Feb

9

Chapter Seven Questions

Filed Under Option Trading Articles | Leave a Comment 

If this is your first time visiting, subscribe to our RSS feed.


1) You own 300 shares of ABC stock, trading for $60, and have written 3 $65 calls. You have the:
a) Right to buy 300 shares of ABC for $65
b) Obligation to buy 300 shares of ABC for $65
c) Right to sell 300 shares of ABC for $65
d) Obligation to sell 300 shares of ABC for $65

2) You purchased 200 shares of stock at $40 and have written two $40 calls for $1. Your cost basis on the stock is effectively:
a) $39
b) $41
c) $38
d) Cannot be determined

3) You have written 4 $50 call options against your stock. How much money will you receive if you are assigned?
a) $200
b) $5,000
c) $2,000
d) $20,000

4) The risk of a covered call is that:
a) You might have to give up your stock at a very unfavorable price
b) The stock price falls
c) The premium of the short call falls
d) The stock price stays the same

5) Covered call writers should:
a) Only write short-term calls since they are exposed to the sharpest time decay
b) Write the month that brings in an adequate premium relative to the risk.
c) Never write out-of-the-money calls
d) Never write in-the-money calls

6) Assuming you are not looking for highly-speculative investments, one of the most important standards for selecting stocks to write calls against is for you to:
a) Write calls that have large premiums
b) Write calls against stock that you are comfortable holding
c) Write calls on highly-volatile stocks
d) Write calls only on long-term options

7) If you write a covered call and the stock’s price rises above the strike price prior to expiration, you should:
a) Expect to get assigned on the ex-date
b) Expect to get assigned the following day
c) Expect to get assigned that day
d) Only expect to get assigned at expiration if the stock’s price is still above the strike

8) You have written a $50 call against your stock, which is trading for $57 with 20 days remaining until expiration. If you decide to buy back the $50 call and simultaneously sell the $55 call (same expiration), what is this called and will is produce a net credit or debit?
a) Roll-up, net credit
b) Roll-up, net debit
c) Roll-down, net credit
d) Roll-down, net debit

9) You bought 200 shares of ABC stock for $30 and have written two calls against it for $1 each. The calls have expired worthless and you wish to write calls again for the following month. However, the stock has now dropped to $25 so you decide to write two $25 calls for $2 each. What is your new cost basis and what is your profit or loss if you are assigned?
a) $30 cost basis, $5 loss
b) $27 cost basis $2 loss
c) $24 cost basis, $1 loss
d) $24 cost basis, $1 profit

10) You bought 1,000 shares of XYZ stock for $20 and wrote 10 $20 calls for $2. At expiration, the stock is trading for $15. What is your unrealized profit or loss at this point?
a) $2 gain
b) $2 loss
c) $3 gain
d) $3 loss

11) You bought 100 shares of ABC stock for $50 and wrote the $50 call for $1. At expiration, the stock is trading for $55 and the call is trading at parity (worth the $5 intrinsic value). If you buy the call to close:
a) You will be left with a loss since you sold the call for $1 and bought it back for $5.
b) You will have a $1 gain
c) You will have a $5 loss
d) You will just break even

12) If you write a covered call, you:
a) Can always exit it by purchasing the call back
b) Must remain in the covered call until expiration
c) Can exit the position by exercising the call
d) Can exit the position by selling a put

13) You bought 100 shares of ABC for $30 and wrote the $30 call for $2. What is your static return?
a) 8.4%
b) 6.7%
c) 7.1%
d) 5.8%

14) You bought 100 shares of ABC for $30 and wrote the $30 call for $2. What is your breakeven return?
a) 8.4%
b) 6.7%
c) 7.1%
d) 4.8%

15) You bought 100 shares of ABC for $70 and wrote the $70 call for $3. What is your return if exercised?
a) 5.9%
b) 3.2%
c) 6.2%
d) 4.5%

16) If you write an in-the-money call against your shares, you:
a) Can only make the risk-free rate as a maximum return
b) Are guaranteed to make money on the position
c) Cannot make money on this position
d) Can make money as long as a time premium is present

17) In the long run, covered calls must be:
a) More risky due to the added risk of the short call
b) More risky due to the downside risk of the stock
c) More conservative and therefore have lower returns
d) More conservative and therefore have higher returns

18) Buy-writes are orders that are used primarily to:
a) Increase execution risk
b) Eliminate execution risk
c) Increase your cost basis
d) Increase the breakeven point

19) You purchased 100 shares of XYZ for $50 and sold a one-month $50 call for $2. The stock is $53 at expiration and you are assigned on the call. What is your ANNUALIZED rate of return?
a) 30%
b) 40%
c) 50%
d) 60%

20) What is the rationale for the covered call strategy?
a) To make lower returns by increasing risk
b) To make higher returns by lowering risk
c) To make higher returns by increasing risk
d) To make more consistent returns and allow compounding to work for you

Feb

8

Options 101 Part 86

Filed Under Option Trading Articles | Leave a Comment 

In the Long Run, Covered Calls Are Less Risky

There are some studies that have shown where covered calls have produced superior returns to the market while reducing downside risk, which seems to go against the premise of the risk-reward tradeoff. But these studies are considering shorter time periods when the markets are relatively flat and, in these times, covered calls will outperform the market. But it’s a myth that they will always outperform the market while reducing your risk, which is what these studies lead many to believe. They are not taking into account the “homeruns” that stocks sometimes hit during good markets, and covered call writers will not participate in these to the same degree as long stock holders. In the long run, covered call writing is more conservative than owning stocks. As stated before, this doesn’t mean that there won’t be situations where the covered call writer outperforms the long stock holder. We just mean that you cannot consistently reduce your risk and increase your returns over time.

Despite this fact, covered call writing can be a very lucrative and rewarding strategy. In fact, in 2002, the CBOE created a buy-write index (BXM), which shows how a portfolio of covered calls would have performed over a given time period by writing slightly out-of-the-money calls against the S&P 500 Index. At certain times, the BXM can boast some pretty impressive results. Covered calls are also a good strategy that can be combined with other strategies; they do not need to be used as an independent strategy.

For example, rather than buying shares of stock, you could start by selling naked puts as a way to acquire the stock. Remember, if you sell a put, you create the potential obligation to buy stock. Selling naked puts is not a strategy that we will cover, but we’re just trying to make the point of how option strategies can be used in conjunction with one another. Continuing, once the stock is acquired, you could then write calls as a way to sell the stock. By adding the additional step of selling puts, the investor acquires at least two option premiums – one to buy the stock and one to sell the stock. He may acquire more if he’s able to write additional puts to acquire the stock and additional calls to sell the stock.

So while covered calls may be presented as a basic strategy, don’t think that experienced investors do not use them. They can be very powerful when combined in the right ways for specific situations. As with any strategy, there are many ways to fine-tune them to suit your needs. The important thing is that you understand the basics. Once you do, you’ll find that covered calls may not be so basic after all.

Feb

5

Options 101 Part 85

Filed Under Option Trading Articles | Leave a Comment 


Buy-Writes
There is a special order that allows traders to enter into a covered call as a “package deal” to the market maker, which is called a buy-write. With a buy-write, you can send an order to “buy” the stock and simultaneously “write” (sell) the call, which can be executed “at market” or as a “limit order.” Regardless of how the order is placed, any executed order results in a net debit (because the stock must always be more valuable than the call). Since you’re giving the market maker two trades rather than one, you will generally get a little better price for the package deal and every little bit helps.

Are Net Debits Confusing?
Sometimes new traders have trouble with the concept of net debits but it’s very similar in concept as when you negotiate with a car dealer to trade in a used car for a new one. If the dealer is asking $30,000 for a new car and you would like to receive $10,000 for your used car then there is a $20,000 difference between the two prices. You may, for example, try to make a deal by telling the dealer that you want to buy the new car by trading in your used car plus $18,000 cash. In other words, you’re telling the dealer you want to buy one asset and sell another for a net payment or “net debit” of $18,000. It’s should be of no concern to you if the dealer says he cannot sell the new car below $30,000 but is willing to give you $12,000 for your trade-in since that is still a net payment of $18,000 to you. Car dealers often work with the differences between the two cars.

This is exactly the idea behind the net debit with buy-writes. When you enter a buy-write, you’re telling the market maker that you don’t care what price they charge you for the stock or what price you receive for your calls as long as it is executed for a price less than or equal to your net debit limit.

The simultaneous execution of both positions eliminates execution risk, which is the result of adverse price movements. For example, assume the stock is $50 and you wish to buy the stock and then sell a $50 call, which is trading for $3. Notice that this means you are expecting to end up with a net debit of $47 for the two trades. However, if you place an order to buy the stock at market, you may get filled at a little higher price than $50, say $50.25. Then you immediately place the order to sell the $50 call and the stock’s price suddenly drops, which makes the call price $2.90. Because of the adverse price fluctuations, you paid more for the stock and received less for the call and end up with a net debit of -$50.25 + $2.90 = 47.35 instead of the expected $47. If you enter the two trades as a buy-write, you will not face this adverse movement. If the stock’s price suddenly jumps higher while the order is being executed, you’ll pay more for the stock but will also get more for the call. If the stock price drops lower during execution, you’ll get less for the call but also pay less for the stock. The result is that the net debit should stay pretty close to the same and not leave you with any unwanted surprise fills.

Incidentally, there is a mirror-image trade that allows the investor to simultaneously get out of a covered call, which is called an unwind. If you unwind a covered call, you will sell your stock and simultaneously buy back the call option. As before, the reason for doing both transactions simultaneously is to prevent execution risk. Most brokerage firms that offer buy-write screens also have unwind screens available online. If you are an avid covered call writer, you should strongly consider using the buy-write and unwind transaction screens if you are buying the shares at the same time you are writing the calls.

We said last blog entry that investors can write calls against shares they have been holding in the account. This is usually called overwriting and generally leads to a conservative use of covered calls since the investor is obviously willing to assume the downside risk. The buy-write, however, is typically used as a one-time strategy for the sole purpose of writing the call, which is a speculative use of covered calls. The buy-writer’s philosophy is usually (not always) to find a high option premium and then buy the stock and simultaneously write the call. After all, why would he need to buy the stock at that same moment? The answer is that he usually wishes to capture a premium-rich option and must buy the stock to cover the upside risk. Entering the orders together as a buy-write gives these investors a little added edge.

While buy-writes are generally speculative, they do not have to be. Some investors, as we discussed previously, may be perfectly comfortable holding a certain stock but wish to write in-the-money calls to provide for a bigger downside hedge. These investors often do end up getting assigned and losing the shares. Buy-writes can be a cost-efficient way to continually enter into new trades.

Regardless of whether or not you are comfortable assuming the downside risk, the buy-write can add a little edge for those times when you wish to buy the stock and write the call in the same transaction. You may wish to check with your broker to see if they offer a “buy-write” screen and get in the habit of using it whenever you wish to enter the two trades simultaneously. If you are entering buy-writes, just be certain that you have properly identified your reason for buying the stock. If it is purely for the ability to write the call, then understand that it is a speculative investment and adjust the size of your trade accordingly.

Roll-Outs
We learned earlier that it doesn’t really matter if the stock price rises above the strike of the short call at expiration since this is the maximum gain portion of the profit and loss curve. While it may not be the ideal situation, it is not a losing situation by any means. When this happens, most investors feel they only have two choices. First, they can let their shares get called away. Second, they can buy back the call and end up with an unrealized gain in the stock. However, there is a third and often overlooked strategy available, which is called a roll-out.

Assume that AGIX is $21 at expiration and the October $20 call that you sold is trading for $1 intrinsic value and November $20 call is trading for $3. You could buy back the October $20 call and simultaneously sell the November $20 call for a net credit of $2. In other words, you have rolled out to the following month. Effectively you sold another $20 call for $2, which again lowers the cost basis of your stock by the same amount.

Of course, you could choose to sell other strikes as well. If, instead, you sold the November $25 call you would be rolling out and up (rolling out in time and up in strikes). This strategy is used when the stock makes a significant upward move. For example, assume AGIX is trading for $25 at October expiration and the $20 call you sold is trading for the $5 intrinsic value. Further assume that the November $25 call is trading for $3. You could buy back the October $20 call and sell the November $25 call for a net debit of $2. Effectively, you have paid $2 for the chance to make an additional $3 (the difference in strikes less the $2 paid) if AGIX is above $25 at expiration.

In our example, you had a cost basis of $14.41 on the stock. If you buy back the $20 call and sell the $25 call then your cost basis increases by $2 to $16.41. You could make a maximum of $25 for a net gain of $8.59, which is $3 more than your previous gain. Rolling out or rolling up trades are collectively known as rolling trades and they allow investors to make another investment based on the same shares that are already in the account. If you don’t want to let go of your shares, you can always execute a rolling trade. The important point is that you make your decision based on sound objectives rather than rolling up just because you don’t want to see your stock taken away.

Roll-Downs
A roll-down is the reverse of a roll-up. With roll-downs, the investor buys back the existing strike but sells a lower strike call against the shares. Investors are often forced to do this when the stock price falls since the higher strike price may be trading for too low of a price to make it worthwhile. For example, assume AGIX is trading for $15 at expiration. The October $20 call you sold is close to worthless, but you may find that the November $20 isn’t commanding much of a premium either. You could execute a simultaneous order to buy back the October $20 call and sell the November $15 call.

The problem with writing the $15 call is that it reduces the potential sales price of the stock. By selling the $15 calls, you have the potential obligation to sell your shares for $15, which means the potential sales price is reduced by five dollars. You will always reduce your potential selling price when you roll down. For example, assume you can buy back the October $20 call and sell the November $15 call for a net credit of $2. Your cost basis on the stock is reduced from $14.41 to $12.41 but now you have the potential obligation to sell your shares for $15. In this case, the roll-down worked out okay but, depending on the cost basis of the stock you could lock yourself into a potential loss if assigned. For instance, if your cost basis on the stock was $18 and you rolled down for a net credit of $2 then your cost basis is $16 but you may have to sell the shares for $15.

Remember that the covered call strategy is a neutral to slightly bullish strategy. If the stock price is falling then you may be in the wrong trade and it’s usually not the best idea to try to “write” your way out of the loss by selling lower strike calls. In most cases, you just end up digging a deeper hole. But depending on your cost basis it can be a viable trade, so it’s worth understanding.

To be continued……

Feb

4

Options 101 Part 84

Filed Under Option Trading Articles | Leave a Comment 

Hedging with Covered Calls
Many investors are attracted to covered calls because of the immediate cash that can be generated into the account. Because of this, they tend to write the “full amount” of contracts against their shares. For example, if they own 500 shares, they will write five contracts. While this does maximize the amount of cash generated for any given strike (and create the largest downside hedge), it does have its drawbacks. That is, if the stock makes a sudden move upwards, then your gains are capped and the covered call writer often has regrets about having written the calls in the first place. One way to combat this potential regret is to not write the full amount of contracts against your shares. For example, if you own 500 shares, you may consider writing something less than five contracts – anything from one to four contracts. While you will not bring in as much money, you will keep some of the upside open in the event the stock does spike up. By writing less than five contracts, you are hedging your bet between writing no calls and writing the full amount. It’s just something to consider, especially in cases where you believe there is potential for the stock to break out of a range and continue higher. It’s very tempting to want to write calls but it may come with large regrets later. Hedging the position by writing fewer calls can be a simple solution. How does this affect the position? Take a look at Figure 7-6. The shaded line is the profit and loss curve for an investor who buys 300 shares of AGIX and writes three of the $20 calls for $4.40. The bold line is the curve for the investor who buys 300 shares but only writes two of the $20 calls for $4.40:

Notice that the profit and loss diagram for the bold line does not flatten out after the $20 stock price. The reason is that this investor purchased 300 shares but only wrote two calls so he is only obligated to sell 200 of those shares. This investor will always have 100 shares free and clear to participate in upside gains above $20.

The tradeoff between writing two calls instead of three is that you don’t get as much of a downside hedge since you receive less money. Figure 7-6 shows that the bold line doesn’t have as much downside protection. It is therefore riskier and that’s why it comes with a bigger reward.

This is a good example showing once again that all option strategies are about tradeoffs. Any time you buy or sell an option to create some type of advantage there must be a negative aspect somewhere. Do not enter into any strategy until you clearly understand what the benefits and drawbacks are. It is impossible to find a strategy that only offers benefits. It is also impossible to find a strategy that beats all other strategy for all stock prices. It is up to the investor to decide which benefits are worth having in exchange for the drawbacks.

Will I Get Assigned Early?
If you write a covered call, don’t expect to get assigned or “called out” early even if the stock’s price is well above the strike price. In Chapter Four, we showed that it is never optimal to exercise a call option early with the exception of collecting a dividend. With a covered call, you have a short call position; another trader somewhere has the long side of that trade. If it is not in his best interest to exercise that call early then you shouldn’t expect to get assigned early.

Now that you have a better understanding of covered calls, we can revisit that topic and gain a new appreciation why it is not in the best interest of the long call holder to exercise early. Assume that you buy stock for $100 and write a one-year, $100 call for $10. That means that the most you could make from this trade is $10 if the stock’s price is above $100 in one year, which would net you a 10% gain (actually, your gain would be higher than 10% since you’re collecting the $10 up front but we’re just trying to make the example simple to follow). But if you hold the position for less than a year, your gains are magnified. For example, if you are assigned after six months, then your annualized rate of return jumps to 20%. If you are assigned after three months, your annualized return is 40% and so on. This shows that the shorter time frame you hold the covered call, the better off you are since you were paid $10 to hold the stock for a full year but ended up holding it for less time. The better off you are then the worse off is the long call holder. Since the long call holder controls the right to buy stock (he controls the exercise instructions), he will not exercise early. This shows that you should not enter into a covered call with the intent of being called out early. Also remember that it is not your decision as to when to end the contract; that’s up to the long call holder.

As an example, I remember a client who once wrote covered calls with nearly a year until expiration. He collected a healthy premium but the stock quickly rose above the strike price, which means his account wasn’t reflecting any of the daily gains in the stock. He called in one day and said, “I think I’d like to be called out on this stock now.” After I explained that it was only the long position that could submit exercise instructions, he then realized the tradeoff of writing longer-term calls. While he did get a much higher premium for writing a longer-term contract, his money was tied up in the stock for that year. The investor could buy the calls back but then that cuts into the anticipated gains. So if you are writing longer-term contracts, you should not expect to get assigned until expiration. Also, you should not expect to get assigned even if a dividend is about to be paid. The reason is that upon exercising a call, the long position sacrifices the call (he cannot sell it) so he loses all of the time value in the call. If you are writing longer-term calls, the value of the time premium is probably far greater than the dividend.

However, anything is possible in the markets. We have seen people get assigned (called out) early on covered call positions. If this happens it is only an advantage to the call writer. Remember, if you get assigned early you just receive your money earlier rather than later. It’s a huge advantage to you. But again, this is why you shouldn’t expect it to happen.

How Will I Know If I’m Assigned (Called Out of a stock)?
If you are ever assigned on a call, you will be notified by your broker the following business day.

But be careful at expiration and do not assume that you will not be assigned just because the stock closed below the strike price on Friday. The reason is that many brokers allow you to exercise the call after the closing bell. It is possible that after-hours news could propel the stock to new higher prices and you could get the assignment notice on Monday.

Using our AGIX example, assume you have purchased 100 shares and sold one $20 call. It is now expiration day and the stock is trading below the $20 strike, say $19. Because its price is below the strike, you decide to not pay the commission to close the call and just let it expire worthless. However, after the close, a news story hits stating that the company will be bought out at $30 per share. Upon hearing this news, the long call holders who thought their $20 calls expired worthless could potentially make $10 just by exercising the call. All they have to do is call their broker and exercise the call option.

They will pay $20 but receive stock worth $30, which they can immediately sell for a $10 gain rather than the 100% loss they took by letting the option expire. Even if the call owners are afraid the stock might fall on Monday, they could short shares in the after-hours market for $30 per share and then cover it for $20 by exercising the option. That’s the risk-free route. The point is that there will be big demands to exercise the call and you can bet that assignment notices are likely to follow on Monday. If you do not have an assignment notice on Monday morning following expiration (assuming that’s not a holiday), you can be sure that you were not assigned on the call.

To be continued…..

Feb

3

Options 101 Part 83

Filed Under Option Trading Articles | Leave a Comment 


Covered Call Trap
At the beginning of this chapter, we said that covered calls can contain an unforeseen risk, and we’re now ready to show how investors unknowingly can take step right into a trap if they believe that all covered call positions are conservative.

Because most investors do not realize the downside risk inherent with covered calls, they unknowingly choose their covered call trades based on the volatility of the underlying stock. An investor new to the covered call strategy may hear that covered calls are conservative and, when searching for investment ideas, will end up choosing the call options that have the highest premiums. After all, if all covered calls are conservative, he feels he might as well choose the call option that brings in the highest premium. However, if you choose the call options with the highest premiums, you have automatically chosen the riskiest stocks since it is the higher-volatility (risky) stocks that command higher option premiums. The investor ends up holding onto a highly volatile stock that he otherwise would not be comfortable holding. These call writers are often called “premium seekers” since they seek out the options with the highest premiums and then they buy the stock for the sole reason of writing the calls. This is a high-risk way to use covered calls that can lead to disastrous results.

For example, assume that you are comfortable holding stocks in your IRA (Individual Retirement Account) such as Conservative Consolidated Company but not comfortable with highly-volatile stocks such as Gargantuan Growth Company. If you are new to options and decide to write calls, you would find that the premiums for Conservative Consolidated are not nearly as large as they are for Gargantuan Growth. The reason is simply that Gargantuan Growth is far more volatile. And when stocks are more volatile, option traders are willing to pay more for the options so that they don’t have to hold the stock. When you decide on which stock to buy in order to write calls, you may see a one-month, at-the-money call on Conservative Consolidated trading for 50 cents while an at-the-money call on Gargantuan Growth may be $5.

When faced with these prices, you may think that it doesn’t make sense to buy 100 shares of Conservative Consolidated and only receive $50 from the sale of the call when you can buy 100 shares of Gargantuan Growth and receive $500. So you decide to buy 100 of Gargantuan Growth and write the call to gain the $500. But look what just happened. You ended up with the stock that you weren’t comfortable holding. It was the high option premiums that lured you into buying the stock. That’s what happens when you let option premiums dictate which stocks to buy. Investors who base their covered call decisions on option prices end up taking far more risk than they intend and end up holding a risky asset that could fall substantially.

Example:
Around 1998, I remember one investor who bought 7,000 shares of Egghead Software (EGGS) at $53 during the “dot-com” craze. (To make matters worse, he bought the shares on margin or borrowed funds.) He thought he was laughing all the way to the bank when he discovered that a three-week option was bidding $8 for a $55 stock. “Wow, that is over 15-fold on your money” he exclaimed. “At that rate, it would take less than two and a half years to turn $1,000 into $1,000,000.”

The trader bought the shares and wrote the calls waiting patiently for his windfall to arrive. At option expiration, the stock was trading at $4. Yes, he did get to keep the entire $8 premium for the calls. I will let you decide if it was worth it.

This trader was correct in realizing that the $8 premium was tremendously high. But there was a reason the markets were bidding up the call options so high. They wanted someone else to hold the risky stock. The risk of a covered call is that the stock falls.

Notice how it’s possible for two investors to be using covered calls and yet be on nearly opposite ends of the risk spectrum. Options are risky only if used improperly. Don’t be misled into thinking that all covered call positions are conservative no matter how convincing the argument may sound. If any broker tells you that the risk of a covered call is that you miss out on upside gains then ask him why the strategy is called “covered.” He will immediately tell that it’s because you’re not at risk if the stock rises since you already own the stock. That’s the correct answer but it presents a dilemma since he also believes that you’re at risk if it does rise. The reason that people make this mistake is because they are confusing “risk” with “missed opportunity.” Once again, risk is never defined as missing out on some reward (missed opportunity). People who forget the simple risk-and-reward relationship are easily led to believe that the risk of a covered call is that they miss out on the upside gains and are inevitably led to writing calls on the riskiest stocks they can find. If the “risk” is that you may miss out on some upside gains, you might as well collect the biggest premium you can! These investors usually learn the hard way that there is a big difference between risk and missed opportunity.

The very best tip we can give you for writing calls in a conservative way is to be sure you’re buying stock that you wouldn’t mind holding anyway even if options were not available. That way, it shows you’re willing to assume the downside risk and the sale of the call does not change the risk. It simply provides a downside hedge. Don’t let the tail wag the dog by purchasing stocks based on the prices of the options. Of course, it doesn’t mean that it’s wrong to write covered calls because of the high premiums; it just means that it changes the nature of the strategy from conservative to speculative. The point to remember is that all covered calls are not equal. Just because you’ve written a covered call does not make it a conservative strategy. It is your reason for doing it that dictates the risk in the strategy.

Synthetic Positions
We can use put-call parity to show us added insights into any strategy so let’s see what it has to say about the covered call strategy. Let’s start with the basic equation found in Chapter Five (Formula 5-15):

S + P – C = 0

Now let’s solve it for a covered call. We know that a covered call is the combination of long stock plus a short call, so we need to get those two assets on one side of the equation. We can see that they are already on the left side, so let’s just move the long put to the right side and change its sign in the process:

S – C = -P

This equation tells us that the combination of long stock and a short call (left side) is equal to a short put (right side). Any broker will tell you that short puts are one of the riskiest strategies available. Brokerage firms will require your account to have the highest option approval rating along with significant equity before they will allow you to write naked puts. At the same time, they will tell you that the covered call is conservative in nature. Both statements cannot be correct. It depends on how they are used. If you want to use them in conservative ways, make sure you are buying stock you don’t mind holding.

Another way to verify if a particular covered call is suitable for you is to ask yourself if you would be comfortable selling naked puts at that time. If the answer is no, then you should not be using a covered call because it is exactly the same thing packaged a little differently.

To be continued….

Feb

2

Options 101 Part 82

Filed Under Option Trading Articles | Leave a Comment 


Writing In-the-Money Calls
New investors often wonder how it is possible to profit by purchasing a stock for one price and giving someone else the right to buy it for less money. The answer is there is a time premium associated for that right that more than makes up for this loss. We know this from Pricing Principle #4 in Chapter Two which showed us that all call options must be worth their intrinsic value plus some time premium. If you sell an in-the-money call, you receive more money than the intrinsic value you’re sacrificing.

For example, using Table 7-1, you could buy AGIX for $18.81 and sell the $15 call for $6.20. Notice that you are taking a loss on $18.81 – $15 = $3.31 worth of intrinsic value but are paid $6.20, which more than covers the loss.

Pricing Principle #1 showed us that lower strike calls are more expensive. Therefore, writing in-the-money calls against your shares provides a bigger cushion if the stock price should fall. Even though in-the-money calls are more expensive overall, they carry a smaller time premium and it’s the time premium that reduces the cost basis of the stock. This is why writing in-the-money calls increases the downside hedge (they are more expensive) but provides lower returns (there is not as much time premium as an at-the-money call). In other words, investors who write in-the-money calls are taking less risk and will therefore get lower returns.

Buying the stock for $18.81 and selling the call for $6.20 gives you a cost basis of $18.81 – $6.20 = $12.61 and gives you the potential obligation to sell your shares for $15 call, which represents a 12.6% return.

Figure 7-4 compares the profit and loss diagrams for selling the $20 call (bold line) verses the $15 call (shaded line). You can see that the $20 call provides for a higher return but the $15 call provides better downside protection. Selling the $20 call carries more risk and more reward than sale of the $15 call:

If there were lower strikes available for AGIX, we would find that the returns would eventually converge on the risk-free rate. Notice this is consistent with our observations about time premium in Chapter One where we said that lower strike calls will have very relatively small amounts of time premium in them and it’s the time premium that creates the returns for the covered call strategy. Now that you understand the covered call strategy, you have another way of understanding why time premiums shrink as you move deeper in-the-money. If you write calls that are so far in-the-money then the shares will be nearly guaranteed to be called away and, as with any guaranteed investment, you will only receive the risk-free rate of return.

For example, assume a stock is trading for $100 and that a one-year $20 strike exists. Interest rates are 5%. How much should the $20 call be trading for? In this case, if you buy the stock for $100 and write the $20 call, the market would probably view this as being a nearly guaranteed sale for $20 in one year. If you are “guaranteed” to receive $20 in one year, then it is worth $20/1.05 = $19.05 today, which means there is a cost of carry of $20 – $19.05 = 95 cents. We know the call must also be trading for the intrinsic value so it should be worth $80.95. You can verify this by using a Black-Scholes Model with a volatility of 50% or lower so that our assumption of “nearly guaranteed” is valid. You’ll find the $20 call is worth $80.95. As a call writer, you’d only receive the cost-of-carry for this trade since you’re not taking that much risk in the eyes of the market. If you increase the volatility to something higher than 50%, you’ll find the time premium starts to increase showing these higher volatility levels are casting some doubt as to whether that option seller is guaranteed to receive $20 in one year.

Which Expiration Should I Write?
As with strike prices, there will be several expiration months from which to choose. All things being equal, you’re better off writing the shorter-term contracts for a couple of reasons. First, shorter-term contracts are exposed to a much more rapid pace of time decay. This means their value diminishes quickly, which is what you want to happen as the writer. A second reason is that short-term options are more expensive per unit of time, which we learned from Pricing Principle #5 in Chapter Two.

But this does not mean there’s no benefit in writing longer-term options. Longer-term options do provide more money and therefore provide a larger hedge if the stock should move against you. As we have shown, the risk of a covered call is that the stock falls and, by bringing in higher premiums, longer-term options help to hedge against this risk. Also, what if it takes a while for a fallen stock’s price to recover? During the recovery time, you may not be able to write the strike prices you had hoped and may end up not able to write any calls until the stock recovers (if at all). By writing longer-term options, this risk is mitigated.

Every option strategy in the world is a unique tradeoff between risk and reward, so it’s not correct to say you should only write short-term options. We’re just saying all things being equal you’re better off writing shorter-term calls. And having the stock price remain the same month after month is one of the assumptions in the phrase “all things being equal.” If the stock price is very volatile, you may consider writing a longer-term option against it to further hedge the downside risk. When people tell you to only write the short-term options, they are implicitly assuming the stock price will remain fairly constant and they will be able to write calls month after month. If that turns out to be false, then writing a longer-term option may end up being the better strategy. So when deciding which month or strike to write, just be sure to take all risks and rewards into account and make sure they are in line with your outlook on the stock.

Regardless of which month or strike you choose to write, most covered call writers wait for the time value to get near zero, which will be close to expiration, and then write another call at that time. The idea is to continually collect premiums over time. The covered call strategy is usually not used as a “one-time” strategy although it certainly could be used in that way or for shorter-term applications. But for the most part, the strategy is designed to be a long-term, systematic way to continually collect premiums and reduce the cost basis of your shares and enhance returns.

Covered Call Rationale
Now that you understand the profit and loss profile of the covered call, we can answer one of the most frequently asked questions about the strategy. Many investors wonder why anybody would write a covered call since it limits your upside potential. They reason that it doesn’t make much sense to take in a couple of bucks up front in exchange for limited upside gains and therefore, it must be a bad strategy.

But let’s take a little different view by considering the fact that for any stock price, there is a range of possible stock prices that fall into a bell curve pattern. So while “unlimited” upside gains are a possibility, they do not come with equal probability. Each successive higher stock price is less likely than the previous price. Figure 7-5 compares a long stock position in AGIX (shaded straight line) to the long stock + short $20 call position (bold line). We have also overlaid a bell curve at the current stock price of $18.81 to simulate the possible range of stock prices at expiration:

Now we see a different picture. If the range of probable (not possible) prices falls under the bell curve, notice that the covered call beats the long stock position for the majority of the ranges under the curve. In other words, the bold line lies above the shaded line for nearly all stock prices under the curve. This means that over time, the covered call will provide more stable returns and will provide higher returns most of the time. However, this does not mean that the covered call strategy produces higher returns for less risk. The covered call writer attempts to keep a steady increase in the returns while allowing the compounding of those returns to work to his advantage.

While it may be the winning strategy for some stocks (or for some periods of time) it cannot always be the higher return strategy for the market overall. The reason is that you will miss out on occasional homeruns by continuously staying in the covered call. Notice though, that these “homeruns” occur well outside of the bell curve, which means these homeruns are more like lottery tickets and that you shouldn’t invest with the expectation of those returns. Covered call writers are looking for steady gains month after month. And when it comes to investing, slow and steady can produce remarkable returns especially when you consider the compounding effects over time. It is often the strategy that wins the race and is one of the strongest motivations for using covered calls.

To be continued….

Feb

1

Options 101 Part 81

Filed Under Option Trading Articles | Leave a Comment 


Which Strike Should I Write?
One of the first questions new traders have is which strike they should write. There really is no correct answer although, upon reflection, some strikes will certainly sound better to you than others. If you remember the covered call is a premium collection strategy it makes sense to sell an option that is rich in time premium; hopefully you remember that is the at-the-money strike. It would also make sense to sell a relatively short-term option, say 30 days to expiration or so since these options are hit hardest by time decay. By selling a short-term, at-the-money option, you have a mathematical advantage by bringing in a relatively large premium that will quickly lose its value, which is good for you as the covered call writer.

However, different investors have different objectives and every strategy comes with a unique set of risks and rewards so we can’t really say that selling the at-the-money option is “the best.” It’s just that it has a lot of nice characteristics but there are always tradeoffs.

Which strike to write boils down to different philosophies of why you’re writing the calls in the first place. Because options are classified as out-of-the-money, at-the-money, and in-the-money then those are the different scenarios we can create with covered calls. Each comes with its own philosophy and sets of risks and rewards so let’s look at each in detail.

Writing Out-of-the-Money Calls
One of the most common approaches is to write calls against your long stock position but with the intent of never losing the shares. These investors usually write short-term, out-of-the-money (higher strike) calls. Investors who write out-of-the-money calls are really hoping the stock will rise to the strike price (or very close) but still leave the call out-of-the-money at expiration. In the AGIX example presented earlier, we assumed the investor wrote the $20 call for $4.40. This investor would ideally want the stock to rise to $20. If the stock’s price does not exceed $20 at expiration, there is no reason for the long call holder to exercise the call since they could just pay $20 in the open market. The $20 call expires worthless but the covered call writer enjoys the price appreciation of the shares plus the premium received from the sale of the call yet is never forced to sell the shares. Avid covered call writers with this philosophy hope this situation happens time after time so they can write new calls when the current call expires while continuing to hang on to the shares. The sale of many call options can greatly enhance the returns that you may otherwise receive from holding onto the shares alone. In fact, if you successfully write calls month after month, you may even write your shares into a negative cost basis.

For example, assume an investor buys the stock at $18.81 and writes the $20 call for $4.40. Let’s assume the stock rises during this time very close to $20 at expiration. Because the stock price doesn’t exceed $20, the call will expire worthless and the investor keeps his shares and can write another call the following month. With the stock near $20, perhaps the investor will write a one-month, $22.50 call. The price received obviously depends on the price the market is placing on that call at the time. But let’s say it is trading for $4. If the investor writes this call, the cost basis for the stock falls by another $4 to $14.41 – $4 = $10.41. The investor then hopes the stock will rise but close near $22.50 at expiration. At that time, the investor may write a $25 strike for $4 thus making his cost basis $6.41 and so on. Of course, hoping a stock will behave this well for sustained periods is an unrealistic expectation but the covered call strategy will still work even under less favorable assumptions. We’re just saying this is the ideal situation for those investors who choose to write out-of-the-money calls.

The covered call strategy would also work with the stock price remaining the same. In the previous example, we had written the cost basis down to $6.41 with the stock price near $22.50 at expiration. Obviously, there’s nothing wrong with this cost basis if the stock’s price had remained at $18.81.

Investors who never want to lose their shares tend to write out-of-the-money call options. They are willing to take a small chance for the stock’s price to exceed the strike in exchange for collecting monthly premiums.

The problem with the philosophy of writing covered calls with the intent of never losing the stock is that you are really acting like a “naked” call writer even though you also happen to own the underlying stock. A naked call writer, as we said earlier, is one who writes calls but does not own the underlying shares. This is a high-risk strategy since there is no limit as to how high the shares may be trading if you are forced to deliver them. Naked call writers definitely do not want the stock to rise. If you are writing call options against your stock but do not want to lose the shares, then you are acting like a naked call writer. Because of this, you will tend to write short-term, out-of-the-money calls to reduce the chance you’ll lose your shares. But when you write short-term, out-of-the-money calls, you will usually not bring in much premium either (since higher strike calls are cheaper), but you still have the potential obligation to sell your stock.

Because there’s not much time premium involved, you will not have a lot of downside protection either. Writing out-of-the-money calls can yield very high returns but most of those returns are due to stock price movement and not from the sale of the option. So for many investors, writing out-of-the-money calls doesn’t make a lot of sense no matter how small the chance of getting assigned (“called out”) may seem.

Writing At-the-Money Calls
If there were such a thing as a textbook definition of a covered call, it would probably be defined as one where the investor writes the front month, at-the-money call. Remember, the idea behind the covered call is to collect a relatively large premium from an option that will quickly decay in value. The strike that carries the most time value and sharpest decay is the at-the-money strike. Investors who write at-the-money calls collect the highest amount of time premium and also create a lower cost basis on the stock, which provides a little bigger downside hedge.

Investors who write at-the-money calls will not have the room for capital appreciation like out-of-the-money call writers. However, at-the-money calls provide a little more downside protection so they are less risky.

Risk of Covered Calls
As Figure 6-2 showed, the covered call writer is exposed to all of the downside risk of the stock (less the premium received from the option). The one thing you don’t want to have happen as a covered call writer is for the stock’s price to fall below the cost basis. This also corresponds to why we said that covered call writers should have a neutral to slightly bullish outlook. You do not want to write a call if you think the stock is going to crash. However, many new investors believe that you should write calls against stocks that you think are about to fall. You must remember when combining assets in a portfolio (such as shares of stock plus short calls) that it is the overall behavior of all assets that counts. When new investors learn about options, they learn that selling a call is bearish so they immediately infer that the covered call strategy is bearish since they are selling a call. But this ignores the fact that the covered call writer is also long the stock. In Chapter Two, Pricing Principle #5 showed us that the maximum price for a call option is the price of the stock. This shows that the call option will always be worth less than the stock. So if you own the shares and write the calls, you are holding an asset (stock) that is far more valuable than the calls. The last thing you want is for the price of that asset to drop significantly even if that action may be beneficial for the lesser-valued option.

Obvious as this may seem, there are many “professional” brokers of financial planners who will emphatically tell you that the risk of the covered call is that you give up potential price appreciation. In fact, here are three samples found on three different financial sites on the Internet:

• Since the short call is covered by the portfolio, this strategy has no downside risk. The only upside risk is that you give up the price appreciation above the strike price of the call; however, the call premium paid at the outset may compensate for this risk.

• While the covered call writer has no risk of losing huge amounts of money, there is an attendant risk of missing out on large gains. This is pretty simple: if a stock has a large run-up in price, and calls are nearing expiration with a strike price that is even slightly in the money, those calls will be exercised before they expire, i.e., the covered call writer will be forced to deliver shares (known as having the shares “called away”).

• Writing covered calls (i.e., call options over stock that you own) is perhaps the safest of all options strategies and possesses minimal risk. The aim is to generate income through premiums with the potential to collect capital gains as well, should the share price remain below the exercise price.

You can see that the suggestion or tone of many “professionals” is that covered calls are essentially risk-free. In fact, the first and second examples state that the risk is that you miss out on large gains. As we said before, the risk of any financial asset is never defined as missing out on some reward, and you must question the judgment of anyone who tells you that it is. If that were true, then the risk of buying Microsoft at $30 is that you might sell it later for $35 only to see it trading higher. Missing out on potential gains is always a regrettable possibility with any asset – but it is not the risk. To combat the downside risk of the covered call, many investors write in-the-money calls and there are many benefits to considering this often-overlooked variation.

The risk of the covered call is that the stock price falls. The risk is not getting assigned on the short call and selling below market price. That is a missed opportunity and risk is never defined as missing out on some reward.

Jan

29

Options 101 # 80

Filed Under Option Trading Articles | Leave a Comment 


Breakeven Return
Another calculation we’d like to check is the break-even return. This just tells us how far the stock can fall before we’d break even. In this example, the stock could fall by the amount of premium received from selling the call, which is $4.40. The $4.40 cash collected acts as a downside hedge in the event the stock falls. If the stock falls $4.40, that represents a drop of $4.40/$18.81 = 0.23, or 23%. Or if you prefer the second method of calculating the return, the ending price would be $18.81 – $4.40 = $14.41. If we divide the ending value by the beginning value and then subtract one we get $14.41/$18.81 = 0.7661. After subtracting one, we find the answer is -0.23, which is a 23% drop.

In other words, if the stock is $14.41 at expiration we will just break even on the trade since we effectively paid $14.41 for the stock. Remember, with the stock at $14.41, the $20 call will be worthless so there is no cost for us to get out of the contract. Any stock price below $14.41 at expiration will lead to a loss in the position. This calculation shows that we can afford for the stock’s price to fall 23% before the position heads into losing territory. Figure 7-2 compares a long stock position in AGIX at $18.81 (shaded line) to the covered call (bold line). The arrow shows that the breakeven point is reduced by 23%:

The breakeven calculation gives us an idea about the size of the downside hedge in the strategy. When we say the position is “hedged” that just means you are not losing money for some adverse moves in the stock’s price. If the stock price falls, that loss will be offset by the increase in the short call. The size of the hedge depends on the premium you received from the sale of the call options.

Max Gain, Max Loss
The maximum you can ever make from a covered call position is the amount of premium received from the sale of the call plus any potential capital gains that may be available as shown by the “return if exercised” calculation. Another way of looking at the maximum gain is that it is the difference between the cost basis of the stock and the exercise price. The maximum loss is the amount of the cost basis.

Do I Need to Stay in the Contract Until Expiration?
There is nothing that says you must remain in the covered call position over the next 29 days; you can always get out of the contract at any time by buying back the call option. Once you buy back the contract, the shares of stock are yours, free and clear, with no obligations attached. Of course, there is nothing that says you will be able to buy that call back at a favorable price. Whether you buy back the call at a lower or higher price depends on what has happened to the stock’s price and volatility of the stock during the intervening time. But you can always get out of the contract.

There are many scenarios we can create with buying back the call option since the option’s price can rise or fall all by itself (with no movement in the stock) due to changes in volatility. And if the stock’s price moves then it will definitely have an impact on the option’s price. Regardless of the scenario you choose, the calculation for finding your return is always the same. You simply take the cost basis of the stock and add back the purchase price of the call. Then you compare that figure to the current stock price and see what your return is.

For example, let’s assume the stock’s price stays the same at $18.81 but the value of the call is dropping due to time decay. At a later date, you may, for example, be able to buy back the call for $2, which is a favorable price since you sold the call for $4.40. In this case, your return is the $14.41 cost basis + $2 to buy back the call for a new cost basis of $16.41 on the shares of stock. You are now out of the contract and could sell the stock for the current price of $18.81, which represents a return of $18.81/$16.41 = 1.146, or 14.6%. Again, this shows that investors can make money on a stock whose price is not moving (or fluctuating sideways) over time by using covered calls.

If the stock’s price stays the same or relatively flat then time decay will erode the call’s price and the investor can buy the call back at a cheaper price. The reason this example worked out to be a gain is because the time premium was $4.40 when the call was sold but only $2 when it was purchased back. However, it is possible to profit from a covered call even if you buy the call back at a higher price. As you go through the following examples, notice it’s the net time premiums that determine whether or not the covered call is profitable or not. In other words, if you receive more time premium than you spend you will be profitable; otherwise, you have losses.

Example
Let’s look at an example assuming the stock’s price has moved higher. Assume the stock quickly rises to $20 and the option’s price rises from $4.40 to $6. If you wish to get out of the contract, you can buy back the $20 call for the current $6 market price. By purchasing the call option, you no longer have the potential obligation to sell your shares. Your cost basis is now $14.41 + $6 = $20.41 and you can sell the stock for $20, which represents a slight loss. The reason this scenario ended up with a loss is because of the relationship between the time premium and stock price. The stock’s price rose from $18.81 to $20, which is a $1.19 gain that certainly helps the long stock position. However, the time premium on the option rose from $4.40 to $6, which represents a loss on the call option since you must pay $1.60 more to buy back the call. The net difference is $1.19 gain – $1.60 loss = 41 cents loss. This 41 cents loss is exactly the difference between our $20.41 cost basis and the current market price of $20.

However, just because the stock’s price rises does not necessarily mean you will be left with an overall loss. Assume the value of the call is still $6 as in the previous example but this time it is mostly represented by intrinsic value. For instance, consider what would happen if the stock rose to $25 and the $20 call was $6. Now the $20 call has $5 of intrinsic value and only $1 of time premium. If you buy back the call, your cost basis is $14.41 + $6 = $20.21 and you could sell the stock for $25, which is a 23.7% gain. In this example, you still took a loss on the call since you sold it for $4.40 and bought it back for $6. However, the stock’s price rose substantially so the intrinsic value came back to you when you sold the stock. In other words, the $5 intrinsic value that you paid to buy the option was returned to you since you could now sell the stock for the current price of $25 rather than the $20 strike. You paid $5 to increase your sales price by $5, which is not a loss. It is therefore not enough to only consider whether the call was purchased back for a gain or a loss to determine profitability. The covered call strategy involves two assets – stock plus a short call – and it is the relative performance between the two assets that determines the performance.

To really drive the point, let’s consider a very high call price. Let’s still assume your cost basis is $14.41, the stock is trading for $40 and the $20 call is trading at parity, or $20. Is it a bad idea to buy back the call at a loss? Surprisingly, the answer is that it doesn’t matter from a financial standpoint. Many investors are inclined to believe so and just let their shares go rather than take this “loss.” But if you work through the math, you’ll find there isn’t a financial difference. First, if you choose to do nothing, you will be assigned on the call and receive the $20 strike price, which represents a gain of $5.59.

Now let’s take a look at your second choice, which is to close out the call with $20 intrinsic value. If you sold the call for $4.40 and bought it back for $20 then that is a huge loss for the call. Your cost basis on the stock rises to $14.41 + $20 = $34.41 but you can now sell the stock for $40, which still represents a gain of $5.59, or a return of $40/$34.41 = 1.1625, or 16.25%. Once again, the $20 cost of the option is returned to you since you can now sell the stock for $40 rather than $20. In other words, you spent $20 cash to free up $20 worth of intrinsic value. With this second choice, you are giving up $20 cash for certain in exchange for a $20 unrealized gain in the stock (it’s an unrealized gain until you sell the shares). Either choice nets you a $5.59 gain at that moment in time. The first choice creates a $5.59 gain for sure while the second choice results in an unrealized $5.59 gain. It’s a different set of risks and rewards, too, since you are still holding on to the shares with the second choice. But, financially speaking, there really is no difference between the two choices at that moment in time provided that you are still comfortable holding the stock.

The bottom line is that any intrinsic value in the call option will not hurt your performance if you buy back the call. The reason is that the call option’s price will reflect all intrinsic value (Pricing Principle #3 from Chapter Two) and that value is also reflected in the stock’s price. It’s only when you pay more time value to buy back the call that the amount of time value you received at the time of the sale will hurt the covered call’s performance.

We can show this easily by considering that an in-the-money call option’s value prior to expiration equals the intrinsic value plus some time value, which we can write as (S – E + T). Next, if you buy stock, S, and sell the call then you receive cash and your account has a value of stock + cash (S + C). Your account is therefore long (S + C) and short (S – E + T) since you wrote the in-the-money call. The value of the position today is then:

(S + C) – (S – E + T)
= S + C – S + E – T
= (E + C) – T

This shows the value of that covered call position (assuming the call is in-the-money) is simply the exercise price plus the cash you received from the sale of the call less any time premium you must pay to close out that call. Of course, if you wait until expiration and the call stays in-the-money then the time premium will be zero and the position is worth the exercise price plus the cash. This shows that only increases in the time premium will hurt your position since that is the only negative in the equation. No matter which scenario you construct with the call being at-the-money or in-the-money, we can immediately tell if it is a losing or winning situation by simply looking at the time premium you received versus the time premium you must pay to close out the call. If the scenario you create involves a falling stock price, then all we need to be concerned with is that the stock’s current market price remains above the cost basis.

As a recap, there are only two situations that a covered call can be in. Either the call is in-the-money or it is not in-the-money (which includes at-the-money). If the call is in-the-money we will have a loss if we close out the call by paying more time premium than we received. If the call is out-of-the-money, we will have a loss if our proceeds selling the stock and buying back the call are less than the cost basis.

To be continued…..

Jan

28

Options 101 # 79

Filed Under Option Trading Articles | Leave a Comment 


Assume you buy 100 shares of AGIX for $18.81 and then sell the October $20 call for the current $4.40 bid. By selling the call, you will immediately receive $4.40 *100 = $440 cash in exchange for the potential obligation to sell your shares for the $20 strike price through expiration Friday in October (29 days later). That $440 is yours for assuming the potential obligation to sell your shares of stock for the strike price if the long call holder decides to exercise the call.

The above transactions show up in your account as a long position of 100 shares of AGIX valued at $1,881 and a short $20 call valued at minus $480. New traders often wonder why they see a -$4.80 next to the short $20 call. After all, if they received cash, shouldn’t it be a positive number? The answer is that long positions show up as positive values while short positions show up as negative values. If your account shows that you are long 100 shares valued at $1,881 then that is how much you will receive if you sell those shares (100 shares at $18.81). On the other hand, the short $20 call is valued at -$480 because that is how much you will have to spend right now to buy it back (the current asking price). So where did the $440 cash go? If you look closer at your account, you will find that your money market has been credited with $440 cash. In this example, your account value will not immediately increase by $440. Instead, it will show a slight loss of $40 since you received $440 cash but must pay $480 if you wanted to close out the call right now. As the value of that call drops toward zero, your account will slowly increase by $440 assuming all other factors constant.

Because you collect cash, the cost basis (net cost) of your stock is immediately reduced. In this example, you paid $18.81 for the stock and then immediately received $4.40 cash, which means you effectively paid $18.81 – $4.40 = $14.41 for the stock. We will often make reference to the cost basis of the stock when talking about covered calls since it is an important characteristic of the strategy. Please understand the reason we can subtract the full $4.40 from the $18.81 stock price is because we have assumed you wrote one call against 100 shares of stock; that is, the calls were written in equal proportion to the shares of stock. As we said earlier, it is possible you might decide to write fewer contracts and we’ll find out the reason for that later. If you do write fewer contracts though, you cannot just subtract the option price from the stock price to find your cost basis. For example, if you bought 200 shares of AGIX for $18.81 and then wrote one call for $4.40, your cost basis is not $14.41. In these cases, we must find the weighted average by subtracting the $440 cash from the 200 * $18.81 = $3,762 total cost of the stock, which is $3,322. If we divide $3,322 by the 200 shares, we get $16.61 for the cost basis.

Let’s go back to our example of buying 100 shares of AGIX and selling one $20 call. By selling the $20 call, you are potentially obligated to sell 100 shares of stock for the $20 strike price no matter how high that stock’s price may be at expiration. This means the most you will receive from the sale of your stock over the next 29 days is the $20 strike * 100 shares = $2,000 (the exercise value of the contract).

From a profit and loss standpoint, this AGIX covered call looks like Figure 7-2:

The profit and loss diagram shows that the covered call provides for a limited upside gain. Notice that the “bend” in the profit and loss diagram occurs at the $20 strike. This shows that no matter how high the stock’s price may be at expiration, the most the covered call writer will ever receive is the $20 strike price at expiration. No matter how high the stock’s price may rise, the covered call writer can only gain a limited amount.

The profit and loss diagram also shows that the covered call writer is vulnerable to all of the downside risk in the stock; that is something you cannot forget when writing covered calls. We’ll talk more about this risk later but just realize that the covered call writer has limited upside potential and unlimited downside risk.

If the strategy has limited rewards and unlimited downside risk then why would anybody use it? Remember that all strategies are tradeoffs in risk and reward. The strategy is less risky that the outright ownership of stock yet it can yield some impressive returns. In this example, you have the potential obligation to sell your shares for a fixed price of $20, which is not a bad deal when you consider your cost basis is only $14.41. How good of a deal is it? For this, we need to turn to several performance numbers that will help you determine if a particular covered call will accomplish your goals.

Return If Exercised
One calculation you’ll want to make is called the “return if exercised.” To calculate it, you simply find the percentage increase between the cost basis and the strike price. In this example, you’d have a gain of $20 – $14.41 = $5.59 if assigned on the call. Because you made this $5.59 gain from a principal value of $14.41, this represents a $5.59/$14.41 = 0.39, or 39% return in only 29 days.

Another method for finding the return is to simply divide the ending value by the beginning value and subtract one. Here, the answer would be $20/$14.41 = 1.39. After subtracting one, we’re left with the same answer of 0.39, or 39%. Use whichever method is easiest for you to remember.

If we want to annualize the figure, we just need to find out how many “29-day” groups there are in a year, which is found by 365/29 = 12.6. This tells us that if we were able to replicate this same trade throughout the year we’d have 12.6 trades, so our annualized percentage return at the end of the year would be 12.6 * 39% = 491%. Of course, being able to replicate this trade for about 12 times during the year is an unrealistic assumption but it still allows us to make comparisons with other investments since rates of return are always posted on an annualized basis.

Notice that this rate of return is abnormally high, which should give you a clue to the risk in the position. Remember high rewards come with high risk. Why do you suppose these rates of return are so high? Because the last chapter just showed us the volatility on AGIX was very high and, in order to execute the strategy, you must be willing to own the stock. That stock was very volatile at the time, which means it could rise – or fall – substantially. We’ll look more at the risk in a covered call later but just understand you shouldn’t think this is a “conservative” strategy when you find rates of returns like this. There is a reason the market is willing to pay such high rates of return. That reason is risk.

Static Return
There is another calculation we can do to find out if a particular covered call strategy is appealing. That calculation is called the “static return,” which calculates the return if the stock’s price is unchanged or “static” at expiration. In the “return if exercised” calculation, we allowed for the stock’s price to rise from the current level of $18.81 to the $20 strike in order to calculate the return. For this calculation, we want to see how the strategy would perform if the stock closed at the current price of $18.81 at expiration. We know the cost basis is $14.41 so the static return is $18.81/$14.41 = 1.3053, or 30.5%.

The static return doesn’t assume the stock’s price will remain unchanged throughout the life of the option. Instead, it assumes that it will finish at the same price. Whether this is a realistic assumption or not, it is just meant to give us an idea about the rate of return from the option time premium alone and does not consider movements in the stock’s price. This clearly shows that covered call writers can make money on stocks without any movement in the stock’s price. That is definitely something that cannot be done with stock alone.

To be continued…..

Jan

27

Options 101 Part 78 Chapter Seven Covered Calls

Filed Under Option Trading Articles | Leave a Comment 


Up to this point, we have covered many topics on options and are now ready to put those concepts to use so you can understand and appreciate some basic option strategies. Before we get started though, it’s imperative to reiterate that all strategies are about tradeoffs. Chapter Three showed us by looking at a profit and loss diagrams, we can find the tradeoffs between any two strategies. Strategies are tools used to take advantage of particular opportunities much like hammers, saws, and screwdrivers for a carpenter. No option trader should tell you one strategy is superior to another any more than a carpenter should tell you that one tool is better than another. It depends on what you’re trying to accomplish. Each strategy presents a unique set of risks and rewards, and it is up to you to decide which is best for the opportunity you have uncovered.

There are several basic strategies, and it’s difficult to say which is the easiest to start with. Many books start with long calls and long puts since they represent rights. However, we are going to start with a strategy called the covered call since it represents a good starting point for most option traders. The reason is that it is one of many “stock-friendly” strategies, which means this strategy requires you to own stock. Further, covered calls are initiated by purchasing stock and often exited by selling stock, which also makes it easy for investors to understand. Since you probably already own stocks, the covered call represents an easy way to explore options.

However, covered calls can contain an unforeseen risk depending on subtle changes in the way the strategy is carried out. Covered calls can be a wonderful strategy if used properly, so it is critical that you understand the principles and risks described in this book and find out if it’s right for you before you attempt to make use of this popular strategy.

Covered Call Strategy
When you enter into a covered call, you buy the stock and then sell (or write) a call option against those shares. The shares of stock can be purchased at the same time the call is written or the shares may have been sitting in your account for some time. As long as you own shares, you can write calls against them.

The investor writes calls in a 1:1 ratio against the stock. For example, if you own 100 shares, you’d write one contract, 200 shares and you’d write two contracts, 300 shares and you’d write three contracts and so on. For every 100 shares of stock, you write one call option. Be careful that you are not writing an option that controls more than 100 shares. One of the biggest mistakes that investors make is to find option premiums that look relatively high and then sell them against 100 shares of their stock. Many times they find out the reason the option’s price looked so enticing is because it controlled 150 shares. (Naturally, if you owned 150 shares then you could certainly write such an option against them.) Just be sure that you own the same number of shares as the amount you are giving someone the right to buy.

We’ll find out later there may be times where you’d want to write fewer calls against your shares but you will never write more. For example, if you own 400 shares of stock, you may decide to write only three contracts (rather than four) but you would never write more for reasons we’ll talk about shortly.

For every call option you sell, you have the potential obligation to sell 100 shares of stock for the strike price. It is a potential obligation because it is up to the long call holder to decide if he wishes to exercise those calls and buy your shares. Just because you write a call does not in any way guarantee you will sell your shares; it just locks you into the obligation to sell your shares if the long position decides to buy. Of course, in exchange for accepting that obligation, you are paid a fee that is yours to keep regardless of what happens.

Why is it called a “covered” call? If you sell a call option without owning the shares of stock it is called a “naked” call, since you do not have the shares in your account to deliver. If you are assigned on a naked call and forced to sell 100 shares of stock, you must go into the open market and buy those shares and there is no telling what that price might be! Because of this, naked call-writing is considered to be among the riskiest of all option strategies since there is no limit as to how high a stock’s price can rise. This is why you never write contracts that represent a greater number of shares than what you own (such as writing 5 contracts against 400 shares). By doing so, you are never exposed to this potentially devastating upside risk.

However, by selling call options in proportion to the number of shares you own the upside risk is eliminated since you already own the shares. In other words, the upside risk of naked call writing is “covered” because you will always be able to deliver the shares at a known cost. You have already paid for those shares and that cost will never change.

The important point to understand now is that selling calls creates the potential obligation to sell your shares for the strike price. For example, if you buy 100 shares of ABC stock for $50 and then write a $55 call against them, you have the potential obligation to sell those shares for $55 no matter how high that stock may be trading. At some point though, every investor’s goal is to sell the shares, so this potential obligation is not a risk in the strategy. While it’s true that you may end up selling your shares far below the current market value, it is NOT a risk of the strategy since it still represents a profit. Selling below current market value at a profit is simply a lost opportunity and risk is never defined as missing out on some reward.

As long as you remain in the covered call position, you have limited upside potential since the most you will ever receive for your shares is the strike price. As with any option, you can get out of the contract by simply buying it back at some time but for now just remember that a covered call limits your upside potential.

The fact that you are capping your upside potential profit means the covered call strategy is designed for those investors who have a neutral to slightly bullish outlook on the stock. You should not write calls on stocks you feel will make explosive upward moves nor should you write calls on shares you think will fall in price. You should be reasonably confident that the stock price will fluctuate sideways through the life of the option (neutral outlook) or you should feel it may climb somewhat higher (slightly bullish).

Philosophy
The goal of the covered call writer is to collect many option premiums over a long period of time. Every time you write a call option against your shares you are effectively lowering your cost basis on those shares. This reduces your risk since you are reducing the amount of cash you have in the position. Covered call writers are not attempting to profit from rising stock prices; remember that the position is neutral to slightly bullish. It’s okay if the stock price rises (since higher stock prices will not generate a loss) but that is not the main goal of the strategy. If you are bullish on the stock you should just buy the stock (or long calls as we’ll find out in the next chapter) and just hang on. Covered call writers, on the other hand, have limited upside potential because they are obligated to sell their shares for a fixed price so the strategy is not designed to make money from rising stock prices. The goal is to generate your profits by writing calls over and over – collecting premiums – against those shares.

Covered Call Basics
Let’s start with the basics of covered calls by looking at an example using the AGIX quotes we have used earlier, which have been reproduced as Table 7-1:

Jan

26

Options 101 #77 Answers-Chapter 6

Filed Under Option Trading Articles | Leave a Comment 


Chapter Six Answers

1) If a bet is fairly valued then that means that you are expected to:
d) Break even over the long run
The fair value of any bet is the price where you are expected to break even over the long run. That is, after hundreds and hundreds of similar bets, you’d walk away no richer or no poorer.

2) If you pay more than fair value then you are expected to:
b) Lose over the long run
If you pay more than the fair value for a bet, you are expected to lose over the long run (after hundreds and hundreds of attempts). If a bet is priced above fair value, you can certainly win it over the short run but not over the long run.

3) You run a Black-Scholes calculation and find that the theoretical price of the call option is $3.50. What does this mean?
a) If you pay $3.50 for similar calls hundreds of times you’d just break even
The theoretical price of any investment (or any bet) is the same thing as the fair value. A call option that has a theoretical value of $3.50 means that if you were to pay $3.50 for hundreds or thousands of similar calls that you’d just break even over the long run. Bear in mind that the theoretical price of an option depends on your perspective of the future volatility. So while the theoretical value of an option does carry a distinct definition, it is impossible to really say what that value is in practice.

4) In order to successfully trade options you must be correct about the underlying stock’s direction and:
b) Speed
When trading options, you must not only get the direction of the underlying stock correctly but you must also determine how quickly it will move. It’s this second dimension of “speed” or “pace” that separates options from stocks. If you buy a stock, you will make money if it rises today, tomorrow, or next week. This is not true for an option. Long options generally need fast, aggressive moves in the underlying stock to be profitable.

5) Over time, volatility tends to move:
a) Sideways
Volatility tends to move sideways over time due to mean reversion. There is a long-run average for volatility so when it rises above this average it tends to fall and vice versa.

6) To find the true value of an option with the Black-Scholes Model, we need to know the:
c) Future volatility
In order to really know the true value of an option, we need to know the future volatility of the stock. That is, we need to know what the volatility will be over the life of the option. In practice, we substitute a forecasted volatility in for the future volatility. This forecast is usually some type of moving average of the past volatility.

7) If you are bullish and wish to trade options you should:
d) Either a or b depending on how quickly you think the stock will move
Long calls and short puts both make money as the stock rises so they are therefore bullish instruments. If you think the stock will rise sharply, you may wish to buy the call as that gives you unlimited upside potential but it comes at the expense of time decay. On the other hand, if you sell a put, the stock doesn’t need to rise for you to make money; it just cannot fall. The tradeoff is that the gain is limited to the amount of the premium received.

8) To reduce the “speed” component of an option, it is advisable to buy options:
a) With a delta of around 0.80 to 0.85
The higher the delta, the less time premium is present in the option. And it’s the time premium that creates the speed component. If you buy options with relatively high deltas, say 0.80 or higher, then you will not need the stock to move as aggressively for the simple reason that there is relatively little time value on the option. It’s advisable for new traders to buy options with deltas of 0.80 or higher for the fact they will behave more like the stock, which is what most people new to options are familiar trading.

9) Whether you feel an option is fairly valued or not depends on your:
c) Perception of the future volatility
As stated in Question 3, your perception of volatility is not a fact, so there’s no way to say for sure if an option is fairly valued or not. To say that an option is fairly valued means you must make a judgment call as to the volatility used in calculating that fair value. If that volatility seems reasonable, then you may feel the option is fairly valued. The fair value of an option depends on your perception of the future volatility.

10) If your call (put) option loses money even though the stock is rising (falling) quickly that is most likely due to:
d) Falling volatility
If the stock is moving quickly and the option is losing money, then this is likely due to falling volatility. If the stock were moving slowly, then the option may be losing to time decay. But the question states the stock is rising quickly so we can assume that volatility must be falling.

11) If you buy a put and the stock falls, you:
c) May or may not make money
Whether you make money or not depends on how quickly the stock’s price falls. If it falls sharply there is a good chance you’ll make money. But if it slowly and steadily falls then there’s a chance you won’t make money since the option will be gaining intrinsic value but losing value due to time decay. For long options, the speed at which the underlying stock moves is critical.

12) The fact that volatility measurements tend to move toward the long-term average is known as:
a) Mean reversion
Mean reversion just states that the data rise and fall toward their long-term average.

13) The time premium on an option can be thought of as the:
a) Point-spread on a bet
It’s the time premium on the option that creates the speed component. The reason is that you must recoup this time premium by expiration in order to be profitable. In a sense, the time premium acts as a point-spread on a bet since you must beat the spread before making money on the bet.

14) A low priced option:
d) Is not necessarily a good value
Just because an option is fairly inexpensive does not mean it’s a good value. To the contrary, it could be greatly overpriced. Whether an option is a good deal or not depends on the volatility assumption that went into pricing it. If that volatility assumption appears to be way out of line to the high side then the option is considered to be overpriced even though it is relatively cheap. When option traders speak of “cheap” or “expensive” they are referring to volatility and not the absolute price.

15) How many factors are needed in the Black-Scholes Model to determine the fair value of an option (including dividends)?
a) 6
The six factors are the stock price, exercise price, risk-free interest rate, time to expiration, dividends, and volatility.

16) What happens to the price of a call if interest rates rise assuming all other factors stay the same? Call prices will:
a) Rise
Rising interest rates will increase call option prices assuming all other factors stay the same. Remember though, this may not be what you experience in the real world. When interest rates rise, stock prices generally fall, which will also drag down options prices. But assuming all factors remain the same (of which stock prices would be included) then rising interest rates will increase call option prices.

17) What happens to the price of a put if dividends rise assuming all other factors stay the same? Put prices will:
a) Rise
As dividends rise, the price of the underlying stock will fall and that means put option prices will fall as well. As with Question 16, we must remember this assumes all other factors remain the same. In the real world, rising dividends will generally increase stock prices, which would decrease put prices.

18) What happens to the price of calls and puts if volatility increases?
a) Call and put prices rise
Rising volatility creates higher call and put prices. The reason is that higher volatility creates the potential for higher (or lower) stock prices, and that means call and put options have a greater chance of being profitable, so the market bids their prices higher. Remember that higher volatility would normally bring asset prices down but because options have asymmetrical payoffs their prices will rise with increased volatility.

19) Increasing the time to expiration has what effect on call and put prices?
a) Prices Increase
More time to expiration means that the stock has more time to either rise or fall, which is good for calls and puts. This means call and put prices will rise as the time to expiration increases.

20) One of the key differences between long and short options is that:
a) Long options need stock price movement to make money; short options do not
Option buyers must pay a time premium and this time premium must be recouped before a profit can be made. Long options therefore need the stock to move before a profit can be made. Short positions collect a premium up front, which is also the maximum profit they can make on the trade. Short positions do not need for the stock to move but, instead, just cannot have it move adversely.

To be continued…..

Jan

25

Options 101 #76 Questions-Chapter 6

Filed Under Option Trading Articles | Leave a Comment 


Some Final Thoughts
This chapter is not meant to teach you how to trade volatility, because that is an advanced subject upon which entire books could be written. This is an introduction designed to give you the basic concepts. It’s unfair to turn new traders loose into the options arena without letting them know about the volatility component of an option and how that component can adversely affect an option’s price.

I remember working for an active trader option team and one day answered the phone only to hear, “Give me the number to the SEC.” The client was noticeably upset so I asked what the problem was. The client proceeded to show me a call option he was ready to close out that would result in a loss even though the stock had risen in a short time. He concluded his dispute by saying, “I placed my bet, I was correct, and I demand to be compensated. This is fraud.”

I then had a very lengthy conversation with the client about the volatility component of options and, as you can tell from this chapter, is not an easy thing to talk out over the phone. But the client managed to understand the basic concept and said he wished he had been told that when he started trading options. So that’s why we’ve included this chapter. It is meant to alert you to what can happen if you are not aware of volatility or do not take it into account when buying or selling options.

When call option prices fall while stock prices are rising (or when put prices fall while the stock is falling), it is called a volatility trap. In trader’s lingo, we would say that anybody buying the AGIX $20 call for $4.80 and then wishing to sell it six days later when the stock was trading higher was caught in a volatility trap since he’d only receive $4.70 at that time.

How can you avoid volatility traps when starting out? You should buy in-the-money options. Chapter Two showed that in-the-money options are less risky. Remember that options are two-dimensional assets; you must correctly guess the direction and speed of the underlying stock. Shares of stock, on the other hand, are one-dimensional asset since you only need to determine if it is going to rise or fall. When stock traders become option traders they often buy at-the-money call options (since they are cheaper) as a substitute for the stock. Doing so subjects them to a two-dimensional asset when they are used to trading a one-dimensional asset, and that’s where the problems begin. When you are starting out, buy in-the-money calls with deltas in the 0.80 to 0.85 range and you will have an asset that behaves similar to the stock you’re used to trading. They will be more expensive but they are actually less risky. That’s a difficult concept to explain to new traders, but hopefully this chapter has convinced you that it’s true. You cannot beat the laws of probability when trading options but you can use those laws to put the odds on your side by selecting the right strategy and strike price. Understanding volatility is the key.

Key Concepts
1) Volatility can be considered a measure of how far a stock price typically drifts from its average.
2) Volatility is the key component to an option’s price.
3) Volatility is the only unknown variable for determining an option’s price.
4) The fair value of an option is the price at which you would break even over the long run if you were allowed to buy (sell) it many, many times at that price.
5) The price of an option is in no way related to its value. Very “cheap” options can be grossly overpriced and very “expensive” options can be a steal. It all depends on the volatility.
6) Volatility moves sideways over time.
7) To trade options successfully, you must take direction and volatility into account. If you wish to trade on option based on a directional outlook then use 0.80 to 0.85 deltas.

Chapter Six Questions

1) If a bet is fairly valued then that means that you are expected to:
a) Break even over the short run
b) Lose over the long run
c) Win over the long run
d) Break even over the long run

2) If you pay more than fair value then you are expected to:
a) Break even over the short run
b) Lose over the long run
c) Win over the long run
d) Break even over the long run

3) You run a Black-Scholes calculation and find that the theoretical price of the call option is $3.50. What does this mean?
a) If you pay $3.50 for similar calls hundreds of times you’ll just break even
b) If you pay $3.50 or less you will definitely make money
c) If you pay $3.50 or less you will definitely lose money
d) If you sell for $3.50 you will definitely make money

4) In order to successfully trade options you must be correct about the underlying stock’s direction and:
a) Earnings
b) Speed
c) Forward P/E ratios
d) Price to sales ratios

5) Over time, volatility tends to move:
a) Sideways
b) Up
c) Down
d) There is no discernable pattern

6) To find the true value of an option with the Black-Scholes Model, we need to know the:
a) Forecast volatility
b) Implied volatility
c) Future volatility
d) Historic volatility

7) If you are bullish and wish to trade options you should:
a) Buy calls
b) Sell puts
c) Sell calls
d) Either a or b depending on how quickly you think the stock will move

8) To reduce the “speed” component of an option, it is advisable to buy options:
a) With a delta around 0.80 to 0.85
b) With a delta near 0.50
c) With a delta near 0.25
d) With the lowest delta possible

9) Whether you feel an option is fairly valued or not depends on your:
a) Strike price
b) Time to expiration
c) Perception of the future volatility
d) Broker

10) If your call (put) option loses money even though the stock is rising (falling) quickly that is most likely due to:
a) Discrepancies in fair value
b) Arbitrageurs
c) Price manipulation
d) Falling volatility

11) If you buy a put and the stock falls, you:
a) Will at least break even
b) Will definitely lose money
c) May or may not make money
d) Will definitely make money

12) The fact that volatility measurements tend to move toward the long-term average is known as:
a) Mean reversion
b) Reverse conversion
c) Conversion
d) Put-call parity

13) The time premium on an option can be thought of as the:
a) Point-spread on a bet
b) Bid-ask spread
c) Fair value
d) Delta

14) A low priced option:
a) Is low risk since there’s little to lose
b) Is better to buy than a high-priced one
c) Puts the odds in your favor of making money
d) Is not necessarily a good value

15) How many factors are needed in the Black-Scholes Model to determine the fair value of an option (including dividends)?
a) 6
b) 5
c) 4
d) 3

16) What happens to the price of a call if interest rates rise assuming all other factors stay the same? Call prices will:
a) Rise
b) Fall
c) Stay the same
d) Cannot be determined

17) What happens to the price of a put if dividends rise assuming all other factors stay the same? Put prices will:
a) Rise
b) Fall
c) Stay the same
d) Cannot be determined

18) What happens to the price of calls and puts if volatility increases?
a) Call and put prices rise
b) Call and put prices fall
c) Call prices rise; put prices fall
d) Put prices rise; call prices fall

19) Increasing the time to expiration has what effect on call and put prices?
a) Prices Increase
b) Prices Decrease
c) Prices stay the same
d) Cannot be determined

20) One of the key differences between long and short options is that:
a) Long options need stock price movement to make money; short options do not
b) Long options do not need stock price movement to make money; short options do
c) There is no difference between the outlooks for long or short positions
d) Short calls need stock price movement but short puts do not

Answers will be presented next issue…

Jan

22

Options 101 #75

Filed Under Option Trading Articles | Leave a Comment 

How Option Prices Are Affected by the Model Factors
The Black-Scholes Model assumes we can fully determine the fair value of an option just by knowing the six factors that go into the model. Up to this point, we have touched on the way option prices behave based on changes in some of these factors. Despite the overlap, Table 6-26 lists all six Black-Scholes Model variables and shows how call and put prices respond to changes in these variables:

The most important thing you can learn from Table 6-26 is that option prices can move for reasons other than changes in the stock’s price. Let’s work through each of them just to be sure you have the concepts down.

Stock Price
Table 6-26 shows as the stock price increases, the price of a call will increase and the price of the put will decrease with all other factors constant. But after reading this chapter, you should know this is a theoretical statement and you should not be alarmed if your call option is not up even if the underlying stock is trading higher. The reason is that the other factors rarely stay constant. Even though the stock price rises, you could have a decrease in volatility. And if that decrease is big enough, the price of the call option will be down even though the stock is up.

Exercise (or Strike) Price
The exercise price is closely related to the stock price. In fact, they are really just two ways of looking at the same thing. When we were considering movements in the stock price above, we assumed the strike price (as well as all other factors) remained constant. Now, if we hold the stock price constant but change the strike price, we are effectively changing the relative value of the option. That is, we are making it more in-the-money or out-of-the-money. This is just another view of Pricing Principle #1 from Chapter Two. That principle stated that lower strike calls and higher strike puts must be more valuable with all other factors the same.

For example, if we lower the strike price of a call, effectively we are raising the stock price. We are moving the call option more in-the-money. Therefore, rising stock prices (or falling exercise prices) are beneficial for call option holders. Falling stock prices (or rising exercise prices) are good for put holders. Movements in the strike price are no different from movements in the stock’s price.

Interest Rates
How interest rates affect calls and puts are a little more difficult to understand. In Chapter Five, we showed that call options are a form of borrowing money by the following rearrangement of put-call parity:

C = S – Pv (E) + put

Once you look at this variation of put-call parity, it should be clear why call options increase with increases in the interest rate. Notice in the above equation the call price equals the stock price minus the present value of the exercise price. As interest rates rise, the present value of the exercise price falls and the right hand side of the equation gets bigger. That is, the price of call options increases. Although this is fairly easy to show mathematically, it is easier to remember if you understand it conceptually so let’s look at another line of reasoning.

Say interest rates are very high, perhaps 20%. You have $100,000 in the money-market that you would like to invest in stocks. You can either buy the stocks today or, for a fee, buy a call option which gives you control of the stock but allows you to defer payment. The choice should be easy; buy the call option so you can hang on to your money and continue to earn interest. Investors in the market follow this same line of reasoning and bid the calls higher as interest rates rise.

What about the puts? Puts give you the right to sell your stock, which represents a cash flow into the account, which is nice to have if interest rates are really high. So do you elect to buy puts to defer the sale? No, in fact, you may even sell the puts to generate cash into the account so it can earn the high rate of interest. The lack of put buyers (or the increase of put sellers) causes the price of puts to fall.

As with all the other factors, we must remember that these relationships assume that the other factors remain constant, which is rarely the case in the real world. So if interest rates rise suddenly, do not be surprised if your call options decrease in price rather than increase as we have said so far. This is due to the fact that stock prices fall when interest rates rise and falling stock prices correspond with falling call prices. But it should be evident that all factors did not stay the same in this case since we assumed interest rates rose and stock prices fell. However, if all factors remain constant and the only thing that changes is an interest rate hike, then we will see call prices rise and put prices fall.

Volatility
We have shown that increases in volatility cause increases in call and put prices. The reason had to do with the asymmetrical payoff structures of options. Because increased volatility can only help option prices then the market bids them higher.

Remember this is backwards from our normal view of risk. Riskier assets usually have their prices bid down, which is what we discovered in the Pricing Game in Chapter Two. But options are an exception to this principle since they have an asymmetrical payoff structure.

Time to Expiration
This factor is fairly straightforward. Pricing Principle #2 in Chapter Two stated the more time to expiration, the higher the prices of calls and puts. We said earlier an option could be viewed as a bet that the stock will be above the strike price (for calls) or below the strike price (for puts) by expiration. In other words, you are in effect betting the option will have intrinsic value. Because of this, the more time available, the more likely the stock will have intrinsic value.

Dividends
Last, we will consider the effect of dividends on calls and puts, which is fairly straightforward too. If a stock pays a dividend, the price of the stock is reduced by the amount of the dividend for the next trading session. The reason the price is reduced is because the company has paid out cash – one of its assets – so the company is now worth less than before it paid the dividend. If the stock price is down and all other factors stay the same, what will happen to the options? Call prices fall and put prices rise with all other factors the same.

Option prices can change for any of the six factors listed in the model, and this is what makes option trading more difficult to understand than stock trading. It is for this reason that you should be well aware of these six factors and how they affect option prices.

To be continued…..

Jan

21

Options 101 #74

Filed Under Option Trading Articles | Leave a Comment 

In order to make a successful trade, we must pick a strategy that properly aligns both beliefs – direction and volatility. Always remember that options are two-dimensional assets and we must be right on both counts. We must take into account our beliefs on the direction of the stock and the volatility of the options. In this case, our beliefs are:

• Direction = Bullish on the stock
• Volatility = Option volatility is too high (need to be the seller)

How can we create a bullish trade by selling an option? We need to sell puts. A long put is bearish since it makes money if the stock falls. A short put, being on the opposite side of the trade of a long put, is bullish. Most traders who are bullish are tempted to immediately reach for the long calls. It just seems to makes sense because of the unlimited gains afforded by long calls. If we were to buy calls, we could make unlimited gains but would be facing an unrealistically large point-spread.

A short put also makes money if the stock rises. But more important, short puts will also make money if the stock stands still. And there’s the big difference between long calls and short puts. A long call option needs the stock to move. But by selling puts, we can only make a limited gain; however, we do not need the stock to move. We don’t need to have the stock rise for us to make money; we just can’t have it fall. We have eliminated the speed component of the option.

So by selling a put, we are taking a bullish position and are not exposed to the large point spread. We have aligned both directional and volatility outlooks correctly. How would we have done if we had sold puts? Figure 6-23 is a reprint of the before and after quotes on AGIX (Figures 6-6 and 6-7) and you can see that we could have sold the $20 puts for $5.50 and bought them back for $3.90, which is a winning trade:

Notice that just because volatility was high, we cannot just arbitrarily sell calls or puts and necessarily make money. For example, if we had sold the $20 calls, Figure 6-23 shows we would have sold them for $4.40 and bought them back for $5.10 for a loss. Traders who sold these calls were correct for selling options because volatility was so high. However, they were wrong about the direction of the stock – the stock went up. And again, just because we believe the stock will rise, that doesn’t mean we can immediately jump to conclusions and buy calls. As we showed before, the traders that bought the $20 calls paid $4.80 and sold for $4.70. They were correct on the direction but wrong about the volatility. It is only the traders who were correct on direction and volatility who made the winning trade; it was the traders who sold puts.

Is the sale of the $20 puts the only winning trade in the Figure 6-23 matrix? No, the trader who bought the $15 calls could have paid $6.70 and sold them for $7.30. We could also have purchased the $17.50 calls for $5.60 and sold for $5.80. Why were the $15 and $17.50 calls profitable while the $20 call was not? Hopefully, you are starting to understand why. The $15 and $17.50 calls have less time premium in them because they are in-the-money. This means they have a smaller point-spread (breakeven point) and are not subjected to the “speed” component of the option like the at-the-money or out-of-the-money options. If you remember from Chapter Two, in-the-money options are less risky and now you clearly see why. They are not subjected to the volatility component in quite the same way as their riskier at-the-money or out-of-the-money counterparts and can make money even if volatility falls.

Regardless, please note the trade that produced the biggest profit was the one that made best use of direction and volatility – it was the sale of the $20 puts. The sale of any of the puts made money but not as much as the $20 puts since they had the highest time premium. Table 6-24 shows all of the long call and short put trades and their profits or losses:

Volatility is Relative
One of the most important concepts to learn as an option trader is that volatility is relative. If volatility is relative then so are option prices. This simply means you cannot look at an option that is priced low, say $5, and conclude that it must be a good value. In fact, we just found an example of one priced at $4.80 that was a horrible value – even though the price may appear to be relatively cheap. Conversely, we might find an option that is priced high, say $12, that turns out to be a steal. However, you will find countless people, including “professionals” who confuse these issues. For example, here is a sample of an email ad we received for an option training DVD:

You can see this professional got it wrong too. According to his “simple” rules, you only need to buy an option when it is undervalued and sell it when it is overvalued – just as you do for stocks. Let’s assume you run the Black-Scholes Model and find an option priced at $3 that is undervalued so you buy it. Later, it is trading for $1 but, according to the model, is overvalued so you sell it. You can see that paying $3 and selling for $1 is no way to make money even though you bought undervalued options and sold overvalued options. Undervalued and overvalued options are relative to your perceptions of future volatility. Value has nothing to do with “cheap” and “expensive” in absolute dollar terms.

Which Strike Should I Buy?
Table 6-24 shows that the in-the-money calls ($15 and $17.50 strikes) made profits while the $20 call did not. Once again, this is due to the fact the stock did not rise fast enough for the $20 call to make a profit. In other words, the time value on the $20 call was too high and therefore had more to decay with time. The in-the-money calls, however, had a much smaller time premium so were able to show a profit.

Even though in-the-money calls are less risky, that does not mean you shouldn’t buy the lowest strike call (or highest strike put) available. The reason is there may be many strikes with high deltas and we only need one that has a sufficiently high delta but not more. The goal is to find a good balance between intrinsic and time values.

As a general rule, if you are buying short-term options, say three months or less, you should look for options with deltas around the 0.80 to 0.85 level. In fact, this delta level is a good rule to always follow regardless of the time frame if you are using options as a stock substitute. However, if you are considering longer-term options, say up to a year, you may be able to get away with using slightly lower deltas. And if you are using options with more than a year’s time, you might decide to use an at-the-money option or even slightly out-of-the-money. The reason we mention these different levels is because investors invariably avoid in-the-money calls when they see the prices get expensive in terms of absolute dollars. It’s difficult for most traders to buy an option with a price of $20, $30, or higher even though it may be the right thing to do mathematically. So we’re not saying to never buy an at-the-money or out-of-the-money option. However, most traders stick with shorter-term options (usually because they’re cheaper) and buying deltas below 0.80 is often a huge mistake. For example, Table 6-25 shows option quotes for Dell Computer:

If we are bullish on Dell and want to buy a call option, we should look for one with a delta of around 0.80. This delta provides a nice balance between performance and price. For instance, we could buy the $27.50 call, which has a delta of 1.0, which is obviously equivalent to owning the stock (remember, long stock has a delta of one since it rises dollar-for-dollar with itself). However, that $27.50 comes with a price of $7.90 as shown by the last trade. We could therefore do better by purchasing the $30 strike because it also has a delta of 1.0 but only costs $6.40. If both calls provide a delta of 1.0, why pay the extra $1.50 for the $27.50 call? Remember, the key to finding the right strike is to find a good balance between delta and the cost so let’s keep looking at higher strikes.

The $32.50 call also has a delta of 1.0 and only costs $3.40. But the $35 call has a delta of 0.73 and costs $1.10; that’s the strike we want to trade. It has a sufficiently high delta (near the 0.80 mark we’re looking for) without paying the higher prices that come with the lower strikes. It will behave much like a long stock position yet cost a lot less and provide tremendous downside protection.

If your broker does not provide delta values there is a little trick you can use for times when you cannot look up the values on the other sites we mentioned. In Chapter Five, we said that the time value of the call (above the cost of carry) must equal the price of the put. If that’s true, then we can look at the put prices for one that is bidding a small amount, say 30 or 40 cents above the cost of carry and that should correspond to a sufficiently high delta for the corresponding call. If you are trading relatively short time periods, say three months or less, the cost-of-carry component will not be too great and you can just look for a put with a total value of 30 or 40 cents. In Figure 6-25, you can see that the $35 put was worth 40 cents and that is the same strike as the call we determined to buy by looking at deltas.

To be continued…..

Jan

20

Options 101 #73

Filed Under Option Trading Articles | Leave a Comment 

Time Decay?
Many traders believe the AGIX $20 call lost money simply because of time decay. In fact, most traders believe that any time you find an option whose value is less today than it was previously must be due to time decay (assuming the stock’s price is about the same). You must remember that there are two forces acting on the option’s price at all times – stock price and volatility. (Actually, there are other forces as shown in the Black-Scholes Model but they are relatively insignificant compared to these two.)

Find it hard to believe? Take a look at Figures 6-18, which shows the same set of eBay quotes taken seven days apart:

Notice the stock price is identical for both days. However, the asking price for the October $32.50 is higher on October 20 than on October 13! How can that happen? Even though seven days have passed, the perceived volatility of the future stock prices has increased. (You can see the stock was down $2.86 on the second day, which showed higher price changes than in recent history.) The amount of that volatility increase was more than enough to offset the loss from time decay. Remember, an option’s price can change for reasons other than time and stock price movements. But if you don’t understand the role of volatility, it’s easy to think that something is wrong with the quotes.

Let’s go back to our AGIX $20 call and see if time decay was the culprit in creating the loss. First, let’s define what we mean by time decay. Time decay means that time has been subtracted from the life of the option and therefore the option must be worth less money, assuming all other factors are the same. We can use the Black-Scholes Model to see if time decay was the culprit. Figure 6-19 shows that if we use 251% volatility then the price of the call is $4.80, which was the market price at the time we considered buying the $20 call:

The $20 call would not be in for a loss because the model shows us it would have been worth $5.71 and we paid $4.80. So the fact that time decayed by six days was not the culprit of the loss on the AGIX $20 call. You cannot just look at an option whose price is lower in the future and necessarily claim it’s due to time decay.

So if the $20 call should be worth $5.71, why was it bidding only $4.70? The only variable that we could possibly change is volatility. What is the volatility necessary to create a $4.70 bid price? Figure 6-22 shows that an implied volatility of about 200% (199.45%) creates a $4.70 call price. This shows the reason the $20 call lost money was not because of time decay but rather that the implied volatility fell from 251% to 200% in six days.

The Black-Scholes Model allowed us to see the volatilities the market was using to price the $20 call. Had we not used the model, all we’d have seen is the $4.80 call price and we’d have had to make our decision on which option to buy based on our belief about the direction of the stock. But as we’ve seen, there’s more to profiting on options than correctly guessing on the direction. We must also guess how quickly the stock will move. Had AGIX moved from $18.81 to $21.18 the next day, there’s no doubt the call would have been profitable. But it took six days to get there and that’s a different story. Although that may sound like a negligible amount of time, it’s a lot once you understand that the $4.80 price was extraordinarily high to begin with. And extraordinarily highly priced options have a lot of premium to decay. Their prices can fall rapidly with decreases in time and volatility.

Creating a Winning Trade
We’ve just demonstrated with a real-life example that option trading requires more than a directional belief about the underlying stock. In other words, just because you may be bullish does not mean buying calls is the right strategy to capitalize on that outlook. The reason is, as we previously learned, long option positions have a “point-spread” built into them in the form of a time premium. If that time premium is too high, we can lose on the option even though the stock price may rise.

In order to trade options successfully, you have to remember they are two-dimensional assets. If your only opinion is that you are bullish on the stock, you may be better off just buying the stock since it is a one-dimensional asset. But if you want to use options, having an opinion on the direction of the stock is certainly part of the puzzle but we also need to have an opinion on the volatility level. Using our football example, just because we may think the Patriots will win does not necessarily mean we should bet on them. We need to know what the point spread is before we take the bet. If we feel the point spread is too big, we would be better off betting against the Patriots even though we think they’ll win. In the same way, we cannot just believe that AGIX is moving higher and buy the call options until we understand the point spread facing us. That is, we must have an opinion on the volatility.

In this example, we were bullish on AGIX and, as we have discovered, it appears that volatility is too high. We believe volatility will be 55% over the next 30 days but the market is pricing the $20 call at 251%. In addition, volatility has never been remotely close to 251% in the past. Because we believe volatility is too high, the price must be too high (and the point spread is too big). That is, although we think the stock will rise, we’re not so sure it will rise past $18.81 + $4.80 = $23.61 at expiration. Remember, this is the “at expiration” breakeven point. You could certainly make money on this option even if the stock never reaches $23.61 – but the stock has got to move quickly.

Now, if the point spread is too high, do we want to be the buyer or seller of the bet? Obviously, we want to be the seller. In order to use options to make a bullish play on AGIX, in this example, we’ll need to be the seller of the option.

On the surface, many traders erroneously think that if the time premium is too high then we should simply sell options, whether calls or puts, but that’s not necessarily true. The options appear to be priced at astronomical volatility levels but it is possible there is good reason. Remember, there is some potentially powerful news circulating on the stock at this time. If we sell the call and the stock’s price jumps much higher, we could end up with devastating losses. So we don’t necessarily want to sell calls “just because” volatility is high. Also remember that selling calls is contrary to our directional outlook. In this example, we are bullish on AGIX but selling calls is a bearish strategy.

To be continued…..

Jan

19

Options 101 # 72

Filed Under Option Trading Articles | Leave a Comment 


It’s important to understand how to interpret this chart. Remember, this is not a price chart on AGIX; it’s a chart of the volatility. To create this chart, the computer takes the first 30 days, calculates the volatility number, and then plots that number as a single point on the chart. Next, it takes days 2 through 31, finds the volatility number, and then plots that number as a single point on the chart. This process continues for all 30-day groups in the data. When it’s done, all the dots are connected and you’re left with a fluctuating line as shown in Figure 6-14.

You can see the highest 30-day group had a volatility of about 70% and the lowest around 35%. The current level is about 55%. The million-dollar question now is which volatility should we expect over the next 30 days? In other words, which volatility should we use to determine the value of the AGIX $20 call?

Figure 6-14 shows us a yearly historic range but we need an estimate for the future – the next 30 days. Many traders use the current volatility level based on a simple theory the next 30 days should be about like the last 30 days. To understand this theory a little better, think of the weather. Our temperatures range from lows in the winter to highs in the summer. However, these temperatures are not random. We do not expect it to be 90 degrees and hot one day and then have snow on the ground the next. Instead, we observe that tomorrow’s weather is about the same as today’s. Weather changes slowly over time but any given small block of time has very similar temperatures. Using this theory, we should expect the next 30 days to have a volatility about like the last 30 days.

As Figure 6-14 shows, the current level is 55% and we may wish to use that as a future volatility estimate for the Black-Scholes Model. Although 55% is one estimate, it is not the only one we could use. Remember, volatility is the only true unknown in the Black-Scholes Model and now you see why – volatility does not stay constant. However, most option traders would agree the estimate you choose should be fairly representative of the average moves we observe in the chart.

Let’s assume we decide to use 55% for our volatility estimate and see what the Black-Scholes Model says about this $20 call option. We know the current stock price is $18.81, we’re interested in buying is the $20 strike, there are 29 days until expiration, and we’re using 55% as a future estimate of volatility. One of the nice features about the CBOEs Black-Scholes Model is that it will find the current risk-free interest rate based on T-bills with the same maturity as the option so this is not even a number you need to look up. At this time, the risk-free rate was 2.42%. Figure 6-15 shows the fair value of this call option is just over 70 cents:

As a reminder, this means if we were able to take this exact trade over and over hundreds of times, we would just break even by paying 70 cents – assuming our volatility assumption in the model is correct.

Despite the fact that we do not know what the future volatility will be, we do have reason to believe our estimate of 55% should be reasonably close to the truth. So now we have a benchmark for value just as we did with the Iraqi currency. The open market told us the currency was worth $680 while the asking price on eBay was $990 so we knew that was a price to avoid. In a similar way, we have good reason to believe that 70 cents is a reasonable price to pay for the $20 call but the market asking price is $4.80.

Clearly, there is a discrepancy between what we think the call is worth when compared to the market price. In other words, the price of the option appears to be far greater than the value to us. What is causing this discrepancy? There’s only one factor that we can change and that is volatility. Because the market must be using the same stock price, exercise price, time to expiration, dividends, and risk-free rate (at least reasonably close) this only means that the market’s volatility estimate is different from ours.

This is where an option pricing model, such as the Black-Scholes, can really help with trading. Our volatility estimate is different from the market’s estimate but how far off? If we had used 56% instead of 55% would we be closer in price? Or would we have to drastically increase it to, say 800%, in order to match the market’s estimate? This question is difficult to answer until you get a feel for how sensitive an option’s price is to changes in volatility. And that’s difficult to do since that depends on the time to expiration and strike price. That’s where a pricing model such as the Black-Scholes really helps.

We can find the volatility estimate the market is using in one of two ways. First, we could gradually increase the volatility number in Figure 6-15 from 55% until the call’s price equals $4.80 (we know to increase volatility since higher volatilities equate to higher option prices). Whatever volatility makes the price equal, $4.80 must be the one that the market is using to price the option.

Fortunately, there is an easier way. We can find out which volatility estimate the market is using by simply entering the $4.80 asking price into the “implied volatility” section in the lower right hand corner of the calculator, which is circled in Figure 6-16. (Make sure you also select the correct type of option from the drop-down menu. In this case, we need to select “call.”) After we hit the calculate bar below, the calculator shows the market is using a whopping volatility estimate of 251%!

Because the market is willing to pay $4.80, we mathematically backed into the volatility and found they are using 251% to value the option. As a check, you could type 251% into the “Volatility %” field on the left side of the calculator (where we previously typed 55%) and the call’s value would jump from 70 cents to $4.80. In other words, a volatility of 251% is required to make the option’s price equal to $4.80. It’s consequently called the implied volatility of the option since that is the volatility implied by the market just by the fact it is willing to pay $4.80 for the option.

Now, as option traders, we need to make a decision: Does this seem to be a reasonable estimate of volatility? After checking the volatility over the past year (or longer) we find it doesn’t seem to be in line with any of the volatilities we’ve seen in the past. Further, we know volatility reverts to the mean. This does not mean that it’s impossible to make money with this option but rather that the odds are stacked very much against us. It’s like paying $1.50 to make $1 at the flip of a coin. It is a trade we’re better off avoiding.

If you pay $4.80 for this option, you are probably overpaying. Sure, there’s a chance that the stock takes off like a rocket and you make money. After all, there is a tremendous amount of bullish news on the stock at this time. However, if you pay
$4.80, you are facing an enormous point-spread that is unlike any point spread we’ve ever seen in the stock. In our Super Bowl example, it would be like betting on the Patriots with a 30-point spread. Even if the volatility in the stock did rise to 251%, you can be reasonably certain that it will fall back to its average. If the volatility hits 251%, that’s like Mark McGwire hitting his 70th homerun; we should not expect it to maintain that level much less rise above it. Instead, we should expect it to fall. And if it falls, it will drag down the option’s price, which will cause you to lose even if the stock’s price rises.

That’s exactly what happened with the AGIX trade. Figure 6-17 shows the stock did rise from $18.81 to a high of more than $37, which certainly had a positive impact on the option’s price. However, during that same time, the volatility fell from a level of about 260% right back down to the long-run average of 55%, which is what we used to value the option. This fall in volatility had a negative impact on the option’s price. We ended up with a tug-of-war contest between the stock’s price rising and the volatility falling.

The falling volatility is what caused the loss on the AGIX $20 call even though the stock’s price went up. Remember, option prices (calls and puts) get cheaper as volatility falls.

It’s interesting to note the 30-day volatility did, in fact, rise to about 260% so the market was pretty good, in this instance, at guessing the future volatility. While it correctly guessed the volatility, it was not able to prevent the drastic mean reversion you see in Figure 6-17. (In Figure 6-17, we are using a 10-day moving average so you can see how quickly it fell since shorter-term volatilities are more sensitive to changes.)

The net result between these two forces was an overall loss at the time the quotes in Figure 6-7 were taken. Now, this does not mean the $20 call never became profitable. In this case, it did become profitable days later once the stock reached the higher price levels. The point we’re trying to make is that at the time the quotes in Figure 6-7 were taken, the stock price had risen but the option’s price had fallen. It’s the timing of the movements between stock price and volatility that determine whether or not the trade will be profitable. Unfortunately, that’s something we will never know until it’s time to exit the trade.

In this example, it’s also possible that AGIX may never have moved much higher than the $21.18 price in Figure 6-7 thus leaving the $20 call as an everlasting losing option. If AGIX never reached much higher than $21.18, the buyer of the $20 call would have paid $4.80 and never had a chance to sell it for a higher price. The decision to hold the option becomes a big dilemma for option traders. If you had purchased the $20 call for $4.80 and saw it trading for $4.70 with the stock significantly higher, would you continue to hold it? If so, every day you hold it with no movement in the stock leads to bigger losses due to time decay. Further, every day that volatility drops the losses are compounded. If the stock’s price doesn’t move, option traders have two potential forces that could drag down the price of their option – time decay and volatility. The decision to hold the option in hopes for profitability can become very costly.

To be continued…..

Jan

18

Options 101 #71

Filed Under Option Trading Articles | Leave a Comment 

When we value a football bet, there is no way to say for certain it is properly valued. It’s a question of the perceptions of the bettors. The casinos simply find out how many people wish to bet on each team and then create the necessary point-spread to balance the number of buyers.

Prior to 1973, this is exactly how the options market worked. Traders had to throw out bids and offers based on what they felt the trade was worth. Of course, this type of valuation means that traders tend to bid low and offer high, which creates very large bid-ask spreads. This makes the market very inefficient and never quite gets off the ground. Fortunately, that all changed in 1973 when Fisher Black and Myron Scholes created the Black-Scholes Option Pricing Model, which allows us to get a more scientific idea of what an option “bet” should be worth. It’s no surprise that this was the very year the Chicago Board Options Exchange (CBOE) was created since there was now an objective way to readily determine the fair price of a “bet” with an option.

As you get more advanced with your option trading, it is imperative that you use some type of option-pricing model. Option-pricing models allow traders to judge whether the price of an option reflects a good value. As we will show later, had we used the Black-Scholes Model, there would have been a big red flag flying above the $4.80 price of the $20 call option.

Let’s see how the Black-Scholes Model could have prevented us from taking this loss. We’ll rewind back to the beginning when we were looking at the AGIX $20 call for $4.80. Before we make this trade, we need to get a benchmark for value very much like we did for the eBay Iraqi currency. As traders or investors, we cannot just pay the asking price as if it’s the price of a lottery ticket. Lottery tickets have no point-spread to them. You either win or you lose (mostly lose). You cannot be correct on the numbers for a lottery game and still lose the bet. With options though, it’s different because the price we pay has a point- spread built into it and we need to understand what that spread is. In order to value this $20 call, we need to estimate the future volatility of the stock.

Volatility Moves Sideways
Before we show you how to estimate the future volatility, we need to take a short detour here and explain a very important characteristic about volatility. That is, volatility tends to move sideways over time. For example, Figure 6-10 shows an 18-year history of the Volatility Index, or VIX, which measures the volatility of the S&P 500 Index. Although the index has risen substantially over this time period, notice that the volatility chart just moves sideways.

This sideways characteristic of volatility is about the only constant in options trading and that’s why it’s so important to understand. When volatility rises, there’s a tendency for it to fall and vice versa. This shows that there is some long-term average that the volatility oscillates around. The tendency for volatility to fall toward the long-term average is called mean reversion. That is, volatility tends to revert to the mean (average). Mean reversion is nothing new and occurs in many types of events, not just options trading. In order to understand the mechanics of mean reversion let’s take a look at a well-known and rather intriguing mystery known as the Sports Illustrated Jinx.

The Sports Illustrated Jinx is a marvel well-known to professional athletes. The jinx states that if a professional athlete makes the cover of Sports Illustrated, they have just been jinxed and their performance is headed for a slump. There has been a very long (and quite convincing) history of this ever since Sports Illustrated was first published. The jinx became so commonly believed that in January 2002, Sports Illustrated wanted to publish a feature story about the jinx and asked St. Louis Rams quarterback Kurt Warner to pose on the front cover holding a black cat. But Warner refused so they shot the cover with the black cat by itself with the intriguing caption: “The Cover that No One Would Pose for. Is the SI Jinx for Real?”

Mathematician and author John Allen Paulos came up with a brilliant way to show that the Sports Illustrated Jinx is nothing but mean reversion at work and not an apparent slump as it appears. He suggests that the magazine choose the player with the worst record of the season and place his picture…on the back cover. Paulos is quite certain that you will see an increase in the player’s performance the following season. So whether you’re the best player on the front cover or the worst player on the back, we should expect both players’ averages to move toward the center. The bottom line is this: Any time an extreme event happens, whether good or bad, chances are that following events will be less extreme, not more.

Figure 6-10 shows that the VIX tends to bounce back and forth between 20% and 40% most of the time. When it moves significantly outside of this range, we should expect it to revert back to the average rather than to continue to rise or fall. That’s why the overall volatility trend moves sideways. We should not expect to see volatility rise month after month any more than we should expect Mark McGwire to continually outperform his record each season. Instead, we should expect extreme events to be followed by less extreme events.

Using Volatility
Now that you understand volatility, let’s see if there is a way we can use this sideways characteristic to gauge the value of an option. Let’s go back to the AGIX trade we discussed at the beginning of the chapter. Figure 6-6 showed us that the $20 call was priced at $4.80. But we also said that there can be significant differences between an option’s price and its value. How do we check the value? We must compare the current price with past volatilities. Before we buy this (or any) option, we need to check the past volatility of the underlying stock.
Most option brokers supply this information if you have an account with them. However, if they do not, you can find some basic information free of charge at www.ivolatility.com. Figure 6-13 shows what you will see on the front page:

If you type the option symbol in the box shown by the upper circle and then click on the chart in the lower circle, it will take you to the moving average of the volatility of that stock. As a general rule, you’ll want to match (at least closely) the volatility moving average to the expiration of the option. In this example, the AGIX $20 call had 29 days until expiration so we’d want to use a 30-day moving average, which is one of the standard time frames available from this website. Figure 6-14 shows the 30-day volatility moving average for AGIX over the previous year (9/16/2004 to 9/16/2004):

It’s important to understand how to interpret this chart. Remember, this is not a price chart on AGIX; it’s a chart of the volatility. To create this chart, the computer takes the first 30 days, calculates the volatility number, and then plots that number as a single point on the chart. Next, it takes days 2 through 31, finds the volatility number, and then plots that number as a single point on the chart. This process continues for all 30-day groups in the data. When it’s done, all the dots are connected and you’re left with a fluctuating line as shown in Figure 6-14.

You can see the highest 30-day group had a volatility of about 70% and the lowest around 35%. The current level is about 55%. The million-dollar question now is which volatility should we expect over the next 30 days? In other words, which volatility should we use to determine the value of the AGIX $20 call?

To be continued…..

Jan

15

Options 101 #70

Filed Under Option Trading Articles | Leave a Comment 


At the time of this auction, there were many similar auctions for this currency because of the radical changes taking place in Iraq. The country was getting lots of U.S. support to help its new government get under way. They also have the second-largest oil reserves in the world, so there is tremendous potential for their currency to rise against the dollar. If you buy a large block of its currency, you’d only need a small movement in the currency against the dollar and you could make a lot of money; at least, that’s the investment story the sellers of Iraqi currency are touting on eBay. Figure 6-8 shows this opportunity could have been yours for the low, low price of only $990.

We know the price is $990 but that really tells us nothing. Any asset can be priced too high no matter how good the story is that comes with it. The rarest works of art and most precious gems can be a horrible investment if too much is paid for them. As investors, we cannot just look at the $990 price tag on this eBay auction and think it is a good deal because of a good story. We need to somehow compare the price to the value.

That’s easy to figure out since there is an open market for currency. All we need to do is look at the exchange rate for Iraqi dinars and convert them to U.S. dollars. At the time of this auction (May 27, 2005), the exchange rate for U.S. dollars per Iraqi dinar was .00068, which means that one million Iraqi dinars were worth 1,000,000 * .00068 = $680. Now we have a benchmark for value since we know what the crowd is willing to pay. However, this auction dealer wants $990 for something that is worth $680 in the open market. Not only is this not a good deal but there’s a more insidious side to the trade than just being overpriced. If you pay $990 for the block of money and its value rises, you could still lose. For example, if the block of money rises from $680 to $900, it certainly went up substantially in value but you still lost money since you paid $990. This is exactly what happened with our AGIX $20 call. The price of the underlying stock rose, but our option was overpriced. The moral of the story is that if the price you pay is greater than the value, you can end up with a loss even if your directional outlook is correct. The legendary investor Warren Buffett said it beautifully: “Price is what you pay. Value is what you get.”

The price of an option is in no way related to its value.

Option Prices and Point Spreads
One of the best ways to understand option trading is to realize they can be viewed as a directional bet on the underlying stock. (This is not to say we are using options to bet on stocks. Instead, it’s a framework to help us understand what went wrong with the AGIX $20 call.) As with any bet, you put up some money in hopes of making a particular reward. There is some probability of winning along with a probability of losing. The amount you’re willing to wager on a bet can be thought of as the price of the bet. But, as we will show shortly, some prices reflect a good deal while others do not.

In order to better understand how some prices can be too high, imagine that it is 2004 and you are betting on the Super Bowl between the New England Patriots and Philadelphia Eagles. You do your homework and find that all of the analysts are predicting that New England will win. To the unwary, it sounds like betting is too easy; all you have to do is bet big on New England and you’ll make money. Unfortunately, you find that everybody wants to bet on New England and you cannot find anybody to take the other side of the bet. How can you entice someone to take the other side? There are several ways but one of the easiest is to offer a point spread. While nobody may be willing to bet on the Eagles in actual points (or “even up”), people will take the bet if you create a point spread. For instance, if you offer a seven-point spread on New England then anybody betting on that team must subtract seven points from the Patriots’ score before comparing it to the Eagles’ score in order to determine who wins the bet. If the Patriots win 21-14, there is exactly a seven-point spread and no money is won or lost. A bigger spread results in a win for the person betting on the Patriots while a smaller spread results in a win for the one betting on the Eagles.

If nobody accepts the bet with a seven-point spread, you can always increase it until you find a “buyer.” At some point, people will think the bet is fair and take the other side. Figure 6-9 shows the spreads at the Stardust and Mirage Casinos and you can see they were offering a seven-point spread, which is designated by the -7 under each of their names:

The spread acts as a way to even up the bet. It’s the way in which markets are created; otherwise everybody would bet on the favored team and there would be nobody left to take the other side of the bet. The spread is increased until we find an equal number of buyers and sellers. If the spread is too big, bettors will realize that they are better off betting against their team even though they think they will win. It’s only when the spread is just right that we end up with an equal amount of buyers and sellers on either side of the bet.

Figure 6-9 shows the final score was 24-21 in favor of New England. This means anybody who predicted New England would win betted correctly, but they still lost the bet. In other words, New England won but not by a big enough margin to win the bet.

Now let’s see how this football analogy relates to the options market. At the time the AGIX quotes were taken there were numerous articles about upcoming experiments for one of its drugs to reduce the amount of fatty plaque that causes clogged arteries. If the experiment is positive, the stock’s price could jump significantly.

Now think about this. If everybody believes that AGIX will rise, then everybody would want to buy call options (just as if everybody thinks the Patriots will win then everybody wants to bet on them). And if everybody wants to buy calls then there is a problem. Who is going to sell those calls? The answer is that nobody will. That is, nobody will sell them unless you offer a point spread on the “bet.” And that’s exactly what has happened with the AGIX $20 call.

Figure 6-6 showed that the $20 call was asking $4.80. In essence, anybody buying this call is really betting that the stock’s price will be above $20 + $4.80 = $24.80 by expiration since that’s the breakeven point on the option. The $4.80 time premium of the option acts in the same way a point-spread does for a football bet. It’s only because of this $4.80 “point-spread” that a market between buyers and sellers could be created. If the time premium was higher than $4.80, then the point spread would be too big and we’d have too many people wanting to sell the bet and the price would fall. If the premium is less than $4.80, then the point-spread is too small and traders would believe the $20 call is a good deal. We’ll end up with too many people wanting to buy the call and the price will rise. A price of exactly $4.80 is what is required to balance the number of buyers and sellers at that point in time.

Notice that, at expiration, if the stock rises from $18.81 to $24.80 or less, any trader who paid $4.80 for the $20 call loses the bet – even though the stock’s price rose. This is exactly what happened to those who bet on the Patriots with a seven-point spread. Even though they were betting on the correct team, they still lost the bet since they did not win by a big enough spread. And this is exactly what happened to the traders who bought the $20 call on September 16 and tried to sell it six days later. Although traders buying the call were correct on the direction, they accepted too big of a point-spread on the bet. In short, the price of the call was much higher than the value.

To be continued…..

Jan

14

Options 101 #69

Filed Under Option Trading Articles | Leave a Comment 


The only variable we’re not sure of is volatility and that’s why it’s the most important variable in the model. If it’s an unknown variable, then how did we look up volatility numbers for Google and McDonald’s earlier? When we looked those numbers up they were historic numbers; they had already occurred in the past. When the Black-Scholes Model asks for volatility, it really needs to know the future volatility of the stock and not the historic volatility.

To understand why, go back to our two-price stock model where the stock could move up or down $5. If this is how the stock has behaved in the past then we would value the $50 call at $2.50. However, suppose we have reason to believe the stock will now move up or down $10 in the future. Now the $50 call is worth $5 and not $2.50. It’s the future volatility of the stock that determines the price of an option and, unfortunately, that is something we will not know until expiration.

In order to truly know the value of an option we must know the future volatility of the underlying stock. And that is something that can never be known for sure until expiration.

Using the Black-Scholes Model
Let’s take a look at how to use a Black-Scholes Model. There are many available online, but one of the best can be found at the CBOEs website www.cboe.com:

Let’s assume we are looking at a stock trading for $50. We’d simply type “50” in the “Price” field on the left side of the calculator. If we wish to evaluate a $50 strike, we’d type 50 into the “Strike” field. We’ll also assume that there are 365 days to expiration and that interest rates are 2%, which we type into their respective fields. Last, we’re going to assume that the future volatility of the stock will be 17.62% over the course of the year (you’ll find out why this specific number was chosen shortly). What is the $50 call worth under these assumptions? All you have to do is click the “calculate” button in the middle of the screen and the call and put prices show up on the right by the “Option Value” field (circled).

It’s showing us the call should be $3.99 and the put should be worth $3. The reason 17.62% was chosen as the volatility is because that’s the volatility that makes the put worth exactly $3, which fits an example we worked by hand in Chapter Five. If you recall in that chapter, we were trying to figure out what a market maker should charge for a one-year, $50 call with the stock at $50. We also assumed he paid $3 for the put and interest rates were 2%. From put-call parity, we calculated that the market maker should charge $3.98 for the call, and the Black-Scholes Model in Figure 6-2 is coming up with $3.99. So we’re off by a penny, but that is due to differences in the interest compounding assumptions and number of days assumed in a year.

Although the Black-Scholes Model makes use of some very complex mathematics, the essence behind the calculations is similar to what we worked through when trying to figure out how much the market maker should charge for a call option.

Why do you suppose the call in Figure 6-5 is roughly $1 higher than the put? Hopefully you remember from put-call parity that it’s due to the cost-of-carry on the stock. If interest rates are 2%, it will cost $50 * .02 = $1 in lost interest to buy and hold the stock for one year. In other words, if you pay $50 for stock and hold it for a year, you could have had $51 at the end of the year if you had left the money in a risk-free account instead. So there is a $1 cost of carry on a $50 stock over a year if interest rates are 2%. That’s why the call is priced $1 higher than the put. The Black-Scholes Model is a complex form of put-call parity with volatility as the key ingredient.

Why You Need to Understand Volatility
This chapter is by no means meant to be a comprehensive lesson on volatility. However, most beginning option books do not even mention it, and that’s a huge disservice to new traders and investors. If you don’t understand the role of volatility, you can end up with unpleasant surprises as we will now demonstrate.

Many option traders believe option trading is a relatively easy task and that you buy calls when you think the stock is going up and buy puts when you think it’s going to fall. After all, that’s all that’s needed to trade stocks. When most traders make the switch to options, they apply this same directional procedure to the options market. However, this approach ignores the time value of calls and puts in terms of volatility and unexpected, almost paradoxical, losses can occur as the following real-life example shows.

On September 16, 2004, Atherogenix (AGIX) was trading for $18.81 as shown by the quotes in Figure 6-6. At the time, there was tremendous bullish news on the stock regarding a new heart medication. Most option traders who were bullish might have been tempted to buy the $20 call since it was the next-highest strike from the (then) current stock price. Figure 6-6 shows the $20 call (circled) would cost $4.80, or $480 per contract.

Direction Versus Speed
What happened? How did this call option lose money even though the stock’s price went up? Loosely speaking, the reason is because options are two-dimensional assets. That is, option traders must not only guess the direction of the stock correctly but they must also guess how quickly the stock’s price will get there – the speed.

Stock traders, on the other hand, only need to correctly guess the direction; they are dealing with a one-dimensional asset. It doesn’t matter how long it takes for the stock to move, just as long as it moves in the right direction.

As an analogy, you car moves in one dimension – horizontally. An airplane, on the other hand, can move in two-dimensions – horizontally and vertically. It is this second dimension that makes flying an airplane so much more difficult than driving a car. Just because you may have driven a car accident-free for 20 years does not mean you should just jump into an airplane and start flying. There is a second dimension you’re not used to dealing with. Likewise, just because you may have been trading stocks successfully for 20 years does not mean you should just jump into the options market and start trading options based on direction. That’s an equally bad idea.

In this example, the $20 call option trader got the stock direction right but not the speed; it took too long for the stock to get there. If the stock had moved to $21.18 in a shorter time, say a day or two (rather than six), the $20 call would certainly have made money. It is this second dimension of speed that makes options trading so much more difficult than stock trading. Notice that a stock trader would have made money by purchasing the stock for $18.81 and selling at $21.18. The speed at which the stock rises doesn’t matter. So while both traders guessed the stock direction correctly, only the stock trader made money.

This example shows that call options are not necessarily a direct substitute for stock. If you think a stock is moving higher, you cannot just buy a call in place of the stock and expect to make money if you are correct. Yet most option traders mistakenly apply this one-dimensional stock trading technique to options and, consequently, end up losing money. What is responsible for this speed component? It’s the time premium of the option. If the time premium is relatively high, then the breakeven price is pushed too high and the option may lose money even though the underlying stock moves favorably. In order to prevent that from happening, option traders must learn to separate the price of an option from the value.

To be continued…..

Jan

13

Options 101 #68

Filed Under Option Trading Articles | Leave a Comment 

We can even use computer simulation to see if we’re right. Figure 6-2 shows a computer model with the number of tosses on the horizontal axis and our total profit or loss on the vertical axis:

You can see that after 500 tosses, we’re about back at breakeven. However, prior to that, we can certainly end up winning or losing due to chance. But in the long run, we’d expect to just break even. The “zero” horizontal mark in Figure 6-2 acts like a magnet for a fairly valued bet in that the profit and loss line doesn’t get too far from it. The profit or loss line can stray from zero but it cannot just move away from it indefinitely. The profit and loss line just tends to oscillate around zero.

Let’s use this same formula to see what it says about paying $1.50 for the $1 reward:

(0.50) * +$1.00
+ (0.50) *-$1.50
Expected value = -25 cents

The formula shows that we are expected to lose 25 cents per flip. Paying $1.50 for this bet is therefore too high a price, since we would expect to end up with certain losses over time. Figure 6-3 shows that a computer simulation agrees with the formula:

In fact, mathematically, after 500 tosses we would expect to end up at 500 tosses * -.25 cents = -$100 and that’s roughly where the computer simulation ended. Curiously enough, notice that even though we’re paying above fair value it’s still possible for us to end up on the winning side in the short run. Figure 6-3 shows that we ended up on the winning side even after 100 flips. But that is just due to some short-term good luck on our side. We had significant winnings to cover our losses after 100 flips. But if we stay in the game long enough, the profit and loss line does not tend to get pulled toward zero. Instead, it moves into a definite downward path and never returns. Once again, this shows that $1.50 is too high of a price to bet on this coin flipping game.

Let’s see what the formula has to say about wagering 50 cents for the $1 reward:

(0.50) * +$1.00
+ (0.50) * -$0.50
Expected value = +25 cents

Wagering only 50 cents to win $1.00 at the flip of a coin is a good deal for us, as we now expect to win about 25 cents per flip. Figure 6-4 shows a computer simulation of this arrangement:

Again, we would expect to have 500 tosses * +25 cents = $100 profit after 500 flips and that’s about where this computer simulation ends. Notice too, however, the chart shows we actually lost money after 75 flips even though the odds were on our side. That’s because the profit and loss line dips below zero up until the 75th flip mark. At that point, we head into uninterrupted profits. This profit and loss line is not pulled toward zero in the long run. Although we could certainly lose in the short run, we will end up on the winning side after numerous flips, which is confirmed in Figure 6-4.

Only when the price of the bet is $1.00 can we say that it is “fair” for both parties. As a reminder, just because the bet is fair does not mean you cannot end up on the winning or losing side. The fair price for both just means that, over the long run, neither side is expected to end up on the winning or losing side.

Fair Value Depends on Perspective
In the coin toss example, we calculated that $1.00 was the fair value of the bet. However, that result is due to our assumption that the chance of winning (and losing) is 50%. Obviously, if we used different probabilities, we would get different results. This means the fair value of any bet depends on our perspective; it depends on our views of the probability of winning.

For example, let’s assume that somebody offers to wager $1.50 for this bet. There are two ways we could look at it. First, we could assume there is a 50% chance of winning and losing and assume that is too high of a price since it results in an expected loss of 25 cents per flip:

(0.50) * +$1.00
+ (0.50) * -$1.50
Expected value = -25 cents

However, we could also look at this bet another way. We could assume that it’s priced fairly since nobody should intentionally pay more than what they think is fair. If someone offers to pay $1.50, we could say that the gambler must think it is a fair price to pay. In order for that to be true, the gambler would have to think his chances of winning are 60% since that results in a fairly valued bet:

(0.60) * +$1.00
+ (0.40) *-$1.50
Expected value = 0

If a gambler were willing to pay $1.50 for this bet, we would say he is implying that his chances of winning are 60%. In other words, just by the fact he is willing to pay $1.50 for such a bet we can back into it mathematically and assume he believes his chances of winning are 60%; otherwise he would not bid so high.

This shows there are two ways of looking at any bet. First, if we believe there is only a 50% chance of winning then paying $1.50 is too high a price. Second, we can assume the $1.50 is a fair price and adjust the probabilities to make the expected value equal to zero. We can back into this figure algebraically and, in this case, we’d say the gambler willing to pay $1.50 for this bet is implying that there is a 60% chance of winning the $1.00 prize and a 40% chance of losing the $1.50 wager.

Now, as gamblers, it’s up to us to decide which viewpoint is more realistic. Should we assume the chances of winning are 50% and be willing to pay only $1.00? Or is 60% a better assessment? Notice that if we assume 50% is the better guess we will be outbid by another gambler if he feels 60% is the more realistic probability. We would only be willing to bid up to $1 for the bet while he would be willing to pay up to $1.50. It is critical that we are confident in our assessments. If 60% sounds like too high of a probability, we’re probably better off forgoing the bet and letting someone else make it. It’s better to miss out on some reward rather than lose our money.

Whether we should use 50%, 60% (or something else) to value this coin flip is an important question. It’s even more important when valuing options. However, few option traders ever check to see how the price of an option compares to their assessment of value. Failure to do so is the leading reason that option traders lose with options. In order to make that assessment, option traders need to use the Black-Scholes Model.

The Black-Scholes Option Pricing Model
We briefly mentioned the Black-Scholes Model in Chapter Five. There are many mathematical pricing models that can tell us what the price of an option “should be.” Naturally, there will be minor variations in the answers depending on the assumptions in the model. The most famous is the Black-Scholes Option Pricing Model named after Fischer Black and Myron Scholes. Its development was no small feat, as the model relies on complex mathematics and arbitrage pricing relationships to determine what the price of an option should be and is considered to be one of the biggest breakthroughs in the modern financial era. In fact, the 1997 Nobel Prize in Economics was awarded to Myron Scholes for its development (unfortunately, Fischer Black died in 1995 and the Nobel prize is not awarded posthumously).

According to the Black-Scholes Model, there are six factors needed to determine the price of a call and put option:

• Stock Price
• Exercise Price
• Risk-Free Interest Rate
• Time to Expiration
• Dividends
• Volatility

Notice the last factor, volatility. Of these six inputs, volatility is the most important for the fact that it’s the only true unknown factor. For example, assume the risk-free interest rate is 5% and hundreds of traders are trying to value a 30-day, $100 call option on a stock trading for $95. We’ll also assume the stock pays no dividends over the life of the option. Notice all of the factors are automatically determined except volatility:

• Stock Price = $95
• Exercise Price = $100
• Risk-Free Interest Rate = 5%
• Time to Expiration = 30 days
• Dividends = 0
• Volatility = ?

To be continued…..

Next Page →

Copyright © 2004 - 2008 by Options University™ All Rights Reserved Site designed by KillerDesign.com