Aug

7

Stock Replacement Options Trading Strategy

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Stock Replacement
 
If you are a stock trader, thinking about getting involved in options, stock replacement strategies will make a lot of sense. If an investor thinks that they want to make money on a stock within a time frame of a month to three years, it makes indisputable sense to use stock options. The reason: if done properly with stock options, the same results can be purchased for about 15%-20% of the capital required to buy the stocks themselves, which means a tremendous boost in Return on Investment (ROI). Or, an investor can have the benefits of owning many times as much stock for the same amount of capital. Moreover, to put the icing on the cake, when owning stock, the investor may face unknown significant losses in value whereas stock options have a known maximum loss.
 
So, according to Option University’s Stock Option Mastery Course, “for a stock trader and someone who is very good at picking stocks, using a stock replacement strategy using stock options can be a very easy, safe, cost efficient way to reduce risk, increase profits and obtain a much higher return on investment. It’s as simple as that”.
 
Stock replacement strategy combines the exact same philosophy and analysis that a stock trader uses to find opportunities but is just a different way of executing that opportunity. As a stock trader, you do your analysis and decision making in the same fashion but it is the last step in acquisition that changes when using options to replace stock. Instead of purchasing the stock, you will purchase a call option (if you would be long the stock).
 
In the stock replacement strategy, a trader wants to accomplish the same thing as if they own the stock and we want the option to act just like the stock. If the stock moves up $1, we want the option to also move up $1. The key to the stock option strategy is to purchase an option contract (100 shares) with a Delta very close to 100 Deltas for the contract (close to one Delta per share). That means that the option will closely mimic the movement of the underlying stock.
 
Let’s use an example taken from the Options University Mastery Classes. Say you were going to buy an $80 stock because you thought it was going to run up $10 and let’s say you were right. You bought the stock for $80 and it ran up to $90. You’ve got a $10 return on an $80 investment, 12.5% return; nice job. 
 
What if you can replace that stock with an option that costs only 25% of the stock price but mimics the stock movement to 80%? Hence, you have an 80 Delta, $80 option. So now when the stock runs up $10 your $80 option (purchased for $20) is going to mimic that stock’s movement to about 80%. If the stock runs up $10 your option that you spent $20 for is going to increase by $8 (80% of the stock movement); that’s what an 80 Delta does.
 
You now have an $8 return on a $20 investment and that’s a 40% return on capital invested and that’s a lot better than the 12.5% return when the stock was purchased outright. You only had to put up $20 freeing up another $60 to do something else or you could have invested a little bigger. Either way, you have a much better return for much less capital.  
 
But why pay such a high price for an option when there are much cheaper options? The answer is simple and important. To replace, or closely mimic the movement of the underlying stock, you need to buy an in-the-money option; the higher the Delta, the higher the correlation to the underlying stock. Not only that, for an option to have any value, it needs to be in-the-money before expiration. If it’s out-of-the-money at expiration, the value of the option will be exactly zero.
 
 

For information on all things stock option, go to www.optionsuniversity.com

Aug

7

Comparing Returns Amoung Funds and Managers

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 Comparing Returns Amoung Funds and Managers

You will be persuaded by different types of investments or individual stock pickers to put your money with them because they “beat” the Dow or some other index. While their returns may be higher, it does not mean that they necessarily beat it on a risk-adjusted scale. As an example, assume the Dow increases 10% over the year but a money manager tells you to put your money with him since he earned 20%. On the surface, it seems like he did much better. However, we haven’t considered the risk. What if this manager invested all his clients’ money into lottery tickets to get the 20% gain? Now it doesn’t appear too impressive. If he is taking that much risk, you’d certainly want better than a 20% increase on your money. We’d say that, on a risk-adjusted scale, this manager didn’t perform as well as the Dow even though his return is higher.
 
Traders and money managers who place their money in high-risk investments will do better than the Dow or S&P 500 or other broad-based index from time to time. But the chances that they will sustain that record are very low. People who place their money with a fund or manager just because they posted the highest numbers are mistakenly assuming that all of them took the same amount of risk. Before you place your money with them, find out what they are investing in before you get too impressed with the numbers. At any given time, there are thousands of speculators and hedge fund managers who speculate with high-risk investments. It shouldn’t be a surprise that a great number of them will beat the Dow or S&P 500 during the course of a year. This doesn’t mean that they are more skilled than the manager who consistently returns a smaller number.
 
Make sure you understand the risk-reward relationship before you start investing. Risk and reward never separate. They are joined together by a rational force – the same force that caused you to price the earlier games in the order you did. If you always seek the investments that have the highest potential for return, you are by default, seeking the ones with the highest risk. We have tried to give you many examples of how to use the risk-reward relationship so that you do not forget it, which is easy to do. For example, we just received an email promotion from an options trader with the following advice:
 
Quote in Promotional Email:
“Cheaper options are usually the best plays. They give you the most leverage, the percentage returns are better, and if the market or stock goes against you, you are risking less.”
 
You can see that even this professional got it wrong. You are not “risking less” by purchasing cheap options – you are taking on more risk. It is true that if you buy a cheap option there is less money to lose, but that is because you have a higher chance of losing it. And why are the percentage returns better? Because there is more risk. Why do cheap options give you the most leverage? Because there is more risk. But if you look at the quote, he is making it sound as if you’re getting all the positive attributes (high leverage and higher percent returns) without any negative consequence since you are “risking less” for all of these benefits. That is simply not true. All of those positive attributes are a direct result of the higher risk in cheap options.
 
Understandably, it is easy to make this mistake with financial investments since we do not have little pictures (such as the coin and cards) off to the side like we did with the pricing game reminding us of the risk in each game. When you start trading options remember this one thing: Cheap options are priced that way for a reason. That reason is risk.
 
Key Concepts
 
1)       The time value of an option is determined by the volatility of the underlying stock.
2)       The time value is purely determined by what traders are willing to pay for additional time.
3)       The higher the risk, the cheaper the price (and the higher the reward).
4)       Higher strike calls (and lower strike puts) are riskier.
5)       There is no inherent advantage in trading options on high-volatility stocks because they will be priced correspondingly higher. Price is the equalizer.
 

Option Price Behavior
One of the biggest mysteries to new (and experienced) traders is the way in which option prices move with changes in the underlying stock. For example, let’s assume you buy a $50 call for $3 with the underlying stock trading for $50. Within a few minutes, the stock climbs up $1 to $51. What would you expect to happen to the price of your option? Would it climb $1 too? The answer is, unfortunately, no. Although it seems like it should be trading for $4 at that point, the option will rise by something less than $1. Why is that?
 
This is a very difficult concept to explain to new traders, and the explanation belongs in a more advanced book, but it’s important that you at least understand that options will generally not move dollar-for-dollar with the underlying stock. Please understand that the following details are not really necessary to understand in order to trade options. We’re just showing you this to explain why options will usually not move dollar-for-dollar with the stock and so you are not alarmed when you see it occur. Let’s see if we can make some sense of why this might happen by going back to our pizza coupons.
 
Assume that pizzas are selling for $10 and you have a coupon that allows you to buy it for $7. If these coupons were actually traded in a market, we know that it must be worth at least $3. Why? Just as with our call options – arbitrage. Let’s say the coupons were missing $1 of intrinsic value and trading for $2. Arbitrageurs could buy a coupon for $2 and then pay $7 for the pizza thus spending only $9 for the pizza. They could then sell it in the street for $10 thus making a free dollar. The buying pressure on the coupons will raise the price, and the arbitrage opportunity will stop once the coupon is trading for at least $3.
 
Now let’s assume that the storeowner announces that tomorrow the price of pizzas will go up for certain by one dollar to $11. Upon hearing the news, the market will immediately raise the price of the coupon from $3 to $4. If not, arbitrage is possible again for the same reasons as in the previous paragraph. In other words, if pizzas are now worth $11 then the $7 coupon must fully reflect the $4 intrinsic value. In this case, the pizza price rose one dollar and so did the coupon.
 
But now let’s go back to the beginning when pizzas were $10 and change the situation a bit. Let’s say that, instead, the storeowner announces that he will flip a coin tomorrow to decide whether or not to increase his prices by $1. If the coin lands heads, he will raise prices to $11. If it lands tails, they stay the same at $10.
 
We know that when the storeowner announced that pizzas would definitely rise by one dollar that the coupons also rose by the same amount. In other words, because prices were guaranteed to rise, the market immediately priced that $1 increase into the coupons. With the coin flip though, the owner introduces some risk and we’re now only 50% sure that pizza prices will rise. What should we pay for the coupon now?
 
To be continued….

Aug

7

The Sweet Spot When Trading Stock Options

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The Sweet Spot
 
If you’re going to buy a call, it’s best to buy one that will closely mimic the movement of the stock. This philosophy pretty much demands that option traders buy in-the-money calls. Of course, in-the-money calls cost more than out-of-the-money calls. But the question then arises, “how far in-the-money is optimal?”
 
In the Options Mastery Class offered by Options University, they talk about “the sweet spot”. This is an area where we combine the two important factors involved in a stock replacement strategy. We want to mimic the stock as close as possible but at the same time move far enough away or down the ladder in terms of total dollar price.
 
When we try to mimic the stock’s movement and also move away from the at-the-money option price, the option is filled with all that extrinsic value, all that money that decaying premium demands that the option has to outperform and at the same time is going to decay while we’re waiting for it to go into-the-money. During this time, the out- of-the-money option is susceptible to movements in volatility, which we’re obviously not playing here, we’re trying to get away from at-the-money but we don’t want to go too far in-the-money either because then we get into higher dollar values.
 
What we want to do is look at an in-the-money option and hunt for the “sweet spot”. How do we do that? Well, we look far enough from the at-the-money option price where we can get rid of any extrinsic value in the price without getting too deep into-the-money. As a result, normally the sweet spot is located right around 80-85 Deltas; just far enough from the at-the-money and not too deep into-the-money. No need to do complicated calculations, just look for 80-85 Deltas. If you do that, you will be at or near the “sweet spot”.
 
Along with locating the sweet spot is optimizing your timing. In other words, how far do you want to go out in time? First thing, look at the chart of the stock and see if your projected movement has happened in the past and how long it took to take place; in other words, what‘s a reasonable rate of movement for the stock? Can this rate of movement take place within the option expiration period? In effect, you are trying to use historical movement as an indicator of future movement. Of course, you need to investigate what had caused the past movements and determine if the reasons are related to your analysis. You want to understand if past large movements were caused by unusual events or events similar in today’s scenario. If it is, then the comparison has more validity.
 
Also, you want to try to give enough time for your forecast movement to take place but not too much because of the cost of Theta decay. So, take a look for the type of stock movement you anticipate and use that as a guide and provide enough pad on front and back end of the expiration period you choose to allow for a variance in time.
 

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

Aug

6

Greek Sensitivities and Going Naked When Trading Stock Options

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Greek Sensitivities and Going Naked
 
In ancient times, Greek Oracles played an important part in trying to foresee the future. Appropriately, the Greeks produced by the Option Pricing Model do much the same. Let’s take a look at how the Greeks function within the context of a call.
 
First of all, when you buy a call, you become long Deltas. If you sell a call, you become short Deltas. Gamma will also be long when buying a call and negative if sold. With Gamma comes short Theta because from the moment you buy the call, the extrinsic value is decaying. More specifically, the call will lose value due to negative Theta. Finally, Vega, like Delta and Gamma, is long when a call is purchased.
 
When an option trader acquires a call, they acquire sensitivity to movements in volatility. When volatility goes up, the price of the option will also increase. The reverse also holds true; if volatility decreases, that will negatively impact the option price.
 
In summary, for a long call, you will be long Delta, long Gamma, long Vega and short Theta.
 
If an option trader sells a call, they’re going to acquire short or negative Deltas. As a generalization, when a trader sells a call, they’re going to acquire negative Delta; the actual amount of negative Deltas will depend on the Delta of the stock option you’re selling. Gamma will also be negative when a trader is selling options. However, because a trader is short the call, negative Theta will yield a net positive Theta. In other words, the trader will be collecting the amount of extrinsic value that would normally be decaying over the life of the contract time. Remember, when selling a call, the trader keeps the premium when the option expires provided it hasn’t moved into-the-money. In affect, the trader are accrues the value of the premium each day. Finally, a trader will be short Vega when selling a call. If Vega is decreasing when in a short position, that is a good thing because there is less of a chance of the option moving into-the-money.
 
Professional traders such as Options University’s Ron Ianieri feel that it’s important to be aware of the quantity of each Greek in your long or short calls. This can become particularly important when hedging becomes a factor.
 
Going Naked
 
Speaking of hedging, what happens when an option trader trades naked calls? When talking of a naked option we refer to an unhedged position. To get a better understanding, let’s look at the risk-reward profile of being “naked”.
 
If a trader buys a naked call, they have a maximum potential loss of the premium if the stock goes down and an unlimited potential profit if the stock goes up. Some say that you actually are hedged in the sense that the loss is limited to the premium amount.
 
But what happens when you sell a naked call? A completely different profile emerges. When a trader sells a call, the maximum profit is the premium received for selling the call. But what happens if the stock zooms up? The potential loss is unlimited.
 
Considering that the markets have a positive bias, this strategy of selling naked calls can be precarious. That is why almost all knowledgeable options traders strongly believe that selling naked calls is not a wise strategy. Any strategy that exposes a trader to an unlimited loss shouldn’t be traded. That doesn’t mean that selling a call is bad, it just means that some sort of hedging is needed to reduce the upside risk.
 

For more information on all aspects of stock options, go to www.optionsuniversity.com for a listing of online classes, webinars and mentoring programs.

Aug

6

Price is the Equalizer when Trading Options

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Price is the Equalizer 

The market places a lower price on riskier assets as a way to equalize the demand. In the pricing game, you placed a higher price on the coin game than the card game. This doesn’t mean that the coin game is necessarily the better game. If the coin game and card game were priced the same, then we could say for sure that the coin game is better. After all, it wouldn’t make sense to pay the same price to play the card game. But because there is more risk with the card game, you will bid a lower amount. Once the prices are established for all three games, then all games are theoretically equally attractive. Your decision on which one to play just depends on how much risk you wish to take (or on how much reward you’re looking for). If you don’t like the $51 payoff of the coin game, you can certainly jump to the riskier card game and go for the $99 reward. Just understand that this decision means you are taking more risk and therefore have a higher chance of losing your investment. The important point to understand is that you cannot jump to a better payoff and take less risk. If you want more reward, you must be willing to take more risk.
Now let’s go back and look at some of the eBay option quotes from Table 1-1, which have been reprinted below in Table 2-8:
Table 2-8
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
 
 
As we pointed out before, the price of the call options gets cheaper as we move to higher strikes. Notice that this is the same progression as with our pricing game when we move from the guaranteed game to the card game. The price gets cheaper as you move in that direction. This can only mean one thing for the options. They must be getting riskier as we move to higher strikes. However, most traders look at the quotes in Table 2-8 and think that all options could theoretically make an unlimited amount of money since they are all tied to the same underlying stock. It only makes sense to buy the cheapest one, which is the $40 strike. And this is usually a fatal mistake for options traders. Traders who use this line of reasoning assume that the risks are all the same. We now know that cannot be true since the prices are not the same. The market is bidding down the prices of the higher strikes due to the higher risk.
 
Our first pricing principle stated that lower strike calls must be more expensive. We said that a statistical reason for this is that lower strike calls are able to “catch” more intrinsic value and therefore must be more desirable. Lower strikes are more desirable because they are less risky. If it is less risky, it must cost more money.
 
We can show this effect by considering the breakeven points for a call option. If you buy the $32.50 strike for $4.90, the stock would have to close at $32.50 + $4.90 = $37.40 in order to break even at expiration. Because CYBX is currently $37.11, you’re only 29 cents away from your breakeven point. However, if you elect to buy the cheapest option, the $40 strike, then the stock must climb to $40 + $0.35 = $40.35 just to break even at expiration. With the stock at $37.11, that means the first $40.35 – 37.11 = $3.24 worth of movement doesn’t even count for you at expiration! The stock must climb higher than $3.24 by expiration before you make money. There is a very big difference between the $32.50 strike and the $40 strike – and that difference is the risk.
 
Using Table 2-8, many new traders still believe that the $32.50 call must be riskier than the $40 call since there is more money to potentially lose. If eBay falls from its current price of $37.11 to $32.50 at expiration, the $32.50 call buyer loses $4.90 while the $40 call buyer loses only 35 cents. However, if eBay falls to $32.50 at expiration then the stock has lost $4.61 worth of value. This means that the first $4.61 worth of loss on the $32.50 call is a risk that is common to both the stock and the option. It is not a risk that is unique to the option, so it should not be counted as a risk in the option. It is only the value above $4.61 – the 29 cents worth of time value – that is a risk of the $32.50 call. The $40 call loses only 35 cents but it does so if the stock falls, stays still, or even rises to $40 at expiration. It is far riskier than the $32.50 call.
 
Many traders feel uneasy about putting much money into the trade when there are other strikes available for much less money. The key to trading options is to strike a balance between the two. We don’t suggest buying options so far in the money that it costs a fortune but, at the same time, we stay away from buying at-the-money and out-of-the-money options unless we are buying them with a lot of time remaining – perhaps more than a year to expiration. For the most part, you’ll be better off buying options with intrinsic value.
 
Now let’s look at the July and August calls in Table 2-8 above. Why do you suppose the July $32.50 is cheaper than the August $32.50? You should now understand that it is cheaper because it is riskier. As we stated before, the August call gives you more time for the stock to move higher – to build intrinsic value – and that means there is a better chance to make money. In other words, there is less risk with that option, and that’s why its price is higher. Many option traders make the mistake of buying the shortest-term, cheapest option available thinking they are reducing their risk; this is usually why most people lose with options. The short-term, high strikes should be treated like lottery tickets, not investments. Our basic risk-reward relationship can be found in many other areas outside of the financial markets too. As long as there is a price paid in exchange for a possible financial reward, the risk-reward relationship holds. Let’s look at an example outside of the financial markets.
 
Lotteries
Why do you suppose that you can pay one dollar for a state lottery ticket for the chance to make $7 million or more? The reason is that the chance of making that huge reward is very small and so the price will also be low. It does not mean that it must be a great investment because of the “great risk-reward ratio” that so many traders talk about. If there is a great reward, there is a low price – and also a lot of risk.
 
As another example, Figure 2-9 shows two versions of the Florida lottery scratch-off Monopoly game: Instant Monopoly and Super Monopoly.
 
Figure 2-9: Florida Lottery’s Instant Monopoly and Sly
 
 Price is the Equalizer when Trading OptionsPrice is the Equalizer when Trading Options
 
Instant Monopoly costs $1 and offers a $5,000 grand prize while Super Monopoly costs $5 and offers a whopping $100,000 grand prize. Instant Monopoly offers $5,000 of reward per dollar at risk while the Super version has $20,000 of reward per dollar of risk. As so many players ask, “Why should I risk $1 to make $5,000 when I can risk $5 to make $100,000?”
 
Is Super Monopoly the better game since it has a “better” risk reward ratio? Not necessarily. In order to answer that, we need to know the probabilities of winning each game. Depending on the probabilities, it may turn out that one is better than the other. However, the point is that you cannot just look at the “risk-reward ratios” and make that determination. What we do know for sure is that the Super Monopoly game must be more difficult to win. The higher payout is a reflection of the higher risk involved in that game. In fact, you can verify this by going to the website www.FloridaLottery.com and looking at the odds. For Super Monopoly, the odds are 1:2,520,000 and are 1:890,000 for Instant Monopoly. Although you are not likely to win either game, there is no doubt that, on a relative scale, you are more likely to win Instant Monopoly; that’s why the payout is lower. However, now that we know the odds, we can make comparisons. In this case, Super Monopoly offers four times the reward but is not four times as difficult to win. On a risk-adjusted basis then, Super Monopoly turns out to be the better game to play. However, in the financial markets, this favorable risk-reward ratio would never exist as arbitrageurs would buy Super Monopoly and simultaneously sell Instant Monopoly until the prices were exactly in line with the risk. Because these games are not subjected to buyers and sellers, it is possible (as we see in this example) to find games that are more favorable than others. Despite the unbalanced risk-reward ratios offered by these two games, one thing is for certain: The creators of these games will not increase your reward without making you assume more risk.
 
To be continued…

Aug

5

Risk and Reward when Trading Options

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Risk and Reward when Trading Options

 
Now that you understand the concept of volatility, we can figure out why options have value while pizza coupons do not. Many are inclined to think that it’s due to the prices; stocks are far more expensive than pizzas. That’s partly true, but the bigger reason is due to the uncertainty of prices. You can be pretty sure that pizza prices will be the same price next week or even next year. And as competitive as the pizza market is, there’s even a good chance that prices may fall. Because we’re pretty certain about the price we’ll pay for pizza in the foreseeable and they don’t make up a large portion of our incomes or net worth, there’s no reason we’d want to “lock in” the price of a pizza. Consequently, pizza coupons have no value. With stocks, it’s a different story. One day the stock is up 2%, the next it could be down 10%; we’re never really sure what’s going to happen. And because stock portfolios typically do make up significant portions of our wealth, investors and traders are willing to pay to hedge those risks. They are willing to give options value. Options have value because stock prices fluctuate. Options were designed to control these fluctuations and therefore reduce risk.
 
 
Risk and Reward
While we’re learning about options pricing, this is a perfect point to introduce one of the most misunderstood concepts in option pricing – risk and reward. It is, in fact, so misunderstood that you will find it misinterpreted even among professional traders. Because of this, it is also one of the biggest reasons for option losses by new and seasoned traders. If you are to trade options successfully, you need to understand the indisputable relationship between risk and reward.
 
Will Rogers once said, “Why not go out on a limb? That’s where the fruit is.” This is one of the simplest ways of expressing the relationship between risk and reward. He was, of course, referring to the fact that in order to get the fruit (reward) you must venture out onto the tiny, unstable limbs. You must take some risk. The same concept applies to every financial decision you will ever make. In financial terms, if an investment is considered risky, that means there is a chance you might lose some or all of your initial investment. The greater the chance for loss, the greater the risk of the investment.
 
Risk and reward are the inseparable dynamic duo of finance, and they always increase and decrease together. If the potential reward from an investment is great, you can be sure that it comes with a lot of risk. And if the risk is low, you can forget about making a lot of money.
 
While the concept of risk and reward may make intuitive sense, it is one of the most overlooked concepts among investors and causes many problems for those who only consider the reward side. If you want to succeed in investing, it is crucial that you understand the risk-reward relationship and why this pair cannot be separated. We can easily convince you why risk and reward go hand-in-hand by playing a simple game.
 

Pricing Game
Imagine that you are offered the chance to play the following three games. An auction is held to play each game for which there is a $100 cash prize. The highest bidder is allowed to play the game one time and does not get his bid amount back. Think about each of the games and then jot down your answers on a piece of paper:
 
1. For the first game, the highest bidder is guaranteed to win $100 cash. No risk. No hidden strings attached. If you are the high bidder, you walk up and collect $100. How much would you bid to play this game?
 
 
2. For the second game, you must correctly call heads or tails at the flip of a coin in order to win the $100 prize. How much do you bid to play the game now?
 
 
3. For the third game, you must draw the ace of spades from a well-shuffled deck of cards in order to win $100. How much would you pay to play this game?
 
Even though we don’t know the particular answers you chose for each game, we are 100% certain that you elected to pay the highest price for the guaranteed game, the next highest amount for the coin game, and the least amount for the card game. How do we know this? It’s because of the relative risks involved in each game. The first game has no risk; we know that the winner always wins $100. And because of this, most people will bid this game up fairly close to the $100 reward. For the coin toss, we know that you would win $100 half the time and lose your bid amount half the time, which is certainly not as good as winning all of the time. In other words, we are less confident in the outcome – there is risk. There is no chance of losing with the first game but a significant chance of losing with the coin game. Because of this, you should be willing to spend less for this game. For the card game, we know you would win $100 only once out of every 52 tries, on average. This means you are almost certain to lose your money. On a comparative basis among the three games, this is the riskiest so you should be willing to spend the least to play it.
 
We just reviewed each game in terms of risk and found that the higher the risk, the lower the price you are willing to pay. We can also look at the three games in a positive light as we did when considering which strikes should cost more. We do that by simply asking which game is more desirable;that is the one that will carry the highest price. The guaranteed game is more desirable than the coin game and that’s why its price is higher. Or conversely, the coin game is riskier (it is less desirable) than the guaranteed game so it is cheaper. It doesn’t matter which dollar amounts you picked for each game but, just for the example, let’s assume you bid the following amounts:
 
Guaranteed game: $99
Coin game: $49
Card game: $1
 
These are results that we typically get when this game is presented at Option University seminars. Once we have some prices to work with, we can look at the three games in a different light. If you were willing to pay $99 for the first game, that’s the same as saying you were willing to invest $99 in order to make a $1 profit. The coin game, on the other hand, represents a game where you could invest $49 for the chance to make a $51 profit while the card game represents an opportunity to invest $1 in hopes of making a $99 profit. These costs and potential profit opportunities are summarized in Table 2-7:
 
Table 2-7
Game
Cost
Potential Profit
Guaranteed
$99
$1
Coin
$49
$51
Card
$1
$99
 
Notice the relationship between the prices and the rewards: The higher the price (cost), the lower the reward (potential profit). The guaranteed game carries the highest price of $99 and comes with the smallest reward of $1. The coin game has a lower price and a correspondingly bigger reward. The card game has the lowest price of all and also has the biggest reward. You can see why it would be easy for someone to just look at the prices and potential profits in Table 2-7 and wonder why they should play anything but the card game. After all, it doesn’t seem to make sense to pay a high price to get a small reward when you can pay a tiny bit and possibly make a fortune. People who interpret the numbers in Table 2-7 this way are unintentionally assuming that the risks are equal across the board. That is easy to do if you’re just looking at the numbers. But once you understand the nature of each game, you start to see why people are willing to pay higher prices for some of the games.
To be continued…

Aug

5

What are Your Hard Deltas and Parity When Trading Stock Options

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Hard Deltas and Parity
 
According to Options University founder Ron Ianieri, “when we’re looking at an in-the-money option, you have to think about hard Delta”. What does “hard Delta” mean?
 
In-the-money options that have a higher Delta (above 90) are called “hard Delta”. Keep in mind that although an option may be in-the-money, it doesn’t mean that the option’s Delta must be at 100. An option can be ITM and have a Delta in the 60s. By definition, when an option contract has a hard Delta of 100 that means the option’s movements will exactly match those of the underlying stock. It follows that lower Deltas are also referred to as “softer” Deltas. Because an ITM option with a hard Delta acts very much like the underlying stock, hard Delta is much less influenced by external events than options with soft Delta.
 
One of the advantages of options is that if the option is allowed to expire, the maximum loss is the premium. This is important in that inexperienced option traders might panic when they see the option price move away from them and lose more money by closing out the position rather than just let the option expire! This is a common mistake in rookie traders along with an equally disastrous mistake of not closing out in-the-money positions before expiration.
 
Another rookie error is forgetting to figure out the breakeven for the position; you need to always consider the premium costs in relation to the breakeven for the trade.
 
For example, if you buy a $40 call option for a $2 premium (per share), you would need the stock price to move up to $42 before the option starts to produce a profit. This breakeven stock price is called Parity, which is the same thing as breakeven. Every time a trader buys an option they will need to consider parity (breakeven) before a trade can be considered a gain; an option really becomes in-the-money after parity.. On the other hand, when selling an option below Parity, the option becomes a loser.

Insert figs 22-2 and 22-2

For more on all aspects of stock options, go to www.optionsuniversity.com

 

Aug

4

Understanding Volatility

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As stated earlier, it is the “scoring potential” of the teams that drives the values of the bets. And that means that time plays a critical role since teams can produce higher scores the longer they are allowed to play. For example, if the basketball bet was only good for the first five minutes of the game then you should be willing to pay less than if it applied to the entire game.
 
It’s exactly this same reasoning that drives the true time premium component (the component above the cost of carry) of an option. If you have a $20 call, it will have intrinsic value for every price above $20 at expiration. If the stock closes at $23 at expiration, the call will be worth exactly $3. If it closes at $32, the call will be worth $12. How much will you pay for this $20 call? As with the sports bet, the answer depends on the “scoring potential” of the stock. If you are dealing with a stock whose price fluctuates wildly, you will pay much more for the call than if the stock price hardly moves. If there is more ability to make money on the bet, then the bet should be worth more money. In option trading, the “scoring potential” is known as volatility. A high-volatility stock has large price fluctuations. It can be up or down several percentage points in a day. A low-volatility stock, on the other hand, has almost no fluctuations in its price. The time value portion of an option is solely determined by the market’s perception as to the volatility of the stock between now and expiration. There is no way to say for sure if the time premium is too high or too low. It is strictly a value that exists in the minds of the traders.
 
To further understand volatility using an everyday example, we would say that gas prices are more volatile than milk prices. We’re pretty sure that a gallon of milk will cost about the same next week or next month but we’re not nearly so sure about a gallon of gas. While there are many ways to measure the volatility of a stock, that’s getting a little ahead of our goal. Just understand that the more volatile the stock’s price – the more uncertain its price is from day to day – the more money you’re going to pay for an option. High-volatility stocks have greater potential to move higher, and traders are therefore willing to pay higher time premiums for the option. It is the high-volatility stocks that carry the largest time premiums on their options.
 
For example, imagine that you are looking at two options:
 
ABC Jan. $50 call = $2
XYZ Jan. $50 call = $6
 
Both underlying stocks are $50 and both options expire at the same time. What can we conclude about the relative volatilities of these two stocks? We can conclude that XYZ must be more volatile than ABC, which is why traders are willing to pay more for that call option. XYZ is like a high-flying tech stock while ABC is more like a blue-chip company.
 
At the beginning of this chapter, Principle #2 conveyed that longer-term options are worth more than shorter-term options, so we know the ABC or XYZ March $50 calls will be worth more than the January $50 calls. Now you probably understand better why that is. For any given stock, the longer the timeframe, the better the chance for “high scores” or high stock prices, and that makes the value of calls and puts rise. Remember that put options will rise too since stock prices behave a little differently from basketball and football games in that they can rise or fall with equal ease.
 
There is no way to limit what time value traders will place on an option – it is a value that exists in their heads. It depends on how bullish or bearish traders are at that time. Obviously, if traders are extremely bullish, then they are willing to pay more for the time value. If they think the stock will just sit flat, they may not be willing to pay anything. The time value portion of an option is an indication of the volatility that traders believe the underlying stock will exhibit through the life of the option.
 
Does this mean that you should only buy options on high-volatility stocks? Although there are many traders who will tell you that you should only trade options on high-volatility stocks, that is actually a misconception. Those options, for reasons just stated, also have the highest time premiums, and that makes it that much harder to earn a profit.
 
For example, assume you are looking at the ABC and XYZ $50 calls we saw previously. The XYZ $50 call was trading for $6 while the ABC $50 call was trading for $2. The XYZ $50 call certainly has more potential for greater profit but it also costs more.
 
We can show that the high-volatility stock needs more movement to make a profit by calculating the breakeven points for each option at expiration. To find the breakeven point for a call, we simply add the cost of the option to the strike (we subtract it from the strike for a put option). For the ABC $50 call, this means the stock must close at $52 at expiration in order for the trader to break even. If the stock is $52 at expiration, the $50 call is worth exactly the intrinsic amount of $2. This means you paid $2 for the option and sold it for $2 so you just broke even. The XYZ $50 call, on the other hand, must have the stock close at $56 at expiration in order to break even. If the stock is $56 at expiration, that $50 call is worth exactly the intrinsic amount of $6, which is the amount that was paid for it, so you break even. Notice that the benefits of a high-volatility stock are balanced by the higher breakeven price. The market realizes the benefit in buying high volatility and prices those options higher.
 
When you hear traders tell you to only buy options on high-volatility stocks, they are unknowingly making the assumption that both options will cost the same. If that were true, you can be sure that the high-volatility options would be the right choice. However, the financial markets will always bid the prices higher for options on high-volatility stocks.
 
Let’s return to our main idea about what gives an option value. We said the first factor was intrinsic value, which is determined by favorable price movement. The second is due to time, which is affected by traders’ beliefs in the future volatility of the stock. This leads to a very important point about the characteristics of option prices: Option prices can rise or fall with no movement (or with adverse movement) in the underlying stock.
 
This can happen simply because of a change in traders’ outlooks on the volatility of the underlying stock. For example, assume you buy a three-month $50 call option for $3. A month later the stock is still $50 and the option is trading for $2. However, at that time, a buyout rumor starts circulating on the stock. We might see the $50 call trading for more than $3 even though less time remains on the option and the stock price hasn’t moved. The reason is that traders now believe the “scoring potential” or volatility will be greater in the near future so they are willing to bid the option higher than its price a month earlier.
 
Exercise
Go to www.cboe.com and check out option quotes on Google (GOOG) and McDonald’s (MCD). Look at the prices for the at-the-money calls and puts. Which stock has the more expensive options? Why?
 
To be continued….

Aug

4

Stock Options- In, At and Out-of-the-Money

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Stock Options- In, At and Out-of-the-Money
 
An in-the-money call is any call whose strike price is less than the current stock price. If you own a May call option with a strike of $30, and the stock price is at $35, the option is in-the-money by about $5. I say “about” because you might have paid more for the option premium than the real value and you need to consider all transaction costs. As a matter of fact, if a trader hasn’t computed the breakeven of the trade, they might possibly close their position too low in-the-money and actually lose money.
 
Another way to look at being in-the-money is to imagine that if you exercise your call option today, would you make money? If you would be able to buy stock under the option contract for $30 a share and immediately sell it on the market for its current price of $35 you’d have a gross profit of $5 per share and you’d be singing “I’m in-the- money”. And, indeed, you would be!
 
Along a similar vein, a call option is out-of-the-money when the strike price is above the current price of the stock. For instance, if you purchased a May 60 call and the current price is $55, the option is out-of-the money. So, you ask yourself, “if I exercise my option and buy the stock for $60, and then sell it for $55, I would be a fool; out of your mind, out-of-the-money.
 
In-the-money calls have intrinsic and can also have some extrinsic value. An out-of-the money call has only extrinsic value. Remember, extrinsic value is time value; the probability of moving into-the-money. An in-the-money call option that has both intrinsic and extrinsic value means that even though the option is in-the-money, there is some extrinsic value because there is still time for the option to become more in-the-money and accrue more intrinsic value. When an option expires either unexercised or not closed out, both values go to zero. Not option, no value. In other words, if you happen to have intrinsic value, don’t forget to close out the position before expiration.
 
In using a premium collection strategy, the option seller wants the sold option to expire so that the premium can be kept. Of course, a sold option can be sold before expiration but that will depend on the current price of the option. To obtain an optimum return on the premium collected, the option needs to expire without being exercised.
 
An important fact is that not all options have the same exercise rules. If an option trades in the American style, an option can be exercised anytime during the option period. If an option trades in the European style, options can only be exercised after expiration. Many index options and ETFs trade the European style. Needless to say, it’s a good idea to check out what each option style is. If you are trading European style and the option moves into-the-money, you have time to get out of the position before expiration. Not so with the American style, it can be exercised as soon as the option moves into-the-money.
 
The final way to describe a type of option is when the strike and the price are close to the same; this is called at-the-money. The stock doesn’t have to be exactly at the strike price to be considered at-the-money. For instance, if you have an option with a strike at 25, the stock could be trading at $25.20, $25.50 or $24.80, $24.50 and the $25 strike will still be considered the at-the-money.
 
To learn more about all aspects of stock options, go to www.optionsuniversity.com.

Aug

3

What Gives an Option Value?

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Table 2-6: CYBX Option Quotes

 

What Gives an Option Value?

Look at the asking prices of the first two listed calls, the June $12.50 and $15 strikes. The asking prices are $25.50 and $23, respectively, which is a $2.50 difference. And that’s exactly the difference in their strikes. Once the price of the $15 call is established by the market, the market will pay a maximum of $2.50 above that price for the $12.50 strike.
 
What’s the difference in prices between the $15 call and the $20 call? Their prices are $23 and $18, which is exactly $5 and, again, the difference in strikes. Once the price of the $20 call is established, the market will not pay more than $5 above that price for the $15 call.
 
These prices expanded to the full difference in strikes because the stock price was so far above them at expiration. In other words, these strikes were very deep-in-the-money. With the stock at $37.55, the market didn’t see a chance for any of these strikes to close out-of-the-money, so their prices converged to the exact differences in strikes. (You may have noticed that the difference between the $35 and $40 strikes is $5.10; this is simply a fluke. These quotes were probably in the process of being updated and you can be sure this fell to exactly a $5 difference in strikes.)
 
Now take a look at the $35 and $40 strikes. Their prices are $3.00 and 15 cents respectively, which is only a $2.85 difference. Here we have a five-dollar difference in strikes but only a $2.85 difference in price. Remember, this principle states that the difference in prices cannot exceed the difference in strikes. It does not say that it cannot be less. Because CYBX was trading for $37.55, neither the $35 strike nor the $40 strike are seen as being “guaranteed” to finish with intrinsic value at this time. That’s why the market is not pricing a full five-dollar difference in their prices.
 
There are two conditions under which you’d see a $5 difference between the $35 and $40 strikes. First, if stock’s price is sufficiently higher than these strikes, say $43, then you’ll see a five-dollar difference between the $35 and $40 calls. The more time that remains until expiration (or the more volatile the stock) the higher that stock’s price needs to be before you’ll see a $5 difference between these two strikes.
 
The second condition under which we’d see a $5 difference is if these quotes were taken in the final seconds of trading and the stock was $40.01 or higher. The sole determining factor is the market’s perception as to whether both of these options will expire in-the-money. If there is time remaining, then the stock’s price needs to be well above both strikes. If there is little time, then the stock’s price only needs to be just slightly above the higher strike in order for the difference in prices to be equal to the difference in strikes.
 
Now you should have a basic understanding of why this principle is true for any set of option quotes. If the option is deep enough in-the-money, the markets will view them as guaranteed to expire with intrinsic value, in which case the difference in strikes will equal the difference in price. Once risk is introduced though, the difference in their prices will be reduced to something less than the difference in strikes.
 
While option prices are free to fluctuate, there are invisible boundaries governing their prices. These are not rules set by exchanges or any person. Rather, they are economic and financial principles at work. Traders and investors who understand these six principles will be ahead of the game once we start talking about strategies.
 
 
The difference in the prices between any two calls (or any two puts) cannot exceed the difference in their strikes.
 
 
Key Concepts
1)      Lower strike calls and higher strike puts are always more expensive (all else constant).
2)      The longer the term to expiration, the more expensive the option (all else constant).
3)      Options are either worth zero or intrinsic value at expiration. Long options cannot have negative value.
4)      Prior to expiration, calls option are worth at least today’s value of the interest that could be earned on the exercise price.
5)      The maximum price for a call is the stock price. For puts, the maximum price is the strike price.
6)      The price difference in two calls (or two puts) cannot exceed the difference in strikes (all else constant).
 
Up to this point, we have covered some basic principles about option prices. We have looked at some pricing examples assuming the prices have already been set by the market. Let’s take the next step and ask a very important question: What gives an option its value in the first place?
 

What Gives an Option Value?
We’ve learned that an option’s price, or premium, can be broken down into the two component parts of intrinsic value and time value. If there is any intrinsic value present in an option, it must be reflected in the price; otherwise arbitrage is possible. The arbitrageurs make sure that options will always have intrinsic value. For example, if you have a $50 call and the stock is currently $53, we know that the call option must be trading for at least $3.
 
In addition to that $3 though, there will be an additional value – time premium – that is due to the fact that time still remains on the option. Part of this time value is derived from the cost of carry as Pricing Principle #4 showed. But traders are willing to pay more than this cost of carry since it gives the stock more time to build intrinsic value into the option. So even though the time premium will eventually be zero, traders are willing to pay for time since it gives the stock more of a chance to move in a favorable direction, thus making the option’s price go higher.
 
So up to this point, we know there are at least two factors that give an option value. The first is favorable stock price movement and the second is time. Favorable stock price movement means that if you are holding a call option, you’d like to see the underlying stock price rise. Remember that a call option locks in a buying price for the stock. The higher the stock price, the more valuable a call option becomes. For example, with the stock at $55, a $50 call must be worth at least $5. But if the stock rises to $60, the $50 call must be worth at least $10.
 
If you are holding a put, you’d like to see the underlying stock fall. Since a put option locks in a selling price, the further the stock falls, the more valuable put options become. For example, with the stock at $55, a $60 put must be worth at least $5. But if the stock falls to $50 the $60 put must be worth at least $10.
 
The second action that gives an option value is time. What drives the value of the time premium other than the cost of carry? We can clarify the point with an analogy. Imagine that someone makes you the following proposition: He will pay you $1 for every point scored above 20 by the end of an upcoming professional football game. For example, if the team scores 23 points, you are paid $3. If the team scores 32 points, you are paid $12 and so on. In exchange for this opportunity, you pay him a flat fee.
 
Now imagine that you are offered the same bet but for an upcoming basketball game. In either case, you’ll make money after 20 points, but does that mean that both bets have the same value to you? Think about it for a moment: Which would you pay more for, the football or basketball bet?
 
You probably realize that scores tend to be much higher for basketball than for football. It’s pretty rare that a football team will score more than 40 points but not uncommon for a basketball team to score more than 100. That means there is probably more money to be made from betting on the basketball team. In other words, because there is more “scoring potential” for basketball, the value of that bet should be worth more to you. No matter what you’re willing to pay for the football bet, you should be willing to pay more for the basketball bet. In this example, your perception about the scoring abilities between football and basketball teams leads you to believe that the basketball bet is worth more. The key word here is “perception.” It might turn out after the fact that the football bet was the better one to make. But prior to the games, your perception tells you that the basketball game is most likely the one that will produce the biggest reward.
 
As stated earlier, it is the “scoring potential” of the teams that drives the values of the bets. And that means that time plays a critical role since teams can produce higher scores the longer they are allowed to play. For example, if the basketball bet was only good for the first five minutes of the game then you should be willing to pay less than if it applied to the entire game.
 
To be continued….

Aug

2

The Maximum Price for a Call Option

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Principle #5:

The Maximum Price for a Call Option is the Price of the Stock. (The Maximum Price for a Put Option is the Strike Price.)
 
While stock prices may theoretically be unlimited, the same is not true for an option. Option prices are tied to the price of the stock and that stock price defines the maximum price of a call option. For example, assume that a stock is trading for $50. What is the maximum value for a $50 call? The maximum price it could ever be trading for is the same as the stock, $50. How do we know this is the maximum when we haven’t said anything about the amount of time remaining on the option? It turns out that it doesn’t matter. If the $50 call had a zero strike price (theoretically the lowest and best strike possible) with unlimited time remaining, it would be trading for the price of the stock. By now you’ve probably guessed that arbitrage is the reason. Let’s assume that the $50 call is trading for $51 with the stock at $50. Arbitrageurs would buy the stock and sell the call for a net credit of one dollar:
 
Buy stock = – $50
Sell $50 call = +$51
Net credit = $1
 
By selling the call for $51, the arbitrageur has effectively been paid $1 to buy the stock. In the worst-case scenario, the stock crashes to a price of zero, the short call expires worthless, and the arbitrageur keeps the dollar. What if the stock rises? Because the arbitrageur sold the $50 call, he also has the potential obligation to sell the stock for $50. If he is forced to sell the stock for $50, he will end up with an additional credit of $50 from the sale for a total credit of $51, which is the maximum profit from this arbitrage.
 
No matter what happens to the stock’s price, the arbitrageur is guaranteed a minimum of one dollar profit, which is exactly the amount over the theoretical value of this hypothetical $50 call. The arbitrageur’s actions put buying pressure on the stock and selling pressure on the call until the stock is priced higher than the call. At that point, the arbitrage opportunity is gone and the option is priced less than the stock. (For those investors who have used the covered call strategy, you may have realized that your broker will only let you enter the trade for a net debit. This pricing principle shows why. The covered call strategy entails the purchase of stock and the selling of a call. Because the call option can never be more valuable than the stock, the covered call can only be executed for a debit.)

Maximum Value for Puts

           
 
So $51 is the best that the arbitrageur can do and $1 is the worst. In other words, no matter what happens the arbitrageur is guaranteed to make money all from the fact that the put was sold for a higher price than the strike price. Arbitrageurs will continue selling the overpriced put until its price falls below the $50 strike, at which point the arbitrage opportunity disappears.
 
We could extend this argument a little further and say that the maximum price for a put prior to expiration is the present value of the exercise price. The reason, of course, is that the arbitrageur earns interest on the cash balance from the sale of the put. While call and put prices can rise in value, these limits are not without boundaries. There are limits. Principle #5 shows us what those limits are.
 
The maximum price for a call option is the price of the stock. The maximum price for a put option is the strike price.
 
Pricing Principle #6:
 
For Any Two Call Options (or Any two Puts) on the Same Stock with the Same Expiration, the Difference in Their Prices Cannot Exceed the Difference in Their Strikes.
 
This relationship demonstrates that for any two call options, the difference in their prices cannot be greater than the difference in their strikes. This assumes that both options cover the same stock and have the same time to expiration. Say we see the following option quotes one day on the same underlying stock:
 
April $50 Call = $10
April $55 Call = $4
 
We know from the first pricing relationship that the $50 call should be worth more than the $55, and we see that it is. However, Principle #6 says that there cannot be this much of a difference. The difference in strikes is $5, yet the difference in price is $6. The difference in prices has exceeded the difference in strikes, which is a violation of this principle.
 
How will the markets correct for this? An arbitrageure will buy the relatively cheap asset and sell the relatively expensive one. In this case, he will buy the $55 call and sell the $50 call for a net credit of $6:
 
Buy $55 call =    $4
Sell $50 call = +$10
Net credit      +$6
 
Now check the rights and obligations. The arbitrageur has the right to buy stock for $55 and the potential obligation to sell of $50, which would create a $5 loss as a worst-case scenario. However, he was paid $6 to take the $5 loss, which leaves a $1 arbitrage profit. This profit would occur for any stock price above $55.
 
If the stock falls below $50 at expiration, both options expire worthless and the arbitrageur keeps the full $6 credit. If the stock closes between $50 and $55 the arbitrageur makes something between $1 and $6. For example, with the stock at $52, the arbitrageur will be assigned on the short $50 call and be required to deliver stock worth $52 and receive only $50, thus creating a $2 loss. He can pay for this loss out of his $6 initial credit, which leaves him a net gain of $4. No matter where the stock price may be at expiration, the arbitrageur is guaranteed to make at least $1 and as much as $6.
 
An easier way to understand Pricing Principle #6 is to think back to the pizza coupon examples. Assume two coupons are identical except that one allows you to pay $7 while another lets you pay $10. Now let’s say the market places a $1 value on the $10 coupon. What’s the maximum value of the $7 coupon? We know the $7 coupon must be worth more than the $10 coupon so it is worth more than one dollar. But we also know that the maximum value is $4, because the $7 coupon gives you a $3 advantage over the $10 coupon, so that is the maximum value it could ever have over the $10 coupon. For example, assume pizzas are selling for $20. The holder of the $7 coupon has a $13 advantage, while the $10 coupon holder has a $10 advantage. The difference in these two advantages is $3. Work through this scenario with any price for the pizza and you will see that there is always an exact $3 advantage.
 
To be continued….

For put options, the maximum value is the strike price. If you have a $50 put, the most it could ever be worth is $50, and that only happens if the stock’s price is zero. Whenever you exercise a put, you give up the shares and receive the strike price. Because of this, the best you could ever do is surrender stock that is worthless and receive the strike price. And that means nobody would ever pay more than $50 for the $50 put.

How would the market correct for it if the put option’s price did happen to exceed the strike price? Let’s assume that the stock is $50 and the $50 put is trading for $51. An arbitrageur would simply sell the put and receive $51 cash. By selling the put, he has the potential obligation to buy the stock for $50, which he can always do by using the $51 cash. Of course, he would receive stock in exchange for the cash, which he can always sell in the open market. The worst that could happen is for the stock’s price to fall to zero in which case the arbitrageur would still make a one dollar profit. If the stock should rise above $50 at expiration, then the put will be worthless at expiration and the arbitrageur is left with the $51 credit.

Aug

2

Advanced Options Trading – Selling Calls

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The buyer of a call has the rights but not the obligation to exercise the contract. On the other hand, the seller of a call option has the obligation to fulfill the contract requirements if the buyer exercises their rights. If the option sold goes into-the-money and the buyer wants to purchase the stock, it’s the obligation of the seller to provide the stock. If the seller already owns the stock, it’s a simple matter of signing over the stock required. However, it is most common that option sellers don’t own the stock and write a “naked call” knowing that if the option is exercised, the option seller must go into the market and provide the stock at the contract price.
 
The buyer of a call has an unlimited potential return and a total risk limited to the purchase cost of the call. The seller, on the other hand, has a much different risk reward scenario. The maximum gain for the seller is the premium amount collected by the sale of the call. The risk is that the stock moves into-the-money and the writer of the naked call must go into the market to purchase the stock. It is possible that by the time the seller can get the stock at the market price, the cost of purchase could be way beyond the strike price and cause a big loss as compared to the premium collected. If a call option seller is not paying attention and goes on a trip while the call is exercised, there could be an almost unlimited upward movement in the underlying price and the seller would be liable to buy the stock at inflated current market prices. In other words, the potential risk is really unlimited. So, buying and selling a call have opposite risk reward profiles. The buyer has unlimited profit potential and limited risk. The seller has limited profit and unlimited risk. However, the real world is not so bleak for the sellers of options.
 
If the underlying stock goes down in price, the chances of the sold call staying out-of-the-money increases and the probability of being able to keep the premium collected also increases. When the option expires worthless, the call option writer keeps the premium. In other words, a call option writer is not concerned if the underlying goes down but only if the underlying moves into-the-money.
 
Because the seller of a call option collects a credit, the breakeven for the seller is above the strike price. For example, if you sell a call option for a $4.00 premium, you will collect $400 for each contract. If you sold one contract that means that the underlying needs to move an additional $4 above the strike price before you start losing because you have the $400 credit for the collected premium. If the call option is exercised by the buyer, you will still have the $400 credit to help offset the costs between the current market price and the strike price of the contract.
 
Even though the risk reward profile is not as attractive for the seller of an option as it is for a buyer, selling stock options has a popular following. For example,  if an option trader feels that a stock is stagnant and won’t be moving up any time soon, selling a call is a viable strategy. The returns are limited to the collected premium but get this: studies have shown that 82% of the time the sell side is the right side of the trade. That’s because stocks have a higher tendency not to move rather than move.
 

No doubt, often stock options function in a non intuitive manner but when fully understood, they offer a plethora of opportunities. For more information about stock options, contact the Options University to find out about their popular online courses, webinars and mentoring programs specifically dedicated to stock options. (www.optionsuniversity.com).

Aug

1

Advanced Options Trading – Back to Basics – Calls

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Contrary to what you might think, calls and puts are not opposites. Of course, you’re thinking that one gives the right to buy and the other to sell. That would be opposites, right? Hold that thought as we proceed.
 
A call is an instrument used to assume a long position. When an option trader is bullish on something, a call allows the trader to take advantage in any bullish moves of the underlying. A call allows the buyer or owner of the call the right to purchase a specific security at a specified price within a specified period of time. To reiterate, a call provides the right and not the obligation. The owner of a call can let the call expire, sell out of the position or whatever. There is no obligation. However, if an option trader is selling a call, things are different.
 
As a seller of a call, an option trader is obligated to fulfill the contract sold to the buyer. If the buyer is able and desires to exercise their rights as defined by the sold option contract, the seller of the option is obligated to deliver on the contract and is legally bound after accepting the premium for the sold call option.
 
As the buyer of a call, to make a profit, the price of the underlying must not only be in the money but also move enough to make up for the cost of buying the call option. For example, if the buyer of a call paid $2 per share premium that means that one contract cost a total of $200-not including commissions. If the strike price is $35, the underlying must be at least $37 to cover the total cost. This is called the breakeven price for the call contract. Once the stock moves past the breakeven, the call option starts to make a profit for the trader.
 
As an option buyer, you have a specific risk reward scenario. The call option trader has an unlimited upside potential and an unlimited potential return. In respect to potential losses, when an option trader buys a call, no matter how far down the stock goes, the loss is limited to only the amount that was spent purchasing the call; thus, a long call has unlimited potential and limited risk. No wonder stock options are growing rapidly in popularity. It’s all a matter of education and overcoming the bad wrap perpetuated by untrained option traders (most probably having been on the wrong side of an option trade).
 
When an option moves above its strike price, it becomes in-the-money. However, that does not mean that as the underlying stock continues to move up that the option price will match the gains in the stock. Not until the option has reached a Delta of 100 does the option move in lockstep with the underlying stock. For example, when an option moves into-the-money, it may have a Delta of .7 which means that the option may only match 70% of the stock’s movement. So, if the stock moves up $1, the option price may only move up 70 cents. This is important to remember. When an option reaches 100 Deltas (there are 100 shares in an option contract), the option will exactly mimic the movements of the underlying stock.
 
The call is the simplest from of an option and is usually the most widely known type of stock option.  However, most option buyers don’t understand the concept of Delta and believe that once a stock in in-the-money that the option becomes a surrogate for the stock. That is not so.
 
To learn everything there is to know about trading stock options, contact the Options University (www.optionsuniversity.com) to find out about their online courses, webinars, and mentoring programs.

Aug

1

Minimum Value for a Put Option Prior to Expiration

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Now we find that there are two components to an in-the-money call option’s minimum value (we’ll learn in Chapter Five that there is a third). The first is that all in-the-money call options must be worth the intrinsic value, or S – E. The second is that their value must also include the present value of the interest that could be earned on the strike price, or E – Pv (E). In other words, there is an interest rate component to a call option’s price.
 
To understand this second formula, E – Pv (E), we need to calculate the present value of the exercise price is $50/1.05 = $47.62. So the formula E – Pv (E) equates to $50 – $47.62 = $2.38 and is what we calculated previously. In other words, the difference between the exercise price and its present value is today’s value of the interest that could be earned on the exercise price. (Again, if the interest that can be earned is $2.50 then today’s value is $2.50/1.05 = $2.38.)
 
Therefore, prior to expiration, all in-the-money call options must be worth at least the sum of these two components: (S-E) + [E – Pv (E)]. If we remove the brackets, the expression reduces to S – E + E – Pv (E). The – E and + E cancel out, which further reduces the expression to S – Pv (E). And that’s exactly what Principle #4 tells us. Pricing Principle #3 stated that an in-the-money call option must be worth S – E. But if time remains on the option and interest rates are positive then the option’s value must be a little bit bigger than S – E. How much bigger? By the amount of interest that could be earned on the exercise price.
 
What would happen if a call option’s price didn’t reflect this minimum value? Let’s say the one-year $50 call option is trading for $7 in the open market rather than the $7.38 minimum value we calculated. Once again, arbitrageurs would come to the rescue. Arbitrageurs would short the stock and buy the call for a net credit of $48:
 
Short stock =           +$55
Buy $50 call =           -$7
Net credit =              +$48
 
The arbitrageur would hold on to this credit and allow it to earn interest. The $48 would grow to a risk-free value of $48 * 1.05 = $50.40. At the end of the year, the arbitrageur can exercise the $50 call to cover the short position and spend $50 from his credit balance, thus leaving him with a 40-cent arbitrage profit. While 40 cents may not sound like much, you must remember that arbitrageurs would short enough stock and buy enough calls so that their final profit is potentially tens of thousands of dollars or more. And remember, this is risk-free money so that makes the above transactions all the more worthwhile.
 
Even though the arbitrageur is shorting stock to take part in this arbitrage, he is never at risk of rising stock prices since he owns the $50 call and is therefore assured of never spending more than $50 to buy back the short stock. Of course, he could make more money if the stock falls during the year, which would allow him to purchase the stock back at a price cheaper than $50. But at a minimum, the arbitrageur will make 40 cents. Here’s a good question to see if you understand the time value principle of money: Why does the arbitrageur make a 40-cent profit when only 38 cents were originally missing? The answer is that the 40-cent profit is made at the end of the year so the present value is 0.40/1.05 = 0.38, which is exactly the amount of missing value in the call today.
 
We just saw the effects of Pricing Principle #4 on in-the-money options. If you are considering an at-the-money or out-of-the-money call option there is no intrinsic value but there is still an interest rate component to their prices.
 
For example, with the stock at $55 what is the minimum value for the $55 call? It is $55 – Pv ($55) = $2.62. With interest rates at 5%, the one-year $55 call must be trading for at least $2.62 otherwise arbitrage is possible. The $2.62 figure is today’s value of the interest that could be earned by waiting for expiration to exercise. If you bought the stock today, you must pay $55. But if you buy the option, you can wait until expiration to pay $55 and therefore earn interest on the balance. If the option were priced for exactly $2.62, you would have $55- $2.62 = $52.38 in cash left over by purchasing the option over the stock. This balance would grow to $52.38 * 1.05 = $55 in one year, which is the exercise price.
 
If the result from the formula S – Pv (E) is negative then there is nothing we can say about the minimum value for the call in terms of cost of carry. For instance, according to the formula, the one-year $60 call must be worth $55 – Pv ($60) = -$2.14. Because this is a negative number, there is no arbitrage that can be carried out due to interest rates. However, if interest rates were sufficiently high, say 10%, the $60 call must be worth at least $55 – Pv ($60) = 45 cents. If this option were priced for exactly 45 cents you would have $55 – 0.45 = $54.55 remaining by purchasing the call over the stock. This balance would grow to $54.55 * 1.10 = $60 exercise price in one year.
 
Whether we’re considering in-the-money, at-the-money, or out-of-the-money calls, they all must be worth at least S – Pv (E) otherwise arbitrage is possible. Obviously, if you are looking at short-term options or if interest rates are low, there will not be a very big interest rate component. But if you’re dealing in longer-term options, high priced stocks, or if interest rates are high, the minimum values for calls may be much higher than you’d expect.
 
For instance, a new investor may be looking at a two-year, $310 call on a $300 stock and find that the price appears surprisingly high. If interest rates are 5%, you now know that this call must trade for at least $300 – $310/1.052 = $18.82. At first glance, this may seem a very high price to pay for an option that is 10 points out-of-the-money. But it is merely a reflection of the interest that you will earn by not paying the $310 strike price for the stock today. If that minimum value is not there, arbitrageurs will be sure to correct for it.
 
 
Minimum Value for a Put Option Prior to Expiration
Prior to expiration, a put option must be worth at least the exercise price minus the stock price, or E – S. Principle #3 showed us that a put option must be worth exactly E – S at expiration. But prior to expiration, we can only expand on that principle slightly by stating that a put must be worth at least that much. In other words, the put option must be worth its intrinsic value plus some additional value for the time remaining. Unlike the call option though, we cannot state a minimum amount for that time value.
 
The reason for this is that long call arbitrage involves short stock, which can earn interest. The arbitrageur is long the call and is fully hedged to short stock and earn interest. For the long put, however, the arbitrageur has the right to sell stock. He could fully hedge a long stock position but that means he would have to buy stock and that creates a cash outflow, which counteracts an arbitrage.
 
Prior to expiration, all call options must be worth at least the present value on the cost of carry of the exercise price. All in-the-money put options must be worth the intrinsic value plus some time value.
 
To be continued….
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