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Long or Short Stock Strategies
A trader may be long or short stock based on long term valuations, but still want to either take advantage of or be protected from short term happenings. We will go over some strategies based on the scenario of being long or short stock.
If you are long or short stock and fear a major event/move, you can simply buy puts or calls respectively in proportion to the stock you are long or short and be protected. For the life of the option, this essentially turns the position into a synthetic call or put.
long stock + long put = synthetic long call
short stock + long call = synthetic long put
If you are long stock and buy an out-of-the-money put, then if stock goes up or stays still you make money on your stock and have lost the price of the put, which will expire worthless. If stock goes down through the put strike, then your stock will have been called away (as that now in-the-money put will be exercised) and your maximum loss is the price of the put plus what you have lost on the stock going down until that strike. A protective put is also referred to as a married put.
Graph from Option Volatility and Pricing by Sheldon Natenburg, p. 260.
One might buy a protective option if there is a major bifurcating event upcoming where the underlying might move drastically in either direction. Or if implied volatility is trading incredibly low and you perceive the puts or calls to be a very good deal as an insurance policy since the stock tends historically to be more volatile. Unfortunately, before major bifurcating events implied volatilities tend to trade high.
Which call or put to buy depends on how much pain you are willing to take if stock moves against you. The further out of the money, the cheaper the call or put will be, but the more money you will lose on your stock position before you are protected. A near term call or put will be cheaper, but your protection lasts only until it expires. These options are insurance policies and the better the insurance the more you have to pay for it.
Covered writes allow the trader to generate cash and protect against small contrary moves. Essentially it is a strategy you might use if you think that an underlying that you are long or short might move only slightly in the near term or if you are nearing a point where you’ve made some gains and were thinking of selling to close or buying back at a certain price point. We will go through the example of a covered call, but the mirror image would apply to the covered put.
If we are long a stock, but feel we are entering a time period when it might sit still temporarily, we can generate income by selling upside calls in proportion to the stock we are long (1 call for every 100 shares). Our graph of P&L until that call’s expiration will look like that of a short put.
Long underlying + short call = synthetic short put
Graph from Option Volatility and Pricing by Sheldon Natenburg, p. 262.
If stock moves down, we are protected up to the price of the call, if stock moves up but not through the strike or stays still, then we will receive the decay on the call which will expire worthless. If stock blows through the strike then the call we are short will be exercised and our stock will be called away. Our profit will be the premium we received on the option sale. So this strategy is very different from a protective option. We are only protected on the short side by the price of the call and our upside profit becomes limited. You have to be willing to sell your stock at that strike price if it goes there before your call’s expiration. That’s why this can be a nice strategy if you have seen some gains and are approaching a level where you might sell your stock anyway. For example, stock could be reaching what you see as a resistance point. You can sell a call at that resistance point strike. If it gets close but not through you have made the price of the call and are still long the stock if it tries again. If you do have to sell your stock, it is a point where you were willing to sell anyway.
During the lifetime of the call, one can lose money if the implied volatility goes up and you decide you want to buy it back before expiration. This could happen if there were news that was perceived as positive and you decided you weren’t willing to sell stock at that price. Then you would have to buy back the call for what might be more than you received for it.
Which call to sell depends on what you think the stock will do and where you are willing to sell it. Obviously, the closer to at-the-money the higher the premium and so the more downside protection you will have but you will not be able to partake in any upside profit. The farther out-of-the-money the option is the less you will receive for selling it. The covered call is a strategy we would primarily recommend for near term options as the decay, theta, is greatest.
If the buying of the stock and selling of the call is done at the same time it is referred to as a buy/write.
Say you want to buy stock if it goes down to a certain price. You could put out a limit order, but another way to do this would be to short a put at the strike where you want to buy the stock. If the stock goes down to your strike you will be assigned on the put and will buy stock, plus having received the premium for the sale of the put. If stock doesn’t go down through that strike or goes up, then the put will expire worthless and you will have profited by the price of the put.
This is not a protective strategy. It is simply a way to generate a little income if you were planning on buying stock at a certain price point anyway. Again the danger is if news comes out that makes you change your opinion on buying stock and implied volatility goes up so that you have to buy back the put for more than you received for it.
A collar, also known as a fence, is the combination of a protective option and a covered write. You have limited both your profit and your loss.
Long stock collar. Graph from Option Volatility and Pricing by Sheldon Natenburg, p. 264.
Short stock collar. Graph from Option Volatility and Pricing by Sheldon Natenburg, p. 265.
From the long stock perspective, for every 100 shares of stock you are long, you would buy one put and sell one call. This is a nice strategy if you are nervous about a big move down, but don’t want to pay a lot for the protection and are willing to lose some upside profit potential. Again if you’ve seen some nice gains already in a stock and are approaching an earnings that you think might be questionable this can be a good strategy.
Dan recommended collars as a way to protect a long position going into Apple (AAPL) earnings on January 20, 2012. His reasoning was that the stock had gone up in recent months, and although the fundamentals were strong and sentiment positive that there was reason to be questionable about these earnings and conference call with a new CEO. There was precedent with a big down move in Google (GOOG) on January 19th when, despite generally good sentiment leading up to it, earnings sent the stock down over 8%. In this case, after earnings on January 25, 2012 stock went up just beyond the upside call that he recommended shorting with the collar. But, with three weeks to expiration there was still time for for that call to decay and implied vol to come in after the event of earnings and be bought back for less premium if the trader doesn’t want to be called in on the stock. See Dan’s update here. That’s why thinking about the Greeks and how they affect option prices over time is important for trade management as events and expiration often don’t coincide.
The collar is a nice conservative strategy if you think stock is going up generally, but are anxious about a big move down on an event. The same thing can be done with a short position, buying a call and selling a put. The collar can be put on for a credit, debit or even. Again which options to choose depend on how much downside you can take if stock goes against you and how much upside you are willing to lose if stock goes the way you are long or short. It is important to consider these actual scenarios rather than just the price of the collar. Putting on a collar for credit can be very tempting, but you may not be completely satisfied with the consequences.