Aug

22

Rolling Covered Calls Options Trading Strategy

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Rolling Covered Calls
 
Writing covered calls has become a popular way for more conservative investors to make use of stock options. As a matter of fact, even retail brokerages like the strategy. This says volumes because most brokerages usually try to keep the average investor away from stock options. This is due to the fact that stock options are more complex than stocks and most brokers don’t have the training in options. 
 
As you already know, a covered call is long stock and short call. You sell the options, collect premiums and if the stock doesn’t move much and the option stays out-of-the- money, you keep the collected premiums from selling the calls at expiration. If the stock stays stagnant, you can repeat this process over and over again. But what happens if the stock moves into-the-money?
 
If the short call goes into the money, the chance increases that the call option will be exercised. Moreover, it becomes more expensive to buy out of the position (buying back the short call). As a result, you consider “rolling” the position if it appears that the stock isn’t making a second or third standard deviation type move. “Rolling up” involves buying back this month’s option and selling the call for the next strike up in the next month.
 
Keep in mind that the stock you hold as part of the covered call position has also appreciated in value and this will usually more than offset the costs of closing out the short option position. Of course, when you roll up and sell the new call, you collect the premiums again. If the stock keeps moving up, you can also keep rolling up. So, even though premium collection is mainly for range bound, stagnant stocks, you can also roll up as the stock moves up. OK, but what happens if the stock starts trading down?
 
When the stock moves down, we don’t roll the position. Why is that? In a covered call strategy, you get out of the call. The covered call strategy no longer applies. If the stock looks like it’s breaking down, you could then buy puts if you intend on keeping the long stock.
 
As a matter of fact, you can close out the short call by purchasing the corresponding put. (The corresponding put is the put opposite the call-same strike and month). However, if you plan on keeping the stock, just buy two corresponding puts and you will end up with long a put. Of course, you are in a one-to-one ratio with the stock and options. So, if you were long 500 stocks you would have 5 long puts. When you “morph” a position it is also called a continuation strategy.
 
As Ron Ianieri, stock option guru and founder of the Options University states: “I might roll up strikes as the stock is going in my direction but when the stock stops going in my direction and heads the other way, it’s time to close out unless I have the wits about me to say that the reason I’m closing this position is the stock broke its up trend. It can’t be that it’s just trading down just a bit. It has to be a technical break like when that stock moves below the 50 day moving average and then follow through the next day down further.
 
I can close out my buy write with the purchase of the first corresponding put, but I can actually get short by buying a second corresponding put and then play the downward movement; that’s called a morph and completely changes the position with just one little trade. I went from being in the wrong covered call position with a stock that’s broken its up trend and has now broken its up trend and is breaking down.
 

For information, online classes, mentoring and all things stock option, contact the Options University at www.optionsuniversity.com

Aug

21

More on Stock Option Premium Collection Options Trading Strategy

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More on Stock Option Premium Collection
 
If you insist on owning stocks in your portfolio, a covered call strategy should be an important strategy to pull out of your investor tool box when the stocks you own hit a stagnant period. Being able to capitalize on covered calls can add significantly to the overall return of the stock by adding premium collections during slow times to the gains made in times of the stock appreciation.
 
As with most stock option positions, each strategy has a sister position. As you may recall, a covered call is constructed of long stock and short calls in a one-to-one ratio. So, what is the sister of the covered call? Well, it is the opposite of the long stock-short call and is short stock and long call, normally referred to as a Synthetic Put. When you sell the call, you collect premiums. With the synthetic put, instead of writing for a premium, you pay for the put options. In other words, a covered call creates a credit to your trading account and a synthetic put creates a debit. Typically, because you are long call, the synthetic put anticipates a slight bias for a slow up trend in the stock. However, the long call is more of insurance and the real philosophy behind the synthetic put strategy is that the stock will make a rapid drop.
 
So, even though the positions between the covered call and its sister synthetic put are opposite, (long stock-short call; short stock, long call), the philosophy behind the strategies are a bit different. The covered call anticipates little stock movement, whereas the synthetic put anticipates a downward movement in the stock. Moreover, the covered call strategy is a premium collection strategy and the synthetic put is more of a directional play.
 
An important thing to remember is: the odds are in favor of the seller of an option. You see, stocks are typically range bound more than they make large moves. If this is the case, could a strategy of continuous premium collection-month after month- be an effective strategy? Even though profits are limited on a month by month basis, if they can be repeated with frequency, this can be a very effective long term strategy.
 
As you can see, a buy-write (aka covered call) strategy can be good strategy particularly when hedged by a long stock position. The worst that can happen is that you lose the potential future profits from the stock if the call buyer is able to exercise the call option you sold them.
 
This premium collection strategy has become further refined by the creation of certain combinations of stock options, which can replace the need to be long or short stock. These option spreads make it possible to participate in premium collection with much less capital investment. Two of the most popular premium collection spread strategies are the “Bear call credit spread”-usually used in flat to slightly down markets and the sister strategy the “Bull put credit spread” which is usually used in flat to slightly up markets.
 

For information on just about everything concerning stock options, contact the Options University at www.optionsuniversity.com

Aug

20

More on Writing the Covered Call Options Trading Strategy

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More on Covered Call Writing
 
As you know, an option can have two types of value: intrinsic and extrinsic value.
Intrinsic value is achieved when the option moves into-the-money. If the strike price was $50 and the stock price moves to $51, the call option will have $1 of intrinsic value. If the option is out-of-the money, it has some value because it has a chance of going into-the- money. This option has no intrinsic value; just extrinsic value for its potential. However it’s important to understand that all extrinsic value decreases as time runs out for the option period.
 
Extrinsic Value Decay
 
About 20 days out from the expirations date, chances for moving into-the-money become reduced and there are fewer buyers for that month’s option at that strike price. Option traders will move on to other further out months. As a result, demand for these options fall as does the option premiums. This happens to all out-of-the money options. As a matter of fact, during the last ten days or so of the option period, the drop in premium prices accelerates to zero as the option heads to  expiring worthless; after all, there will be no premium left because there will be zero chance of getting into-the- money and producing any intrinsic residual value.
 
If you plan to sell an option, you are always best to sell at-the-money options because they have the highest amount of extrinsic value. After all, just a bit more and the option gains intrinsic value; needless to say, there is more demand for these options and premiums are priced accordingly.
 
If you plan to write an option to collect premium, you are best advised to sell a front month option at-the-money. In this way, you can ride the decay as extrinsic value goes to zero and the option stays out-of-the-money. By writing short term contracts with the anticipation of not going into-the-money, you can take advantage of the ability to use this strategy repeatedly so that even small gains can compound over time.
 
In the “Options Mastery Course” offered by the Options University, the case is established that you are mathematically better off writing front-month contracts than writing out-month contracts.
 
Profit, loss and breakeven when writing Covered Call options.
The first thing you need to find out is the breakeven; the point that your position makes zero gain or loss. To figure out breakeven, all you need to do is take the stock price and subtract the call price. For example, if you sold a call for a $2 premium, and the at-the-money- strike is at $40, your breakeven would be at $38 for the stock. If the stock goes down to $38, you would lose $2 but you received $2 for selling the options, which would offset the loss.
 
When you write an option, your maximum profit is the premium collected. If the option goes into-the-money and is exercised, your loss will be the stock you hold, which may not be a loss at all; however, any potential gains from owning the stock is lost due to giving up your stock. Of course, the premium collected helps to offset any losses.
 

For more information about all things options, go to www.optionsuniversity.com

Aug

19

Advanced Options Trading – Making Money with Stagnant Stocks

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Making Money with Stagnant Stocks
 
Most stock investors can become comfortable investing in stock options. The fundamentals are easy to understand and usually, once an investor has purchased stocks on margin, it becomes a fairly easy transition to stock options. However, to make the process of transitioning to options easier, it’s a good idea to start using stocks and options in combination.
 
One of the most simple and conservative ways to incorporate options into a trading strategy is to use what is called “Covered calls” (aka “Buy-write”).
 
Covered Call/ Buy-Write
 
This basic options strategy is made up of buying stock and then writing a call; “writing” means selling. This strategy is also called a buy-write because stock is owned or purchased and calls on the stock are sold on a one-to-one ratio. In other words, if you purchase or already own 500 shares of IBM, to set up a covered call position you would sell (write) 5 IBM calls (each contract is 100 shares). In exchange for selling the rights of your shares to the call buyer, you receive payment. This payment is referred to as the premium. If the premium for one share of IBM is $4.00, you would receive $400 for each contract or in the case of our example a total of five contracts is $2,000.
 
If at the end of the option period the IBM stock hasn’t gone into-the-money, you get to keep all of the premiums you collected. If IBM stock is currently worth $ 120, your 500 shares would be worth $60,000. If your covered call strategy works as you hoped, the $2,000 premium collected yields a 3.3% return based on the value of the stock. Not bad for one month seeing that this strategy can be repeated time and again with the same stock. Of course, if you were successful for 12 straight months, your return would be 39.6 %. So, if your long term hold stocks aren’t performing and you don’t want to sell them, consider writing covered calls while you’re waiting for them to appreciate.
 
But what happens if the options you sold go into-the-money? Well, first the buyer of the option must exercise their rights by requesting the stock you owe them at the strike price you sold the options for. For example, if you sold 5 options contracts of IBM with a strike price of $125, you would be required to transfer 500 shares of IBM stock at a value of $125 per share. So, if you had purchased the stocks at $110, you would make the $15 profit per share and also keep the $2,000.
 
However, if IBM continues skyward, that would be your opportunity cost of being forced to hand over your stock. By the same token, if IBM goes down in value, you suffer the loss of the stock, but the premium you collected helps to mitigate the losses. For instance, on the $2,000 premium you collected in the example, the IBM stock would have to go down $4.00 to breakeven. So, in effect a covered call strategy does provide some limited downside protection associated with the holding of the stock. Because of these fairly benign consequences, the covered call strategy (or buy-write) is considered a conservative position and is allowed by most retail brokerages.
 
When to use the Covered Call strategy
 
This strategy is called a premium collection strategy and gains are based on the non movement of the stock. Normally, stock investors think of a gain as something coming from the appreciation of the stock (if long) or devaluation of the stock-if short. Rarely does it occur that money can be made by no movement at all!
 

For information on stock options-from beginner to expert-contact the Options University at www.optionsuniversity.com

Aug

18

Advanced Options Trading – Understanding Synthetics: the Basic Formula

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Understanding Synthetics: the Basic Formula
 
Let’s talk about put/call parity. Say What? You remember that’s the fact that a corresponding call and put are equal to the parity of the stock at that strike price. In other words, a corresponding call/put will be mathematically related to the current value of the underlying stock. This is key to understanding the option strategy of stock replacement.
 
In Options University’s Options Mastery course, this relationship is expressed in a formula: Call price-Put price= Stock price-Strike price.
 
So, when we look at this base formula and we see the call price minus the put price, what we’re doing is canceling out the extrinsic value of that strike and only leaving the intrinsic value of that strike. When we do this, we are left with just intrinsic value of the strike. After all, only one of the corresponding call or put can have intrinsic value.
 
Likewise, when we subtract the strike price from the stock price, we are left with intrinsic value if the strike is in the money.
 
The following example taken from the Mastery Course will help to prove the point. For example, let’s take the June 70 calls with the stock at $69.50. From here let’s go back and plug in our numbers and see what we get. We’ll go back for our call price and put price but we know the strike price was $70 and we know that our stock price is $69.50. What type of value do we get, a minus .50 cents, simple math.
 
Now, let’s look at our call price minus our put price. Our call price is going to be $1.65 and our put price is going to be $2.09, so let’s plug that in, $1.65 for the call and $2.09 for the put. What we come up with is a minus .44 cents. You may say wait, the two of those aren’t equal. That’s because we haven’t adjusted for interest rate and dividend. The bottom line is that if you buy a call and sell the corresponding put, it will create a long synthetic stock position; however, there is no adjustment for interest rate or dividends.
 
Of course, the same holds true if you want to create a short synthetic stock; buy the put and sell the call. Moreover, we can create the six synthetic stock positions. For example, by either buying stock and buying puts, which will give a long call position, we can create a short call by selling the stock and selling the put. You can create a long put by selling the put and buying a call. Key to making this work is using corresponding options in a one to one ratio.
 
According to Ron Ianieri, author of the Mastery Course, “These six majors are critical because everything else that we’re going to be doing is going to involve synthetic relationships at some level. This is what separates the men from the boys and the women from the girls. This is what separates people that really understand what they’re doing in options and those who don’t. This is what separates the people who make money in options and the people who lose money in options.”
 
For information on everything stock options, contact the Options University at:

www.optionsuniversity.com

Aug

17

Advanced Options Trading – More on Synthetic Stock Positions

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More on Synthetic Stock Positions
 
Anything synthetic is made up of components that when put together in the right way can make up a completely different object. Often times, synthetic products are produced because they accomplish the same thing as the “real thing”, but there are distinct advantages in using the synthetic over the real. In the case of creating a synthetic stock position, stock options have some real advantages for certain situations.
 
Stock options and stocks are mathematical entities made up of certain measurable entities. For example, one stock has a Delta of 1.0. It is totally correlated to itself. A stock option, on the other hand, has the relational factors of Delta, Gamma, Vega and Theta, which define a specific option (derivative) with its underlying stock. When we want to create an investment in a synthetic stock position, we use stock options that will exactly mimic the movements of the actual stock. From a mathematical standpoint, we want the total Deltas of the options to match the total Deltas of the stock.
 
For example, if you have 1000 shares of XYZ stock, you would have a total amount of 1000 Deltas. If you want to construct an option position that would exactly mimic the movements of the 1000 XYZ shares, you would need to create an option position which would also have a total of 1000 Deltas.
 
The Option Pricing Model, which is in constant evolution, mathematically defines the relationship between option derivative and the underlying stock. To construct a synthetic stock position, it is essential to understand how options relate to each other and the underlying stock.
 
According to Ron Ianieri, one of the founders of Options University, If you can understand synthetic positions, then not only is it going to help you make money but also it’s going to give you a much deeper understanding of options in general. If you can create the exact same position in two different ways, then there is a possibility that one of those ways might be cheaper than the other.
 
For example, you may often times find that creating a synthetic stock position is cheaper to buy than the underlying stock. If this is the case, than the corresponding ROI will be higher. By being less expensive, a synthetic position will also allow for lower entry and exit points. When talking about the nature of stock options, we talk about flexibility and synthetic positions are just one example.
 
In the Options University Options Mastery Course, the students learn that there are six basic types of synthetic positions:
 
·        Synthetic long stock and synthetic short stock; by using a combination of a call and its corresponding put you can recreate a long stock position or a short stock position just using a call and a put.
 
·        Synthetic long call and synthetic short call; using a combination of the corresponding put and the stock you can create a long call or a short call simply using the corresponding put and the stock.
 
·        Synthetic long put and synthetic short put; by using a combination of the stock and the call, you can create a long put or a short put, depending on the combination I use.
 
For everything you want to know about stock options, contact the Options University at:

www.optionsuiversity.com

Aug

16

Rolling-up Options Trading Strategy

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Rolling-up
 
What happens if your timing is off and the stock replacement strategy you established looks to expire before the move you anticipated has been completed? Do you have to bail out of the position? The answer is no; you can roll it.
 
When an option trader wants to maintain a position into a new option period, they can “roll up” the call by selling it and buying the next strike up (if the stock is moving up). Of course, you will be selling a more expensive call and buying a cheaper call. This will create a credit. That credit is actually taking part of the profit you may have made up to that point. This is very different from selling a stock.
 
When you take some profit from your stock position, you lose some of the position. You must sell the stock.  In the case of rolling, you keep a bit of your profit and maintain the same position. Rolling-up allows the option trader to extend the same position and take some profits at the same time.
 
Morphing
In their Options Mastery Course offered by the Options University, the many ways that an option trader can close out of a trade are explained. For example, if you have established a vertical spread and are considering how best to close out a call spread, you find there are three possible outcomes.
 
First, the spread can finish out-of-the-money and become valueless. For a call spread, this scenario occurs when the stock closes at or above the strikes of the spread. In order to close out the spread, an option trader would just let it expire. Both options finish out of the money so there is no residual position left over. Say goodbye the premiums you paid to get into the position.
 
Now, if the spread finishes in-the-money, meaning both options are in-the-money, both options are exercised. You will exercise your long call and your short call will be assigned. They cancel each other out leaving you with no residual position. This scenario occurs when the stock price closes lower than the lower strike call involved in the spread.
 
The last scenario is a bit problematic; what happens if a stock closes between the two strikes of the spread? This creates a situation where one strike winds up being in-the-money while the other ends up out-of-the-money. We know that when both options expire in-the-money, they are both exercised. One creates a long stock option, the other a short position canceling each other out. But in the case of a closing price between both strikes, it’s different. The option that is in-the-money leaves a residual stock position. Since the other option is out-of-the-money, it cannot offset the residual stock position created by the expiring in-the-money option.
 
In this situation, there are two actions possible. One is to trade out of the spread on expiration Friday just before the close. Because of the bid/ask spread of the two options, you will probably have to give away some of your profits in order to close out the position. This may be the best thing to do in order to avoid being caught “naked”. If you only trade out of the in-the-money option, you run the risk that the stock moves adversely and the out-of-the-money option suddenly becomes in-the-money.
 

For more on all things about stock options, go to www.optionsuniversity.com

Aug

15

Advanced Options Trading – Options Vs Stop Loss Orders

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Options Vs Stop Loss Orders
There is a laundry list of advantages of holding stock options over owning the underlying stock. Everybody knows about the lower costs, higher ROI (Return on Investment), and multiple strategies available with using stock options, but few are aware of the risk management strategies that options also offer.
 
According the Options Mastery Course offered by Options University, options are immune from the flaw that stop loss orders can have. For example, the bad news came out before the opening and the stock drops like a rock as soon as the markets open. The news hasn’t really hit the wires and before any action can be taken, your stop loss has been trampled and the stock is ten dollars lower before your stop order is filled. It happens all the time.
 
Sometimes, a stop is like that wimpy usher that shyly whispers “you can’t go in there”. You laugh and push yourself by. So, when there is some surprising or catastrophic news which can cause big moves, your peace of mind of having a stop loss in place is blown to pieces. You know, it isn’t the little losses that burn you; it’s the big ones where stop losses can be ineffective.
 
Options are different in that they are a “full time” stop that will work properly all the time. A strike price, once hit, becomes active from the get go. No worry about getting filled; either it is or it isn’t, period. Indeed, options were developed to become a perfect hedge.
 
For example, you think XYZ is going to be moving up within the next three months, so you decide to buy an at-the-money call. To protect yourself, you decide that you could accept a 5% loss so you figure out that buying a put that is $5 out-of-the-money will give you that down side protection during the option period. It doesn’t matter what happens, if the price hits the out-of-the-money strike, the put starts making money to help offset the losses suffered by the call. Of course, you must also figure in the cost of the put, which will lower the strike accordingly.
 
Brokerages recognize the safety of using an option as a stop to help reduce risk and can require much less margin to cover a trade. For example, suppose you set up a bear call credit spread where you sell a $50 call and buy a $52 call. The credit from the short sale usually more than offsets the cost of the long call so the risk is between $50 and $52; less than $200 per contract. Lower capital requirement also raises ROI.
 
Sometimes, setting up a bear call credit spread might require the precaution of setting up a stop for the short call if there is a significant spread between the short and the long.
 
For example, if you sell a $50 call and buy a $55 call, you might want to set a stop on the short call around $52 to get you out of the short and leave you long on the OTM call-or you can get totally out of the position. Why not just buy a $52 call? There may not be a strike at this price.
 

To find out more about all things stock option, contact the Options University for all of their online courses, webinars and mentoring services at www.optionsuniverstiy.com

Aug

14

Advanced Options Trading – More on Synthetic Stock

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More on Synthetic Stock
 
We know that if we want to simulate an option position that will exactly mimic the movement of the underlying stock, we can but we need to buy an at-the-money call and also buy the corresponding put. We do this because corresponding option contracts produce 100 Deltas and cancel out all the other Greeks. In effect, the position becomes a low cost, time limited simulation of the stock. If the stock moves up $1 the position will move up $1. If the stock moves down $1, the position will move down $1. It is, indeed for the option period a perfect surrogate for the underlying stock.
 
OK, but why would an option trader want to use a synthetic stock position? As Ron Ianieri of the Options University states: “whenever a trader decides to use the synthetic position instead of the real position, it’s because there’s some type of “volatility skew” creating one way to be cheaper than the other way (owning the stock) yet we know that both ways are the same”. In other words, a synthetic position can provide better pricing and higher profits.
 
To be more specific, there is something called a “put/call skew”. There is a negative and a positive put/call skew. When a corresponding call is selling for a higher price than its corresponding put, you have positive skew or vice versa when you have a negative skew. Either way, the skew produces more favorable pricing which allows for more profit than the actual purchase of the stock. It’s not a huge amount, but for an active options trader, the advantage can add up over time.
 
Synthetic Short Stock
 
Just as we have a synthetic long stock, we also have a synthetic short stock position.
It’s no surprise that the construction of the synthetic short stock position is opposite the construction of the synthetic long stock position. In the synthetic short stock position, we’re going to be long the put and short the call in a one to one ratio.
 
So, to create a synthetic short, a trader would buy a put which makes you short and then sell the corresponding call which also makes you short. Needless to say, both put and call must be corresponding options and at a one-to-one ratio. Since they are corresponding, they have Deltas that will total negative 100 and Gamma, Vega and Theta that will cancel out. Let’s look at an example.
 
Suppose you sold a real stock for $67.50 and it went down to $63.50. In this case, you made $4. To construct a synthetic short position, you would pick the closest strike and go short the call and long the put. The closest strike is $65 and you sold the call for     $3.32 and now it’s worth $1.09 In this case, you made $2.25 on the call. The put, on the other hand, you purchased for .77 cents and it’s now worth $2.53; a profit of $1.76. The call and the put equal a total profit of $4.01. >That’s the same as selling the stock; however, it was much cheaper to sell the call and buy the put. (Keep in mind that unless you actually own the stock, most brokerages will not let a retail client sell unhedged short positions.)
 

To find out more about synthetic stock and much more, contact the Options University at www.optionsuniversity.com

Aug

13

Synthetic Stock Options Trading Strategy

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Synthetic Stocks
 
Personally, I prefer the name “shadow stock”; it sounds so much more romantic and mysterious compared to the rather sterile name of “synthetic stock”. I smacks of something you’d buy at Wal-Mart. But, undaunted, we press forward to discuss an important aspect of the many facets of stock options.
 
Creating a synthetic stock position-either long or short-has some distinct advantages when trading stocks. They’re cheaper, more flexible and have limited risk as opposed to the theoretical “unlimited risk” of actually owning the stock. Yes, an option has a limited life but we are talking a trading strategy and not a buy and hold scenario.
 
The first synthetic position we’ll talk about is creating the long synthetic stock. The major objective of establishing a synthetic position is to construct a position that will closely mimic the movements of the underlying stock.
 
Construction of synthetic long stock
 
In order to create a synthetic long stock position, you want to buy a call and sell the corresponding put in a one-to-one ratio. But how can an option position be just like a stock when you’re buying a call and a put?
 
What happens is that both option positions are identical because they are corresponding options, which means that both positions have the exact same Greeks, or in other words, the same risk factors and profit potential of the real long stock position; the synthetic long as created by the corresponding options will exactly mimic the real long position in all ways.
 
In the Options Mastery course offered by the Options University, they give an example of what you are looking for. Suppose you want to set up a synthetic long position for a stock currently trading at $65.50. First thing, you decide that you will hold the position for about three months, a time you estimate sufficient for the stock to do what we think will happen. Let’s say you pick a June option period. You look at the June $65 strike. You see that the call has 56 long Deltas.
 
However, you now need to sell a put at the same strike and month and you see that this put option will short 44 negative Deltas. If you sell the put, you will be short, which is also a negative and the two negatives of the put and the short sale equals a positive. At this point we are long 56 Deltas from the call and also long the 44 Deltas from the put. This means that the position made up of the corresponding call and put has 100 long Deltas; 100 Deltas means that the position is exactly correlated with the long stock position. This is no coincidence, you see, corresponding options will always sum to an absolute value of 100 Deltas. The relative value depends on whether the position is short or long.
 
Here’s the kicker, corresponding options also have the same Gamma, Vega and Theta but a real stock position only has 1.0 Delta for each stock. However, the long call and short put Gamma, Vega and Thetas cancel each other out; so, in effect, both the option positions now have only 100 Deltas (100 share contract) as will the 100 shares of underlying stock; therefore, they are both the exactly the same. When this happens, the option positions will match the underlying stock movement penny for penny.
 
Of course, to assume a synthetic position will cost a fraction of what buying the stocks would cost. This allows you to either “buy more stock” or diversify your capital into other investments. The only difference is time.
 

For more information on everything to do with stock options, go to: www.optionsuniversity.com

Aug

12

Advanced Options Trading – Timing Stock Options

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Timing Stock Options
It’s an established fact that to get the best correlation for the buck, options traders should look for in-the-money options with Deltas around 80-85. In this way, you can capture at least 80-85% correlation with the movements of the underlying stock. OK, but what expiration month do you choose?
 
If you think the stock is going to make a similar type of downward movement it made in the past and it made the same downward movement seven months ago, again two years ago, and again four years ago, you think the current pattern is a close match to past patterns and this will be a good indicator of what might happen. In the past, each time it looked like it had taken two to two and a half months to complete the breakdown cycle. So, you decide to buy put options that fit that timing pattern. If you think that it should take about two and a half months to complete the pattern, you would decide to buy an option that expires in three months; in other words, you want to match the days to expiration on the option to the amount of time you think it’s going to take for the stock to make the anticipated movement.
 
Of course, you can be off a bit on both ends, but picking a month that is most likely to contain at least some of the movement we expect is the key.
 
In the case of a short stock position, you locate a put option that closely will mimic the short stock position. So, you go out three months and look for an in-the-money put with Deltas around 80-85; this is called “the sweet spot”. Now, you have a good idea of the timing and an option at the best price for what you want to accomplish.
 
Exception to the Sweet Spot
 
In the Options Mastery course offered by the Options University, it’s mentioned that there is a time when an option trader doesn’t want to use the sweet spot. That is when a stock is going through a breakout; you should consider buying an at-the-money put. Why is that?
 
An at-the-money option has a mix of intrinsic and extrinsic value. With extrinsic value, the stock has to perform better than at an in-the-money option to over come the extrinsic value cost; every penny of extrinsic value is one additional penny more that the stock has to move to start making a profit. When an option is deep in-the-money, option and stock prices move in lock-step. But there are times when you would want to capture the volatility of an option; it’s like catching a wave before it breaks.
 
A break down in a stock is normally a violent, aggressive movement lasting four to maybe eight days.  If thisis the case, the problem of time decay is not a major concern because you won’t be in the position for that long. In this case, the at-the-money put becomes a better play. Break downs give you the opportunity to benefit from the volatility and not get hurt as much from the decay because break down stocks usually make their big moves within a short time span.
 

For a total knowledge of stock options, go to www.optionsuniversity.com

Aug

12

Options Trading – Chapter Two Answers

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Chapter Two Answers
 
1)       ABC stock is trading for $76 near expiration and your $70 call is bidding $5.20. How do you capture the missing intrinsic value?
b) Short the stock and exercise the call
With the stock trading at $76, the $70 call must be worth at the $6 intrinsic value at expiration. However, sometimes the bid-ask spreads can make the bid price slightly less than this intrinsic value. In this question, there are 80 cents missing from the intrinsic value. Rather than just sell your $70 call in the open market and receive $5.20, you can short the stock at $76 and immediately exercise the $75 call, which will leave you with a $6 gain.
 
2)       ABC stock is trading for $37 near expiration and your $40 put is bidding $2.80. How do you capture the missing intrinsic value?
b) Buy the stock and exercise the put
With the stock trading at $37, the $40 put should be worth the $3 intrinsic value at expiration. But just as for call options, sometimes there is some missing intrinsic value near expiration. In this question, you could place an order to buy shares of the stock for $37 and immediately exercise the put and sell the shares for $40 thus capturing a $3 rather than the $2.80 gain you’d get by selling the put in the open market. It does not matter if you don’t have the cash to buy the shares of stock since the exercise of the put guarantees the funds.
 
3)       What is the key factor that gives an option, whether a call or put, its value?
c) Volatility
The volatility of the underlying stock is the key factor in determining an option’s value. Volatility simply measures the fluctuations in a stock’s price. The greater the fluctuations, the greater the uncertainty of prices and options become more valuable.
 
4)       The higher the risk:
c) The lower the price, the higher the reward
If an investment is risky, the market will bid down its price to a level where it becomes desirable. If the price is low, then the potential return, or reward, will be higher.
 
5)       Out-of-the-money option prices move:
c) Only a small fraction with the underlying stock
                Out-of-the-money options have a low delta, which means the option’s price will only move a
small percentage when compared to the move in the stock’s price.
 
6)       The maximum value that a call option could ever be is:
a)       The price of the underlying stock
The maximum price a call option could ever reach is the price of the stock (Pricing Principle #5). If the price of any call option were to exceed the stock price then arbitrage would be possible.
 
7)       Interest rates are 6% and you will definitely receive $5,000 six months from now. How much should you be willing to accept if the other party wants to settle the debt today?
b) $4,854
If interest rates are 6% per year then they are effectively 3% per six months. The present value of $5,000 would then be $5,000/1.03 = $4,854. This just means you should be indifferent between receiving $4,854 today and $5,000 in six months from now if interest rates are 6%. If you accepted $4,854 today, you could invest that money at the risk-free rate of 6% and it would grow to $5,000 in six months.
 
Options Trading Chapter Two Answers        You are looking at quotes on IBM March calls. Which is more expensive, the $80 call or the $85 call?
d) $80 call is more expensive
With all else being equal (that is, same underlying stock and expiration), lower strike calls must be more valuable than higher strikes (Pricing Principle #1). Although we don’t know what the price of either call will be, we do know that the $80 call would be more valuable since it gives the holder the right to buy shares at a lower price.
 
9)       You are looking at Dell Computer April $30 calls and July $30 calls. Which is more expensive?
d) July will be more expensive
With all else being equal, longer-term options will be more valuable than shorter-term expirations (Pricing Principle #2). The reason is simply that more time allows the underlying stock to make bigger moves, whether higher or lower.
 
10)   You are looking at Intel December puts. Which is more expensive, the $30 put or the $40 put?
c) $40 put is more expensive
With all else being equal, higher-strike puts will be more valuable than lower-strike puts (Pricing Principle #1). The reason is that the higher-strike put allows the holder to sell stock at a higher price, which is more beneficial (valuable) than selling at a lower price.
 
11)   Delta measures:
b) The sensitivity of an option’s price compared to the stock’s price
If a call option has a delta of 0.50, then we know that the option’s price will rise 50 cents for the next dollar move in the stock’s price. If a put has a 0.50 delta, then its price will rise 50 cents for the next dollar fall in the stock’s price. Delta therefore shows how sensitive an option’s price is to movements in the stock’s price.
 
12)   One interpretation of delta is:
b) The probability that the option will expire in-the-money
One mathematical interpretation is that it roughly shows the probability that an option will expire in-the-money at expiration. If an option has a delta of 0.70 then there is roughly a 70% chance that it will expire in-the-money at expiration.
 
13)   XYZ stock is trading for $44.50 near expiration. Your $40 call must be worth at least:
b) $4.50
All options must be worth their intrinsic value at expiration. In this example, the $40 call must be worth $4.50. (If it were worth less than that, you’d simply short the stock and immediately exercise the call as in Question 1.)
 
14)   If the $50 call delta is 0.70, the $50 put delta is:
d) -0.30
Same-strike call and put deltas must sum to one (ignoring the minus sign of the put delta). If the call delta is 0.70, the corresponding put delta must be -0.30.
 
15)   The ABC $50 call is trading for $7. What is the maximum amount the $45 call could be trading for?
a) $12
For any two calls (or puts) the difference in their prices cannot exceed the difference in the strikes (Pricing Principle #6). In this question, there could not be more than a five-dollar difference in their prices since there is a five-dollar difference in strike prices. We also know that lower-strike calls must be more valuable than higher strikes so if the $50 call is $7, the $45 call could not be worth more than $12; otherwise arbitrage is possible.
 
16)   What are the only two prices that are possible for an option to have at expiration?
b) Zero or intrinsic value
An option will be worthless if it is out-of-the-money at expiration. If it is in-the-money, it will be worth exactly the intrinsic value. Remember, prior to expiration, out-of-the-money options will certainly have some value since time remains. But at expiration, they are worthless.
 
17)   You purchased a $40 call for $3. What is the breakeven point on the option?
d) $43
The breakeven point for a call option is found by taking the premium and adding it to the strike price. In this question, the breakeven point is $40 strike + $3 premium = $43 stock price. If the stock is $43 at expiration, the $40 call is worth exactly $3, which is the same as the amount you paid – you have just broken even.
 
18)   You purchased a $70 put for $2. What is the breakeven point on the option?
a) $68
The breakeven point for a put option is found by subtracting the premium from the strike price. In this question, the breakeven point is $70 – $2 = $68 stock price. If the stock is $68 at expiration, the $70 put is worth exactly $2, which is the amount you paid so you have just broken even.
 
19)   Because high-volatility stocks have a better chance for price appreciation, you should:
c) Not choose trades based on this fact because the volatility will be priced into the option.
You will hear many traders tell you to only trade options on high-volatility stocks since there is more room for price appreciation. But this is really a big myth. The reason is that the markets are well aware of that advantage so traders bid the prices of the high-volatility options higher. The net result is that there is no net advantage in trading high-volatility stocks.
 
20)   If a 30-day option has a delta of 80 today:
b) It will change over time
The delta of an option does not stay constant over the life of the option. The delta changes as other factors change. The key factors are time, volatility, and price of the underlying stock. But just because you buy an 80-delta option today does not mean that it will be the same next week. In fact, all in-the-money options approach a delta of 1.0 as expiration gets closer, while all out-of-the-money options approach zero. The delta does not stay constant.
 
To be continued,,,

Aug

11

Options Trading – Chapter Two Questions

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Chapter Two Questions
 
1)       ABC stock is trading for $76 near expiration and your $70 call is bidding $5.20. How do you capture the missing intrinsic value?
a) Buy the stock and short the call
b) Short the stock and exercise the call
c) Buy the stock and exercise the call
d) Short the stock and short the call
 
2)       ABC stock is trading for $37 near expiration and your $40 put is bidding $2.80. How do you capture the missing intrinsic value?
a) Short the stock and exercise the put
b) Buy the stock and exercise the put
c) Buy the stock and short the put
d) Short the stock and short the put
 
3)       What is the key factor that gives an option, whether a call or put, its value?
a) The strike price
b) Price of the stock
c) Volatility
d) Open interest
 
4)       The higher the risk:
a) The higher the price, the higher the reward
b) The lower the price, the lower the reward
c) The lower the price, the higher the reward
d) The higher the price, the lower the reward
 
5)       Out-of-the-money option prices move:
a) Dollar-for-dollar with the underlying stock
b) About 50 cents on the dollar with the underlying stock
c) Only a small fraction with the underlying stock
d) About 75 cents on the dollar with the underlying stock
 
6)       The maximum value that a call option could ever be is:
a) The price of the underlying stock
b) There is no limit
c) Only half of the underlying stock’s price
d) The price of the put
 
7)       Interest rates are 6% and you will definitely receive $5,000 six months from now. How much should you be willing to accept if the other party wants to settle the debt today?
a) $4,716
b) $4,854
c) $4,981
d) $4,622
 
Options Trading Chapter Two Questions        You are looking at quotes on IBM March calls. Which is more expensive, the $80 call or the $85 call?
a) Cannot be determined with this information
b) They will be about the same price
c) $85 call is more expensive
d) $80 call is more expensive
 
9)       You are looking at Dell Computer April $30 calls and July $30 calls. Which is more expensive?
a) Cannot be determined with this information
b) They will be about the same price
c) April will be more expensive
d) July will be more expensive
 
10)   You are looking at Intel December puts. Which is more expensive, the $30 put or the $40 put?
a) Cannot be determined with this information
b) They will be about the same price
c) $40 put is more expensive
d) $30 put is more expensive
 
11)   Delta measures:
a) The intrinsic value of the option
b) The sensitivity of an option’s price compared to the stock’s price
c) The time value of the option
d) The sensitivity of an option’s price compared to the overall market
 
12)   One interpretation of delta is:
a) The probability that the option will expire out-of-the-money
b) The probability that the option will expire in-the-money
c) The probability that the option will expire without being exercised
d) The probability that the option will expire
 
13)   XYZ stock is trading for $44.50 near expiration. Your $40 call must be worth at least:
a) $4.00
b) $4.50
c) $44.50
d) There is no way to determine based on this information
 
14)   If the $50 call delta is 0.70, the $50 put delta is:
a) There is no way to determine based on this information
b) -0.50
c) -0.70
d) -0.30
 
15)   The ABC $50 call is trading for $7. What is the maximum amount the $45 call could be trading for?
a) $12
b) $7
c) $8
d) There is no way to determine based on this information
 
16)   What are the only two prices that are possible for an option to have at expiration?
a) Premium or intrinsic value
b) Zero or intrinsic value
c) Zero or time value
d) Time value or intrinsic value
 
17)   You purchased a $40 call for $3. What is the breakeven point on the option?
a) $3
b) $37
c) $40
d) $43
 
18)   You purchased a $70 put for $2. What is the breakeven point on the option?
a) $68
b) $2
c) $72
d) $70
 
19)   Because high volatility stocks have a better chance for price appreciation, you should:
a) Only place trades during highly volatile markets to increase your edge
b) Only trade options on low-volatility stocks for more consistent profits
c) Not choose trades based on this fact because the volatility will be priced into the option
d) Only trade options on high-volatility stocks
 
20)   If a 30-day option has a delta of 80 today:
a) It will remain at 80 over the life of the option
b) It will change over time
c) It cannot fall below 80 but could rise above it
d) It can fall below 80 but not rise above it
 
Answers coming in next part…

Aug

11

Advanced Options Trading – Puts, the Sweet Spot, and Other things

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Puts, the Sweet Spot, and Other things
 
 Let’s say you decided that you wanted to buy XYZ at a $40 but unfortunately it’s trading now at $50. XYZ is at $50; it’s running up, but if it ever came back down to $40 you’d love to buy it. Ok, here is one way to position yourself; you’re going to sell an out-of-the-money $40 put for XYZ  and if the stock ever trades lower than $40 during the option period, then you’re going to own it as more than likely somebody will exercise their rights as the buyer of the put and place the stock with you-the seller. If the stock doesn’t reach $40, no big deal, you’re going to keep the entire premium from the put, a win, win situation, right?
 
That might be good for some stocks that are volatile but the real world may turn out to be different when you do get the stock when it hits $40. You see, something happened to make the stock move down $10 from $50 and that $40 strike price may just be another tick on the way down to some undefined bottom. In other words, why not just wait until you have an idea of where the bottom might be. So, this strategy of selling a put to buy on the cheap and collect a credit in the process may be more risky than you think.
 
Puts in Stock Replacement
 
Some brokerages have rules that prohibit clients from shorting stock. Other brokerages charge such a high margin for going short that it discourages most traders.  But, alas, you can buy a put and solve both of those problems. You see, you can use puts as a stock replacement strategy trade, which replaces a short stock position.
 
Most traders have a pre-disposition to concentrate on making money on the way up. Few realize that they can double the amount of potential winning trades by being open to making money on the way down. Part of the tunnel vision is from the broker restrictions on shorting stocks; in other words, if you can’t do it, why learn about it?
The truth is that traders are passing up a huge opportunity to play both sides of the market. But with puts, no problemo, you can be right there by using a stock replace-ment strategy.
 
When looking for shorting opportunities, you use the same philosophy that you would use with shorting stock. You are looking for a break down technically or fundamentally-usually a combination of both. You identify your entry point and your protective stop. You establish a potential profit target but before you call your broker or click on the trade, you turn to a put purchase. You don’t short the stock but instead you purchase a put. As a matter of fact, puts are not only much cheaper than shorting the stock but also provides a defined maximum risk-the cost of the premium for the option contracts. However, you need to pick the right put to buy.
 
As we are using puts as a surrogate for being short stock, we want a put that will closely match the movement of the underlying stock. What we want is an in-the-money put with lots of Delta and not a lot of Vega, Theta or Gamma. We want an option that will mimic the movement of the stock and that means “hard” Delta.
 
Finding the Sweet Spot
 
When looking for the best in-the-money strike to buy, you need to find a strike that is not too deep in-the-money, which would be more expensive but not too close to at-the-money, which still has extrinsic value that evaporates away every day. So, you look for a strike contract that will have a Delta in the range of 80 to 85. That means that if the stock moves down $1, the option will move down 80-85 cents. In this way, you are- in affect- replacing the stock with options that mimic most of the movement of the stock. This strategy is much less expensive and with limited, defined risk.
 

For information on all things stock option, contact the Options University at www.optionsuniversity.com

Aug

10

Advanced Options Trading – Puts, Calls and Moneyness

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Puts, Calls and Moneyness
In his Options Mastery Course at Options University, Ron Ianieri uses the term “moneyness” to describe out-of, at-the and in-the-money conditions of a stock option.
 
In-the-Money
 
A put is in-the-money if the strike price is greater than the current stock price. For example, if a stock is trading at $50 and the strike price is $60, the put is in-the-money. Another way to remember when an option is in the money-be it a call or put- is when you imagine what would happen if you exercised  your position rights at the current price. In our example, if you were long a put and exercised, you would be able to get stock for the current $50 price and turn right around and sell the stock for the strike price of $60. You pocket the $10 per share difference less commissions.
 
Out-of-the-Money
 
If you buy a put, you are out-of-the-Money when the strike price is below the current price. For example, if you buy a put with a strike of $50 and the price is currently at $60 the stock must go below the strike price before it would be in-the-money. Imagine if you could exercise the $50 strike you would have the right to sell the stock for $50; why would you do that when the stock is at $60? So, because exercising the $50 strike put provides no benefit, the $50 put-in this case-is considered to be out-of-the-money because the strike price is less than the stock price. The stock price is the elevator and the strike is the floor. Before the door can open, the elevator must arrive at the floor. The analogy holds for calls, as well.
 
At-the-Money
 
The at-the-money put doesn’t mean that the put strike has to be exactly equal to the stock price. It doesn’t have to be equal; it just needs to be close. The at-the-money put is the put whose strike price is the closest to the current stock price.
 
In the Options Mastery Course, they give the example of looking at a $30 strike put when the stock is trading at $29. Even though the stock is a bit in-the-money, it is still considered at-the-money. Likewise, if the price were at $31, that would also be considered at-the-money. At-the-moneyis the put whose strike price is closest to the current stock price, not directly equal to it, just the closest. So, what that means is our at-the-money put might actually be slightly in-the-money or slightly out-of-the-money in real terms.
 
Another more subtle thing about being in-the-money has to do with having a “harder” Delta. This means that because an in-the-money put isn’t as susceptible to movements of time and volatility as the at-the-money put is, and probably not quite as much as the out-of-the-money put; we call the in-the-money put or call as having a “hard” Delta. The thing that‘s really driving that in-the-money put is the mostly just the stock price. When a call or put is deep in-the-money, Delta is close to 1.0 and the option moves in total sync with the stock price movement.
 
Not surprisingly, the out-of the money and the at-the-money puts and calls are called “soft” Delta. The values of these options are more susceptible to movements in volatility and time decay than movements in the stock.
 

To learn just about everything you need to know about stock options, find about the Options Mastery Course offered by the Options University at www.optionsuniversity.com

Aug

10

Relationship between Call and Put Deltas

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Options 101
 
If we define delta as the probability of the option expiring with intrinsic value, we can see that if there is a 90% chance of the $32.50 call expiring with intrinsic value then that call will increase by 90 cents for the next dollar move. The $35 call will only appreciate by 39 cents since it only has a 39% chance of expiring with intrinsic value. Since the $32.50 has a 90% chance of expiring with intrinsic value while the $35 call only has a 39% chance, this is yet another way to show that the $35 call is riskier than the $32.50 call. The reason that deltas change is because the probability of an option expiring with intrinsic value changes. Obviously, that probability hinges on the stock price and time to expiration. As time goes by or as the stock price moves, you will get different probabilities and therefore different deltas. The main point you want to understand about delta is that it does not remain the same throughout an option’s life.
 
Put deltas are always shown as a negative number. This is not because there is a negative probability of them expiring in-the-money but rather it is a notation to remind us that a put loses value as the underlying stock rises and gains value as it falls. For example, in Table 2-10, the $32.50 put has a delta of -0.10. If eBay were to rise by $1 right now, the put would lose 10 cents. But if the stock were to fall by one dollar, the put would gain 10 cents because -$1 * -0.10 delta = +0.10. The negative sign on a put delta is really a reminder that put option profitability moves in the opposite direction of the underlying stock.
 
Relationship between Call and Put Deltas
If we know the delta of a call, is there anything we can say about the corresponding same-strike put? In other words, if we know the $32.50 call has a delta of 0.90, what can we conclude about the $32.50 put delta? The answer is easy with a little thought about probability. We know from basic probability theory that the sum of all mutually-exclusive events must add up to one. This just means that if you break any event into two or more parts that cannot overlap (mutually exclusive), then the sum of all those probabilities must be one.
 
For example, if you have a 90% chance of passing an exam then that means there is a 10% chance you will fail since passing and failing are mutually exclusive – you can’t pass and fail at the same time. All probabilities must add up to one and, in this case, 0.90 + 0.10 = 1. If your favorite football team has a 60% chance of winning their next game then they must have a 40% chance of losing since they cannot win and lose. As before, all probabilities must sum to one and we see that 0.60 + 0.40 = 1.
 
Now think about stock prices. No matter where eBay is currently trading, it will either be above $32.50 at expiration or it won’t. If the stock is above $32.50 then the $32.50 call will be in-the-money. If the stock is below $32.50 at expiration then the $32.50 put will be in-the-money. Therefore, if there is a 90% chance (delta) that the $32.50 call will expire in-the-money then there must be a 10% chance the $32.50 put must be in-the-money. And that means that the delta of the $32.50 put must be 0.10. The delta for the call and put will nearly always add up to one (ignoring the minus sign of the put) since all probabilities must sum to one.
 
Exercise
Using Table 2-10, check the sums of the deltas for the same-strike calls and put. Ignoring the minus sign of the put deltas, do they add up to one?
 
If the concept of delta has you confused, don’t worry. Believe it or not, many professional traders confuse the definition and interpretation. The key point to remember is that an option’s price will generally not move dollar-for-dollar with the underlying stock. If you want to get a ballpark figure on how much the option will gain or lose with the next, immediate one-dollar move in the stock you’ll want to look up the delta of that option. The only time that an option will move nearly dollar-for-dollar is when the option is viewed by the market as being guaranteed to expire with intrinsic value. This means the option must either be very deep in-the-money or in-the-money with a very short time until expiration. If it seems as though the options are guaranteed to expire with intrinsic value, then the long call option will behave like long stock (delta = 1) and the put option will behave like short stock (delta = -1). The delta of a stock is always one, since it rises and falls dollar-for-dollar with itself. (Consequently, the delta for short stock is always negative one, since it loses dollar-for-dollar as the price rises and gains dollar-for-dollar as the price falls.) So once a call option’s delta reaches one, it is considered to be long. Once a put option’s delta reaches negative one, it is considered to be short stock.
 
The relationship between call and put deltas should tell you that it’s pretty difficult to have more than 50% of the options expire worthless. For instance, if all of the call options expire in-the-money, then all of the put options must expire out-of-the-money. Because there are an equal number of call and put strike prices, this means that 50% of the options expire worthless. If the stock’s price closes in the middle of all strike listed strike prices then, again, half of the calls and half of the puts expire worthless. Despite this relationship, there is a persistent myth that 90% of all options expire worthless. You will undoubtedly hear this figure quoted many times but you will never find a single study to substantiate it. In fact, the OCC (Options Clearing Corporation) publishes statistics on its website at www.OptionsClearing.com and you will find that historically the numbers are roughly as follows: 10% of all options are exercised, 30% expire worthless, and 60% are closed in the open market. There are obviously variations in these numbers from year to year, but they rarely fluctuate by more than five percentage points in any direction.
 
Roughly 60% of all options are closed in the open market. About 30% expire worthless and 10% are exercised. It is NOT true that 90% of all options expire worthless. It is a mathematical impossibility.
 
Key Concepts
 
1)       An option’s price does generally not move dollar-for-dollar with the underlying stock.
2)       An option’s price will rise or fall by its delta on the next, immediate one-dollar move in the underlying stock.
3)       Assuming the same expiration, calls and puts with the same strike will generally have deltas that add up to one (ignoring the minus sign of the put delta).
 
To be continued…
 
 
 

Aug

9

Options University’s Options 101 – Part 27

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Options 101
Part 27
 
Out-Of-The-Money
If stock price is:
At expiration, $100 call will be worth:
91
0
92
0
93
0
94
0
95
0
96
0
97
0
98
0
99
0
100
0
101
1
If stock price is:
At expiration, $100 call will be worth:
89
0
90
0
91
0
92
0
93
0
94
0
95
0
96
0
97
0
98
0
99
0

In our previous examples, we saw that the at-the-money option will move about 54 cents for the next dollar move. Deep-in-the-money options, on the other hand, will move dollar-for-dollar with the underlying stock. What can we expect to happen with out-of-the-money options?

Let’s assume the stock price is now $94 so that the final stock prices will be between $89 and $99. In other words, the option has no chance for a payoff:
 
 
 
 
 
If stock price is:
At expiration, $100 call will be worth:
90
0
91
0
92
0
93
0
94
0
95
0
96
0
97
0
98
0
99
0
100
0

The option’s price is now $0/11 = $0. If the stock rises one dollar to $95, we have removed a zero from the bottom and added a zero to the top so the option’s price is still zero.

 
This shows that if your option is far enough out-of-the-money, its price may not even move even if the stock rises by a full dollar. Now let’s take it a step further and assume that stock rises another point to $96:
 
Now the options price is (0+0+0+0+0+0+0+0+0+0+1)/11 = 9 cents. For a full point move in the stock, this option gained only nine cents in value. Further, if we make the comparison from a stock price of $94 then the stock moved two full points from $94 to $96 and yet the option only gained nine cents. This shows that far out-of-the-money options are relatively insensitive to stock price movements.
Deep-in-the-money options respond nearly dollar-for-dollar with changes in the stock’s price.
 
At-the-money options respond about 50 cents on the dollar.
 
Out-of-the-money option prices barely move with changes in the stock’s price.  
 
This is a very simple model of stock price movements. In reality, we’d assign higher probabilities for stock prices near today’s price and lower probabilities for the extreme values. But to make the math easy, we just assumed that all stock prices were equally likely and still came up with similar option price movements as those observed in the real world. These fractional movements are in agreement with what we previously said will happen to the price of pizza coupons if we were less than 100% certain of a price increase. Notice that this simplified stock price model is also based on probabilities but in a more subtle way. When the stock was $100, the $100 call was worth $1.36. If the stock rises one dollar to $101, we cannot be sure of retaining the full value of the highest option price possibility. With the stock at $101, the highest price possibility is $6. Since each price is equally likely, we should bid 1/11 * $6 = 54 cents higher for that option. And we did find that the new option price would be $1.36 + $0.54 = $1.90. The price of an option is ultimately determined by the probabilities for a particular range of stock prices.
 
What makes option pricing so unique is that it is based on an asymmetrical payoff schedule. If a stock trader buys stock, he gains dollar-for-dollar as the stock price rises and loses dollar-for-dollar as the stock price falls. Now look at the option prices in the previous tables. The options only have payoffs (values) for all stock prices above the $100 strike; all other values are zero. It is this asymmetrical payoff schedule that makes the options prices move less than dollar-for-dollar with the underlying (unless the option gets so far in-the-money, in which case it moves dollar-for-dollar).
 
Now let’s consider the July $32.50 call in Table 2-8. If the stock were to rise by one dollar right now, we are more certain that the $32.50 will retain intrinsic value at expiration when compared to the $35 call. This is because the stock has to fall much further to wipe out all of the intrinsic value on the $32.50 call. This means that the price of the $32.50 call will rise by a larger amount than the $35 call on the next dollar move in the underlying stock. If the stock were to move up one dollar from its current price of $37.11, we might see the $32.50 call rise by, say 85 cents, while the $35 call rise by only 70 cents. The $40 call, on the other hand, may not even budge in price. Once again, we see that the market is pricing the options according to risk. The $32.50 call gets bid up by a higher amount (in terms of dollars not percentages) than the $35 call because the $32.50 call is more certain to retain intrinsic value. In other words, the $32.50 call is less risky than the $35 call, which is what we stated earlier.
Delta of an Option:
In the previous paragraph, we said that the $32.50 call may only rise by 85 cents for the next, immediate one-dollar increase in the stock. An alternative wording is that the option is capturing 85% of the stock movement at this time. When traders talk about how an option’s price moves in relation to the underlying stock, they are really talking about an advanced concept called delta. Delta is a measure of how much an option’s price will move for the next, immediate one-dollar move in the underlying stock. We have to include the word “immediate” to remind us that the move must occur immediately and not later today or next week. Delta simply shows us how sensitive an option’s price is to changes in the stock’s price at that moment in time.
 
Most option trading software will show you the delta of an option. However, if your broker’s platform does not, you can find them at a number of online resources, free of charge, such as at the Options Industry Council’s (OIC) site at www.888Options.com, PC Quote at www.pcquote.com, or from the Philadelphia Stock Exchange at www.phlx.com.
 
Table 2-10 shows our eBay options at this point in time with their corresponding deltas. Notice that the $32.50 strike has a delta of 0.90 (circled)[1]. This means that if eBay were to immediately move one dollar, then that option will increase in price by 90 cents. Notice that the $35 call listed below shows a delta of only 0.39 so it will only increase in price by 39 cents on the next dollar move in the underlying stock.
 
Table 2-10: Option Prices with Deltas
insert table27-1 
 
We recently stated that the $32.50 call might move 85 cents while the $35 strike might move 70 cents, which is only a 15-cent difference. However, Table 2-8 informs us that the $32.50 strike will move 90 cents while the $35 strike will move only 39 cents, which is a 59-cent difference. Why is there such a big discrepancy between what we previously said versus what Table 2-10 is telling us? Why did we say there would be roughly a 15-cent difference when Table 2-8 shows there is a 59-cent difference? The reason is that eBay has fallen from $37.11 to $34.43 when the quotes in Table 2-10 were taken, which means the $35 strike is now out-of-the-money. It is no longer in-the-money as it was when the stock was $37.11. If eBay were still at $37.11, you’d see a much higher delta for the $35 call in Table 2-10.
 
This shows that delta changes over time. Just because the $32.50 call delta is 0.90 right now does not mean that it will always be 0.90. Why does delta change? There is another interpretation of delta we can look to for a better understanding. Delta is mathematically an approximate measure of the probability that the option will expire with intrinsic value (in-the-money) at expiration. We must multiply that probability by the stock price move in order to see how the option will respond. In the pizza coupon example, we had a 50% chance of an increase in price and it’s no coincidence that we figured out that the market would bid up the coupon by 50 cents because 50% of $1 = 50 cents.
To be continued…



[1] Sometimes you will see delta quoted as a whole number such as 90 rather than a decimal as 0.90 to reflect the fact that each option controls 100 shares. However, the concept is the same. A delta of 0.90 or 90 will rise about 90 cents for the next one-dollar move in the stock.

Aug

9

About Stock Option Puts

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About Stock Option Puts
 
Simply put (no pun intended), a put gives the buyer the right-but not the obligation-to sell a certain security at a specified price within a specific time period. When you want to use a stock replacement strategy on a stock you think will move up in value within a specific time, you buy calls. Puts work the same way but are used when you think the stock will move down in value within a specific time. As Ron Ianieri of Options University says,” as a mechanism, puts are identical to calls in the way they operate and perform and how sensitive they are to different stimuli. They’re a lot more similar to calls than they are different”. Indeed, the only thing that separates the two is direction.
 
Another really big difference between the practical use of calls and puts is that a trader should stay away from selling naked puts. A naked call has a risk profile that has the risk limited to the premium paid and with an unlimited profit potential. On the other hand, a naked put has a completely different risk-reward profile. With a naked put, the risk is unlimited if the stock moves up. If the stock price moves down, the profit is limited to the premium collected if the stock stays below the strike by expiration. So, selling naked puts has an unlimited risk and a limited reward. So, stay away from writing naked puts.
 
Puts are a short instrument and are used when a trader is bearish. Puts benefit the trader when the underlying stock goes down in value. So, in a way, when buying puts a trader is in affect shorting the stock. As mentioned, aput enables the buyer to have the right but not the obligation to sell a specific underlying security at a specified price within a specified time period. In effect, what that means is that an owner of an in-the-money put can force somebody else to buy the stock. Of course the put has to be in-the-money and exercised but it’s important to know that there is no worry about liquidity thanks to the OCC (Options Clearing Corporation).
 
The risk-reward profile of buying a put is very similar to buying a call; that is to say, limited risk and “almost” unlimited potential. We say almost unlimited potential gain because a stock can conceivably only go to zero.
 
A buyer has rights and a seller has obligations. So, selling a put means that the seller can be “assigned” and forced to receive stock at the strike-no matter what the current market price may be. So, if the buyer of the put chooses to exercise their rights if the put is in-the-money, the seller is obligated to take delivery of the stock at the strike price. Another little talked about risk of selling a put is the lost opportunity if the stock makes a big upside move. Yes, as a put seller you would be able to collect the premium but that is all. If the stock goes sky high, a put seller must be satisfied with only crumbs but as a high probability trade, writing can be much more reliable even though there are no home runs.
Again, as Options University proselytizes, option traders should stay away from selling naked puts. However, there are some traders who will sell naked puts on cheap stocks. For instance, if a trader sells a naked put on an $8 stock, the loss is limited to $8.
 

For more information on stock options go to www.optionsuniversity.com

Aug

8

More about Stock Option Calls

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More about Stock Option Calls
 
Most of the time, when buying a naked call to mimic the underlying stock’s movement, we need to locate the sweet spot; just far enough in-the-money to give about 80-85 Deltas. In this way, we don’t pay too much to mimic the stock’s movement. However, there are exceptions to using the sweet spot.
 
According to Ron Ianieri of the Options University, most break out type of movements usually take place in four to eight days. That means since it’s such a short period of time, we don’t really need to worry about time decay as we normally do. As you recall, if a stock needs time to make the anticipated move, we don’t want to buy a lot of extrinsic value just to have it decay day- by-day. Moreover, we need high Deltas to make sure that we are closely mimicking the stock.
 
However, if we are talking about a break out move, we don’t need to be so concerned about time decay if the move takes just 4 to 8 days. In the Mastery Options course presented by Options University, they put forth the idea that in this particular situation.
 
We can look for the at-the-money option, which will give us the best bang for the buck
Needless to say, a breakout normally is accompanied by an increase in volatility and seeing that Vega is highest at-the-money (remember Vega is the option price change with a change in volatility) and having a sensitive long Vega will be a plus.
 
Options University makes it very specific when it comes to selling naked calls. “Do not sell naked calls, period”, says Ron Ianieri. (Going “naked” in option lingo means being unhedged). Selling an unhedged call exposes the seller to an unexpected upward surge; indeed, the risk is unlimited. However, buying naked long calls are ok because the maximum risk is the premium paid if the call never gets into-the-money and expires worthless, no matter how low the price goes. So, with limited risk, the position can be considered hedged to a degree and limited to the premium loss.
 
For new option traders, being long calls is exactly like purchasing stock when buying in the sweet spot-(slightly in-the-money with Deltas of 80-85). The main differences being that the option position has a limited term (LEAPS can have a period of over 2 years before expiration) but the capital required is much, much less. The main point being that when the underlying stock moves up, the option will mimic the move. The following is an example taken out of the Options Mastery course offered by Options University.
 
Let’s say the stock is trading at $65.50 and we think the stock is going to run up. If we spend $2.04 for an option with a $65 strike, we’ve got to understand that there’s only .50 cents of intrinsic value in the $65 strike. That means there is $1.54 of extrinsic value and our stock has to move up at least $1.54 by expiration to just break even. However, if we bought this option at the June 60s at $5.74, there’s only .24 cents of extrinsic value there. By expiration, we only need the stock to trade up .24 cents, from $65.50 to $65.74 for us to start seeing a profit. Which would you prefer? If you answered the $65 strike, read this article again.
 

For just about everything about stock options, go to www.optionsuniversity.com

Aug

8

Options University’s Options 101 – Part 26

Filed Under Beginner Options Trading | Leave a Comment

Options 101
Part 26
 
Let’s run through a couple of scenarios and see what happens. Let’s assume that coupon prices do not change and they are still trading for $3. If we buy the coupon for $3, and the coin lands heads tomorrow, it will be trading for $4 and we will make one dollar. If the coin lands tails, the coupon still trades for $3 and we don’t lose anything. So if we can buy the coupon for $3, we can’t lose but we might make money. Everybody figures this out and buys coupons and their price rises. This shows that $3 is too low of a price given the fact that prices have a 50% chance of rising one dollar.
 
Is there a price that’s too high for the coupon? Yes. We know that when the storeowner announced that prices would definitely rise, the coupon immediately rose to $4. Now that we’re not so certain of a price increase, $4 should be too much to pay. But just for argument’s sake, let’s assume that prices do rise to $4 and we buy it. If the coin lands heads, the coupon is trading for $4 and we don’t make any money. We paid $4 and could sell for $4 so we make nothing. However, if the coin lands tails, we could certainly lose since we paid $4 and it is now worth $3. By paying $4, we can’t make money but we could certainly lose.
 
So now we know that $3 is a certainly a favorable price to pay since we can’t lose but might win. We also know that $4 is too high since we can’t win but might lose. This means there must be a price in between that is a fair price to pay. It turns out that price is $3.50. If we pay $3.50 and the coin lands heads, we make 50 cents. If the coin lands tails, we lose 50 cents. If we were able to make such bets over long periods of time, we know that we’d win 50 cents half the time and lose 50 cents half the time and the price is considered fair at $3.50.
 
In other words, even though there is an announcement of a possible $1 price increase, the coupons only increase in value by 50 cents. The market increased the value by the probability of realizing that increase. In this case, there is a 50% chance that the price will rise one dollar so the market increased the coupon’s price by 50% * $1 = 50 cents. They will not increase the price dollar-for-dollar under uncertainty. Only when the storeowner announced that he would definitely raise prices by one dollar does the coupon rise by that same amount.
 
This is really the simplest way to help you to understand why option prices will generally not move dollar-for-dollar with the underlying stock. If the stock rises one dollar, it is not guaranteed to stay there by expiration, so the market will not price in the full dollar move. However, if we are in the final seconds of trading and the stock rises one dollar, then the market will price in the full dollar if the call option is in-the-money. It all hinges on the probability of the option retaining that intrinsic value at expiration.
 
Simplistic Stock Price Model
We can expand our understanding of why option prices generally do not move dollar-for-dollar with the underlying stock by considering an overly simplified model of stock price movements. Let’s assume that a stock is currently trading for $100 and can only move in one-dollar increments. Further, assume the most it can only rise or fall is a maximum of five dollars and that all prices are equally likely. In the real world, all stock prices are not equally likely; a $100 stock has a much better chance of rising to $101 than it does to $105. But just to make the example easier, let’s assume that all prices can occur with equal probability. With the current stock price at $100, this means the lowest it can move is $95 and the highest is $105. Now imagine that you have a $100 call option (at-the-money). In this scenario, your call option can only be worth one of the following values at expiration:
 
If stock price is:
At expiration, $100 call will be worth:
95
0
96
0
97
0
98
0
99
0
100
0
101
1
102
2
103
3
104
4
105
5
What is this $100 call option worth? Assuming that all final stock prices are equally likely, we know that the $100 call is worth the average of all possible prices. We simply add up all possible call values and divide by the total so the $100 call is worth 0+0+0+0+0+0+1+2+3+4+5 = 15 and the average is therefore $15/11 = $1.36. If you pay $1.36 for this call option hundreds and hundreds of times, you would just break even in the long run. If you try to buy this option for less money you can be sure that other traders will outbid you. Likewise, if the price rises above $1.36, traders will start selling, which brings the price down. The end result is that the option’s price should be $1.36 since that is the price at which neither the buyer nor the seller has a long-run advantage. So in theory, if the market feels that the highest stock price is $105 and the lowest is $95 with all prices equally likely, then the option should be trading for $1.36.
 
Now let’s assume that the stock rises by one dollar to $101. Under our assumptions, the stock can only rise or fall by five dollars so the new range of stock prices will be $96 to $106 and the range of possible option prices will be from $1 to $6:
 
If stock price is:
At expiration, $100 call will be worth:
96
0
97
0
98
0
99
0
100
0
101
1
102
2
103
3
104
4
105
5
106
6
The average price of the option is now found by summing up all the potential option values and dividing by 11. Our new $100 call price is 0+0+0+0+0+1+2+3+4+5+6 = 21 and 21/11 = $1.90
 
So if the stock rises from $100 to $101, the at-the-money call rises from $1.36 to $1.90. Notice that this is a $1 rise in the stock’s price but only a 54-cent rise in the options price. Even with this simplistic price model, we are coming up with a very realistic price behavior for an at-the-money call option. Most at-the-money calls will have rise a little more than 50 cents on the dollar for the next one-dollar move in the stock’s price.
 
What would happen for the next dollar move in the stock’s price? If the stock were to rise from $101 to $102, the call would rise by more than 54 cents. The reason is that each time we are dropping off one of the zeros and adding a bigger number. In the first situation, the highest call value was $5. In the second scenario, the highest call value was $6. So each time the stock rises, we add higher and higher values while dropping off zeros. The end result is that the option’s price must rise by bigger and bigger amounts, at least up to a point. After some point, the option will move dollar-for-dollar with the underlying stock since you will eventually be adding one dollar and dropping off one dollar on a net basis. Where is that point? When the option gets sufficiently in-the-money to a point where the market believes it will definitely have intrinsic value at expiration. Let’s take a look at that scenario next.
 
Deep-In-The-Money-Options
Assume that the stock price is now $106 so that the $100 call is deep-in-the-money. Under our assumptions, the stock price can only move up or down a total of five points from its current price, which means the expiration stock price will be between $101 and $111. The total option price possibilities are as follows:
 
If stock price is:
At expiration, $100 call will be worth:
101
1
102
2
103
3
104
4
105
5
106
6
107
7
108
8
109
9
110
10
111
11
The option’s price is now (1+2+3+4+5+6+7+8+9+10+11)/15 = $4.40. What do you suppose will happen if the stock rises another point to $107? Again, assuming the stock price can only rise or fall five points by expiration, the option values at expiration can range between $2 and $12 as follows:
 
 
 
 
 
 
 
If stock price is:
At expiration, $100 call will be worth:
102
2
103
3
104
4
105
5
106
6
107
7
108
8
109
9
110
10
111
11
112
12
To find the new option’s price, we get to add the new, highest number 12 to the average but drop off the lowest number 1, which is a net gain of 11 to the average. Because we’re dividing by 11, the option’s price will rise by 11/11, which equals exactly one dollar. Using the same reasoning, if the stock rises again to $108, we’ll add 13 to the average but drop off 2, which is again a net gain of 11 and the option’s price will rise by one dollar again. This shows that once an option is sufficiently in-the-money, it will rise dollar-for-dollar with the underlying stock. Prior to that, the option’s price will rise by something less than one dollar. The consequence of these actions is that an option’s price will follow a curved path rather than the straight line, dollar-for-dollar action of the stock’s price.

 
To be continued…
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