Options Trading Strategies: The "Up" Scenario

Options Trading Strategies: The "Up" Scenario
The “up” scenario

In the “up” scenario, the maximum gain that can
be attained is the stock finishing at $10.00 or higher.

At $10.00, you would profit from the full value of the
extrinsic value of the option which is $.50 and you would
also have $.50 of capital appreciation from the stock for a
total of $1.00. This represents a 10.52% one-month return
or an annualized return of 126.32%.

It is not realistic to expect this type of return every
month but remember, recent studies show that premium
selling works approximately 80% of the time, which is still
very good.

We stated earlier that the maximum return of this buy-write
will be actualized when the stock reaches $10.00 or above
and the maximum return will be $1.00, and no more than
$1.00. As the stock goes higher, the option will earn less
in direct proportion with the increase in capital
appreciation.

For example, if the stock closes at $10.30 you would
receive only $.20 from the option. The option would now be
worth $.30 because with the stock at $10.30, the 10 strike
call would have $.30 of intrinsic value.

Since you sold the option at $.50, you would see a $.20
profit ($.50 - $.30 = $.20). Since you bought the stock at
$9.50 and it is now $10.30 you have $.80 of capital
appreciation. Combine the two and you have a $1.00 profit.

Let’s look at what happens when the stock trades up
to $12.00 and see if you again have a $1.00 return on the
position. At $12.00, the option will have $2.00 of
intrinsic value (stock price – strike price) because
it is in the money.

You sold the option at $.50 so you have a $1.50 loss.
However, you bought the stock for $9.50 therefore you have
a $2.50 capital gain. Combined, you have a $1.00 profit.

In a third example, if the stock trades up as little at
$.10 you still have a $.60 gain. You will receive $.50 from
the sale of the call which would expire out of the money
thus worthless plus $.10 of capital appreciation. $.60
represents a 6.3% one month return.

Please refer to the chart below for examples of total
dollar profits per number of contracts, remembering that
each contract controls 100 shares of stock.

Observe that if the stock closes over $10.00, then your
stock will be called away because your short calls will be
exercised. This is correct but we will talk about position
management later. For now, let’s get back to our
three scenarios.

In the “up” scenario, you would profit with the
buy-write when the stock is up as little as a penny, but
you are also limited on our maximum profit.

You are limited on your maximum profit as defined by the
formula below:

Maximum Profit = Strike Price + Option Price – Stock
Price.

This method of calculation will work every time. As you
see, the buy-write has a positive but limited upside
potential.

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Brett Fogle is the president of Options University. Brett
and his veteran traders teach safe and effective options
trading strategies. Free strategies can be found at
http://www.optionsuniversity.com/blog