Options 101
08-06-2007, 10:19 PM
#1
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Options 101
I was asked by a member to explain options but it's way too vast a topic to go over in any detail in a single topic. However what I can try to do if give you a flavor for what it's all about and a rough understanding of what options are and how they are traded.
Let's start with the most basic. There are 2 kinds of options, Call options and Put options. An option is a contract. It conveys the right (but not obligation) to buy or sell a set number of units (stock options contracts are traded in 100 unit contacts) of an underlying security (we'll discuss stock options in this case but options can apply to anything) at a fixed price, strike price, on or before a specific date, expiration date.
Simply, a Call option contract allows the holder to buy 100 shares on stock at a set price. A Put option allows the holder to sell 100 shares. Options are traded person to person through an exchange. For every buyer of a call there is a seller, writer. There are no fixed number of options contacts. The number available to purchase are determined by how many contracts have been written by other traders. The total number of contracts is called the open interest and that number dynamically changes.
Time for a simple example:
Tom writes a call option on C at the $55 strike price expiring September 2007. It will look like SEP 07 $55 Call. C is currently trading at $48 and it's early August so there is a little over a month before it expires. Tom asks $0.30 for the contract.
Fred buys Tom's call option bidding $0.30. Tom pays $30 for the contract (100 shares x $0.30). Fred now has the option to buy 100 shares of C for $55 any time between now and the end of trading on the 3rd Friday of September (expiration). He paid a $0.30/share premium for the option.
Ok, that example is going to form much of the remainder of this post. First some things to note:
Fred doesn't own any shares. He only owns the option to buy some. Fred doesn't earn dividends or have any privileges associated with being a shareholder; he isn't one.
Tom may or may not own and shares of C. If he owns the shares he's offering to sell then he is writing a covered call option. If he doesn't he is writing a naked call option.
The option has no intrinsic value. They are worthless intrinsically because nobody would pay $55 for a $48 share of stock. The call option only conveys an option to buy shares. If it doesn't make sense to do so the option is considered out-of-the-money.
Had Tom written the call at the $40 strike then it would be considered in-the-money and would have an intrinsic value of $8/share.
Now, on to the important bits. Options are traded at a premium to the intrinsic value. The premium is higher based on two factors: the time left before expiration, time value and the implied volatility of the underlying stock.
The more time before expiration and the more volatile the underlying price the more likely the option will end in the money. The more likely it is that the writer will have to cough up the goods the higher the premium they get for writing the contract.
C is a particularly bad stock to trade options on because the premiums are quite small. It's not a stock which moves much so even with 5 weeks left on Fred's option there is a low likelihood the stock will rise $7 in price and hence the low premium.
Buying a call option is generally considered bullish. You expect the underlying stock price to rise and so to it the premium. It would not be ridiculous to think that you could double your money with only a $1.50 increasing the price of C.
Selling a call option is considered bearish. When you sell a call like Tom did you are saying they you don't think the stock will reach the strike price and thus expire worthless. Tom got his $30 upfront and that is all he can ever expect to make on the trade. When you write an option you get the maximum profit upfront in cash.
Buying a put option is considered bearish. When you buy a put you think the stock will go down in price increasing the premium value of the option. Traders often use puts to put a floor under their common stock positions in times of uncertainty. If you owed C at $48 and you wanted to limit the amount of money you could potentially lose if it goes down then you could buy a $50 put for about $3. That put would ensure you could sell your shares for $47 ($50-$3) even if the stock drops 90%. You can also use a put as a short position with a built in stop. For example, if you bought a $50 put thinking the stock will go down and it instead goes up to $55 your loss is limited to the value of what you paid for the option, in this case $300. Had you shorted 100 shares of the stock at $48 instead you would lose $700 if you covered at $55.
Selling a put option is bullish but with a twist. You are betting the stock will rise or at least not fall below the strike price of the put. However your total profit is fixed. If you write a put for $40 on C you would have received $60 in profit. However if the stock rises above $48.60 you would have been better off buying the stock or a call option since your profit is limited to $0.60/share. If the stock fell to $35 you would be obligated to buy the stock for $40 regardless. You would lose money, as much as $4000 if you have to buy shares worth $0.0001 for $40.
That pretty much covers the basics however it doesn't really cover how options are actually traded. For all the talk of buying and selling shares the fact is that most options contracts are never executed. They either expire worthless or a re bought back buy those who wrote them prior to expiration.
Consider the example. If C's stock rises to $54.99 by Sept 20/2007 they are worthless. Tom keeps his profit, Fred loses his $30. That is actually unlikely to happen. It's more likely that as the option rises in value Fred will sell it long before it expires. If the price is "close to the money" Tom may opt to buy it back . At $54.99 it would be worth $0.01 on Sept 20/2007 and Tom may prefer to pay the buck to avoid having to go to market and buy the shares to give to Fred. The point is that exchange traded options are rarely executed and trade on their premium values until the writers buy them back.
If you have written in-the-money contracts or hold in-the-money contracts when they expire they will be automatically executed on Saturday following by the exchange. Exercising options in advance of expiration is even rarer. Why pony up the $ to buy the stock when you get the same profit potential for a fraction of the money.
This is by no means a working manual of how to trade options. It's just a brief introduction for those who don't know anything about them. I'll try to expand on the topic over time with more details and some trading strategies.
If you want to learn more I suggest you go to the CBOE website and look into their courses and education programs. http://www.interactivebrokers.com offer free webinars as well.
Let's start with the most basic. There are 2 kinds of options, Call options and Put options. An option is a contract. It conveys the right (but not obligation) to buy or sell a set number of units (stock options contracts are traded in 100 unit contacts) of an underlying security (we'll discuss stock options in this case but options can apply to anything) at a fixed price, strike price, on or before a specific date, expiration date.
Simply, a Call option contract allows the holder to buy 100 shares on stock at a set price. A Put option allows the holder to sell 100 shares. Options are traded person to person through an exchange. For every buyer of a call there is a seller, writer. There are no fixed number of options contacts. The number available to purchase are determined by how many contracts have been written by other traders. The total number of contracts is called the open interest and that number dynamically changes.
Time for a simple example:
Tom writes a call option on C at the $55 strike price expiring September 2007. It will look like SEP 07 $55 Call. C is currently trading at $48 and it's early August so there is a little over a month before it expires. Tom asks $0.30 for the contract.
Fred buys Tom's call option bidding $0.30. Tom pays $30 for the contract (100 shares x $0.30). Fred now has the option to buy 100 shares of C for $55 any time between now and the end of trading on the 3rd Friday of September (expiration). He paid a $0.30/share premium for the option.
Ok, that example is going to form much of the remainder of this post. First some things to note:
Fred doesn't own any shares. He only owns the option to buy some. Fred doesn't earn dividends or have any privileges associated with being a shareholder; he isn't one.
Tom may or may not own and shares of C. If he owns the shares he's offering to sell then he is writing a covered call option. If he doesn't he is writing a naked call option.
The option has no intrinsic value. They are worthless intrinsically because nobody would pay $55 for a $48 share of stock. The call option only conveys an option to buy shares. If it doesn't make sense to do so the option is considered out-of-the-money.
Had Tom written the call at the $40 strike then it would be considered in-the-money and would have an intrinsic value of $8/share.
Now, on to the important bits. Options are traded at a premium to the intrinsic value. The premium is higher based on two factors: the time left before expiration, time value and the implied volatility of the underlying stock.
The more time before expiration and the more volatile the underlying price the more likely the option will end in the money. The more likely it is that the writer will have to cough up the goods the higher the premium they get for writing the contract.
C is a particularly bad stock to trade options on because the premiums are quite small. It's not a stock which moves much so even with 5 weeks left on Fred's option there is a low likelihood the stock will rise $7 in price and hence the low premium.
Buying a call option is generally considered bullish. You expect the underlying stock price to rise and so to it the premium. It would not be ridiculous to think that you could double your money with only a $1.50 increasing the price of C.
Selling a call option is considered bearish. When you sell a call like Tom did you are saying they you don't think the stock will reach the strike price and thus expire worthless. Tom got his $30 upfront and that is all he can ever expect to make on the trade. When you write an option you get the maximum profit upfront in cash.
Buying a put option is considered bearish. When you buy a put you think the stock will go down in price increasing the premium value of the option. Traders often use puts to put a floor under their common stock positions in times of uncertainty. If you owed C at $48 and you wanted to limit the amount of money you could potentially lose if it goes down then you could buy a $50 put for about $3. That put would ensure you could sell your shares for $47 ($50-$3) even if the stock drops 90%. You can also use a put as a short position with a built in stop. For example, if you bought a $50 put thinking the stock will go down and it instead goes up to $55 your loss is limited to the value of what you paid for the option, in this case $300. Had you shorted 100 shares of the stock at $48 instead you would lose $700 if you covered at $55.
Selling a put option is bullish but with a twist. You are betting the stock will rise or at least not fall below the strike price of the put. However your total profit is fixed. If you write a put for $40 on C you would have received $60 in profit. However if the stock rises above $48.60 you would have been better off buying the stock or a call option since your profit is limited to $0.60/share. If the stock fell to $35 you would be obligated to buy the stock for $40 regardless. You would lose money, as much as $4000 if you have to buy shares worth $0.0001 for $40.
That pretty much covers the basics however it doesn't really cover how options are actually traded. For all the talk of buying and selling shares the fact is that most options contracts are never executed. They either expire worthless or a re bought back buy those who wrote them prior to expiration.
Consider the example. If C's stock rises to $54.99 by Sept 20/2007 they are worthless. Tom keeps his profit, Fred loses his $30. That is actually unlikely to happen. It's more likely that as the option rises in value Fred will sell it long before it expires. If the price is "close to the money" Tom may opt to buy it back . At $54.99 it would be worth $0.01 on Sept 20/2007 and Tom may prefer to pay the buck to avoid having to go to market and buy the shares to give to Fred. The point is that exchange traded options are rarely executed and trade on their premium values until the writers buy them back.
If you have written in-the-money contracts or hold in-the-money contracts when they expire they will be automatically executed on Saturday following by the exchange. Exercising options in advance of expiration is even rarer. Why pony up the $ to buy the stock when you get the same profit potential for a fraction of the money.
This is by no means a working manual of how to trade options. It's just a brief introduction for those who don't know anything about them. I'll try to expand on the topic over time with more details and some trading strategies.
If you want to learn more I suggest you go to the CBOE website and look into their courses and education programs. http://www.interactivebrokers.com offer free webinars as well.
08-06-2007, 10:34 PM
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One more detail: cthree described what are known as American options; these allow the option-holder to exercise his right any time up to and including the date that the options expire.
Some option contracts only allow the option-holder to exercise his right on the expiration date, not before. These are known as European options.
In general, European options are easier to analyze (i.e., price); American options are worth more to the option-holder than equivalent European options (because they give the option-holder more, well, options).
Some option contracts only allow the option-holder to exercise his right on the expiration date, not before. These are known as European options.
In general, European options are easier to analyze (i.e., price); American options are worth more to the option-holder than equivalent European options (because they give the option-holder more, well, options).
08-06-2007, 10:40 PM
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Well actually, this is true. When an option goes in the money it can be executed at any time; a pressure on the writer as they have to be prepared to cover that option any time it's in the money. With a European style option the writer never has to worry about in-the-money options being executed on them without notice.
All US traded equity options are American style.
Also I'll share some of my trades right now...
I wrote 5 AAPL SEP $125 PUTs the other day for a premium received of $4.00/ea. It was touch and go with the stock dipping to $128 today but it closed the day at $135 so I'm good.
I bought 1 WYNN AUG $105 PUT today to protect my WYNN shares from potential loss following earnings today. It's worthless now that the stock popped to $118. I gave up $3 in profits to insure I wouldn't lose any.
All US traded equity options are American style.
Also I'll share some of my trades right now...
I wrote 5 AAPL SEP $125 PUTs the other day for a premium received of $4.00/ea. It was touch and go with the stock dipping to $128 today but it closed the day at $135 so I'm good.
I bought 1 WYNN AUG $105 PUT today to protect my WYNN shares from potential loss following earnings today. It's worthless now that the stock popped to $118. I gave up $3 in profits to insure I wouldn't lose any.
08-07-2007, 09:53 AM
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it almost sounds like options are like layaway at the department store...
i say i wanna buy a stock for $x so i put a deposit (buying option call for $.30 x100 = $3). if by september 20 that stock is $x(+$) then i buy it and if it is $x(-$) then i let it expire. does that sound right?
i say i wanna buy a stock for $x so i put a deposit (buying option call for $.30 x100 = $3). if by september 20 that stock is $x(+$) then i buy it and if it is $x(-$) then i let it expire. does that sound right?
08-07-2007, 11:41 AM
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Originally Posted by meth,Aug 7 2007, 01:53 PM
it almost sounds like options are like layaway at the department store...
i say i wanna buy a stock for $x so i put a deposit (buying option call for $.30 x100 = $3). if by september 20 that stock is $x(+$) then i buy it and if it is $x(-$) then i let it expire. does that sound right?
i say i wanna buy a stock for $x so i put a deposit (buying option call for $.30 x100 = $3). if by september 20 that stock is $x(+$) then i buy it and if it is $x(-$) then i let it expire. does that sound right?
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08-07-2007, 12:18 PM
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Yes, you could say that and if you don't really "get it" then that may be what you would be tempted to do.
Let me restate what you said.
If you think a stock will go up in price to $x (I need a number so let's say $55) so you buy a call option for $0.30 (x100 = $30). If at some point between now and sept 20 the stock goes up, say to $50, the call option is re-priced to $0.60 then you sell it and make a 100% return on your investment.
Remember, options are rarely exercised by traders. You don't buy them for that. If you want to buy the stock, buy it now and get it for $0.30 cheaper.
You don't buy options to make 10%. You buy options to make 100% in a short time. You aren't trading the stock. The stock doesn't have to double for the option price to double, you just have to narrow the gap to the strike by half.
Let's look at CSCO, they report tonight so the options market is closed and I can use real prices. The stock closed at $29.80. If you think they will beat earnings then you buy call options, your choice of which one but let's pick the August $25 calls.
The august $25 costs $5.00. You buy 4 for a total of $2000. Let's say CSCO beats big and the stock jumps to $32 tomorrow morning. Your $25 calls which had an intrinsic value of $4.80 and a time premium of $0.20 and now worth on the order of $9.40 ($32-$25 intrinsically + time/volatility premium). You sell the 4 options tomorrow at 10AM @ $9.40 for a gross of $3760, a pre-tax profit of $1760 or a return of 88% in under 24 hours.
That is why people trade options!!
Now, consider what happens if CSCO misses and falls to $27. The options you paid $5 for are repriced at about $2.10. You sell having blown the trade for a gross of $840, a loss of $1160 or 68%.
Easy come, easy go. Options are risky (as illustrated) but those who trade then know how to manage and spread that risk or at least do their best.
Let me restate what you said.
If you think a stock will go up in price to $x (I need a number so let's say $55) so you buy a call option for $0.30 (x100 = $30). If at some point between now and sept 20 the stock goes up, say to $50, the call option is re-priced to $0.60 then you sell it and make a 100% return on your investment.
Remember, options are rarely exercised by traders. You don't buy them for that. If you want to buy the stock, buy it now and get it for $0.30 cheaper.
You don't buy options to make 10%. You buy options to make 100% in a short time. You aren't trading the stock. The stock doesn't have to double for the option price to double, you just have to narrow the gap to the strike by half.
Let's look at CSCO, they report tonight so the options market is closed and I can use real prices. The stock closed at $29.80. If you think they will beat earnings then you buy call options, your choice of which one but let's pick the August $25 calls.
The august $25 costs $5.00. You buy 4 for a total of $2000. Let's say CSCO beats big and the stock jumps to $32 tomorrow morning. Your $25 calls which had an intrinsic value of $4.80 and a time premium of $0.20 and now worth on the order of $9.40 ($32-$25 intrinsically + time/volatility premium). You sell the 4 options tomorrow at 10AM @ $9.40 for a gross of $3760, a pre-tax profit of $1760 or a return of 88% in under 24 hours.
That is why people trade options!!
Now, consider what happens if CSCO misses and falls to $27. The options you paid $5 for are repriced at about $2.10. You sell having blown the trade for a gross of $840, a loss of $1160 or 68%.
Easy come, easy go. Options are risky (as illustrated) but those who trade then know how to manage and spread that risk or at least do their best.
08-07-2007, 01:16 PM
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Originally Posted by cthree,Aug 7 2007, 04:18 PM
...$0.30 (x100 = $300)...
How much is .3 x 100?
Thanks for the explanation cthree.
I've never ventured into the options market and probably still won't but at least I sort of understand it now. It almost sounds like a game better suited to Las Vegas.