Excerpt

.....Two factors determine the profitability of any trading strategy: the ratio of average profit to average loss and the percentage of profitable trades. One, for instance, might use a strategy that produces a greater profit/loss ratio and reduce the need to be right about the particular trades more than 50% of the time. Conversely, a strategy that wins a greater percentage of the time doesn’t need to win as much on any individual trade.

     Profit = Number of trades *(win probability * average profit – loss probability * average loss)     (1) 

  For example, assume a win probability of 0.55, a loss probability of 0.45, an average profit of $1.5, an average loss of $1.00, 
then the profit realized for 100 trades of various sizes is

     Profit = 100 * (0.55 * $1.5 – 0.45 * $1.0) = $37.8 per share for average trade size, 
i.e., $37,800 for 1,000 share trades or $11,340 for 300 share trades.

  If another strategy increases the average profit, the winning percentage necessary correspondingly drops.  
For example, assume a win probability of 0.40, a loss probability of 0.60, 
  an average profit of $2.5, an average loss of $1.00, then for 100 trades the profit is

     Profit = 100 * (0.40 * $2.5 – 0.60 * $1.0) = $40.0 per share for average trade size, 
i.e., $40,000 for 1,000 share trades or $12,000 for 300 share trades.

Interestingly, the reason that I brought it up here is that option strategies fit the second scenario: they increase the profit/loss ratio (due to the financial leverage) while often decreasing the win probability (due to their inherent disadvantages: larger commissions, greater bid/ask spreads, need to be right on price move and time necessary for the move, and inherent option pricing characteristics that we’ll touch on). Too, if technical chart information (price/volume relationships) is incorporated into an option strategy, then the winning percentage should not drop off as precipitously. From expression (1), total profit is improved—in a profitable strategy—by increasing the number of trades, by increasing the win probability, or by increasing the average profit. Option strategies offer the last.

.....My goal here is to acquaint the average investor/trader with the potential offered by using a selected few option strategies. It’s not to discuss all their possibilities or, for that matter, their more mathematical characteristics. Additionally, I want to acquaint the reader with an Excel spreadsheet that I’ve developed to aid your evaluation of profit opportunities offered by these strategies: the covered call (buy stock and sell calls), the long call or put (buy calls or puts), the naked put (sell puts), a position repair strategy (long stock/long call/short call), and the bullish spread (long and short puts). These plays can be used to generate income, to control risk, to leverage bullish or bearish markets, to buy stocks at a bargain price, and at other times, to repair a position that’s gone bad. Too, I will introduce you to another spreadsheet that can be used to evaluate statistical ranges through which a stock’s price might be expected to travel over a given period of time (a day, a week, a month, etc.).

.....After these somewhat wordy and formal descriptions, let me draw two analogies for those of you encountering options for the first time. A call contract is similar to a lease with option to buy in the real estate business. For example, you might lease a home for a year (expiration date) then pay some additional premium up front for an option to buy the house at any time during that year at an agreed upon price (strike price). You, the call option buyer, are betting that the home will appreciate over the next year to be worth more than the strike price. In effect, you are buying tomorrow at today’s price. The call option seller, on the other hand, is receiving a premium today to give up any appreciation beyond the strike price because, to him, it’s extra income today and still a profitable sale tomorrow. Call option contracts for stock work exactly the same way on its underlying stock. Think of the stock as the house.

A put, on the other hand, acts like an insurance policy for the buyer in much the same way as an insurance policy acts to protect your home. You, the homeowner (put buyer) buy the insurance from the insurance writer (put writer). While you want to protect against a catastrophic loss, the insurance writer (like State Farm) wants to collect the premium for insuring that loss. Back to put options, the seller of the put (the writer of the put) is paid the option’s premium and, for doing so, guarantees the put buyer that he will buy the underling stock at an agreed upon price (the strike price) at any time up to the option’s expiration date. The seller of the put writes the insurance policy for the buyer of the put; the first gets the premium (income), and the second, the guarantee that his stock’s price will not fall below the option’s strike price.

Typically, people buy puts for two reasons: (1) they believe that the stocks price will fall, and want to bet that way, or (2) they own positions in stocks that they want to protect from the fall (they want to hedge their bet)—a kind of insurance if you will. Others sell puts for income or as a method to buy stocks tomorrow at cheaper prices than would be available today. Calls, on the other hand, give buyers the right, but again not the obligation, to buy your stock up to some specified point in the future at a specified price. Call buyers are most often betting on a price rise in the underlying stock and are leveraging their cost. Sellers again are looking to generate income. If the seller already owns the stock on which he is writing calls, the options are commonly referred to as “covered” calls—perhaps the most conservative of all option plays, and one available in most IRA accounts.