THE OPTIONS COURSE
The Big Picture
Options are probably the most versatile trading instrument ever invented. They provide a high-leverage approach to trading that can significantly limit the overall risk of a trade, especially when combined with stock or futures. As a result, understanding how to develop profitable strategies using options can be extremely rewarding, both personally and financially. The key is to develop an appreciation about how these investment vehicles work, what risks are involved, and the vast reward potential that can be unleashed with well-conceived and time-tested trading strategies.
First, it is important to differentiate between futures and options. A futures contract is a legally binding agreement that gives the holder the right to actually buy (and take delivery of) or sell (be obligated to deliver) a commodity or financial instrument at a specific price. In contrast, purchasing an option is the right, but not the obligation, to buy or sell a financial instrument (stock, index, futures contract, etc.) at a specific price. The key here is that buying an option is not a legally binding contract. In contrast, selling (writing or shorting) an option obligates the seller to provide (or buy) the instrument at the agreed-upon price if
asked to do so.
So, option buyers have rights and option sellers have obligations. Option buyers have the right, but not the obligation, to buy or sell a stock, index, or futures contract at a predetermined price before a predefined expiration date. In contrast, option sellers, sometimes called writers, have the obligation to buy or sell the underlying stock shares (or futures contract) if an assigned option buyer or holder exercises the option.
There are two types of options contracts: puts and calls. A put option is an options contract that gives the owner the right to sell (or put) the underlying asset at a specific price for a predetermined period of time. Call options, in contrast, give the option holder the right, but not the obligation, to buy a stock at a predetermined price for a specific period of time. Importantly, for every option buyer there is a seller.
Buyers and sellers do not deal with one another directly, but through their respective brokerage firms. If an investor sells a call and the new owner exercises the call, the call seller has the obligation to deliver the financial instrument to the option holder at the call strike price. The call seller will get notice from the broker that he or she must provide the stock or futures contract to the option holder. This is known as assignment. Once assigned, the option writer is obligated to fulfill the terms of the options contract.
A put seller, in contrast, has the obligation to accept delivery of the financial instrument from the option holder. If the put seller is assigned, the brokerage firm will notify the put seller that he or she must buy the financial instrument at the predetermined price. For now, it is important to understand that a put owner has the right to exercise the options contract and, if so, the option seller will face assignment on the option. Therefore, if you decide to write an options contract, you must be willing to face the prospect of assignment—which, as we later see, can involve significant risks.
To see how options work, let’s consider an example using a stock option. Say that you believe the price of IBM is going to rise over the next three months. But instead of buying 100 shares of IBM, you decide to buy a call option. The IBM call gives you the right, but not the obligation, to buy 100 IBM shares for a specific price until a specific point in time. For this right you pay a price: the option premium. Furthermore, you can exercise the right at any time until the option expires—that is, unless you close the position before the option expires. You can close an option position at any time through an offsetting transaction. For example, if you buy an IBM call options contract, you can close the position at any time by
selling an identical IBM call options contract.
In another example, suppose you do not own any options and you agree to sell or write a call option on IBM. Why would you do this? Well, some traders sell options in order to collect the premium and earn income. However, if the stock rises dramatically, the trader may be asked to sell IBM shares to the option holder at the call strike price, which is well below the current market price.
Options on stocks, indexes, futures, and exchange-traded funds are similar. However, each option will have a different underlying asset. It is important to understand the underlying asset, how its price changes, and how those changes impact the price of the option. Options are derivatives, which means their price changes are derived from the value of an other asset (stock, futures contract, index, etc.). The asset is known as the underlying security.
In addition to understanding the underlying asset, traders must also understand the trading terms used to describe an options contract. For example, every option has a strike price—a price at which the stock or future can be bought or sold until the option’s expiration date. Options are available in several strike prices depending on the current price of the underlying asset. As a result, the profitability of an option depends primarily on the rise or fall in the price of the underlying stock or futures contract (and its relation to the strike price of the option). An option’s premium also depends on the time left until expiration, volatility, and other factors.
Not all stocks have options available to be traded. Currently in the United States there are more than 4,000 stocks that have tradable options. This number grows daily. Each stock option represents 100 shares of a company. Therefore, if you buy one XYZ stock option, it represents 100 shares of XYZ stock. If XYZ shares are trading at $10 per share, then you are controlling $1,000 worth of stock with one option ($10 per share × 100 shares). And you may be controlling this $1,000 amount with only $250, depending on the price of the option’s premium. This would give you leverage equal to four to one—not too shabby odds.
Most futures markets have tradable options, including gold, silver, oil, wheat, corn, soybeans, orange juice, Treasury bonds, and so on. However, unlike stocks, each contract represents a unique quantity. Options on futures have the futures contract as the underlying instrument. It is the futures contract that is to be delivered in the event an option is exercised.
Each futures contract represents a standardized quantity of the commodity. As you begin to trade futures, you have to become familiar with the specifics of each futures market. (If you have any questions, you can always call your broker.) For example, a gold futures contract is equal to 100 ounces of gold. With gold trading at $410 per ounce, the futures contract is worth $41,000: (100 ounces × $410 per ounce). Each futures contract has its own unique specifications, and that can be quite confusing to a novice futures trader.
Options on Indexes and Exchange-Traded Funds
An index option is an option that represents a specific index—a group of items that collectively make up the index. We have already discussed the index markets and exchange-traded funds. Options on indexes and ETFs fluctuate with market conditions. Broad-based indexes cover a wide range of industries and companies. Narrow-based indexes cover stocks in one industry or economic sector.
Index options allow investors to trade in a specific industry group or market without having to buy all the stocks individually. The index is calculated as the average change of the stock price of each stock in the index. Each index has a specific mathematical calculation to determine the price change, up or down. An index or ETF option is an option that is tied directly to the change in the value of the index or exchange-traded fund.
Index options make up a very large segment of the options that are traded. Why are so many options traded on indexes? The explosive growth in index trading has occurred in recent years due to the increase in both the number of indexes and the number of traders who have become familiar with index trading. The philosophy of an index is that a group of stocks—a portfolio—will diversify the risk of owning just one stock. Hence, an index of stocks will better replicate what is happening in an industry or the market as a whole. This allows an investor or trader to participate in the movement of a specific industry, both to the upside and to the downside.
It appears that index and ETF options will continue to proliferate and trading volume will increase in many of the instruments. A word of caution: A number of these instruments do not have much liquidity. However, used wisely, index options can be an important instrument in your trading arsenal. Also, it is important to understand the difference between the way ETF options and index options settle. Namely, exchange-traded funds, which can be bought and sold like stocks, settle for shares. Cash indexes cannot be bought or sold. They settle for cash.
Liquidity is the ease with which a financial instrument can be traded. It can be defined as the volume of trading activity that enables a trader to buy or sell a security or derivative and receive fair value for it. A high volume of people trading a market is needed to make it rewarding. Liquidity provides the opportunity to move in and out of positions without difficulty. For example, at-the-money options often have excellent liquidity because they have a better chance of being profitable than out-of-the-money options. Therefore, they are easier to trade and many traders focus solely on the at-the-money contract.
When I first started trading, I visited the exchanges. A friend who was a floor trader walked me from one pit to another. In one pit, there were two guys sitting around reading the newspaper. Was there a lot of opportunity there? I didn’t think so. I figured when an order hits that pit, everyone probably starts laughing at the poor sucker who placed it. Then I checked out the bond pit. There were 500 people fighting for an order. I quickly recognized that the bond market had high liquidity and plenty of opportunity.
I went to the natural gas pit at the New York Mercantile Exchange. It was a madhouse. There were 200 people in a pit 10 feet wide (prior to moving to their new state-of-the-art building), yelling and screaming. I couldn’t understand a thing they were saying, but once again I recognized high liquidity. To this day, I look for pits where there are plenty of people playing the game because plenty of players equals opportunity.
How can you avoid illiquid markets? Well, since you probably don’t have the ability to actually visit an exchange, you can still check out the liquidity of a market by reviewing the market’s volume to see how many shares or contracts have been traded. Both The Wall Street Journal and Investor’s Business Daily report volume changes. It is vital for a trader to ascertain whether trading volume is high or low, increasing or decreasing. It’s hard to quantify just how much volume is enough to qualify a market as one with liquidity. However, as a rule of thumb, I prefer to look for stocks that are trading at least 300,000 shares every day.
Futures markets vary widely, and it is best to monitor activity daily and pick a market that trades many more contracts than you trade. Since there are no absolutes, there are situations when this rule can be tossed out the window in exchange for common sense. But until you have enough experience, this may be a good rule of thumb to follow. Bottom line, a plentiful number of buyers and sellers and an elevated volume of trading activity provide high liquidity, which gives traders the opportunity to move in and out of a market with ease. Illiquid markets can make the process much more difficult and more costly.
Profitable markets are those markets that provide opportunity for making good returns on investments. Obviously, some markets are more trader-friendly than others. Opportunity in a market is contingent on a number of factors. Volatility is one of the most important and misunderstood of these factors. It measures the amount by which an underlying asset is expected to fluctuate in a given period of time. In more simple terms, volatility can be thought of as the speed of the change in the market.
There are two basic kinds of volatility: implied and historical. Historical volatility, often referred to as actual or statistical volatility, is computed using past stock prices. It can be calculated by using the standard deviation of a stock’s price changes from close-to-close of trading going back a given number of days (10, 20, 90, etc.). High or low historical volatility also gives traders a clue as to the type of strategy that can best be implemented to optimize profits in a specific market.
That is, strategies that work well in volatile markets will not generate big profits in a low-volatility environment. A variety of indicators, such as Bollinger bands, can be used to create historical volatility computations. Implied volatility (IV) is another type of volatility. It is calculated by using the actual market price of an option and an option pricing model (Black-Scholes for stocks and indexes; Black for futures). If the premium of an option increases without a corresponding change in the price of the underlying asset, the option’s implied volatility will have increased also.
Overpricing and undervaluing an option’s premium can be caused by an inaccurate perception of the future movement in the price of an asset. For example, if implied volatility rises significantly for no reason (and there is no increase in historical volatility), the option may be overpriced. Traders can take advantage of changes in implied volatility by applying specific option strategies.
Proper money management and patience in options trading are the cornerstones to success. The key to this winning combination is discipline. Now, discipline is not something that we apply only during the hours of trading, opening it up like bottled water at the opening bell and storing it away at the closing. Discipline is a way of life, a method of thinking. It is, most of all, an approach. If you have a consistent and methodical system, discipline leads to profits in trading.
On the one hand, it means taking a quick, predefined loss because it is often better to exit a losing position rather than letting the losses pile up. On the other hand, discipline is holding your options position if you are winning, and not adjusting an options position when it is working in your favor. It also entails doing a significant amount of preparatory work before market hours. This includes getting ready and situated before initiating a trade so that, in a focused state, you can monitor market events as they unfold.
Discipline can sometimes have a negative sound, but the way to freedom and prosperity is an organized, focused, and responsive process of trading. With that, and an arsenal of low-risk/high-profit options strategies, profits can indeed flow profusely. The consistent disciplined application of these strategies is essential to our success as professional traders. Plan your trade and trade your plan.
Finally, as option traders, in order to improve in the discipline arena we must identify and either change or rid ourselves of anything in our mental environment that doesn’t contribute to the strictest execution of our well-planned trading approach. We have to stay focused on what we need to learn and do the work that is necessary. Your belief in what is possible will continue to evolve as a function of your propensity to adapt.
Almost every successful trader I know has an area of expertise. For some, it is trading futures. Others like trading commodities. Some traders specialize in trading the Nasdaq 100 QQQs. My experience is mostly related to stock options. Initially, traders tend to explore a large number of different vehicles and then narrow down their focus to a specific instrument and a small number of winning strategies.
Hopefully, this chapter has provided you with a better idea of what financial instruments are available for trading today and how they differ from one another. We discussed a number of different underlying assets including stocks, futures, exchange-traded funds, indexes, and options. All can be used in creating and implementing options trading strategies.
At this point, the readers should also understand that a futures contract is significantly different from an options contract. While both represent agreements between two parties, the contracts are structured in ways that are considerably different from one another. From here, we focus more on options and, discuss specific trading strategies that work in a variety of different market scenarios.