If you are long a call, that means that you own the call or the right to buy the underlying stock at a predetermined price. When you are long a position that simply means that you have bought that position and want that position to increase in value. Being long a call means that you are bullish on the underlying stock and expect that stock to increase in value before your expiration date. Being long a call can be better then simply owning the underlying stock because you can using leverage to better your outcome in the event that you are right. Each call option that you own is equal to 100 shares of stock.

Example:

Potash Corporation of Saskatchewan (POT) currently trading at 205.24 and have 200 or 210 options available for May. The 210 options currently trade at 13.70 x 13.90 which is the Bid Ask spread. Since we are going to belong the call we are buying the call and when you buy an option you are buying at the Ask. So one option for May’s expiration is going to cost use 13.90 or $1,390. Remember options are always shown as the price per each share but each contract is 100 shares so you have to multiply the displayed price by 100.

Our chart shows here that we need this highly volatility stock to move up $28.65 by expiration for us to break even. If the stock price stays below $210 then we would loose all our premium paid for this option. If however, the stock price is above 210 by expiration we would make the price of the stock minus the strike price back. So to make a profit we need this stock to finish over 223.90 to earn a profit. Which in this case is possible because we have earnings between now and expiration.

The power of leverage when it comes to return is that you risk less when you are wrong and earn more when you are right. Here is a chart that compares buying the stock to buying the option at the same price for the same amount of share. If we are right and POT does well and earnings beat expectations and the stock goes to $250.

However, it is not uncommon to use this strategy and the reason is because most options that are written expire worthless. So when you sell an option for the premium, the chances of that option expiring and you keeping the premium are pretty good.

The risk here is that the stock does the opposite of what you hope and then if it does it in a big way, you could end up losing a lot of money. Like Amazon for example, had you sold a call on AMZN back in April of ‘07, you would have lost a good bit a money and all while the options market was closed.

Since options don’t trade in extended hours, you could do nothing but watch as people bought up AMZN when earnings came out after the bell and then before the bell the next day. The reason I pick this stock is because AMZN is a large company, had been pretty stable on its stock price for years prior to this earnings blow out.

Since Jan of ‘05 AMZN had traded as high as $50 and as low as $26 prior to the Q 1 2007 earning released in April of 2007. So there was no reason to think that at around $40 per share, you couldn’t sell a 50 call, take the premium and move onto the next month and do it again. When earnings came out at a whopping 26 cents per share vs. 15 cents estimate, the stock shot up to over $60 per share, which meant if you sold one option naked at the 50 strike, you would have to buy 100 shares at over $60 per share in the open market and then sell it for $50 per share to the lucky option holder.

That is over a $1,000 loss and that is only one contract and at the time, depending on when you sold the option, you probably would have made very little premium on the sale, less then 1.00 since you would have been pretty far out of the money.

(AMZN: 48.96 -2.70%, vol: 19,607,540, avg vol: 10,339,400)

So if you own 150 shares of stock, you can cover 100 of them with one option, it is not advisable to sell two options in this situation though, because if your stock grows faster then expected and you get assigned you will have to buy an additional fifty shares at the market price to cover the full obligation of the second call. In other words you sold half a contract naked, please look what selling naked means naked means.

(Click to enlarge)

Speaking of selling naked the covered call strategy has a very similar risk graph to that of naked selling calls. That is because you are capping your potential earnings at the strike that you so your call option. If the company who’s stock you own goes bankrupt you can loose your entire investment and you would keep just the amount of the call you sold. However, the chances of that happening are pretty slim and you would have probably gotten out of the company you own by the time the stock goes to zero. Remember this is still a bullish strategy, this is a way to generate additional income on slower moving stocks and not a way to capitalize on stocks that you are bearish on, in the case were you are bearish you will want to look at a bearish strategy.

Lets look at an example. Exxon Mobile (XOM) is a great one for this strategy. The stock has been a benefactor of the higher oil and gas prices of late, but is so huge that moving this giant with any sudden swings is pretty tough. The stock currently trades at 84.67 which is very close to the next strike of 85. For this example we will own 100 shares of XOM and sell 1 call. The 85 strike bid is at 1.85, which means I can now add $185 to my $8,467.00 which is 2.18% of my investment.

Again this is for just one month, compare that to the $0.35 dividend or $35 for 1 quarter and we are already doing more then 10 x’s better then the dividend. I mentioned earlier that there is a risk associated with this strategy, that risk is that the stock price moves higher then the strike you sold. If that happens, you are obligated to give your shares to the person who bought the call for $85 per share. Of course you will get the profit of .33 per share or $33 at 0.4% return on your money, plus you keep the amount you sold the option for, which is the $185 or 2.18% return, which isnt bad for a month, but the idea behind this trade is to be able to sell the call month after month, all while retaining the stocks slow appreciation over time. So we will look to the next strike which is 90. Currently that bid is at .40 or $40 per contract.

Not quite as attractive, but again, when you think about the dividend being $35 for the quarter, you are increasing the amount over return on the stock. The further out you go in strikes, the less you will make but the greater the chance that your call wont be executed. If you go out further in time, you can can sell your call for more, but there will be more trading days before expiration which gives your stock more time to go through the strike you sold.

I have found that this strategy really isn’t very effective for trading accounts with less the twenty thousand dollars in it. Here is why: If you display adequate options strategy knowledge to your broker they will allow you to trade spreads so long as the end results doesn’t leave you naked or with a possible loss greater then your account value.

They know that you cant loose more then the spread value and they wont allow you to trade a position that will put you into a loss more then your account can handle. They do this by holding your credit and then holding the difference between your max loss and your credit.

So while they will pay you interest on this amount being held, they will not allow you to trade the amount you just took in on this “credit”. Conversely if you would have traded for the same direction in a debit spread, the max you can loose is your initial debit, so you don’t have to worry about the rest of the spread and they don’t hold any more.

Here are some examples.

March ‘08

Credit spread (Bearish Position)

Calls

Sell the 120’s at 7.15 and buy the 125’s for 4.50 giving you a credit of 2.65 giving us a max loss of 5 net of the credit of course. Your max profit is only 2.65, what you sold the position for, so now you sit and wait, if you are right and the stock drops you keep your 2.65. Again though, the brokerage will hold all 5 in the event that you are wrong and need to pay it out. If you would have bought the bearish debit spread you could have bought double the position and been reward doubly if you were right. If you are wrong you are in a similar position as the bearish credit spread.

Credit Spread (Bullish Position)

Puts

In this instance we want AAPL to appreciate in value by the end of the month. So we would sell the 125’s for 5.70 and buy the 120’s for 3.50 for a net credit of 2.20. The max loss again is 5, so if the stock in deed drops we are covered beyond the 120 mark, but we have to give back our 2.20 credit plus 2.70 more as that was our risk for this position.

(APVCE: 0.00 N/A, vol: 0, avg vol: 0)
(PYPCL: 0.00 N/A, vol: 0, avg vol: 0)
(QAAOD: 0.00 N/A, vol: 0, avg vol: 0)
(APVOE: 0.00 N/A, vol: 0, avg vol: 0)

Typically you want to look for a company who’s share price doesn’t change much over time. This spread takes advantage of time erosion and not stock movement. So as long as the volatility doesn’t play a roll in an options price when approaching expiration the time value should deteriorate nicely and you lock in your profit.

A long calendar spread involves buying an option with a longer expiration and selling an option with the same strike price and a shorter expiration. For example, imagine that Microsoft (MSFT) is trading for $$27.50 per share. To initiate a calendar spread, you might sell the MSFT April 27.50 calls and buy the July 27.50 calls.

Like most long positions, there is a cost to put on this trade. In this case, the cost is $0.93. For the time spread to work, the April option must lose its time premium faster than the July option. If the stock price remains relatively stable as the April expiration approaches, the value of the spread should increase. With only one month remaining before the April expiration, the option prices might look like this.

In this case, the position could be closed for a 1.11 profit by selling the July calls and buying back the April calls.

For long calendar spreads to work, the underlying stock price must remain relatively stable. Volatility is the enemy of a calender spread, any swings in either direction will negatively impact the time value of both options causing the spread to lose value. So plan your spreads appropriately, dont put one on over an important earnings period or when you know a major announcement about the company is due.

(MSFT: 21.96 -1.61%, vol: 153,919,648, avg vol: 90,992,304)

Potash corp of Saskatchewan, Inc ticker: POT has been one of my favorites to play lately.

In this example here I would buy the 155 calls for 13.5 and sell the 160 calls for 9.9 for a spread of 3.6. So that means each contract that I bundle together I would pay $360.00 for. The current price of the stock on Feb 25, 2008 is 164.28 and if the stock were to stay above $160 per share, I would then get the full price of the spread which in this case is $5 or $140 profit on a $360 investment. That is a 40% return on an investment that will end on March 21st 2008. The risk we have here is the stock sells off and goes under 158.60 and we start to loose what we paid for the spread.

OR

Puts, if we think POT is going to pull back over the next 30 days we can put a put debit spread.

In this example I would buy the 170 puts for 10.70 and sell the 165 for 7.70 for a spread of $3.00. So that means each contract that I bundle together I would page $300.00 for. The current price of the stock on Feb 25, 2008 is 164.28 and if the stock were to stay below 165 per share I would get the full spread which in this case is $5 or $200 profit on a $300 investment. That is a 67% return on an investment that will end on March 21st 2008. The risk we have here is the stock continues to get bought up and goes over 167 and we start to loose what we paid for the spread.
OR

We can do what is called legging in. You buy the long side of the position, call or put, and you sell the short side after the stock has already moved. No you cant sell first and then buy second because you would be naked the short position and unless you know what you are doing and the broker you are using will give you that kind of credit with them, chances are they wont even let you try it, it is not recommended either. So as you might have guessed if you are right about your position after you bought the log leg, your short leg will be higher when you sell it and you will lesson the amount you had to lay out for the position.

Currently I have been trading debit spreads like this on expiration that is no shorter then 180 days and getting out with no less then 90 days to expiration. It gives me more time to be right about my trade and I dont have to worry about time decay working against me when I have just my long leg exposed.

(POT: 68.52 +0.04%, vol: 23,863,128, avg vol: 16,822,000)

I have been trading options for several years now and have had my ups and downs and of course I didn’t listen when I was told to paper trade until I felt comfortable with my strategy. It would have saved myself money to start off paper trading and maybe even have me further ahead now that I am confident in my trading decisions. While there are many types of “options” when it comes to investing I am only talking about American style options trading on US publicly listed companies.

Options have their own market and theories of the way they should be traded. Stock options are the right to buy a position on a particular stock by a predetermined time for a predetermined price. The amount that you pay for this right is called the premium and the premium is derived by a formula called Black-Scholes which takes into consideration time to expiration, volatility of the underlying stock and the predetermined price which you decide on when buying the option. So that premium will fluctuate based on time and volatility, but the main way the price of the option will change is based on the underlying stock. If you get a good amount of movement in the stock then the premium will change exponentially. That is because you are controlling 100 shares for every one contract that you own. So for someone who is looking to diversify their holdings, it is a bit easier to do so with an option that costs $1 (which means $100 because the price of the option is always multiplied by 100) as apposed to 100 shares of the underlying stock which could be valued at $30 per share or $3,000 at the time of the investment.

So for those of us just entering the investment arena, options can be a great way to make sure we are not exposed to one type of investment.

What are your thoughts on this? Comment here or go post on the Equodity Forums.

What I’d like to talk about, though, is the overwhelming buzz the over $200 stock caused. You had a lot of excited people. You had a lot of pissed off people and naysayers.

In the end, all that really matters is how much the stock is worth and that only matters if you own the stock.

Where will it go from here? Who knows, but I’ll be keeping an eye on the Big Apple.

What are your thoughts on this? Comment here or go post on the Equodity Forums.

(AAPL: 96.38 -1.88%, vol: 56,787,792, avg vol: 40,469,300)

Companies like Freddie Mac, Fannie Mae, Bear Stearns etc., would pool them and also carry a basic kind of insurance called a credit enhancement.  A credit enhancement is very simply insurance up to a certain dollar value of default on the loans. 

Rating agencies used their historical models with historic default rates and rated many of the Sub-prime Mortgage backed securities as investment grade or better because the credit enhancements covered the expected default rate.  In other words the insurance adequately covered the default risk (based on historic data) according the ratings agencies (Moody’s, Fitch, and S&P).   The next thing to happen was a series of events that greatly increased the default rate far above the historical average that was credit enhanced.  The first catalyst is the fed raising rates 17 times in a row making refinancing at a similar rate impossible.  Also note that most sub-prime loans are 3-1 arms which simply means the interest rate is discounted for the first 3 years.  After 3 years it is reset to an index rate such as the 5 year treasury + x basis points (determined by loan to value and FICO score).  Each year after year 3 the arm reindexes. 

As the housing market tanked, borrowers could longer sell their houses at a gain or even a wash sale.  Since many of these loans were made at no down payment by the borrower, there is no equity to get out of most of these stocks.  Borrowers are better off living in their house for free for 12 months until the foreclosure process runs its course and then moving to an apartment as they have nothing to lose.  So instead of refinancing at a higher rate they default and walk away.  This creates a ripple effect as now the underlying mortgage in the MBS now defaults triggering partial payment of the credit enhancement.  As these continue to default the credit enhancement is used up and the market value of the MBS begins to drop.  Once enough defaults occur it’s possible for one of the ratings agencies to downgrade the debt rating of the MBS below investment grade.  This forces many pension and retirement funds to liquidate the holding as their charters prohibit owning junk rated debt.  Since there is no liquid market for MBS and no way of assessing the risk of the remaining underlying mortgages, to sell them somebody else needs to be willing to take a huge risk.  The only way to entice a sale is to severely discount the MBS which creates a 60-80% loss on the investment on sale.   

lso of note MBS normally pay 4-7% interest.  The reason why they are sought after (or at least previously) is because with the credit enhancements, they could attain an AAA rating which is equal to or near Treasuries.  Basically zero risk with a 1-3% higher return.

Deep sea projects are limited for two reasons: The first of which is that the rigs previously did not have the technology or capacity to drill beyond 10,000 feet.  The second is that at 50$, many deep sea projects do not yield a positive internal rate of return (IRR) (most deep sea projects have an IRR turning positive somewhere around 60$ per barrel).  For those of you who are not familiar with IRR, it is the expected percentage return on each dollar of investment.  This is the primary driver that Management uses to rank which projects they select to undertake.    As the price of oil increases companies decide to undertake the drilling projects because there are both limited prospects on land and oil companies have to replenish their oil.  Since oil production outside of the Middle East is expected to decline 2-3% for each of the next few years, there is a huge rush to find more oil to replenish supply and also meet Wall Street growth expectations.  This is the reason why I love RIG (Transocean Drilling) as an investment.  It is the largest offshore driller in the US.  Other Off-shore drillers include GlobalSantaFe and Diamond Offshore Drilling. In summary I present a perfect example of how the Market agrees with my assessment:  BJS was downgraded $2.50 from its 52 week low today while RIG had its price target raised roughly 20$; a mere 3$ from its 52 week high.