The Options Trading Body of Knowledge Read online

  The Options Trading Body of Knowledge

  (Introduction & Chapter 1)

  Market Overview

  Michael C. Thomsett

  © 2010 by Pearson Education, Inc.

  Publishing as FT Press

  Upper Saddle River, New Jersey 07458

  Company and product names mentioned herein are the trademarks or registered trademarks of their respective owners.

  All rights reserved. No part of this book may be reproduced, in any form or by any means, without permission in writing from the publisher.

  Introduction

  Enhancing profits is a goal for every stock investor. The options market is one avenue to achieving this goal, but it is complex; within the market itself, there are many ways to trade. This makes the options market both exciting and potentially risky.

  The scope of possible strategies can be overwhelming for an options trader. The basic trades—buying calls or puts for speculation—are only the most obvious uses of options. They can be used in a broad range of expanded strategic applications. Some are very high-risk, and others are very conservative.

  One of the most popular strategies is the covered call, which involves selling one call against 100 shares of stock owned. A covered call seller (also called a writer) receives a premium when the option is sold, and that premium is profit if the call ends up expiring worthless. The short position can also be closed at any time or held until exercise. In any of these outcomes, the trader continues to earn dividends on the stock and has a lot of control over the outcome. A properly selected covered call can easily create double-digit profits in any of the possible outcomes. This makes the strategy practical for most people.

  On the far side of the spectrum is the practice of selling naked options. When traders do this, they receive premium income, but they also risk exercise and potentially large losses. Many variations of naked writes might be used to mitigate the market risk. In between the very conservative and the very high risk are numerous other strategies. Options can also be used to hedge stock positions, reduce risk, and enhance profits in many ways.

  This book is designed to provide readers with a comprehensive reference for the entire options market. Most people prefer to focus on the listed options available on individual stocks, and this is the focus of the examples provided in the “Option Strategies” chapters. However, options are also available on futures, indices, and mutual funds, and the options market has expanded beyond its original limited scope and size. In the 1970s, when publicly traded options first became available, only a few traders even knew about options. Today, the entire options market has become mainstream, and a growing number of people are recognizing that options can provide many roles within a market portfolio and can serve a broad range of risks.

  The one change in technology that has made the options market so widely accessible has been the Internet. Two developments have significantly affected the way that traders are able to trade and can afford to be in the market at all. First is access itself. With the Internet, anyone can go directly to current option listings and track their holdings or identify opportunities. Only a few short decades ago, before the Internet existed, options traders had to rely on stockbrokers, which meant having to visit or telephone an office, wait for the stockbroker to look up listings, and then decide on whether to make a trade. Any stockbroker who was not physically on the floor of an exchange had a considerable time lag as part of this process, making active trading impossible.

  The second major change is cost. In the “old days” when you could only trade through a broker, commission costs were quite high compared to today’s cost. With widespread use of online discount brokerage services, options trades cost as little as a few dollars, with the average ranging between seven and ten dollars each way. So a round trip (buy and sell) can be accomplished for less than quarter of one point, which is a huge discount over commission costs of the past.

  Do you need a broker? This is the question that every trader has to deal with when thinking about moving to a discount service, where trade execution is offered without advice. Ironically, the answer for options trading is that you not only do not need a broker, but using one means you probably should not be trading options. By definition, any trader who has enough experience or knowledge to actively trade options should be using a discount broker. The concept of asking a broker’s advice for an options trade is nonsensical for three reasons. First, stockbrokers are not necessarily skilled within the options market, even if they are licensed to execute options trades. Second, options trading demands on-going tracking of both options and the stocks they refer to. Third, paying a high commission to a full-service brokerage firm erodes profits from options trades, making many strategies marginal or impractical.

  This book is designed for the options trader, whether a novice or skilled pro, who understands and appreciates the market issues. They are going to be more likely than average to employ a discount brokerage service, to make their own decisions, and to monitor their investments. Full-commission brokerage is appropriate only for clients who are worried about risk, who are less knowledgeable about markets, and who trust their broker to give them sound advice. This is a large market, although it is not growing. In comparison, the options market is growing and expanding. Not only are options available today on more products than ever before, but the volume of trading has also grown at incredible speed. In 1973, slightly more than one million contracts were traded. In 2007, more than 944 million traded. In the 34 years between 1973 and 2007, the annual volume declined only seven times. But the recent explosion of the options market has been impressive. For example, between 2006 and 2007, total volume grew by 40 percent; the previous year, growth was 44 percent. The future of this market is going to be even bigger, and a growing number of investors will use options in some form as an integral feature of their portfolio. This alone is a substantial change in the options market.

  In the past, options have been viewed by “the crowd” of Wall Street as an oddity, a side-bet, or an entirely separate market, appropriate only for speculators. But as new products and new strategies have been developed, this outlook has evolved. Today, retail and institutional investors use options to (a) insure long portfolio positions, (b) hedge short risks, (c) play short-term market price swings, and (d) enhance profits. Even in the most basic of portfolios, all these applications of options make them valuable management and riskreduction tools. The most basic speculation in options is an entry strategy for many options traders, but it is becoming less important over time. Today, the options market has grown into a means for taking a lot of risk out of the investment equation.

  This book provides a market overview and discussion of risks, in addition to a comprehensive listing of strategies. Most of these strategies are accompanied by tables and illustrations identifying profit and loss zones, as well as breakeven points. The strategy section uses companies for examples. These are based on actual option values for three publicly listed companies; however, their names have been changed due to the ever-evolving share prices of each. All the stock prices and option premium values are based on the closing values of those stocks and options as of December 31, 2007. By using this fixed moment in time, all examples are based on the same data. However, even though stock and option valuation changes constantly no matter when you analyze relative values, the approximate option risks and opportunities remain identical. As long as time to expiration is the same as that in the examples, and proximity between strike price and current market value remains within the same range, the values of options and the likely outcome of strategies will work in the same manner.

  This book also provi
des a very comprehensive explanation of how option premium develops based on various elements of value; calculation of returns from options and stock trading; federal taxation works in the options market; how stocks are picked for options trading; online and print resources; and a very complete glossary of terms that options traders will find valuable.

  Chapter 1

  Market Overview

  The realm of options is a highly specialized, intricate, and often-misunderstood market. The reputation of options as high risk is only partially deserved. In fact, you can find option products to suit any investment profile, from very high risk to very conservative. This market has grown tremendously since 1973, when the modern era of options trading officially began. Since that first year when options trading began in the U.S., annual volume has grown from 1.1 million contracts (in 1973) up to over 3 billion (in 2008).1

  Today, options are more popular than ever and have become portfolio tools used to enhance profits, diversify, and reduce risks. Only a few years ago, a few insiders and speculators used options, and the mainstream investor did not have access to trading. Most stockbrokers were not equipped to help their customers make options trades in a timely manner, placing the individual investor at a great disadvantage. With today’s Internet access and widespread discount brokerage services, virtually anyone with an online hook-up can track the markets and trade options.

  The History of Options Trading

  There really is nothing new about options. They can be traced back at least to the mid-fourth century B.C. Aristotle wrote in 350 B.C. in Politics about Thales, a philosopher who anticipated an exceptionally abundant olive harvest in the coming year and put down deposits to tie up all of the local olive presses. When his harvest prediction came true, he was able to rent out the presses at a greatly appreciated rate.2

  In this example, the deposits created a contract for future use. When that contract gained value, the option owner (Thales) proved to be a shrewd investor. Options enable traders to leverage relatively small amounts of capital to create future profits or, at least, to accept risks in the hope that those options will become profitable later. This all relies on the movement of prices in the underlying security. Thales relied on supply and demand for olive presses, and the same strategic rule applies today. Options are popularly used to estimate future movement in the prices of stocks or indexes. The concept is the same, and only the product is different.

  A similar event occurred in seventeenth century Holland with a much different outcome, when interest in tulips sparked a mania. The tulip had become a symbol of wealth and prestige, and the prices of tulip bulb options went off the charts. By 1637, prices had risen in these options to the point that people were investing their life savings to control options in single tulip bulbs. The craze ended suddenly, and many people lost everything overnight. Banks failed, and a selling panic took the high level of prices down into a fast crash. There is a valuable lesson in this “tulipmania” for everyone trading options today. In an orderly market, prices of stocks and options rise and fall logically. The reasoning is sound because tangible supply and demand factors make sense. In a market craze, prices change quickly and irrationally. In the tulipmania example, there was no rational reason for anyone to invest everything in tulip bulb options—other than the fact that everyone else was doing it, and it seemed that they were getting rich in the process.

  The difference between Thales and the Dutch was one of common sense. Thales saw an opportunity and invested with a clear vision of how profits would follow. He was correct, and he made a profit. In the tulipmania example, greed blinded people, and the reckless actions brought about the crash. Symptoms included the rapidly growing prices, expansion of the market, and the failure to realize that the prices were simply too high.

  For many decades after the Dutch experience, public sentiment about speculation was unfavorable. Of course, there were numerous examples of market speculation, which never seems to disappear altogether. However, in the U.S., nothing really took place in any form of options trading in the public markets until 1872. That year, a businessman named Russell Sage developed the first modern examples of call and put options. He made money on the venture and bought a seat on the New York Stock Exchange two years later. His career was successful, but was spotted with occasional scandals. In 1869, he was convicted under New York usury laws and was later associated with Jay Gould, an infamous market manipulator. Gould had tried to corner the gold market at one point and later invested in the railroad industry, along with Sage and many others.

  The Sage options lacked standardized terms (rules making option features identical in each case), making it difficult to expand the market beyond the initial buyer and seller. Standardized terms in use today include the number of shares of stock each option controls, the day the option will expire, the stock on which an option is being offered, and the stock price pegged to each specific option.

  The Sage options started a trend that never ended. These contracts remained largely limited to a few insiders in the exchanges and were traded over the counter (any form of trading when a specific exchange is not involved in the trade). This trading format remained the same, without any reliable trading rules or valuation, until the 1970s.

  The Chicago Board of Trade (CBOT) was interested in diversifying the options market as a means for bolstering trading in the larger investment market. CBOT established a new organization in 1973, the Chicago Board Options Exchange (CBOE). On April 26, 1973, CBOE initiated the first options market with guaranteed settlement (ensuring every buyer and seller that the market would promise execution) and standardization of price, expiration, and contract size for all listed call options. The Options Clearing Corporation (OCC) was also created to act as guarantor of all option contracts. (This means that the OCC acts as buyer to each seller and as seller to each buyer, guaranteeing performing on every option contract.) Trading was initially available on 16 listed companies.3

  By 1977, when put options trading was first allowed, the market had grown to over 39 million contracts traded (in 1973, only 1.1 million traded). Trading began taking place not only through the CBOE system, but on the American, Pacific, and Philadelphia Exchanges as well. Today, volume is higher than ever before and spread among the CBOE as well as the American, Philadelphia, New York, International, and Boston Exchanges. A breakdown of 2007’s record 2.86 billion contracts traded is provided in Figure 1.1.

  Figure 1.1 Option contract volume by Exchange, 2007

  Source: CBOE 2007 Market Statistics

  Growth in the markets over 35 years has been impressive. This is summarized in Figure 1.2.

  Figure 1.2 Option contract volume by year, 1973–2007

  Source: CBOE 2007 Market Statistics

  In 1982, a new concept was introduced beyond the use of calls and puts on stocks. Index options were originated by the Kansas City Board of Trade with options on the Value Line stocks. This Value Line Index option was followed in 1983 with CBOE’s introduction of the OEX (comprised of 100 large stocks, all with options on the CBOE), which is now known as the S&P 100 Index. The Chicago Mercantile Exchange introduced S&P 500 futures trading, which began a trend in trading of futures indexes as well as options. In 1976, CBOT began trading in Government National Mortgage Association (GNMA, also known as Ginnie Mae) futures, which was the first interest rate futures product. Many more options and futures indexes have since followed. By 1984, after years of futures trading on agricultural commodities, options were first listed on soybeans. This began an expansion of both options and futures markets. Today, you can write options on futures, which is a form of exponential leverage. A futures option is a derivative on a derivative.

  In 1990, the CBOE introduced a new type of options, the long-term equity anticipation securities option, or LEAPS. The LEAPS option is exactly the same as the listed call or put, but its lifespan is much longer. The traditional option lasts only eight months or so at the most before it expires, but the LEAPS option extends out
as far as 30 months. This longer-term option makes strategic planning much more interesting and flexible, allowing traders and investors to use the LEAPS option in many ways that are not practical with a shorter-term call or put.

  Today’s options market looks much different than the market of a few decades ago. It has expanded and continues to expand every month. You can buy and sell options on stocks, futures, indexes, and even exchange-traded funds (ETFs). In the future, additional forms of expansion will broaden the influence of options into many more markets, with the introduction of new and potentially profitable option tools.

  Basics of Options—Standardized Terms

  Today, all listed options include standardized terms. These are the type of option (call or put), the underlying security on which options are bought or sold, the strike price, and the expiration date.

  Calls and Puts

  A Call Is the Right to Buy 100 Shares

  A call is an intangible contract that grants its owner the right, but not the obligation, to buy 100 shares of a specific underlying stock at a fixed strike price per share and on or before a specific expiration date. The owner of the call acquires these rights in exchange for a premium paid for the option. The value of the option rises if the terms become more attractive before expiration, meaning the market price of the stock rises. If the current market value of the call is higher than the fixed strike price, the option value rises; if it remains at or below the fixed strike price, the premium value falls.