How to effectively lock in profits through options

Abstract: This article introduces the methods to lock in profits through options. This is also the unique advantage of investing in options compared to stocks. These are some relatively advanced options operation strategies.

Speaking of last time

Last time we explained the basic knowledge of four option strategies, including long call, short call, long put and short put. You can revise the previous article here.

Options lock-in profits

This time, I will explain some more advanced options operation methods. Options can be applied to many different situations. You can develop different strategies according to your risk acceptance level. On the other hand, if you buy stocks, you often do not have much flexibility which is exact the unique advantages of trading options.

For example, suppose you bought Palantir (US stock code: PLTR) stock at the current price of US$22.95, and you are lucky to see that your stock has risen sharply, say, to US$29. At this time, you basically have only these two choices:

1. Sell the stock to realize the profit directly, that is, make about 26.4%.
2. Continue to hold the stock and expect it to continue to rise.

But if you didn’t buy the stock at the beginning, but instead bought a long call for this stock, if the underlying stock rose sharply after all, you would have at least four choices at this time. Let me apply a practical example. If you bought a call option with a strike price of US$24 in December at the current price of Palantir at US$22.95 in July, the value of the call option is about US$2.6. If Palantir rises to US$29 in September, the option value of the purchased call would rise to approximately US$5.5, which means an appreciation of 111.5%. At this time, you can consider the following four strategies, each of which can produce different risk and reward results.

1. Sell the call with the selling price of US$5.5 while the cost is US$2.6, and the profit will be 111.5%. Of course, the transaction commission fee will be deducted. But if the stock continues to rise afterwards, it doesn’t matter to you anymore. This is the most conservative method of operation with the lowest risk. If the stock continues to rise, this operation will make the least profit out of the four strategies. If on the contrary, the stock falls back to below US$24 before expiration in December, this strategy will make the most profit than the other three.
   
   A chart of the profit or loss versus the stock price at the expiration after liquidating the call option
   
2. Sell the call with the strike price of US$24 in December and gain US$5.5, then roll up to buy two call options with the strike price of US$30 in December, and pay the option premium of US$2.8 multiplied by 2, which is US$5.6. Since you earned US$2.9 when you sold the original call, and you had to pay US$5.6 to repurchase two calls, the total cost became US$2.7. Therefore, after adopting this strategy, if the stock price plummets downwards, at most you will suffer a loss of US$2.7. On the contrary, if the stock price continues to rise sharply, you will make a lot of money. Under this strategy, you double your bet on the upward direction while the downward loss is limited.
   
   A chart of the profit and loss of holding two long calls with strike price of $30 versus the stock price at expiration
   
3. Create an option spread by continuing to hold the call with strike price of US$24 in December, which is a long call, and then sell a call with a strike price of US$30 in December, which is a short call, and receive the option premium US$2.8. This strategy is one of the vertical spreads and is called bull spread. In this case, the option combination has no chance of holding risks, because the long call cost US$2.6, while the short call gained an option premium of US$2.8, that is, a net income of US$0.2. If the stock price falls below US$24 when it expires in December, both calls will not be exercised, that is, a net profit of US$0.2 will be realized, which should be close to a tie after deducting the commission fee; on the contrary, the maximum profit under this strategy is the difference between both strike prices of the two calls, that is, US$30-US$24 equals to US$6. If the stock price rises to more than US$30 at expiration in December, the call with a strike price of US$24 will be always worth US$6 higher than the call with a strike price of US$30, no matter how much the stock price exceeds US$30. When the stock price does not change much, this strategy will generate the greatest profits relative to the other three strategies.
   
   A chart of the profit and loss of holding the bull spread (long call @24 and short call @30) versus the stock price at expiration
   
4. Do nothing and continue to hold the original call with the strike price of US$24 in December. If you plan to hold until the expiration in December, this strategy will be the riskiest. If the stock price falls below US$24 at the expiration in December, this is the only strategy that will lead to losses.
   
   A chart of the profit and loss of holding the original call with strike price of $24 versus the stock price at expiration
   

The risk and reward ratio of the second and third strategies are between that of the first and fourth strategies. They can reduce a portion of the risk, and at the same time, it will not completely give up the potential upside return. Compared with the first strategy, the second and third strategies can continue to capture profits from the rising stock prices.

Which is the best strategy?

In a given situation, no single strategy is definitely the best. Unless you can predict the future and know the future stock price movement in advance, you cannot pre-select the optimal strategy in advance. However, if you can produce a bull spread like in the third strategy at a low cost or close to no cost, this choice may be the most attractive one, because compared to other strategies, this strategy will not be the worst in any situation. However, when the stock price does not change much, this strategy can produce the best return. More importantly, the probability of the stock price being relatively stable is usually higher than that of a big rise or big fall in stock price.

Summary of the four strategies

Let us summarize when the four strategies will have the best or worst results in the following table.

Calculate the profit and loss

Let us practically calculate the numbers of the profit and loss of various strategies under different stock price changes at the expiration. Here we calculate using one call option contract and it is corresponding to 100 shares of Palantir. For the sake of simplicity, the transaction commission and other fees will be ignored.

Margin securities account

The vertical spread mentioned in the third strategy above is a very common option strategy, which is very convenient and easy to use. However, it should be noted that trading vertical spreads must be conducted in a margin securities account, and the net asset value in the account must meet the minimum margin requirements of the firm before trading this type of option strategy.

My option transaction history

I introduced a bit more advanced option strategies this time, and next time I will further introduce some more advanced options strategies. Everyone should note that options can sometimes fluctuate greatly. Before making an investment, you must first understand what you are doing, otherwise it will simply become a gambling rather than an investment. I recommend you to have a look at my “Trading record” in which I explained the reasons why I used the option strategy every time as well as share some views and experience.

Comments and sharing

If you have any questions, please feel free to leave a message or comment below, I will reply you. Or if you find anything incorrect in the article, please let me know and learn from you. If you find it interesting or it may help you in any sense, please share with other people.