Chapter 1-1 The Basics

Trading stocks is reasonably easy, at least in theory.  If you think a stock is going up, buy it.  If you think it is going down, sell it; you can even sell it short if you are a real risk-taker.  If you think a stock is going nowhere, sell it or avoid it all together.   The stock price is determined by supply and demand forces in the market and the current price is exactly what you pay.  Things are not so simple with options trading; there are many more factors that influence the value of an option contract.  It is for largely that reason that most retail options traders drastically underestimate the challenge of trading options profitably.  Before trading options all investors are required to read the Options Disclosure Document as prepared by the Options Clearing Corporation.  This document outlines the characteristics and risks of standardized options and is available online here:  http://www.optionsclearing.com/about/publications/character-risks.jsp

Options are exceptionally versatile.  When executed properly you can accomplish all of the following by buying and/or writing options:

  • Increase leverage without paying margin rates
  • Profit from dropping prices – with limited risk
  • Get paid to enter long stock positions
  • Generate additional income
  • Insure stock positions, or even an entire portfolio

What is an Option?

An option is a standardized contract providing the right – but not the obligation – to buy or sell an underlying financial instrument.  The underlying asset might be a stock, stock index, commodity, or foreign currency.  In our context, this underlying asset is a stock or exchange traded fund (ETF).  Each options contract represents 100 shares and is valid until a predefined expiration date.  The price at which shares can be bought or sold upon expiration is also defined by the contract.  This price is known as the strike price or execution price.

There are two types of options:  calls and puts.  Similar to other financial instruments, you can buy or sell either.  If you buy an option, you are the holder of the contract and considered to be “long.”  Conversely, if you sell an option you are the “writer” of the contract and considered to be “short.” The buyer of a call has the right to buy the underlying asset (e.g. 100 shares of Google) at the strike price on or before the expiration date.  The seller of a call has the obligation to sell the shares, if asked.  The buyer of a put has the right to sell the underlying asset (e.g. 100 shares of Google) at the strike price on or before the expiration date.  The seller of a put has the obligation to buy the shares, if asked.  In summary, options buyers are purchasing rights whereas options writers are selling obligations.

                                                    

HOLDER (BUYER)

WRITER (SELLER)

CALL OPTION

RIGHT TO BUY

OBLIGATION TO SELL

PUT OPTION

RIGHT TO SELL

OBLIGATION TO BUY

Option Price and Value

Premium

The purchaser of an option pays a premium in exchange for the right to buy (call) or sell (put) an underlying asset on or before the expiration date.  The price of the contract is known as the debit, and it represents the purchaser’s maximum risk.  Similar to buying a stock, the maximum loss that can be incurred by an option buyer is the premium paid for the option; gains on long options positions are theoretically unlimited.  On the other side of the trade is the seller, or option writer.  The seller receives the premium as a credit to his/her brokerage account, but is obligated to buy (in the case of a short put) or sell (in the instance of a short call) the underlying shares if the purchaser exercises the contract.  The premium paid by the buyer to the seller is the option writers’ maximum gain; losses on short options positions are theoretically unlimited.  To mitigate counterparty risk, brokerages hold cash from the premium as a guarantee against short positions.

In the money (ITM), At the money (ATM), Out of the money (OTM)

Options can exist in one of three situations- in the money, at the money, or out of the money.  This is determined by the relationship between the strike price and current market price of the underlying asset.  If the strike price of a call option is less than the current market price of the underlying asset, the call is said to be in the money because the holder of the call has the right to buy the stock at a price less than the price he would have to pay to buy the stock in the market.  Likewise, if a put option has a strike price that is greater than the current market price of the underlying asset, it is also said to be in the money because the holder of this put has the right to sell the stock at a price which is greater than the price he would receive in the market.  The converse of in the money is, not surprisingly, out of the money.  Calls with market prices below the strike price and puts with market prices above the strike price are said to be out of the money.  Finally, if the strike price is equal to the current market price the option is said to be at the money.

                                                   

CALL

PUT

In the money (ITM)

Strike price < Stock price

Strike price > Stock price

At the money (ATM)

Strike price = Stock price

Strike price = Stock price

Out of the money (OTM)

Strike price > Stock price

Strike price < Stock price

Intrinsic Value and Time Value

The premium of an option is determined through two components- intrinsic value and time value.  Intrinsic value describes the amount the stock price is above the strike price (for calls), or below the strike price (for puts).  Another way of stating this is that the intrinsic value is equal to amount that the option is in the money.  As a result, the value of the contract at expiration is equal to the intrinsic value.

The time value of an option is defined as the difference between the option premium and the intrinsic value.  It is the amount that you pay for the possibility that it will be worth more in the future.  Therefore at-the money or out-of the- money options have no intrinsic value, only time value.  Options that have a greater time to maturity will always be more expensive than those expiring soon; this difference is accounted for due to the time value.

Intrinsic Value = Stock Price – Strike Price Intrinsic Value = Strike Price – Stock Price

Time Value = Option Price – Intrinsic Value Time Value = Option Price – Intrinsic Value

Intrinsic value is only affected by moves in the underlying asset.  Time value is subject to several factors, primarily time to expiration and implied volatility.  Implied volatility is the market’s expectation of the future volatility of the underlying stock.  It is derived from the option price itself and represents demand for the option.  The higher the implied volatility, the more expectation that the underlying stock will make big moves which in turn increases the option’s chances of being in the money at some point in time in the future.  This also means that the option’s premiums, fueled by an increase in time value, are higher.  However, the monetary value of time decays as expiration nears- time decay increases dramatically as expiration approaches, particularly in the last 30 days.

Consider the following example:

Google (GOOG) is trading at $500 and you bought a 490 call for $25.  $10 of the option would be intrinsic value; the other $15 would be time value.  A 500 call purchased when GOOG was trading for $500 is all time value.  It has no intrinsic value.  If the stock were at 500 when you bought a 500 call it would be the at-the-money (ATM) option.  Buying the same 500 call with the stock at $510 makes it in the money (ITM), because the strike price is below the stock price.  If the strike price is above the stock price, say at $510, then the call is out of the money (OTM).  Only in-the-money options have intrinsic value.  Out-of-the-money options are all time value.

Stock Price:     $500

Strike Price:     490 call = $25             500 call = $18             510 call = $10

In the money               At the money              Out of the money

$10 Intrinsic                $0 Intrinsic                  $0 Intrinsic

$15 time value             $18 time value             $10 time value

 

Option Expiration and Exercise

            Options are expiring assets- they become worthless at a predetermined date in the future.  This date is set when the option contract is written and is known as the expiration date.  Options stop trading on the third Friday of every month and exercise occurs on the next day, Saturday.  Upon expiration, options that have intrinsic value are exercised- money and securities change hands.  Call holders purchase the underlying shares at the strike price from the option writer while put holders sell the underlying shares.  There are two types of exercise that may occur- European style and American style.  American style options allow the holder to exercise the options at any point in time up to and including the expiration date.  The vast majority of all options are American style options.  In comparison, European style options can only be exercised on the expiration date.  For this reason American options are always inherently more valuable than European options.  Exercising an American style option before expiration is known as “early exercise” and is a commonplace occurrence.

Option Terminology

The following terms are some of the most common you will see when discussing options:

Call = The right, but not the obligation, to buy a specific number of shares of the underlying asset at a predefined price at any time until the expiration date.

Put = The right, but not the obligation, to sell a specific number of shares of the underlying asset at a predefined price at any time until the expiration date.

Strike price = The execution price at which option holders (buyers) can exercise their right to buy or sell the underlying asset specified in the options contract.

Exercise = The process in which option holders (buyers) make or take delivery of the underlying asset specified in the options contract.

Assignment = The process by which the writer (seller) of an option is notified that the contract he or she has written has been exercised.

Expiration = The date on which an option expires and thus can no longer be exercised.

In the Money (ITM) = A call (put) option whose strike price is below (above) the stock price.

At the Money (ATM) = An option whose strike price is roughly equal to the stock price.

Out of the Money (OTM) = A call (put) option whose strike price is above (below) the stock price.

American style = An option that can be exercised at any time before expiration.

European style = An option that can only be exercised at expiration.  (Note:  These are mainly index securities.)

Intrinsic value = The portion of an option premium based on the amount that an option is in the money.

Time value = The portion of an option premium based on time to expiration; the price of an option less its intrinsic value.

Option Chains

For any given options contract traders need to know the most recent prices along with other key pieces of information.  Option chains show data for a given underlying asset’s different strike prices and expiration months.  This is very important to traders as the different options for any given asset will behave very differently based on strike price, time to expiration, and open interest.  Options chains are readily available on the Internet; consider the following example from finance.yahoo.com.

option-content-image-1-1-1

At the top, we have the stock information and then different expiration months.  In this case we are looking at Intel (INTC) November 10.

  • Down the middle are the strike prices.  Calls are on the left, puts on the right.
  • Contracts in the money are highlighted yellow, while out of the money contracts are white.
  • Each strike lists:
    • The price of the last trade (“Last”)
    • The current change in the value of the option for the day (“Change”)
    • The price at which there are willing buyers (the “Bid”)
    • The price at which a contract is offered for sale (the “Ask” or “Offer”)
    • The volume of the day’s trading (“Vol”)
    • The contract’s “open interest’ (“Open Int”), which tells us how many active contracts there are for a given month and strike.

High open interest figures, which generally occur near the at-the-money strikes, tell us there are more prospective trading partners who could accept your price.  However, it is important to note that volume does not equal open interest since some trades are made to close positions.

LEAPS

The majority of all options traded on any given day are short-term options.  This is because options were originally created with three, six, and nine month expiration dates to coincide with the quarterly financial cycle most investors focus on.  For the majority of options these time frames work just fine, easily meeting the option-holders needs.  Hedgers rarely look to lock in prices over a year in advance and many speculators buy and sell their options in a matter of days, if not hours.  However, there are some uses for options that just are not satisfied in less than a year and thus, the LEAPS were born.

Long Term Equity Anticipation Securities or LEAPS are options with expirations greater than one year out.  LEAPS are relatively expensive as these options have a tremendous amount of time value.  As such, they have very limited use for both hedgers and speculators.  The most common usage for LEAPS is allowing investors to take long-term stock positions in companies with large market capitalization without putting as much capital to work.  In many ways, LEAPS behave more like stocks than options with Deltas near +/- 0.5 for many strike prices.  Unlike common options that expire every month, LEAPS always expire in January.  For example, in October 2008 investors could buy January options for 2009, 2010, and 2011.  The first (2009) is a common option, the second two (2010 and 2011) are LEAPS.  Bid/Ask spreads are generally wide in LEAPS as they only trade a few contracts a day.  LEAPS are highly specialized trading instruments and should not be used for day trading opportunities.

Consider the following graphics that shows quotes for Jan 2012 and Jan 2013 SPDR S&P 500 (SPY) LEAPS:

option-content-image-1-1-2

option-content-image-1-1-3

January 2013 SPY LEAPS

As you can see in these graphics both spreads and liquidity are both valid issues to consider when investing in LEAPS.  If you look at the 130 calls in particular you see that the 2012 LEAPS have 10,829 contracts outstanding (interest) with 75 traded on this particular day.  The 2013 LEAPS, on the other hand, have 489 contracts outstanding with only 1 traded on this day.  Further examination shows that no 2013 contracts at all have been written for many near- the-money price levels.

Warrants

Another type of long term options are warrants.  Warrants, like leaps, are essentially long term option contracts.  The main difference is in their origination- anyone with a margin account at an options brokerage can write LEAPS (this is how an investor would short the option) while warrants are almost always created by the company in which they represent a long term interest.  For example, warrants are often included in bond offerings or attached to preferred stock as a way to entice investors.  Unlike options which are written on share that are currently outstanding, warrants are written to create new shares, thus they dilute the ownership of a corporation.  For this reason warrants are commonly used in compensation packages, particularly on the executive level.  Warrants are usually issued to and purchased by individuals who actually want to take a position in the company in which the warrants represent- they are designed to be exercised.  While LEAPS are generally limited to two to three years, warrants are written up to 15 years into the future making them the longest lasting financial derivatives.  Finally, warrants are often structured to provide a fractional ownership when exercised, something such as five warrants per share of stock, for example.

Consider the following example that illustrates how warrants provide ownership opportunities in their underlying assets:

  • Research in Motion (RIMM) has warrants outstanding that expire on June 30, 2015
  • Three warrants allow you to buy one share of RIMM for $50.00
  • The warrants are valued at $1.39 while shares of RIMM are trading at $48.28
  • Warrant investors are paying $4.17 (equal to $1.39 * 3) to buy one share of RIMM for $50
  • If you receive Warrants as compensation you will execute them at $50 and above
  • If you purchase Warrants for $1.39 your breakeven price is $54.17; equal to ($50 + ($1.39 * 3))

Questions