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Sep
23
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.
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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.
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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):
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Bid
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Ask
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1.90 (5)
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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:
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Bid
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Ask
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2.00 (10)
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1.90 (5)
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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:
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2.35 (8)
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Bid
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Ask
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2.00 (10)
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1.90 (5)
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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:
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2.35 (8)
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2.25 (4)
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Bid
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Ask
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2.00 (10)
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1.90 (5)
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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:
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2.35 (8)
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2.25 (4)
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Bid
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Ask
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2.00 (10)
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1.95 (6)
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1.90 (5)
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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:
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2.35 (8)
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2.30 (2)
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2.25 (4)
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Bid
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Ask
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2.00 (10)
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1.95 (6)
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1.90 (5)
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To be continued…..
Sep
13
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.
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Market Adjustments
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Whole Number Splits (2:1, 3:1, etc.)
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Odd Number Splits (3:2, 5:4, etc.)
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# Contracts
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Increased by split ratio
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Remains same
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Strike
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Reduced by split ratio
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Reduced by split ratio
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Stock price
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Reduced by split ratio
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Reduced by split ratio
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Multiplier
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Remains same
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Increased by split ratio
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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
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
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
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:
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Jan
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Feb
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Mar
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Apr
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May
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Jun
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Jul
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Aug
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Sep
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Oct
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Nov
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Dec
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X’06
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X
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X
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X
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X’07
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X’08
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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:
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):
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:
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
10
Option Expiration Cycles
Filed Under Beginner Options Trading | Leave a Comment
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
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