Learn a Better Way to Trade Stocks Using Options Presented by James Ramelli Past performance is not indicative of future results.

Learn a Better Way to Trade Stocks Using Options

Presented byJames Ramelli

Past performance is not indicative of future results.

Day trading, short term trading, options trading, and futures trading are extremely risky undertakings. They generally are not appropriate for someone with limited capital, little or no trading experience, and/ or a low tolerance for risk. Never execute a trade unless you can afford to and are prepared to lose your entire investment. All trading operations involve serious risks, and you can lose your entire investment.

RISK DISCLAIMER

Trade Any Stock You Want at a Discount

• The majority of retail investors use equities as their main vehicle for investing in financial markets.

• Most investors are unaware of how they can use options to leverage their returns in markets while minimizing overall risk.

• Here we will talk about one way options can be used to more efficiently trade equity markets.

Namely, how to trade ANY stock at a DISCOUNT, meaning less capital and less risk!

Trade Any Stock You Want at a Discount

So how can a trader use options to trade markets more efficiently?

There are a number of different strategies that we will discuss that show how an options trader can more efficiently deploy their capital.

We will cover: Stock replacement strategies – Using Deep ITM calls and Deep ITM puts to get long or short stock with less capital. Using Puts to Get LONG – Putting time decay on my side using options. Selling Put spreads for income- Collecting Premium on a weekly or monthly basis while getting long stocks. The Options Wheel – How to get long stocks at a lower cost and use options to continually lower the cost basis of your position.

Stock Replacement Strategies

What are Stock Replacement Strategies?

• Options can be used to replicate a stock position.

• Why take these strategies instead of a stock position?

• Why trading options is actually LESS risky than trading stocks?

• How can a trader use calls to make long term investments at a discount?

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Getting Long or Short Stocks While Committing Half as Much Capital

Why this Strategy works for Every Trader

The inherent leverage of options allows for a trader to use them in a MORE capital efficient way than outright equities.

Myths about options:They are riskier than stock.They are too difficult for the average retail trader to trade.They require larger amounts of capital.

So what is an example of getting long a stock using a stock replacement strategy? Lets look at a very recent example in GPRO.

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Stock Replacement in GPRO

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This is an example of how a trader would use a deep in the money call as a long stock replacement strategy.

Before we talk about why a trader would do this instead of buying stock outright lets talk about why he chose this line of calls to run this strategy.

First we need to understand some basics about options greeks, namely delta and gamma.

Calls Instead of Stock

There are some things to consider when choosing which option you

should buy:

- Time until expiration

- The options Delta

- Amount of premium in the option (Extrinsic Value)

First consider delta. Remember the definitions of delta.

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Delta Δ

Delta is simply a measurement of the speed at which the option price changes relative to

the underlying stock price change.

The Delta of Calls range between 0.00 and 1.00, and the Delta of puts range between 0.00

and -1.00. Since Options contracts represent 100 shares of stock, we will discuss delta in

terms of -100 and +100. As stated above, Calls have positive deltas and Puts have negative

deltas.

Another meaning of Delta is "percent chance of finishing in the money". So, an option with

a Delta of 25 is considered to have a 25% chance of expiring in the money. With this in

mind remember that Delta Call + Delta Put almost always equals 100. The exception to this

being American style equity options with large dividends. Also shows the number of shares

an options contract represents

Very Important!!! Delta changes over time regardless of a move in the underlying. As

expiration approaches in the money options move closer to Delta 100 and out of the money

options to Delta zero. Today's Delta is not tomorrow's Delta!

Calls Instead of Stock

So we understand that an options delta will tell us how much the value

of that option will change relative to a change in the underlying stock.

With this in mind we know that we want an option with a high delta

because it will behave more like the underlying stock.

Also remember that the more ITM an option is the higher its delta will

be. You should look for a Call with a delta of at least 0.75.

XYZ STOCK IS CURRENTLY TRADING $22.30

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Strike Price $20 $21 $22 $23 $24 $25Call Option Price

$3.20 $2.50 $1.90 $1.30 $.90 $.60

Call Delta .78 .70 .60 .40 .30 .22

Gamma Γ

Gamma is mathematically the second derivative of Delta and can be viewed in two

ways: the acceleration of the option position relative to the underlying stock price, or

the odds of a change in the probability of the position expiring ITM (in other words, the

odds of a change in Delta).

Gamma is effectively an early warning to the fact that Delta could be about to change.

Both calls and puts have positive Gammas. Typically, deep OTM and deep ITM options

have near zero Gamma because the odds of a change in Delta are very low. Logically,

Gamma tends to peak around the strike price closest to expiration.

Meaning that Gamma measures the change in the Delta for a $1 change in the

underlying. Gamma is also a measure of how much premium one is long or short. So,

if one is long 500 Gammas one will gain 500 Deltas if the stock goes up and lose 500

Deltas if the stock goes down.

Gamma is important because it shows us how fast our position Delta changes in

relation to the market price of the underlying asset. Gamma is always highest in the

front month options than the back and the closer to the ATM strike. Also the closer an

option gets until expiration, the higher the Gamma will be.

Gamma Γ

Gamma is simply a measurement of the speed at which the Delta

changes relative to the Underlying Option price change.

Strike Price $20 $21 $22 $23 $24 $25Call Option Price

$3.20 $2.50 $1.90 $1.30 $.90 $.60

Call Delta .78 .70 .60 .40 .30 .22

Gamma .08 .10 .20 .10 .08 .06

Strike Price $20 $21 $22 $23 $24 $25Put Option Price

$3.20 $2.50 $1.90 $1.30 $.90 $.60

Put Delta -.22 -.30 -.40 -.60 -.70 -.78

Gamma .08 .10 .20 .10 .08 .06


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With an understanding of delta and gamma we can now understand why this trader chose this line of options.

Delta = 100Gamma= 0

These calls will move exactly like the stock does, producing an identical P&L profile.

So if this has the same P&L profile as a long stock position why wouldn’t a trader simply buy the stock?


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2,000 Calls gives the holder control over 200,000 shares of stock:200,000 shares of stock at $93.70 = $18.47 million

With a delta of 100 these calls will have the same P&L profile as this stock position but will require much less capital over the trades holding period.

2,000 calls at $39.00 = $7.8 million

This is a difference of $10,670,000 in capital required.

What is the value of freeing over $10 million between now and January 2016?

Aren’t Options Riskier? What if the Stock Doesn’t Move?

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It is true that there is a risk associated with options that I would not have to consider when trading stock.

Options have time premium so if the stock does not move I am risking this premium.

This risk is easy to quantify:The Jan 55 Calls are bought for $39.00 with stock at $93.70These calls have an intrinsic value of $38.70.

Here I’m only paying $0.30 over parity to hold this position, this is a small amount of capital over time.

Aren’t Options Riskier? What if the Stock Doesn’t Move?

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Cant I lose my whole investment?

Yes options can go to 0. if GPRO is below 55 on expiration then my position is worthless.

However I need to consider that I would have experienced the same amount of losses in stock if it were to sell off that much.

The main upside of using the calls is that I do not participate in any downside below $55.00, my calls will also never trade for less than parity

OPTIONS ARE NOT RISKIER THAN STOCK

Getting Short Stocks With Short Stock Replacement

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I can use the same principles to get short stocks with lower levels of risk.

I want to short GE shares as I believe they will be weak through the end of the year but I am worried the stock could gap higher at anytime and I’m not confident that my stops will hold.

Buying a deep ITM Put:• I’m looking for an option with at least a 0.75 delta.• I want an expiration that lines up with my general market view. • A non 100 delta option will give me extra upside as I get SHORTER as the stock

moves lower


Using deep ITM Puts to get short stock:

A trader can also use deep in the money puts to get short stock. Again

you're going to want to look at a Put option with a delta of around -0.80.

Remember that put deltas get higher the further out of the money you

go. A put with a delta of -0.80 should rise in value $0.80 for every dollar

the stock sells off.

Stock XYZ is trading at $22.30

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Strike Price $20 $21 $22 $23 $24 $25

Put Option Price

$.70 $1.00 $1.40 $1.80 $2.40 $3.10

Put Delta -.22 -.30 -.40 -.60 -.70 -.78


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GE:

I buy the Jan 2015 28 Puts for $3.15 with stock trading at $25.25

Delta= 0.85Gamma= 0.10

This position is going to perform like 85 shares of short stock and as the stock heads lower I actually get shorter.

I am only paying $0.40 over parity for these puts.

What is my risk here?

I buy 10 GE Jan 28 Puts for $3.15Risk: $3,150Breakeven: $24.85

If I shorted the stock:

I sell 1000 shares of GE at $25.25Risk: UnlimitedBreakeven: $25.25


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Selecting Stocks to Use Stock Replacement Strategies

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What is my selection process?

The selection process is simple. I run this strategy in any stock where:• I am worried the stock would run my stop

• I do not want to be exposed to gap risk from the long or short side

• I want to have a defined level of risk

• When I don’t want to tie up capital in a long term position

• Stocks that are especially exposed to headline shocks

A Note on Early Exercise

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the market makers can capitalize on amateur traders who lack knowledge. They, along with other pros can take advantage of traders who do not know the answer to the question

When would you choose to exercise an option early?

Retail traders who don’t know the answer to this question leave tens of millions of dollars on the table each year.

The Answer: Dividends. Let’s talk about a few ways dividends affect options.


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Understand that:

• Increases in Dividends raise the price of puts and lower the price of calls.

• Increases in dividends lower the forward price of the stock.

Although this seems simple, professionals will use the average trader’s misunderstanding of this concept to take money from them. This happens when these traders fail to exercise their options when it is optimal due to dividends.

• In stocks that do not pay dividends a call holder will not elect to exercise their position early

• Exercise if: The dividend amount minus the carry costs (interest rate) is greater than the price of the same strike put.


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• The market makers and other pros are hoping that traders like you will fail to exercise their calls early and will experience a loss after the resulting drop in the stock.

• The assignment is random so if a few of the market makers shorts are not assigned it is like free money.

• Remember to exercise your in the money calls if they are trading at 100 delta. This small consideration costs traders (mostly retail) massive amounts of money each year. If you have deep in the money calls in any stock be sure you know when the ex-dividend date is.

Using ITM Puts to Get LONG Stock

Take advantage of volatility skew and put time decay in your favor.

Selling Deep ITM Puts

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What if I think a stock is going higher but I’m worried it might take a long time?

Think back to our GE example. Why did these puts seem so “expensive?”

The answer is skew. In general options traders are in the market as hedgers looking to buy downside protection.

This make put premiums trade at a higher level than calls in most names.

I can use to my advantage when looking to get long a stock.

Lets look at an example of this in GPRO

Put Time Decay on Your Side

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Selling Deep ITM puts in GPRO:

I want to be long GPRO through January of 2015

I sell the GPRO Jan 2015 130 Puts for $57.00 with stock at $90.00Risk: $7,300 per 1 lot (if stock goes to $0)Reward: $5,700 per 1 lotBreakeven: $73.00

As you can see, in a high vol stock like GPRO I collect a huge amount of premium. I only paid $0.30 over parity to get long via deep ITM calls, the vol skew means I am able to collect much more premium when selling puts

Multiple Ways to Profit

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I plan on holding this until expiry:

GPRO stock does not move much and closes on Jan Expiration at $92.00

My short puts will now be worth $38.00Profit: $1,900 per 1 lot

GPRO rallies hard through the end of the year and closes on Jan expiration at $110.00

My Short puts are now worth $20.00Profit: $3,700 per 1 lot

Multiple Ways to Profit

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I plan on holding this until expiry:

GPRO sells off 15% between now and January expiration and closes at $76.50My short puts are now worth $53.50Profit: $350 per 1 lot

So as you can see the number of scenarios where I profit increases meaning this trade has a higher probability of success.

I don’t even need the stock to move for me to make money and my breakeven point is nearly 20% below the stocks current price level. Look again at my range of profitability.

Drawbacks to Selling Deep ITM Puts

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Nothing is free:

When trading options I have to pay for everything, in this case the trade off for more scenarios of profitability is a higher level of risk.

In this trade I still participate in losses below $73.00 per share.

I do not have the built in stop like I did with the deep ITM call.

This trade also requires a large amount of capital. I have to have the cash in my account to buy the stock if these puts are exercised.

Drawbacks to Selling Deep ITM Puts

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Nothing is free:

I am limiting my upside- If GPRO rallies above $130 I do not participate in that move.

My losses in a downward move of the stock price can be just like owning the underlying stock.

While this strategy is not optimal in all situations it can work well for situations where I want to try and get long depressed stocks without having to lay out cash or where I might be expecting a declining implied volatility environment.

Selling a Put In Beaten Down Stocks

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JCP collapsed as negativity around their conference increased:

Maybe I believe that this move was overdone and there is a good chance that JCP will recover through the holiday season and test its recent highs above $11.00.

I sell the JCP Jan 11 Puts for $3.15 with stock at $8.20Risk: $785 per 1 lotReward: $315 per 1 lotBreakeven: $7.85

So how is this different from simply buying shares of JCP at $8.20?

Lowering My Exposure

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Benefit of Selling a Put:

If I had bought stock my total risk would be $8.20 per share, here I am able to lower that by $0.35, which may not seem like a lot but it is nearly 4.5% between now and January Expiration.

So I am essentially getting a premium to sell a put rather than buy the stock.

Best case Scenario:• The stock rallies back to recent highs and closes above $11.00 on January expiration• I capture the $3.15 in premium I collected• I profit 40% on my risk in just a few months

Other Outcomes

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What if the stock doesn’t make it above $11.00?

If shares of JCP remain little changed between now and expiration and close at $8.15My short puts are now worth $2.85I profit $30 per 1 lot

What if shares sell off?JCP shares sell off to $7.75 on expirationMy short puts are now worth $3.25 and I am now in the red.

I have 2 choices. I can buy back my put for a loss or I can take the stock and begin running another strategy. Enter the Options Wheel

The Option Wheel

Get Long Stocks or Collect Money Not ToContinually Lower the Cost of Long Stock Positions

The Option Wheel

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Two ways to run the wheel:

There are two different ways I can implement this strategy that we will discuss. 1. To help repair a deep ITM put trade that may have gone against me

2. To get long a stock that I wouldn’t mind owning at a lower price or collect premium not to.

First lets look at how I can use this strategy to repair a trade that has moved against me.

Lets look back to the JCP example from the previous section.

Repairing a Bad Trade

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I sell the JCP Jan 11 Puts for $3.15 with stock at $8.20Risk: $785 per 1 lotReward: $315 per 1 lotBreakeven: $7.85

January expiration rolls around and JCP stock is trading at $7.75. I don’t want to buy back my put for a loss because I still believe the stock is undervalued so I take the stock.

My effective cost basis per share is $7.85 plus whatever commissions I paid to put on the options position.

To begin repairing this trade I need to start lowering my cost basis.

Repairing a Bad Trade

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I am now long shares of JCP at a cost basis of $7.85

It is January so I will look out to the February 9 calls

I will sell these calls for $0.25 in the process lowering my cost basis another $0.25

Trade: I sell the Feb 9 Calls for $0.25 against long stock at $7.85 (original cost)Risk: $760 per 1 lot (if stock goes to $0)Reward: $140 per 1 lotBreakeven: $7.60

I have lowered my cost basis and can profit from this trade in a number of different scenarios.

How Can This Play Out?

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On Feb expiration:

Shares of JCP are unchanged and still trading at $7.75My short calls go out worthless and I capture the whole premium.

My cost basis is $7.60 so I profit $0.15 per share and I have recovered my original loss. I have 2 choices:1. Unwind the whole position2. If I STILL like JCP stock I can sell another covered call and start the process over

again

In theory I can keep doing this until the stock is called away or I have a cost basis of $0If it is called away after the first call sale I have turned a loser into a nice winner.

Running the Wheel In Stocks I Like

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What stocks would I do this in?

ONLY in stocks that I would not mind owning. Remember, I put this trade on with the understanding that I might have to buy the stock.

Example: The wheel in a stock I wouldn’t mind owningYHOO is trading at $41.00 and there is 2 weeks until October expirationI believe there is a huge level of support at $40.00

Trade: I sell the Oct 40 puts for $0.50Risk: $3,950 per 1 lot (if stock goes to $0)Reward: $50 per 1 lotBreakeven: $39.50

On Expiration

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It is October expiration:

YHOO is still trading above $40.00My short puts are worthless and I pocket the $50 per 1 lot that I sold them for

YHOO is trading below $40.00If the stock is still above $39.50 I am still profitable and I can close out the trade for a profit or I can take the stock at the lower cost basis and begin he wheel.

YHOO is below $39.50I can close the position and take the loss or I can begin running the wheel to try and repair the trade.

Risks of Selling Puts

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How much am I risking here?

Remember that when I am short puts my P&L profile is similar to being long the underlying stock.

This is why I only run this strategy in stocks that I am willing to get long at a lower price.

This strategy can be more attractive in a stock that trades at a lower price level because my total risk is a little more defined.

Look at the breakdown of the short YHOO put.

Sell Put Spreads for Income and to Get Long

Take Advantage of Time Decay and Create an Income Stream

Selling Put Spreads

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Take advantage of time decay with out all the risk:

I like the idea of the short put, It gets me long the underlying and puts time decay in my favor.

It also lets me benefit from drops in implied volatility.

What I don’t like is the level of risk that I am required to take.

The level of risk I am exposed to on higher priced stocks is too much.

I can set up a similar strategy without the large level of risk. Enter put SPREADS.

Bull Put Spread

Outlook: Moderately Bullish

Trade: (credit spread) Buy low strike Puts & Sell high strike Puts

Advantages: reap some advantages of short put strategy. Stock can stay flat and this position can

still make profits & protected from blowout losses

Disadvantages: Profits are capped

Max Risk: High strike – Low Strike

Max Reward: Credit received for the total spread

Breakeven: high strike – credit received

Time Decay effect: Theta is negative when this position is OTM and positive for this position when

it is ITM

Delta: Positive – peaks at the midpoint between strike prices

Gamma: Lowest below the long strike and highest above the short strike

Vega: Rising volatility helps this position when it is OTM and hurts this position when it is ITM

Rho: Rising Interest rates help this position

Graphs of a Bull Put Spread

Selling Put Spreads

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A better risk vs. reward setup than short puts:

Let’s look at another example in TSLA: • I want to get long the stock

• I want to be short premium

• I AM NOT willing to buy the stock

Since I am not willing to buy the stock I cannot sell a put or run the option wheel. The high price of TSLA stock also means that a short put strategy will expose me to too much risk.

Selling Put Spreads

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Selling a put spread in TSLA:

TSLA is trading around $255.00 and I believe that the stock will be flat to higher through November expiration.

Trade: I sell the TSLA Nov 250-240 Put Spread for $4.00Reward: $400 per 1 lotRisk: $600 per 1 lot Breakeven: $246.00

Like a short put trade, there is a number of different ways this trade can play out that would result in profits for me.

Scenarios for TSLA

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On November expiration:

TSLA Stock closes little changed and is at $257.00Both legs of my spread expire worthless and I capture all of the premium I Sold the Spread for.Profit: $400 per 1 lot

TSLA Sells off hard and closes at $235.00I do not participate in losses below my long strike (240) so my losses are cappedLoss: $600 per 1 lot

As you can see the risk in this case is much lower than the naked short put.

What Stocks Do I Run This In?

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I will run this strategy in similar setups to my short put examples, I will do this specifically when these conditions are present.

• I see blocks of puts being sold in UOA and I am not willing to buy the stock

• The stock trades at a high dollar amount and I do not want to take on a large level of risk

• When I want to get long and be short premium ahead of a catalyst event

Summary And Key Takeaways

• Most traders use equities to trade the market when in fact using options actually exposes them to less risk with more potential for reward.

• Stock replacement strategies can be used to get long or short equities with a significantly lower amount of initial capital.

• Trader can use deep ITM calls to get long stocks and replicate the P&L profile of a long stock position.

• Options are not riskier than stock, if used properly the inherent leverage that options provide can be a great benefit to any trader.

• Options do not require more capital than stock positions, in most cases, stock replacement strategies are a more efficient and effective way to trade stocks.

• When buying deep ITM calls I am looking for an option with at least a 75 delta

Summary And Key Takeaways

• Although my gamma is low in these positions I will get LONGER as the stock moves higher.

• The extrinsic value of an option is the amount I am risking over a stock position with a stop at the strike.

• Stock replacement strategies offer staying power than long and short equity positions do not.

• I can get long stocks by selling deep ITM puts for a credit. • Skew will allow me to collect large amounts of premium and I can make

money even if the stock does not move. • If I am long deep ITM calls I have to be aware of ex-div dates. • I can use the options wheel to get long stocks I wouldn’t mind owning or

to repair a short put trade that went against me.

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