Jul

30

Expiration Values for Put Options

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

Expiration Values for Put Options

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

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

Jul

29

Square-Root Rule for Trading Options

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

Jul

28

More Time Means More Money

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

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

Jul

27

Option Pricing Principles

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

Jul

23

Breakdown of Time and Intrinsic Values When Trading Options

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

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

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

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

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

Jul

22

Understanding a Real Put Option

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Understanding a Real Put Option 

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

Jul

21

Bid and Ask Prices when Trading Options

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

 

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

 

Jul

20

Options Are Standardized Contracts

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 Options Are Standardized Contracts

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

To be continued…

 

Jul

19

Option Basics

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Physical versus Cash Delivery
 
If you exercise an equity option, you will either buy or sell the actual (physical) shares of the underlying stock. This is called physical delivery or physical settlement.
 
On the other hand, most index options, such as SPX (S&P 500), are cash settlement rather than physical delivery. In other words, if the long position exercises an index option, he receives the cash value of the option rather than taking actual delivery of all the stocks in that index. Just realize that not all options settle in physical delivery. As you continue to learn more about options you will hear the terms “physical settlement” and “cash settlement,” and it’s important you understand what these terms mean.
 
 
Exercise versus Assign
 
We said earlier that it is the long positions who get to exercise their options. What do short positions get to do? Nothing. Remember, short positions have no rights. The short position may get a phone call from his broker stating that he has just purchased or sold shares of stock due to a call option he sold. If you are required to buy or sell shares of stock due to a short option, it is called an assignment.
 
If you get assigned on an option, your broker will notify you the next business day to inform you of the assignment. He may say something like, “I’m calling to inform you that you’ve been assigned on your short call options and have sold 100 shares for the strike price of $50.”
 
The words exercise and assign should only be associated with long and short positions respectively. However, in the real world, if you are assigned on a short option, brokers may say things like “you got exercised” on an option even though it is technically incorrect. Long positions exercise. Short positions get assigned. In truth, it doesn’t really matter in practice if an incorrect phrase is used such as “you got exercised” rather than “you got assigned” as long as you understand the message. However, if these terms are used, you do need to understand the difference. Most books and literature on options carefully choose between the words “exercise” and “assign” and you need to understand the actions they are referring to.
 
Let’s work through some examples to be sure you understand. If you are long a call option, you have the right to exercise it and buy shares of stock. If you are short the call, you might get assigned and be required to sell shares. If you are long a put option, you have the right to exercise it and sell shares. If you are short the put option, you could get assigned and be required to buy shares. To continue further, if a long call holder uses his call to buy shares of stock he would say, “I exercised my call.” The short call holder would say, “I got assigned on my call.”
 
It is important to understand that once you submit exercise instructions to your broker and the shares and cash have exchanged hands it is an irrevocable transaction. Make sure you want to exercise before submitting instructions. Also, many firms have cutoff times after which exercise instructions cannot be changed (even though the shares or cash may not have yet been exchanged). Check with your broker as to what these cutoff times are before you submit exercise instructions.
 
Option Basics
 
You now have enough information to understand some hypothetical call and put options. These two assets – calls and puts – are the building blocks for every option strategy you will ever encounter. This is why it is crucial that you understand the rights and obligations that they convey. Most confusion with option strategies stem from not understanding (or simply forgetting) who has the right and who has the obligation.
 
Because options are binding contracts, they are traded in units called contracts. Stocks are traded in shares; options are traded in contracts. An option contract, just like a pizza coupon, will always be designated by the underlying stock it controls along with the expiration month and strike price. For example, let’s assume we are looking at a Microsoft June $30 call.
 
We’ll soon show you where you can look up actual option quotes and symbols for options, but for now let’s make sure you understand what this option represents.
 
Using your understanding of pizza coupons, what do you suppose the buyer of one contract is allowed to do? The buyer of this call has the right (not the obligation) to purchase 100 shares of the underlying stock – Microsoft – for $30 per share at any time through the third Friday in June. (Remember that the expiration date for stock options is always the third Friday of the expiration month.) The buyer of this coupon is “locked in” to the $30 price no matter how high Microsoft shares may be trading. Obviously, the higher Microsoft trades, the more valuable the call option becomes.
 
To understand this concept a little better, assume that you have found a piece of property valued at $300,000 and wish to buy it. But you’d first like spend a few days researching the area before buying it. If you do, you’ll run the risk of losing it to another investor. What can you do? You can go to the broker and put down some money to hold the property for you. For instance, you may pay $500 for several days worth of time. If you decide against the property, you lose the $500. These arrangements are done all the time in real estate and are called “options” on real estate. Assume that you pay the $500 for five days worth of time and are now locked into a binding agreement to buy the property for $300,000 over the next five days. Now suppose that some news is spreading that the area is about to be commercially zoned and some big businesses are interested in it. Property in the area goes up dramatically overnight. But even if you decide to not buy the property, don’t you think that somebody else would love to be in possession of the contract that you have giving them the right to pay $300,000? Of course they would. And these people will start offering you large amounts of money to persuade you to sign over the contract to them. You could just sell it to them and they could sell it to others. This is exactly what most traders do with the equity options market.
 
Now let’s go back to our option example. How much will it cost you to use (exercise) your call option? Because you are buying 100 shares of stock, the strike price must be multiplied by 100 as well. If you were to exercise this Microsoft $30 call option, you would pay the $30 strike * 100 shares = $3,000 cash. This is called the total contract value or the exercise value. In exchange for that payment, you’d receive 100 shares of Microsoft. It works just like a pizza coupon. You pay a fixed amount of cash and receive some type of underlying asset. Most brokers charge a standard stock commission to exercise your options. If you exercised this call, your broker would probably charge you his regular commission for buying 100 shares of stock. After all, the long call option is simply a means for buying regular shares of stock.
 
To restate a previous point, it is important to understand that if you buy call or put options, you are not required to ever buy or sell shares of stock. Further, you do not ever need the shares of stock in your account at any time. Most option contracts are opened and closed in the open market without a single share of stock changing hands. Even though you’re allowed to purchase or sell stock with your options, most traders never do. Instead, they just buy and sell the contracts in the open market amongst other traders.
 
Now let’s assume we are looking at a Microsoft June $30 put option. Think about your auto insurance policy and try to figure out what this option allows you to do. If you buy this put option, you have the right to sell 100 shares of Microsoft for $30 per share at any time through the third Friday in June. Because you are locking in a selling price, put options become more valuable as the stock price falls. If you exercise this put option, you are selling 100 shares of Microsoft, which means you will have 100 shares of Microsoft taken from your account and delivered to someone else. In exchange, you will receive the $30 strike * 100 shares = $3,000 cash. If you exercise this put, your broker will probably charge the regular stock commission for selling 100 shares of stock since the put option is simply a means for selling regular shares of stock.
 
What if you only wish to buy or sell fewer than 100 shares of stock? You can do that but in a roundabout way. Using the call example above, let’s say you only wanted to buy 60 shares of Microsoft for $30. You would still exercise the call option for 100 shares and then immediately submit an order to sell 40 shares (which would carry a separate commission). Each contract is good for 100 shares and you must buy and sell in that amount. But there’s nothing stopping you from immediately entering another order to customize those amounts to suit your needs. Likewise, if you exercised a put option but only wanted to sell 60 shares of stock, you would have to exercise the put and sell 100 shares and then immediately place an order to buy 40 shares.
 
To be continued…

Jul

18

The Options Clearing Corporation

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The Options Clearing Corporation (OCC)

Okay, this may sound good in theory but how do you know that the short positions will actually follow through with their obligations if you decide to use your call or put option?

The answer is that there is a clearing firm called the Options Clearing Corporation, or OCC. The OCC is a highly capitalized and regulated agency that acts as a middleman to all transactions. When you buy an option, you are really buying it from the OCC. And when you sell an option, you are really selling it to the OCC. The OCC acts as the buyer to every seller and the seller to every buyer. It is the OCC that guarantees the performance of all contracts. By performance we obviously do not mean profits but rather that if you decide to use your option, you are assured the transaction will go through. In fact, ever since the inception of the options market and the OCC in 1973, not a single case of unfair or partial performance has ever occurred. If you’d like to read more about the OCC, you can find its website at www.OptionsClearing.com.

Before reading further, make sure you understand the following key concepts:

Key Concepts

1) Long call options give the buyer the right to BUY stock at a fixed price over a given time period
2) Short call options create the obligation to SELL stock at a fixed price over a given time period.
3) Long put options give the buyer the right to SELL stock at a fixed price over a given time period.
4) Short put options create the obligation to BUY stock at a fixed price over a given time period.
5) Option sellers (calls or puts) keep the cash regardless of what happens in the future.
6) The OCC acts as a middleman to all transactions.

More Option Terminology

We’re almost ready to talk about real call and put options but we first must go over some other market terminology that you’ll need to understand. We just covered the terms “long” and “short,” which are critical for understanding who has the right and who has the obligation with any particular strategy. But we have a lot more ground to cover before learning about strategies. Next, we must venture into the remaining terms we will be using throughout the book.

Underlying Asset

In the pizza coupon example, we would say the underlying asset is a pizza. Notice that the coupon limited us to how many pizzas we can purchase; we cannot purchase all we want. In addition, the coupon is not good for any brand of pizza but only the one advertised on the coupon. Call and put options work in similar ways. The underlying asset for a call or put option is generally 100 shares of stock. There are exceptions (which we’ll explore later in Chapter Four) to this rule such as certain stock splits or mergers. But when options are first listed, they always represent 100 shares of the underlying stock.

The “brand” of shares we can buy is determined by the call or put option. For example, if we have a Microsoft call option, we have the right to buy 100 shares of Microsoft. In this case, Microsoft would be the underlying stock. The price of an option is tied to or derived by the underlying stock. Because of this, options are one of many types of derivative instruments. A derivative instrument is one whose value is derived by the value of another asset.

Strike Price (Exercise Price)

In our example, the pizza coupon states a specific purchase price of $10.00. No matter what the price of pizzas may be when you get to the store, you are locked in to the price of $10.00. If this were an option, we’d call this “lock in” price the strike price, which is really a slang term that comes from the fact that we have “struck” a deal at that price.

Another name for the strike price is the exercise price. The reason for this is that if you choose to use your option, you must submit exercise instructions to your broker, which is handled with a simple phone call. With a pizza coupon you just “hand in” the coupon, but in the world of options you must “exercise” the option through your broker.

If you exercise a call option, you must pay the strike price (since you’re buying stock) and that’s why the strike price is also called the exercise price. It’s the price you will pay for exercising the option to purchase shares of stock. If you are short a call option, you’ll receive the strike price (because you’re selling stock). The exercise price is the price that will be paid by the long position and received by the short position.

The opposite is true for put options. If you exercise a put, you’ll receive the strike price since you are selling shares of stock. The short put will pay the strike price since he is the required to buy the stock. The exercise price is the price that will be received by the long put and paid by the short put.

We’ll talk more about exercising options later but, for now, just understand that the strike price and exercise price are two terms meaning the same thing. They both represent the fixed purchase or selling price.

Expiration Date

Notice that the pizza coupon also has an expiration date. You can use this coupon at any time up to and including the expiration date. Equity options (options on stock) always expire on the third Friday of the expiration month. Technically speaking, equity options expire on Saturday following the third Friday but that is really for clearing purposes. That extra day (Saturday) gives the OCC (Options Clearing Corporation) time to match buyers and sellers while the contract is still legally “alive.” From a practical standpoint though, the last day to close or to exercise your option is the third Friday of the expiration month. After that, it’s no longer valid. So just because you may read that options expire on Saturday, don’t think you can get up Saturday morning and call your broker with exercise instructions – it’s too late. The third Friday of the expiration month is your last day (not the only day) to close or exercise the option. (If Friday is a holiday, the last trading day will usually be the preceding Thursday.)

Although a pizza storeowner may allow you to turn in an expired coupon, there’s no such thing with the options market. The second that option expires, it’s gone for good. There are some index options, such as options covering the S&P 500 Index that expire on the third Thursday of the expiration month. However, we will only be discussing equity options in this book, so whenever we talk about the expiration date, we will always be referring to the third Friday of the expiration month unless otherwise stated.

American Versus European Styles

As stated before, most option contracts are simply bought and sold in the open market without a single share of stock ever changing hands. However, if you wish to physically trade shares of stock, you must exercise your option. When can you exercise your option? The answer to that depends on the style of option. There are two styles of options: American and European. The style of option has nothing to do with its origin as implied by the names “American” and “European.” Instead, the style simply tells us when the option may be exercised. American-style options can be exercised at any time through the third Friday of the expiration month. European-style options, on the other hand, can only be exercised on thethird Fridayof the expiration month. You generally do not get to select which style of option you want. All equity options (that is, options on stock) are American style and can be exercised at any time. Most index options are European style. There are a few indices that offer both such as the OEX (S&P 100 Index), which is American style and the XEO, which is the European version of the same index.

It may sound like the American-style option has a big advantage over a European style. After all, for example, if a stock is really flying high it would be nice to exercise a call option and buy the shares at a cheaper price and immediately sell the shares to capture a profit. We’re going to find out in Chapter Four that exercising a call option early for this reason is a big mistake. You will find out that most of the time you are better off just selling the call option in the open market rather than exercising it.

This book is written from the perspective of equity options, so we will assume that all options discussed are American style unless otherwise stated. We only differentiate the terms “American” and “European” so you will know what it they mean if you hear them later while continuing to learn about options. The bottom line is that all equity options are American style, which means the long position can exercise them at any time during the life of the option even though it is rarely optimal to do so.

The last day to buy, sell, or exercise your options is the third Friday of the expiration month.

To be continued….

Jul

17

Long options have rights. Short options have obligations.

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This is not meant to be a course in shorting stocks but rather a way to understand what the term "short" really means when applied to the stock or options market. Shorting means you receive cash from selling an asset you don’t own and then incur some type of obligation. In the case of shorting stocks, your obligation is that you must buy back the shares at some time.

If you short an option, you have sold something you don’t own. You get cash up front and then incur some type of obligation depending on whether you sold a call or put. If you short a call, you get cash up front and have the obligation to sell shares of stock. If you short a put, you get cash up front and have the obligation to buy shares of stock. The cash is credited to your account immediately and is yours to keep regardless of what happens to the option. That is your compensation for accepting an obligation, much like the premiums you pay to an insurance company.

When you sell (short) an option you will receive cash, which is yours to keep regardless of what happens in the future. 

The following table may help you to visualize the rights-versus-obligations relationships:

 

 

LONG

SHORT

Call

Right to buy stock

Obligation to sell stock

Put

Right to sell stock

Obligation to buy stock

Notice that the long and short positions are taking opposite sides of the transaction. For instance, the long call (call buyer) must be matched with a short call (call seller). The long call has a right while the short call has an obligation. Rights and obligations are opposites. In addition, the long call gets to buy while the short call is required to sell. Buying and selling are also opposites.

For put options, the long put (put buyer) must be matched with a short put (put seller). As with call options, it is the long position that has the right while the short position has the obligation (opposites). The long put, however, has the right to sell while the short put is required to buy (opposites).

This arrangement is required to make the options market work. Both parties (the buyer and seller) cannot have rights. They can neither both buy nor both sell. One side has the right to buy (or the right to sell), while the opposite side has the obligation to complete the transaction.

This arrangement is often a source of confusion for new traders. They wonder how the option market can work if everybody has a right to buy or sell. The answer is that it is only the long position that has the rights. The short position has an obligation. It is important to understand this relationship when going through this book, especially when you get to strategies.

Long options have rights. Short options have obligations. 

Getting Out of a Contract

We just learned that you can get into an option contract by either buying or selling a call or put. But once you’re in the contract, is there a way to get out of it at a later time? The answer is yes. All you have to do is enter a closing transaction (also called a reversing trade). In other words, you can always "escape" from your rights or obligations by simply doing the reverse set of actions that got you into the contract in the first place.

For example, if you are short an option and decide at a later time you don’t want the corresponding obligation, you can get out of it by simply buying the options back. This is much like you do with shares of stock if you are short. However, just because you can get out of the contract doesn’t mean that you can avoid any losses that may have accrued. The price you pay to get out of the contract may be higher and, in some cases, much higher than the price you originally received from selling it – just as when shorting shares of stock. But the point is that you can get out of a short option contract by simply buying it back.

If the idea of buying back a contract sounds confusing, think of the following analogy. You probably have a cell phone are locked into some type of agreement such as a one-year contract. Cell companies do this to prevent people from continually shopping around and jumping to the hot promotion of the month. However, your cell provider will also have some type of "buy back" clause in the contract. That is, if you wish to get out of the agreement, you must pay a fixed amount of money, perhaps $200, and you can escape your remaining obligations. If you pay this fee, the company cannot take you to court later and say that you didn’t fulfill your obligations. The reason is that you bought the contract back – it no longer exists between you and the company. That’s the fee they specified to end all obligations.

This is mathematically the same thing that happens when you buy back a contract in the options market. Although it is not a fee to end the contract, what you’re really doing is going long and short the same contract, thereby eliminating all profits or losses beyond that point. If you’re long the contract and you’re short the same contract, then you’ve effectively ended all obligations.

Likewise, you can get out of long call option by simply doing the reverse; that is, selling the same contract that you own. Because of this possibility, most option traders simply trade the contracts back and forth in the open market rather than using them to buy or sell shares of stock. As we will later see, trading option contracts is a big advantage because they cost a fraction of the stock price.

You can always get out of an option contract at any time by simply entering a reversing trade.

Let’s make sure you understand the concepts of long and short calls and puts by using our pizza coupon and car insurance analogies. If you are in possession of a pizza coupon, you are "long" the coupon and have the right, not the obligation, to buy one pizza for a fixed price over a given time period. In the real world, you do not buy pizza coupons; they are handed out for free. But that doesn’t put an end to our analogy because the basic idea is still there. Since you are holding the coupon, that means you posess the right to use it, and that’s the role of the long position. The pizza storeowner would be "short" the coupon and has an obligation to sell you the pizza if you choose to use your coupon. You have the right; he has the obligation.

If you buy an auto insurance policy you are "long" the policy and have the right to "put" your car back to the insurance company. The insurance company is "short" the policy; it receives money in exchange for the potential obligation of having to buy your car from you. Whether you make a claim or not, the insurance company keeps your premium just as you will when selling options. That’s its compensation for accepting the risk.

In the real world of car insurance, you cannot just force the insurance company to buy the car back for any reason. There are certain conditions that must be met; for example, the car must be damaged or stolen. You can’t just obligate the insurance company because you don’t like it anymore or because it has depreciated. However, in the real world of put options, you can sell your stock at a fixed price for any reason while your put option is still in effect. There are no restrictions. Of course, you wouldn’t want to do that if the fixed price you’d receive is less than the current market price. The main point is that if you are long a put option, you call the shots. You have the rights. You have the "option" to decide. You have the right to sell your stock for that fixed price at any time during the time your "policy" is in effect.

To be continued…….

 

Short selling works because traders are obligated to return a fixed number of shares and not a fixed dollar amount. In our example, you shorted 100 shares with a value of $7,000. Your obligation is to return 100 shares of IBM and not $7,000 worth of IBM. If you can purchase the shares for less money than you received, you will make a profit.

Jul

16

Option Sellers’ Rights

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Option Sellers

We know that buyers of options have rights to either buy or sell. What about sellers? Option sellers have obligations. If you sell an option, it is also called “writing” the option, which is much like insurance companies “write” policies. Buyers have rights; sellers have obligations. Sellers have an obligation to fulfill the contract if the buyer decides to use their option. It may sound like option buyers get the better end of the deal since they are the ones who decide whether or not to use the contract. It’s true that option buyers have a valuable right to choose whether to buy or sell, but they must pay for that right. So while sellers incur obligations, they do get paid for their responsibility since nobody will accept an obligation for nothing.
 
There are some traders who will tell you to always be the buyer of options while others will tell you that you’re better off being the seller. Hopefully, you already see that neither statement can always be true, because there are pros and cons to either side. Buyers get the benefit of “calling the shots,” but the drawback is they must pay for that benefit. Sellers get the benefit of collecting cash but they have a drawback in that there are potential obligations to meet. What are the sellers’ obligations? That’s easy to figure out once you understand the rights of the buyers. The seller’s obligation is exactly the opposite of the buyer’s rights. For example, if a call buyer has the right to buy stock, the call seller must have the obligation to sell stock. If a put buyer has the right to sell stock, the put seller has the obligation to buy stock.
 
These obligations are really potential obligations since the seller does not know whether or not the buyer will use his option. For example, if you sell a call option you may have to sell shares of stock, which is different from saying that you will definitely sell shares of stock. A call seller will definitely have to sell shares of stock if the call buyer decides to use his call option and buy shares of stock. If you sell a put option, you may have to buy shares of stock. A put seller definitely must buy shares of stock if the put buyer decides to use his put option and sell shares of stock.
 
It’s important to understand that options only convey rights to buy or sell shares of stock. For example, if you own a call option, you do not get any of the benefits that come with stock ownership such as dividends or voting privileges (although you could acquire shares of stock by using your call option and thereby get dividends or voting privileges). But by themselves, options convey nothing other than an agreement between two people to buy and sell shares of stock.
 
Now that you have a basic understanding of call and put options, let’s add some market terminology to our groundwork.
 
The Long and Short of It
The financial markets are filled with colorful terminology. And one of the biggest obstacles that new option investors face is interpreting the jargon. Two common terms used by brokers and traders are “long” and “short,” and it’s important to understand these terms as applied to options. If you buy any financial asset, you are “long” the position. For example, if you buy 100 shares of IBM, using market terminology, you are long 100 shares of IBM. The term “long” just means you own it. Likewise, if you buy a call option, you are “long” the call option.
 
If “long” means you bought it then “short” means you sold it, right? Not quite. Some people will tell you that “short” just means you sold an asset, but that is an incomplete definition. For example, if you are long 100 shares of IBM and then sell 100 shares you are not short shares of IBM even though you sold 100 shares. That’s because you bought the shares first and then sold them, which means you have no shares left.
 
However, let’s say you bought 100 shares of IBM and then, by accident, entered an order online to sell 150 shares of IBM. The computer will execute the order since it has no way of knowing how many shares you actually own. (Maybe you have shares in a safe deposit box or with another broker.) But if you really owned only 100 shares then you would be “short” 50 shares of IBM. In other words, you sold 50 shares you don’t own. And that’s exactly what it means to be short shares of stock. It means you sold shares you do not own. However, when we short shares in the financial market, it’s not meant to be by mistake – it is done intentionally. How can you intentionally sell shares you don’t own? You must borrow them. In order to further understand what it means to be “short” and how that applies to options, let’s take a quick detour to understand the basics of short selling.
 
Traders use short sales as a way to profit from falling stock prices. Assume IBM is trading for $70 and you think its price is going to fall. If you are correct, you could profit from this outlook by entering an order to “short” or “sell short” shares of IBM. Let’s assume you decide to short 100 shares. Your broker will find 100 shares from another client and let you borrow these shares. Although this sounds like a lengthy, complicated transaction it takes only seconds to execute.
In terms of the mechanics, shorting shares is similar to making a purchase on your credit card. Your bank finds loanable funds from somebody else’s account to let you borrow and you then have an obligation to return those funds at some time. How complicated is it to short shares of stock? About as complicated as it is to swipe a credit card at a cash register.
 
Let’s assume you short 100 shares of IBM at $70. Once the order is executed, you have $7,000 cash sitting in your account (sold 100 shares at $70 per share) and your account shows that you are short 100 shares of IBM – you sold shares that you do not own. Do you get to just take the $7,000 cash, close the account and walk away? No, once you short the shares of stock, you incur an obligation to replace those 100 shares at some time in the future. In other words, you must buy 100 shares at some time and return them to the broker. Obviously, your goal is to purchase those 100 shares at a cheaper price.
 
Let’s assume that the price of IBM later drops by $5 to $65 and you decide to buy back the shares. You could enter an order to buy 100 shares and spend $6,500 of the $7,000 cash you initially received from selling shares. Once you buy the 100 shares, your obligation to return the IBM shares is then satisfied and you are left with an extra $500 in your account. In other words, you profited from a falling stock price. This profit can also be found by multiplying the number of short shares by the drop in price, or 100 shares * $5 fall in price = $500 profit. If you have shorted 300 shares of IBM, you would have ended up with a 300 shares * $5 fall in price = $1,500 profit. Of course, if the price of IBM had risen at the time you purchased them back, then you’d be left with a loss since you must spend more than you received to return the shares. If short selling still sounds confusing, just realize that the short seller generates profits in the same way as a stock buyer but by entering transactions in the opposite order. For instance, when you buy stock, you want to buy low and sell high. When you short stock, you want to sell high and buy low. If you short a stock and then buy it back at a higher price, you’re left with a loss because you really bought high and sold low.
 
To be continued…..

Jul

15

Risk for Sale When Trading Options

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 Risk for Sale

Believe it or not, the options market was designed to allow investors to either accept or transfer risk. The options market is technically a market for dealing in risk. You’re probably wondering who would ever want to willingly accept risk. Odd as that may sound, we do it all the time.
When you buy an auto insurance policy, you are paying a fee to the insurance company. In exchange for that fee, they are accepting the risks associated with you having an accident. The insurance company is accepting risk in exchange for cash. You are paying cash in exchange for transferring the unwanted risk. The agreement between you and the insurance company creates an intangible market – the market for risk. So to answer the question of who would ever willingly accept risk, you must remember that someone is getting paid to accept that risk. If the fee is high enough, you can be sure that someone will step in and accept the risk.
This highlights why the options market is perceived to be so risky. After all, it is a market whose only product for sale is risk. As stated before, the riskiness of options depends on how you’re using them, but now we can state it a little more clearly: It depends on whether you are transferring or accepting risk. None of us would consider the car insurance market to be risky since we use it to transfer risk away from us. However, the insurance companies see it quite differently. It depends on which side of the agreement you’re on.
 
The options market works within a simple principle: while many investors wish to reduce risk, there are some people who actively look for risk. The latter are called speculators. Speculators are willing to gamble for big profits; they aren’t afraid to take a long shot if there is potential for big money. People who patronize casinos and play state lotteries are acting as speculators. If there are speculators out there who are willing to accept risk in the stock market, wouldn’t it make sense to be able to transfer it to them? Of course, in order to make it worth their while, we will have to pay them some money to accept that risk. So if there is a risk you wish to avoid, you can do so by purchasing an option. Conversely, if there is a risk you’re willing to assume, you can get paid through the options market to accept the risk for someone else. So while one investor may be using options to avoid risk, it is possible that the person on the other side of the trade is a speculator willing to accept that risk. Investors who do not understand this interplay between investors and speculators hear both sides of the story and that’s where the confusion comes in.
Unfortunately, this confusion often makes many investors avoid options altogether. This is a big mistake in today’s marketplace. As our economies expand, our financial needs increase; that’s why you see so many new financial products coming to market. Each product is different – sometimes only in small ways – but each provides the solution to a specific problem. Options allow you to selectively pick and choose the risks you want to take or avoid. And that is something that cannot be done with any other financial asset. Because you can select the individual risks to take, options can be used in very conservative as well as very speculative ways. It’s all up to you. If you’d like to make the stock market a less risky place, options are your answer. If you’d like to increase the risk and speculate more efficiently for bigger profits, options are your answer too.
Let’s get started and find out how you can improve your investments from this mysterious market.

Jul

14

Why is there an Options Market?

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Introduction
 
Chances are you’re reading this book because you’re brand new to options. You’ve heard about them but can’t really explain to someone else what they are. You’d like to start trading them, but you have lots of questions and nobody seems to have the answers you’re looking for. This book is for you!
 
At Options University, we believe there is only one way to teach; you must start by learning the most fundamental concepts. While it is possible to provide a quick overview and send you on your way with a false sense of confidence, we know that will only be detrimental in the long run. That is the “ready, fire, aim” approach often used by most books and instructors. Instead, we make sure you truly understand the essence of an option and what makes it different from stock. Once we examine these core competencies, we will then introduce you to some basic strategies that you can use immediately. But don’t underestimate these strategies just because they’re labeled as basic. On the contrary, the basic strategies are what often pack the most punch and are most widely used – even by professional traders. Advanced strategies, even though they appear far more complex, are just moderate extensions of the basics. If you understand the concepts presented in this book, you will make a smooth transition into advanced strategies should you choose to continue further with options trading. Most important, you will have enough knowledge to confidently use the most powerful trading tool ever to hit the financial markets.
 
Before we get started, let’s clear up the one unfair misconception that you have probably heard: Avoid options because they are too risky.
 
As you will find out, options were created to manage the risks and rewards of stock investing, which is certainly a good feature. However, if you talk to investors or traders about options you will find there are a myriad of opinions. To some investors, the word “options” suggests feelings of risk, gambling, speculation, and reckless investing. To others, options mean hedging your bet, insurance and good money management. How can the same asset cause two opposing views? The reason is that both can be correct. It depends on how you’re using the options. Credit cards are a good analogy. One person can use them to spend excessively and end up in bankruptcy while another uses them to pay for an emergency car repair after being stranded on a deserted road. Are credit cards good or bad? Just as with options, the answer depends on how they are used and managed. Be wary of people who tell you to not waste your time with options because they are too risky, because we can show you strategies that completely eliminate risk. What’s important is that you are able to separate which feature of an option is a benefit for you and which is a risk for you. A risk to someone else may be a benefit for you, and the options market will let you earn money for assuming that risk.
 
After reading this book, you will know which strategies are right for you and which are too risky. It all depends on your goals and risk tolerances. We want to show you how options can be used to enhance and strengthen your current investment style.
Those who choose to not learn about options may be overlooking the most important and powerful investment tool available. It is our experience that the people most skeptical of options are the ones who often see the most benefits. We believe, by the end of this book, you will find at least one new strategy that appeals to you, and that means you’ll be a little bit better than you are at this point. And that’s how good investors eventually become great – by continually getting a little bit better. At least take the time to understand options; you can always decide to not use them. But our guess is that this book will only open the doors to a new and exciting investment world you never thought possible. So let’s begin our journey and answer a frequently asked question: Why is there an options market?
 
Why is there an Options Market?
New traders and investors are often overwhelmed by the different financial products available. They are kept busy enough trying to understand and choose between stocks, preferred shares, bonds, mutual funds, closed-end funds, ETFs (Exchange Traded Funds), UITs (Unit Investment Trusts), REITs (Real Estate Investment Trusts), and CMOs (Collateralized Mortgage Obligations).
 
And now you want to add options?
 
You must understand that whenever a new product is created, there are always new variations designed to fill slightly different needs. For example, when the Model T was first invented, it solved the broad problem of transportation. People didn’t really care what it looked like. In fact, it is rumored that Henry Ford once quipped, “Customers can have any color they want as long as it’s black.” The Model T was only meant to solve the broader issues of transportation, namely, getting from Point A to Point B.
 
But once the Model T appeared, others soon came to market with modifications to solve different problems. Today we have many variations such as SUVs, vans, four-wheel drive trucks, extended cabs, crew cabs, compacts, hybrids, and convertibles. While they are all forms of transportation, they fill different needs.
 
The financial markets are no different from any other product. As problems arise, new financial products are developed to handle them. The stock market was created as a way for publicly-traded companies to raise cash. For example, in March 1986, Microsoft had its IPO (Initial Public Offering) and sold 2.8 million shares for $21 per share. That amounted to an instant check for $58,800,000 for Microsoft. In a relatively short time and very efficiently, Microsoft created nearly 59 million dollars with which the company could grow.
 
The creation of the stock market solved a very important problem of raising capital but it also introduced a new problem. That problem is risk. If you buy shares of stock you are buying a piece of the company, and that purchase creates the potential for high rewards. Many investors who bought shares of Microsoft in 1986 are millionaires many times over today. But that potential for high reward comes with the potential for high loss. In early 2001, Enron was regarded as a market leader in the energy trading business and one of the largest corporations in the world. Later that year, it filed for what was to become the largest bankruptcy in United States history. Many investors lost their life savings by investing in Enron. So are stocks good or bad? Obviously, it depends on what happens to the stock’s price – and that is something we cannot know beforehand. In other words, there is risk associated with stock investing. In order to make the financial markets run smoother, it would be nice to invent ways to manage the risk involved with stock investing. And that’s exactly the problem that options solve.
 
To be continued…
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