Derivatives Part 2

You should analyze this article only after you have fully understood the content of “Derivatives – Introduction” and “Derivatives Part 1.”

Theoretical knowledge should eventually be applied to practical trading. Many brokers offer simulated trading platforms for education, and it’s beneficial to use them initially to avoid common order-entry mistakes. However, ultimately, you must take responsibility for your mistakes, and only real trading offers the genuine experience you need.

Option Chain

The trading table below shows an options chain (example taken from Saxo Bank broker platform).

For now, focus on the key elements:

• The name of the underlying asset – in this case, the company with the symbol TCFP.
• Call options are listed on the left side of the table, and put options on the right side, in columns labeled “Bid” and “Ask.”
• The middle column shows the options’ expiration month and the available exercise quantities.
• Place an order by clicking on a specific table cell. In the image, find the cell showing $7.40 in the Ask column of the Call options table, in the row for the MAY 2024 expiration date with a $140 strike price. Clicking this cell will set the order TCFP MAY 15’24 140 LCALL (a long call position expiring on May 15, 2024, with a $140 strike). Ignoring transaction costs, you will pay at least $740 for this order immediately after completing the trade if you buy the option at your bid price, because bid and ask quotes fluctuate with incoming orders (due to supply and demand and the order-matching system). 
• If we click the cell in the same row within the Call area under the Bid column (where the amount displayed is $7.10), we will specify the order TCFP MAY 15’24 140 SCALL, which is a short position in a call option expiring on May 15, 2024, with a strike price of $140 per share. Ignoring transaction costs, after completing the trade, we will receive at most $710 if we sell this option at our bid price, as bid prices fluctuate with incoming orders. 
• If we want to buy or sell a PUT option, clicking the Bid column in the right-hand section of the table creates an SPUT order (selling a PUT option), while clicking the Ask column creates an LPUT order (buying a PUT option). The payment and payout of the option premium remain unchanged. The Bid column pays us; the Ask column pays us, and that’s it.

The trading table includes additional critical information, such as a column estimating the historical volatility of the underlying asset (the stock price), but I’ll postpone discussion of it for now.

“Playing” Ping Pong.

Please see the FSLR (First Solar) stock chart; the current share price is approximately $160. Suppose you think the price might go above $163. Look at the options table this time using the “Interactive Brokers” trading platform.

We can sell a put option with a $150 strike price and an April expiry (38 days). Much can happen during this time, but if FSLR’s price remains above $150, we keep the premium of about $435 (click the BID column for the put option at row 150).

If we enter into this trade, we have written a put option, which creates a short position and an obligation to buy 100 shares of FSLR at $150 per share if the price falls below $150 within 38 days.

We still won’t lose much even if the stock price drops to $145.65, which is $150 minus $4.35. What should we do then? For example, we could sell a call option with a $155 strike price and collect a premium of $400 to $500, hoping the stock price will reverse its decline. We would use our 100 shares of the company as collateral for this trade. If the stock price exceeds $155 per share by the call option’s expiration date, we would realize a profit of $1,000 plus the call option premium on the 100 shares we hold, and then sell the shares.

I refer to this as “Ping-Pong”.

Note that if the stock price drops further to $140/share, we will effectively lose almost nothing because the SCALL option will expire, leaving us with the option premium and the shares in our portfolio. The combined two premiums (from the written call and put options) result in an effective purchase price of approximately $140.

As the example above illustrates, an investor should establish an exit strategy before investing, even if it is a medium-term plan with several action scenarios. Such straightforward strategies require meticulous selection of the company as the underlying asset. We are seeking a company with characteristics that support the implementation of the proposed approach.

• a company with solid fundamentals and favorable investor valuations to minimize the risk of significant price drops,
• a share price in the range of $120-180 per share and high price volatility (around 60%), ensuring an option premium that justifies the risk
• a share price staying in a sideways trend with solid, confirmed support and resistance zones
• a potential lack of significant information during the option’s maturity period (dividend, split, M&A transaction, earnings release, etc.).

Will Ping-Pong with SPUT/SCall always work? – Of course not. The following chart and the history of my various CAR options trades demonstrate this.

It ate repeatedly and then died!

I entered seven consecutive SPUT and SCALL options trades on CAR. After collecting seven premiums totaling approximately $3,200 between September 2022 and December 2023, I took a break from this stock due to negative technical analysis (share price volatility had decreased, and the risk of a breakout at $157/share had increased).

In January, the so-called “crunch” occurred, and, driven by a wave of negative emotions, the shares unexpectedly declined from approximately $169 per share to roughly $100 per share. This resulted in a decrease of approximately $6,900 in the value of a 100-share portfolio. I saw this as a good opportunity to buy in on SPUT 100, as I concluded that:

• The $100/share price level should likely hold; the company is fundamentally strong, and purchasing its shares at this price presents an opportunity. Higher volatility increases option premiums. The only negative signal is the weak technical condition, which may indicate the start of a downward trend.
• The share price immediately rebounded to approximately $115-$120 per share, presenting an opportunity to take a position in SCall 150 with a reasonable option premium and a short expiration.
• There was also a risk of another quick price drop to $100 or even $95 (based on technical analysis).
• It was necessary to develop scenarios to be triggered in the future to improve the position in the event of adverse developments.

How did I do with options? – I capitalized on the momentum from the announcement of CAR’s quarterly results.

Under these conditions, if the investor is almost sure that the share price will not fall below USD 100, they can proceed by simultaneously selling the CALL option with a strike price of USD 150 per share and the PUT option with a strike price of USD 100 per share (SCALL + SPUT), collecting a total premium of approximately USD 700. As the share price increases, they can sell subsequent CALL and PUT options at different strike prices, especially since the CAR share price volatility has once again increased significantly, along with option prices and premiums received.

The limit to this madness is the amount of capital available to secure currently active positions, because cash management is paramount.

The above examples are still ABC.

Typically, a trading portfolio comprises multiple option positions. Nothing is stopping you from varying the number of long and short call or put options with the same or different expiration dates. Sometimes, assessing the potential profit and risk of such a portfolio can be challenging. The value of a single option depends on five variables simultaneously, making it a multidimensional system. Additionally, each of these variables exhibits distinct dynamics, with or without a correlation with the stock price. The prices of some underlying assets may also be directly or inversely correlated.

Two useful rules:

• When taking short positions: SPUT or SCALL, keep at least 50% of your capital in cash.
• When considering options, avoid leveraging your financing.

When you put the above ABCs into practice, you’ll quickly see that:

• Alternatively, you can synthesize the profit/loss profile from buying 100 shares at $150 each by simultaneously trading LCALL 150 and SPUT 150 with the same expiration date.
• Interestingly, you won’t invest much money when the premium paid for LCALL is nearly equal to the premium received for SPUT. Instead of spending $15,000 to buy 100 shares, you might only spend or receive a few dollars from the difference between the premiums. It might seem like a silly investment, but do you consider the risk of such a position?
• Unlike a long position in a portfolio of 100 shares, an LCall + SPut portfolio may expire at an inconvenient time, given the current share price level relative to the call and put strike prices. When the stock price has fallen too much, an SPUT carries the risk of a substantial loss (we will be forced to buy 100 shares well above their market value, and the option premium (minimal or zero) will not cover us).
• If the strategy succeeds, LCall will be in the money at option expiration with almost zero investment, generating a substantial percentage return.
• Of course, the dynamics and risks of these alternative transactions vary in several other ways, so the pros and cons must be carefully considered.
• In the event of a very likely decline in the stock price, instead of selling 100 shares at $150 per share, you can create a synthetic short sale of 100 shares using a portfolio of SCALL 150 + LPUT 150 transactions (check this visually on the profit/loss profile chart). This method closely mimics the profit/loss profile of a short position in a portfolio of 100 shares.

Options strategies are a broad topic and a flexible tool that lets you combine different profit and risk profiles using a portfolio of options and stocks.

However, everything hinges on:

• Investment goals (aggressive capital growth versus systematic low income),
• The amount of capital invested in risky investments
• Adopted capital and risk management principles (we follow them as if they were independent),

I’ve learned that simplicity and the ability to “grasp” the topic are crucial here. There’s no point in struggling “in uncharted waters with many degrees of freedom”—as a mathematician analyzing objects in multidimensional spaces with strange metrics might poetically say—or, to put it simply, “KEEP IT SIMPLE!!!!”

If you’re still interested in the topic, more will come.