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Strike Price Hints For Your Trading

By Chris Ebert

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Q: I'm nearly certain that the share price of ConAgra Foods (NYSE:CAG) will be much lower 2 - 3 months from now. Is there a way to use options to short CAG in a way that would not expose me to too much risk? They report earnings on 12-19. - Jeff Pierce

A: One way to start is to go with the old, hackneyed advice: If the stock price is falling, buy puts. But, I think we can improve on that advice somewhat, and in the process we will be able to take better control of the exposure to risk.

First, let's start out with an attempt to buy a put. But, which put? Which expiration date? If a put with the December 21, 2013 expiration is purchased and the earnings report on the Dec. 19 causes a temporary spike in the stock price, the trade would experience a loss even if the prediction of the share price being much lower in 2-3 months was later proven correct. So, for the intended use of the put option being to profit from a longer-term drop in the share price, it is therefore less risky to use a more distant expiration, such as March 22, 2014.

Choosing a strike price can have a huge effect on the outcome of the trade.

  • Low strike price, low risk, profits will tend to be very small

If the expectation is that the price may fall 10% from the current $33, then a strike price of $30 may initially appear to be the best choice. The $30 strike puts with March expiration are currently trading for about $0.45 per share, so the cost of a single contract of 100 shares is just $45, which is very affordable. The risk is also very low, since $45 is the maximum loss that could occur on the trade. However, these options would likely produce little or no profit unless the share price fell well below $30. To look at it another way, the prediction of a 10% decline in the stock price could be correct and the trade might experience a loss.

  • Moderate strike price, moderate risk, small to moderate profits are possible

Choosing an at-the-money strike price, where the strike price is nearly the same as the current $33 share price, is another alternative. But, at a cost of $1.20 to $1.40 per share, the maximum loss on the trade could be as high as $140 per contract. The risk at the $33 strike is much higher than the $45 maximum loss at the $30 strike, and yet the profit potential is only slightly higher than that of the $30 strike put. In this case, the stock could decline 10% while the put experiences only a very small gain.

  • High strike price, high risk, large profits are possible

By far, the best option for capturing the greatest gain when the stock price declines is an in-the-money put, where the strike price is well above the current share price of the stock. The only problem - the premium on such options is much higher than the premium at other strikes, and since the entire premium can be lost if the share price unexpectedly surges higher, the risk of loss is much greater. As an example, the $35 strike puts with March expiration currently have a premium of $2.85, or $285 per contract, all of which may be lost if the option becomes worthless due to an increase in the share price, but these options would experience a gain of nearly 100% if the stock price fell 10%.

  • High strike price, moderate risk, possible large profits

Traders who buy stocks often protect those stocks from excessive losses by buying put options . The same process applies to traders who short stocks and protect those shorts by buying call options. The call options limit losses on the short stock position in case of an unexpected rally. In much the same way, a trader of in-the-money puts may limit the potential loss on a trade by buying call options.

For example, if a trader was to buy an in-the-money put on CAG at the $35 strike with March expiration, the risk of loss on the trade would be $2.85 per share, or $285 total. However, if the trader also bought a $35 strike call at a premium of about $0.45, it would add just $45 to the cost of the position. The total cost to buy both the $35 put and the $35 call would amount to approximately $330. While it might appear that the maximum risk on the trade has increased to $330, an astute trader can easily decrease the maximum risk to as little as $180.

The combination of the in-the-money put ($35 strike) and out-of-the-money call (also $35 strike) form a trade known as an option straddle. One of the important properties of option straddles is that the combined value can never go to zero until expiration day. In fact, the minimum value of a straddle will occur when the strike price of both options is equal to the share price of the underlying stock. As an example, the current value of a March $35/$35 straddle on CAG is approximately $150. Although changes in implied volatility may affect the minimum value of a straddle, it is not likely that the value will change drastically until expiration is near. Thus, of the $330 potential risk on the $35/$35 straddle, only $180 of that amount is truly at risk, since the minimum value of the straddle would not be expected to fall below $150.

Given the reasoning shown above, the purchase of a March $35 put on CAG would provide high potential for profits if the share price fell 10% or so during the next 2-3 months, while the simultaneous purchase of a March $35 call would provide inexpensive protection for the trade in case the share price did not fall as expected, but instead rose.

It should be noted that liquidity on CAG options is not ideal, especially at the strikes mentioned above, which could result in unfair pricing, or the inability to open or close positions, and should be avoided by traders not experienced with the risks of low liquidity.

The preceding is a post by Christopher Ebert, co-author of the popular option trading book "Show Me Your Options!" He uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to Follow Chris @optionscientist for updates on the options market.

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