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Webster’s Dictionary defines the term strategy as “ 1 a) the science of planning and directing larger scale military operations, specifically (as distinguished from TACTICS) of maneuvering forces into the most advantageous position prior to actual engagement with the enemy b) a plan or action based on this. 2 a) skill in managing or planning, especially by using stratagems b) a stratagem or artful means to some end.

When applying a definition to investing in the market, we want to pay particular attention to the words “maneuvering into the most advantageous position prior to actual engagement” and the words “skill in managing or planning especially by using stratagems.”

Picking a stock or group of stocks is only half the battle. Making the most from the chosen investment opportunity is the other half. This is where your strategy comes in.

The wrong strategy even when applied to the right opportunity can produce increased risk, decreased profits and even potential loss. Therefore, understanding and applying the proper strategy is critical.

The actual selection of an investment opportunity from those offered normally depends on the type and style of research the investor favors and deems necessary.

This selection process, or “investment selection protocols,” is a checklist of different types and pieces of data that are favored by the individual investor. These pieces of data can consist of charts, indicators, oscillators, fundamental analysis, news or even tips.

Each investor has his/her own investment selection protocol. As an investor, once you complete this process and choose your investment opportunity, your strategy takes over. Inherent in the selection of the stock is expectation.

Every investor has some expectation for any chosen opportunity. Therefore a strategy must be selected which best fits those expectations.

The proper strategy will be the strategy thay allows for the highest possible return with the least amount of risk and the best possible protection that can be afforded.

Obviously, since every opportunity will have a somewhat different expectation along with different variables surrounding it, each opportunity should have a different “ideal” strategy. By and large, when choosing a stock to invest in, most investors look to purchase a stock they think will go up. The directional play is as good a place as any to start our discussion of option strategies.

 

 

Popularity: 7% [?]

A put option is a contract between two parties (a buyer and a seller) whereby the buyer acquires the right but not the obligation to sell a specified stock or other underlying instrument at a specified price by a specified date.

The seller of a put option assumes the obligation of taking delivery of the stock or other underlying instrument from the buyer should the buyer wish to exercise his option. The put is known as a short instrument which means that the buyer profits from the stock going down.

For the seller to profit, the stock must not move below the strike price plus the amount of money received for the sale of the option. This point is known as the breakeven point and is calculated by adding the call’s strike price to the option’s premium. Obviously, the buyer hopes that the stock price exceeds the breakeven point.

For example, you buy the MSFT January 65 put for $2.00 because you think Microsoft is going to go down. This option gives you the right, but not the obligation to sell the stock at $65.00. In order to obtain this right, you had to spend $2.00. In order for you to make money, the stock would have to trade down below $63.00 by expiration.

This is because the stock has to trade down below the strike plus the cost of the option. If the stock traded down to $60.00, you would make $5.00 because you have the right to sell it at $65.00. However, because you paid $2.00 for the put, you must subtract that from your $5.00 profit for a total profit of $3.00. You have just made $3.00 on a $2.00 investment. Not a bad return.

The buyer of the put has limited risk and unlimited potential gain. His risk is limited only to the amount of money he spent in purchasing the put. His unlimited potential gain comes from the stocks unlimited downside potential.

The seller, on the other hand, has limited potential gain and unlimited potential loss. The seller can only gain what he was paid for the put. The unlimited risk comes from the stock price’s ability to decline during the life of the contract.

For example, if a seller sold the MSFT January 65 put for $2.00, he is giving the buyer the right to sell 100 shares (per contract) of MSFT to him at $65.00 per share at any time until the option expires.

If MSFT declines and trades down to $55.00, the seller would realize a $10.00 loss less the amount he received for the sale of the option ($2.00), for a net loss of $8.00. Meanwhile, the buyer would realize a $10.00 profit less the amount he paid for the option ($2.00), for a net gain of $8.00 per contract.

If MSFT were to trade up to $75.00, the seller would realize a $2.00 profit (the amount of money he was paid from the buyer). Meanwhile, the buyer would only lose what he paid for the option ($2.00). The seller is obligated to take delivery of the stock from the buyer at the strike price regardless of the present market price of the stock. This is why the seller receives premium for the sale.

Again, the following graphs are called parity graphs. They are intended to show you your option’s profit and loss at expiration (when they are trading at parity: i.e. when they are trading without intrinsic value). The first graph shows a put purchase and the second shows a put sale. The graphs show the amount of your expenditure (in the case of a purchase) or the amount you have received (in the case of a sale) and the dollar price of the stock where you would breakeven.

Using the fictitious stock XYZ below, make note of where the stock needs to be at expiration in order for you to be profitable, and how the premium paid (in the case of a purchase) or the premium received (in the case of a sale) affects your profitability.
Also notice the difference in the profit potential between a purchase of the option as opposed to a sale of the option. Lastly, it is important to note the unlimited potential risk inherent in the sale of an option, compared to the fixed risk of an option purchase.

 

 

Popularity: 7% [?]

Today’s tickers: JBHT, WYNN, VIX, AL, WHR, SYNA, AEO, CVS, RAD, JNPR & TZOO

JBHT – Conjecture about consolidation in the transport industry and comments from the analyst community on the “undervalued” nature of the sector as a whole spun options in JB Hunt Transport (JBHT) into a momentum web earlier this week. While the immediate rumors failed to pan out, options are still trading at 10 times their average volume today – and the 15,000-plus active contracts amounted to just shy of half the number of contracts outstanding - against a .65% gain in share prices to $26.27. Much of this volume appeared to be tied up in collar plays in the February ‘08 and May ‘08 contracts, involving the 25.0 puts and the 30.0 calls, against stock held. Given current premiums, the position in the February risk reversal play costs $0.95 to enter while the May position costs $0.80. A trader in this case is limiting upside by selling the call at the upper strike, but is still hoping for a break above $30 next spring.

WYNN – Casino operator Wynn Resorts, that mainstay of the Vegas strip, saw the price of its October 170 calls shoot up in price to $6.80 yesterday – having traded as low as $0.70 a pop a week ago, on price speculation regarding a secondary share offering. When news of the share price - $158 – gapped below the moxiest market forecasts, Wynn shares fell back 4.78% to $158.96, and the price of the 170 call retreated 45%, attracting volume from buyers and sellers today. Elsewhere in the October contract we observed heavy buying and selling in the 160 straddle, which is going for $15 today. A buyer of this position is looking for a break above $175 or below $145 – an ambitious bet given that options traders are pricing in 50% degree of fluctuation in share prices as expressed in implied volatility. A seller of this position is taking advantage of still-elevated premiums in the series against the belief that shares will remain at or around current levels for the month to come.

VIX – The CBOE volatility index rose 6.2% Friday to 18.06 despite only a moderate easing for equity prices. November and December call options were bought. The November 30 strike and December 22.5 were in strong demand. But the headline trade for the day went to what appears to be a 20,250 lot strangle in the February contract. The trade involved puts at the 17 strike and calls at the 27.5 strike at a net premium of 2.4. If the strangle was sold as we believe it may have been, this investor expects implied volatility to remain within the boundary of these strike prices by expiration. If that’s the case the investor gets to keep the 2.4 premium. A seller of the strangle would profit if implied volatility burst outside of the trade strike prices beyond the value of the total premium. In other words a breach of 14.6 or 29.9 for the VIX by expiration would see the trade in the black for a buyer. During the course of the past 28 trading days the VIX has traded within a range of 28.82 and 16.91 and on only three days during August did the index close above 29.

AL – Shareholders in U.K. listed Rio Tinto voted 97% in favor of the takeover of Canadian aluminium producer, Alcan Inc. today. The company hopes to conclude the $101 per share deal in the final quarter of this year in a $38.1 billion takeover deal. Alcan’s share price was steady at $100.08 but options traders used the confirmation of the event to take in premium on nearby put options. Given the almost certain outcome that Alcan’s share price will remain above $101 to close the year has given confidence to put sellers to take in the nickel per contract premium available on the October, November and December contracts. The most active contract was the December 95 put strike where a block of 17,875 contracts traded. It’s understandable that, given the friendly nature of the deal now backed by shareholder approval, options traders see little to cause Alcan’s shares to decline. Implied option volatility at just 3.6% supports that notion.

WHR – Whirlpool shares rallied .94% to stand at $89.10 with one news service attributing elevated options buzz to an unsubstantiated market rumor that General Electric might bid for the maker of domestic appliances. Certainly there was above average interest in Whirlpool options, where current open interest stands at 44,710 lots. Today’s 14,840 contracts in action favored the bulls with 2 times as many calls traded when compared to puts. However, of interest to us is that in the bigger picture there are 1.4 puts in play according to open interest data compared to calls. And looking at the chart pattern confirms why investors have traditionally south protection. The share price has been in freefall since closing below $110 in July. Both first and second quarter sales were impressive, but recent weakness in the domestic housing market seems to have undermined investor confidence in the stock.

Since then shares have pulled back firmly towards $85. Implied volatility is higher today at 39.4% but that’s more likely thanks to call-inspired demand than any substance to the rumor. The historic volatility on the stock runs at around 34%. Today’s volume was focused on the October calls between the 90-100 strikes. The upper strike commanded a premium of 0.55, which is 120% higher than Thursday’s closing price. Traders currently see a one-in-eight chance of shares closing at or above $100 by October. However, the chances of that happening by the time the November contract expires is one-in-four. The premium in that contract today stands at around 2.0 per 100 shares.

SYNA – Synaptics Inc. After reaching a new 52-week high early on Friday, shares in this touch-pad maker turned tail as protective put-buyers perhaps eager to lock in gains came out of the woodwork. Shares have doubled in less than six months in the company, which provides interface software solutions for mobile devices that communicate with one another. With shares lower by 4.5% this afternoon at $47.76 it looks as though some put spreading may have occurred with October 40 strike puts sold in order to finance buying in the 45 strike. The November 50 puts were eagerly bid and traded 5,249 times at prices between 3.2 and 4.5. Overall volume today at 15,347 lots was equivalent to more than half of total open interest on the stock options. Implied volatility at 43% stands just a shade higher than historic volatility on the shares. The company did file earlier today with the SEC to report the forthcoming departure of its founder who has served with the company for 20 years. Still, a single buyer of 1,400 November calls at the 50 strike took advantage of today’s share price decline, scooping up calls 19% cheaper than at yesterday’s closing price.

AEO - Shares in teen clothing retailer American Eagle Outfitters (AEO) have benefited in recent days from a major bank upgrade and reports that the chain is one of a handful of mass-market fashion names benefiting from the emergent trend of “second wave” back-to-school shopping. The 18,000 active contracts in play today equalled more than 10% of its open interest, making it a volume story of note to us, as shares gave back early gains to close flat at $26.31. Buying in the October 30 calls was fresh, where 9,875 lots traded on premiums of $0.30 each. A modest groundswell of fresh call buying was also observed at this same strike in the November and January calls. Although we’d seen online reports attributing the early-session resurgent call interest to “unsubstantiated chatter,” the volume build, strike price positioning, and implied volatility as yet lack the momentum that might lend credence to scuttle of that sort. American Eagle shares traded above $30 for much of the first half year, but dipped below that level in May in a general down trend. Since bottoming out in August, its share price has shown signs of slow recovery, and today’s call-buying may be an indication that “second wave” back-to-school buying will help it patch back to early ‘07 highs.

CVS - Two days after hitting a new high for the year at $39.80, shares in retail drugstore chain CVS/Caremark are closed flat just below the highs at $39.63. It appears that option traders may have been looking to unload open strangle positions in anticipation of a low-volatility environment for CVS share prices heading toward year’s end. The November 35/37.50 strangle traded to the middle of the market, on volume of 14,000 lots, a level within existing open interest. Action was also seen in the February contract, where 5,000 lots of the 37.50 puts sold to the bid at $1.30, and the 42.50 calls traded to the middle of the market at $1.30.

RAD - Today’s option volume has been strictly five-and-dime at CVS competitor, RiteAid (RAD), whose shares lost nearly 6%, closing at $4.55 after second quarter earnings fell short of street estimates, due in part to the absorption of costs from its acquisition of Eckerd pharmacies. The development lent to a nearly 30% climb for implied volatility, which peaked earlier today at 49% - significantly above the 34% level of volatility that Rite Aid shares have documented in the past. By comparison, CVS options implied volatility at 21% is below the historic reading. The development is reflected in today’s higher put-side premiums in Rite Aid options. Overall open interest shows puts moderately outnumbering calls by a factor of 1.3. JNPR - Options in Juniper Networks, the Silicon Valley telecom company that makes routers, firewalls and IP phone equipment for partners including Ericcson and Alcatel-Lucent, traded on a volume of 42,000 lots today, calls and puts trading with equal frequency. With shares closing .80% higher at $36.61, it appears that traders may have been looking to unload the October 37.50 straddle for a combined premium of $2.90, while calls were bought at the same month’s 40.0 strike. The market is currently pricing in a one-in-five probability that Juniper shares will break above $40 next month.

TZOO - Momentum swarmed throughout the session around online travel site Travelzoo, and the buzz bore out in option activity. This ticker caught our attention early this morning as our market scanners showed options were moving at 64 times the average volume, coinciding with a 45% climb in implied volatility to 72% - all this as its shares gained 13.4% on the session to close at $22.95. Today’s volume was cloistered in at-the-money 22.50 calls in the October and November contracts, while 3,275 lots have traded one strike higher at 25.00 for a buck-fifty apiece.

Andrew Wilkinson Senior Market Analyst

Rebecca Engmann Darst Equity Options Analyst

Popularity: 8% [?]

Premium is the total amount of money (price) you pay for an option. So, if the Microsoft (MSFT) May 65 calls cost you $1.50 then the $1.50 is the amount of the premium of the option.

The total price of an option (premium) consists of two components. Those two components are intrinsic value and extrinsic value.

Intrinsic value, also called parity, is the amount by which an option is in the money. In the case of a call, the intrinsic value is equal to the present stock price minus the strike price. In the case of a put, the intrinsic value is equal to the strike price minus the present stock price. Only in-the-money options have intrinsic value. Out-of-the-money options have no intrinsic value.

For example, with MSFT trading at $65.00, the MSFT January 60 calls will have $5.00 of intrinsic value. If the MSFT January 60 calls were trading at $5.70, then $5.00 of that premium would be intrinsic value.

At the same time, the MSFT January 70 put will also have $5.00 of intrinsic value. So, if the MSFT January 70 puts were trading for $5.70, then $5.00 of that premium would be intrinsic value.

Extrinsic value is defined as the price of an option less its intrinsic value. In the case of out-of-the-money options, the option’s entire price consists only of extrinsic value. Extrinsic value is made up of several components, with the largest being volatility.

In the examples above, if the MSFT January 60 calls were trading at $5.70 and $5.00 of that was intrinsic value, then the remainder ($.70) is extrinsic value. The same also holds true for the January 70 puts. If they were trading at $5.70 and $5.00 of that was intrinsic value, then the rest ($.70) is extrinsic value.

Popularity: 8% [?]

Q: If you buy a call and then sell it back into the market, are you in effect then writing a call and is all of the intrinsic value profit? For example, you buy 1 abc option for $200 at a strike price of $40 and the stock rises to $45. Is your total profit a guaranteed $300 if you close your position prior to expiry?   Tony

A:

Hi Tony,

Theoretically, all option prices must reflect all of their intrinsic value otherwise an arbitrage opportunity is present. In your example, with the stock at $45, the $40 call must be worth at least the $5 intrinsic value plus some time premium. If it did not, arbitrageurs would buy the undervalued call and simultaneously short the stock thus locking in a guaranteed profit. For example, assume the $40 call was missing 25-cents of intrinsic value and trading for $4.75. Arbitrageurs would short the stock at $45 and buy the call for $4.75 thus spending only $40.25. They could then immediately exercise the $40 call to cover the short position. They would get the $40 from the $40.25 credit thus leaving them with a 25-cent guaranteed profit, which is exactly the amount of missing intrinsic value.

However, this theory applies only to the asking price for options. Because of the bid-ask spread, you may see this not hold especially as expiration draws closer. So to answer your question, in MOST cases, you will always receive the full intrinsic value for your option (plus any time premium if applicable). In your example, with the stock at $45, you can be sure the $40 call would be trading for at least $5 (plus some time premium) and you would therefore capture the full $300 profit less commissions.

But even for those times when the bid price does drop below the intrinsic value, you can still get the full value with a little trick. For example, assume it is near expiration and the $40 call is only bidding $4.75 with the stock at $45. You have 10 contracts you’d like to sell. What can you do to get the additional 25 cents of missing intrinsic value? You do the same thing the arbitrageurs would. Simply short the stock and then immediately exercise the call. Doing so will entail one additional stock commission but you would collect an extra $250 from the trade!

Q: 

I would like to know when to use debt or credit spread? Thank you for your time. James Lin.

A: 

Hi James,

For any given set of strike prices, the debit and credit spreads should be identical in every respect. That’s the theory anyway. However, because of “skews” in the call and put prices, you will always find that the debit or credit version will be more advantageous in terms of price. Generally, you will not see any difference for the at-the-money strikes but will find potentially great differences as you move away from that central point.

For example, assume the stock is $102.50. You will likely find that the $100/$105 vertical call spread (buy the $100 call, sell the $105 call) can be purchased for $2.50, which means you could make $2.50 since the maximum value the spread could be worth is the $10 difference in strikes. However, if you wanted to buy an in-the-money vertical spread, you may decide to buy the $95/$100 strikes (buy $95, sell $100). This may cost, say, $4 thus allowing you to make a maximum of $1. Of course, it is less risky, which is why the market will bid the price higher. With the current stock price at $100, the $95/$100 spread only needs the stock to stay at the same price. It does not need the stock price to rise (although that certainly won’t hurt it).

Rather than buy the $95/$100 call spread though, you could also take a look at the $95/$100 put spread (buy $95 put, sell $100). In most cases, you will find there is a slight price advantage by using the put spread. Because market participants are willing to pay dearly for out-of-the-money puts as insurance, you may, for example, receive $1.10 credit. The most you could lose is the difference in strikes thus making your maximum loss $3.90. So the $95/$100 call spread costs $4 and can make $1 while the put version can make $1.10 but lose $3.90. In most cases, traders would use the put version since all other greek risks are identical.

You will discover a similar relationship when comparing the out-of-the-money call spreads with the in-the-money put spreads. Sometimes the debit spread turns out to be the better choice and other times it is the debit spread. The main point to understand is that you should never use a credit spread “just because” it appears to be better to receive money rather than spend it on a debit spread. Check the maximum gains and losses to find your answer.

---

To ask your biggest question about options trading go here

Popularity: 10% [?]

Parity - When we discuss parity in terms of options, we say that parity is the amount by which an option is in the money. Parity refers to the option trading in unison with the stock. This also means that parity and intrinsic value are closely related. When we say that an option is trading at parity, we mean that the option’s premium consists of only its intrinsic value.

For example, if Microsoft was trading at $53.00 and the January 50 calls were trading at $3.00, then the January 50 calls are said to be trading at parity. Under the same guidelines, the January 45 call would be trading at parity if they were trading at $8.00. So, parity for the January 50 calls is $3.00 while parity for the January 45 calls is $8.00

Now if these calls were trading for more than parity, the amount (in dollars) over parity is called ‘premium over parity.’ Thus, the term ‘premium over parity’ is synonymous with extrinsic value, which was discussed above.

If the stock is trading at $53.00 and the January 50 calls are trading at $3.50 then we would say that the calls are trading at $0.50 over parity. The $0.50 represents the premium over parity that is also the amount of extrinsic value. The $3.00 is the amount of intrinsic value or parity.

The term time decay is defined as the rate by which an options extrinsic value decays over the life of the contract.

This concept can be illustrated by the charts below.

Volatility is defined as the degree to which the price of a stock or other underlying instrument tends to move or fluctuate over a period of time.

Implied Volatility is a value derived from the option’s price. It indicated what the market’s perception of the volatility of the stock or underlying will be during the future life of the contract.

A stock that has a wide trading range (moved around a lot) is said to have a high volatility. A stock that has a narrow trading range (does not move around much) is said to have a low volatility.

The importance of volatility is that it has the single biggest effect of the amount of extrinsic value in an option’s price. When volatility goes up (increases), the extrinsic value of both the calls and the puts increase. This makes all the option prices more expensive. When volatility goes down (decreases), the extrinsic value of both the calls and the puts decrease. This makes all of the option prices less expensive.

As stated earlier, a call option is a contract between two parties (a buyer and a seller) whereby the buyer acquires the right, but not the obligation, to purchase a specified stock or other underlying instrument, at a predetermined price on or prior to a specified date.

The seller of a call option assumes the obligation of delivering the stock or other underlying instrument to the buyer should the buyer wish to exercise his option.

The call is known as a long instrument, which means the buyer profits from the stock going up, and the seller hopes the stock goes down or remains the same. For the buyer to profit, the stock must move above the strike price plus the amount of money spent to purchase the option.

This point is known as the breakeven point and is calculated by adding the strike price of the call to its premium. While the buyer hopes the stock price exceeds this point, the seller hopes that the stock stays below the breakeven point.

The buyer of the call has limited risk and unlimited potential gain. His risk is limited only to the amount of money he spent in purchasing the call. His unlimited potential gain comes from the stock’s upside growth potential.

The seller, on the other hand, has limited potential gain and unlimited potential loss. The seller can only gain what he was paid for the call. His unlimited risk comes from the stock price’s ability to rise during the life of the contract.

The seller is responsible for delivering the stock to the buyer at the strike price regardless of the present market price of the stock. This is why the seller receives premium for the sale. It is compensation for taking on this risk.

For example, if a seller sold the MSFT January 65 call for $2.00, he is giving the buyer the right to buy 100 shares (per contract) of MSFT from him for $65.00 per share at any time until the option expires.

If MSFT rallies and trades up to $75.00, the seller would realize a $10.00 loss less the amount he received for the sale of the option ($2.00). Meanwhile, the buyer would realize a $10.00 profit less the amount he paid for the option ($2.00).

If MSFT were to trade down to $55.00, the seller would realize a $2.00 profit (the amount of money he was paid from the buyer). Meanwhile, the buyer would only lose what he paid for the option ($2.00).

The following graphs are called parity graphs. They are intended to show you your option’s profit and loss at expiration (when they are trading at parity: i.e. when they are trading without intrinsic value). The first graph shows a call purchase and the second shows a call sale. The graphs show the amount of your expenditure (in the case of a purchase) or the amount you have received (in the case of a sale) and the dollar price of the stock where you would breakeven.

In this example, we use the fictitious stock XYZ. Please make note of where the stock needs to be at expiration in order for you to be profitable, and how the premium paid (in the case of a purchase) or the premium received (in the case of a sale) affects your profitability.

Also notice the difference in the profit potential between a purchase of the option as opposed to a sale of the option. Lastly, it is important to note the unlimited potential risk inherent in the sale of an option, compared to the fixed risk of an option purchase.

 

 

Popularity: 7% [?]

An option can be described by its strike price’s proximity to the stock’s price. An option can either be in-the-money (ITM), out-of-the-money (OTM), or at-the-money (ATM).

An at-the-money option is described as an option whose exercise or strike price is approximately equal to the present price of the underlying stock.

For instance, if Microsoft (MSFT) was trading at $65.00, then the January $65.00 call would an example of an at-the-money call option. Similarly, the January $65.00 put would be an example of an at-the-money put option.

Please view charts below for at-the-money option examples.

An in-the-money call option is described as a call whose strike (exercise) price is lower than the present price of the underlying. An in-the-money put is a put whose strike (exercise) price is higher than the present price of the underlying, i.e. an option which could be exercised immediately for a cash credit should the option buyer wish to exercise the option.

In our Microsoft example above, an in-the-money call option would be any listed call option with a strike price below $65.00 (the price of the stock). So, the MSFT January 60 call option would be an example of an in-the-money call.

The reason is that at any time prior to the expiration date, you could exercise the option and profit from the difference in value: in this case $5.00 ($65.00 stock price - $60.00 call option strike price = $5.00 of intrinsic value). In other words, the option is $5.00 “in-the-money.”

Using our Microsoft example, an in-the-money put option would be any listed put option with a strike price above $65.00 (the price of the stock). The MSFT January 70 put option would be an example of an in-the-money put.

It is in-the-money because at any time prior to the expiration date, you could exercise the option and profit from the difference in value: in this case $5.00 ($70.00 put option strike price - $65.00 stock price = $5.00 of intrinsic value. In other words, the option is $5.00 “in-the-money.”

Please view charts below for more in-the-money option examples.

An out-of-the-money call is described as a call whose exercise price (strike price) is higher than the present price of the underlying. Thus, an out-of-the-money call option’s entire premium consists of only extrinsic value.

There is no intrinsic value in an out-of-the-money call because the option’s strike price is higher than the current stock price. For example, if you chose to exercise the MSFT January 70 call while the stock was trading at $65.00, you would essentially be choosing to buy the stock for $70.00 when the stock is trading at $65.00 in the open market. This action would result in a $5.00 loss. Obviously, you wouldn’t do that.

An out-of-the-money put has an exercise price that is lower than the present price of the underlying. Thus, an out-of-the-money put option’s entire premium consists of only extrinsic value.

There is no intrinsic value in an out-of-the-money put because the option’s strike price is lower than the current stock price. For example, if you chose to exercise the MSFT January 60 put while the stock was trading at$65.00, you would be choosing to sell the stock at $60.00 when the stock is trading at $65.00 in the open market. This action would result in a $5.00 loss. Obviously, you would not want to do that.

Please view charts below for out-of-the-money option examples.

 

Popularity: 7% [?]

Today’s tickers: BBBY, F, SHW, GM, IYT, DAL, NWA, SLM, CBAK & CSUN

From Yahoo! Finance

GM – General Motors – Resolution to the auto workers strike was greeted with a 6% pop-up in shares at GM to stand at $36.52. Implied volatility on options traded on the stock dropped by almost one quarter to 45%. That meant that call buyers eager to capitalize on the anticipated rise in the stock got hurt as they paid up to 3.3 for rights to buy GM shares at a fixed $35.00 by October’s expiration. The drop in volatility was accompanied by call selling on the rally leaving those calls with gains of 20% rather than the 74% gain as trading started. Call sellers at 3.3 for example are protected against share price gains until the stock reaches $38.30, which would still require a 6.6% rally from today’s current price.

Meanwhile put prices in the October contract reflected the double-whammy of “good news” (a rally in the stock and a drop in volatility) by cratering by as much as two-thirds. The 35 strike shed 54% on yesterday’s session leaving premiums at just 1.2. the November series was most active on the call side at the 37.5 strike where 2,300 lots traded in comparison to 1,590 puts at the lower 35 strike. Overall some 127,000 contracts traded by 11am with 1.8 calls trading in comparison to puts.

F – “Detroit fever” in the options market finally made its way to Ford (F), where option traders have remained firmly on the sidelines in view of the unfolding strike drama at GM. Shares tacked on a 5.6% gain to $8.81, and with 99,000 options trading it appears that some investors felt assured enough of the sticking power of today’s UAW/GM deal to let go of about 61,750 “doomsday puts” in the January ‘09 series that would have allowed them to dump Ford shares for $5 apiece in January of 2009. Elsewhere, we observed confident positioning in the December 10 calls, where more than 10,000 lots traded. As is the case with GM, implied volatility beat a fast retreat and at 34% is now about 2% below the historic volatility reading for Ford shares.

BBBY – A seeming contradictoriness over the market’s perception of home improvement retailers to navigate in the current dicey environment is also apparent in shares of Bed Bath & Beyond, due to report earnings today. Shares were up 6% after the bell at $35.19, with 18,000 options moving actively, showing a slight skew to the puts. While option traders appeared loath to venture “beyond” the October contract, the positioning here suggests a couple of scenarios. We can ascertain that about a quarter of today’s volume - 3,000 lots – is seated in the October 35 calls, but because these are logged to the middle of the market, we can’t confirm whether they were bought or sold. Given that we know the 1,200 lots calls trading at the 32.50 strike were bought on the offer, some traders may be selling the 35 calls to fund exposure at the 32.50 level. Or they may be involved in sold straddles or strangles involving puts at the 30 and 32.50 strikes. Whether the market has simply become inured to pale prognostications on the buying power of home-loving US shoppers, traders do not appear to be positioning for any great shakes in volatility for Bed Bath & Beyond, and even an upside surprise in earnings is unlikely to take shares past the $35 level.

SHW – A whitewash of the current housing market woes, or is the market being primed for yet another takeover rumor? We were surprised to see this morning’s M&A rumor-mill seize upon a ticker with such unmitigated exposure to the sagging home improvement market. Sherwin-Williams, producer behind the eponymous Sherwin-Williams and Dutch Boy paint brands, is commanding more than 6 times the average volume in options trading today, with shares up 3.4% to $66.91. So what’s in the Sherwin-Williams mix that hasn’t rubbed off on the likes of Lowe’s? We’re observing heavy buying in the October 70 and 75 calls, in positioning that’s as fresh as a coat of buff! Heading into today’s session, total open interest showed about 2.7 open put positions for every call, implying a prevailingly bearish sentiment on Sherwin-Williams, a company that has underperformed the S&P by about 3.4% for the year to date, but outperformed peers in the consumer discretionary index.

IYT – iShares Dow Jones US Transport index ETF – shares rose 0.6% to $86.58 Wednesday and continued to pull away from support at $80.40 and $83.49 put to the test over the summer months. No doubt the high price of crude oil has been adding additional weight on the sector, yet the sector seems to have found some friends at least. Option open interest is scant at just 11,983 lots, which is why put trading today is of interest to us. The deep-in-the-money December 100 strike puts saw heavy volume of 2,731 lots at a price of 13.50. The bulk of that volume appears to have traded to the bid side indicating that investors have confidence that transport share prices will rally going forward. If they do continue to rally the put premium at the 100 strike will erode. Not only that, but as time lapses towards expiry the time value element that makes up options prices will decay. As long as share prices at least stand still in the sector these investors may be onto a healthy trade. Yesterday we noted a buzz in the options market as trucker YRC Worldwide took on the appearance of a takeover target.

DAL – Delta Airlines options were notably active thanks to the purchase of 21,000 calls at the December 17.5 strike price. Shares in the airline were higher by 4.5% at $17.84 and so left these calls in-the-money. An investor clearly sees relief in the sector ahead following a rebound for Delta off a $15.90 low. Implied volatility pretty much matches the activity on the underlying share price performance at around 54%. Today’s option volume stacks up to around 15% of overall open interest on Delta’s options contracts.

NWA – Northwest Airlines options volume was also significant. The bulk of today’s trading, unlike as occurred with Delta, was on the put side, where it would appear that a large chunk of October 15 puts were bought. Some 15,000 lots traded today premium of 0.50. However, an investor is picking these up at a nickel below Tuesday’s closing price at a time when shares have rallied 2.9% to stand at $17.01. This investor is looking for a share price slide of as much as 6.9% before breaking even on this trade. Also in play today were puts at the March 22.5 strike where a buyer snapped up 2,100 lots at around a 6.0 premium.

SLM – Shares closed 2.4% lower at $45.08 after Sallie Mae confirmed that a JC Flowers/Bank of America consortium had reneged on the terms of its $25 billion buyout. Options traders reacted immediately, putting more than 200,000 contracts in play. Earlier today, option traders appeared keen on volatility positioning in the front month contract. Once news of the shelved agreement was made public late in the session, traders made a rush to shed calls at the 50 and 55 strikes in the November and January contracts. A telling commentary on the volatile plight of this troubled takeover candidate, option implied volatility stands at 67% - compared to 28% historic volatility.

CBAK, CSUN - The ranks of relative volume gainers included a couple of conspicuous Chinese tech companies with exposure to the consumer electronics sector. China Bak Battery (CBAK), one of the leading makers of rechargeable lithium-ion batteries, saw its volume surge to more than 80 times the average as shares added 26% on the day to stand at a $6.35. Implied volatility rose 40% to 66.3 on the session, as option traders rushed to buy calls at the 7.50 in the October and December contracts. Meanwhile, options in the ADR-traded shares of China-based solar cell maker China Sunergy (CSUN) attracted 14 times the average volume against a modest 2.7% gain in shares to $10. Traders appeared to zero in on the front month at-the-money strangle, which at $2.35 represents more than20% of today’s share price.

Andrew Wilkinson Senior Market Analyst

Rebecca Engmann Darst Equity Options Analyst

Popularity: 8% [?]

A call option gives the buyer the right but not the obligation to buy a specific security at a specific price by a specific date. It’s a way of “locking in” the purchase price of the stock for a period of time.

A put option gives the buyer the right but not the obligation to sell a specific security at a specific price by a specific date. It’s a way of “locking in” the sales price of a stock for a period of time.

The specific date is known as the contract’s expiration date. On or prior to the expiration date the holder of the option contract has the right to “exercise” the option.

The term exercise means the process by which the buyer of an option converts the option into a long stock position in the case of a call or a short stock position in the case of a put.

The term assign or assignment means the process by which the seller of an option is notified of the buyer’s intention to exercise.

Buyers of options exercise. Sellers of options are assigned.

The strike price or exercise price is defined as the price at which the holder has the right to buy (for a call) or sell (for a put), the underlying security. Strike prices are quoted in dollars, i.e. May 50 calls means May $50.00 strike calls.

There are several other important terms in an option contract:

A long position is defined as any position which will theoretically increase in value should the price of the underlying security increase. Vice versa, the position will theoretically decrease in value should the underlying security decrease.

The buying of stock, the buying of a call, or the sale of a put all constitute a long position.

A short position is defined as any position which will theoretically increase in value should the price of the underlying security decrease. Vice versa, the position will theoretically decrease in value should the underlying security increase.

The selling of stock, the selling of a call, or the buying of a put all constitute short positions.

The “option class” identifies the specific underlying security the option is written on. The “option series” describes the expiration month and strike price. As an example, let’s use the Microsoft (MSFT) May 65 calls.

MSFT is the option class. May 65 call is the option series. May is the expiration month and 65 is the strike price.

Let’s try one more. How about the Home Depot January 35 puts? Home Depot (HD) is the option class. January is the expiration month and 35 the strike price.

All stocks and options are identified by symbol. We have discussed how the stock itself has a symbol (stock symbol HD = Home Depot, while MSFT = Microsoft.)

Options have symbols too. These symbols are standardized for all exchange traded (listed) options. A different letter identifies each specific month’s call or put. The chart below shows which letters coincide with which month’s calls and which month’s puts.

Month	Calls	Puts
January	A	M
Febraury	B	N
March	C	O
April	D	P
May      &nbs