The Options Trading Body of Knowledge Read online

  The call buyer is not obligated to exercise the option; there are three choices. The option may be allowed to expire worthless, which occurs if the current market value remains below the strike price. The contract can also be closed at a profit and sold on the open exchange. The sale might also occur at a small loss; the options trader may realize that the position is unlikely to become profitable, and taking a partial loss then becomes preferable to letting the contract expire. Finally, the options owner can exercise that option and buy 100 shares at the fixed strike price. For example, if the strike is 50 and current value per share is $56, exercise of the option enables its owner to buy 100 shares at the fixed price of $50 per share, or six dollars per share lower than current market value.

  The call seller does not pay a premium, but receives one. When a trader sells an option, or goes short, the trading sequence is reversed from the sequence most people understand. Rather than the well-known long position of buy-holdsell, a short position has the sequence sell-hold-buy. When a trader sells a call, this grants the rights under the option contract to someone else: a buyer. The seller and buyer do not meet face to face because all options trading is done through the Options Clearing Corporation (OCC), which facilitates the market (acting as seller to each buyer and as buyer to each seller). When exercise does occur, the OCC matches the transaction and assigns the shares of stock to an options writer. In the case of a short call, the seller is obligated to sell 100 shares of the underlying stock at the fixed strike price. For example, if the strike is 50 and current market value per share is $56, a seller is obligated to sell shares at the fixed strike of $50 per share, even if that means having to buy the same shares at $56 per share, or for a loss of six dollars ($600 for 100 shares).

  A Put Is the Right to Sell 100 Shares

  A put is the opposite of a call. This option grants its owner the right, but not the obligation, to sell 100 shares of stock at a fixed strike price, on or before a specific expiration date. Just as a call owner hopes the value of the stock will rise, a put owner hopes the value of the stock will fall. The more the price falls, the more valuable the put becomes.

  A put buyer might take one of three actions before expiration. The put can be closed at its premium value and a profit or loss taken. The put can also be allowed to expire worthless, which occurs if the underlying stock is at or above the strike price at the time of expiration. Finally, the put can be exercised. This means the owner is allowed to sell 100 shares of the underlying stock at the fixed strike price. For example, if a trader owns 100 shares purchased at $50 per share and also buys a 50 put, exercise will occur at that price. If the stock’s value falls to $41 per share before expiration, the put owner can exercise the put and sell 100 shares for $50 per share, even though current market value is far lower. The put protects the stock investor from the decline by offsetting the stock loss in the appreciated value of the put.

  A put seller grants the option rights to a buyer. So if a trader sells a put, it means that he might be obligated to accept 100 shares of the underlying stock at the fixed strike. If the strike is 50 and the current market value of the stock falls to $41 per share, the put will be exercised. The put seller will have 100 shares put to them at the fixed price of $50 per share, or nine points above current market value.

  The Underlying Security

  The underlying security in an option contract is fixed and cannot be changed. Options are traded only on a single security, which may be a stock or an index, future, currency, commodity, or exchange-traded fund (ETF). Many creative expansions and variations of the options market have been developed and continue to be introduced. Examples in this book focus on options on stock, as the best-understood and most popular form of listed options trading.

  Every option refers to the rights on 100 shares of stock. A single option grants rights to those 100 shares, either to buy (call) or sell (put). The option’s current premium value is expressed on a per-share basis, however. For example, if an option is currently valued at 4.60, that means it is worth $4.60 per share, or $460.00 (per 100 shares).

  Strike Price

  The value at which options can be exercised is called the strike price (also known as striking price and exercise price). For example, if the strike is 50, it means the option will be exercised at $50 per share if and when exercise does occur. The proximity between strike price and current market value determines the option’s value, along with the amount of time remaining until expiration.

  When the underlying stock’s current value is higher than a call, the call is in the money (ITM). When the price is lower than the strike, the call is out of the money (OTM). When it is exactly equal to the strike, the call is at the money (ATM).

  For puts, this is opposite. When the stock’s price is higher than the put strike, it is out of the money (OTM); when the stock price is lower than the fixed strike, that put is in the money (ITM). These distinctions are very important; a strategy for buying or selling options relies on stock moving in a desired direction to create profits.

  Expiration

  Every option is scheduled to expire in the future. The farther away the expiration date, the higher the option’s value. With options, traders coordinate time with proximity of price. The closer the strike to current market value of the underlying stock, the more the price of the option reacts to price changes in the underlying stock; the closer the expiration date, the more the option’s premium value reacts to the stock’s price movement.

  When a trader opens an option, the time remaining until expiration affects the decision about which specific contract to buy or to sell. Time to expiration affects the value of the option and defines risk. For options sellers, the longer the time until expiration, the greater the risk of exercise. Exposure to this risk is one of the most important factors in comparing option prices. Exercise is most likely to occur on the last trading day, but it can occur at any time during the life of the option. For options buyers, a long time until expiration is positive because with more time, there is an increased chance of movement in the price of the underlying stock. A desirable change in value (upward for call buyers or downward for put buyers) defines whether options will be profitable or not. But a negative to this expanded time is higher cost. The more a trader pays to buy an option, the more difficult it will be to create future profits.

  The Option Premium and Its Components

  The premium—the cost of the option—is going to vary over time based on three factors: time to expiration, volatility, and intrinsic value.

  Time to Expiration

  The longer the time until expiration, the higher the “time value” of the option. Time value tends to change very little for exceptionally long-term options. For example, for a LEAPS (long-term equity anticipation securities) option, which may have as much as 30 months to expiration, changes in the underlying stock’s price have little or no effect on the time value. As time approaches expiration, however, the rate of decline in time value premium accelerates. At the point of expiration, time value will have declined to zero.

  The tendency for time value to accelerate as expiration approaches affects the decision about when to buy or sell an option, especially for those trading short positions (selling options). The majority of long options are not going to become profitable, mainly due to the declining time value. However, short options traders know that time value creates profits. As time value evaporates, the option loses premium value. And because short traders go through the sequences of sell-buy-hold instead of the opposite, reduction in value equals profits. So the short trader sells to open, and then when value has fallen, buys to close at a lower premium level. This is where time value works for the seller.

  Volatility

  The most elusive and hard to understand part of premium value is due to the level of volatility in the underlying stock. This volatility is an expression of market risk. Stocks with relatively narrow trading ranges (the distance between highest and lowest price levels) are less risky,
but they also offer less opportunity for profits in the stock or in options. Stocks with broad trading ranges and rapid changes in price are high-risk but also offer greater profit opportunities. The option premium level is directly affected by this price volatility. The level of unpredictability in a stock’s current and future price level defines an option’s premium value.

  Some analysts include this volatility effect as part of time value, but this only confuses the analysis of options. Time value by itself is quite predictable and, if it could be isolated, would be easily predicted over the course of time. Simply put, time value tends to change very little with many months to go, but as expiration nears, the rate of decline in time value accelerates and ends up at zero on the day of expiration. But time value cannot be separated from the other elements of value, so it is often seen as part of the same price feature. Time/volatility value is often described as a single version of “time value premium.” If these two elements are separated, option analysis is much more logical.

  The portion attributed to volatility might be accurately named “extrinsic value.” This is the portion of an option’s OTM premium beyond pure time value. Extrinsic value can be tracked and estimated based on a comparison between option premium trends and stock volatility.

  To understand how volatility works for the underlying stock, a few technical tools are required. The trading range is easily quantified for most stocks. If you study and compare stocks, you discover that trading ranges vary considerably. The greater the breadth of the range, the more extrinsic value you find in option premium. Even so, the most popular version of price volatility is far from accurate. To accurately track and predict extrinsic value, you need to adjust the method for calculating volatility for the underlying stock.

  In its most common definition, price volatility is calculated by mathematically reviewing the price range over the past 52 weeks and then assigning a percentage to the range. For example, if the stock’s range has been between 27 and 34 points, volatility is 26 percent. The calculation requires dividing the net price difference by the low, as follows:

  (34 − 27) ÷ 27 = 26%

  This seven-point price range is really quite narrow when you consider what can happen over a period of 52 weeks. Now consider how those seven points change in terms of volatility when the price range is between 85 and 92:

  (92 − 85) ÷ 85 = 8%

  The same seven-point price spread has been reduced to an eight percent volatility level, even though the price range is the same.

  Another problem with volatility is that it does not distinguish between rising and falling price trends. One stock might experience a 52-week range but currently reside at the low end. Another with an identical price range might currently be valued at or near the top of that range. This price trend also affects the value of options at various strikes.

  Finally, the price range does not allow for the occasional price spike. In statistics, one principle required to arrive at an accurate average is to exclude any unusual spikes in a field of values. This should apply to stock prices as well, but the adjustment is rarely made. For example, a review of Yahoo! (YHOO) at the end of August 2008 showed a 52-week price range from 18.58 to 34.08. The volatility was 83%, as follows:

  (34.08 − 18.58) ÷ 18.58 = 83%

  However, this price range includes a spike up to the top of 34.08 when Yahoo! was negotiating with Microsoft, and rumors were that the Microsoft offer might be made at that highest level. Negotiations fell apart, and the price retreated. If you exclude this one-time price spike, the trading range was closer to 18.58-30.00. In this situation, volatility is reduced considerably:

  (30.00 − 18.58) ÷ 18.58 = 61%

  Applying a basic statistical rule that spikes should be removed, the volatility for this company would be far lower than with the spike included. The definition of a spike is that it takes price above or below the trading range and that following the spike, prices return to the normal range without repeating the spike again.

  The unreliability of the typical method for computing volatility should be discounted. To select options based on volatility, it is first necessary to develop a more comprehensive method for the basic calculation. This includes consideration of the following:

  1. Price spikes, requiring adjustment of the 52-week range.

  2. Changes in the breadth of the trading range over time (a changing trading range implies increases in volatility, which is likely to affect future premium value).

  3. The number of points in the range compared to the stock price itself. For example, a seven-point trading range for a stock trading in the mid-20s is more significant than a seven-point trading range for a stock trading in the high 80s. Although this point spread varies in significance based on stock price, its effect on option premium is what really matters. Thus, the analysis of the point count should also track the trend from the beginning to the end of the one-year range.

  Determining the level of extrinsic value (or, volatility value) requires considerable technical analysis of the stock’s price and its trend. No current value should ever be studied as fixed in time, but rather takes on meaning when its change is part of the analysis. The trend affects recent changes in option extrinsic value and may also point to how that trend is going to continue to change in the future.

  Intrinsic Value

  The final portion of the option’s premium is the most easily explained and understood. Intrinsic value is that portion of the premium attributed to in the money (ITM) status of the option. When an option is at the money (ATM), meaning strike is equal to stock price, there is no intrinsic value. When the option is OTM, meaning call strike is higher than current stock price or put strike is lower than current stock price, there is no intrinsic value. The only time intrinsic value exists is when the option is in the money (ITM).

  For example, a call has a strike of 60 and the current stock price is 62. This option has two points of intrinsic value, worth $200. Each change in the stock’s price will be matched by change in intrinsic value, down to the strike and upward indefinitely.

  For a put, the movement is opposite. For example, a put has a strike of 45, and the stock price is currently at 42. There are three points of intrinsic value. So if this put’s premium is reported today at 4.50, that consists of 3.00 points in intrinsic value and 1.50 points in some combination of time and extrinsic value. Like the call, the put’s intrinsic value moves point for point with the stock. As the stock’s price declines, the put’s intrinsic value rises; and as the stock’s price rises, the put’s intrinsic value falls.

  A Range of Strategies

  Within the options market, a broad range of strategies can be employed to control risk, enhance profits, or to create combinations between stock and options or between related option contracts.

  The range of strategies can be distinguished as bullish, bearish, or neutral. A bullish strategy produces profits if the price of the underlying stock rises. A bearish strategy becomes profitable when the stock price falls. And a neutral strategy does best when the underlying stock’s price remains within a narrow price range. The types of strategies can also be broken down into a few broad classifications, as follows:

  1. Single-option speculative strategies. The speculator uses options simply as an estimation of how the underlying stock price is going to move in the future and leverages that movement. This means the option cost is far lower than the cost of buying 100 shares; so, a portfolio of speculative options controls far more stock than trading in the stock itself. Long option positions benefit when the price of the stock rises (for long calls) or falls (for long puts). Short speculative strategies, also called uncovered or naked writes, assume higher risk positions. Although the holder of a long position will never lose more than the cost of opening the position, naked short selling includes potentially higher risks. A naked call writer has potentially unlimited risk based on the possibility that a stock’s price could rise indefinitely. A naked put writer faces a downside risk; if th
e stock value falls, the put will be exercised at the fixed strike price, and the writer will be required to buy shares at a price above market value.

  Speculative strategies serve a purpose in many circumstances and can be efficiently used for swing trading. This is an approach to the market in which trades are timed to the top or bottom of short-term price swings. Rather than using shares of stock for swing trading, using long options provides three major advantages. First, it requires less capital, so a swing trading strategy can be expanded. Second, risk is limited to the cost of the long option, which is significantly lower than buying or selling shares of stock. Third, using long puts at the top of a short-term price range is easier and less risky than shorting stock.

  Single options are also used to insure other positions. For example, traders may buy one put to protect current paper profits in 100 shares of long stock. They might also buy calls to mitigate the risks of being short on stock. Insurance of other positions, or hedging those positions, has become one of the most important ways to manage portfolio risk.

  2. Covered calls. The most conservative options strategy is the covered call. When a trader owns 100 shares of the underlying stock and sells a call, the market risk faced by the naked writer is eliminated. If the call is exercised, the writer is required to deliver those 100 shares of stock at the strike price. Although the market value at that time will be higher, the covered call writer received a premium and continues earning dividends until the position is exercised, closed, or expired. A variation of covered call writing that varies the risk level is the ratio write. This strategy involves selling more calls than full coverage allows. For example, a trader who owns 200 shares and sells three calls has entered a 3:2 ratio write.