Options Trading

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These days, many investors' portfolios include investments such as mutual funds, stocks and bonds. But the diversity of securities you have at your clearance does not end there. Another type of security, called an option, presents an array of opportunities to sophisticated investors. The power of options lies in their flexibility. They enable you to adapt or alter your position according to any situation that occurs. Options can be as exploratory or as conservative as you want. This means you can do everything from defending a position from a decline to complete betting on the movement of a market or index.

Before you decide not to invest in options, you should be aware of them. Not understanding how options function is as dangerous as jumping right in: without knowing about options you would not only sacrifice having another item in your investing toolbox but also lose insight into the workings of some of the world's largest corporations. Whether it is to evade the risk of foreign-exchange dealings or to give employees ownership in the form of stock options, most multi-nationals today use options in some form or another.

What Are Options?

An option is a treaty that gives the buyer the right, but not the compulsion, to buy or sell an underlying asset at a precise price on or before a definite date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties.

Still confused? The thought behind an option is present in many everyday circumstances. Say, for example, that you see a house that you'd love to purchase. Unfortunately, you won't have the money to buy it for another three months. You talk to the proprietor and negotiate a deal that gives you a choice to buy the house in three months for a price of $200,000. The owner agrees, but for this option, you pay a price of $3,000.

Now, consider two theoretical situations that might arise:

1. It's found out that the house is actually the true birthplace of Elvis! As a result, the market value of the house shoots up to $1 million. Because the owner sold you the option, he is obligated to sell you the house for $200,000. In the end, you stand to make a profit of $797,000 ($1 million - $200,000 - $3,000).
2. While touring the house, you discover not only that the walls are chock-full of asbestos, but also that the ghost of Henry VII haunts the master bedroom; besides, a family of super-intelligent rats have built a fortress in the basement. Though you originally thought you had found the house of your dreams, you now consider it useless. On the upside, because you bought an option, you are under no obligation to go through with the sale. Of course, you still lose the $3,000 price of the option.

This example demonstrates two very important aspects. First, when you buy an option, you have a right but not a compulsion to do something. You can always let the expiration date go by, at which point the option becomes worthless. If this happens, you lose 100% of your investment, which is the money you used to pay for the option. Second, an option is merely a contract that deals with an underlying asset. For this reason, options are called derivatives, which means an option derives its value from something else. In this instance, the house is the underlying asset. Most of the time, the underlying asset is a stock or an index.

Calls and Puts

The two types of options are calls and puts: A call gives the holder the privilege to buy an asset at a certain price within a precise period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase considerably before the option expires. A put provides the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will plunge before the option expires.

Participants in the Options Market

There are four types of participants in options markets depending on the position they take:

1. Buyers of calls
2. Sellers of calls
3. Buyers of puts
4. Sellers of puts

People who buy options are called holders and those who sell options are called writers; in addition, buyers are said to have long positions, and sellers are said to have short positions. Here is the important difference between buyers and sellers:

• Call holders and put holders (buyers) are not constrained to buy or sell. They have the choice to exercise their rights if they choose.
• Call writers and put writers (sellers), however, are obligated to buy or sell. This means that a seller may be required to make good on a promise to buy or sell.

Don't worry if this seems puzzling - it is. For this reason we are going to look at options from the point of view of the buyer. Selling options is more complicated and can be even riskier. At this point, it is enough to understand that there are two sides of an options contract.

Benefits of Trading Options

There are two main reasons why an investor would use options: to speculate and to hedge.

• Speculation: You can conceive speculation as betting on the movement of a security. The plus of options is that you aren't limited to making a profit only when the market goes up. Because of the versatility of options, you can profit when the market goes down or even sideways. Speculation is the region in which the big money is made - and lost. The use of options in this way is the reason options have the reputation of being risky. This is because when you buy an option, you have to be correct in deciding not only the direction of the stock's movement, but also the magnitude and the timing of this movement. To do well, you must correctly predict whether a stock will go up or down, and you have to be correct about how much the price will change as well as the time frame it will take for all this to materialize. And don't forget commissions! The blend of these features means the odds are piled against you. So why do people speculate with options if the odds are so twisted? Aside from versatility, it's all about using leverage. While controlling 100 shares with one contract, it doesn't consume much of a price movement to generate substantial profits.
• Hedging: The other function of options is hedging. Consider this as an insurance policy. The way you insure your house or car, options can be implemented in insuring your investments against a depression. Critics of options say that if you are so unsure of your stock pick that you need a hedge, you shouldn't make the investment. Alternatively, there is no suspicion that hedging strategies can be effective, especially for large institutions. Even the individual investor can benefit. Imagine that you wanted to avail of technology stocks and their upside, but say you also wanted to limit any losses. Options enable you to restrict your downside while enjoying the full upside in a cost-effective way.

Option Trading Example

Now that you know the fundamentals of options, here is an instance of how they work. We'll use an imaginary firm called Cory's Tequila Company. Let's say that on May 1, the stock price of Cory's Tequila Co. is $67 and the premium (cost) is $3.15 for a July 70 Call, which shows that the expiration is the third Friday of July and the strike price is $70. The total price of the contract is $3.15 x 100 = $315.

In practice, you'd also have to consider commissions, but we'll overlook them for this example. Remember, a stock option contract is the option to buy 100 shares; hence to get the total price, you must multiply the contract by 100.

The strike price of $70 means that the stock price must rise above $70 before the call option is worth anything; furthermore, because the contract is $3.15 per share, the breakeven price would be $73.15. When the stock price is $67, it's less than the $70 strike price, so the option is worthless. But don't forget that you've paid $315 for the option, so you are currently down by this amount.

Three weeks later the stock price is $78. The options contract has increased along with the stock price and is now worth $8.25 x 100 = $825. Subtract what you paid for the contract, and your profit is ($8.25 - $3.15) x 100 = $510.

You nearly doubled your money in just three weeks! You could sell your options, which is called "closing your position," and take your profits - unless, of course, you think the stock price will go on to rising. For this example, let's say we let it ride. By the expiration date, the price drops to $62. Because this is below our $70 strike price and there is no time left, the option contract is worthless. We are now down to the original investment of $315.

To recap, here is what happened to our option investment:

The price variation for the length of this contract from high to low was $825, which would have returned over double our original investment. This is leverage in action.

Exercising Versus Trading-Out: Till here we've talked about options as the authority to buy or sell (exercise) the underlying. Though true, in reality, a greater part of options are not actually exercised. In our example, you could make money by exercising at $70 and then selling the stock back in the market at $78 for a profit of $8 a share. You could also retain the stock, knowing you were able to buy it at a discount to the present value.

Intrinsic Value and Time Value: At this juncture it is worth elaborating on the pricing of options. In our example the premium (price) of the option went from $3.15 to $8.25. These fluctuations can be explained by intrinsic value and time value. Basically, an option's premium is its intrinsic value + time value. Remember, intrinsic value is the amount in-the-money, which, for a call option, means that the price of the stock equals the strike price. Time value represents the possibility of the option increasing in value.

So, the price of the option in our example can be figured as the following:

In real life, options almost always trade above intrinsic value. If you are guessing, we just picked the numbers for this example out of the air to demonstrate how options work.

How to Read An Options Data?

OpSym – Column 1: designates stock symbol IBM, month & year of contract – MAR10 is March 2010, shows strike price in figures 110 etc, shows if it is call or put option – C or P.

Bid(pts) – Column 2: The latest price that has been offered by a market maker to buy a certain option is “bid” price. The implication is if a “market order” is entered for selling March 2010, 125 call, it would be sold at bid price $3.40.

Ask (pts) – Column 3: The latest price offered by a market maker to sell a certain option is the “ask” price. The implication is if a “market order” is entered for buying March 2010, 125 call, it would be bought at ask price $ 3.50.

Extrinsic Bid/Ask (pts) - Column 4: Displays the time premium in the price of the option (there are two prices here, one based on bid price, the other based on ask price). The entire time premium is lost by all options by the time the option expires. So the amount of time premium built in the option price is reflected in this value.

IV Bid/Ask (%) – Column 5: An option pricing model, like the Black-Scholes model, is used to calculate this value. It represents the expected level of future volatility based on the option’s current price, and other pricing variable options (this includes amount of time till expiration, difference in strike price and stock price, and risk free rate of interest). A high IV Bid/Ask (%) means more time premium built into the option price, and vice versa. If you can access the IV value’s historical range for a particular security, you will be able to determine whether the extrinsic value’s current level is at the high end (which is good for writing of options) or whether it is at the low end (which is good for buying the options).

Delta Bid/Ask (%) – Column 6: Delta represents a Greek value which has been derived from one of the option pricing models. It represents the "stock equivalent position" for an option. The delta for a call option can range from 0 to 100 (and for a put option from 0 to -100). The present reward/risk traits connected with holding a call option with a delta of 50 is essentially the same as holding 50 shares of stock. If the stock goes up one full point, the option will gain roughly one half a point. An option which is in-the- money acts more like a stock position. The option trades more like its underlying stock as delta approaches the 100 mark, which means if an option has a delta of 100 it would gain or lose a full point per each one dollar loss or gain in its underlying stock price.

Gamma Bid/Ask (%) – Column 7: Gamma represents one more Greek value which has been derived from one of the option pricing models. Gamma shows how many deltas will be gained or lost by the option in a situation where the underlying stock rises by a full point. Therefore, if the March 2010 125 call had been bought at $3.50, the delta would be 58.20. Which means if there is a dollar rise in the IBM stock, this option would roughly gain in value by $0.5820. Further, if there is a price rise in the stock the same day by a full point, this option would gain by 5.65 deltas (which is its gamma value) and it would then have 63.85 deltas. From there, a further gain of one point in the stock price would result in the option gaining roughly $0.6385 in price.

Vega Bid/Ask (pts/% IV – Column 8: Vega represents another Greek value. It indicates to what extent the option price can be expected to rise or fall if it is based on an implied volatility of a one point increase. So if we look again at the March 2010 125 call, the option price would gain by $0.141if the volatility rose one point from 19.04% to 20.04%. This shows it is better to buy options when the volatility is low (relatively less time premium has to be paid and a subsequent rise in IV inflates the option price). Similarly, it is better to write options when volatility is high (more premium available and a decline in IV deflates the option price).

The at Bid/Ask (pts/day) – Column 9: As shown in the extrinsic value column, options lose all time premium at expiration. Moreover, as expiration comes closer, what is known as “time decay” also accelerates. Theta represents the Greek value which indicates the extent of value likely to be lost by an option in the course of one day’s time. The March 2010 125 call stands to lose $0.0431 in value due to one day’s passage of time, even if the other Greek values and the option remains otherwise unchanged.

Volume – Column 10: Denotes the number of contracts traded in a certain option during the last session. Usually, but not always, options with a large volume are likely to have tighter bid/ask spreads because the great competition for buying and selling these options.

Open Interest – Column 11: Indicates the number of contracts that have been opened for a certain option but not yet been offset.
Strike – Column 12: This is the option’s “strike price”. If the buyer of the option chooses to purchase the underlying security, he will do so at this price. Similarly, the writer of the option must also sell the underlying security at this price if this option is exercised against him.

A table showing the respective put options are similar, but it will have two basic differences:

1. The lower the strike price, the more expensive the call options; the higher the strike price, the more expensive the put options. In the case of calls, low strike prices have higher option prices, and option prices wane at each of the higher strike levels. The reason for this is that the successive strike prices are either more out-of-the money or less in-the-money, so each has lower intrinsic value compared to the option at the next lower strike price. It is the opposite with puts. Put options either become more in-the-money or less-out-of-the money as strike prices go higher, and so gain more intrinsic value. Therefore, options prices are greater as strike prices rise in the case of puts.
2. Delta values are higher at lower strike price for call options. Delta values are higher at higher strike price for put options. Put options show negative values because of the stock equivalent position they represent. When buying a put option, it is like entering a short stock position, hence the resulting negative value of delta.

Option trading began a few decades ago and the sophistication level of average option traders has increased significantly since then. These advances are reflected in today’s option quote screen.