Friday, February 20, 2009

Options Strategy

Not all options questions involve T-charts and calculations. Many have to do with strategy/suitability. The old what-should-the-pretend-investor-do-now questions are often the hardest of all, so let's have a little fun with one of these early on a Friday morning.

Dante purchased 100 shares of XYZ @44 several weeks ago. Now that XYZ last traded at $45, Dante is concerned that the stock has met resistance, and is, therefore, not likely to rise significantly. Therefore, you would recommend that Dante
A. buy 1 XYZ Oct 45 call
B. buy 1 XYZ Oct 40 put
C. sell 1 XYZ Oct 40 put
D. sell 1 XYZ Oct 50 call

Many students absolutely hate a question like that. Notice how it doesn't fit neatly into some magic options decoder chart, nor does it have anything to do with a memorized formula. You basically just have to think analytically. And, as usual, your job is to find something wrong with each of the recommended strategies so that you can eliminate three of them. We need to take the facts presented in the question and apply them first to "buy 1 XYZ Oct 45 call." Well, if Dante doesn't think the stock will rise, he would not want to buy a call. Call buyers are bullish; they think the stock is going up. Period. A is eliminated, then. What about "buy 1 XYZ Oct 40 put"? Is there anything in the fact pattern that says he expects the stock to plummet? No? So, he would not buy a put--B is eliminated. At this point many students want to choose "sell 1 XYZ Oct 40 put," but I'm not sure they really think through the strategy; instead, I think they just want the question to be over at this point. But, if Dante already owns the stock, he's at risk that it could drop. If he sells a put, he will get hurt twice if the stock drops. In other words, he'll lose money on the stock position, and he'll lose money on the short put for every dollar the stock drops. What about "sell 1 XYZ Oct 50 call"? At least this position is a hedge--a covered call. He's bullish on the stock; writing the call is bearish/neutral. In other words, it's not crystal clear whether he should sell the put or sell the call. But with analytical thinking and good test-taking skills, at this point you eliminate "sell 1 XYZ Oct 40 put" because there is something inherently wrong with a strategy that will double Dante's pain if the stock drops. And you're left with Choice D, the answer that was hardest to eliminate.

If you see a tough options question, post it in a comment.
Let's have some more fun with options, people. Heck, the weekend is nearly upon is.
BTW, today's Friday Free Broadcast is on "Rules and Regulations," which is key to the Series 7 and several other exams. Pull down the schedule at under Get Free Stuff.

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