Picking the Magic Strike PriceErnie Zerenner President Power Financial Group, Inc. PowerOptions – www.poweropt.com Copyright Power Financial Group http://www.poweropt.com/oxp2/ 1 Introduction Option investing has several degrees of freedom more than equity investing: Strike price Time decay Month selection This talk will concentrate on the choice of the strike price for both buying and selling strategies. Copyright Power Financial Group http://www.poweropt.com/oxp2/ 2 Basic Covered Call Calculations Using the option premium for each strike price, our option chain calculates: % Downside Protection % if Unchanged % if Assigned % Probability the Stock Price will be above the Strike Price Copyright Power Financial Group http://www.poweropt.com/oxp2/ 3 Copyright Power Financial Group http://www.poweropt.com/oxp2/ 4 Observations on Option Chain Observe the general trend in pricing as the strike price increases: Option premium declines % Downside protection declines % if Unchanged is highest ATM % If Assigned increases % Probability Above declines Copyright Power Financial Group http://www.poweropt.com/oxp2/ 5 XYZ ($81) with 44 days left Strike Price 75 ITM 80 ATM/ITM 85 OTM Option Prem. $6.70 $2.75 $0.65 %DnSd Protect. 8% 3% 1% % if Unchg. 1% 2% 1% % if Assign. 1% 2% 6% % Prob. Above 90% 60% 18% Copyright Power Financial Group http://www.poweropt.com/oxp2/ 6 How to interpret the data High returns comes with a “risk” Highest return (if unchg) is ATM Greatest safety is ITM Greatest potential gain is OTM The more the potential gain then the lower the possibility of success based on probability Copyright Power Financial Group http://www.poweropt.com/oxp2/ 7 Back to the point in Question: What strike? It all depends on your own risk reward profile: Looking at the last 2 columns of % if Assigned and % Prob. Above as a pair The lowest return of 1% has a 90% chance of happening (highest % Probability Above) The highest return of 6% has only an 18% chance of happening (lowest % Probability Above) Copyright Power Financial Group http://www.poweropt.com/oxp2/ 8 What Strike based on Risk Looking at the % Downside Protection and the % If Assigned columns as a pair: The highest downside protection has the lowest return, but the stock price can fall and still win The highest return is possible at the highest strike price, but it has the lowest downside protection To achieve the highest returns requires the stock to rise in price. If it does not rise the return is lowest of all. The highest strike price is a play on stock appreciation not covered call income Copyright Power Financial Group http://www.poweropt.com/oxp2/ 9 Real Life Example Retired and looking for income Preservation of capital is more important than speculative gains Want a better return than a CD or a Bond Want to reduce the volatility of my holdings Copyright Power Financial Group http://www.poweropt.com/oxp2/ 10 Some of My choices Case 1 – Already own stock and want to earn income. Case 2 – Have cash and want to do a buy / write to generate income Copyright Power Financial Group http://www.poweropt.com/oxp2/ 11 Case 1 – Already own Use strikes ATM or slightly OTM Want to avoid being assigned therefore must roll up and out if ITM. Must watch dividend exposure to avoid early assignment. Actively manage by buying back the option if it declines and rolling down Copyright Power Financial Group http://www.poweropt.com/oxp2/ 12 Case 2 – Buy / Write Always go ITM Sacrifice large returns for safety As a rule of thumb limit annual gains to 20 to 30% Max. Reduce the excess gain by going further ITM. Actively manage the position by liquidating once 70 to 80% achieved. Copyright Power Financial Group http://www.poweropt.com/oxp2/ 13 Summary on CC Strikes It’s all about risk / reward Each situation is different, but each strike has a set of characteristics, which can be tailored to your circumstances Be sure you have the tools and calculations available to make the smart choices Copyright Power Financial Group http://www.poweropt.com/oxp2/ 14 That was selling options Now we discuss buying options Investors tend to pick the wrong strike price! Choices based on number of contracts? Go deep OTM for cheap options Go ITM for high delta and low time premium Copyright Power Financial Group http://www.poweropt.com/oxp2/ 15 Picking a Strike when Buying We need to decide: Which month & strike. How much time premium should we buy The more ITM the more it costs More time costs more money This all effects the number of buy contracts But, where is the best return? Copyright Power Financial Group http://www.poweropt.com/oxp2/ 16 Tool to Maximize Returns Assumptions in developing the tool Forecast the stock price Time frame for the move How much will you invest Will volatility change Based on these inputs the best return can be calculated for every possible strike price Copyright Power Financial Group http://www.poweropt.com/oxp2/ 17 Input Example: Copyright Power Financial Group http://www.poweropt.com/oxp2/ 18 Output Example: Copyright Power Financial Group http://www.poweropt.com/oxp2/ 19 Summary of Buying Make a forecast for the stock Determine the time the move will take How much you want to invest Then use a tool to calculate the best strike to use based on returns. Copyright Power Financial Group http://www.poweropt.com/oxp2/ 20 http://www.poweropt. com/oxp2/ Use the above URL for a 30 day FREE Trial Toll free help using the site Try these techniques by paper trading One-click trading for optionsXpress clients 877-992-7971 (toll-free) Copyright Power Financial Group http://www.poweropt.com/oxp2/ 21 Tomorrow’s presentation Tools and Software How to Find Option Trades with SmartSearchXL 4PM Friday May 5th Copyright Power Financial Group http://www.poweropt.com/oxp2/ 22