Basic Option Strategies for Income

1. Basic Option Strategies for Income Enhancing Profits for Building Wealth Walnut Creek – November 18, 2009

2. Tonight’s Topics • Market Stance, Dow, S&P, Nasdaq • Basic Income Strategies • Short Vertical Spreads

3. Assumptions You know what an option is and the basics of how they work • Time Value • Intrinsic Value • ITM, ATM, OTM

4. Basic Points • If you buy a stock you must be right about direction to profit but time does not work against you. • If you buy an option you not only have to be right about the direction of movement but it’s also a race against the clock • If you sell an option you can be wrong about direction and profit - the clock is your friend

5. Critical Concept • Time value is like an ice cube on a hot day, it melts away • Option Selling strategies put time decay in your favor!!! • Vertical spreads are a selling strategy which makes use of time decay

6. Time Decay of an option

7. General Rules for Selling Strategies • Buying options – Buy more time than you need • Selling options – Sell front month – don’t want buyer to have time to be right • Buy back the short options when most of the premium has eroded • Example: lets say you sold an option for 1.00 and the premium has decayed to .20 with two weeks till expiration – Buy it back!!!!! Don’t be greedy!!!!!!!!!!!!

8. Vertical Credit Spreads • Income producing strategy • Can be bullish or bearish • Don’t need to own the stock • Short term plays – generally 20 to 40 days to expiration – Remember the basic rule don’t; give the option buyer more time than necessary to be right

9. Vertical Spreads – How they work • Vertical spreads involve the purchase of one option and the sale of another option • The purchased option is for insurance – limits the risk the trade – for a short vertical the long option must be less expensive than the sold option • The short option is for what brings in the income and for a short vertical spread must be more expensive than the long option • The short and long options are within the same expiration month

10. Short Vertical Spreads • Short vertical Spreads are Credit Spreads!!! The money is deposited into your account immediately. • They are “Defined Risk” trades • Risk is the difference between the two strike prices minus the credit received • The risk is the margin requirement your broker will require you to maintain in your account to cover your potential loss

11. Entering Vertical Spreads • Most brokers permit entry of the spread as a single trade (long and short trade are entered simultaneously) • If your broker does not permit simultaneous entry always execute the long side before the short side (and get a new broker).

12. Determining Max Potential ROI Potential ROI = credit / risk * 100 = credit received / (difference between strikes – credit received) * 100 Difference between strikes = 2 Credit = .42 Risk = 2 - .42 = 1.58 ROI = .42 / 1.58 * 100 = 27%

13. Bullish Vertical Credit Spread • Bull Put Spread • Buy a put at a strike price lower than the put you intend to sell • Sell a put with a higher strike price than the one you purchased which will bring a net credit into your account • May enter both trades simultaneously as a vertical spread

14. Bull Put Spread • Short Strike can be ITM, ATM or OTM • Sell ITM if you are extremely bullish • ITM trades carry lower risk but have lower probability of success • OTM trades have lower rewards but higher probability of success

16. CTRP Bull Put Spread • CTRP has been in a strong upward trend since March • On 10/22 it bounced off strong horizontal support closing above the high of the low day – This is my entry signal for a trade on 10/23 • Strong horizontal support identified at about 55 • Next strong level of support below 55 is at about 47.50 • Good chance if stock price breaches 55 on high volume it will continue down to about 47.50

17. CTRP Bull Put Spread • 10/23 – Enter 55/50 Bull put Spread for a credit of .82 credit ($82 per contract) • Calculate Break Even Price, Risk and ROI on this trade (at expiration) • Look at exit strategies • If correct • If you’re wrong (and, how will you know when you’re wrong) (Fixing Trades will be a topic for another meeting)

18. CTRP Trade • BE = Short Strike Price – Credit Received • Note for a Bear Call Spread the BE stock price is the short strike + the credit received • BE = 55 - .82 = 54.18 • Maximum Risk = 55 – 50 -.82 = 4.18 • Potential ROI = .82 / 4.18 * 100 = 19.6%

19. CTRP Exit Strategy • Close trade at a profit at .10 (GTC order placed when entry order filled) • Buy back the short strike on breach of 55 support level with confirmation (very high selling volume or follow through the next day) – This is an indication the stock is no longer in favor with institutions and the downtrend is likely to continue. Allow the long strike to gain value but the intent is no longer to make a big profit but to get out with your hide. • Note: You can be wrong on the repair so you need to remain nimble – may have to repair the repair. The desire of repairs is to make a small profit or incur minimal loss

20. CTRP – So how did this trade end – Lets take a look • As you’ll soon see the trade was profitable • But not before a few moments of concern • Don’t panic!!!

22. CTRP Trade - ROI • Trade entered 10/23 for .82 Credit • Trade closed 11/12 for .06 • Profit Realized on trade .76 • ROI = .76 / 4.18 *100 = 18.2% • Annualized ROI = 18.2 / 20 *365 = 332% • Not to bad for a 20 day trade

23. Bearish Vertical Credit Spread • Bear Call Spread • Works just like a Bull Put Spread but just the opposite • Instead of utilizing puts the Bear Call Spread uses call options • Hence the name – Bear Call Spread • “Bear” designates our stance on the market or direction on the underlying • “Call” designates we will be using calls to bring money into our account • “Spread” indicates that this is a defined risk trade

24. Bearish Vertical Credit Spread • Bear Call Spread • Buy a call at a strike price higher than the call you intend to sell – This is your insurance • Sell a call with a lower strike price than the one you purchased which will bring a net credit into your account • May enter both trades simultaneously as a vertical spread • This transaction results in a net credit in your account

25. Bear Call Spread • Short Strike can be ITM, ATM or OTM • Sell ITM if you are extremely bullish • ITM trades carry lower risk but have lower probability of success • OTM trades have lower rewards (higher risk) but higher probability of success

26. Possible Future Topics • Repair Strategies • Technical Analysis • Iron Condors • Butterflies • Diagonal Spreads • Calendar Spreads