but you must be prepared to buy the stock should it fall below your strike price. At all times, you must maintain the
cash or margin (for us it's always cash and we recommend you follow that rule, too) to buy shares if they are put to you.
It's important that you only write puts on stocks that you understand well and will be happy and ready to buy at the prices you're
targeting. The risks of writing puts include the fact that the stock could soar away without you. In many cases, it's better to just
buy a great stock once you've found it. The other risk, of course, is that a stock falls sharply and you're stuck owning it. The
biggest risk with selling puts, as with all options, is when investors rely on margin instead of cash. That can quickly wipe out a
portfolio.
Let's review...
Call Option Put Option
The right, but not obligation, to buy a stock The right, but not obligation, to sell a stock at a set price
at a set price (the strike price); calls (the strike price); puts appreciate as the stock falls
Option buyer
appreciate as the stock rises (remember: (remember: "put down")
"call up")
5 of 23 2009/12/13 12:06
The obligation to sell a stock at the strike The obligation to buy a stock at the strike price; must
Option writer (or
price; must hold the stock in the account. have the buying power at the ready (preferably in cash) in
seller)
This is called a "covered" position. case the stock declines
Option buyer Believes the underlying stock will rise Believes the underlying stock will fall
If the stock rises, is ready to sell shares at If the stock falls, is ready to buy it at the strike price,
Option writer (or
the strike price, keeping the premium paid for keeping the premium received for writing the option
seller)
writing the option
8 Tips for Writing (or Selling) Puts
Always choose a strike price at which you'd be happy to buy the stock.
Focus on strong businesses that you'd be excited to own for the long term.
Write "out-of-the-money" puts, meaning your strike price is below the stock's current share price.
Verify that the option premium payment makes the trade worthwhile.
Remember, you often won't get to buy the stock; you'll just get option income. That's why we sometimes write puts on
stocks in which we already own partial positions.
Put writers do not collect dividends paid by the underlying stock.
Never overextend yourself by writing too many puts. Brokers allow put writing on margin, but we write puts when we have
the cash to buy the stock.
Vary the expiration dates among your individual option holdings so they don't all fall in the same month -- this staggers
your risk.
You may write "in-the-money" puts with strike prices above the current share price when you're especially bullish on a
stock and want to capture more upside potential with its options. This strategy also increases the odds that you get to buy
the stock. When you write in-the-money puts, the guidelines in our table don't apply.
Put writing is a bullish, or at least neutral, strategy. When you write a put, you're saying you believe the underlying stock will
eventually increase in price (hopefully after you've bought shares), or at least hold steady -- meaning you'll earn income on your
puts when they expire.
Let's use an example: Assume you're bullish on the health-care company, Kinetic Concepts (NYSE: KCI). The stock increased
from $20 to $25, so you're not as anxious to buy it. If the shares fell to $22 or so, however, you'd be happy to buy. Rather than
just sit and wait, you can write (remember, that's "sell to open") the $22.50 strike price put options. You'll get paid while you wait,
and you'll potentially get that lower buy price.
Before placing this trade, make sure you have the cash (or, for
experienced investors, ample buying power) in your account to buy a
minimum of 100 shares of Kinetic. You can then write $22.50 puts
that expire in a few months. Let's say the puts pay you $1.50 per
When to write puts
share, and you write two contracts representing 200 shares of
You're ready and willing to buy a stock at
Kinetic. You're paid $300 (minus commissions) up front. And now you
a lower price and
wait (cue the Jeopardy theme).
You don't believe the stock will soar
If Kinetic Concepts ends this time period above $22.50, your options away from you in the meantime
simply expire, and you keep the $300. You can then write new puts if (otherwise you'd just buy the stock), or
you'd like. If Kinetic dips below $22.50 at the option's expiration, the
You just want to make income writing
puts you wrote will be exercised, and you're on the hook to buy 200
puts. You don't believe a stock will drop
shares of Kinetic at a strike price of $22.50. Including the option
to your buy price, but if it does, you'd still
premium you received, your start price is actually $21. Nice! Now you
be happy to buy it.
own shares at an attractive start price and can wait for appreciation.
6 of 23 2009/12/13 12:06
So, you write puts when:
You're ready and willing to buy a stock at a lower price and
You don't believe the stock will soar away from you in the meantime (otherwise you'd just buy the stock), or
You just want to make income writing puts. You don't believe a stock will drop to your buy price, but if it does, you'd still be
happy to buy it.
What Can Go Wrong?
Sounds perfect, doesn't it? You're paid to potentially buy a stock you wanted to buy anyway -- and at a price you like. That's
beautiful.
But every investing strategy has some risk. In this case, assume Kinetic Concepts doesn't fall below $22.50 by the time your
option expires, but instead jumps to $30 over the next few months. You miss out on a $5 stock gain for only a $1.50 gain in the
put options, and you still don't own shares. Now what do you do? It might be a tough call.
Kinetic could also drop to $22 soon after you write your puts, but then climb back to $25 just as your puts hit their expiration
date. Because almost all options are exercised only at expiration, you won't get the shares, and you will have missed your buy
price. Of course, you keep the $1.50 option premium and can write new puts, but what if you miss your buy price again?
There's also the scenario that the stock drops and doesn't come back up for a long time. If Kinetic fell to $17, your options would
be far underwater. In this case, you must be ready to just buy the stock at your net price of $21 and hope for a rebound. At least
you're getting a much lower start price than if you had simply bought the stock outright at $25 on day one.
But if you no longer wanted to own Kinetic even at $17 -- say there's a fundamental change in the business -- you would need to
buy back your puts ("buy to close") early -- and at a large loss. So, Fools, whenever you write puts, be confident that you want to
own the stock for the long haul.
7 of 23 2009/12/13 12:06
Make Put Writing Worthwhile
When you like a stock enough to want to own it, be as certain as possible that it's a good strategy to write puts rather than just
buying the shares outright. In general, don't write puts when you believe a stock is greatly undervalued and about to take off --
just buy the stock. Write puts when you believe a stock is a good buy at a certain price yet is unlikely to leave you in the dust if
you don't buy it anytime soon.
Once you've identified a put contender, calculate whether the options are paying you enough to make the risks worthwhile.
Weigh both the risk of waiting to buy the stock instead of buying today (missing potential upside) and the risk if the stock falls
sharply.
You want a large enough cushion on your puts to ensure a much better valuation on the stock you'll potentially buy. At the same
time, you want enough payment from the options to make the trade worth your wait. The table below shows what to generally
seek on options expiring in four months or longer versus those that expire in a few months:
Fact or to Options Expiring in 4 Options Motley Fool options wiz, Jeff Fischer -- an
Consider Months or More Expiring in 3 extraordinary trader with a documented 93%
Months or
Less down, and sideways-moving markets:

Strike price
Strike price should be at dedicated options service, has
should be at least
Strike price least 7% below current
4% below current
stock price.
stock price.
dazzling members...
"84% gain in 3 weeks..." I closed my

NVDA covered call option at a 84% gain in
Trade's break-even 3 weeks!!! I would never ever thought
At least 8% to 9%
price (your strike price At least 14% to 17% below about using options in my years of
below current investing if it wasn't for Jeff and Jim.
minus the option current stock price.
stock price. Thanks guys. -- S.S. Melrose Park, IL
premium paid to you)
"Add to my education and wealth
At least 7% to 10% of your to my toolbox. I have seen the potential
options can add to your portfolio and know
strike price. (This is also At least 4% to 5%
Option premium this service will add to my education and
your return on the cash of your strike wealth building. -- D. Heredia, Keller, TX
payment
you'll be keeping aside for price.
the possible stock buy.) Motley Fool Pro, our slightly
service, employs options,
Target time frame For the above
No more than 9 months; ETFs, and other advanced
until option figures, ideally, 3
ideally, 6 months or less. hedging strategies to help
expiration months or less.
financial dreams...
Now let's apply these guidelines to a real-life scenario. On Nov. 11, 2008,
Kinetic Concepts was trading at $24.35 per share -- but let's say you "Incredible" "My average investment
preferred to buy in the low $20s. The $22.50 January options, which
my annual to 132%. Wow! That is
expire in just two months, we're bidding at $2.20 per share. The strike incredible! Am I missing something or can
price of $22.50 was 7.6% below the stock's current price of $24.35, and this be true?"
-- A. Ward in Brighton, Michigan
the option premiums paid a solid 9.7% of your potential purchase price
($2.20 on a $22.50 strike price). Your breakeven price if you get the "In for the long haul..." "I will be in for the
shares is just $20.30 -- 16.6% below the current share price. long haul with this philosophy!!!! I wish I
had been 'playing the FOOL' since 1995,
These numbers are great, especially for an inexpensive-looking stock and but just since February 2009 it has been
extra fine. Rock on!" -- G. Seibert, Marietta,
options that expire in less than three months. Even if you didn't get the Georgia
shares at expiration, you would have earned $2.20 per share in two
months, or nearly 10% on the cash you have set aside for this trade.
the profit potential and experience for our
8 of 23 2009/12/13 12:06
Closing Early and Rolling Forward premium members -- Motley Fool

Options is by invitation only...
If you no longer want to potentially buy the underlying stock, or if you've So if you're interested in learning more
made most of your potential profit on the options, you can close your puts about Motley Fool Options, or slightly
more advanced Motley Fool Pro, simply
early. Just "buy to close" the puts you sold earlier; you'll pay the going
market price, resulting in a gain or loss dependent upon what you were the moment either service begins
paid for the puts at the start. In most cases, we won't close a put early at a accepting new members.
loss unless we're certain that we don't want to own the underlying stock
anymore -- which would mean our analysis was mistaken from the Click Here
beginning or something drastically changed at the company. It's Free!
You can also choose to close your put-writing strategy early to write new
puts that expire in a later month, paying you a higher option premium. You
might do this if you've made most of the money you can possibly earn on
the trade (about 85% is our guideline); if you want more time for your strategy to play out; or if you simply want to be paid more
now for keeping the strategy in place, for any reason. This is called "rolling forward." Just make sure you can find attractive new
puts to write before closing your old ones.
Bottom Line
Target healthy businesses with attractively valued stocks, and your put writing strategy should leave you happy, whether it
generates income or you end up buying the stock. Write puts on stocks you'd like to own at cheaper prices, or on stocks that
won't likely decline (but you'd happily own if they did) to generate income. If you really want to own a stock, though, buy at least
some shares outright.
Broker Requirements
Applying for options trading permission with your broker involves filling out a form that they'll give you when you ask. Simply say,
"I'd like to apply for full options trading permission, please." You'll need to answer questions about your investing experience,
your assets, and a bit more. It can take a week or longer to get approved. If you plan to follow along with our options trades,
you'll want to apply for full permission right away.
With most brokers, you can buy options even if you have very little money, say $5,000 or $10,000. The advantage of buying an
option contract or two is that you can "control" many shares of the underlying stock for, typically, just a few hundred dollars. If the
stock rises, you'll earn strong higher returns on your money. However, to make options worthwhile after spreads and
commissions, we suggest have at least $10,000 in your account.
To sell -- or write -- options, you should have a higher account

balance and you'll need a margin account as well. Typically, a
brokerage firm will require about $25,000 before you can sell put
options, less if you wish to sell covered calls (there, you only need to
Bottom Line
own the underlying stock). If you're not ready or able to sell puts yet,
Target healthy businesses with attractively
that's perfectly fine. It's probably the strategy you should consider
valued stocks, and your put writing strategy
last if you're new to options. We suggest starting with the more
should leave you happy, whether it generates
practical (and less expensive) strategies of buying calls, buying puts,
income or you end up buying the stock. Write
or writing covered calls. As your account grows over time, you can try
puts on stocks you'd like to own at cheaper
out more involved options strategies.
prices, or on stocks that won't likely decline
When writing any options, the brokerage terminology used to start (but you'd happily own if they did) to generate
the position is "sell to open." To later close the position, you would income. If you really want to own a stock,
use "buy to close." Writing options -- put-writing, specifically -- though, buy at least some shares outright.
requires ample buying power in your account. Be sure to review your
cash and margin buying power before writing a put option.
Meanwhile, buying options is not unlike buying stocks. You can buy
options with cash or partly on margin, but margin is certainly not recommended.
9 of 23 2009/12/13 12:06
Protective Collars
As you move deeper into the world of option strategies, you'll begin to find creative ways to protect, leverage, or hedge your
portfolio -- often with little downside risk and at little to no cost to you.
In this guide, you'll learn how to use options to protect an existing investment from downside, often without any out-of-pocket
expenses. This is called a protective collar -- and when it's free to you, it's called a costless collar.
Protective collars are useful in bear markets or when you're uncertain about a stock's valuation risk. They can also be a prudent
way to protect your gains on stocks that have recently leaped in price, nearing your estimate of fair value. Let's explain how
collars work, starting from the beginning.
Insure Your Positions by Buying Puts
As a long-term investor who remains committed to your core holdings, you

may be reluctant to sell even if you see storm clouds on the economy's
horizon. After all, life is full of ups and downs, and you can't simply disengage
when the going gets tough. However, when it comes to equities, you can Collar Cheat Sheet
protect your portfolio by purchasing put options.
Protective collars can be used to shield
That's right. Purchasing options -- not selling them. When you sell options, against downside risk in rocky markets or
you are obligated to either deliver the shares (in the case of a call) or buy to safeguard gains when you're not ready
to sell -- but would willingly sell at slightly
shares (in the case of a put). But when you buy options, you're not under any
higher prices.
obligation regarding shares of the underlying investment.
Buy puts and sell calls with the same
So if you buy puts on a stock you own, and the puts gain value, you'll simply expiration date but different strike prices
(the most attractive available).
sell those puts later for a profit and still keep your shares of the underlying
stock (assuming you want to). In other words, when you buy them, you're You can "cover" all or some of your
using options as a strategy on their own, without needing to get the shares.
underlying stock involved unless you want to. The position you're protecting usually
needs to decline soon -- or sharply -- for
Now let's explain buying puts, specifically. A put option goes up in value when puts to pay off handsomely.
the underlying equity or exchange-traded fund declines in price. So when you
Don't sell calls on stocks you're not willing
buy a put, you're basically buying insurance for your investment. A put gives to sell or that you believe are grossly
its owner the right to sell the underlying investment at a minimum set price underpriced.
(the strike price) by a set date (the option's expiration date) no matter how far
Typically seek to use options that expire
it falls. In times of uncertainty, buying puts to protect your key holdings makes in six months or more -- or even
plenty of sense. However, it can be expensive -- and who wants to shell out Long-Term Equity Anticipation Securities
piles of cash for insurance policies that will one day expire? (a.k.a. LEAPS) that expire in 18 months or
more. This allows you to choose more
advantageous strike prices and be paid
Enter the costless collar. Using this strategy, you buy your puts -- your
more for the calls.
insurance -- with funds you receive from the concurrent sale of call options,
thus saving yourself the cost of the puts.
The Costless Collar: Buy Puts, Sell Calls
Assume you own shares of Vanguard Emerging Markets (NYSE: VWO). You believe emerging markets will reward investors
in the long run. But in the intermediate term, you still see risk to the downside. You want to protect your investment against a
large decline, just in case.
For example, assume Emerging Markets is trading at $21. For a costless collar, you want to buy puts and sell ("write") calls to
pay for them. Let's say (using real-life quotes available as I write this) that the $19 strike price put options expiring in seven
months can be purchased for $2.30 per contract. Also, the $24 strike price call options can be sold for $2.10 per contract. The
puts will protect you from a meaningful decline in the ETF's price, and selling the calls to pay for them means your net cost for
the strategy is only $0.20 per share plus commissions (remember, you're paid $2.10 for selling the calls, and you need to pay out
$2.30 to buy the puts). Nice -- that's cheap insurance.
The real cost of implementing a protective collar is limited upside. If shares of Emerging Markets exceed $24 by your call option's
10 of 23 2009/12/13 12:06
expiration, you'll miss any upside above that price and need to sell your shares at $24. But if the ETF's price declines over the
next few months, you'll be glad you set up the collar. The puts will provide a profit, and the calls you sold will expire. Meanwhile,
you can keep holding your shares to await eventual gains.
Insure Your Positions and Keep Upside, Too
There is a way to insure your investment and maintain unlimited upside potential on at least some of your shares. Assume you
own 600 shares of Kinetic Concepts (NYSE: KCI), bought at $21. Looking at the options that expire in 10 months, you can sell
$25 strike price covered calls for $4 per contract. With the proceeds, you can buy the $17.50 strike price puts for only $2 per
contract. This means you can protect all 600 shares by buying six puts, but you only need to sell three calls to pay for it -- and
you still pay nothing out of pocket.
Your full position is protected against a sharp decline, and half of your shares still have unlimited upside potential since you
didn't sell calls on them. This type of strategy combines the best of both worlds: Limited downside and unlimited upside.
The Bottom Line
Collars can smooth returns, help hedge your portfolio, protect a holding, and allow you to ride out a rough market with more
confidence. They're not for everyday use, but they're useful in situations that merit protection.
Synthetic Longs
Are you confident about a stock, but reluctant to pony up the cash to buy it today? A synthetic long may be just the ticket.
This option strategy works nearly the same as owning the underlying stock outright -- except you don't need to pay up front.
Usually, you'll set up a synthetic long on a stock if you foresee a strong catalyst for appreciation in the next 18 months or so. As
the stock price goes up, your options gain value along with it, sometimes to a much greater degree.
Earlier, you discovered that when you buy options -- as opposed to

selling (or writing) them -- you aim to profit from the option itself,
rather than getting the underlying equity involved (unless it's to your
benefit). The synthetic long allows for the best of both worlds: On the Synthetic Longs at a Glance
options you buy in this strategy, your upside potential is unlimited;
Synthetic longs are best when you're bullish on
on the options you sell, the worst-case scenario is that you end up
a strong business, at least somewhat bullish
buying the underlying stock at a price of your choosing. This makes
on the market overall, and expect a catalyst
the synthetic long an especially attractive trade for bullish investors.
over the next 18 months or so.
Buy Calls, Sell Puts Typically, you should use the longest-dated
LEAPs (Long-Term Equity Anticipation
To initiate a synthetic long, you buy a call option and concurrently Securities) you can find so you'll have the
sell a put option on the same underlying stock or exchange-traded largest window of time to be proven correct;
fund. For a true synthetic long, the calls and puts will have the same refrain from initiating short-term synthetic longs
expiration date and strike price, although there are attractive that expire in nine months or less.
variations that you'll discover below.
You must be ready to buy the underlying stock
When you buy a call, you believe that the underlying stock is going to if it falls below your put option's strike price.
appreciate considerably over the life of your option. If it does, the call
usually gains value dramatically. If the stock does not appreciate, Remember the three possible outcomes with a
however, your calls will move toward expiration with less and less synthetic long: (1) the stock increases and
value, finally ending with little or no value. both your options make money; (2) the stock
decreases enough that you're obligated to buy
That is always the risk of buying options. You need to be correct by it via your put options; or (3) the stock
the expiration date or the option won't maintain value, and you could stagnates, in which case both your options
lose your whole investment. This potential loss is much easier to may simply expire, and you're back where you
stomach, though, if you use income from a put sale to buy your calls. started.
This is exactly what you do to set up a synthetic long position. Let's
see an example. A true synthetic long uses the same strike price
and expiration date for both calls and puts; you
11 of 23 2009/12/13 12:06
Bullish on Autodesk? Go Synthetic Long! can "split the strikes," however, to set up a
more defensive or aggressive synthetic long,
Suppose you have a bullish long-term stance on 3-D software leader depending on your preference.
Autodesk (Nasdaq: ADSK). You believe the business will be on the
Once your thesis has largely played out and
upswing again within 18 months, so you'd like to set up a synthetic
you've earned money on your calls, consider
long position to benefit.
taking your profit on the calls; use the
With the shares trading around $12.50 (as of March 13, 2009), you underlying stock's valuation and your option's
could have bought the January 2011 $12.50 call options on Autodesk approaching expiration date as guides.
for $3.80 per contract, and concurrently sell (or write) the January
Using a synthetic long option strategy on a
2011 $12.50 put options for $3.50. Your net cash outlay is just $0.30
dividend-paying stock does not entitle you to
per share. Once you make these trades, if Autodesk begins to
the dividend payment.
appreciate, both your calls and puts will start to show gains in your
portfolio, in effect mirroring the stock or even outperforming it. If
Autodesk appreciates to, say, $20 by sometime in 2010, your calls
will gain 100% to 200%, and your puts will be well on their way to becoming a 100% cash gain, too.
On the flipside, let's suppose Autodesk continues to suffer from soft sales, and shares drift lower to $10 or $11 for the next year
or longer. In that case, your call options will slowly lose value, and your put options put you on the hook to buy shares at $12.50.
Given that you paid a net $0.30 to set up your synthetic long, your net start price on Autodesk will be about $12.80 per share.
This is the only number you'll ultimately care about if your trade is underwater. You're ready to buy Autodesk at a net $12.80,
and you can then hold the shares and hope for a recovery. Your synthetic long didn't make you any money, but ideally it bought
you shares of a good company.
Splitting the Strikes
Setting up a synthetic long with identical put and call strike prices near a stock's current share price is the norm (because you're
looking to approximate a stock purchase today), but it may not be the most comfortable choice for you. For more downside
protection, you may consider "splitting the strikes" as you set up a synthetic long. In this case, you still use calls and puts that
expire during the same month, but you use different strike prices.
Using Autodesk as the example, let's say you decide to write the January 2011 $10 put options instead of the $12.50 puts. The
$10 puts pay you $2.50 per share. With that income, you can then buy the January 2011 $15 call options (instead of the $12.50
calls from the first example) for about $2.80 per share. The net cost is the same -- just $0.30 per share -- but you have more
downside protection when you split the strike this way. If Autodesk declines, you don't need to buy it until it is $10 or lower, and
your net start price will be $10.30.
What do you sacrifice? You now need Autodesk to appreciate by a greater degree (compared to buying the $12.50 calls) by
January 2011 for your call options to appreciate meaningfully or at all.
When to Close a Synthetic Long
If all goes well, the underlying shares will appreciate for you well before your options near expiration, at which point -- based on
the valuation of the stock and the amount of time left in your options -- you should start to consider taking your profit in your call
options (unless you prefer to exercise them in order to own the stock at your call's strike price). At the same time, your put
options are on the path to expire for the full cash payment.
Usually, you'll use synthetic longs to profit from the options themselves over the course of your investing thesis -- typically,
around 18 months. Only rarely will you exercise the calls and turn them into a stock position if the options are successful. On the
flip side, when the position works against you and you need more time for your thesis to materialize, you'll be ready to buy the
shares and hold them.
The Bottom Line
When you're bullish on a stock and want to invest without spending capital today, setting up a synthetic long position is a
sensible alternative. The strategy can reward you with handsome profits on two options at once, with unlimited upside on the call
options -- or it nets you shares of a stock that you should be happy to buy at a lower price.
12 of 23 2009/12/13 12:06
Synthetic Shorts
Feeling bearish? If you're looking to profit when stock prices slip,
there's a way to use options to mimic shorting a stock -- but with
distinct advantages. To set up this "synthetic short" position, you
sell a call option and simultaneously buy a put option, using the Synthetic Shorts Synopsis
same strike price and expiration date for each. Unlike a covered call
To replicate shorting a stock with options, you
strategy, in this case you do not own the underlying stock, so when
sell a naked call and buy a put option
you sell (or write) the call, it's a "naked" call.
simultaneously.
That means, just as when you short a stock outright, your potential
For a straight synthetic short, you sell a call
losses are unlimited with synthetic shorts -- so this is a risky strategy.
and buy a put with the same strike price, the
But your potential profits are hefty, and the strategy provides
one that is as close to the current share price
advantages when compared to traditional shorting.
as possible.
First, you don't need to borrow shares of a stock to short it when
Use the same expiration date for both the call
using options -- often, the stocks you want to short most are the most
and put.
difficult to obtain for a traditional short sale. Second, the amount of
money you need to risk up front is typically much smaller with a Be careful -- selling naked calls is risky! The
synthetic short, given the leverage provided by options. Third, unlike higher the stock goes, the greater your
when you short a stock outright, you don't need to cover any potential loss.
dividend payments yourself. Finally, both opening and closing a
synthetic short can be done quickly, while the traditional shorting Use LEAPs so you have more time to be
method sometimes involves a lot of waiting. To get a handle on how proven right.
this strategy works, let's run an example.
Once you have your desired profit, close the
options -- shorts usually involve a narrow time
Sell a Naked Call, Buy a Put frame.
Brave soul that you are, let's say you want to bet against one of To take on less risk, "split the strikes" and use
Warren Buffett's recent investments. Volatile Goldman Sachs a higher call strike price.
(NYSE: GS) has jumped to over $180 per share, and you believe
there's profit to be had by shorting it over the next few months Consider synthetic shorts on indexes (like
(remember, shorting usually involves a narrow time frame). SPY) as a portfolio hedge.
Borrowing shares to short is difficult, and the stock pays nearly a 1%
For less risk shorting with options, simply buy
dividend -- which you don't want to cover yourself -- so a synthetic
puts and forego writing naked calls.
short is your best route.
Although your shorting thesis only covers a few months, you want to
use LEAP options so you have more time to be correct if need be.
Choosing options that are as close to Goldman's current share price as possible, you simultaneously sell the January 2011 $180
calls (which will pay you $30 each) and buy the January 2011 $180 puts (which will cost you $28). This results in a $2 per share
credit to you. You're now effectively short Goldman Sachs -- and Buffett (how do you even sleep at night?).
In the ideal situation for you, Goldman declines 20% or more over the next few months and pushes both your calls and puts
toward sizable profits. Your thesis has played out, and you should close your position -- both options -- profitably while you can.
The terrifying outcome (here's that risk you read about) would be if Goldman soared. Your options would show large losses, and
you would either need to take your lumps and close them or wait and hope for Goldman to fall. Because you have naked calls,
by their expiration you'll be required to buy Goldman stock at the going market price if it sits above $180 per share, and then
deliver the shares at $180 per share for an instant loss -- just as if you'd shorted the stock outright.
Another risk with an underwater call option is that it could be exercised early, forcing you to buy the stock and deliver it sooner
than you wanted. It's rare that an option is exercised early, but -- especially when you don't own the underlying shares -- you
need to be aware that it could happen. You also need to maintain enough buying power to cover your naked call obligations, and
those broker requirements will be updated daily if the stock increases against your position.
Splitting the Strikes
13 of 23 2009/12/13 12:06
If this example sounds too risky, you can add a little breathing room to your synthetic short by "splitting the strikes" (you
discovered this earlier as well). To do this, you still sell your naked calls and buy your puts with the same expiration date, but
you use different strike prices.
For example, rather than using the $180 strike price, assume you sell the January 2011 $195 calls on Goldman for $24 each and
buy the $165 puts for $24 each. This gives you a sleep-aiding 15% window before your naked call's strike price is hit. The lower
strike on the put does make it more difficult to ultimately profit from the stock's decline, but in the short term, the $165 put will
move nearly as much as the $180 put when Goldman declines. So, it's still attractive, and you're still effectively short Goldman,
but with less risk.
Just Buy the Puts
Remember, you can also invest against a stock by simply buying put
options on it and foregoing selling naked calls to finance your put purchase.
Sure, you need to come up with all the money to buy the puts yourself, and Who Should Use Stock
if you're wrong on the trade, most or all of that money will be lost. But that's Repair
the most you can lose with a put purchase, so your risk is known. You won't
have to worry about the potentially unlimited losses that a naked call Someone who is:
entails.
Down 15% to 25% on a stock and
willing to forego profits to sell at
The Bottom Line
breakeven.
Despite the recent rout, the market's long-term trend remains up, so a Not interested in averaging down or
Foolish investor should only "go short" carefully and in special situations. holding for the long haul.
Business is Darwinian by nature, companies come and go every year, and
synthetic shorts provide a way to invest against the losers. You'll likely Using a margin-approved account and
prefer to short companies with high debt, weak or no profits, few growth can write call options.
prospects, a low Motley Fool CAPS score, and inflated valuations. A
synthetic short is also well-suited for shorting a market index to hedge your To Set It Up
portfolio. Naturally, an index doesn't present as much upside risk as an
To set up a stock repair, for every 100
individual company. In closing, while synthetic shorts are as risky as selling
shares of a losing stock you (woefully) own:
short outright and shouldn't be taken lightly, the advantages of the strategy
over straight shorting should earn it a rightful place in your tool box. Buy one call option at a strike price
below the current share price.
Stock Repair
Sell (write) two call options at a strike
At some point, every investor gets stuck hanging onto a stock that has price above the current share price.
declined 20% or so and never seems to recover. This guide will teach you
Use the same expiration date for the
how to use options to exit laggard positions at breakeven. The "stock
options you buy and sell.
repair" option strategy not only recoups your initial investment, but frees up
your cash for new, stronger buys. Typically, use options that expire in 90
days or less.
But first, a reality check: Stock repair does not protect you from additional
downside in the shares you already own -- nor does it offer you a profit
above your break-even price. The strategy can, however, lower your cost
basis in your losing stock and allow you to exit the position at breakeven without introducing any additional risk.
14 of 23 2009/12/13 12:06
Setting It Up
These option trades result in minimal or no cash outlay for you because the call you buy is paid for by the two calls you sell.
Plus, the strategy does not bring new risk to your stock -- your options are neutral and covered: They largely cancel each other
out, and the first call option you sell (or write) is covered by the 100 shares of stock you already own, while the second call you
sell is covered by the new call you just bought. Got that? Let's turn to an example to show how it works.
Repair That Dog!
Assume you purchased 100 shares of a stock at $40 per share, and it now trades at $30. You're down 25%, lack hope for the
stock's recovery, and don't want to hold your shares any longer. At the same time, you don't believe there's high risk left in the
stock -- otherwise, you'd simply sell. It seems your best move to get to breakeven is to initiate a stock repair strategy.
To start, you purchase a $30 call option for $2.50 that expires in 60 days.
You then sell two $35 call options for $1.25 each. Your option trades have Motley Fool options wiz, Jeff Fischer -- an
paid for themselves. Your positions look like this:
Original stock, bought at $40, is now $30
down, and sideways-moving markets:
Buy one $30 call option costing $2.50
Sell two $35 call options for $2.50 total income

dedicated options service, has
Here are your possible outcomes: been piling up profits and
dazzling members...
If the $30
Then... "84% gain in 3 weeks..." I closed my
Stock... NVDA covered call option at a 84% gain in
3 weeks!!! I would never ever thought
about using options in my years of
Declines or holds All the options expire, nothing changes (you just investing if it wasn't for Jeff and Jim.
Thanks guys. -- S.S. Melrose Park, IL
steady at $30 lost on commissions). You can try again.
"Add to my education and wealth
Ticks up a few You make $2.50 per share on your $30 call option to my toolbox. I have seen the potential
dollars -- say, to (because you bought it for $0 net cost) and by options can add to your portfolio and know
this service will add to my education and
$32.50 selling the call for the gain, you've effectively wealth building. -- D. Heredia, Keller, TX
lowered your stock's cost basis to $37.50. The
calls you wrote expire. You can use the strategy Motley Fool Pro, our slightly
again. more sophisticated trading
service, employs options,
ETFs, and other advanced
Recovers to $35 Your $30 call is now worth $5 per share, all profit,
-- bingo! so your cost basis in the stock is now $35. You
hedging strategies to help
can sell or close all positions and break even
(commissions aside).
financial dreams...
"Incredible" "My average investment

Soars to $40 No problem. You are breakeven on the stock, and my annual to 132%. Wow! That is
your options cancel each other out. You can close incredible! Am I missing something or can
everything and move on. this be true?"
-- A. Ward in Brighton, Michigan
"In for the long haul..." "I will be in for the

Catapults beyond All of your positions still cancel each other out, and long haul with this philosophy!!!! I wish I
$40 you can still sell your stock at breakeven. You've had been 'playing the FOOL' since 1995,
but just since February 2009 it has been
foregone a profit in the stock, though.
extra fine. Rock on!" -- G. Seibert, Marietta,
Georgia
As you can see, the stock repair strategy has three possible results: (1) no And because we're committed to maximizing
change at all if the stock doesn't move or declines; (2) a lower cost basis if the profit potential and experience for our
premium members -- Motley Fool
the stock ticks up; or (3) a break-even sale if the stock cooperates even
15 of 23 2009/12/13 12:06
halfway. Options is by invitation only...
But what if you set up a stock repair trade only to change your mind and So if you're interested in learning more
turn bullish on your stock again? The situation is salvageable. Let's say more advanced Motley Fool Pro, simply
your stock returns to $40 on good news, and you wish to keep owning it. click the button below. We will notify you
In that case, you can close all of your option trades at or near breakeven the moment either service begins
(they'll largely cancel each other out) and continue to hold the stock.
Choosing Your Strike Prices Click Here

It's Free!
In general, this strategy works best when you're down about 20% on a
stock. You buy your lower-priced call options at a strike price that is about
20% below your stock's start price (or, at about the current share price),
and you write your two other call options at the midway point between the current share price and your stock's start price,
splitting the two. So, in another example, if you bought 100 shares of a stock at $50 that is now $40, to repair it, you'd buy one
$40 call and write two $45 calls.
The Bottom Line on Stock Repair
When you're down a reasonable amount on a lagging stock and simply want out at breakeven, setting up a stock repair strategy
may help you meet your goal more quickly. The strategy does not increase or decrease your risk in owning the stock, but (unless
you close the options early) it does limit your upside to your break-even price. You must be happy to just breakeven and
confident the stock won't fall sharply while you wait.
Buying Straddles
Have you ever thought a stock was about to make a significant move -- but you didn't know which direction it would go? Maybe a
big earnings announcement is looming, an acquisition is pending, or a stock has recently soared and could keep going -- or turn
at any moment. Most investors would sit on their hands, unsure what to do. But if you buy an option straddle, you can set
yourself up to profit whether the stock goes up or down, while risking only the small cost of a few options. This makes buying a
straddle attractive as a bullish or bearish strategy. In fact, buying a straddle can be superior to shorting a high-flying stock
outright, since you'll profit even if it keeps rising -- but also profit if it finally flames out.
Whether bearish or bullish, this strategy positions you to make

money as long as the underlying stock is especially volatile in one
direction, moving at least (as a general guideline) 10% to 30% in the
coming weeks or few months. The strategy works because you gain Why Buy A Straddle?
a much larger profit on one side of your straddle than you lose on the
You believe a stock or index will move
other (more on that later). And, to answer your burning question, it's
dramatically, but you don't know which way.
called a "straddle" because your calls and puts sit symmetrically on
either side of the same strike price -- while expiring in the same You believe volatility will increase in general,
month, on the same stock. so the value of the options you're buying will
increase.
Pros and Cons
You want to leverage potential returns when
Before you walk you through an example, let's go over what can go the underlying investment moves meaningfully
right or wrong. On the plus side, when you buy a straddle, your profit in either direction, but limit your risk.
potential is unlimited -- the more the underlying stock moves in one
direction, the more you can profit on that side of your trade. How The Strategy Works
However, as with any option you buy (as opposed to writing options),
Now let's "straddle up" and see how the
you can lose your whole investment -- in this case, if the stock stays
strategy works. Here are the basics:
tightly range-bound, the options would eventually expire with little or
no value. You buy ("buy to open") an equal
number of calls and puts on the
The clock also plays a large role, as the biggest drag on a straddle
underlying stock or index (usually you'll
purchase is the time value erosion of the options. Buying a call and a
do this as a stand-alone strategy, so you
put, you've paid two option premiums, and with each passing week
16 of 23 2009/12/13 12:06
their value erodes unless the stock's volatility increases. If the won't own the underlying stock).
underlying stock doesn't make a significant move in either direction,
The strike prices of the calls and puts
your options will steadily lose value. Plus, the underlying stock needs
should be the closest available to the
to move enough so that one side of your straddle (either the calls or
current price of the underlying stock or
puts) gains enough value to offset the losses on the other side.
index (also called "at the money").
A Straddle in Action The expiration month on the calls and

puts should be the same, and usually
Let's use a real world example. Autodesk (Nasdaq: ADSK) has been
you'll choose an expiration up to four
volatile as investors try to determine when business will improve.
months ahead if you expect volatility
Suppose you believe the stock will move aggressively, in one
soon, or six months or more if you want
direction or another, depending on the company's outlook in its next
more time. Having more time for the
quarterly report. With shares at $17.50 in July, 2009, you could have
strategy to work can be an advantage,
set up a straddle that expires in three months, buying the October
but will cost more up front.
$17.50 puts for $1.65 each and the October $17.50 calls, also for
$1.65 each. Your combined cost per contract is $3.30 ($330) -- so, if
you buy three contracts of each, your up-front investment is $990.
Say management saw business improving, and the stock returns to $22.50 the next month. Your calls are now worth at least $5
each, up from $1.65 each, while the puts are worth very little -- you're losing money on them. Overall, though, your $990
investment is worth more than $1,500, a gain of more than 50%. On the flipside, if Autodesk's guidance is weak and the stock
falls to $12.50, your puts are worth more than $5 each and your calls have little value. Your profit in this case, as with the
opposite side of the spectrum, is 50%.
What if your thesis is wrong, and Autodesk stays within a few dollars of $17.50 for a few months? You're losing money on both
the calls and puts in this case, and you might want to close them ("sell to close") early to get some capital back -- unless you
believe volatility will increase significantly and soon.
Taking Follow-Up Action
Straddles can benefit from more active management once the position is in place. There are two ways to potentially boost your
profits while being defensive:
If the price of the underlying stock increases to the next higher strike price (compared to the strike price you used to set up
the trade), you may want to -- depending on the number of contracts in play and your commission costs -- close your
existing puts and buy puts at that next-higher strike price to increase your profit potential. This is called "rolling up" the
puts.
Inversely, if the underlying stock declines to the next lower strike price, you should consider selling your calls and buying
new calls at that next-lower strike price. This is called "rolling down" the calls.
While increasing the total cost of your strategy, these follow-up moves increase your chance for higher profits on any
subsequent stock move. Roll up and roll down sparingly, though -- reacting to every zig and zag in the stock can be a detriment
when you consider the commissions, option premium costs, and the fact the stock could easily swing the other way again.
Closing a Straddle
If your original thesis holds true and a stock makes a big move, you'll make more money on one side of your options than you'll
lose on the other. If you believe volatility is subsiding, consider closing ("sell to close") both of your positions at the same time to
lock in your profit. If you wait until expiration, you may slowly lose extra value in your options, or the stock may reverse on you
again.
If your strategy isn't working in time, you may want to close both positions early to recoup some capital and rethink your strategy.
Your calls and puts serve to hedge each other in the early going. However, both options will steadily lose value if the stock isn't
making a move one way or another.
Finally, although it's unorthodox, if you earn a quick profit on one side of your straddle, you may want to lock in that profit and let
the losing side stay active. You won't have much value left on that side anyway, and if the stock reverses, you may regain some
17 of 23 2009/12/13 12:06
of the losing option's worth without risking the profits you've already secured on the closed side.
18 of 23 2009/12/13 12:06
Bottom Line on Buying Straddles
If you believe a stock is going to move significantly -- but you don't know which way -- buying a straddle is a way to profit on
either side. The enemy of the straddle-buying Fool is a stable or merry-go-round stock price, as the value of your purchased
options will steadily erode unless the stock makes a lasting, meaningful move in one direction or another. But when you expect a
big move either up or down, consider buying a straddle.
Writing Straddles
Sometimes a stock -- or the market as a whole -- just takes a nap, and buying or even shorting isn't likely to land you a profit. But
by writing ("sell to open") straddles, you can generate income from a steady stock, or simply from decreasing volatility, as the
market calms down or catches up on some Z's.
Setting Up the Trade
A straddle involves an identical number of calls and puts with the same
strike price and expiration date on the same underlying stock or index. As Motley Fool options wiz, Jeff Fischer -- an
you know, you buy the calls and puts to profit in either direction from high
volatility. Inversely, writing the calls and puts is a way to profit from low or committed to achieving bigger returns in up,
declining volatility. How? Simply by collecting option premium payments down, and sideways-moving markets:
on either side of a potentially sleepy position. There are risks, however.
dedicated options service, has
Uncovered Straddle Writing
When writing an uncovered straddle, you usually don't intend to get the
dazzling members...
underlying stock involved. You're just looking to profit on the value erosion
Motley Fool Pro, our slightly
of the options you write, and you'll plan to "buy to close" them (or let them
expire) once you've earned your targeted profit. (Note: You need a margin
service, employs options, ETFs,
account to write an uncovered straddle.)
and other advanced hedging
As an example, suppose a recently volatile stock just announced strategies to help members
earnings, and you expect its volatility will now all but cease. The options achieve their financial dreams...
still pay well, though, so you'd like to capture the option premium as And because we're committed to maximizing
income. The stock is trading at $25, so you write $25 calls and $25 puts the profit potential and experience for our
and get paid $2 for each contract -- that's $4 total in option premiums per premium members -- Motley Fool
Options and Motley Fool Pro are by
straddle. This means as long as the stock ends the expiration period
invitation only...
between $21 and $29 ($4 above or below $25), you'll at least break even
before commissions -- and in most cases, earn a profit on the trade. (call So if you're interested in learning more
this the "profit range.") more advanced Motley Fool Pro, simply
For example, if the stock ends the period at $27, the puts you wrote expire the moment either service begins
(giving you the full $2 value), and the calls break even, so the trade pays accepting new members.
you $2 per share overall.
Click Here
If the stock ends lower in your profit range, let's say $23, the calls expire
It's Free!
and the puts break even, so you profit $2 per share overall here, too.
However, outside your profit range, it's another story. You face unlimited
potential losses as the stock rises above $29 per share, and you facing
growing losses (along with an obligation to buy the stock and wait for a recovery) the further it falls below $21.
As the table on the next page shows, the maximum profit from an uncovered straddle occurs when the stock ends exactly at the
strike price; you keep the entire $4 per share you were paid in this example. Your total profit declines as the stock moves away
from the strike price in either direction -- which is why you want minimal volatility whenever you write straddles.
Take a minute to study the table and grasp how this works. As the stock rises, the naked (or uncovered) calls you wrote
increase in value, working against you. As the stock declines, the puts you wrote work against you, but you'll still profit anywhere
between $22 and $28, and break even at $21 or $29. Remember, you were paid $2 for each call and put, or $4 total. But since
19 of 23 2009/12/13 12:06
you wrote the options, your desired outcome is that their value goes to $0, or as low as possible:
Stock Price At Ending Call Ending Put Your Total

Expiration Value Value Profit Per Share
$20 and lower $0 $5 and higher ($1) and worsening

as the stock as the stock falls
falls
$21 $0 $4 Break-even
$22 $0 $3 $1
$23 $0 $2 $2
$24 $0 $1 $3
$25 (the strike $0 $0 $4

price)
$26 $1 $0 $3
$27 $2 $0 $2
$28 $3 $0 $1
$29 $4 $0 Break-even
$30 and up $5 and higher $0 ($1) and worsening

as the stock as the stock rises
rises
To help achieve a successful uncovered straddle, you want the widest possible profit range (in other words, you want to capture
generous option premiums). In this example, the range is significant -- $4 in either direction -- assuming the underlying stock isn't
exceptionally volatile and your options expire in two to five months (rather than longer). But remember, the trade creates
unlimited potential losses outside the profit range.
One way to greatly mitigate that risk: When you write your straddle, use some of your option proceeds to simultaneously buy far
out-of-the-money calls and/or puts, too -- with strike prices at the two ends of your profit range (for this example, you might buy
$30 calls and $20 puts; or just buy calls to protect you on that side and be ready to buy the stock via your written puts if it falls).
Doing so, you've hedged and "covered" your written straddle, and because buying these options generally costs little, you'll still
begin with a net credit from your option writing and keep that profit if the stock stays in a now slightly tighter range. For example,
if you paid $0.80 total for the protective calls and puts, your profit range decreases by that amount on either side of the strike
price. If you don't buy protective options initially, be ready to do so if the trade starts to work strongly against you.
Given that a steady stock can suddenly make a big move for any number of reasons, it's risky to write uncovered straddles
without this added protection. However, another route is to simply own the underlying stock outright. Let's take a look.
Covered Straddle Writing
20 of 23 2009/12/13 12:06
Owning the underlying stock takes away all of the naked call option
risk when writing a straddle. In fact, a covered straddle-writing
strategy is basically a covered call strategy, but it generally offers
more profit potential because you're also writing puts on the stock. Why Write A Straddle?
The key difference with a straddle is that both options are at-the-
You believe a stock or index is going to hold
money, so you're more likely to see your options exercised. As with a
steady.
covered call, it's important that you're ready to sell your stock if it
rises. And as with writing puts, you need to be ready to buy more You believe a stock that was recently volatile
stock if it declines (or close the options early). The benefits of writing will calm down considerably.
a covered straddle are two-fold:
You believe the market's overall volatility is
Your profit can be higher and your profit range wider than with going to decrease.
a mere covered call.
You have more ways to close your options profitably -- and still Writing Straddles: The Basics
keep your stock if you like.
Write ("sell to open") an equal number of puts
Continuing the earlier example, let's assume you want to write a and calls on the same stock or index.
straddle on a steady $25 stock -- but in this case, you own the
Use the same strike price and the same month
underlying shares. You write $25 calls and puts, getting paid $2
of expiration on both options.
each, with the same expiration date. Since you own the stock, no
matter how high it climbs, you're covered on that side of your trade. The strike price with a straddle is "at-the-
Let's consider some potential outcomes: money": as close to the current underlying
stock price as possible.
You end up selling your stock via the covered calls, but you
keep the $4 option premium you were paid on the puts and When you write an uncovered straddle, you
calls, netting a sell price of $29 (compared with just $27 if you'd don't own the underlying stock, so your risk is
only done a covered call and not a straddle). high (more on this in a minute).
The stock declines below $25. You end up buying more
When you write a covered straddle, you own
shares, but at a net $21 given the option premiums you were
the stock, lowering your risk. Here the straddle
paid. You've added to your existing stock holding.
works like a covered call strategy -- but your
The stocks holds steady, around $24 to $26. You can "buy to returns are potentially goosed with additional
close" both the calls and puts by expiration and capture much put-writing income.
of the profit while keeping your existing shares. Nice!
The most you can earn writing straddles is
Finally, as an example of the added flexibility here: Assume the
what the options pay you initially.
stock increases to $28 by expiration, and you decide you want
to keep your shares. Since you were paid $4 per share in
option income, you could close your calls for $3, still have a $1
per share profit on your straddle, and keep your stock. If you had only written covered calls and not a straddle, you'd need
to book a loss if you wanted to keep your stock.
Taking Follow-Up Action
Writing uncovered straddles requires keeping a close tab on your trade. If the stock is moving sharply against you in either
direction, you may want take action to limit your losses. One way to do so is to close the losing side of your straddle when the
stock reaches your break-even price. In this example, if the stock rises to $29, you might close your call options for a loss and let
your puts go, presumably to expiration, keeping your overall losses marginal. If the stock falls, just be ready to buy it via your
puts. Uncovered straddles don't usually lend themselves to rolling forward (to a later expiration date), rolling up (to higher strike
prices), or rolling down (to lower strike prices), so you can't depend on these defensive follow-up moves being available to you.
As mentioned above, if you buy out-of-the money protective calls (and puts, if you like) when you set up your straddle, your
potential profit on the straddle is lower, but you won't need to consider follow-up action.
Writing covered straddles is much less risky and requires less upkeep, but you still want to keep a watchful eye on your strategy,
since only your calls are truly covered. You need to be ready to accept more shares if the stock falls below your puts' strike
price. For this reason, some investors will use a lower strike price on the puts they write, providing more leeway -- but once you
start to stagger strike prices on your calls and puts, you're not using a straddle anymore, you're using a strangle.
21 of 23 2009/12/13 12:06
Bottom Line on Writing Straddles
You're not likely to write uncovered straddles without using some protective options as well. Writing covered straddles, however,
is a sensible way to increase option profits on a covered call strategy as long as you're also willing to buy more shares if need
be. With this strategy, you have another tool to profit no matter what the market throws your way -- in this case, even if the
market goes nowhere.
Options Glossary
Call option: A call option is the right to buy the underlying stock at a set price (the "strike price") at or before the option's
expiration date. A call rises in value as a stock rises and declines in value when the stock falls.
Delta: The amount that an option's price will change with any change in the underlying share price.
Gamma: A measure of risk in an option based on the amount that the delta will change with a $1 change in the stock (we don't
concern ourselves much with delta or gamma, since we're much more concerned about the underlying value of the equity we're
targeting, but they're still good things to know).
In the money: This term is used when an option has intrinsic value. Call options are in the money when the underlying stock is
above the call's strike price. Put options are in the money when the underlying stock is below the option's strike price (a stock is
at $22 and the put option has a strike price of $30, allowing the holder to sell the stock at $30).
Intrinsic value: This is the value of an option if it were to expire immediately. It's an option's value in direct proportion to the
underlying stock's current price. If a call option gives the owner the right to buy a stock at $10, and the stock is trading at $12,
the option's intrinsic value is the difference: $2. The option may actually be priced at $3, with $1 of time value (see below)
because it doesn't expire for a few months, and much could change by then.
LEAPS (Long-Term Equity Appreciation Securities): These are simply stock options that, when first offered, expire at least
two years in the future. Most new LEAPS become available every July. Although generally more expensive, we like LEAPS
because they give you a relatively long time for an investment thesis to play out.
Option contract: Each option contract represents 100 shares of the underlying stock. A contract is quoted at the price for just
one share, so you need to multiply it by 100 to get the full value. So, if you buy two option contracts for $1.50 each, it actually
represents 200 (2 x 100) shares of stock, and would cost you $300 ($1.50 x 200).
Out of the money: This is the opposite condition as "in the money." Here, an option has no intrinsic value, only time value. This
occurs when, for example, a stock is trading at $8 and a call option has a strike price of $10.
Premium: Not unlike an insurance premium, the value paid for an option contract is called the "premium." The more volatile a
stock is, generally the higher the premium on its options. Also, all else equal, the longer until an option expires, the higher the
premium it commands, accounting for more unknowns.
Protective collars: Profit on a stock you own if it declines, while assuring a higher sell price if that price comes along. You sell
covered calls on a stock you own to buy protective puts.
Put option: A put option is the right to sell a stock at a set price at or before the option's expiration date. A put's value increases
as a stock falls.
Straddles: Use both puts and calls simultaneously on a stock, with the same strike price and expiration date, to profit if the
stock makes a dramatic move either up or down (when you buy a straddle), or profit it stays in a range (when you write, or sell, a
straddle).
Strike price, expiration, and exercise: Every option has a strike price and expiration date (which is always the third Friday of
a month, after the market closes). The strike price is the value at which the underlying stock can be bought or sold. When an
option is converted into a stock transaction, the option has been "exercised."
Synthetic longs: Approximate stock ownership at a much lower net cost, or no cash cost at all -- this trade can often be set up
with a net credit to your account. Sell puts to buy bullish call options.
Time-value premium: This is the price of an option above its intrinsic value. It's the value placed on an option purely to
account for unknowns and expected volatility between now and expiration. Time value declines as expiration draws closer.
22 of 23 2009/12/13 12:06
Writing a contract: Selling a new option contract (opening a position) is usually called writing a contract; the brokerage
command to do so is usually "sell to open," just as when you short a stock. The new option seller is called the "option writer;" to
close the position, the trade command is called "buy to close."
23 of 23 2009/12/13 12:06

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Fool.com: A Motley Fool Special Report http://www.fool.com/newsletters/50/sfr/01/PrintAll.htm?v...

The Motley Fool "Options Edge" Handbook

You're in a very fortunate position...

So if you're interested in learning more

What Are Options?

Stock options formally debuted on the Chicago Board Options Exchange

And because we're committed to maximizing

obtain leverage and potentially increase returns several-fold. Call options

Next up, the antithesis to call options: puts.

Selling Covered Calls

So, write covered calls when:

Call Option Put Option

8 Tips for Writing (or Selling) Puts

Put writers do not collect dividends paid by the underlying stock.

So, you write puts when:

You're ready and willing to buy a stock at a lower price and

What Can Go Wrong?

Make Put Writing Worthwhile

Motley Fool Options, our

"84% gain in 3 weeks..." I closed my

Closing Early and Rolling Forward premium members -- Motley Fool

To sell -- or write -- options, you should have a higher account

Insure Your Positions by Buying Puts

As a long-term investor who remains committed to your core holdings, you

The Costless Collar: Buy Puts, Sell Calls

Insure Your Positions and Keep Upside, Too

The Bottom Line

Earlier, you discovered that when you buy options -- as opposed to

Splitting the Strikes

When to Close a Synthetic Long

The Bottom Line

Splitting the Strikes

Just Buy the Puts

Repair That Dog!

Sell two $35 call options for $2.50 total income

"Incredible" "My average investment

"In for the long haul..." "I will be in for the

halfway. Options is by invitation only...

Choosing Your Strike Prices Click Here

The Bottom Line on Stock Repair

Whether bearish or bullish, this strategy positions you to make

A Straddle in Action The expiration month on the calls and

Taking Follow-Up Action

Bottom Line on Buying Straddles

Setting Up the Trade

Stock Price At Ending Call Ending Put Your Total

$20 and lower $0 $5 and higher ($1) and worsening

$25 (the strike $0 $0 $4

$30 and up $5 and higher $0 ($1) and worsening

Covered Straddle Writing

Taking Follow-Up Action

Bottom Line on Writing Straddles

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