Nature of Options
Options can be traded on stocks, indices, and futures contracts. For simplicity sake, most of our discussion will focus on stock options. The definitions and strategies, however, are generally applicable to all.
An Option is a contract that gives the purchaser the right, but not the obligation, to buy or sell a stock (or other tradable security) at a specified price. This specified price is called the strike price. An option contract to buy a stock at a specific strike price is referred to as a CALL. An option contract to sell a stock at a specific strike price is called a PUT. The price you pay when you buy a Call or Put is called the premium.
An option is considered a contract, because:
a) it gives the purchaser the right to
exercise their option if the strike price is achieved
b) it obliges the seller to fulfill the contract if the option is exercised
c) it has a date of expiration
Although an option is a contract, you don't receive a piece of paper to sign on the dotted line. Instead, your broker places your order with the Options Exchange, which handles the actual transaction. The Exchange is the "official" buyer and seller, so the millions of people who buy and sell options never actually have a direct contractual relationship. Normally, brokerages specify the conditions under which you can buy or sell options, to insure that all parties concerned can meet their obligations. The Options Exchange also requires it. These conditions include having a sufficient amount of cash, or margin, or a corresponding quantity of stock, depending on the type of option trade that is involved.
Options are considered "derivatives," because they derive their value from the security they are based on, which is referred to as "the underlying." So, if you purchased 10 Call options on XYZ Industries, its stock would be the underlying. If you purchased 10 Puts on the S&P 500 Index, then the index is the underlying. One option contract is equivalent to 100 shares of the underlying.
Time & Price
Part of an option's value is based on where it's strike price is relative to the price of the underlying:
If the strike price equals the price of the underlying, it is said to be "at-the-money"
If the strike price is greater than the price of the underlying, it is said to be "in-the-money"
If the strike price is less than the price of the underlying, it is said to be "out-of-the-money"
An option has to be at-the-money or better before it can be exercised.
Because an option has a date of expiration, it must be acted on before it expires. Therefore, if the strike price is at-the-money or in-the-money, the buyer must either exercise their right, or resell the contract, in order to avoid losing their investment. Moreover, an option has a cash value only for the period that it is active, and its cash value gradually diminishes as it approaches expiry. If the option remains out-of-the-money through expiration, its value can deteriorate to zero. In other words, it expires worthless.
This is an important thing to remember about options. Contract prices tend to be far cheaper than the underlying, and if you picked the right option, it can appreciate in value at an even greater rate than the stock. Because of this, options are said to be "high leverage investments," and it's a big part of their allure. But, never forget that options do not trade like stocks. If you buy a stock and it goes down, you at least have the chance it may rise again. If you buy an option and it expires worthless, then your investment is lost and unrecoverable. However, you can never lose more than the premium you paid for the option, so your risk is known in advance. (We should also mention that sellers of options face greater potential risks than buyers, for reasons we discuss below and at length in Part II.)
Along with the strike price, option contracts are tied to specific months of expiration. The price quote for an option will normally contain this information. So, for example, if you bought a "03 March 40 Call" on XYZ Industries, it means you bought a Call on XYZ Industries with a strike price of $40 that expires in March 2003. The month closest to expiration is called the "front month." For a front month contract, the last day of trading is the third Friday of the month. The contract then expires the next day (Saturday).
Inside an Options Trade
Below are some screen shots of an option quote spreadsheet I downloaded from the CBOE's website (these are free downloads). Take a moment to scan through.
Above are Call prices for the NASDAQ 100 trading stock, QQQ. The quote board is indicating that the price of the stock (i.e., the underlying) was $25.32 at the time I was looking at the option quotes (also referred to as the "option chain"). Notice that each specific strike price has a corresponding option symbol that identifies it. So, for example, the December 2002 $10 Call has the symbol QIQLI. If you wanted to purchase this option, the symbol would tell your broker and the Options Exchange specifically the contract you want to buy. You might also notice that the letters "A" and "E" appear after the symbol. These refer to the option's "style"and indicate whether it's an American or European style option. An American style option gives the buyer the right to exercise anytime before expiration day. Generally, a European style option can only be exercised on the last day before expiration. Unless you indicate a preference (and if it's available) an option on a U.S. stock is American style by default.
The quote board also indicates the current price of the option, i.e. the Bid and Ask price. Normally, options are purchased at the Ask and sold at the Bid. In this example, the option QIQLI has an Ask price of $15.50, and if you bought one contact you'd be paying a premium of $1,550 ($15.50 x 100 shares). In this particular case, since the underlying is trading at $25.32, the $10 Call strike has risen so much in value that it is said to be "deep in-the-money." That's one of the reasons why it's fetching $15.50 per contract. Look what happens to the Ask price, though, as the strike price moves closer to the price of the underlying. The $10 strike is costing $4 more than the $14 strike.
As far as the other significant quotes, Volume indicates the number of contracts at each strike price traded for the specific day. Open Interest indicates the number of contracts that are outstanding (i.e., purchased to date) and which strike prices are getting the most action. So, for the QIQLI Call, the quote board is telling us there were no contracts bought so far that day (Volume), but there are 222 that have been purchased to date (Open Interest). Additionally, Open Interest (also called "OI") is telling us that the $14 strike contract is getting the most action.
Now, take a look at the Put prices for the same stock.
The $10 Put strike is so far from the underlying that the Ask price is only 10 cents. In this case, the Put is said to be "far out-of-the-money." You might also notice in this example that the strikes that are closer to the underlying are actually selling for 5 cents less. Normally, they would actually cost a little more, but the pricing indicates how market makers at the Options Exchange are valuing each of these strike prices. The fact that all the Bid prices are zero also indicates that there are no takers for anyone who wants to sell options at these strikes. And if you happen to be one of the folks who previously bought one of them, it will likely expire worthless. We review option pricing extensively in Part II -- and warn you what to look out for.
Brokers & Options
Remember that broker's fees need to be added as an additional cost of the options trade. Brokerages charge their own individual fees for options, and the fees are generally higher than they are for stocks. The fees could be based on a percentage of the options trade, or on flat fees for the number of contracts traded. In recent years, flat fees have become more common, particularly with discount brokerages.
If you plan to trade options regularly, you might want to look into a brokerage that is experienced in, or specializes in, executing options trades, and whose fees are reasonable. If the fees are relatively high, then they should be earned, and the broker should be doing more for you than just sending your order, most of which is done electronically anyway. They should:
a) Personally insure you
are getting the best possible quote
b) Offer a wide range of options strategies
c) Personally guide you through these strategies and offer recommendations (if you need their assistance)
Remember too that option trades involving use of margin add to broker costs.
Now that we've discussed some of the basics, let's tie it all together with a look at the different ways that options are used.
1) To Secure an Investment Position
If you believe that a particular stock is going to rise in price, but don't have the money to purchase it at the moment, you can buy a Call option to secure a position in the stock at a preferred price. For instance, let's say you want to buy 100 shares of XZY Industries, whose stock is now selling at $20/share. You don't have the money to buy the stock right now, but your research tells you it can rise to $30. You could buy a Call with a $20 strike price, which gives you the right to buy it at $20 no matter how much it rises. So, if the Call price were $3 per contract, you'd be paying a $300 premium to secure your position. If XYZ's stock indeed rises to $30/share and you decide to exercise the option, your net profit will be the difference between the increase in the stock's price (from $20 to $30) less the cost of the premium (i.e. $1,000 - $300 = $700).
2) Portfolio Protection &
If you hold a particular stock, and believe it may fall in price, you can "insure" it with a Put, which gives you the right to sell your stock at an advantageous strike price no matter how much it falls. Let's say you are another person who owns 500 shares of XZY Industries, and you are concerned that the stock is going to fall, but that the setback should only be temporary. Still, you don't want to take any chances. You originally bought it at $10, it's now at $30, and you want to protect the hefty profit you've made. You could buy a Put with a $30 strike price, and if XYZ falls sharply and you decide to get out of the stock, you can exercise your Put option and still sell the stock at $30/share.
Since you would only want to buy a Put that is at least at-the-money, the contract will be more expensive relative to the lower strike prices. But, it's the price you pay for the guarantee of being able to sell the stock at a higher price. So, let's say a $30 Strike Put costs $8/contract. You want to protect your 500 shares, so you'd buy 5 Puts, and pay a premium of $4,000. You originally bought XYZ at $10, so if you sell at $30, you've made a profit of $10,000. Now, you have to reduce that profit by the cost of your "insurance," which leaves you with a net profit of $6,000. This raises an important point about using Puts for insurance, and you should always weigh this decision against whether might be better to simply sell the stock if you believe it's going to fall, and re-buy it at a later time.
For every option buyer, there is an option seller. People who own a particular stock may sell an option against it in order to collect the premium. This is known as "writing a covered option." It's covered, because they already own the stock. If the option they sell is never exercised, or expires worthless, they get to keep the premium. Besides income, some folks use this strategy to try and recover losses. For instance, if you still hold one of those high-flying tech stocks you bought a few years back, and it's now down substantially in price, you can write covered options against it to collect premium and reduce some of those losses. This strategy, though, doesn't come without its risks, the biggest one being that the strike price is reached and you are required to honor the contract. For example, if you sold the Call to the person who wanted to buy the 100 shares of XZY at $20, and you originally purchased the stock for $50, you have to give them your 100 shares at a loss of $30 per share. In a situation like this, the premium you collected may not be enough to offset the loss. This is one of the reasons why sellers of options face greater potential risk.
Hedging is similar to income, because you are using an already established position to sell options against and collect the premium. By definition, hedging means taking a position opposite the one you have for the purpose of protecting your investment. In trader parlance, you'd be "long" in the stock market, and "short" in the options market. So, why would you want to hedge instead of buying a Put for insurance? Some people prefer this strategy, because they are actually collecting premium. If you buy a Put, you are spending premium, which may be worthwhile if the price of your stock falls. But if it doesn't, your Put will expire worthless. The only way to "reinsure" your investment is to buy another Put, which might expire worthless too. So, rather than having a bunch of Put premiums eating away at their investment, some folks prefer to hedge. Of course, the risk with hedging is the same as it is with income.
To offset this risk, some folks employ yet another hedge and buy an option for same strike price. Since this gives the hedger the same right of exercise as any other buyer, it has the effect of neutralizing their position. However, the profit margin could be minimal or nil, and if the cost of buying the option was more than the premium received from selling it, then the hedger still has a net loss (though perhaps a smaller one). The bottom line: if you sell options for income or for hedging purposes, you need to be very aware of the inherent risks.
5) Buying Options for Speculation
Speculating on the value of contracts is one of the biggest attractions of the options market, because of the potentially high percentage gains. These speculators are looking for a rise in contract premium, with the goal of reselling the contract at a higher price than they bought if for, and pocketing the difference.
Looking at an earlier example, let's say that our friend who bought the $20 strike Call on XYZ did so to speculate on the value of the contract, instead of using it to secure a position in the stock. Recall that the price paid was $3/contract, or $300 to buy 100 shares. Within a few weeks, XYZ has its meteoric rise to $30, and the $20 Call is now selling for $9/contract, or $900. In rising from $20 to $30, the stock gained a profit of 50%. In rising from $3 to $9, the Call premium gained 200%. Keep these percentages in mind, as we compare the profits from the two strategies.
As we know from the earlier example, if our friend chose to exercise their right, they could buy their hundred shares of XYZ's stock for $2,000, then turn around and sell them for $3,000, for a net profit of $700 after they deduct the $300 premium. If, however, our friend had chosen to speculate on the value of the contract, $1,800 would have bought them 6 contracts on the same Call, which now has a premium of $900 per contract. They would have pocketed $3,600 on the trade, and made a profit more than five times greater than the first strategy.
The same strategy works for a Put purchased at-the-money if the underlying falls in price. The more it falls, the greater the value of the contract, and therefore. its resale value. Sounds great, doesn't it? Well, in order for the speculator to realize such gains, all this has to occur before the contract expires. It's important to remember that when you buy options, time is always working against your position, and picking the right contract month is essential. Novice option buyers should avoid front month contracts, since the risks of losing premium are much greater. So, if our friend who's so bullish on XYZ doesn't permit enough time for the stock to rise as anticipated, their option will expire worthless. Instead of a $3,600 profit, they end up with a $300 loss. They might try to sell the option even for a loss if there is enough time before expiration, but depending on how much value it's lost, there may be no takers. Just scroll back up to the quote board I showed earlier for all those losing Put positions. Behind each of those Open Interest numbers is somebody stuck with a worthless option.
6) Selling Options for Speculation
Someone who speculates by selling options wants the exact opposite of the option buyer. They're expecting (and hoping) the option they sell expires worthless, so they can keep the premium. Normally, someone who sells options for pure speculation isn't doing so against a position they hold (as in the previous examples). Instead, they are selling against margin, which is a credit being extended to them by the brokerage. Because of this, their position is considered "short," since they don't actually own (i.e., are short of) the stock to back up their sale. In options talk, such an option is called an uncovered (or "naked") option. If the short option seller is savvy about options pricing, they can make a nice amount of money selling options and collecting premium, only having to pay the broker transaction fees. This is one of the main attractions of selling naked options, and some short option sellers quip that it's almost the same as getting "free money."
At the same time, this is the riskiest of all option trades, and it won't just be the option whose out there naked if the seller guesses wrong. Let's say, for instance, the short option seller sold an out-of-the-money Put on XYZ with a strike price of $15. The stock is now selling at $30/share, and the short seller is actually expecting it to rise, and that the option will therefore expire worthless. Instead, XYZ falls from $30 to $10, and the Put buyer decides to exercise. Now, the short seller is in a jam, because they are obligated to buy XYZ at $15, which means using whatever cash and margin they have available to cover their position and buy a stock whose market price is now $5 less than the price they're forced to pay for it. If the stock continues to fall in price, their losses are compounded. The seller might try hedging to minimize this risk by also buying the same Put. The profit or loss would be the same as we discussed earlier for hedging.
Beyond the Basics
There are a number of different ways the core strategies we've discussed can be combined, and which fall under the heading of "Advanced Option Strategies." The variety and complexity of advanced strategies would take a whole guide alone, but we did want to mention some of the basic concepts as we start to wind up this discussion.
Most of these advanced strategies fall into two general categories:
Spreads: A spread involves simultaneously buying one option and selling another of the same type on the same security. We saw some examples of that when we discussed hedging and short selling. Generally, when an options trader employs a spread strategy, they are trying to profit from the difference between the prices of the two options.
Straddles: Straddles are different from spreads in that they involve either buying Puts and Calls, or selling Puts and Calls on the same security. On the buying side, the straddle player is trying to make a profit no matter which way the market moves. When a big move comes, they'll exit the losing position, and hope that the winning position earns enough to offset the loser. On the seller side, the straddle player is hoping the security doesn't move much at all. Sell straddles are also very popular, because they are about the only strategy that lets you make money when the market is in a fairly narrow range of movement.
Advanced strategies can not only take advantage of price, but time as well. For instance, option players may take positions in contracts with different expiration months to profit from price differences that are affected by time to expiration.
Index Options v.s. Stock
As we alluded to earlier, options can be traded on the price value of indices. Without getting too technical, an index consists of a basket of stocks whose prices are aggregated and weighted to arrive at a price value. An index may be specific to a particular market segment (i.e., the Biotechnology Index) or focus on the performance of the market as a whole, like the S&P 500 Index. Whereas one option contract for a stock is based on 100 shares, one option contract for an index is based on $100 cash. In the end, you're still paying 100 x the price of the contract. Most (but not all) index options are European style.
Index options are traded for both contract speculation and investment-related goals. For example, rather than buy several different stocks, an investor may want to buy options on one or more indices. This would give them the opportunity to benefit from the performance of whole sectors and/or overall market performance. They may also want to use index options to employ protective strategies for existing stock positions.
As you might suspect, at-the-money index options are more expensive than stock options that are at-the-money, and the "spreads" for index options (i.e., the difference between the Bid and Ask prices) are wider. So, premium price is particularly important when you trade index options in terms of dollar value and pricing. (We elaborate more on this point in Part II).
If your goal with an index option is the right of exercise, then you should be aware of the differences in how index options and stock options are settled. With a stock option, settlement of an exercised option involves the transfer or sale of stock. For an index option, settlement is based on the transfer of cash, regardless of whether the option was a Call or a Put. How much cash gets transferred is determined by the difference between the index value (also called the settlement value) and the strike price at the time of exercise.
So, let's say you bought 10 Calls on the S&P 500 Index, with a 900 strike price. The option trades European style, and it's the Friday before expiration (the last and only day you can exercise). At the close of trading, the S&P settles at 920 points, so you are in-the-money by $20. The settlement price is $100 x the amount you are in-the-money. Since you bought 10 contracts, you've made $20,000. Your account is credited for this amount, and the seller's is debited. Your net profit will be $20,000, less the cost of the premium.
Another class of options are known as "Long-term Equity Anticipation Securities." Since that's a mouthful, they're called LEAPS for short. LEAPS are essentially options that have longer-term periods before they expire. Whereas options contracts begin with 8 months to expiration, LEAPS can begin as far ahead as 3 years. Because of the longer duration of their contract life, LEAPS are slower to react to price fluctuations in the underlying than their shorter-term cousins. This feature makes them attractive to long-term investors who want to allow more time for their option positions to succeed.
END OF PART I
CONTINUE TO PART II: OPTIONS PRICING
ęCopyright 2003 Tony Carrion. All content presented is the exclusive property of Market Harmonics. com, which is owned & operated by T. Carrion & Co., LLC, and may not be duplicated or distributed without the express written consent of the author.