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Sep

23

Options University’s Options 101 – Part 51

Filed Under Beginner Options Trading | Leave a Comment

Stop Limit Orders

A stop limit order is an extension of a stop order. The difference is that stop limit orders convert to a limit order, which means your shares will be sold only if the limit price or higher can be hit and guarantee a price. But as with any limit order, if you guarantee the price, you cannot guarantee the fill.

Key Differences Between Stops and Stop Limits

Stop Orders become a live “market” order if stop price is triggered. Guarantees that the order will be filled but cannot guarantee the price.

Stop Limit Orders become a live “limit” order if stop price is triggered. Guarantees the price but cannot guarantee that the order will be filled.

In order to place a stop limit order, you must specify two prices. The first price is the stop price. Once you specify the stop price, you must then specify a stop limit price (which must be less than or equal to your stop price).

Let’s use the previous example but now apply a stop limit. Assume you purchased 200 MSFT at $36 and have now placed the following order:

Sell 200 MSFT at a stop price of $35 with a stop limit of $34.50.

Notice that two prices must be entered. The first price ($35) is the stop price. This just tells the computer when to activate the order. If the stock trades at $35 or below, the order will become activated and becomes a live limit order to sell 200 shares of MSFT at the stop limit price ($34.50) or higher. The stop limit price you enter (second price) you enter must be less than or equal to the first price. Many traders like to reduce the second price a bit to allow for some market fluctuations if the order is triggered.

Now let’s go back to your stop limit order and assume that MSFT opens at $27. The order is activated because the stock traded at or below $35. You now have a live limit order to sell at $34.50. Obviously, the order cannot be executed since you are requiring a price of $34.50 or higher. This shows that stop limit orders do not prevent losses any more than stop orders. However, stop limit orders will keep you from selling at prices you consider unfavorable.

Which should you use, stop or stop limits? That depends on the situation; you may find that you use both at different times. The one question you need to answer is this: If MSFT opens below your stop price do you want to sell the shares at any price? Is your goal to simply get rid of the shares regardless of price? If the answer is yes, then use a stop order. However, if there is a price at which you’d rather hold onto the shares rather than sell then use a stop limit order.

Option Stop Orders

The key point you want to understand with stop and stop limits when applied to options is that the orders are “triggered” if the asking price equals the stop price or lower. Option stop orders and stop limits are not based on the last trade. The reason is that it is possible to not have any trades on the option even if the stock’s price is falling. In other words, there might not be any activity and therefore no last trades. However, the bid price and asking prices on the options will definitely change in response to the falling stock price. That’s why the exchanges trigger stop and stop limit orders on the asking price for options and execute the orders on the bid price.

Limit Order Display Rule

In Chapter Two, we how the bid-ask spread near expiration can make a big difference on your profits, especially if the bid price falls below intrinsic value. In a similar fashion, the spreads at any time during the option’s life can have a dramatic negative impact on profitability even if the bid price represents the full intrinsic value. For example, assume a stock is trading for $51 and the $50 call is bidding $2 and asking $2.25. Both the bid and ask prices contain the $1 intrinsic value. However, if you were to buy at the asking price of $2.25 and immediately sell at the $2 bid price, you would instantly lose over 11% of your money just because of the spread. Many traders dream of making a quick 10% on their money but notice how the spread can quickly eat that away. The spread causes buyers to pay a higher price and sellers to receive a lower price than the theoretical fair value; it is a serious threat to profitability, especially when you consider the relatively low prices of options when compared to stocks.

But there is an effective way we can trade between the bid and ask to reduce this detrimental effect. The effectiveness of this technique hinges on an exchange rule called the Limit Order Display Rule. In order to understand how we can use this rule to our advantage, we must first understand how the quotation system works.

Understanding the Quote System

Let’s say you see an option with the following quote:

Bid: $2.00 Ask: $2.25

What exactly does this mean? We learned in the first chapter that the bid price represents the price at which you can sell while the asking price represents the price at which you can buy. In many ways, this is like the difference between retail and wholesale; you can buy this option for $2.25 but you can sell it for only $2.00.

While this is a correct interpretation of the bid and ask prices, it hides the source. Chapter One showed us that the bid price represents the highest bidder among a list of many bidders while the asking price (also called the offer price) is the lowest selling price among a list of many sellers. In order to understand this bid-ask interpretation better, it helps to see how option orders are accumulated by market makers. Whenever you submit an order to your broker, it is received by a market maker who will stack all orders according to price and time.

Here’s how the process works: Let’s assume the market is not open yet and the maker has no orders on the books. When orders are placed through the various brokerage firms, the market maker will accumulate them in a specific manner. Assume that the first order is an order to buy 5 contracts at a limit of $1.90. Because this is an order to buy, the market maker will list it under the “bid” column (remember, buyers place bids):

Bid	Ask
1.90 (5)

The number in parenthesis shows the number of contracts at that price. Assume that the next order is an order to buy 10 contracts at a limit of $2.00. Because this is another buy order, the market maker will place it under the “bid” column as well. However, this trader is considered a “stronger” buyer since his buy price is higher than the person at $1.90. The markets are only concerned with the highest bidder and lowest offer. Because of this, the market maker will place the order above the $1.90 price as follows:

Bid	Ask
2.00 (10)
1.90 (5)

Assume the next order is an order to sell 8 contracts at a limit of $2.35. Because this is a sell order, the computer will place it in the “ask” column (remember that sellers submit “asking” prices). As a matter of convention, asking prices are generally stacked on the top for reasons we will see shortly:

	2.35 (8)
Bid	Ask
2.00 (10)
1.90 (5)

The next order is an order to sell 4 contracts at a limit of $2.25. This trader is considered a “stronger” seller since the selling price is less than the previous order at $2.35. Because of this, the market maker will place this order below the previous order:

	2.35 (8)
	2.25 (4)
Bid	Ask
2.00 (10)
1.90 (5)

Notice how the orders are being stacked. The bids are being stacked in descending order from strongest to weakest; that is, from highest to lowest. The sellers are stacked in ascending order from strongest to weakest; that is, from lowest to highest. Let’s say the next order is to buy 6 contracts at a limit of $1.95. This trader is the stronger than the buyer at $1.90 but not as strong as the one at $2.00, so that order will get placed between the two:

	2.35 (8)
	2.25 (4)
Bid	Ask
2.00 (10)
1.95 (6)
1.90 (5)

To finish the example, assume that the next order is to sell 2 contracts at a limit of $2.30. This trader is a stronger seller than the one at $2.35 but not as strong as the one at $2.25, so that order will get placed between those two:

	2.35 (8)
	2.30 (2)
	2.25 (4)
Bid	Ask
2.00 (10)
1.95 (6)
1.90 (5)

To be continued…..

Sep

13

The Key to Understanding Stock Splits.

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Options 101

Part 41

The key to understanding stock splits is that the stock split cannot change the total value of the company and therefore cannot change the total value of your position. If it did, companies could create unlimited value by continually splitting their stock which doesn’t make any more sense than you being able to create infinite wealth by continually splitting ten dollar bills into two fives.

The key to understanding how stock splits affect your options is to understand that if a stock split cannot change the total value of the stock then it cannot change the total exercise value of your options.

Let’s now see how various stock splits will affect your option contracts. Assume you own one $180 call option that is trading for $6. If the stock does a 2:1 split, the split ratio is 2/1 = 2. You will then control twice as many contracts, or two for this example. The strike price will be reduced to $180/2 = $90. In addition, the price of the option will be $6/2 = $3. Your options are packaged a little differently but the total exercise value is the same. You are controlling $18,000 worth of stock before and after the split. In addition, the value of your options is $600 before and after the split.

If the stock does a 3:1 split, the split ratio is 3/1 = 3. You then own three times as many calls. The strike is $180/3 = $60 and you still control $18,000 worth of stock. The price of the option will drop to $6/3 = $2 and the value of your options is still $600.

Now let’s look at how fractional splits affect your option contracts. Recall that fractional splits are anywhere the split ratios have a last digit greater than one, such as 3:2 and 5:4, and 8:7 for example. Fractional splits affect options in a similar way as the whole number splits we just reviewed. However, they create a small problem because the number of shares is not increased in units of 100. To alleviate the problem, the exchanges decided to adjust the number of shares each contract controls.

For instance, if you own one $180 call trading for $6 and the stock does a 3:2 split then the split ratio is 3/2 = 1/5. After the split, you will still own one contract; however, it will now control 150 shares of stock and the strike price will be $180/1.5 = $120. After the split, you still control 150 shares * $120 = $18,000. In this case, the “multiplier” is increased to 150 since that is how many shares the option controls. The option’s price will fall to $6/1.5 = $4. So if you see this option quoted at $4, you must remember to multiply it by 150 to find its total value.

If the stock does a 5:4 split then the split ratio is 5/4 = 1.2. After the split, you will own one contract that controls 100 * 1.2 = 120 shares with a strike price of $180/1.2 = $150 and you will still control 120 * $150 = $18,000 worth of stock. The option’s price would fall to $6/1.2 = $5. All options, calls and puts, are adjusted in the same way. In addition, all short positions are adjusted in the same way as the long positions. After all, the short position is simply on the other side of the trade from the long position.

For any “whole number” split (2:1, 3:1, 4:1 etc.) the number of contracts you own increases by the split ratio. The multiplier stays the same.

For any “fractional” split, (3:2, 5:4, 8:7, etc.) the number of contracts stays the same but the number of shares it controls is multiplied by the split ratio.

The market price of the stock, the strike price of your option, and the market value of the option are always reduced (divided) by the split ratio regardless of the type of split.

The following chart may help you to see the differences. Notice that the procedures for the strike price and market price are the same regardless of the type of split.

Market Adjustments	Whole Number Splits (2:1, 3:1, etc.)	Odd Number Splits (3:2, 5:4, etc.)
# Contracts	Increased by split ratio	Remains same
Strike	Reduced by split ratio	Reduced by split ratio
Stock price	Reduced by split ratio	Reduced by split ratio
Multiplier	Remains same	Increased by split ratio

Reverse Splits

There is another type of split called a reverse split, which is done for the opposite reasons of a stock split. Companies whose share price is very low may vote for a reverse split to lift the price in hopes of getting it “recognized” as a viable investment. Many times this is done so that the company meets certain listing requirements in order to trade on a nationally recognized exchange.

Reverse splits are most often seen in the penny stocks or other troubled stocks looking for a boost in price (and hopefully awareness). Because of this, you will rarely see reverse splits on optionable stocks since they must be above $10 to meet listing requirements to trade options. However, they can occur. If they do, the math previously described works exactly the same way but in the reverse direction.

For example, assume that XYZ is trading for $4. The company may vote for a 1:3 reverse split. The split ratio is then 1/3 = 0.33. This just means that shareholders will receive one share for every three they currently own and the price will rise by a factor of three. If you own 300 shares today, you have $1,200 worth of stock. After the split, you’ll have 300 * 0.33 = 100 shares after the split. The stock price will rise to $4/0.33 = $12. Once again, this doesn’t affect any the value of your position because the value of your position will still be $1,200 after the split.

Let’s see how the reverse split would affect your option contracts. Assume you own 20 XYZ $10 calls trading for $1 and the company announces a 1:5 reverse split. The split ratio is 1/5 = 0.20. The number of contracts you own is now 20 * 0.2 = 4 and the strike price is increased to $10/0.20 = $50. The price of the option rises to $1/0.2 = $5. Let’s check the math to make sure we got the right answer. The original position was worth $1 * 20 contracts * 100 shares per contract = $2,000 and had an exercise value of $10 * 20 contracts * 100 shares per contracts = $20,000. After the split, it is worth $5 * 4 contracts * 100 shares per contract = $2,000 and the exercise value is 4 contracts * $50 * 100 shares per contract = $20,000. Nothing has changed; only the packaging.

Whenever an option undergoes an adjustment, you’ll probably see a notation stating “adjusted option” or “adj opt” while placing the trade. You may see this in the final “readback” screen where you verify the order before sending it, or you may see it next to the symbol when looking up symbols. Whenever you see this notation, be sure to check the number of shares it controls.

For example, when we get to strategies, we will talk about the “covered call” where we will buy 100 shares of stock and then sell one call controlling 100 shares. If you inadvertently sell a call that controls 150 shares rather than 100 there could be potential problems if the stock price rises substantially. That’s because you own 100 shares but may have to deliver 150 shares if the stock’s price rises above the strike. In essence, you would be short 50 shares of stock.

Just as you should develop habits of checking option symbols when entering orders, you should also check to see if the total cost of the trade is roughly what you think it should be before sending the order. For example, assume you are placing an order to buy one ABC $50 call trading for $4. If you place an order to buy one contract and the computer tells you the estimated cost of the trade is more than $600 including commissions, you should realize that something isn’t right. One contract at $4 should cost $400 plus commissions, so the $600 price is obviously too high. Assuming you entered the right quantity (one contract) you can be sure this discrepancy is a sign that you’re dealing with an option that controls 150 shares.

To be continued…….

Sep

12

Double, Triple, and Quadruple Witching

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Double, Triple, and Quadruple Witching

By the way, you can always find out which contracts will be available for any stock going to www.cboe.com and then clicking on “Trading Tools” and then “Cycles and Strike Month Codes.”

You can also find similar tools at the homepage for the Options Industry Council (OIC) at www.888options.com. Click on “Tools and Literature,” “Pricing Calculators,” and then “Cycles.”

Double, Triple, and Quadruple Witching

Now that you understand option cycles and how the contract months are determined, let’s talk about the terms double witching or, more commonly, triple witching. These are days when multiple derivative products expire on the same day. For example, if stock futures, stock index options, and stock options all expire on the same day then that is a triple-witching day. Typically, stock futures expire on the quarterly expiration (the last month of each quarter) months of March, June, September, and December so triple witching occurs only in these months. Double witching occurs when any two of the three assets expire at the same time. Less commonly knows is quadruple witching, which occurs when single-stock future contracts expire on the same day as well. It is widely believed that volatility in the market is much greater on these days as traders scramble to close positions. The truth is that few professional traders wait until the very last day to close positions, so these witching days are probably not as disruptive as many believe. Still, it is worth knowing what these terms mean as you will definitely hear them once you start trading or investing in options.

Contract Size (The Multiplier)

In the first chapter, we said that options generally cover 100 shares of stock. In this section, we’re going to show you why we said “generally.” When options first start trading, the contract size is always 100 shares. This 100 share-sized lot is also referred to as the multiplier because that is the amount we must multiply the option premium by to find the total cost of the contract. For example, if a call option is asking $3, you will pay $3 * 100 = $300 (plus commissions). It is also the amount we must multiply by to find the total contract value. If you exercise a $30 call, you will pay $30 * 100 = $3,000 and receive 100 shares of stock. So the “contract size” and “multiplier” are two different ways of expressing the unit of trade of the option.

While all options start with a contract size of 100, there are corporate actions that can change that. The most common event is a stock split. Stock splits generally occur when the price of the stock is perceived to be too high, so the company will split the stock to bring down the price.

A stock split is really a cash dividend, which means the company pays you a dividend in shares of stock rather than cash. With a 2:1 stock split, the company pays you one share of stock for each that you own thus doubling the number of shares you own.

However, because the company is paying a dividend (whether in cash or shares) the price of the stock must be reduced to reflect the fact that some value of the company has been paid out to shareholders. A stock split therefore will always increase the number of shares outstanding (and therefore in your account) and the stock price will always fall.

How many shares will you have and by how much will the stock price fall? These

questions are easy to answer once you understand the mechanics of a stock split. Any time a split is announced, it is always reported as the ratio of two numbers such as 2:1. If you take the first number divided by the second, you get the “split ratio,” which is 2 for this example. The number of shares will always be multiplied by this ratio and the stock price will be divided by the same number.

There are many types of splits with 2:1 being the most popular. However, you will also see variations such as 3:1, 4:1 and so on. We will refer to these as “whole number” splits since you always end up with multiple 100-share lots after the split. In addition to whole number splits, you may see “fractional” splits such as 3:2, 5:4, 8:7, and so on. Any split ratio where the second number is greater than one creates a fractional split. These types of splits increase the number of shares you own just as whole number splits; however, that new number will not be evenly divisible by 100. For instance, a 3:2 split means that you will receive 3 shares for every 2 that you have thus increasing the number of shares by 50%. If you had 100 shares prior to the split, you will have 150 shares after the split. A 5:4 split leaves you with 125 shares for every 100 shares you previously held.

For instance, assume ABC stock is trading for $180 per share. At this price, the company may think its share price is too expensive as it is difficult for many investors to buy shares, at least in round lots of 100, since that will cost $18,000. In order to bring the price per share down, the company may announce a 2:1 split. If you own 100 shares of ABC prior to the split, you will own 200 shares at a price of $90 after the split. Notice that we multiplied the number of shares by two (split ratio) and divided the price by two as well.

Because we doubled the number of shares but cut the price in half, the total number of dollars invested does not change. If you have 100 shares of ABC at $180, then the position is worth $18,000. After the split, you’d have 200 shares at $90, which is still $18,000 worth of stock.

A 3:1 stock split would give you 300 shares at a price of $60 per share after the split ($18,000 worth of stock). A 4:1 split yields 400 shares at a stock price of $45 ($18,000 worth of stock).

Now let’s take a look at some fractional split examples. If the same stock had a 3:2 split, then the split ratio is 3/2 = 1.5. If you had 100 shares prior to the split, you’d have 100 * 1.5 = 150 shares after the split and the price would fall to $180/1.5 = $120. Again, notice that after the split you still have 150 shares * $120 = $18,000 worth of stock. A 5:4 split provides a split ratio of 5/4 = 1.2 so you’d end up with 100 * 1.2 = 120 shares at a price of $180/1.2 = $150 per share. In both of these cases, you still own $18,000 worth of stock.

So a stock split doesn’t change the total value of your investment but only the way in which it’s packaged. It’s no different than when you exchange one $10 bill for two $5 bills. You have twice as many pieces of paper (shares) at half the value so the total value of your wallet hasn’t changed. When viewed in this light, stock splits aren’t really a big deal even though they are often met with much fanfare by the investing public. After a stock split, it is true that the company may create more demand by the public to own it and that certainly can put upward pressure on the price. However, the stock price is now twice as hard to move because there are twice as many shares outstanding, so there are drawbacks to splitting a stock. But regardless of whether stock splits are good or bad, they do occur and they can change the contract size.

To be continued,,,

Sep

11

Which Cycle Is My Stock On?

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Jan FebMar AprMay Jun Jul Aug Sep Oct Nov Dec

When April expires, June will be added to the list since we must always have the current month and the following month available:

Jan FebMar Apr MayJun Jul Aug Sep Oct Nov Dec

When May expires, we will only have the following three contracts traded: June, July, and October. This means we must add a fourth. However, by default, we have June and July contracts traded (the current month and following month):

Jan FebMar Apr May Jun Jul Aug Sep Oct Nov Dec

This means we must add the next quarterly contract. October is the next quarterly contract, but it is already traded, so we must move to the next quarterly month, which is January:

Jan FebMar Apr May Jun Jul Aug Sep Oct Nov Dec

So the January contracts will start trading once May expires.

Leaps

As options gained in popularity, investors showed an interest in choosing from contracts that included longer times to expiration. In 1990, the CBOE answered by creating LEAPS. While the name makes them sound complicated, they are simply options but with longer lives. LEAPS is a registered trademark of the Chicago Board Options Exchange and stands for Long-term Equity AnticiPation Securities (as if that wasn’t obvious) and have expiration dates nearly three years in length.

When options first started trading, they were available for up to nine months in the future. But with the addition of LEAPS, you can find options nearly three years forward. If a stock has LEAPS options traded, there will be more than four contracts listed at any given time. So while your local newspaper or other sources may only print three expiration months to conserve space, understand that there are always at least four different contract months traded at any given time.

How do option cycles work with the addition of LEAPS? Once you understand the basic option cycle, adding LEAPS into the rotation is not too difficult.

As mentioned earlier, LEAPS usually trade in January for a maximum of three years forward although there are exceptions. If a stock trades LEAPS, then new LEAPS will be issued sometime between May and July. This is difficult to explain without the use of examples so let’s go back to our Intel options.

It is currently July ’05 and Intel has the following months trading: July, August, October, January ’06, January ’07, and January ’08 as shown by the “Xs” in the table below:

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

X_’06

X_’07

X_’08

At this point, January ’07 and January ’08 are LEAPS contracts. The January ’06 is considered a quarterly contract since it is less than nine months until expiration.

When July expires, September will be added. We will then have August, September, October, and January ’06, thus providing four months of regular contracts (nine months or less):

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

X_’06

X_’07

X_’08

When August expires, we will have September, October, January ’06 thus providing only three different months of regular contracts:

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

X_’06

X_’07

X_’08

At this point, the next January cycle month will be added, which is April:

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

X_’06

X_’07

X_’08

This process continues and eventually the date will become May ’06. The January ’06 options will have been expired for four months and we will have the following months traded (Notice that the January ’06 options are no longer listed):

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

X_’07

X_’08

When May options expire, we will only have three contracts in existence (not counting the LEAPS January options). These months will be June, July, and October. This is where we need to add another January contract since it is the next January cycle month. It is at this point where the January ’09 contract will be rolled out:

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

X_’07

X_’08

X_’09

At the same time, the January ’07 contracts will lose their LEAPS designation because they have less than nine months to expiration. The root symbol will change to show that it is no longer a LEAPS option. If you are holding this option, the symbol will automatically change in your account and there is nothing that you need to do. Just be aware that this can happen as some investors are puzzled when there is a symbol change on some of their LEAPS. This will happen in May, June, or July when the current year LEAPS option becomes a regular option. This process is called melding. Melding is when LEAPS options become regular options. Technically speaking, LEAPS options do not expire; instead, they meld to a regular option and then it is the regular option that expires.

So, depending on which cycle your stock is on, look for new LEAPS to be added sometime in late May, June or July.

Which Cycle Is My Stock On?

As mentioned earlier, there will be times when you will need to know when a particular month will be added to the list. Before you can find out, you will need to know on which cycle your stock is traded. This is easy to find out once you understand the expiration cycles. For example, let’s see if we can figure out which cycle Intel is on. It is now July and Intel has the following months being traded:

July
August
October
January ‘06
January ‘07
January ‘08

From what we learned earlier, we know there must be a July and August contract and we see that there is. You can never tell which cycle a particular stock is on just by looking at the first two months, since all options will have these months being traded. But we can find out which cycle the stock is on by looking at the third month and fourth months. The reason we cannot just look at the third month is that it may be January and we would not be sure if it is a LEAPS contract or not. In this case, the third month is October:

Now we just need to ask which cycle October falls under? It is part of the January cycle (it is the first month or the “January “position of the fourth quarter). So we just figured out that Intel trades on a January cycle.

Let’s try another. Which cycle is Dell Computer on? It is still July and Dell has the following contracts traded:

July
August
November
January ‘06
February ‘06
January ‘07
January ‘08

Once again, we know that the current and following month must be traded for all stocks so the first two months tell us nothing about which cycle the stock is on. However, the third month is November and that does reveal the cycle. Because that month is November, we know that Dell Computer trades on a February cycle (because November is the middle month or “February” position of the fourth quarter).

Let’s try one more example but this time we’ll show why you cannot consider January if it falls in the third month. We’ll still use Dell Computer but now assume that the July options have expired. If so, we’d see the following contracts traded:

August
November
January ‘06
February ‘06
January ‘07
January ‘08

We know to not look at the first two month of August and November since all stocks will have those months listed. However, in this instance, if we look at the third month, we’d find January and we’d be led to believe that Dell is on a January cycle. Remember, all stocks that have LEAPS options will have them listed in January so we cannot be sure if this is a January cycle stock or not. To be sure, we’d need to move down to the fourth month, which is February and now we know that Dell is on a February cycle. In order to find which cycle your stock is on, you can never do so by looking at the first two expiration months. All stocks have those months traded. You must find the next quarterly contract (with the exception of January) that is listed and that will guide you to the cycle on which your stock is traded. Once you know which cycle your stock is on, it never changes. You will always be able to determine which months will be traded and which will be added at expiration.

To be continued,,,

Sep

11

Options University’s Options 101 – Part 39

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Options 101

Part 39

Jan FebMar AprMay Jun Jul Aug Sep Oct Nov Dec

When April expires, June will be added to the list since we must always have the current month and the following month available:

Jan FebMar Apr MayJun Jul Aug Sep Oct Nov Dec

Jan FebMar Apr May Jun Jul Aug Sep Oct Nov Dec

This means we must add the next quarterly contract. October is the next quarterly contract, but it is already traded, so we must move to the next quarterly month, which is January:

Jan FebMar Apr May Jun Jul Aug Sep Oct Nov Dec

So the January contracts will start trading once May expires.

Leaps

How do option cycles work with the addition of LEAPS? Once you understand the basic option cycle, adding LEAPS into the rotation is not too difficult.

It is currently July ’05 and Intel has the following months trading: July, August, October, January ’06, January ’07, and January ’08 as shown by the “Xs” in the table below:

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

X_’06

X_’07

X_’08

At this point, January ’07 and January ’08 are LEAPS contracts. The January ’06 is considered a quarterly contract since it is less than nine months until expiration.

When July expires, September will be added. We will then have August, September, October, and January ’06, thus providing four months of regular contracts (nine months or less):

When August expires, we will have September, October, January ’06 thus providing only three different months of regular contracts:

At this point, the next January cycle month will be added, which is April:

So, depending on which cycle your stock is on, look for new LEAPS to be added sometime in late May, June or July.

Which Cycle Is My Stock On?

July
August
October
January ‘06
January ‘07
January ‘08

Let’s try another. Which cycle is Dell Computer on? It is still July and Dell has the following contracts traded:

July
August
November
January ‘06
February ‘06
January ‘07
January ‘08

August

November
January ‘06
February ‘06
January ‘07
January ‘08

To be continued,,,

Sep

10

Option Expiration Cycles

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Option Expiration Cycles

Every time you enter an option order, go through the motions of checking those last two letters and the patterns will eventually become second nature. With one quick glance, you will know the month, strike, and type of option (call or put). It is a relatively simple thing to learn over time and it will increase your confidence and speed at which you can enter an order.

Option Expiration Cycles

As you start trading options, you will notice that not all stocks have the same expiration months available. For example, it is now July and Dell Computer has November options listed but Intel does not. Why is that? When will November options become available for Intel? In order to answer these questions, you need to understand option expiration cycles. Understanding the expiration cycles is important for option traders and investors; you might wish to trade an option in a particular month and find that it is not available. Obviously, it would be nice to figure out when it will start trading.

When options started trading in 1973, the Chicago Board Options Exchange(CBOE) decided that there would only be four months of equity options traded at any given time. (This is one of the limitations of having standardized contracts that we talked about in Chapter One.)

Originally, all optionable stocks were assigned to one of three cycles: a January, February or March cycle. (These cycles are also called Cycle 1, Cycle 2, and Cycle 3, respectively.) The assignment was purely random and had nothing to do with earnings cycles of a company or any other reason you might hear; it was purely a random assignment.

Under the original rules, A January cycle (Cycle 1) meant that options would have expirations matching the first month of each quarter. So if a stock were assigned a January cycle, options on that stock could only have the first months of each quarter available:

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

A February cycle stock could only have option expirations for the middle months of each quarter available:

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

And, of course, the March cycle would have expirations for the end months of each quarter available:

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Because these expirations are arranged at equal intervals in each quarter, they were called quarterly expirations. Because of these positions, sometimes you will hear the cycles referred to as front-month (January), mid-month (February) or end-month (March) cycles. Once a stock is assigned a particular cycle, it does not change. For example, a January-cycle stock always trades as January-cycle stock.

As we just showed, when options started trading in 1973, if you were deciding on an option to buy on a January-cycle stock, you would only have four months to choose from: January, April, July, and October. For a February-cycle stock, you would only have February, May, August, and November expirations to choose from. A March-cycle stock would only have March, June, September, and December expirations.

As options gained in popularity, traders were looking for ways to trade or hedge with shorter-term options, which weren’t always available due to the way the cycles were structured. For example, assume it is now January and you were trading options on a January-cycle stock. If you did not want to trade the January expiration then the next month available would be the April contract – more than three months into the future. To insure that there would always be shorter-term options, the CBOE decided to change the rules around 1984.

New Rules Create Shorter-Term Contracts

Under the new rules, there would still be four option expiration months listed at any given time but two must be reserved to represent the current month and the following month (these two contracts are also called the “front month” and “near-term” contracts, respectively). The remaining two months would remain from the original quarterly cycle. The current and following months are referred to as serial months.

Let’s take a closer look at how these rules work. Assume it is now January and we are looking at a stock that trades options on a January cycle. Which months will be traded under the new rules? Remember, under the new rules, the CBOE decided that there would always be the current month plus the following month available. Because it is January in our example, then January and February must be available. Because four months must trade, the remaining two months will be from the original quarterly cycle, which would be April and July:

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

So if it was now January and we were looking at a stock that was assigned a January expiration cycle, we would find January, February, April, and July options to choose from. January and February are the serial months (or the serial contracts) while April and July are the quarterly contracts.

What happens when January expires? Looking at the expiration months above, you can see that when January contracts expire we will be left with only three expiration months: February, April, and July. However, we know that we must have four expiration months listed and we also know that we must have February and March listed. This means the March expiration must be added to the list:

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

After the March contracts are added, we have four contracts with the current month (February) and following month (March) on the list – exactly what the new rules say we should have.

When February expires, we are left with only three contracts: March, April, and July. However, this time we do have the current month and following months available by default (March and April). Even though April was originally issued as a quarterly contract, it now serves as a serial month. So once February expires, we will add the next quarterly contract, October, to the list:

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Once the October contracts are rolled out, we are left with the current month plus following month (March and April) along with two quarterly contracts (July and October).

This pattern continues regardless of which cycle we’re on. The current month and the following month must always be made available. No matter which cycle a stock may be trading, it will always have the current month and following month contracts available. The remaining two contracts will be from the corresponding quarterly cycle.

One problem many investors face is trying to figure out when a particular contract will be traded. For instance, let’s continue with our above example using the January cycle and see if we can figure out when the November contract will be traded. This is easy once you understand option cycles. The first thing you want to ask is this: Is November one of the January cycle months? No, it is part of the February cycle. This means that November can never be added to the list unless it is a serial month. It can never be added months in advance as a quarterly contract. The only time it will become available is when October starts trading (September contract expires). When September expires, October will be the current contract and November will be added to the list as a serial contract.

If you work through the steps outlined above, you will see that the January contract will start trading when May expires. Once May is expired, June will become the current month, so there will be a June, July and October for a total of three months. The fourth month will be the addition of January. The steps are outlined in the following box:

We started with April, May, July and October contracts traded and wonder when the January contract will begin trading:

To be continued….

Sep

9

Option Market Mechanics

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Option Market Mechanics

The first three chapters introduced you to options, critical pricing principles, and profit and loss diagrams. With these tools, you now understand what an option is, how its price behaves and why, and how to read what the profits or losses will be at various stock prices. Our next step is to dive into the market mechanics of options. In this chapter, you will discover practical skills on placing orders, reading symbols, understanding option cycles, trading between the bid and ask, leaning against the book, stock splits, and many other topics you need to master options trading. Let’s start by taking a look at option symbols.

Option Symbols

In Table 1-1, we saw that each option has a unique identifying symbol. For example, the symbol for the July $32.50 call was XBAGZ. Although the letters may appear random, there is actually an organized structure to their makeup. Understanding the symbol structure is important for one critical reason. It serves as a backup that you have, in fact, entered the correct symbol for your option order. Believe it or not, entering the wrong symbol is one of the top mistakes year after year for retail traders (and brokers as well). Most of the time this is due to a simple typing mistake; however, many of these could have been prevented had the traders understood option symbols. Entering wrong symbols creates numerous problems. First, you must pay extra commissions to get out of the wrong trade and into the correct one. Second, the erroneous trade may move against you and thus provide a loss in addition to the extra commissions. Third, you may miss out on any favorable price movement in the option intended to buy. All of these provide reasons for understanding option symbols. In this section, we’ll take a closer look at how these symbols are created and what they mean.

All option symbols follow the format of XXX – MS where “XXX” represents the root symbol. The root symbol is a code that identifies the underlying stock and can be any length from one to three letters. The “M” designates the “month” and “S” tells us the strike price. When you are learning option symbols, train your eye to look at the last two letters of any option symbol; they represent the month and strike, respectively. All other letters make up the root symbol.

If a stock is listed on an exchange such as the New York Stock Exchange or American Stock Exchange for example, the root symbol will usually be the same as the ticker symbol. It is easy to spot a listed security as it will always have a symbol of three or fewer letters. So IBM, GE, and T are all listed securities, and their option root symbol will usually be the same as the stock ticker (although it may be different from splits, mergers, or acquisitions).

For any Nasdaq-traded stock (any stock with four or more letters in the ticker symbol), the option root symbol will usually be reduced to three letters. In many cases it will be similar to the original symbol but with the addition of the letter "Q” to designate Nasdaq. For example, the root symbol for DELL is DLQ, INTC is INQ, and MSFT is MSQ.

Once you have the root symbol, it is fairly easy to find the letters that represent the month and strike. For call options, the letters A through L (the first 12 letters of the alphabet) represent each month of the year. For puts, the letters M through X (letters 13 through 24) are used:

Option Month Symbols

For the strike prices, a similar coding system is used. The letter A represents $5, B is $10, C is $15, etc. Once you reach $100 (letter T), a new root symbol is created and you start back at letter A, which is now $105. Here is a partial list showing the sequence of option strikes:

Option Strike Price Symbols

Obviously, this pattern can continue for stocks priced higher than $200. In addition to the above letters strikes, the letters U through Z are usually reserved for $2.50 strike intervals:

Option Strike Price Symbols for $2.50 Increments

It may look confusing but it is actually very easy. Say you want to buy a Microsoft October $45 call. The root symbol is MSQ. The October call symbol is J and the $45 strike symbol is I. So the call option symbol for the option will be MSQJI. Of course, you are not expected to drum up this symbol on your own to enter the trade. When you are looking at a list of option quotes, they will have the symbols listed as in Table 1-1. Most brokerage firms allow you to click on the option to enter an order on that specific option, which means the symbol is automatically entered for you. However, it is still possible to click on the wrong one. Further, some brokers require that you type the symbol into its own field when entering the order. And there is obviously lots of room for error there. Understanding how option symbols are created can keep you out of trouble. If you were comfortable with the symbol construction, you would realize that the letters “JI” in this example represent an October $45 call and this serves as a double check for your order. Just understanding the last two letters will tell you three important pieces of information. They tell you the month, strike, and option type (call or put). Even as a basic check, if you are buying a call option, you know that the “month” designator (second to the last letter of the option symbol) should fall between A and L. If you’re buying a put, that letter should fall between M and X.

Remember, this is only a guideline. You should always check with your broker or with some of the resource sites at the CBOE (www.cboe.com) if you are unsure about an option symbol. The reason is that option root symbols change for different reasons.

Standard root symbols and strikes can change for a number of reasons but splits, mergers, acquisitions, and special dividends are probably the most common. For example, on July 30, 2004, Microsoft declared a special $3 dividend and the option strike prices and root symbols were adjusted to reflect this payment. If any option you are holding goes through a symbol change, it will automatically change in your account. The main point is that you should always check your symbols before entering the trade. Just because MSQ may have been the root symbol for Microsoft while you were last trading those options does not mean that it is still the same the next time you trade. This is especially true if the stock has made recent highs or lows and new strikes are being rolled out. For example, JDS Uniphase (JDSU) currently uses UQD for strike prices up to $65, XXZ for strikes $70 to $90, UCQ for $95 to $140, and YSU for strikes $145 and higher. Don’t try to memorize all the root symbols or to construct them on your own based on past experience. Use your understanding of option symbols covered in this section as a backup measure to ensure you have entered the correct symbol.

As mentioned before, entering the incorrect symbol is always one of the top three errors – even among professional brokers (the others are wrong quantity and wrong action (buy versus sell). With today’s low commissions and traders entering their own orders online, brokers are very unforgiving if you enter a wrong symbol.

Try the following few examples to make sure you have the hang of it. Which options do the following symbols represent? Remember, the last two letters always represent the month and strike. The remaining letters represent the underlying stock, which you will probably recognize. If not, at least try to figure out the month, strike, and whether it is a call or put:

1) FAH

2) DLQOE

3) IBMCE

4) GEXD

5) XBAHH (Hint: “XBA” is the root symbol for eBay)

Okay, let’s see how you did:

1) FAH. We know that all option symbols use the last two letters to designate the month and strike. In this example, we only have one letter remaining, which is F and that must be used to designate the underlying stock. The symbol F is for “Ford” so this symbol represents the Ford January $40 call.

2) DLQOE. We said earlier that DLQ is the root symbol for Dell Computer. This option represents the Dell March $25 put.

3) IBMCE. The last two letters represent the month and strike, so the remaining IBM letters are used for the underlying stock, which is obviously IBM. This represents the IBM March $125 call. (IBM was trading near $125 at the time so the letter “E” would represent $125 rather than $25.)

4) GEXD. Again, the last two letters are used for the month and strike, which means that only GE remains to identify the underlying stock, which is obviously General Electric. This option represents the GE December $20 put.

5) XBAHH. We are told that XBA represents eBay and the last two letters tell us this is an August $40 call. Table 1-1 is reprinted below and you can see that this is the symbol for the August $40 call. (Recall that the “dash E” represents the exchange, which is the CBOE and is not part of the symbol.)

To be continued….

Sep

8

Options Trading – Chapter Three Answers

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Chapter Three Answers

1) What is a profit and loss diagram?

b) A picture of your profits or losses at various stock prices

Profit and loss diagrams provide a picture of where profits and losses will occur at various stock prices. Further, they show the size of those profits and losses.

2) One of the most insightful observations we can get from profit and loss diagrams is that:

a) No strategy is superior to another for all stock prices

For any two strategies, you will always find that neither is superior to the other across all stock prices. Profit and loss diagrams clearly show that no strategy is superior to another in all respects. It is up to the investor to figure out which attributes are desirable based on the outlook.

3) For any profit and loss diagram, the area that lies above zero represents:

b) The potential rewards

Profit and loss diagrams show us the range of potential rewards and potential losses. All areas that lie above the horizontal “zero” line (the breakeven point) represent gains.

4) Which two pieces of information do you need to construct any profit and loss diagram?

d) How much the asset is worth at various stock prices and the price paid for the asset

Profit and loss diagrams are constructed by plotting the various profits or losses against various stock prices. Because of this, we must know how much the asset (option) is worth at the various stock prices as well as the price paid for the asset (option).

5) The profit and loss diagram for a long stock position shows that:

a) Long stock positions carry a large amount of downside risk

Profit and loss diagrams show that long stock positions carry unlimited downside risk – all the way down to a stock price of zero. Options, on the other hand, have a limited amount of downside risk.

6) When drawing profit and loss diagrams without theoretical values, you always calculate the option values:

c) At expiration

Because we don’t know the values of a particular option prior to expiration, we usually draw profit and loss diagrams based on the option values at expiration. At expiration, we know that an option must be worth either zero or the intrinsic value. If you wish to plot a profit and loss diagram prior to expiration, you must use a theoretical pricing model to generate option values. Profit and loss diagrams drawn prior to expiration are almost always generated by a computer.

7) The breakeven point for any profit and loss diagram is always where:

d) The curve crosses the horizontal axis at zero

If the profit and loss diagram crosses the “zero” axis, then that tells you that the position produces no profit or loss. In other words, it breaks even at that point.

The profit and loss diagram for a long call option shows that:

d) Long calls have limited downside risk and unlimited upside potential

9) The area below the zero horizontal axis for any profit and loss diagram represents:

b) The risk

Any space below the “zero” horizontal mark represents losing territory so it therefore represents the risk of that position at various stock prices.

10) For any profit and loss diagram, a “bend” will occur at:

b) Every strike price

Because options create rights or obligations, there are changes that occur at each strike price of any profit and loss diagram.

11) If you compare any two strategies, you will always find there are points where the two intersect. These intersections are called:

b) Crossover points

Crossover points simply show where the two strategies are equal. You will always find that one strategy does better than the other to the right of the crossover and vice versa.

12) The profit and loss diagram for a long put shows that:

a) Long puts have limited upside risk

The risk of short-selling a stock is the unlimited upside risk. Option traders can effectively short stock without this risk by simply buying a put.

13) Which of the following best summarizes the reason for using profit and loss diagrams?

a) They allow you to clearly see the risks and rewards for any strategy

14) The axes for any profit and loss diagram are always:

d) Vertical = profit and loss; Horizontal = stock price

15) Profit and loss diagrams show that the profit to the long position is exactly the loss to the short position and vice versa. This is another way of saying that options are:

c) A zero-sum game

A zero-sum game is any game where one person wins at the loser’s expense. If you make a $5 profit on an option then somebody had to lose $5 on that same option. In the options market, money simply shifts hands from the losers to the winners. No new capital is created in the market by using options (but none is destroyed either).

16) The profit and loss diagram for a long call position shows that:

a) Long calls have limited downside risk

Profit and loss diagrams easily show that call options have limited downside risk, which is one of the biggest advantages of owning call options.

17) If you plot the profit and loss diagram for a $50 call purchased at $4, it will cross the zero line at:

a) $54

The breakeven point for a $50 call purchased at $4 is $54. As learned in the first chapter, the reason is that if the stock is $54 at expiration, the $50 call would be worth exactly the $4 intrinsic value. Because the zero line represents the breakeven point, the profit and loss diagram would cross zero at $54.

18) If you plot the profit and loss diagram for a $100 put purchased at $3, it will cross the zero line at:

b) $97

The breakeven point for a $100 put purchased at $3 is $97. Put options become more profitable as the stock falls. In this case, the stock must fall $3 by expiration just to break even. If the stock is $97 at expiration, the $100 put will be worth exactly $3. Because you paid $3 for it then you would just break even at this stock price.

19) If you plot the profit and loss diagram for a $50 call sold at $4, it will cross the zero line at:

a) $54

Remember that options are a zero sum game. Therefore, the breakeven points for the long and short position must be the same. If you sell a $50 call at $4, you’d receive $4 up front but would have the obligation to sell stock for $50. If the stock is $54 at expiration, you’d have a $4 loss since you’d have to buy stock for $54 and deliver it for only $50. Because you received $4 up front, you’d just break even at a stock price of $54.

20) If you plot the profit and loss diagram for a $100 put sold at $3, it will cross the zero line at:

b) $97

As with Question 19, options are a zero sum game, which means the breakeven points for the long and short position must be the same. If you sell a $100 put at $3 you’d receive $3 up front but would have the obligation to buy stock for $100. If the stock is $97 at expiration, you’d have a $3 loss since you’d have to buy stock for $100 that is only worth $97. Because you received $3 up front, you’d just break even at a stock price of $97.

To be continued…

Sep

7

Options Trading – Chapter Three Questions

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Chapter Three Questions

1) What is a profit and loss diagram?

a) A picture of the maximum losses

b) A picture of your profits or losses at various stock prices

c) A picture of the breakeven points

d) A picture showing the risks and rewards of long stock

2) One of the most insightful observations we can get from profit and loss diagrams is that:

a) No strategy is superior to another for all stock prices

b) Long call options are definitely better than long stock positions

c) Call options have no risk

d) Some option strategies perform better than others for all stock prices

3) For any profit and loss diagram, the area that lies above zero represents:

a) The potential losses

b) The potential rewards

c) The breakeven point

d) The value of the contract if exercised

4) Which two pieces of information do you need to construct any profit and loss diagram?

a) The breakeven point and the price at which the asset was sold

b) The price paid for the asset and the price at which it was sold

c) The price paid for the asset and the breakeven point

d) How much the asset is worth at various stock prices and the price paid for the asset

5) The profit and loss diagram for a long stock position shows that:

a) Long stock positions carry a large amount of downside risk

b) Long stock has an asymmetrical payoff

c) Long stock has multiple breakeven points

d) Long stock has little reward

6) When drawing profit and loss diagrams without theoretical values, you always calculate the option values:

a) Based on the bid-ask spread

b) Prior to expiration

c) At expiration

d) By subtracting the delta from intrinsic value

7) The breakeven point for any profit and loss diagram is always where:

a) The curve bends at the strike price

b) The curve lies above zero

c) The curve lies below zero

d) The curve crosses the horizontal axis at zero

The profit and loss diagram for a long call option shows that:

a) Long calls have two breakeven points

b) Long calls have a symmetrical payoff

c) Long calls are better than long stock

d) Long calls have limited downside risk and unlimited upside potential

9) The area below the zero horizontal axis for any profit and loss diagram represents:

a) The strike price

b) The risk

c) The reward

d) The breakeven point

10) For any profit and loss diagram, a “bend” will always occur at:

a) Every breakeven point

b) Every strike price

c) The maximum gain

d) The maximum loss

11) If you compare any two strategies, you will always find there are points where the two intersect. These intersections are called:

a) Breakeven points

b) Crossover points

c) Maximum gain points

d) Maximum loss points

12) The profit and loss diagram for a long put shows that:

a) Long puts have limited upside risk

b) Maximum upside risk

c) Long puts have two breakeven points

d) Make money if the underlying stock rises

13) Which of the following best summarizes the reason for using profit and loss diagrams?

a) They allow you to clearly see the risks and rewards for any strategy

b) They can locate superior strategies

c) They allow you to reduce your losses

d) They help you find undervalued stocks

14) The axes for any profit and loss diagram are always:

a) Vertical = option theoretical value; Horizontal = option price

b) Vertical = option price; Horizontal = option theoretical value

c) Vertical = stock price; Horizontal = profit and loss

d) Vertical = profit and loss; Horizontal = stock price

15) Profit and loss diagrams show that the profit to the long position is exactly the loss to the short position and vice versa. This is another way of saying that options are:

a) A way to create wealth in the markets

b) More lucrative by selling

c) A zero-sum game

d) A losing proposition

16) The profit and loss diagram for a long call position shows that:

a) Long calls have limited downside risk

b) Long calls have unlimited downside risk

c) Long calls are superior to long stock for all stock prices

d) Long calls have no downside risk

17) If you plot the profit and loss diagram for a $50 call purchased at $4, it will cross the zero line at:

a) $54

b) $50

c) $4

d) $46

18) If you plot the profit and loss diagram for a $100 put purchased at $3, it will cross the zero line at:

a) $100

b) $97

c) $103

d) $3

19) If you plot the profit and loss diagram for a $50 call sold at $4, it will cross the zero line at:

a) $54

b) $50

c) $4

d) $46

20) If you plot the profit and loss diagram for a $100 put sold at $3, it will cross the zero line at:

a) $100

b) $97

c) $103

d) $3

Answers in the next part …

Sep

6

Learning Strategies and Assessing the Risks and Rewards of Any Position When Trading Stock Options

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Let’s now draw a profit and loss diagram for a long $50 put position purchased for $3. Hopefully, you’re starting to understand the steps and realize that we need to know what the $50 put would be worth for various levels of the stock at expiration. Second, we need to know the cost of the put. With those two pieces of information, we can draw the profit and loss diagram. We’ll start by making a profit and loss table to show us the various values for our chart:

Table 3-11: Profit and Loss Table (Long $50 Put)

Learning Strategies and Assessing the Risks and Rewards of Any Position When Trading Stock Options

The explanations of the numbers in this table should be fairly obvious to you now. Reading across the first row, if the stock price is $35 at expiration, the $50 put is worth exactly $15. Because we paid $3 for it, we have a $12 profit. For all stock prices above $50, the put expires worthless and we lose our $3 investment. If we plot the profit/loss values against the stock prices, we get Figure 3-12:

Figure 3-12: Profit and Loss Diagram (Long $50 Put)

Learning Strategies and Assessing the Risks and Rewards of Any Position When Trading Stock Options

We can see in this chart that long put options gain value as the stock price falls, which tells us this is a bearish position. The chart “bends” at the $50 strike price and all area to the right of $50 results in a maximum loss while all area below the $47 break-even brings a profit. Remember, the breakeven for a put option (long or short) is found by taking the strike minus the premium. In this case, a $50 strike – $3 premium = $47 breakeven. The trader who buys a $50 put for $3 needs the stock to be below $47 at expiration in order to profit. Now, this does not mean that a profit cannot be made prior to expiration even if the stock never falls below $47. The reason is that quick movements in the stock can cause the option to increase in price even if the stock is not below the strike price. It is certainly possible that we pay $3 for this put and the stock quickly falls to $49, which makes the put worth more money. However, remember that these charts are drawn “at expiration” and that’s why Figure 3-12 shows that we need to have the stock below $47 in order to make a profit.

As we stated before, profit and loss diagrams are invaluable for understanding strategies or comparing different strategies. We have just looked at two simple strategies, a long $50 call purchased for $5 and a long $50 put purchased for $3.

Let’s make a small change and see if you can answer a tricky question. Which do you think is better, a long $50 call for $5 or a short $50 put for $3? Many traders might be led to believe that the long call is a superior strategy since it makes more money if the stock rises and loses less if the stock falls. What do you think is the correct answer? Hopefully you now understand that by checking the profit and loss diagrams for each, the answer will be readily apparent. Figure 3-13 shows the two strategies plotted on the same chart:

Figure 3-13: Comparison of Long $50 Call (solid line) for $5 and Short $50 Put for $3 (shaded line)

Learning Strategies and Assessing the Risks and Rewards of Any Position When Trading Stock Options

Now it is easy to see that the long call is not superior over all ranges. Yes, it’s true that the long call makes more money if the stock rises substantially and loses less if the stock falls substantially. However, we can see there are two crossover points at $42 and $58. (Recall that the crossover points are where the two graphs intersect.) This means that the short put will be the superior strategy if the stock closes between $42 and $58 at expiration. And because the stock is currently $50, that is an eight-point swing, or 16%, on either side of the current price, which is a pretty big move. So even though the long call may have some nice qualities in that it makes more than the short put if the stock rises and loses less if it falls, those qualities come at a price. In this example, that price is that the stock must rise or fall more than 16% in order to beat the short put strategy. Once again, note how easy this is to see when you look at a picture rather than trying to figure it out in your head or by hand.

Profit and loss diagrams can also show one of the most fateful characteristics about options. If you look at Figure 3-14, you’ll see the profit and loss diagram for a long $50 call at $5 (solid line) and a short $50 call at $5 (shaded line).

Figure 3-14

Learning Strategies and Assessing the Risks and Rewards of Any Position When Trading Stock Options

Notice that the two profit and loss lines are mirror images of each other; that is, the gains to one trader are exactly the losses to the other. We say that options are a zero-sum game, which simply means that no new money is created in the markets by their use as there is for stock. For instance, if Intel rises one dollar, then all holders of stock make money. The increase in the value of the stock creates wealth for all investors. There will be some speculators who will lose from the increase in share price; however, the number of short sellers is far less than the number of stock owners. Remember that corporations issue physical shares of stock and there are far more people who own those shares than are short. Therefore, an increase in the stock’s price creates overall wealth to stockholders. Option contracts, however, are not issued by the company. For the options market, it takes a long and short position to create a contract, and that’s why options are a zero-sum game. If Intel rises one dollar, then all long call owners benefit at the expense of the short call writers.

At the same time, Figure 3-14 shows that options do not create a “black hole” where money is funneled out of the financial system inevitably leading to its collapse, which is a theory that many steadfastly believe. Instead, money just shifts from the pockets of the losers to those of the winners. The options market only redistributes the wealth but it does not destroy it.

Let’s revisit a question we posed at the beginning of this chapter: Why do we have an options market? The reason is that the “risk” one investor is trying to avoid by purchasing options might be willingly accepted by the investor who sells the option. For example, if you wish to speculate on a fall in the stock’s price, you might buy a $50 put for $3 to avoid the upside risk of a short stock position. The person who sells you that $50 put might be very willing to buy stock for $50. Now let’s assume the stock falls to $45 at expiration. You could exercise the put and receive $50 for your stock rather than the current $45 market price. This means you have a $5 gain for a $3 cost for a 66% gain. The short put seller must buy your stock for $50 but was willing to do that anyway. The fact that he received $3 for selling the put just offset his losses. Rather than being down $5, he is now only down $2. So you gained $2 on the put while the short put seller lost $2 from the sale. However, both of you see yourselves as better off. This shows that just because one investor “loses” on the option, it doesn’t mean that he is truly worse off than if he hadn’t entered the trade. Options were designed as a way to accept or reject risks in the market. If another party is willing to accept risks another doesn’t want, then all investors can be better off.

Okay, let’s finish this section with one final example to really show the power of profit and loss diagrams. We’re going to name an advanced strategy that you’ve probably never heard of and one that we’re not even going to discuss in this book. That strategy is the Short Iron Condor. This particular example will be constructed by selling the $55 put and $60 call. Next, we will buy the $50 put and $65 call. We will assume that these transactions bring in a $3 credit to the account. Now for the hard part. Can you tell if this a bullish or bearish strategy? What are the maximum gains and losses? Where will the strategy break even? You can see that these questions are nearly impossible to answer without the visual aid of a profit and loss diagram. Figure 3-15 shows the profit and loss diagram for a short iron condor established for a $3 credit:

Figure 3-15: Short Iron Condor

Learning Strategies and Assessing the Risks and Rewards of Any Position When Trading Stock Options

Now that you have a picture, you should readily see the answers. You can see that the strategy outlined in this example can make a maximum of $3, which occurs if the stock price is between $55 and $60 at expiration. The maximum loss is $2, and that occurs if the stock’s price is below $50 or above $65 at expiration. This strategy is not looking for big price moves in either direction. Instead, it needs the stock to stay relatively quiet between $55 and $60. It is not bullish or bearish – it is a neutral strategy. This strategy has two breakeven points: The first is at $52 and the second is at $63. Even though the ideal situation is to have the stock close between $55 and $60, it can actually close between $52 and $63 at expiration and still be profitable. Below $52 and above $63 is losing territory.

Notice how much we can tell about a strategy that we knew nothing about just by looking at its profit and loss chart. They are invaluable tools for learning strategies and assessing the risks and rewards of any position. As you start trading options, computer software will draw these charts for you. The important thing is that you know how to read them. In fact, most programs will even draw profit and loss diagrams prior to expiration. This requires the aid of an option pricing model to help with theoretical calculations (that’s why we draw them at expiration by hand). The pictures will change but the way you read them is the same. If you take the time to work with profit and loss diagrams, you will have a much better understanding if a particular strategy really is right for you.

To be continued….

Sep

5

Closing an Option

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Closing an Option

In Chapter One, we stated that you can effectively escape any option contract by entering a “reversing” trade. This just means that in order to get out of the contract, you do the opposite set of actions that got you into it. So if you own an option, you can simply sell it. If you sold an option, you can buy it back. These actions effectively get you out of the contract. Now that you understand profit and loss diagrams, you will have a better appreciation for why this works.

Assume you buy a $50 call “to open” for $4 and later sell it “to close” for $6. What has effectively happened? Take a close look at the two trades forgetting about the opening or closing notations:

Buy a $50 call = -$4

Sell a $50 call = +$6

These transactions are really no different from buying and selling stock. If you buy 100 shares of Intel for $30 and sell 100 shares of Intel at $35, you no longer have any Intel shares. All you’re left with is the difference in cash (whether a gain or a loss). The same idea is true for the options. If you buy a $50 call for $4 and then sell a $50 call for $6, you no longer have the call but only the cash difference; in this case, a $2 profit.

We can use profit and loss diagrams to better understand why this works mathematically. Assume for a moment that the above two transactions were “opening” transactions; that is, you bought the $50 call for $4 “to open” and the sold $50 call for $6 “to open.” In the real world, you’re not allowed to be long and short the same contract in the same account; the reason for that will be apparent shortly. But for now, just assume that we could do these transactions in the same account. Figure 3-8 shows a profit and loss diagram for each of these two transactions:

Figure 3-8: Long $50 Call for $4 (solid line) and Short $50 Call for $6 (shaded line)

Closing an Option

The solid line shows the starting position of purchasing a $50 call for $4. The shaded line shows our profit and loss from selling the $50 call for $6. If we actually held these two positions separately in our account, then our profit and losses from this point forward will be the vertical sum of these two lines. In other words, for any stock price you’d just find the profit or loss of each position and combine them. For example, at a stock price of $45, the green line shows +$6 while the red line shows -$4. The result must be a profit of $2. At a stock price of $55, the red line shows a +$1 gain, as does the green line, so the total profit is $2. At a stock price of $60, the red line shows a profit of $6 while the green shows a loss of $4, which is another gain of $2. We can actually combine these two profit and loss diagrams into one, which gives us Figure 3-9:

Figure 3-9

Closing an Option

Notice that buying and selling the same option creates a flat line from a profit and loss perspective. That is, your profits or losses are not in any way affected by stock price movement. So theoretically, you could buy the $50 call “to open” and then sell the $50 call “to open” and you’d be out of the contract. However, if you have two “opening” contracts then this creates additional “open interest” that really isn’t there. It is for this reason that the OCC (Options Clearing Corporation) does not allow you to be long and short the same option in the same account. Effectively there’s nothing there. That’s why you must either buy the contract “to open” and then sell it “to close” or do the reverse and sell the contract “to open” and then buy it “to close.” One action just undoes the other and you’re effectively out of the contract and hopefully holding onto a profit as a result.

What’s the Best Strategy?

One of the biggest benefits of using profit and loss diagrams is that they allow us to compare strategies or positions. For instance, Figure 3-10 compares the previous two profit and loss diagrams we’ve examined. It compares long stock purchased at $50 with the long $50 call purchased for $5:

Figure 3-10: Comparison Between Long Stock (solid line) and Long Call (shaded line)

Closing an Option

We’ve extended the range of stock prices from $20 to $65 so that you can really see that the $50 call provides downside protection. The long stock holder can lose the entire $50 investment while the long call holder can only lose $5. If the stock is trading above $50 at expiration, both the call and stock owner participate dollar-for-dollar. The long call holder participates fully to the upside but does not lose as much to the downside. So why would anybody trade anything other than options? The reason is that this “favorable” risk-reward of the call option does not come for free. Notice in Figure 3-10 that the long stock position intersects the long call position at a stock price of $45. This is called the crossover point. This shows that both strategies are equal at expiration at a stock price of $45. If the stock closes at $45 at expiration, the long stock holder loses five dollars and so does the long call holder.

However, below the crossover point, the long call performs better since its line lies above that of the long stock position. Even though both positions lose in this region, the long call has a fixed loss of five dollars while the long stock position continues to lose all the way down to a stock price of zero.

On the other hand, above the crossover point, the long stock position performs better for all stock prices since its line lies above the $50 call line. In other words, the profit is higher for the long stock holder for all stock prices above $45 at expiration. How much better off is the long stock position? For all stock prices above $50, the long stock holder will have five dollars more profit than the long call holder. The reason is that the long call owner paid a five-dollar time premium thus making his breakeven point $55 while the long stock holder breaks even at $50. So the distance between those two lines above $50 is exactly $5, which is the cost of the call.

This shows that options are all about tradeoffs. Whenever you compare two (or more) strategies on the same graph, you will always find that one strategy is better than the other for certain areas while it is worse off in others. No strategy can be superior to another for all areas on the profit and loss diagram (otherwise arbitrage is possible). In Figure 3-10, you can see that the long stock position performs better for all stock prices above the $45 crossover point and worse for all stock prices below. It is up to the option trader or investor to decide if the cost of the option is worth the benefit it provides. Profit and loss diagrams are the easiest way to visualize exactly what the tradeoffs are.

To be continued…

Sep

4

Picking The Stock Prices Based On The Strike Price Of The Option

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Picking The Stock Prices Based On The Strike Price Of The Option

Let’s take the next step and try a more difficult problem by creating a profit and loss diagram for a long $50 call option that we purchased for $5.

Remember, we always start with a column of stock prices. However, when dealing in options, we pick the stock prices based on the strike price of the option (or options) rather than the purchase price as we did for the long stock example. Because we’re trying to figure out the profit and loss diagram for a $50 call, we would create a column of stock prices starting $50 and then select a few stock prices above and below $50 such as shown in the first column of Table 3-4:

Picking The Stock Prices Based On The Strike Price Of The Option

Table 3-4: Profit and Loss Table (Long $50 Call)

Notice that our stock prices are in five-dollar increments rather than one-dollar increments we used for the previous long stock example. In actuality, it doesn’t matter which increments you use since all methods produce the same picture. But in order to keep the tables small, we generally count by five-dollar increments when dealing with options.

The second column in Table 3-4 shows what the $50 call will be worth at expiration. It’s important to understand that when drawing profit and loss diagrams for options, we are drawing them at expiration of the option. For example, we know that if the stock is $50 or less at expiration that the $50 call expires worthless. However, if the stock is $55, the $50 call would be worth exactly $5 at expiration. If the stock is $60 at expiration, the $50 call is worth $10 and so on.

The third column in Table 3-4 shows us the cost of the call, which we assumed was $5 for this example. In this were a real-life example, we may just use the $5 premium for the option or we may be more realistic and include commissions. Either decision will not change the shape of the profit and loss diagram but it would change the profit or loss values. Whether you decide to include commissions or not, the cost you come up with does not change as the stock’s price changes. That’s why the third column in Table 3-4 is the same answer ($5) for the entire column.

Now we have our two necessary pieces of information to draw the profit and loss diagram: (1) We know the value of the $50 call at various stock prices by looking at column 2 and (2) We know the cost of the $50 call by looking at column 3. Now we just need to figure out what our profit or loss will be for the various stock prices in the table. We figure out the profit or loss just as any business would by taking “revenues minus costs.” In this example, if the stock closed at $35 at option expiration, your revenues would be zero from the sale of the option since it is worthless. Because you paid $5 for the option, you’d have a $5 loss with the stock at $35. The formula for the profit/loss column is simply Column 2 – Column 3.

Once we have the necessary pieces of information, all we have to do is plot the profit/loss column against the stock prices (bold columns in Table 3-4) and we get the following profit and loss diagram shown in Figure 3-5:

Figure 3-5: Profit and Loss Diagram (Long $50 Call)

Picking The Stock Prices Based On The Strike Price Of The Option

We read this profit and loss diagram in the same way as we did for the long stock profit and loss diagram. How much would we make or lose if the stock closed at $60 at expiration? We just need to find $60 on the horizontal axis and draw a line to the profit and loss curve. From that point, we just look directly to the left axis to find the answer, which is $5, as shown by the dashed arrows in Figure 3-6:

Figure 3-6: Profit and Loss Diagram (Long $50 Call)

Picking The Stock Prices Based On The Strike Price Of The Option

We can check the answer by hand. If the stock were $60 at expiration, the $50 call would be worth exactly $10. Because we paid $5 for it, our profit must be $5. Hopefully you are convinced that it is much easier it is to look at the picture to arrive at this answer rather than going through all of the steps by hand.

The picture immediately tells us that a long call is a bullish asset since it makes money as the stock price rises. Further, there is no limit to the amount of money that could be made since the chart continues to rise with increasing stock prices. Even if you do not understand a particular strategy, a quick glance at its profit and loss diagram immediately shows what the trader would like to have happen to the stock price.

Notice that the profit and loss diagram for a long call looks more like a “hockey stick” rather than the straight line we saw for a long stock position. This is because the holder of a long call can only lose the purchase price no matter how low the stock’s price may fall below the strike price. If the stock is $50 or lower at expiration, the long call holder loses a maximum of five dollars, which is why the curve flattens out for all stock prices below $50. Any time you see a “flat” segment (running parallel to the horizontal axis) of a profit and loss diagram, it tells you that particular range of stock prices has no effect on your profit or loss at expiration.

But if the stock is above $50 at expiration, the long call holder makes dollar-for-dollar just as the long stock owner does. This demonstrates one of the most important characteristics about long call options. That is, long calls allow traders and investors a way to participate dollar-for-dollar as the stock price rises but not lose dollar-for-dollar if the stock price falls. In other words, long calls provide traders and investors with some downside protection. The diagram visually demonstrates the asymmetric payoff structure of options.

Characteristics of Profit and Loss Diagrams

There are three important characteristics that are common to all profit and loss diagrams:

· A “bend” will occur at every strike price

· There will be a portion above and below zero

· The curve will cross zero at one or more points (the breakeven point)

Let’s think through each of these in a little more detail. First, all profit and loss diagrams will “bend” at each strike price of the option(s). In Figure 3-5, the $50 call bends upward at the $50 strike, but that will not always be the case. Depending on the option, whether it is long or short, and how it is paired with other assets, the profit and loss diagram may bend up, down, or even sideways. But you can always be sure that it will bend at every strike price involved in the strategy.

Fig 3-7

Picking The Stock Prices Based On The Strike Price Of The Option

Key Concepts

1) The area below zero on a profit and loss diagram represents the risk.

2) The area above zero represents the reward.

3) The point(s) where the profit and loss curve crosses zero is the breakeven point.

4) A “bend” in the curve will always occur at a strike price.

To be continued…

Sep

3

Profit and Loss Diagrams For Trading Stock Options

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Profit and Loss Diagrams

In the last chapter, we learned that options have an asymmetrical payoff structure and it is this property that makes them difficult to understand for new traders. As a refresher, if you buy stock, you have a symmetrical payoff structure. If you buy shares of stock, you make one dollar for every dollar it rises and lose one dollar for every dollar it falls. The gains and losses are symmetrical around the purchase price. However, these symmetrical profits and losses are not present for options. If you buy the $50 call, you will make one dollar at expiration for every dollar the stock rises above $50, but you will not lose one dollar for every stock price below $50. Option payoffs are not symmetrical around their purchase price.

Because of this unique asymmetrical payoff property, it can be difficult to understand how an option position will behave over a range of stock prices. Imagine how difficult it would be if you were dealing with two or more options!

Fortunately, there is a handy tool – the profit and loss diagram – that allows us to look at a picture to see how our profits and losses will be affected as the underlying stock price moves. Unfortunately, few investors or traders take the time to understand them and they end up missing out on a wonderful tool that will make their lives easier and also add insightful dimensions to their understanding of options. Profit and loss diagrams can also keep you out of a lot of trouble since they can alert you to potential risks of a particular strategy that you may have never considered. There is probably no better way to sum up the advantage of using profit and loss diagrams than with the saying, “A picture is worth a thousand words.” The risks and rewards of any position, no matter how complex, are brought to life by looking at a simple picture. Even if you’re not familiar with the particular names of strategies, if you can read a profit and loss diagram, you will have a good understanding of what the function of the strategy is.

Let’s take a look at how to construct a profit and loss diagram, and then we’ll show you how easily it reveals the risks and rewards of various option strategies. Please understand that the work we are putting into these exercises is not necessary when trading options in the real world. Computer programs will draw the pictures for you and you will not need to actually create the tables and charts. However, if you work through the calculations by hand while learning, you will understand the pictures much better.

Profit and loss diagrams can be constructed for any asset, not just options. So let’s start with a simple example and create a profit and loss diagram for one of the most basic of all positions, a long stock position.

In order to create any profit and loss diagram, we need two pieces of information. First, we need to know how much our asset in question will be worth at various stock prices. Second, we need to know how much was paid for the asset. With those two pieces of information, we can chart any profit and loss diagram.

Because we need to know what our asset in question is worth at various stock prices, we always start with a table consisting of various stock prices. That’s always the first step. Next, we calculate what the profit and loss would be for our position in question if the stock were at each of those prices.

For instance, assume you purchased stock for $50 per share. To construct the profit and loss table, we’d start with a column of stock prices starting with the $50 purchase price and then extend the range somewhat above and below this center price. For example, we may consider a range of stock prices between $45 and $55 as in the first column of Table 3-1:

Profit and Loss Diagrams For Trading Stock Options

Table 3-1: Profit and Loss Table (Long Stock)

Next, we calculate what the profit or loss would be for our asset in question (long stock) for each of the listed stock prices. For instance, the first cell in Table 3-1 shows a stock price of $45. If the stock price is $45, you have a $5 loss since you paid $50 per share. If you look further down the list, you can see that if the stock price is $53, you’ll have a $3 profit. If you like working with formulas, we can find the values for the profit/loss column by taking “Column 1 – Column 2.”

Naturally, whether the profit/loss column represents a real loss or a “paper loss” depends on whether you actually sell the stock at that moment. For example, if you sell the stock at $45, you have a $5 “realized” loss. If you do not sell it, you have a $5 “unrealized” loss. Either way, if the stock is $45, there is some type of a five-dollar loss facing us and that’s what Table 3-1 is showing us.

Once our table is constructed, we just need to plot this information on a graph. We will always use the “stock price” column as the horizontal axis (x-axis) and the profit/loss column as the vertical axis (y-axis). Once we do, we get a chart that looks like Figure 3-2:

Figure 3-2: Profit and Loss Diagram (Long Stock)

Figure 3-2 is the profit and loss diagram for a long stock position and is simply a picture of the information in Table 3-1. Notice that it is simply a straight line sloping upward to the right. To read the chart, you just select any stock price along the horizontal axis and then trace a line up to the profit and loss line. From there you follow it directly to the left axis and that tells you what your profit or loss would be for that particular stock price. For instance, what would our profit (or loss) be if the stock is $54? All we have to do is draw a straight line from the $54 stock price on the horizontal axis up to our profit and loss line and then over to the vertical axis on the left as shown by the dashed lines in Figure 3-3:

Figure 3-3

You can see that we land on a profit of $4. This tells us that if the stock is $54, then we have a $4 profit. Likewise, if the stock is trading at $46, we’d have a $4 loss, which is shown by the solid arrows.

Notice that the profit and loss line crosses the horizontal axis at $50. This tells us that at a stock price of $50 we have no profit or loss; we are just breaking even. Any time a profit and loss line intersects the horizontal axis that shows a breakeven point. (For some strategies, there will be more than one breakeven point.)

Figure 3-3 shows that we break even at $50 and make one dollar if the stock is $51, two dollars if it is $52, etc. Likewise, it shows that we lose one dollar if it falls to $49, two dollars if it falls to $48, etc. In other words, if we own stock, we gain dollar-for-dollar as the stock price rises and lose dollar-for-dollar as the stock price falls.

Even though Table 3-1 and Figure 3-2 are two different ways of expressing the same information, the picture is easier to follow. It is much harder to visualize the profit and loss behavior by looking at the table. Now, if you are familiar with graphing, you probably figured out that the information in Table 3-1 would plot as a straight line. However, as we move to the asymmetrical payoffs of options and add more complex strategies, the table will be nearly impossible to follow. A picture becomes a much easier way of understanding how your profit or losses will be affected with changes in the underlying stock, which is why we want to understand how to read profit and loss diagrams.

To be continued…

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