Jul

31

More About Vega When Trading Stock Options

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To refresh your memory about the Greek, Vega, she is the goddess who tells us exactly how much the price of an option will move in sympathy with a change in volatility. She also doesn’t care if you buy a call or a put….its all the same to her. Vertically speaking, all she cares about is the strike price. Moreover, if we want to locate the highest Vega for a given month, we know right where to find her….at-the-money. But Vega is different when it comes to the horizontal.
 
                        When we look over time, Vega is most likely to increase. What does that mean for traders? Well, it means that Vega becomes more sensitive to volatility in the out months. As Ron Ianieri of Options University explains, “We don’t trade from the future backward; we trade from now toward the future. We need to see and understand that if we buy an option, especially an out-month option, as it gets closer and closer to expiration its volatility sensitivity decreases. The option becomes less and less sensitive to movements in implied volatility; you need bigger movements to move the value of the option as expiration gets closer and closer. In other words, as our option approaches expiration, it takes more and more implied volatility to change the price of the option. From a Vega point of view, if price changes become less sensitive in the front months it implies that Vega is more sensitive in the out months.
 
Suppose you want to move an option price 17.5 cents. You do it in July where the Vega’s only 4.7 cents, you would need to have a volatility move of four ticks to get the same 17.5 cent movement in one tick of an option four months further out. So, you need to know that as options get closer to expiration their Vega component dwindles; they become less sensitive to tick movements in volatility. This fact is important because if we want to play volatility we might want to go out a little further where volatility movements may have a greater affect on price.
 
So, speaking vertically, Vega is highest at-the-money and decreases in both directions. Horizontally, however, Vega sensitivity increases in the out-months and lowers in the front months. And, although a bit counter-intuitive, as you approach expiration, volatility lessens and as a result, you need more Vega to move price per tick.
 
Another interesting thing about Vega is that spreads have their own Vega. For spreads where you are selling one leg of an option and buying the other, you’re looking at the difference between the Vega’s of the two option components and that will equal the spread’s Vega. However, if you are buying both options, you need to add the two Vega’s together.
 
When using a strategy using multiple options, you must first use the Vega to equalize the volatility levels of the two options. For example, if one leg has a volatility of 32 and the other leg has 30, you either take the 32-volatility option, using its Vega, to recalculate it for 30-volatility and then you’ll have two options at 30-volatility and then   go ahead and balance it out. Or, you can take the 30-volatility option and recalculate that using its Vega to get the theoretical value of the option at 32-volatility. This is how most spread volatility is figured out.
 
                        Because Vega is the first relationship between movement in volatility and the price of your option, it’s important to have an idea of how Vega is affected by time and changing volatility.
 

For more information on Vega and all the other Greeks, contact Options University at www.optionsuniversity.com and check out the current online courses to help boost your knowledge in the dynamic study of stock options.

Jul

31

The Time Value of Money

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Table 2-5: JNPR Quotes Taken on Expiration Day
 The Time Value of Money
I noticed that the stock was bidding $83 5/8, which means that his calls should be worth $83-5/8 – $50 strike = $33-5/8 rather than the $32-1/4 they were bidding. They were missing $1-3/8, or $1.375 worth of intrinsic value! What do you suppose we did? Hopefully you said short the stock and exercise the calls. Doing so brought in an additional 20 contracts * $1.375 * 100 shares per contract = $2,750 less some commissions for shorting the stock and exercising the call.
 
As you start trading options, you’ll find that 20-cent (or greater) discrepancies occur all the time near expiration. You’ll even find lesser, but still viable, discrepancies with as much as a week until expiration.
 
To capture this missing intrinsic value, some of the newer, more progressive firms have an order called “exercise and cover,” which automatically uses the technique we are describing. It allows you to quickly submit an order to sell the shares and then immediately exercise in order to capture any missing intrinsic value on your option. If you are trading even a few option contracts, this method of capturing intrinsic value near expiration day can be quite profitable. Depending on the commissions you’re paying and the number of contracts you’re closing, it pays to check what your difference will be between the outright sale of the option versus trying to capture any missing intrinsic value. In many cases, you’ll find that it is worth paying the extra commissions. Serious money can be hiding there, and you now have the tools to reclaim it.
Pricing Principle #4:
Prior to Expiration, All Call Options Must Be Worth At Least the Stock Price Minus the Present Value of the Exercise Price, or S – Pv (E). Put Options Must Be Worth More Than the Exercise Price – Stock Price, or E – S.
The previous pricing relationship stated that all options must be worth either zero or their intrinsic value at expiration. Is there anything we can specifically say about option prices prior to expiration? The answer is yes. Bear in mind that our previous pricing principle also applies prior to expiration and all options must be worth at least their intrinsic value. If not, arbitrage would be carried out exactly the same way as discussed for Principle #3. However, Principle #4 shows that prior to expiration we can make a stronger claim as to the minimum value. The strength of our claim depends on whether we’re dealing with calls or puts. Let’s start with call options.
 
Pricing Principle #4 tells us that all call options must be worth at least the stock price minus the present value of the exercise price. This may sound a little complicated, but it’s not so difficult once you understand what we mean by the present value. To do so, we to talk about the financial concept of the time value of money.
 
The Time Value of Money
Review of transactions
 
If call option is below intrinsic value:
1) Short the stock
2) Exercise the call
 
If the put option is below intrinsic value:
1) Buy the stock
2) Exercise the put
 
In either case, these actions provide the necessary funds to purchase the stock. You do not need to have any cash in the account.
 

One of the most important fundamental financial concepts is called the time value of money. Simply put, the time value of money states that a dollar today is worth more than a dollar tomorrow. This originates from the simple fact that a dollar today can be invested and earns the risk-free rate of interest. If someone owes you $10,000 in one year and offers to either pay you today or in one year, you’d rather have it today because you could invest that money at the risk-free rate and have more money in one year. The two payments are not the same. If $10,000 today is worth more in one year then it follows that $10,000 in one year must be worth less today. How much less? That depends on the risk-free interest rate. 

Let’s say you deposit $10,000 into an account that pays 5% interest. You will have $10,000 * (1.05) = $10,500 in one year. We call this the future value of money. The future value of money shows us how much a dollar today will be worth in the future at a stated interest rate. In this example, the future value of $10,000 in one year is $10,500 if interest rates are 5%.
 
Now let’s work the same problem backwards. If someone owes you $10,500 one year from now and interest rates are 5% then you should be willing to accept $10,500/(1.05) = $10,000 today. In this example, we say that the present value of $10,500 due in one year is $10,000 if the risk-free rate of interest is 5%. The present value of money shows us how much a future payment is worth today at a stated interest rate.
 
In other words, it should make no difference to you to wait one year and receive $10,500 or collect $10,000 today. The reason is that you can take the $10,000 today, invest it at 5% for one year, and still have $10,500 a year from now. No matter which choice you take, you’d end up with $10,500 in one year. The two choices are identical and it is the time value of money that allows us to line up the different cash flows at different points in time and arrive at that conclusion.
 
It’s important to understand that if we are using the risk-free rate then we must be dealing with guaranteed future payments. You would be indifferent between taking $10,000 today and $10,500 in one year assuming the $10,500 payment in one year was guaranteed. If the person owing you the money is financially unstable and on the verge of bankruptcy, you would probably be willing to take substantially less than $10,000 today to settle the debt.
 
Another way of expressing the present value concept is to say that $10,500 discounted at 5% for one year is $10,000. So the discount value and the present value express the same idea. Sometimes, as a simple notation, you might see Pv ($10,500) = $10,000, where “Pv” is used to denote the present value. We will use this notation throughout the book.[1] 
 
If the $10,500 were due in two years, then we must discount by 1.05 twice. Mathematically, we could go straight to the answer by dividing $10,500 by (1.05 * 1.05), which is 1.052. Doing so, we find that $10,500/1.052 = $9,523.80. To check the answer, $9,523.80 invested for one year at 5% is $10,000. If we invest $10,000 for another year at 5% we end up with $10,000 * 1.05 = $10,500. Therefore, if you are guaranteed to receive $10,500 in two years then you should be indifferent between that or accepting $9,523.80 today.
 
We can use the time value of money concept to place even tighter restrictions on our call option prices prior to expiration and the fourth pricing principle shows us how to do just that. If there is time remaining on the option then the call option’s price must be worth at least the stock price minus the present value of the exercise price, or S – Pv (E).
 
This formula is probably best understood by considering the previous principle that showed us an in-the-money call option must be worth exactly S – E at expiration. In other words, if the call is in-the-money at expiration, the call holder could receive the stock (+S) by exercising and paying the strike (-E). Therefore the value of the call must be S – E. However, prior to expiration that same exercise price must have a value of Pv (E) since the exercise will not take place until the future. The value of the call today must therefore be at least S – Pv (E).
 

The formula S – Pv (E) defines a minimum value for all call options and not just in-the-money calls. Let’s run through some examples using in-the-money, at-the-money, and out-of-the-money to be sure you understand how this formula affects option prices. We’ll begin by considering the in-the-money call.

 Assume you are looking at a one-year $50 call option with the stock trading for $55. You know there is $5 intrinsic value, so the option must be worth at least $5 (Principle #3). But because there is time remaining we know there is a higher minimum that it must be worth (Principle #4). Because you have the $50 call, you do not need to exercise it until the very end in one year, which means you can hang on to your $50 cash for one year and earn $50 * .05 = $2.50 interest. If you could earn an additional $2.50 in guaranteed interest in one year then that must have a value today of $2.50/1.05 = $2.38. This means that our $50 call has $5 intrinsic value ($55 stock – $50 strike) but it also has an additional value today of $2.38 (the present value of the interest that is earned), which means the $50 call value today must be worth at least $5 + $2.38 = $7.38.
 
In some texts, you may see the notation Ee-rt to denote the present value of the exercise price, where E = exercise price, e = the mathematical constant 2.7183…, r = rate, and t = time. The use of the mathematical constant e is just a way to accounting for continuously compounded interest and doesn’t make a big difference in the calculations. To keep things simple and more understandable, we’re going to use Pv (E) to mean the same thing.
 
 
To be continued…


[1] In some texts, you may see the notation Ee-rt to denote the present value of the exercise price, where E = exercise price, e = the mathematical constant 2.7183…, r = rate, and t = time. The use of the mathematical constant e is just a way to accounting for continuously compounded interest and doesn’t make a big difference in the calculations. To keep things simple and more understandable, we’re going to use Pv (E) to mean the same thing.

Jul

30

Calculating Vega When Trading Stock Options

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The essence of an option is the extrinsic value and the biggest component of extrinsic value is volatility. Understanding volatility brings on the importance of Vega because Vega shows us the exact direct affect of movements in volatility to an option price. It is a one step direct link.
 
Vega is given as cents just like Theta and tells us how much the option price is going to change when volatility increases or decreases. Ron Ianieri of Options University (www.optionsuniversity.com) states in his Options Mastery Course, “Vega is probably the source of most of the losses in the options market for new options traders”. He uses the example of a stock that is going up and currently trading at $46. You look at the $50 strike price for a call that is selling at only .80 or .90 cents. You look three weeks later and the even though the stock went up, the price for the $50 call has gone down-the reverse of what one might think. Why didn’t the option price also increase along with the rising stock?
 
Most likely what probably happened is that Vega took a bite out of the price. What happened was that the stock traded up in a nice steady fashion and as a result, the implied volatility decreased by the amount of Vega. This becomes particularly important when using a stock replacement strategy for an option play. Why?
 
Under certain situations, Vega and Theta can work against you and this is not uncommon to see on a regular basis. The stock may go up but not the corresponding call option. You see, Vega beat Delta and Theta (time decay) conspired to erode the option price. As a matter of fact, according to Ron, if you talk to any floor trader and you ask them, over the course of their career did they make more money trading Delta, stock direction, Vega (volatility direction), just about every trader would tell you that their money was made through Vega; that’s how important Vega is. Vega allows an option trader to anticipate what the price of the option will be in the future with the movement in volatility.
 
An important thing about Vega-as well as with Gamma and Theta-is that these three Greeks don’t discriminate between put and call. They just react to month and strike price. So, Vega-as well as the other two-will be the same for put and call at the same strike. For example if the June 70 Strike has a Vega of .053, that means that both the call and put will move 5.3 cents with a one tick change in volatility. So, if the volatility of the June 70 strike is currently at 40 and it moves up to 41, the price of the option will move up 5.3 cents. If volatility goes down, so will the price of the option as a factor of Vega for the particular strike. If Volatility in our example moves up 3 ticks, the option price will move up about 16 cents. The reverse holds true for a 3 tick decline; the option price will decrease about 16 cents.
 
So, if a trader is making a directional play, they need to make sure that Vega won’t become a surprise if volatility starts to drop. Therefore, we look specifically for options that are not very sensitive to volatility. We look for options with low Vega’s and it makes it a heck of a lot easier when we know that Vega is highest at the money and moves down on either side. So, to compare Vegas, look for at-the-money options.
 

For more information about all aspects of stock options, contact Options University at www.optionsuniversity.com and find out about their online courses, webinars and mentoring programs.

Jul

30

Expiration Values for Put Options

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Expiration Values for Put Options
At expiration, put options must be worth either zero or their intrinsic value, which is found by taking the exercise price minus the stock price, or E – S. For example, assume the stock is $53. The $60 put must be trading for $60 – $53 = $7 at expiration. If the stock is above $60 at expiration, the put will expire worthless since there is no reason to exercise a put and collect $60 when you can just sell the stock in the open market for more money.
 
If a put option is in-the-money (stock is below the strike price) at expiration and not trading for the intrinsic value then arbitrage is possible. Assume the stock is $53 but that the $60 put is trading for only $5 thus there is $2 of intrinsic value missing. Arbitrageurs would buy the stock and buy the put for a net cash outlay of $58:
 
Buy stock =           -$53
Buy $60 put =         -$5
Net debit =            -$58
 
The arbitrageur would then immediately exercise the put and receive the $60 strike price thus making an immediate, guaranteed minimum profit of $2 for no cash outlay, which is exactly the amount of missing intrinsic value. The missing intrinsic value can only be restored if the stock price rises to $55 or if the put price rises to $7 or some combination of the two. Notice that the above transactions (buying stock, buying puts) will place buying pressure on the stock and the $60 put, which are the forces necessary to restore intrinsic value.
 
So at expiration, options can only be one of two values: zero or intrinsic value. Now you see why all in-the-money options must retain intrinsic value at expiration. It is not a matter of courtesy or tradition by the market makers; it is forced through the process of arbitrage.
 
All options must be worth either zero or intrinsic value at expiration.
 
Theory Versus Reality
Okay, hopefully you’re convinced that an option must always trade for at least its intrinsic value. Arbitrage is the theory that supports that conviction. However, the reality is that there are really two prices for an option – the bid and ask. The theory holds only for the asking price and not for the bid. For instance, assume that a $50 call option is close to expiration with the stock at $55. Because the option’s price is approaching a pure intrinsic value of exactly $5, the market maker will not bid $5 for it. Instead, the market maker may bid $4.80 so that he can sell it for the $5 intrinsic value and make a 20-cent profit. If you sell this $50 call at the bid, there is 20 cents worth of missing intrinsic value. Most traders have observed this near expiration and just accept it as part of the way the system works. However, there is a way to get it back and it is similar to how the arbitrageurs do it.
 
Here’s how to do it: If you are ever selling a call option that is bidding below intrinsic value, all you have to do is short the stock and then immediately exercise the option. Since you already own the call, you do not need to purchase it like the arbitrageurs do. However, the idea is the same. By selling the stock and exercising the option, you can gain back the missing intrinsic value.
 
Using our example, let’s say you wish to sell 10 contracts of the $50 call that is bidding $4.80. If you sell at the bid, you’ll receive $4,800. But if you short the stock and exercise the call, you’ll get a net credit of $5,000:
 
Short stock = +$55,000
Exercise call = -$50,000
Net credit =   $5,000
 
This represents a $200 difference from selling at the bid price of $4.80. The reason is that the bid price is missing 20 cents worth of intrinsic value, which equals 0.20 * 10 contracts * 100 shares per contract = $200. So in this example, for the commission of shorting the stock, you can pick up an extra $200.
 
You’re probably thinking that this sounds good but with one problem. What if you don’t have the $50,000 to exercise the call? The answer is you do have it. You’ll get it from the $55,000 credit you’ll receive from shorting the stock. The fact that there is intrinsic value in the option tells us that the value of the stock must be greater than the strike. Therefore, shorting the stock will always provide enough funds to pay for the exercise.
 
Also, there is no margin requirement on the short stock position since you own a long call with a lower strike price, which protects you from any upside movement in the stock. The point is that there is absolutely no reason to not grab the extra $200. For two small commissions – one to short the stock and another to exercise the option – you can restore your intrinsic value in the call option. Most firms today charge very low commissions to buy or sell stock but charge significantly higher commissions to buy or sell options. In most cases, you’ll find that commission to short the stock and exercise the option will still be cheaper than the commission charged for selling the call. Exercising an option is normally charged as a regular stock transaction so it is usually worth your while to short the stock and then exercise the call to collect the missing intrinsic value.
 
If you have a put option with missing intrinsic value, you simply buy the stock and then exercise the put. For example, assume you have 10 $50 puts with the stock at $45 near expiration. The market maker might only bid $4.80 for this put even though it is theoretically worth $5. You can capture the missing 20 cents of intrinsic value by purchasing the stock and then immediately exercising the put:
 
Buy stock =      -$45,000
Exercise put = +$50,000
Net credit =         $5,000
 
By exercising the put, you collect the exercise price of $50. And because you only paid $45 for the stock, your net gain is the $5 difference. Once again, you may be wondering where you’ll get the money to pay $45,000 for the stock. The answer is that you will receive it once you exercise the put. Because the OCC guarantees that the transaction will go through, there is no reason for your broker to not allow it. In this example, for one small commission to buy the stock, you picked up an extra $200 for closing your $50 puts.
 
In the previous two examples, we assumed there was 20 cents worth of missing intrinsic value. How realistic is this figure? It’s actually quite common, and sometimes you’ll find the options are missing much more. For example, Table 2-4 shows Cyberonics (CYBX) call and put quotes taken on expiration day June 18, 2004:
 
Table 2-4: CYBX Quotes Taken on Expiration Day
 

Expiration Values for Put Options

Now look at the June $40 puts. With the stock at $37.60, these should be worth $2.40 at expiration but they are only bidding $2.25, which means they are missing 15 cents of intrinsic value. As with the calls, the $2.70 asking price more than reflects the intrinsic value, so you cannot arbitrage these prices. But if you already own the put, you can buy the stock and immediately exercise the put to collect the full intrinsic value.

 
How bad can these discrepancies get? One day in 1999 while working on an active option trader’s team, a client called in to sell 20 of his Juniper Networks (JNPR) Feb $50 calls. Table 2-5 shows the quotes and you can see that the Feb $50 calls were bidding $32-1/4 (this is when stocks and options were still quoted in fractions).
 
To be continued…..

Jul

29

About Theta When Trading Stock Options

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Theta is the Greek that produces time decay in stock options. It’s a bit depressing but true; each day you own a stock option, you lose a certain amount of money due to time decay. Moreover, every option has a different rate of time decay. According to Ron Ianieri of the Options University, quite often Theta is going to play an important part in choosing which strategy or option a trader may choose.
 
Every day that goes by, an option has to either perform for us because it decays. This usually that each day it hurts us just a little bit. It can get to the point that if we wait too long for an option to perform, any gains we might make from the movement may be offset by the loss in value we had already accrued in time decay.
                       
It’s also very important for option traders to realize that when talking about option prices, premium or price consists of two types of values. Value number one is intrinsic value; the amount by which an option is in-the-money. In-the-money options are the only options with intrinsic value and intrinsic value does not decay.
                       
The other value component of option premium price is extrinsic value, and this element of value is all about time decay. An in-the-money option can have both intrinsic and extrinsic value at the same time. At-the-money options have just a little intrinsic and a lot of extrinsic value. Out-of-the-money options are all extrinsic value and its extrinsic value that decays to zero over the period of the option.
 
If a trader is short an option or wants to sell an option to try to take advantage of premium collection, the trader needs to understand Theta. The trader needs to know and be aware of which options are going to have the most amount of extrinsic value and which options are going to decay the fastest. If an option trader is collecting premium, they want to try to collect as much premium and then have the value of the option decay as fast as possible. What tells us that? Theta tells us that. But what exactly does Theta tell us?
 
If you have a Theta of .032, for example, this means that extrinsic value will decay 3.2 cents a day-everyday until approaching expiration. It is also very important to know that Theta does not decay in linear fashion. When within about 20 days of expiration, the rate of decay starts to accelerate. For example, the 3.2 cent per day decay might move up to 5 cents per day and the slope of the decay chart starts to “roll over” as each day the rate of decay increases and the extrinsic value starts to evaporate rapidly and reaches zero at the end of expiration day; that is, the option no longer has  worth once it has expired.
 
Option traders need to keep in mind that most out-month options have little time decay until approaching the last two weeks or so before expiration. That means that selling out-month options is not a good strategy for premium collection. Traders want to collect the premium and then have the option premium race to zero as fast as possible. So, sell the front-month if you’re interested in premium collection.
 
The key concept to remember is: the front-month option decays much more dramatically than an out-month option. So, if we’re going to be a premium collector, if we’re going to sell options to collect premium, which is a great idea, we want to make sure that we’re selling the optimal option and that is always the front month at-the-money.
 

For more information on all aspects of stock option trading, contact the Options University at www.optionsuniversity.com.

Jul

29

Square-Root Rule for Trading Options

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Put options are also more valuable with additional time. The reason is that stock prices are equally likely to rise and fall. A $50 stock, for example, is equally likely to rise or fall by $5. Because put options act like all options but in the opposite direction, puts must also be more valuable with additional time.
 
Will longer-term options always be more expensive than short-term options? The answer is yes and the reason is arbitrage. Let’s assume the July $32.50 call is $4.90 but that the August $32.50 call is $4.75. In other words, a longer-term option is trading below that of a shorter-term option, which is something we said should not happen. Arbitrageurs would sell the July $32.50 call and receive a $4.90 credit, and then use $4.75 of that credit to buy the August $32.50 call, thus taking in a credit of 15 cents:
 
Sell July $32.50 =     +$4.90
Buy August $32.50 = -$4.75
Net credit = 15 cents
 
Now think about their rights and obligations. They have the right to buy stock for $32.50 and may have to sell it for $32.50, which is a wash. If that happens, the arbitrageurs keep the 15-cent credit. However, it is also possible that the July contract expires worthless (the stock falls below $32.50) and the arbitrageur still owns the August contract, which could rise in value after July. This means that the arbitrageur is guaranteed to make at least 15 cents and could potentially make much more. This is a riskless opportunity for which the arbitrageur paid no money. As the arbitrageur buys the August calls and sells the July calls, he will put buying pressure on August and selling pressure on July, eventually making August more expensive than July. At that point, the arbitrage opportunity disappears. A similar set of transactions occurs for put options.
 
With all else being equal, more time to expiration means higher option prices.
 
As before, you don’t need to understand this arbitrage process to trade options. Just understand that there is a very real force that assures us that longer-term options (calls or puts) will cost more than the shorter-term ones assuming all other factors are the same (same underlying stock and same strike price). That part you do need to understand.
 
Square-Root Rule
While options get more expensive with increases in time, there is another mathematical boundary that option prices closely follow. That is, it takes about four times the amount of time in order to double the at-the-money option’s price. For example, if a one-month at-the-money option is trading for $1 then the four-month at-the-money option will be roughly $2. While it may seem that doubling time will double the option’s price it actually takes a quadrupling of time. If you get more into the mathematics of option pricing, you will find that option prices are proportional to the square root of time. If time increases by a factor of four then the option’s price doubles – a factor that is exactly the square root of four. If you double the time on an option, then the option’s price will rise by the square root of two, or about 1.41 times. If the one-month at-the-money option is worth $1 then the two-month at-the-money option is worth $1.41.
 
This means that if you are a buyer of an option, it is a progressively better deal for you to buy time. While options get more expensive over time, they get cheaper per unit of time. In our example, the one-month option costs $1 per month. The four-month option costs $2 for four months of time, or 50 cents per month. So while the four-month option is more expensive in total dollars, it is actually cheaper per unit of time. Think of it like buying soft drinks by the case at the grocery store. A case of Coke will cost more in terms of total dollars but is cheaper per can (per unit). The square-root rule implies that buyers should buy more time as they become progressively a better deal. Sellers should sell short-term options. With all else being equal, buyers are better off buying one four-month option rather than four one-month options. The opposite is true for sellers.
 
Exercise:
Go to www.cboe.com and check out option quotes on several stocks. Are longer-term options always more expensive than shorter-term options? Explain in your own words why this happens.
 
 
Principle #3:
At Expiration, All Options Must Be Worth Either Zero orTheir Intrinsic Value.
At the end of the first chapter, we said that any intrinsic value must remain with an option at expiration. This means that if an option is in-the-money at expiration the price must be the difference between the stock price and the exercise price, or S – E. For example, if the stock closes at $53 at expiration, the $50 call must be worth exactly $3 since there is $3 worth of intrinsic value and no time value left. Because a long option cannot have negative value then all at-the-money and out-of-the-money calls expire worthless.
 
To restate it differently, a call option can only be worth one of two values at expiration: It is either worth the intrinsic value (intrinsic value + zero time value) or it is worth nothing (zero intrinsic value + zero time value).
 
Using our previous example, if the stock is $53, then how can we be sure the $50 call must be worth $53 – $50 = $3 at expiration? Once again, the answer is arbitrage. In order to understand the basics of the arbitrage, think back to the pizza coupons. Imagine that pizza coupons do have value and are traded in the streets (the marketplace). Now assume that pizzas are $15 and a $10 coupon is available, which means the coupon has $5 intrinsic value. However, let’s assume the coupon is trading for only $4. Can anything be done to capitalize on the missing $1 intrinsic value? The answer is yes. The way the market corrects for this missing value is that enterprising individuals would buy the pizza coupon for $4 and then take it to the store and buy the pizza for $10. They would have spent a total of $14 to get the pizza ($4 for the coupon + $10 for the pizza). Then they’d walk out in the street and sell the pizza for $15, thus making a $1 guaranteed profit. This $1 profit is exactly the amount of the missing intrinsic value. As individuals figure this out, they will compete in the market for these coupons thus raising its price. At what point will the competition for coupons stop? When the price of the coupon reaches $5 (or more), which means that the full intrinsic value is now reflected in the price of the coupon.
 
At expiration, all in-the-money options must trade for their intrinsic value; otherwise a similar set of transactions would take place in the market by arbitrageurs. For instance, assume that the stock is $53 and the $50 call is trading for $2 in the final minutes of trading, which means there is $1missing from the intrinsic value. An arbitrageur would short the stock and buy the call for a net credit of $51 to his account:
 
Short stock =           +$53
Buy $50 call =          -$2
Net credit =               $51
 
Because he’s shorted the stock, he has an obligation to buy it back and can do so by exercising the call and paying $50 out of the $51 credit he received. This leaves him with a guaranteed minimum profit of $1 for no out-of-pocket expense, which is exactly the amount of missing intrinsic value. Of course, if the stock price falls below $50, the arbitrageur would just let the call expire worthless and buy the stock in the open market to close out the short position. This would result in a profit greater than one dollar. So whether the stock price rises or falls, the arbitrageur is guaranteed a minimum profit of one dollar. As with all arbitrages, the arbitrageurs’ actions restore the proper pricing relationship. In this example, the above transactions (shorting the stock, buying the call) will put selling pressure on the stock and buying pressure on the call until the full $3 intrinsic value is restored.
 
To be continued….

Jul

28

Advanced Options Trading – Gamma Trading

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It’s never been something that’s caught on in the retail market until recently and that’s because the brokerage prices have come down so much and the spreads of trading stocks have gone from eighths to pennies and that something is called Gamma trading.

Ron Ianieri, in his popular course “Gamma Trading” presented by Options University, explains that Gamma trading can be a way of using the Gamma positions of options to trade stock back and forth when Gamma makes you either long or short Delta. According to Ianieri, the beauty of this strategy is its ability to allow day traders to take an overnight position and help make a winning trade with very high probability.

One of the most difficult things about being a day trader is making that first winning trade of the day. By using Gamma, all a day trader has to do is let Gamma make the decision on the first trade. As you may recall, when the stock moves, either a trader will be long or short Deltas and Gamma will let the trader know whether to acquire short or long Deltas and how much to buy or sell. Moreover, if Delta neutral, a trader is also hedged and can carry positions overnight.

Gamma traders have the benefit of being able to use the Gamma as a hedge or to use it offensively. So a Gamma trader can be a passive one letting the Gamma trade for him/her or the Gamma trader can be an aggressive one using the Gamma as a hedge. Just exactly how to do that can’t be covered in this short article and that is why Options University (www.optionsuniversity.com) offers this special course given by one of the industry’s leading authorities on stock options.

Gamma trading also allows an option trader to trade the same side of the market more than once; typically, the moment a day trade purchase is made, the trader is looking to make a sale. The moment they make the sale, the trader is looking to make a purchase. With Gamma trading, traders can stay on the same side of the market. How does that happen? Once again, that is not within the scope of this article but to let the reader know that it can be done. These kinds of little known tidbits are what make stock options so exciting and challenging. Compared to trading stocks, options are much more sophisticated and complex but if done properly, the effort can be rewarded handsomely.

To find out more about the world of stock options, online courses and live webinars, contact the Options University.

Jul

28

More Time Means More Money

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We’ve shown in two ways that lower strike calls and higher strike puts must always be the more expensive strikes. That’s a pretty bold statement to make. While it may make sense as a practical argument, will these relationships always hold? The answer is yes. The reason is due to a process called arbitrage. Arbitrage is a process where “free” money can be made, and that is a powerful incentive to keep a watchful eye on prices. Traders who search for these opportunities are called arbitrageurs (or arbs, for short). How does arbitrage work? Assume for a moment that the $32.50 call in Table 2-1 is $4.90 but that the $35 call is, instead, priced at $5.00. In other words, the $35 call is priced higher than the $32.50 call, which is something we said cannot be possible in the real markets. This is the perfect setup for an arbitrage opportunity since the more valuable call ($32.50) is cheaper than the less valuable one ($35).
 
In order to exploit this situation, arbitrageurs generally buy the underpriced option and simultaneously sell the higher-priced option. Although simply buying the underpriced option or selling the overpriced one individually will provide a theoretical edge, it is not enough to complete the arbitrage. In this example, the $32.50 call is a cheaper relative to the $35 call; however, just buying the $32.50 call does not guarantee a profit because that option could still lose if the stock’s price falls below $32.50 at expiration.
 
In order to capitalize on the mispricing, arbitrageurs would buy the $32.50 call and spend $4.90. Then they would immediately sell the $35 call and receive $5.00 for a net credit of 10 cents to their account:
 
Buy $32.50 call = – $4.90
Sell $35 call =      +$5.00
Net credit = 10 cents
 
A net credit of 10 cents may not seem like a lot of money but arbitrageurs do things on a very big scale. They may send hundreds of thousands or even millions of dollars worth of trades to take advantage of such a discrepancy. The sale of the $35 call more than pays for the $32.50 call so the arbitrageur has zero money invested. In other words, the sale of the $35 call more than financed his purchase of the $32.50 call. In fact, he was even paid 10 cents to take this trade. Now think about the arbitrageur’s rights and obligations.
 
The arbitrageur now has the right to buy stock for $32.50 (since he bought the $32.50 call) and may have the obligation to sell for $35 (since he sold the $35 call), which means he could potentially make a $2.50 profit. But because he got paid 10 cents to execute the trade, his maximum gain is $2.60, which occurs if the stock price is greater than $35 at expiration. However, it’s also possible for the stock price to fall below $32.50 at expiration so that both options expire worthless. That’s okay too since the arbitrageur always keeps the 10-cent credit. (Remember, when you sell an option, the money you take in from the sale is yours to keep no matter what happens to the stock or option.) He might make as much as $2.60 but cannot earn less than the 10-cent credit. If the stock price closes somewhere between $32.50 and $35 at expiration then the arbitrageur’s profit will fall somewhere between 10 cents and $2.60.
 
The arbitrageur cannot lose and has therefore capitalized on a trade that resulted in a guaranteed profit for no out-of-pocket expense – and that’s the definition of arbitrage. We must include the phrase “for no out-of-pocket expense” otherwise the purchase of a government bond would qualify as arbitrage since it produces a guaranteed return. The difference between arbitrage and a bond purchase is that you must spend money on the bond and wait in order to get that guaranteed return. With arbitrage, you are paid to take the guaranteed trade.
 
Arbitrageurs will continue to execute the above trades – buy the $32.50 call and simultaneously sell the $35 call – as long as the opportunity is there. Unfortunately for the arbitrageur, their actions also guarantee that the opportunity will eventually disappear. As they buy the $32.50 calls they put upward pressure on its price. As they sell the $35 calls they put downward pressure on its price. Eventually the $32.50 calls will be more expensive than the $35 calls and that’s when the opportunity disappears. It is the arbitrageurs who guarantee that lower strike calls will always be more valuable than higher strike calls (and that higher strike puts will be more valuable than lower strike puts).
 
With all else being equal, LOWER strike calls and HIGHER strike puts must be more valuable.
 
Arbitrage is a high-stakes game involving computerized programs that search and execute the proper trades to exploit any mispricings. As a retail investor, you will never be able to participate in arbitrage. The speed at which arbitrage is carried out is too fast and complex for the tools and software that retail investors have to work with. In addition, the arbitrage opportunities that do arise are usually for pennies and retail investors pay too high of a commission to make arbitrage worthwhile. The big brokerage houses such as Merrill Lynch, Solomon Brothers, and JP Morgan are the ones doing the arbitraging. In fact, around 1995 there was an article in the Wall Street Journal about a Japanese firm engaged in triangular arbitrage. Triangular arbitrage is a currency arbitrage that is executed by purchasing one currency, converting it to another, and then immediately converting it back to the original currency. The speed at which these transactions is lightning fast and the article went on to say that this firm paid $23 million dollars to gain one second quicker access time to currency quotes. That’s how big the stakes are and how fast the game is played. (So don’t get any ideas of logging into your brokerage account and participating in arbitrage.)

There are many who feel that arbitrage is “unfair” because there’s something that doesn’t seem right about being able to make free money from the market. But the arbitrageurs provide an important economic function in that they make sure the relative prices stay fair for the rest of us. You don’t need to understand the process of arbitrage to trade options. However, you do need to understand that lower strike calls and higher strike puts will always be more expensive. That’s a big key to understanding many strategies.
 
Exercise
Go to www.cboe.com and check out option quotes on several stocks. Are lower strike calls always more expensive than higher strikes? Are higher strike puts always more expensive than lower strikes? What about for different expiration months? Explain in your own words why this happens.
 
 
Principle #2:
More Time Means More Money
Another principle of option trading is that longer-term options will be more expensive than shorter term ones. As before, this assumes that all other factors remain constant; we must be talking about the same underlying stock and strike price.
 
Take a look at Table 2-3, which shows the July and August call options from Table 1-1. Notice that the July calls are more expensive that the August calls. Why are the August calls more expensive? (Hint: For any strike, think about which is more desirable.)
 
 
Table 2-3
Call Options
Strike
July
August
$32.50
$4.90
$5.50
$35
$2.70
$3.60
$37.50
$1.05
$2.10
$40
$0.35
$1.10
 
You guessed it. The markets realize there is an advantage in having time on your side since the price of the option has a better chance of increasing in value. Think about stock prices. If you buy a stock today for $50, is there a better chance for price appreciation after one day or after one month? Obviously, you have a better chance for the stock to increase in value over a one-month period. That’s all this principle is saying. The market realizes that there is a better chance for the August $32.50 call to rise in value when compared to the July $32.50 call and so will place a higher value on it.
 
Since all other factors between the two calls are the same, the only difference between the July call for $4.90 and August call for $5.50 is the value of the additional time. Why 60 cents extra value? That’s a question for which we will never know the answer. That is up to the market to decide; it’s up to people like you and me. Every day we place orders to buy and sell options, we’re either putting upward or downward pressure on their prices. At the time these quotes were taken, the market was placing 60 cents extra value on the August $32.50 call over the July $32.50 call. We can be sure that longer-term options will always cost more than shorter-term options but we cannot be sure by how much. All we can be sure of is that with all else constant (same underlying stock and strike price), longer-term options will cost you more money.
 
To be continued….

Jul

27

How to Calculate Good and Bad Gamma When Trading Stock Options

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One of the barriers that keep many stock traders from becoming successful option traders is understanding the importance of the Greeks. These are important variables spun out as part of the calculations of the Option Pricing Model. One of them causes particular confusion because it is a second derivative of its important litter mate-Delta. Gamma, the second derivative of Delta, discloses what will happen to Delta if the underlying stock moves $1. For instance, if the Gamma of a certain strike price is 10 and Delta is 55, that means if the underlying stock moves up $1, the option’s Delta will move 10 points to 65. But this rather simple relationship becomes more complicated as one delves deeper into Gamma. For example, there is an anecdotal classification of Gamma into bad Gamma and good Gamma.
 
Long calls and long puts both always have positive gamma. Short calls and short puts both always have negative Gamma. When we talk of short Gamma (negative gamma), that appears to be the reason some call it “bad Gamma”. Some important characteristics of short Gamma are:
 
With a short Gamma position, as the stock trades down, we need to get longer. That means we’ve got to sell, which is equivalent to selling low.
 
Conversely, if the stock goes up when we are short Gamma, we’re getting shorter forcing us to buy more stock to stay flat. This means we are buying high.
 
The above sell-low and buy-high situation is the formula for losing money and has prompted the naming of short Gamma as Bad Gamma.
 
On the other hand, long Gamma is “good Gamma” because you get to buy low and sell high. This can be confusing so to reiterate, when hedging and with long Delta, if the underlying price goes up, we’re going to get longer Delta to stay Delta neutral. If the price goes down, we’re going to get shorter Delta. On the other hand, when short Delta, as the stock trades up we’re going to acquire shorter Delta. As the stock trades down, we’re going to get longer Delta (close out positions). Because of the buy-high sell-low conundrum, most traders stay away from taking up a short Gamma positions. But hold on. If only it were that simple. You see, another Greek, Theta also plays an important part as we get closer to expiration, the time decay of Theta also comes into play by affecting Gamma.
 
When using stock options to hedge a long stock position, it is important to understand how you’re total position is going to change as the stock moves. Gamma is going to tell you that ahead of time from the standpoint of what Delta will become when the underlying stock moves up or down.
 
But that’s not all that Gamma is good for. As a matter of fact, trading Gamma is a specialized trading strategy for making short term swing trades. But that‘s a subject for another day.
 

To find out about the extensive list of online courses, webinars and workshops, contact Options University at www.optionsuniversity.com

Jul

27

Option Pricing Principles

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Option Pricing Principles
We’ve just been introduced to real call and put options and now understand how to interpret their prices when looking at quotes. But did you notice in Table 1-1 that some options are more expensive than others? Why is that? And is there a pattern we should understand? This chapter takes you through some of the most important pricing principles of options. Understanding these principles is essential for mastering option strategies.
 
Principle #1:
Lower Strike Calls (and Higher Strike Puts) Must Be More Expensive
If you look at the prices in Table 1-1, you’ll notice that the lower strike calls are more expensive than the higher strikes. This will always be true assuming, of course, that all other factors are the same. That is, we must be looking at strikes on the same underlying stock and expiration month. For example, Table 2-1 shows the call prices for July from Table 1-1. Why do the prices get cheaper as we move to higher strikes?
                   Table 2-1
July Call Options
Strike
Price
$32.50
$4.90
$35
$2.70
$37.50
$1.05
$40
$0.35
        
 
There are many mathematical reasons why this relationship must hold and we’ll look at one shortly. However, you already know enough to figure it out intuitively by thinking back to the pizza coupon analogy. Imagine that you walked in to buy a pizza and found the following two coupons lying on the counter:
 
insert pizza1       insert pizza2
Notice that both coupons control exactly the same thing (one large three-topping pizza) and have the same expiration date. The only difference is that the coupon on the left allows you to buy the pizza for $10.00 while the one on the right gives you the right to buy it for $20.00. If both pizza coupons allow you to do exactly the same thing but one just allows you to do it for a cheaper price, then obviously you would choose to pay the cheaper price. You should pick up the coupon that gives you the right to buy the pizza for $10.00.
 
The same thought process occurs in the options markets. For example, both the $32.50 call and the $35 call in Table 2-1 allow the trader to buy 100 shares of eBay, so there are absolutely no differences in what those two coupons allow you to buy. However, the $32.50 allows you to buy the 100 shares for less money. Traders realize the benefit in paying $32.50 rather than $35, so they will compete in the market for that coupon. It is a more desirable coupon, so traders and investors will bid its price higher than the $35 coupon. The same process happens all the way up the line. Each successively lower strike is bid to a higher price. Or conversely, each higher strike is bid lower than the strike below it. When you get into strategies, there will be times when you need to figure out which call option is more valuable. You can always find the answer by asking yourself which is more desirable. The answer to that question is the one that has the lower strike price. As our first Pricing Principle states: Lower strike calls must be more valuable.
 
This same reasoning drives many decisions in the financial markets. If it is more desirable then it must cost more with all other factors constant. Consider government bonds. Why are government bond yields lower when compared to the same face amount and maturity as a corporate bond? The reason is that government bonds are guaranteed; corporate bonds are not. So if a government bond and corporate bond both mature to $10,000 at the same time, which would you rather have? Again, there is no difference in what either of these bonds promise. Both promise $10,000 to be delivered to you at the same time. However, there is a big difference in the ability to carry out that promise. The government bond is far more secure so it is more desirable to investors. Investors will therefore pay a higher price for the government bond. And when bond prices rise, yields fall. That’s why government bonds will always have a lower yield than corporate bonds of the same face value and maturity.
 
When first attempting to understand option prices, you must remember that “more desirable” equates to more money with all other factors the same. If you do, you’ll understand many aspects of strategies that many traders must memorize
 
Now let’s take a look at why higher strike puts are more expensive. Table 2-2 is a listing of the July put options from Table 1-1:
                 Table 2-2
July Put Options
Strike
Price
$32.50
$0.20
$35
$0.50
$37.50
$1.40
$40
$3.20
With the put options, the reverse appears to be true and the higher strike puts are more expensive. Why does this pattern occur? The reasoning is similar as it is for calls but you must remember that put options allow you to sell stock. If all prices were the same, which put option would you rather have? In other words, which strike price is more desirable? Obviously, it is more desirable to sell your shares for $40 than for $37.50, so traders will bid the prices of the $40 puts higher than that of the $37.50 puts and the $37.50 puts will be bid higher than the $35 puts and so on down the line. Higher strike puts will always be more expensive than lower strike puts with all other factors the same (same underlying stock and expiration).
 
To better understand the relationship between put strikes and price, think about insurance. If you have a $30,000 car and want to insure it for the full value, you will pay a certain premium. However, if you accept a $500 deductible and only want insurance for the remaining value, you will pay a lower premium. If you accept a $1,000 deductible, you will pay even less. In exchange for assuming some of the risk, you will pay a lower premium. In other words, the higher the value of your car insurance, the higher the premium you will pay.
 
This same relationship holds for put options. In Table 2-2, if a trader owns 100 shares of eBay and buys the July $37.50 put, he is attempting to insure the stock for more than its current value of $37.11. For that coverage he will pay $1.40 premium. However, if he chooses to assume some of the risk, he can pay a lower premium. How can he assume some risk? He can choose lower coverage by selecting a lower strike price. For instance, if he chooses the July $35 put, he will pay on 50 cents for the coverage. But in exchange for that lower premium, he is assuming the first $2.11 in damage since the protection on his stock does not start until a stock price of $35.
 
As we’ve written before, put options can be thought of as a form of insurance. If you want high coverage (high strike prices) you will pay a larger premium for that. If you choose to accept some risk (lower strike prices) you will pay a lower premium. In other words, high strike puts cost more than low strike puts.
 
There’s another way to understand why lower strike calls and higher strike puts must be more valuable. We can do so by looking at different strikes from a probability standpoint. Let’s assume that a stock can only move between $0 and $100 with all prices equally likely at expiration. If you own a $50 call, then there is a 50% chance that you will have intrinsic value at expiration. In other words, the $50 call acts as an asset to “catch” all stock prices to the right of the strike. Obviously, the more prices it can catch, the greater the value of the call. What can we do if we want to catch more strikes? We can shift to a lower strike price such as the $25 strike as shown in the following diagram:
insert diagram14-1 
 
If we lower the strike from $50 to $25, you can see that we have far more area to the right for the stock price to land at expiration as shown by the white arrows. This shows that the $25 call must be more valuable than the $50 call because it allows the trader to potentially catch more intrinsic value. The reverse reasoning shows that higher strike puts must be more valuable since they catch more stock prices to the left of the strike price.
 
Stick with whichever method helps you to understand or visualize why lower strike calls and higher strike puts must be more valuable.
 
 
To be continued…

Jul

26

More About Gamma When Trading Stock Options

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Ron Ianieri, one of the founders of Options University used to be a floor trader and market maker and he has mentioned that as the “insiders” on the trading floor were replaced by computer trading, something the traders used to do is starting to become more popular with the retail traders…. something called Gamma trading.
 
The subject is a bit complex and has spawned a special 8 hour course on Gamma Trading presented by Options University. But to give you some taste of how Gamma is used, we will try to give you an idea of how it works.
 
Gamma trading is a way of setting up using options, a Gamma position and then flipping the stock back and forth when the Gamma makes you long Delta or when the Gamma makes you short Delta. The beauty of this is it’s great for day traders because day traders could now flip the stock back and forth in a hedged fashion. Remember that Gamma is a key in forecasting Delta and its effect on option pricing.
 
Another cool thing about Gamma trading is the resolution of one of the toughest things about being a day trader- getting off on the right foot, to make that first correct trade. If an option trader is unsure or doesn’t have a good feel about the first trade, they can step aside and let Gamma make the first trade. Remember as soon as the stock moves the Gamma position is either going to buy you or sell you Deltas to keep you properly hedged. The beauty of it is Gamma is never wrong so your first trade will always be a winner if you let Gamma make the first trade.
 
If you’ve done day trading, you normally never hold a position overnight. Too much can happen. However, because you have Gamma you can also be properly hedged. As a result, a day trader can carry overnight positions that are hedged. Ron Ianieri, designer of Option University’s “Gamma Trading” course relates the following: “How many times have you bought a stock, it has run up pretty good during the day, big volume, traded up all day and closes on the high. You know that the stock is going to open up the next morning, but the problem is you can’t carry an overnight position. Why? Because you’re unhedged”.
         
Gamma traders have the benefit of being able to use the Gamma as a hedge or to use it offensively. So a knowledgeable Gamma trader can be a passive by letting the Gamma trade for him/her or the Gamma trader can be an aggressive by using the Gamma as a hedge.
 

To learn more about the growing popularity of Gamma trading, contact Options University (www.optionsuniversity.com) and find out when they will be presenting their next course on Gamma Trading.

Jul

25

Advanced Options Trading – Vega

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According to Option University’s Ron Ianieri, “just about every trader you see will tell you that their money was made through Vega. That’s how important Vega is.” Likewise, Vega is probably the source of most of the losses in the options market for new options traders. So, now that I’ve got your attention, let’s talk a bit more about this important Greek output of the Option Pricing Model.
 
Vega measures the change in an option’s price per one tick movement (a tick is one whole number in volatility). Vega is given as cents and is going to tell us how much an option’s price is going to change when volatility moves and it’s going to quantify this for us per strike for every option. For example, if Vega is .060 at a certain strike price-regardless if it is put or call- that means if volatility moves up from, let’s say 30 to 31, the price of the option-either call or put- will move up 6 cents.
 
Why is it important to know about Vega?
 
Perhaps an example will best explain it. Suppose you think a stock is going up and the stock is currently trading at $56 or $57 and you look at it and look at the 50 strike calls and they’re only trading for .80 or .90 cents. This price is really cheap, so you buy those calls. Sure enough, the stock trades all the way up to $59.5 in three weeks and you look at your option and you see that the option is now trading for .70 cents-less than you paid for it and you can’t understand what happened. The stock went up like you thought it would, but not the option!
 
As Ron Ianieri explains in his Options Mastery Class at Options University, what probably really got you here was Vega. You see, as that stock traded up in a nice, slow, gingerly fashion, implied volatility decreased and as it decreased the value of your option decreased by the amount of the Vega, which trumped the effects of Delta.
 
So, what can option traders do is take Vega and anticipate what the price of the option will be with any movement in volatility? That’s why understanding Vega is so important.
 
When volatility increases all the options increase in price and when volatility goes down option prices also go down. If an option trader wanted to play stock direction, they want to play Delta. The last thing they want to do is to have Vega creep into the picture and destroy Delta profits. How does a trader do that?  The simple answer is to look specifically for options that are not real sensitive to volatility: we look for options with low Vega’s.
 
Vega sensitivities are higher in the out month options. If a trader buys an option, especially an out month option, as it gets closer and closer to expiration its volatility sensitivity decreases. Remember the “volatility smile”? The option becomes less and less sensitive to movements in implied volatility meaning an option needs bigger movements in the underlying to move the value of the option as expiration gets closer and closer.
 
This fact is important because that means if an option trader wants to play volatility they might want to go out a little further; maybe  instead of buying a first or second month option, go out to four, five or six months.
 
For more information on all aspects of stock options, go to: www.www.optionsuniversity.com

Jul

24

Advanced Options Trading – Introduction to Gamma

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Most option traders are very familiar with “the big Greek” Delta, which represents the change in the options price with the corresponding movement in the underlying stock. Delta is given as a percentage because the option moves at a certain percentage rate against the stock. As a stock trades up higher an in-the-money option moves further in-the-money, its Delta is also increasing. The famous Delta smile demonstrates how Delta increases on either side of at-the-money. There’s no doubt about the importance of Delta but it’s sister Greek, Gamma, also plays an important part in gaining a full understanding of stock options.
 
Gamma is the second derivative of Gamma and measures the rate of change of Delta. Gamma is going to tell us- before the fact – how much Delta is going to change with a movement in the underlying stock; therefore, Gamma measures the rate of the change of the rate of change.
 
Any time you buy any type of option, whether it be purchasing a put or purchasing a call, it doesn’t matter which one, you are going to acquire long Gamma. When an option trader sells an option they acquire short Gamma.
 
Stock options were originally developed to help hedge risk. It was found that by purchasing a certain amount of puts or selling a certain amount of calls can offset potential portfolio losses of unrealized gains. Hedging is still a very important aspect of stock options and understanding Gamma is key to understanding hedging. But we get ahead of ourselves.
 

When we’re talking about hedging and understanding what’s happening to our position, option traders need to know what is happening to options ahead of time, not after the fact. This is where Gamma comes in. This advance knowledge allows us to hedge properly because we can see before hand how many Deltas we will need to offset the stock.

In its Options Mastery Course, Options University presents the following example. Suppose you are long 1,000 shares. With the stock at $55 your long 1,000 shares equals long 1,000 Deltas. You Hedge with long 20 May 55 puts, which gives you a minus or short 50 Deltas (the-at-the-money puts have a Delta of 50). 50 short Deltas per put contract times 20 is short 1,000 Deltas. Therefore we are delta neutral which is what we need to properly hedge the stock position. But as option owner, you also own some Gamma and in this example we have total Gamma of 250. If you are long 250 Gamma and the stock trades up one dollar from $55 to $56, at $56 we should have a new Delta position of long 250. As the stock trades up, these puts lose their Delta, as they were at-the-money, they’re now becoming out-of-the-money as the stock moves up. They’re having less negative Deltas so at $56 your 20 long 55 strike puts are no longer providing us short 50 Deltas. They’re now providing you with short -750 Deltas. At $56, we’ve got 1,000 Deltas long from the stock but short 750, thus we become long 250 Deltas for every dollar that the stock moves up.
When we’re long Gamma and the stock trades down, you’re going to acquire short Deltas. So that means if the price of the stock goes down to $54, you will be short 250 Gammas. To keep delta neutral, you will know ahead of time how many options you must buy or sell to get back to Delta neutral for balanced hedging. This same scenario of Gamma providing a future idea of where Delta will be can also be used in a trading strategy just trading gamma, but that story is for another day.
 
For more information on all aspects of stock options, contact Options University at www.optionsuniversity.com.   

In its Options

Jul

23

Trumpification: Time and Volatility effects on Delta When Trading Stock Options

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What is Position Delta?
 
The use of options allows a trader to be more than just a directional player in terms of the direction of the underlying. There are two other things that you can trade using options. One is volatility. A second is the passage of time and quite often traders, when trading volatility or time, don’t want to have a Delta. If a trader can’t go Delta neutral, then they never really will be able to isolate trading volatility or time.
 
First, what is Delta neutral? To get a good idea, let’s consider how we incorporate Delta as a hedge ratio. For instance, if I buy 400 shares of XYZ, each share has a Delta of 1 that’s going to give us a total Delta position of plus 400. In order to get Delta neutral, a trader needs to figure out a way of offsetting these 400 long Deltas. You could buy 8 puts with a delta of 50 for each contract (.5 Delta per option share), which would equal negative 400 deltas. This would give a Delta neutral position in that the 400 long Deltas would be offset by the 8 put contracts. Whenever you have a position where your Delta adds up to zero or close (plus or minus ten), you are Delta neutral. So, what does all this mean?
 
Ron Ianieri says: “Typically, a stock trader who’s been trading stock their whole life, the idea of being Delta neutral is tough because they don’t understand how they’re going to make money. How am I going to make money? If I’m not playing the stock going up or going down, how am I going to make money?” That is one of the beautiful things about options; the ability to make money in more than one way. It’s much more sophisticated than stock. It gives a trader many more opportunities than stock. The idea of a position being able to become Delta neutral allows us to eliminate the Delta factor from our position. At that moment in time, we now can isolate price and only trade volatility or only trade time, otherwise the effects of Delta will interfere with these two strategies.
 
Trumpification
Trumpification is a Delta affect where time and/or volatility create an affect where the in-the-money options increase their Deltas as time passes or as volatility decreases and the out-of-the-money options lose Delta as time passes and volatility decreases.
 
Trumpification is affected by two things; decrease in volatility or the passage of time. We know that in-the-money options have their Deltas increase as the option gets closer to expiration. Out-of-the-money options decrease in Delta as time goes by and/or volatility decreases.
 
Time affects the Deltas of in-the-money options and Delta increases as time goes on. Why? Because options are in-the-money now and with even less time to go they will be even further in-the-money because there will be even less of a chance for them to fall out which means there is more of a chance for them to stay in; thus a higher Delta. 
 
Volatility is defined as the more an option moves, the better chance of that stock doing something to make an in-the-money option out-of-the-money. This is the reverse of the effects of time on Delta; higher volatility means lower Delta. As Ron Ianieri describes it in his Options Mastery Course (www.optionsuniversity.com), “with the volatility at 70 this stock is flapping around so much that there is now a higher percentage chance of this option making its way to being in-the-money. Because of the wild gyrations of the stock it’s got a better chance thus a higher Delta. If the stock is not moving as much the stock is probably not going to run up high enough to get this option in-the-money. If that’s true, then this option has less of a chance of becoming in-the-money when volatility decreases. Because it has less of a chance of being in-the-money its Delta must be lower. I know this sounds confusing, but read it over again and try to visualize what happens.

Jul

23

Breakdown of Time and Intrinsic Values When Trading Options

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Any option’s price can be broken down into the two components of intrinsic values and time values. The following formula will help:
 

Formula 1-2:
Total Value (Premium) = Intrinsic Value + Time Value

Using the July $35 call example, we know that the intrinsic value is $2.11 and the time value is 59 cents, so the total call value must be $2.11 intrinsic value + $0.59 time value = $2.70 total value. Figure 1-3 may help you to visualize the breakdown of time and intrinsic value:

Figure 1-3: Breakdown of Time and Intrinsic Values
Breakdown of Time and Intrinsic Values When Trading Options 
If there is no intrinsic value then the option’s price is comprised totally of time value. For example, in Table 1-1, the July $37.50 is trading for $1.05. However, the stock is only $37.11. If you buy the $37.50 call, you’re buying a coupon that gives you the right to buy the stock for a higher price than it is currently trading. On the surface, it may seem that the $37.50 call has no value. But the real way to say it is that it has no intrinsic value; the $37.50 call has no immediate value. There may be value in the future, but there’s no immediate value at this time. The $1.05 premium on this call is made up of pure time premium. The only reason value exists on this call is because time remains.
 
Using Formula 1-2 for the July $37.50 call we have $0 intrinsic value and $1.05 time value, so the total value is $0 intrinsic value + $1.05 time value = $1.05 total value.
 
If you like mathematical formulas, you can find the intrinsic value of a call by taking the stock price minus the strike price (exercise price). If that number is positive, there is intrinsic value on the call option.
 
Intrinsic Value Formula for Calls:
Stock price – Exercise price = Intrinsic Value (assuming you get a positive number).
 
For example, the $35 call must have intrinsic value since $37.11 – $35 = $2.11. The $37.50 call, on the other hand, has $37.11 – $37.50 = -39 cents. Since this number is negative, there is no intrinsic value on this call.
 
For puts, we use the same reasoning but in the opposite direction. In Table 1-1, the July $40 puts are trading for $3.20. There is obviously an immediate benefit in holding the $40 put since we could sell our stock for $40 rather than the market price of $37.11. The amount of that benefit is $40 – $37.11 = $2.89. The intrinsic value is therefore $2.89. Because the put is trading for $3.20, the remaining value must be time value. The time value is $3.20 – $2.89 = 31 cents. Once again, using Formula 1-2 we see that the $2.89 intrinsic value + $0.31 time value = $3.20 total value.
 
If you wish to use mathematical formulas to find intrinsic value for puts, we can just reverse the call formula (remember, puts are like calls but they work in the opposite direction). For put options, if the exercise price minus the stock price is positive then there is intrinsic value. For example, the July $40 put has intrinsic value since $40 exercise price – $37.11 stock price = $2.89 intrinsic value. We know this is the intrinsic value since the result is a positive number. The July $35 put, on the other hand, has no intrinsic value since $35 exercise price – $37.11 stock price = -$2.11 (negative number).
 
Intrinsic Value Formula for Puts:
Exercise price – Stock Price = Intrinsic Value (assuming you get a positive number).
 
We can rearrange Formula 1-2 to come up with another useful formula for finding time value: Premium – Intrinsic Value = Time Value. We can abbreviate this formula as P – I = T, which looks like the word “pits.” Just remember that option formulas are the “pits” and you should have no trouble finding time values. What is the time value for the July $35 call? The premium is $2.70 and the intrinsic value is $2.11 so the time value is $2.70 – $2.11 = 59 cents.
 
Time Value for Calls and Puts:
Premium – Intrinsic Value = Time Value.
 
Intrinsic value is the key value to solve. If you can find intrinsic value, you can find time value. We can’t emphasize enough the importance of practicing by using the words “immediate benefit” or “immediate advantage” to determine if an option has intrinsic value. Formulas are nice if you are programming a computer but they do not allow you to understand why the formula works. Understanding the concepts is crucial to successful options trading. Use the formulas to check your answers.
 
Let’s revisit the thought process again for finding intrinsic value. For example, if someone asks you if the July $35 call in Table 1-1 has intrinsic value, you should ask yourself if there is an “immediate advantage” in being able to buy stock with the call for $35 when the stock is trading for $37.11. The answer is obviously yes. That means the $35 call has intrinsic value. How much intrinsic value? We just need to figure out the size of that advantage. If the stock is $37.11 and you can buy it for $35, there is $37.11 – $35 = $2.11 worth of advantage in the $35 call. The intrinsic value must be $2.11. Any remaining value in the option’s price is due to time value. Because the option is trading for $2.70, there must be $2.70 – $2.11 = 59 cents worth of time value.
 
What about the $40 put? Again, we know there is an “immediate advantage” in being able to sell your stock for $40 rather than the current price of $37.11, so this put has intrinsic value. How much intrinsic value? Again, we just need to find out how big the advantage is. If the owner of that put can sell stock for $40 when the stock is trading for $37.11, there must be $40 – $37.11 = $2.89 worth of intrinsic value. Any remaining value in the option’s price is due to time value. Because the option is trading for $3.20, there must be $3.20 – $2.89 = 31 cents worth of time value. Keep practicing these steps and intrinsic and time values will become second nature to you.

Moneyness
 
We just learned the difference between time and intrinsic values, and that allows us to understand some more option terminology. Options are generally classified by traders as in-the-money, out-of-the-money, or at-the-money, which are sometimes referred to as the “moneyness” of an option. An option with intrinsic value is in-the-money, while an option with no intrinsic value is out-of-the-money. An option that is neither in nor out of the money is at-the-money.
 
The phrase “in-the-money” is generally used to imply that something is profitable. If someone says their new business is in-the-money, it means they are making money, and that’s really what this term is implying with options. For example, in Table 1-1, the $32.50 and $35 calls are in-the-money since both have intrinsic value. The owners of these calls are able to buy the stock for less than it is currently trading and therefore have some real value in holding the option. The $40 call is out-of-the-money since there is no immediate benefit in holding it; there is no intrinsic value. Technically speaking, an at-the-money option has a strike that exactly matches the price of the stock. But since it is rare that the stock price will exactly match a particular strike, we usually label the at-the-money strike as the one that is closest to the current stock price. In Table 1-1, we’d say that the $37.50 strikes are at-the-money calls (even though they are technically slightly out-of-the-money).
 
If an option is very much in-the-money (usually by a couple of strike prices or more) the option is considered deep-in-the-money. If it is several strikes out-of-the-money it is considered to be deep-out-of-the-money.
 
For put options, the same definitions apply; all strikes with intrinsic value are in-the-money. For puts, this means that all strikes higher than the stock’s price are in-the-money. In Table 1-1, the $40 puts are in-the-money since they have intrinsic value. The $35 puts are out-of-the-money since they have no intrinsic value. The at-the-money strike will be the same for calls and puts, so the $37.50 puts would be considered the at-the-money strikes (even though they are technically slightly in-the-money).
 
The terms in-the-money, out-of-the-money, and at-the-money are used just for description purposes; it just makes it easier for option traders to describe types of options and strategies. For example, rather than tell someone that you bought some call options whose strike price is lower than the current value of the stock, it’s easier to say you bought some in-the-money calls.
 
To be continued….
 

Jul

22

Understanding a Real Put Option

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Understanding a Real Put Option 

Okay, let’s try the next call on the list in Table 1-1, which is the 05 Jul 35 call (notice that the strikes are in $2.50 increments since eBay is below $50, which is in agreement with what we stated earlier). If you buy this call option, you have the right, not the obligation, to buy 100 shares of eBay for $35 per share through the third Friday in July ‘05. Since eBay is trading for $37.11, we know that anybody holding this option has an immediate advantage of $37.11 – $35 = $2.11 by buying this call and we now know that this advantage must be reflected in the price. You can verify that the asking price is $2.70, which shows the apparently free $2.11 benefit is not free. Again, the reason traders will pay more than the $2.11 benefit is because there is time remaining on the option and it certainly could end up with more value. If you want to buy this contract, it will cost you $2.70 * 100 shares = $270 per contract + commissions. If you buy two contracts, you will control 200 shares and that will cost $540 and so on.
 
While we’re talking about the prices in Table 1-1, let’s delve into what the rest of the columns mean. The LAST SALE column records the price of the last trade of the option. Option traders rarely look at this, since that price could have occurred during the last minute but it also could have been last week. We don’t know when that trade took place. We just know that was the price when it last traded. For stock traders, the last sale will generally be very close to the bid and ask of the stock, because optionable stocks generally have high volume — but that is not necessarily true for their options. In Table 1-1, you can see that the last trade on eBay was $37.11 with the bid at $37.10 and the asking price at $37.11. The last sale for the stock is very close to the current bid and ask, which will usually be the case. But notice that the last trade for the $32.50 call was $4.40 with the bid and ask at $4.70 to $4.90. This shows that the last trade is somewhat stale; that’s why option traders generally do not look at the last trade. If you were buying this option, the last sale would lead you to believe that it would cost $4.40 when it would really cost $4.90. If you were selling the option, the last sale may make you decide against it since it appears you would only receive $4.40 when, in actuality, you get $4.70.
 
The NET column shows the net change between prices for the two most recent trades just as it does for stocks. For the July $32.50 call, the last trade was $4.40 and that price was down $1.20 from its previous price, which means the previous trade was $4.40 + $1.20 = $5.60. If this option traded at $5.60 and the next trade was at $4.40 then that represents a $1.20 drop in price, which is what the NET column shows. Again, the reason for the apparent big drop in price is because there was a big time delay between those two trades.
 
The VOL column shows us the volume, which is simply the number of contracts traded that day. For the stock market, volume refers to the number of shares traded; for the options market, it refers to the number of contracts but the idea is the same. The OPEN INT column shows how many contracts are currently in existence, which is called the “open interest.” We’ll find out more about open interest in Chapter Four.
 
Understanding a Real Put Option
Now that we’ve looked at a couple of call options, let’s take a look at some real put options. In Table 1-1, what does the 05 Jul 32.50 put option represent? If you buy this put, you have the right to sell 100 shares of eBay for $32.50 per share through the third Friday of July ’05. For that right, you would have to pay 0.20 * 100 = $20 plus commissions. No matter how low a price eBay might be trading, you are guaranteed to get $32.50 if you exercise this put option to sell your shares. Remember, you do not need to own the shares of stock to buy a put. By purchasing this put, you have the right to sell shares for $32.50 and somebody else will be very willing to buy this from you if eBay falls below $32.50. By purchasing the put, you’re banking on eBay’s price falling. If you think the price of eBay will fall, you can buy the put and then sell it to someone else, thus capturing a profit without ever having the shares to sell. Notice that with this option, there is no immediate benefit in owning the $32.50 put. If you owned shares of eBay and wanted to sell, you’d just sell the shares in the open market for $37.11. Once again, the reason there is any value to this $32.50 put at all is because there is time remaining and it may end up with a lot more value if eBay’s price falls. Traders are willing to pay for that time.
 
Let’s try the next one on the list, the July $37.50 put. If you buy this put, you have the right to sell 100 shares of eBay for $37.50 per share through the third Friday of July ’05. Now this put does appear to have an immediate value since we could sell the stock for a higher price than it is currently trading. It appears that if we buy this put, we could buy the shares for $37.11 and immediately use the put option and collect $37.50 for an immediate guaranteed profit of 39 cents. As with our call option examples, any immediate benefit must be paid for, and we can verify that by observing the 50-cent asking price. In other words, you’re paying 50 cents for that 39-cent benefit. The market is willing to pay more than the immediate benefit since there is time remaining on the option. You cannot use options, whether calls or puts, to collect “free money.”
 
Key Concepts
1)      The price of an option is called the premium.
2)      The “ask” price tells us how much we have to pay for an option. The “bid” price tells us how much we can sell it for.
3)      To find the total price for one option contract, multiply the bid or ask by 100.
4)      The last day to trade an option is the third Friday of the expiration month.
 
 
Intrinsic Values and Time Values
In the previous section, we found out that some options have an “immediate value” or “immediate benefit” at the time they are purchased while others do not. It’s time now to introduce some more terminology that will help you understand why.
 
We discovered that an option’s price must reflect any immediate value in holding it. For instance, we found that the July $35 call could give a trader an immediate benefit of $2.11 since the stock is trading for $37.11. If the stock is trading for $37.11 and you have a call that gives you the right to buy the stock for $35, you’re better off with the call by $37.11 – $35 = $2.11. That $2.11 worth of immediate benefit must be reflected in the price, and we see that it is since that call is priced higher at $2.70. In option lingo, we’d say that the $35 call has $2.11 worth of intrinsic value. It will really help if you learn to substitute the words “immediate benefit” or “immediate value” for intrinsic value. If the stock is trading for $37.11, we know the $35 call must be worth at least $2.11 in the open market. In other words, options must be worth at least their intrinsic value.
 
If there is any value in the option over and above this amount, it is called time value or time premium. (Some texts will also refer to this as extrinsic value.) The time value is due to the fact that there is still time remaining on the option. Since the July $35 call was trading for $2.70 and the intrinsic value is $2.11 then the time value must be $2.70 – $2.11 = 59 cents.
 
 
To be continued….

Jul

22

Hedging with Delta When Trading Stock Options

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The third important fact that all stock option traders and portfolio managers should understand about the Greek, Delta, is how to formulate a strategy to help reduce risk. This objective was the major motivation for the develop-ment of stock options.
 
As you know, Delta is one of the many important variables produced by the Option Pricing Model. Delta does three important things: 1) Provides an indication of the probability of finishing in-the-money; 2) Describes the correlation of price movement between options and underlying; 3) Provides ratios for options to stock for risk reduction. Let’s talk about this last topic commonly known as Hedge Ratio.
 
Hedge ratio tells us how many options at a certain Delta we would need to reduce the total position risk to near zero. For example, if we have 1000 shares of a certain stock, how many stock options will we need to buy or sell to offset potential losses of value in the underlying stock? This is an important tool for portfolio managers who want to “lock in” unrealized portfolio gains. Here is how it works.
 
Suppose you have 1000 shares of XYZ stock and you have realized a nice gain over the years. Now, the market seems to be entering a period of correction or there are potential short term problems within the company. To help protect the shares against losses, stock options in the form of long puts or short calls can act to offset potential losses. For out purposes, we will buy puts. But the big question is: How many puts must we buy and at what strike price to protect at a 100% correlation any downward move in price of the underlying stock. In other words, if the stock price goes down, how many puts must be purchased at a certain strike price to gain profits on the options to offset the losses on the underlying stock?
 
One share of a stock has a delta of 1. Its value is in itself. How many options must I buy to produce a Delta of 1? You could buy two options with a Delta of .5 to cover each share or 3 options with a Delta of .34; or 4 options with a Delta of .25. You get the picture. Keep in mind that a long position always has a positive Delta; a short position or a put has a negative Delta. Therefore, to reduce Delta to zero requires offsetting Deltas.
 
To test your understanding, try this example: You have 300 shares of ABC and you want to protect against a downward move. How many options should you buy (or sell) to cover the total downside risk? First of all, how many long Deltas does the position have? How many negative Deltas must I find to offset the long position? How many puts must I buy if I buy an ATM put with a .5 negative Delta or if I buy an OTM put with a negative Delta of .4?
 
Answer: The 300 shares of ABC have total positive Deltas of 300. To offset the 300 long (positive) Deltas would require 300 short (negative) Deltas. If you use the ATM options with 50 deltas (100 shares per contract) you would need to buy 6 contracts of the ATM options. For the OTM options with a .4 Delta, you would need to buy 40 (negative Deltas per contract) and divide that into the positive Deltas of the 300 shares. Thus, you would need to buy 7.5 contracts (round off to 7 or 8). Don’t forget to deduct the cost of the put positions from unrealized gains.
 

In summary, not understanding the power of Delta is to not understand stock options. For more information on the tremendous potential and flexibility of stock options, contact Options University (www.optionsuniversity.com) for a listing of online courses, seminars, webinars and other educational stock option opportunities.

Jul

21

Bid and Ask Prices when Trading Options

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Options 101
Part 8
Click image to enlarge
Bid and Ask Prices when Trading Options

 

Before we continue, we need to introduce some more terminology that has been deliberately withheld until now for the fact that it will be easier to understand at this point. There are three main classifications for options. First, there are two types of options: calls and puts. Second, all options of the same type and same underlying represent a class of options. Therefore, all eBay calls or all eBay puts (regardless of expiration) make up a class. Third, all options of the same class, strike price, and expiration date make up a series. For instance, all July $32.50 calls form a series.
 
At the time these quotes were taken, eBay stock was trading for $37.11, which you can see in the upper right corner of Table 1-1. The first column is labeled “calls” and several columns to the right you will find one labeled “puts.” The first call option on the list is 05 Jul 32.50. The “05 Jul” tells us that the contract expires in July ‘05 and the “32.50” designates that it is a $32.50 strike price. The last trading day for this option will be the third Friday in July ‘05. All you have to do is look at a calendar and count the third Friday for July ‘05 and that is the last day you can trade the option (which happens to be July 15 for this particular year). Remember, you can buy, sell, or exercise this option on any day, but the last day to do so is July 15. All 05 July options will expire on the same date regardless of the strike price or whether they are calls or puts.
 
The “XBAGZ-E” notation is the symbol for that option. Just as every stock has a unique trading symbol, each option carries a unique symbol. However, you can forget about the “dash E,” as the letter E is a unique identifier for the CBOE, which just tells us these quotes are coming from that exchange. If you wanted to buy or sell this option online, you’d enter the symbol “XBAGZ.” Your broker, however, may require you to follow this symbol with “.O” to show that it is an option (for example, XBAGZ.O). Your broker will make it very clear if he has these requirements, but the actual symbol (XBAGZ in this example) will always remain the same regardless of which brokerage firm you use.
 
 Your brokerage firm may list option symbols as “OPRA” codes. The committee named for consolidating all of the option quotes and reporting them to the various services is called the Options Price Reporting Authority or “OPRA.” An OPRA code is the same thing as the option symbol. You can read more about OPRA at www.OpraData.com.
 
The $32.50 strike means that the owner of this “coupon” has the right, not the obligation, to buy 100 shares of eBay for $32.50 through the third Friday of Jul ‘05. No matter how high a price eBay may be trading, the owner of this call option is locked into a $32.50 purchase price. Now this seems like a pretty good deal since the stock is trading much higher at $37.11. It appears that if you got the $32.50 call, you could make an immediate profit of $37.11 – $32.50 = $4.31. In other words, it appears that if we could get our hands on this coupon, we could buy the stock for $32.50 and immediately sell it for the going price of $37.11 thus making an immediate profit of $4.31. However, you must remember that call options, unlike pizza coupons, are not free. It will cost us some money to get our hands on it.
 
How much will it cost to buy this coupon? We can find out by looking at the “ask” column, which shows how much you will have to pay to buy the option. It shows a price of $4.90 to buy this call. This means the apparently free $4.31 is no longer free since you’re paying $4.90 for $4.31 worth of immediate benefit. In fact, you will find that you must always pay for any immediate advantage that any call or put option gives you. The main point is that you cannot use options to collect “free money” in the market. When traders are first introduced to options, they often think they can buy a call option that gives them an advantageous price and then immediately exercise the call for a free profit. They overlook the fact that the price of the option will more than reflect that benefit. Why would someone pay $4.90 for $4.31 worth of immediate benefit? Because there is time remaining on the option. It is certainly possible that the option will, at some point in time, have more than $4.31 worth of benefit, and traders are willing to pay for that time.
 
The $4.90 price is also called the premium. The premium really represents the price per share. Since each contract controls 100 shares of stock, the total cost of this option will be $4.90 * 100 = $490 plus commission to buy one contract. So if you spend $490, you can control 100 shares of eBay through the expiration date of the contract. That’s certainly a lot less than the $3,711 it would cost to buy 100 shares of stock. If you buy two contracts, you will control 200 shares and that will cost $980 plus commissions, etc. Remember, we said that all options control 100 shares when they are first listed but it is possible for them to control more shares, which is usually due to a stock split. If that happens, it is possible for the contract size to change, which we will expand on more in Chapter Four. The main point to understand is that you always multiply the option premium by the number of shares that the contract controls in order to find the total price of the option. In most cases, you will multiply by 100.
 
Bid and Ask Prices
Let’s take a brief detour here to learn more about what the bid and ask represent since they can be confusing to new traders. Notice that the $32.50 call shows a bid price of $4.70 and an ask price of $4.90. You have to remember that the options market, just like the stock market, is a live auction. There are traders continuously placing bids to buy and offers to sell. The bid price is the highest price that someone is willing to pay at that moment. The asking price is the lowest price at which someone will sell at that moment. If these terms are confusing, think of the terms you use when buying or selling a home. If you wish to buy a home, you submit a bid. Buyers place bids. If you were selling your home, you’d say I am “asking” such-and-such a price for it. Sellers create asking prices. Sometimes you will hear the word “offer” instead of “ask” but they mean the same thing. If the bid represents the highest price someone is willing to pay that means you can receive that price if you are selling your option. You are selling to a buyer and the trade can get executed. Notice that you cannot sell at the $4.90 asking price because that is a seller too and you cannot execute a trade by matching a seller with a seller.
 
Likewise, if you are buying this option, you should refer to the asking price to see how much it will cost you. Since the asking price shows the lowest price that someone will sell, we know you can buy the option for that price. In this case, you are buying from a seller and the trade can get executed. This is important to remember since the price you pay or receive depends on the bid and ask. This trade may appear to be a good deal if you can sell for $4.90 but you will be disappointed if you find that you only receive $4.70. You need to be aware of which price applies to your intended action. In summary, if you are selling then you should reference the bid price. If you are buying, you should look at the asking price. This is especially critical for options traders since the volume on options is not as high as it is for the stock and, consequently, options will have larger spreads between the bid and ask. For example, in the upper right corner of Table 1-1, you can see that the stock (eBay) is bidding $37.10 and asking $37.11, which represents a one-cent spread between the buyers and sellers. However, the $32.50 call option is bidding $4.70 and asking $4.90, which is a 20-cent spread. The bigger that spread, the more critical it is to understand what these numbers mean, otherwise you could be in for an unpleasant surprise when trading. We’ll learn more about the bid and ask in Chapter Four when we examine the Limit Order Display Rule and how you can use it to your advantage to lessen the effect of the spread.
 
The “bid” price represents the highest price that a BUYER is willing to pay. It is consequently the price at which you can sell the option.
 
The “ask” price represents the lowest price that a SELLER is willing to receive. It is consequently the price at which you can buy the option.
 
 
To be continued….

 

Jul

21

The Importance of Delta When Trading Stock Options

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#8 The Importance of Delta
Wouldn’t it be nice to know before entering a trade what your chances are of making a profit? If you look at several potential trades and one has a much better statistical probability than the other of finishing in-the-money, which one would you choose? For example, imagine the normal distribution curve with the current price at the median. If the strike price is the same as the current price, there is a 50% probability that at the time of expiration the stock will be in-the-money. That is, if at expiration the sock price is at or above the current price it will be in-the-money. If it is below the current price, it will be out-of-the money and worthless.
 
Now, if you have a strike price below the current price at the meridian (50% point) there is a greater probability that the current price will end up ITM. The current price would have to move to the left and the additional distance between the median and the lower strike price increases probability that the current price will end up ITM. Moreover, the more the strike price is below the current price, the greater the probability of finishing ITM. As a matter of fact, if the strike price is near the low end of the curve, the probability of finishing ITM is near 100%. Of course, the greater the amount of volatility in the stock, the wider the end-points of the curve.
 
                $30       $38 strike                $50                                     $70
insert fig8-1
                                 .94 prob of ITM    .5 probability of ITM           
 
Strikes to the right of the current price (median) would be probability of ending out-of-the-money (OTM). The width of the curve is representative of the stock volatility; therefore even though a strike may appear to be close to the current price that doesn’t necessarily represent a high probability as defined by Delta. Additionally, Delta has two other definitions besides probability of finishing ITM.
 
Delta also tells us how much the derivative option will move in relation to the underlying stock. For example, if the stock moves $1 and the option has a Delta of 50 (a contract is 100 shares with a delta of .5 each), the option will move 50 cents in the same direction as the stock. When an option is deep in-the-money, it very closely matches the movement of the underlying stock. A Delta of 90 means if the underlying moves $1, the option contract premium will move 90 cents. Many beginning option traders don’t understand this important relationship. They think that an out-of-the-money option is just another less expensive surrogate for the underlying stock. As you now under-stand, an option has to be pretty deep ITM to act as a correlated surrogate. The more in-the-money an option is, the higher the premium. As a matter of fact, buying ITM is more expensive but with a greater probability of being a profitable trade. OTM options do offer a higher ROI (return on investment) but with less statistical frequency.
 
Finally, Delta provides an important input for hedging risk but this topic will be a subject for another article. Stay tuned.
 
For a complete education on the subject of stock options, contact Options University at www.optionsuniversity.com
 

Jul

20

Options Are Standardized Contracts

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 Options Are Standardized Contracts

The reason that options are inflexible as to the number of shares is because options are standardized contracts. A standardized contract means there is a uniform process that determines the terms, which are designed to meet the needs of most traders and investors. By using standardized contracts, we lose some flexibility in terms (such as the number of shares, strike prices, and expiration dates) but increase the ease, speed, and security in which we can create the contracts.
 
In fact, if the exchanges find there is not sufficient demand for options on a stock, they will not even list those options. Most of the well-known companies have options available. If a stock has listed options, it is an optionable stock. Microsoft and Intel, for example, are optionable. There are currently more than 2,300 optionable stocks, so the list is quite large.
 
Another limitation of standardized contracts is the fixed strike price increments. If the stock price is below $50, you will find options available in $2.50 increments. If the stock price is between $50 and $200, options will be in $5 increments. And if the stock price is over $200, you will find option strikes in $10 increments. Notice that the strike price increments have nothing to do with the current price of the stock. The increments are based on the stock’s price at the time the options start trading. If a stock’s price has been greatly fluctuating, you might find different increments for different months. For instance, you may find $2.50 increments for the first two expiration months and $5 increments in later expiration months. This just tells you that the stock’s price was above $25 when the later months started trading.
 
By having standardized strikes, we can quickly bring new contracts to market that meet the needs of the vast majority of people. Imagine how overwhelming the task would be if the exchanges tried to meet everybody’s needs by creating strike prices at every possible price such as $30, $30.01, $30.02, etc. and then matched those with every possible expiration date such as June 1, June 2, June 3, etc. It would be a near impossibility. To solve these problems, the exchanges created standardized contracts so that we can have some flexibility while still keeping the list manageable.
 
What if you really want a customized contract? Is it possible to get one? Technically, there is nothing illegal about two people having a contract drawn up by an attorney that specifies the terms on which they agree to buy and sell stock. You could therefore have an attorney write a contract for you and another trader, thus creating your own call or put option. A contract drawn in this manner is completely flexible — but it is also very time consuming and costly. In addition, even though you may have a legally binding contract, it is possible that the seller decides to not fulfill his obligation if the buyer wishes to exercise his option. If that happens, now you’ve got your hands tied up in court trying to get the seller to conform to the terms of the contract. In other words, customized contracts are subject to performance risk. That is, will the seller perform his part of the agreement if the buyer decides to exercise?
 
Standardized options solve the performance risk problem too since the OCC acts as the buyer to every seller and the seller to every buyer. If you exercise an option, the OCC uses a random process to decide who will be assigned. When you enter an options contract, you do not know who is on the other side of the trade. Nobody knows. It is strictly the person who ends up with the random assignment. Standardization increases confidence and influences the progress toward a smoothly running, liquid market.
 
Besides having an attorney draw up a contract, there is another way to get flexible contracts. You can buy FLEX contracts through the Chicago Board Options Exchange (CBOE) that are totally customizable, but they also require an extremely large contract size – usually more than one million dollars. Because FLEX options are traded through the OCC they are not exposed to performance risk despite their large contract sizes. Because of the size requirements though, FLEX options are mostly used by institutions such as banks, mutual funds, and pension funds. The standardized market is the solution for the rest of us.
 
Key Concepts
 
1.      Options are derivative assets. Their prices are derived from the price of the underlying stock.
2.      Your “lock in” price is called the “strike price” or the “exercise price.”
3.      If you decide to use your option, you must submit exercise instructions.
4.      You are not ever required to buy or sell stock if you buy options.
5.      Your last trading day for options is the third Friday of the expiration month.
6.      Options trade in units called “contracts.”
7.      The exercise price multiplied by the strike price equals the total contract value, or exercise value.
8.      Options are standardized. You can only get them in a limited number of “flavors.”
 
 
Understanding a Real Call Option
Now that you know how call and put options work, let’s take a look at some real call and put options. Let’s pull up some quotes and see if we can make some sense of what we’re looking at.
 
You can obtain option quotes for any optionable stock by going to www.cboe.com. That’s the homepage for the Chicago Board Options Exchange (CBOE), which is one of the largest option exchanges in the world. Bear in mind that the options market is open from 9:30am to 4:02pm ET (it is open until 4:15pm ET for index options). If you are pulling up quotes after 4:02pm, you’re looking at closing prices rather than live quotes. Also, most options go through what is called an opening rotation every morning. This is simply an open outcry system that establishes option prices based on the current stock price openings. For this reason, you may not see live option quotes until 9:35 or 9:40 even though the options market is technically open at 9:30. As electronic trading increases, the opening rotation times will diminish and eventually disappear.
 
If you click on “Quotes” and then “Delayed Quotes” you will find a box where you can type your stock ticker symbol. If you are looking for options on eBay, for example, just type the ticker symbol “EBAY” and hit enter. At this time, the shortest-term options on eBay were July ’05 (26 days until expiration) and the longest term was January ’08 (943 days to expiration). The lowest strike is $22.50 and the highest is $80. So even though option contracts are standardized, there are many to choose from. Table 1-1 shows some of the shorter-term options available at the time of this writing:
 
Click image to enlarge
Options Are Standardized Contracts

To be continued…

 

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