Options trading strategies examples

10 Options Strategies to Know.

10 Options Strategies To Know.

Too often, traders jump into the options game with little or no understanding of how many options strategies are available to limit their risk and maximize return. With a little bit of effort, however, traders can learn how to take advantage of the flexibility and full power of options as a trading vehicle. With this in mind, we've put together this slide show, which we hope will shorten the learning curve and point you in the right direction.

10 Options Strategies To Know.

Too often, traders jump into the options game with little or no understanding of how many options strategies are available to limit their risk and maximize return. With a little bit of effort, however, traders can learn how to take advantage of the flexibility and full power of options as a trading vehicle. With this in mind, we've put together this slide show, which we hope will shorten the learning curve and point you in the right direction.

1. Covered Call.

Aside from purchasing a naked call option, you can also engage in a basic covered call or buy-write strategy. In this strategy, you would purchase the assets outright, and simultaneously write (or sell) a call option on those same assets. Your volume of assets owned should be equivalent to the number of assets underlying the call option. Investors will often use this position when they have a short-term position and a neutral opinion on the assets, and are looking to generate additional profits (through receipt of the call premium), or protect against a potential decline in the underlying asset's value. (For more insight, read Covered Call Strategies For A Falling Market.)

2. Married Put.

In a married put strategy, an investor who purchases (or currently owns) a particular asset (such as shares), simultaneously purchases a put option for an equivalent number of shares. Investors will use this strategy when they are bullish on the asset's price and wish to protect themselves against potential short-term losses. This strategy essentially functions like an insurance policy, and establishes a floor should the asset's price plunge dramatically. (For more on using this strategy, see Married Puts: A Protective Relationship . )

3. Bull Call Spread.

In a bull call spread strategy, an investor will simultaneously buy call options at a specific strike price and sell the same number of calls at a higher strike price. Both call options will have the same expiration month and underlying asset. This type of vertical spread strategy is often used when an investor is bullish and expects a moderate rise in the price of the underlying asset. (To learn more, read Vertical Bull and Bear Credit Spreads.)

4. Bear Put Spread.

The bear put spread strategy is another form of vertical spread​ like the bull call spread. In this strategy, the investor will simultaneously purchase put options at a specific strike price and sell the same number of puts at a lower strike price. Both options would be for the same underlying asset and have the same expiration date. This method is used when the trader is bearish and expects the underlying asset's price to decline. It offers both limited gains and limited losses. (For more on this strategy, read Bear Put Spreads: A Roaring Alternative To Short Selling.)

Investopedia Academy "Options for Beginners"

Now that you've learned a few different options strategies, if you're ready to take the next step and learn to:

Improve flexibility in your portfolio by adding options Approach Calls as down-payments, and Puts as insurance Interpret expiration dates, and distinguish intrinsic value from time value Calculate breakevens and risk management Explore advanced concepts such as spreads, straddles, and strangles.

5. Protective Collar.

A protective collar strategy is performed by purchasing an out-of-the-money put option and writing an out-of-the-money call option at the same time, for the same underlying asset (such as shares). This strategy is often used by investors after a long position in a stock has experienced substantial gains. In this way, investors can lock in profits without selling their shares. (For more on these types of strategies, see Don't Forget Your Protective Collar and How a Protective Collar Works.)

6. Long Straddle.

A long straddle options strategy is when an investor purchases both a call and put option with the same strike price, underlying asset and expiration date simultaneously. An investor will often use this strategy when he or she believes the price of the underlying asset will move significantly, but is unsure of which direction the move will take. This strategy allows the investor to maintain unlimited gains, while the loss is limited to the cost of both options contracts. (For more, read Straddle Strategy A Simple Approach To Market Neutral . )

7. Long Strangle.

In a long strangle options strategy, the investor purchases a call and put option with the same maturity and underlying asset, but with different strike prices. The put strike price will typically be below the strike price of the call option, and both options will be out of the money. An investor who uses this strategy believes the underlying asset's price will experience a large movement, but is unsure of which direction the move will take. Losses are limited to the costs of both options; strangles will typically be less expensive than straddles because the options are purchased out of the money. (For more, see Get A Strong Hold On Profit With Strangles.)

8. Butterfly Spread.

All the strategies up to this point have required a combination of two different positions or contracts. In a butterfly spread options strategy, an investor will combine both a bull spread strategy and a bear spread strategy, and use three different strike prices. For example, one type of butterfly spread involves purchasing one call (put) option at the lowest (highest) strike price, while selling two call (put) options at a higher (lower) strike price, and then one last call (put) option at an even higher (lower) strike price. (For more on this strategy, read Setting Profit Traps With Butterfly Spreads . )

9. Iron Condor.

An even more interesting strategy is the iron condor. In this strategy, the investor simultaneously holds a long and short position in two different strangle strategies. The iron condor is a fairly complex strategy that definitely requires time to learn, and practice to master. (We recommend reading more about this strategy in Take Flight With An Iron Condor, Should You Flock To Iron Condors? and try the strategy for yourself (risk-free!) using the Investopedia Simulator.)

10. Iron Butterfly.

The final options strategy we will demonstrate here is the iron butterfly. In this strategy, an investor will combine either a long or short straddle with the simultaneous purchase or sale of a strangle. Although similar to a butterfly spread, this strategy differs because it uses both calls and puts, as opposed to one or the other. Profit and loss are both limited within a specific range, depending on the strike prices of the options used. Investors will often use out-of-the-money options in an effort to cut costs while limiting risk. (To learn more, read What is an Iron Butterfly Option Strategy?)

6 Great Option Strategies For Beginners.

Option rookies are often eager to begin trading – too eager. It’s important to get a solid foundation to be certain you understand how options work and how they can help you achieve your goals – before trading.

Here’s a list of my favorite methods. Note: this list contains strategies that are easy to learn and understand. Each is less risky than owning stock. Most involve limited risk. For investors not familiar with options lingo read our beginners options terms and intermediate options terms posts.

1. Covered call writing. Using stock you already own (or buy new shares), you sell someone else a call option that grants the buyer the right to buy your stock at a specified price. That limits profit potential. You collect a cash premium that is yours to keep, no matter what else happens. That cash reduces your cost. Thus, if the stock declines in price, you may incur a loss, but you are better off than if you simply owned the shares.

Example: Buy 100 shares of IBM.

Sell one IBM Jan 110 call.

2. Cash-secured naked put writing. Sell a put option on a stock you want to own, choosing a strike price that represents the price you are willing to pay for stock. You collect a cash premium in return for accepting an obligation to buy stock by paying the strike price. You may not buy the stock, but if you don’t, you keep the premium as a consolation prize. If you maintain enough cash in your brokerage account to buy the shares (if the put owner exercises the put), then you are considered to be ‘cash-secured.’

Example: Sell one AMZN Jul 50 put; maintain $5,000 in account.

3. Collar. A collar is a covered call position, with the addition of a put. The put acts as an insurance policy and limit losses to a minimal (but adjustable) amount. Profits are also limited, but conservative investors find that it’s a good trade-off to limit profits in return for limited losses.

Example: Buy 100 shares of IBM.

Sell one IBM Jan 110 call.

Buy one IBM Jan 95 put.

4. Credit spread. The purchase of one call option, and the sale of another. Or the purchase of one put option, and the sale of another. Both options have the same expiration. It’s called a credit spread because the investor collects cash for the trade. Thus, the higher priced option is sold, and a less expensive, further out of the money option is bought. This strategy has a market bias (call spread is bearish and put spread is bullish) with limited profits and limited losses.

Example: Buy 5 JNJ Jul 60 calls.

Sell 5 JNJ Jul 55 calls.

or Buy 5 SPY Apr 78 puts.

Sell 5 SPY Apr 80 puts.

5. Iron condor. A position that consists of one call credit spread and one put credit spread. Again, gains and losses are limited.

Example: Buy 2 SPX May 880 calls.

Sell 2 SPX May 860 calls.

and Buy 2 SPX May 740 puts.

Sell 2 SPX May 760 puts.

6. Diagonal (or double diagonal) spread. These are spreads in which the options have different strike prices and different expiration dates.

1. The option bought expires later than the option sold.

2. The option bought is further out of the money than the option sold.

Example: Buy 7 XOM Nov 80 calls.

Sell 7 XOM Oct 75 calls This is a diagonal spread.

Or Buy 7 XOM Nov 60 puts.

Sell 7 XOM Oct 65 puts This is a diagonal spread.

If you own both positions at the same time, it’s a double diagonal spread.

Note that buying calls and/or puts is NOT on this list , despite the fact that the majority of rookies begin their option trading careers by adopting that strategy. True, it’s fun to buy an option and treat it as a mini-lottery ticket. But, that’s gambling. The likelihood of consistently making money when buying options is small, and I cannot recommend that strategy.

Mark Wolfinger is a 20 year CBOE options veteran and is the writer for the blog Options for Rookies Premium. He also is the author of the book, The Rookie’s Guide to Options.

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Option Strategies.

Because options prices are dependent upon the prices of their underlying securities, options can be used in various combinations to earn profits with reduced risk, even in directionless markets. Below is a list of the most common strategies, but there are many more—infinitely more. But this list will give you an idea of the possibilities. Any investor contemplating these strategies should keep in mind the risks, which are more complex than with simple stock options, and the tax consequences, the margin requirements, and the commissions that must be paid to effect these strategies. One particular risk to remember is that American-style options — which are most options where the exercise must be settled by delivering the underlying asset rather than by paying cash — that you write can be exercised at any time; thus, the consequences of being assigned an exercise before expiration must be considered. (Note: The examples in this article ignore transaction costs.)

Option Spreads.

An option spread is established by buying or selling various combinations of calls and puts, at different strike prices and/or different expiration dates on the same underlying security. There are many possibilities of spreads, but they can be classified based on a few parameters.

A vertical spread (aka money spread) has the same expiration dates but different strike prices. A calendar spread (aka time spread, horizontal spread) has different expiration dates but the same strike prices. A diagonal spread has different expiration dates and strike prices.

The money earned writing options lowers the cost of buying options, and may even be profitable. A credit spread results from buying a long position that costs less than the premium received selling the short position of the spread; a debit spread results when the long position costs more than the premium received for the short position — nonetheless, the debit spread still lowers the cost of the position. A combination is defined as any strategy that uses both puts and calls. A covered combination is a combination where the underlying asset is owned.

A money spread , or vertical spread , involves the buying of options and the writing of other options with different strike prices, but with the same expiration dates.

A time spread , or calendar spread , involves buying and writing options with different expiration dates. A horizontal spread is a time spread with the same strike prices. A diagonal spread has different strike prices and different expiration dates.

A bullish spread increases in value as the stock price increases, whereas a bearish spread increases in value as the stock price decreases .

Example — Bullish Money Spread.

On October 6, 2006, you buy, for $850, 10 calls for Microsoft, with a strike price of $30 that expires in April, 2007, and you write 10 calls for Microsoft with a strike price of $32.50 that expires in April, 2007, for which you receive $200. At expiration, if the stock price stays below $30 per share, then both calls expire worthless, which results in a net loss, excluding commissions, of $650 ( $850 paid for long calls - $200 received for written short calls ). If the stock rises to $32.50, then the 10 calls that you purchased are worth $2,500 , and your written calls expire worthless . This results in a net $1,850 ( $2,500 long call value + $200 premium for short call - $850 premium for the long call ). If the price of Microsoft rises above $32.50, then you exercise your long call to cover your short call , netting you the difference of $2,500 plus the premium of your short call minus the premium of your long call minus commissions.

Ratio Spreads.

There are many types of option spreads: covered calls, straddles and strangles, butterflies and condors, calendar spreads, and so on. Most options spreads are usually undertaken to earn a limited profit in exchange for limited risk. Usually, this is accomplished by equalizing the number of short and long positions. Unbalanced option spreads , also known as ratio spreads , have an unequal number of long and short contracts based on the same underlying asset. They may consist of all calls, all puts, or a combination of both. Unlike other, better-defined, spreads, unbalanced spreads have many more possibilities; thus, it is difficult to generalize about their characteristics, such as reward/risk profiles. However, if long contracts exceed short contracts, then the spread will have unlimited profit potential on the excess long contracts and with limited risk. An unbalanced spread with an excess of short contracts will have limited profit potential and with unlimited risk on the excess short contracts. As with other spreads, the only reason to accept unlimited risk for a limited profit potential is that the spread is more likely to be profitable. Margin must be maintained on the short options that are not balanced by long positions.

The ratio in a ratio spread designates the number of long contracts over short contracts, which can vary widely, but, in most cases, neither the numerator nor the denominator will be greater than 5. A front spread is a spread where the short contracts exceed the long contracts; a back spread has more long contracts than short contracts. A front spread is also sometimes referred to as a ratio spread, but front spread is a more specific term, so I will continue to use front spread only for front spreads and ratio spreads for unbalanced spreads.

Whether a spread results in a credit or a debit depends on the strike prices of the options, expiration dates, and the ratio of long and short contracts. Ratio spreads may also have more than one breakeven point, since different options will go into the money at different price points.

Covered Call.

The simplest option strategy is the covered call, which simply involves writing a call for stock already owned. If the call is unexercised, then the call writer keeps the premium, but retains the stock, for which he can still receive any dividends. If the call is exercised, then the call writer gets the exercise price for his stock in addition to the premium, but he foregoes the stock profit above the strike price. If the call is unexercised, then more calls can be written for later expiration months, earning more money while holding the stock. A more complete discussion can be found at Covered Calls.

Example—Covered Call.

On October 6, 2006, you own 1,000 shares of Microsoft stock, which is currently trading at $27.87 per share. You write 10 call contracts for Microsoft with a strike price of $30 per share that expire in January, 2007. You receive . 35 per share for your calls, which equals $35.00 per contract for a total of $350.00 . If Microsoft doesn't rise above $30, you get to keep the premium as well as the stock. If Microsoft is above $30 per share at expiration, then you still get $30,000 for your stock, and you still get to keep the $350 premium .

Protective Put.

A stockholder buys protective puts for stock already owned to protect his position by minimizing any loss. If the stock rises, then the put expires worthless, but the stockholder benefits from the rise in the stock price. If the stock price drops below the strike price of the put, then the put's value increases 1 dollar for each dollar drop in the stock price, thus, minimizing losses. The net payoff for the protective put position is the value of the stock plus the put, minus the premium paid for the put.

Protective Put Payoff = Stock Value + Put Value – Put Premium.

Example—Protective Put.

Using the same example above for the covered call, you instead buy 10 put contracts at $0.25 per share , or $25.00 per contract for a total of $250 for the 10 puts with a strike of $25 that expires in January, 2007. If Microsoft drops to $20 a share, your puts are worth $5,000 and your stock is worth $20,000 for a total of $25,000. No matter how far Microsoft drops, the value of your puts will increase proportionately, so your position will not be worth less than $25,000 before the expiration of the puts—thus, the puts protect your position.

A collar is the use of a protective put and covered call to collar the value of a security position between 2 bounds. A protective put is bought to protect the lower bound, while a call is sold at a strike price for the upper bound, which helps pay for the protective put. This position limits an investor's potential loss, but allows a reasonable profit. However, as with the covered call, the upside potential is limited to the strike price of the written call.

Collars are one of the most effective ways of earning a reasonable profit while also protecting the downside. Indeed, portfolio managers often use collars to protect their position, since it is difficult to sell so many securities in a short time without moving the market, especially when the market is expected to decline. However, this tends to make puts more expensive to buy, especially for options on the major market indexes, such as the S&P 500, while decreasing the amount received for the sold calls. In this case, the implied volatility for the puts is greater than that for the calls.

Example—Collar.

On October 6, 2006, you own 1,000 shares of Microsoft stock, which is currently trading at $27.87 per share. You want to hang onto the stock until next year to delay paying taxes on your profit, and to pay only the lower long-term capital gains tax. To protect your position, you buy 10 protective puts with a strike price of $25 that expires in January, 2007, and sell 10 calls with a strike price of $30 that also expires in January, 2007. You get $350.00 for the 10 call contracts , and you pay $250 for the 10 put contracts for a net of $100. If Microsoft rises above $30 per share, then you get $30,000 for your 1,000 shares of Microsoft. If Microsoft should drop to $23 per share, then your Microsoft stock is worth $23,000, and your puts are worth a total of $2,000. If Microsoft drops further, then the puts become more valuable — increasing in value in direct proportion to the drop in the stock price below the strike. Thus, the most you'll get is $30,000 for your stock, but the least value of your position will be $25,000. And since you earned $100 net by selling the calls and writing the puts, your position is collared at $25,100 below and $30,100 . Note, however, that your risk is that the written calls might be exercised before the end of the year, thus forcing you, anyway, to pay short-term capital gains taxes in 2007 instead of long-term capital gains taxes in 2008.

Straddles and Strangles.

A long straddle is established by buying both a put and call on the same security at the same strike price and with the same expiration. This investment strategy is profitable if the stock moves substantially up or down, and is often done in anticipation of a big movement in the stock price, but without knowing which way it will go. For instance, if an important court case is going to be decided soon that will have a substantial impact on the stock price, but whether it will favor or hurt the company is not known beforehand, then the straddle would be a good investment strategy. The greatest loss for the straddle is the premiums paid for the put and call, which will expire worthless if the stock price doesn't move enough.

To be profitable, the price of the underlier must move substantially before the expiration date of the options; otherwise, they will expire either worthless or for a fraction of the premium paid. The straddle buyer can only profit if the value of either the call or the put is greater than the cost of the premiums of both options.

A short straddle is created when one writes both a put and a call with the same strike price and expiration date, which one would do if she believes that the stock will not move much before the expiration of the options. If the stock price remains flat, then both options expire worthless, allowing the straddle writer to keep both premiums.

A strap is a specific option contract consisting of 1 put and 2 calls for the same stock, strike price, and expiration date. A strip is a contract for 2 puts and 1 call for the same stock. Hence, straps and strips are ratio spreads. Because strips and straps are 1 contract for 3 options, they are also called triple options , and the premiums are less then if each option were purchased individually.

A strangle is the same as a straddle except that the put has a lower strike price than the call, both of which are usually out-of-the-money when the strangle is established. The maximum profit will be less than for an equivalent straddle. For the long position, a strangle profits when the price of the underlying is below the strike price of the put or above the strike price of the call. The maximum loss will occur if the price of the underlying is between the 2 strike prices. For the short position, the maximum profit will be earned if the price of the underlying is between the 2 strike prices. As with the short straddle, potential losses have no definite limit, but they will be less than for an equivalent short straddle, depending on the strike prices chosen. See Straddles and Strangles: Non-Directional Option Strategies for more in-depth coverage.

Example—Long and Short Strangle.

Merck is embroiled in potentially thousands of lawsuits concerning VIOXX, which was withdrawn from the market. On October, 31, 2006, Merck's stock was trading at $45.29, near its 52-week high. Merck has been winning and losing the lawsuits. If the trend goes one way or the other in a definite direction, it could have a major impact on the stock price, and you think it might happen before 2008, so you buy 10 puts with a strike price of $40 and 10 calls with a strike price of $50 that expire in January, 2008. You pay $2.30 per share for the calls , for a total of $2,300 for 10 contracts . You pay $1.75 per share for the puts , for a total of $1,750 for the 10 put contracts . Your total cost is $4,050 plus commissions. On the other hand, your sister, Sally, decides to write the strangle, receiving the total premium of $4,050 minus commissions.

Let's say, that, by expiration, Merck is clearly losing; it's stock price drops to $30 per share. Your calls expire worthless , but your puts are now in the money by $10 per share, for a net value of $10,000 . Therefore, your total profit is almost $6,000 after subtracting the premiums for the options and the commissions to buy them, as well as the exercise commission to exercise your puts. Your sister, Sally, has lost that much. She buys the 1,000 shares of Merck for $40 per share as per the put contracts that she sold, but the stock is only worth $30 per share, for a net $30,000. Her loss of $10,000 is offset by the $4,050 premiums that she received for writing the strangle. Your gain is her loss. (Actually, she lost a little more than you gained, because commissions have to be subtracted from your gains and added to her losses.) A similar scenario would occur if Merck wins, and the stock rises to $60 per share. However, if, by expiration, the stock is less than $50 but more than $40, then all of your options expire worthless, and you lose the entire $4,050 plus the commissions to buy those options. For you to make any money, the stock would either have to fall a little below $36 per share or rise a little above $54 per share to compensate you for the premiums for both the calls and the puts and the commission to buy them and exercise them.

Option Trading Examples.

Adjusting and Managing Leveraged Investing Option Trades.

The purpose of this page is to provide option trading examples , including real life examples of trade adjustments and management.

I've created this page at the request of a number of individuals who purchased The Essential Leveraged Investing Guide and who wanted to see more real life examples of how I select and then manage trades.

I'm also including it as a free web page as a courtesy for those who are considering the Leveraged Investing approach (using conservative option strategies to acquire high quality at a significant discount and then perpetually lowering the cost basis of those investments thereafter).

In addition to general trade information, I also include extensive notes to explain the background of the trade as well as my motivation and rationale for various decisions and adjustments.

The annualized returns are calculated by taking the amount of the "booked" return, dividing that by the implied capital requirement if I were to be assigned (e. g. 1 naked put at a 70 strike price = $7000 implied capital requirement), and then annualizing that based on the number of days the trade was open.

Short/Naked Puts on Pepsico (PEP)

So here goes - the following is a sequence of trades originally initiated in the fall of 2010 on PEP. As you'll see, even though the share price seemingly went against me, I not only didn't lose money, but I also actually continued to make very good returns.

I sold 4 Jan 2011 puts at the 65 strike price 2.62/contract. PEP traded in the range of 65.85-66.52 on 9/13.

Over the next 3 weeks, the intraday share price move a couple bucks higher to the 66.91-67.82 range on 10/5, and I closed out the transaction for a quick profit, buying the puts back for 1.85/contract.

I initially received $1034.99 when I wrote the puts, and paid $752.99 to close them out 22 days later for a booked profit of $282.

2 days following the previous trade, PEP traded lower again, to the 65.85 - 66.52 range on 10/7, and I sold 4 new Jan 2011 65 puts 2.44/contract for a total premium amount of $962.99.

This time the stock moved back higher again, and 5 days later on 10/12,the intraday range was 66.91-67.82 and I bought back the 4 puts again at the 1.85/contract level for the 752.99. The booked profit this time was $210 in 5 days.

I had no other open trades on PEP for 6 months until I wrote 1 slightly in the money PEP May 2011 70 put 1.42 for a total premium of $131.25 after commissions. The 4/28 price range was $67.87 - $69.92.

A couple weeks later, on 5/13, with a little more than a week to go until expiration, PEP traded 70.22-71.27. Although the share price remained above 70 through expiration, I chose to close the position a week early and lock in the profits, buying back the put $0.18 for a total cost of $28.74.

I actually wrote 2 new/additional 70 puts for the June expiration cycle in the days before choosing to close this one out (see entry below). I initially anticipated that the stock would continue to trade higher and didn't want to wait until the May contracts expired before opening June positions.

Note: This short PEP June 70 put and the one below it were opened while the May 70 put (see above) was still open.

But after writing these two new puts on 5/9 and 5/13 respectively, I closed the May 70 put a week or so early, locking in the majority of the potential gain for that trade in an abbreviated 15 day holding period.

Re: this position, I wrote this June 70 put on 5/9 for an initial premium of $145.25 (1.56/contract).

On 5/9, the PEP share price traded between 69.48-69.98. By 5/23, PEP had climbed back above 70 and traded between 70.78-71.34, and I was a little nervous about the market in general when I decided to close the trade early for a quick profit.

It cost $187.49 to close out both short puts (for this entry and the entry that follows below) $0.88/contract. Dividing that amount by two, I recorded the net cost on this single put position at $93.74 for a net premium booking of $51.51 on a 14 day holding period.

See trade above. I opened this second short PEP June 70 put on 5/12 when the share price traded between 69.96 and 71.05. I initially received a premium payment of $91.25 (1.02/contract less commissions).

When I closed out both 70 short June PEP puts at 0.88 per contract, it cost a total of $187.49 to close out the entire trade. I deducted half that amount and recorded a marginal net loss of $2.50 on this portion of the trade ($91.25 less $93.75).

Taken as a whole, however, the 2 June short puts were profitable at somewhere near an annualized rate of return of around 10% on the 9-14 day holding period.

I basically re-opened the 2 short PEP June 70 puts on 5/27 that I had closed just four days earlier. The stock traded between 70.28 and 71.03. I had expected the stock to trade lower but it didn't and I received a total of $154.50 (I wrote the puts at 0.83/contract, or 0.05/contract less than I'd closed the position for 4 days earlier).

I got very lucky on timing my trades the previous October (see the first two entries above), but clearly I would've been better off not closing the 2 June 70 puts early.

And on 6/13, with about 4 trading days remaining until the puts expired, and the stock trading between 68.62 and 69.32, I rolled the 2 June 70 puts to July.

The way I calculate "booked" returns is that I subtract the cost of rolling from the new premium received for a net premium received designation (see trade below). So that means even though this trade was in the money and it cost more to close than I received when I initiated the trade, I consider it "booked" income of $154.49 over a 17 day holding period, which converts to a 23.69% annualized rate.

On 6/13, with PEP trading between 68.62 and 69.32, I rolled my 2 short PEP June 70 puts to July 70 puts. I bought back the June 70 puts 1.06/contract and sold the July 70 puts 1.66/ contract for a net premium credit of $107 (-$213.50 + 320.50).

This was another roll on my 2 short 70 puts, this time from the July cycle to the August cycle. With PEP trading between 68.92 and 69.48 on 7/11, I rolled for a net credit of $137 (bought 2 July 70 puts $1.03/contract and sold 2 Aug 70 puts 1.78/contract).

This is where it might start to get a little confusing. These 4 long puts were actually part of a bull put spread I opened on 7/18:

I sold 4 Aug 2011 65 puts 0.54/ contract and bought these 4 Aug 2011 62.50 puts 0.26/ contract for a net premium of $96.00.

On 7/18, the PEP share price fluctuated between 67.38 and 68.61. One week later, on 7/25, the PEP share price had fallen, and was trading on that day between 64.27 and 65.38.

The net result was that these long 62.50 puts had increased in price to 0.40/ contract. I chose to sell the long puts and booked a small gain of $40 ($107 initial cost + $147 final sell price). Buying back the 4 long puts then changed the remaining short 65 puts from a bull put spread to regular naked puts (see trade entry below).

The artificially high annualized rate of return is based on calculating the $40 return on the $107 initial cost of the long puts held for just 7 days.

See trade entry above - this position of 4 short PEP Aug puts at the 65 strike price was originally part of a 65-62.50 bull put spread, but when the underlying stock fell, I sold the 4 long 62.50 puts for a small gain.

And as an additional trade off, selling the 4 long puts eliminated any further downside protection, but it also increased the potential gain from the short portion of the trade should the stock rebound.

Originally, the maximum gain was $96 ($203 premium received less the $107 paid for the long puts). With the long puts removed, the net premium received here returns to $203, which is what I recorded as "booked" income on 8/11 when PEP traded in a volatile daily range of 60.41 - 63.59 and I rolled these short Aug 65 puts to short Sept 65 puts (see two trades below).

One more roll on the 2 short 70 puts. On 8/10, with PEP trading all the way down to the 60.10 - 62.89 range, I was pleasantly surprised that I could actually do a straight roll out one month to the same strike price and still generate a decent net premium.

This coincided with some pretty volatile 500+ point intraday swings in the DJIA so that premium levels were extremely elevated.

I bought back the 2 Aug 70 puts 8.93/ contract for a total cost of $1787.50 and wrote 2 new Sept 70 puts 9.45/contract for a premium amount of $1878.47, or a new net credit of $90.97.

On 9/6 with PEP still essentially trading in the low 60s (61.52-62.58 on this day), I made another important trade adjustment in order to lower the strike price on these 2 short puts from the 70 strike price to 67.50 (see two trade entries below).

Options are always about trade offs.

This position was the result of a roll, but with a twist that I used to lower my overall risk. Instead of simply rolling my in the money short PEP Aug 65 puts to Sept 65 puts, I actually used the time decay advantage to reduce the number of short puts from 4 to 3.

Here's what it looked like: I bought back 4 short Aug 65 puts for a total cost of $1084.99 (3 2.66 + 1 2.74) and then rewrote 3 Sept short 65 puts for a $1088.73 credit (3 3.67).

If I would have rolled all 4 short puts, I would've generated something short of an additional $400 net premium credit (4 contracts a net credit of 1.01/ contract less commissions). But because I also had 2 additional short 70 PEP puts open, I felt it was more prudent to begin lowering my risk rather than trying to maximize my income (which was basically in the category of loose change on this particular trade adjustment).

On 9/6 with PEP still essentially trading in the low 60s (61.52-62.58 on this day), I made another important trade adjustment and combined a roll on these as well as my other position of 2 short 70 puts. Basically, I bought back the 2 puts at the 70 strike and these 3 puts at the 65 strike, and rewrote 5 short October puts at the 67.50 strike for a total net credit of $304.45 (see trade entry below)

More trade offs - here I rolled 2 Sept 70 short puts and 3 Sept 65 short puts into 5 Oct 67.50 short puts for a net credit of $304.45. Trade off here is that I lowered the strike price on the 70 puts to 67.50, but in order to do so, I raised the strike price on the 65 puts to 67.50 as well.

But I also generated an additional $300 in net premium (although this was actually achieved by the overall/average increase in strike price - 2 came down, 3 went up). On day of roll (9/6/2011) PEP traded in the range of $61.10-$61.49.

When you're managing an in the money naked put position, there are only two ways to reduce risk via rolling - either by reducing the number of outstanding puts or by lowering the strike price on those puts.

In this case, after getting all my outstanding short puts at the 67.50 strike price, I chose to do what was necessary to lower those further to the 65 strike price and still generate a net credit on the roll.

In order to achieve this, I increased the number of naked puts in the position from 5 all the way to 8. On the surface, you could argue that I significantly increased my risk because whereas before I had potentially been on the hook for $33,750 worth of stock (500 shares $67.50), this trade increased my potential liability to $52,000 (800 shares $65).

Still, I believe this was a good move, and that lowering the strike price a full notch from 67.50 to 65 was a very good adjustment. Much of my confidence stemmed from the quality nature of the underlying business. PEP is a world class business and while it was definitely out of favor during these last several months, the business model is still sound and it's a company that I'm confident will continue to generate consistent and growing profits for decades.

If I didn't have such long term confidence in the company, there's no way I would be adding short puts or, in effect, "doubling down" on the trade (and hopefully, I wouldn't have initiated any kind of trade on such a company to begin with). On the day of the roll/adjustment (11/10/11), PEP traded in a range of $62.29-$63.26.

After lowering the strike price on my outstanding naked PEP puts from 67.50 to 65 (and increasing the number from 5 to 8) on the last roll, I rolled again on 11/10/2011 (PEP traded in a range of $62.29-$63.26 that day). This was about a week prior to the November expiration.

Because the share price had finally started to rise, I found that I was able to roll to December, decrease the number of outstanding puts from 8 to 7, and still maintain a net credit. It basically cost me $2096.10 to close out the 8 Nov 65 puts and I collected $2329.62 for writing the 7 Dec 65 puts.

UPDATE: PEP closed at the November expiration $63.89. In hindsight, I would have been dramatically better off if I had held off doing this roll until the final day of the expiration cycle instead of doing it a week earlier as I did.

This really illustrates the power of the accelerating time decay at the end of an option's lifespan. I could have rolled to December 65, stayed essentially flat on the premium, and actually reduced the number of naked puts from 8 all the way down to 4. Or I could have even lowered all 8 of the November naked puts from the 65 strke to the 62.50 strike in December while basically remaining flat on the new net premium.

Obviously, I wish I had waited now, but the rationale for my decision a week or so earlier was that was the first opportunity I saw to reduce the number of outstanding short puts. The U. S. markets have been very volatile over the last several months and in the short term I could see the PEP share price just as easily decline as rise. I didn't want to find myself in a situation at the end of the Nov cycle where PEP was trading at or below $60/share with me sitting on a bunch of short puts at the 65 strke.

This time around, I held on to the previous position (December 2011) much longer before rolling.

Although for the December 2011 cycle PEP finished $64.85/share, the stock actually closed $65.19/share one week earlier as well as topping the $65 level on an intraday basis in 3 of the final 5 trading days of the December expiration cycle.

On Thursday 12/15/2011, the day before the last trading day of the cycle and with the stock trading in a range between $63.94 and $65.10, I was able to roll from the December 2011 65 strike to the January 2012 65 strike, reduce the number of outstanding naked PEP puts from 7 to 5, and still generate a new net premium of $400.85 (which, projected out across the full 37 day holding period until January expiration, equated to a 12.17% annualized rate of return based on the assumed capital at risk of $32,500, or 500 shares of PEP at the $65 strike).

Including commissions, it cost me a total of $225.33 to close out the 7 December puts and I received $626.18 in new premium by writing the 5 January PEP 65 puts.

Could I have done a little better on the timing? Sure - the ideal time to roll probably would've been Friday morning when the stock opened $65.28 and traded as high as $65.40 before pulling back and closing at $64.71. This is a great example of how the closer to your strike price that a stock ends the expiration cycle at, the more lucrative and flexible future rolls become.

UPDATE: On 12/30/2011, the last trading day of the year (with PEP trading in a range between $66.24-$66.69), I closed out this trade "early" (an ironic descripton to be sure considering how long I've been rolling and adjusting). I closed out the trade for a couple of reasons.

The primary reason was to find a way to wrap up this example at a nice chronological stopping point (i. e. the end of the year). And I was alos willing to close the trade nearly three weeks early, because the final net premium income that I ended up booking resulted in a slightly higher annualized rate (14.38%) than holding it for the whole period would have produced.

And secondly, this has been a tough and long trade, especially when you consider that I originally had 2 short puts at the $70 strike. Although, I've been able to maintain net premium credits month after month even as I've worked to lower the strike prices on the rolls (which sometimes required I expand the total number of short puts), it's still nice from a psychological standpoint to step back, claim victory, and know that I finally have zero exposure on the trade . . . and that I also booked $2344.73 in the process.

And finally, this last trade demonstrates just how quickly an "underwater" trade can reverse itself if/when the share price finally trades near the strike price. Once the puts are at the money or close to it (whether the stock rebounds or you have to lower the strike price on rolls yourself) the trade really begins to works in your favor. In this example, I was able to generate substantially higher returns while simultaneously reducing overall risk (i. e. reducing the number of short puts in the trade).

Summary of PEP option trades.

The above option trading examples are a terrific illustration of how option trading, when used conservatively, methodically, in conjunction with high quality businesses, and all without panicking when things seem to go the wrong way, can still generate lucrative returns even as the trade seemingly goes against you (and even as I failed to always make the best adjustments in hindsight).

By the end of 2011, the trade was in much better shape than it was over the previous several months. But throughout these series of trades, and despite the challenges and technically being "underwater" much of the time, I was still able to generate $2344.73 of booked income in the roughly 8 month trading period detailed in the table above (from the first trade to the last was around 15 months, but recall that I had no PEP option postions open at all from mid-September 2010 until the very end of April 2011).

Compare my results since September of 2010 to the hypothetical investor who purchased shares at that time. At the end of 2011, the share price was essentially flat. The only income he or she would have seen would have been in the form of dividends.

In contrast, the $2344.73 of booked income I received would translate into approximately 36 free shares of PEP (assuming a $65/share price) should I choose to purchase shares at this time. At the current dividend payout that would equate to $74.16 in annual dividends.

Don't look at the small number - look at the huge implications behind that small number. That $74.16 in annual dividends would have a zero cost basis - they would have cost absolutely nothing. In effect, it would be income manufactured out of thin air.

And what happens when you multiply the above over a full portfolio and over a full lifetime of investing? Do you see now why I am so optimistic about the future?

These PEP Trades Going Forward.

Although I closed the final roll from this sequence of trades early at the end of 2011, in 2012, I continue to write new puts on PEP and I continue to book additional premium income.

Regardless of the zigs here and the zags there, I remain confident that I will always be able to meet one of either two objectives - continue to generate additional booked premium income , or if the options trade in the money, continue to lower the strike price on future rolling trades until the short puts eventually expire worthless, at which point I can then write new trades at a more advantageous strike price and subsequently generate much higher levels of premium income.

No matter what, I expect to come out ahead of those investors who simply bought on the open market. And the premium income I've received (and will continue to receive in the future) affords me many advantageous choices - from buying X amount of free shares (matching the net premium received to date) to allowing me to define the exact amount of a discount on X mumber of shares I choose to purchase to even retaining the total premium amount as personal income.

Finally, please remember that the above is what I consider a worst case example of Leveraged Investing. What other system or approach allows you to generate these kind of returns even when you're wrong?

That's because when you focus on only the highest quality companies, in my opinion, the downside is significantly limited because even in volatile and declining markets, the share price on high quality companies declines less and rebounds more quickly than most of the market's other average choices.

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