Conservative Option Strategies in a Bear Market

1. Conservative Option Strategies in a Bear Market Robert Rubin April 9, 2008

2. What Are Options? • Options give you the right to buy or sell a stock at a set price within a set time • The set price is the strike price • The set time ends on the expiration date • The option becomes worthless if not exercised by expiration • Calls give you the right to buy stock at the strike price • If a call’s strike price is below the market price, the call is worth the difference, plus the value of remaining time • If a call’s strike price is above the market price, the call is worth the value of remaining time • Puts give you the right to sell stock at the strike price • If a put’s strike price is above the market price, the put is worth the difference, plus the value of remaining time • If a put’s strike price is below the market price, the put is worth the value of remaining time • Options are traded • Option price most affected by underlying stock price, and time remaining to expiration • You can “write” your own options • Sell others the right to buy from you or sell to you

3. Buy Stocks for Much Less than Market Price • Buy stock, and write deep in the money (covered) calls • Calls are deep in the money when the strike price is much less than the market price, making the calls expensive • Writing deep in the money calls reduces your net purchase price for the stock you buy • Buy the stock you want, at a price you want • Enjoy a margin of safety since you buy for less than market • Raise your profit potential • Reduce risk • No loss unless the stock falls more than you got for the call • If the call expires, you pocket the premium, and you can sell another call • If the call is exercised, your profit is the strike price less your net cost

4. Buy Stocks for Much Less than Market Price • Example – DLX (Deluxe) • $19.67 per share on 4/1/08 • January 2009 $10 calls asked $10.20 per share • $0.75/share dividends for last 3 quarters of 2008 • Net cost = $1967 for 100 shares - $1020 for 1 call - $75 dividends = $872 ($8.72 per share) • If the call is exercised, you net $1000 for 100 shares - $872 cost = $128, a 14.7% return in 9 months or less ($128/$872) • If the call expires, you keep the $1020 premium and can sell another call • The stock could fall from $19.67 to $8.72 (55.7%) before you start to lose money - a real margin of safety! • You can also write out of the money covered calls • Short-term, so the call is likely to expire worthless

5. Make Money Whether Prices Go Up or Down • Suppose you expect a big price move soon • Earnings report, FDA ruling, patent suit settlement, breakout from consolidation, report on major project, etc. • Stock volatility and index volatility is high • But which way will prices move? • Buy a straddle • Profit from any big move – up or down • Lose only if price stays in the same narrow range • Straddle – buy a call and a put on the same stock or index • Same strike price and same expiration date • Pick strike price closest to the current stock price • Both call and put will have equal chance to go up • You profit if the price of the straddle – the combined price of both options – goes up • Two break-even points – the strike price +/- the straddle price • The bigger the move – up or down – the bigger your profit

6. Make Money Whether Prices Go Up or Down • Buy straddles if large price move expected • You lose if the price does not move • So take profits fast before they vanish – use stop orders • Look for volatility – see Bollinger Bands, average true range, candlestick charts, etc. • Straddles are popular – but dangerous – just before earnings releases • Big demand inflates option prices, which fall after the release • Buy your straddle 3-5 days before an earnings release • Straddles more profitable with less costly options • Less price movement to reach break-even • If you expect a specific price moving event, use short-term options

7. Make Money Whether Prices Go Up or Down • Example – PG (Proctor & Gamble) • $70.60 on 4/4/08 • Closest strike price is $70 • July 2008 $70 call asks $3.10, and $70 put asks $2.65 • Straddle costs $5.75 = $3.10 + $2.65 • Break-even at $75.75 = $70 + $5.75 or break-even at $64.25 = $70 - $5.75 • Break-even with 8.2% move up or down

8. Buy Options for Much Less than Market Price • Buy spreads • Buy an option, then write a less expensive option • Both options on the same stock with same expiration • Both options the same type – two puts or two calls • Lowers cost • The option you write offsets the cost of the option you buy • Lowers risk • The option you buy covers the option you write • Profit capped at the difference between the strike prices of the two options • This can exceed 100% return on investment

9. Buy Options for Much Less than Market Price • Example – OEX (S&P 100 Index) • $633.36 on 4/02/08 • July 2008 $620 put asks $25.10 for one contract – wow! • But the July 2008 $560 put asks $9.70 – let’s do a spread! • Buy a $620 put and write a $560 put • Be sure to place a spread order with your broker, not separate orders • Your cost is $15.40 = $25.10 ($620 put) - $9.70 ($560 put) • You profit if OEX closes below $604.60 = $620 (strike price) - $15.40 (cost of spread) • If OEX closes below $560, you make $44.60 = $620 ($620 put) - $560 ($560 put) - $15.40 (spread). 290% profit ($44.60/$15.40)! • You lose if OEX closes above $604.60 • Maximum loss is $15.40 (cost of spread) if OEX closes above $620 • You can close the spread long before