Analyzing Simple Call & Put Options

Long Call Analysis (See term definition)

• Long calls are bullish investments. Entry into such an investment must be predicated on a belief that the price of the underlying will rise past the breakeven price during the life of the option.
• Risk is limited to the premiums paid for the options.
• Profit per share is the underlying's price at option maturity minus the option's strike price and the option premium.
• Typically, for a long call investment, return on risk is very high, but the probability of profit is low.
• Example: A $100 stock has a $105 Call option that expires in 30 days available at a premium of $2. If the stock finished at $110, your 30 day return on risk is 150%, but the probability of making any profit at all may be 10%.
• There are two major reasons for entering into long call positions, specific knowledge and inefficient pricing. If you have specific knowledge of events that will significantly increase a company's stock price, long calls can be used to create more upside leverage for your investment than investing directly in the company's stock. Investor fear often results in pricing which is undervalued relative to theoretical pricing based upon historical trends. Provided that the fear is unfounded, the pricing inefficiency that results can be profited from using a long option position.
  Look for undervalued options with high breakeven probabilities.
• This analysis facilitates investor decision making by computing the historically trended option prices, the amount the options are undervalued, the breakeven prices of the investment, the probability that the option will expire In-the-Money, and the probability that the breakeven price will be achieved.

Covered Call Analysis (See term definition)

• Out-of-the-Money Covered Calls are typically a good investment if the price of the underlying is believed to remain relatively unchanged. The ideal investment scenario for a covered call would be the increase of the underlying's price to near, but not in above the option strike price. A greater increase would result in a lower profit to you because the stock would be "called away from you" at the strike price and you would have to pay the brokerage fee for the transfer of stock as well as deal with the tax consequences of the sale. A significant decrease in the price of the underlying is also not desirable, because the option premium collected would be more than offset by the portfolio value loss.
• Covered calls must not be confused with Uncovered Short Calls, which are extremely risky and therefore not dealt with on this web site.
• The risk of a covered call is the risk of holding the underlying stock plus the "lost opportunity" that would result if the price of the underlying significantly increased. For the purposes of return on risk calculation, the amount risked is calculated to be the initial stock price minus the option premium received.
• Maximum profit is defined as the received option premium. Any gain in value of the underlying is not included in this number because covered call income is typically viewed as incremental to that of a stock portfolio.
• It is not uncommon to find covered call premiums that result in 12% annual return, with <15% probability of assignment.
• Example: A $100 stock has a $110 Call option that expires in 60 days sellable at a premium of $2. The $2 received for a 60 day obligation is a 12% return on risk. In addition to the option return, the assignment of this option would result in a 10% gain from the stock being sold at the Call strike price. Look for overvalued options with low probabilities of assignment. The tool can also help select stock to be used for covered call writing. Some stocks never seem to have good option trading volume and/or overvalued options. These cases become obvious with consistent use of the analyzer.
• If you have stock in your portfolio that you intend to hold long term, regardless of near term market fluctuations, consider the below scenarios for a covered call. (Assuming the numbers from the above example.)
  Stock price dropped 10% to $90. Your paper loss is only 8% due to the $2 premium.
  Stock price is unchanged. You have a 2% gain over just holding the stock.
  Stock price increased 8% to $108. You have a 10% gain, 2% more than just holding the stock.
  Stock price increased 15% to $115. You have a 12% cash gain, 3% less than just holding the stock.
  The only negative scenario of a covered call relative to just holding the stock occurs if the price of the underlying significantly increases over a short period of time, and the negative is a lower profit (not a loss). Note that covered call writing is allowed in IRA accounts (other forms of option investing may not be allowed).
• This analysis facilitates investor decision making by computing the theoretical option prices, the amount the options are overvalued, and the probability that the option will be assigned.

Long Put Analysis (See term definition)

• Long puts are bearish investments. Entry into such an investment can be based either upon a speculative belief that the price of the underlying will drop past the breakeven price during the life of the option or upon the desire to buy insurance against decline (hedge) for stock in a portfolio.
• Risk is limited to the premiums paid for the options.
• Profit per share is the option's strike price minus the underlying's price at option maturity and the option premium.
• Typically, for a long put investment, return on risk is very high, but the probability of profit is low.
• Example: A $100 stock has a $95 Put option that expires in 30 days available at a premium of $2. If the stock finished at $90, your 30 day return on risk is 150%, but the probability of making any profit at all may be 10%.
• There are two major reasons for entering into speculative long put positions, specific knowledge and inefficient pricing. If you have specific knowledge of events that will significantly decrease a company's stock price, long puts can be used to take advantage of the decrease with far less risk than directly selling short the company's stock. Investor exuberance often results in pricing which is undervalued relative to theoretical pricing based upon historical trends. Provided that the exuberance is unfounded, the pricing inefficiency that results can be profited from using a long option position. Look for undervalued options with high breakeven probabilities.
• Long puts can be used as insurance to reduce risk in a stock portfolio. Example: You bought a biotech stock at $90/shr months ago. The stock has increased to $100/shr on the expectation that its new breakthrough drug will pass trials. You expect that the trial results will be announced in about 30 days and that the results will dramatically effect the stock one way or the other. You purchase a 60 day Put at $95/shr for a $5/shr premium. By giving up $5/shr of your profit, you have insured yourself against losing money on the on the stock, significantly reduced your portfolio risk. If there is bad news regarding the trials, you can exercise the Put and exit effectively at the same price you entered the position ($95 exercise price minus the $5 Put premium). If the trials are successful and the stock increases to $120/shr, you have made $25/shr.
• This analysis facilitates investor decision making by computing the theoretical option prices, the amount the options are undervalued, the breakeven prices of the investment, the probability that the option will expire In-the-Money, and the probability that the breakeven price will be achieved. Note that the Black-Scholes style theoretical option pricing is based upon historical price movement. Theoretical pricing is not a good predictor of the option's value when there is specific knowledge of a significant near term event pending such as in the above biotech example. However, in this situation the analysis report's display of option chain data and historic option "low prices" should help select an option and time its purchase.

Short Put Analysis (See term definition)

• Out-of-the-Money Short Puts are typically a good investment if the long term prospects of the underlying stock are bullish, but the stock is currently overvalued and you would like to accumulate the stock "on a dip". This scenario requires you to reserve sufficient liquid funds to purchase the stock in the event your options are assigned. The ideal outcome for this scenario is the underlying's price remaining relatively unchanged. In this case, you collect the option premium and the interest on the reserved funds.
• The risk of a short put is the similar to the risk of holding the underlying stock plus the "lost opportunity" that would result if the price of the underlying significantly increased. For the purposes of return on risk calculation, the amount risked is calculated to be the option strike price minus the option premium received.
• Maximum profit is the received option premium.
• It is not uncommon to find short put premiums equivalent to 12% annual return, with <15% probability of assignment.
• Example: A $55 stock has a $50 Put option that expires in 60 days sellable at a premium of $1. If the stock were to "dip" to $50 and your options are assigned, your purchase price for the stock is effectively $49. If the stock stays above $50, you have made a 60 day return on risk of 2% (12% annualized).
• This analysis facilitates investor decision making by computing the theoretical option prices, the amount the options are overvalued, and the probability that the option will be assigned.

Analyzer assumptions:

• If options are assigned, they are assigned upon expiration.
• The option strike price compares directly to the underlying's price. (Adjusted options, caused by events such as mergers, sometimes compare with a multiplier.)
• Dividends are treated as continuously paid out.
• The average volatility of the underlying's stock price over the option's life is approximately equal to the volatility over the previous 20 days.

Analyzer operation:

1. Historical data is retrieved on the underlying security and historical volatility is calculated.
2. The option chain for the underlying is retrieved and the options in the chain are screened using by their volume and their degree Out-of-the-Money or In-the-Money.
3. The options, which pass the screening criteria, are analyzed.
4. Analysis results are compared against filtering criteria.
5. Results, which pass filtering criteria, are displayed.

Screening criteria:

Percent Out_of_the_Money - In_the_Money:

A range is two numbers separated by a dash. The first number corresponds to the maximum acceptable "Out-of-the-Money" percentage. The second number corresponds to the maximum acceptable "In-the-Money" percentage. If the dash and the second number is omitted, the first number is used for both "Out-of-the-Money" and "In-the-Money" percentages (in the above example 30 is the same as coding 30-30).

Each range is applied to successive expiration periods. That is, range 1 is used to screen the options with the nearest expiration date, range 2 is used to screen the next nearest option expiration date, etc.

Number of contracts to be traded = ___.

This field is used to calculate brokerage fees on option's net expected value and net return. Brokerage fees often have a significant impact on profitability. (See Brokerage Fee Calculation)

Include only liquid options (Options with the previous days' volume>0).

Analysis parameters:

Ticker Symbols:

Risk neutral annual growth rate: (term definition) ( tutorial)

Filtering criteria:

Include only options that last traded with a "time value" at or better than __.

An option's premium price is composed of intrinsic value and time value components. The intrinsic value is the amount that the option is In-the-Money. The time value is the premium minus the intrinsic value. Out-of-the-Money options have no intrinsic value, the entire premium amount is time value. An option's time value is one of the barriers that must be overcome for the option to be profitable for the buyer. Therefore, when scanning for opportunities, it is often desireable to set a limit for this barrier. Call and Put buyers desire a low barrier, sellers desire a high barrier.

Include only options that are undervalued/overvalued by more than __%.

Checking the box for this parameter will activate the undervalued/overvalued filter. If the type of analysis selected is "Long Call" or "Long Put", then only options which are undervalued by more than the specified percentage pass the filter. If the type of analysis selected is "Covered Call" or "Short Put", then only options which are overvalued by more than the specified percentage pass the filter.

Include only options with probability of profit better than __%.

Include only options with expected values of more than __.

Include only options with annualized net returns of more than __%.

Checking the box for this parameter will activate the net return on risk filter. The net return is defined as the expected value divided by the amount risked. For short options, the amount risked is calculated at the 99th percentile.

Report description:

The underlying section reports important statistics on the underlying security's price movement over the last 90 days. The volatilities reported are computed historically over 20 day periods.

The field under the heading "Filter result" has the format:
ccc->sss->fff    Example: 108->12->4

ccc represents the number of options in the underlying's option chain that were input for screening. From the example, 108 options were input to screening.

sss represents the number of options that passed the screening criteria and were analyzed. From the example, 12 options passed screening.

fff represents the number of analyzed options whose analysis results passed filtering and are therefore displayed in the option section of the report. From the example, 4 options passed post-analysis filtering.

The option section of the report displays the option analysis results that have passed filtering.
The first column displays the option's symbol (without the .o suffix).

The "Strike" column displays the option's strike price.

The "Days" column displays the number of days remaining until option expiration.

The "Volume" column displays the most recent session's trading volume for the option.

The "Last" column displays the price of the last trade of this option. Note that this trade may have occurred several sessions ago.

The "B-S" column displays the calculated theoretical value of the option according to the Black-Scholes Option Pricing Model.

The "Ask" column will be displayed for Long Call and Long Put analysis. The column contains the current option Ask price.

The "Bid" column will be displayed for Covered Call and Short Put analysis. The column contains the current option Bid price.

The "Size" column displays the number of contracts associated with the displayed Ask or Bid.

The "%OV" column displays the percentage overvalued status of the option based upon the last trade price (last/theoretical-1). Positive values indicate percent overvalued. Negative values indicate percent undervalued.

The "Impl Volat" column displays the Implied Volatility of the option.

The "Return Expired" column displays the gross return (brokerage fees and taxes not considered) if the option expires Out-of-the-Money. This field is only displayed for short options.

The "%OTM" column displays the percentage Out-of-the-Money the option is relative to the underlying's last trade price. Negative values indicate the percentage In-the-Money.

The "Prob Profit" column displays the calculated probability of making a gross profit with this investment. For "long call options" and "short put options", this is the probability that the underlying will finish above the breakeven price. For "covered call options" and "long put options", this is the probability that the underlying will finish below the breakeven price.(See The Role of Probability in Modeling Investments in the Education section of the site.)

The "I-Prob Profit" column displays the probability of profit calculated using the option's Implied Volatility rather than its Historical Volatility.

The "Net ExpVal" column displays the option's per share Expected Value, including the impact of brokerage fees. (See the "Expected Value" description in the site's education section.)

The "Annual NetRtn" column displays the option's annualized expected return, including the impact of brokerage fees. This value is the annualized expected value divided by the amount risked. For "long options", the amount risked is the option premium. For "covered calls", the amount risked is the profit which would be lost if the option finishes In-the-Money. Since this amount is not known at the time of investment, it is estimated to be the theoretical value of the option (Black-Scholes price).

The "1d-Lo", "2d-Lo", and "5d-Lo" columns will be displayed for Long Call and Long Put analysis. The columns contains the lowest trade price for the last trading day, last 2 trading days, and last 5 trading days, respectively.

The "1d-Hi", "2d-Hi", and "5d-Hi" columns will be displayed for Covered Call and Short Put analysis. The columns contains the highest trade price for the last trading day, last 2 trading days, and last 5 trading days, respectively.