THE OPTIONS COURSE- Option Basics

THE OPTIONS COURSE


Option Basics


MECHANICS OF PUTS AND CALLS

As we have duly noted, there are two types of options: calls and puts. These two types of options can make up the basis for an infinite number of trading scenarios. Successful options traders effectively use both kinds of options in the same trade to hedge their investment, creating a limited risk trading strategy. But, before getting into a discussion of more complex strategies that use both puts and calls, let’s examine each separately to see how they behave in the real world.

Call Options

Call options give the buyer the right, but not the obligation, to purchase the underlying asset. A call option increases in value when the underlying asset rises in price, and loses value when the underlying falls in price. Thus, the purchase of a call option is a bullish strategy; that is, it makes a profit as the stock moves higher. In order to familiarize you with the basics of call options, let’s explore an example from outside the stock market. A local newspaper advertises a sale on DVD players for only $49.95. Knowing a terrific deal when you see one, you cut out the ad and head on down to the store to purchase one. 

Unfortunately, when you arrive you find out all of the advertised DVD players have already been sold. The manager apologizes and says that she expects to receive another shipment within the week. She gives you a rain check entitling you to buy a DVD player for the advertised discounted price of $49.95 for up to one month from the present day. You have just received a call option. You have been given the right, not the obligation, to purchase the DVD player at the guaranteed strike price of $49.95 until the expiration date one month away.

Later that week, the store receives another shipment and offers the DVD players for $59.95. You return to the store and exercise your call option to buy one for $49.95, saving $10. Your call option was in-the-money. But what if you returned to find the DVD players on sale for $39.95? The call option gives you the right to purchase one for $49.95—but you are under no obligation to buy it at that price. You can simply tear up the rain check coupon and buy the DVD player at the lower market price of $39.95. In this case, your call option was out-of-the-money and expired worthless.

Let’s take a look at another scenario. A coworker says her DVD player just broke and she wants to buy another one. You mention your rain check. She asks if you will sell it to her so she can purchase the DVD player at the reduced price. You agree to this, but how do you go about calculating the fair value of your rain check? After all, the store might sell the new shipment of DVD players for less than your guaranteed price. 

Then the rain check would be worthless. You decide to do a little investigation on the store’s pricing policies. You subsequently determine that half the time, discounted prices are initially low and then slowly climb over the next two months until the store starts over again with a new sale item. The other half of the time, discounted prices are just a one-time thing. You average all this out and decide to sell your rain check for $5. This price is the theoretical value of the rain check based on previous pricing patterns. It is as close as you can come to determining the call option’s fair price. This simplification demonstrates the basic nature of a call option. 

All call options give you the right to buy something at a specific price for a fixed amount of time. The price of the call option is based on previous price patterns that only approximate the fair value of the option. If you buy call options, you are “going long the market.” That means that you intend to profit from a rise in the market price of the underlying instrument. If bullish (you believe the market will rise), then you want to buy calls. If bearish (you believe the market will drop), then you can “go short the market” by selling calls.  If you buy a call option, your risk is the money paid for the option (the premium) and brokerage commissions. 

Call Option Moneyness:


If you sell a call option, your risk is unlimited because, theoretically, there is no ceiling to how high the stock price can climb. If the stock rises sharply, and you are assigned on your short call, you will be forced to buy the stock in the market at a very high price and sell it to the call owner at the much lower strike price. We will discuss the risks and rewards of this strategy in more detail later. For now, it is simply important to understand that a call option is in-the-money (ITM) when the price of the underlying instrument is higher than the option’s strike price. For example, a call option that gives the buyer the right to purchase 100 shares of IBM for $80 each is ITM when the current price of IBM is greater than $80. 

At that point, exercising the call option allows the trader to buy shares of IBM for less than the current market price. A call option is at-the-money (ATM) when the price of the underlying security is equal to its strike price. For example, an IBM call option with a strike price of $80 is ATM when IBM can be purchased for $80. A call option is out-of-the-money (OTM) when the underlying security’s market price is less than the strike price. For example, an IBM call option with an $80 strike price is OTM when the current price of IBM in the market is less than $80. No one would want to exercise an option to buy IBM at $80 if it can be directly purchased in the market for less. That’s why call options that are out-of-the-money by their expiration date expire worthless.

                                                                  Price of IBM = 80

                Strike Price                               Call Option                         Option Premium
                      100                                                   OTM                                                    .50
                        95                                                   OTM                                                   1.00
                        90                                                   OTM                                                  2.25
                        85                                                   OTM                                                  4.75
                        80                                                   ATM                                                  6.50
                        75                                                     ITM                                                10.00
                        70                                                    ITM                                                 13.75
                        65                                                    ITM                                                 17.50
                        60                                                    ITM                                                20.75

Purchasing a call option is probably the simplest form of options trading. A trader who purchases a call is bullish, expecting the underlying as-set to increase in price. The trader will most likely make a profit if the price of the underlying asset increases fast enough to overcome the option’s time decay. Profits can be realized in one of two ways if the underlying asset increases in price before the option expires. The holder can either purchase the underlying shares for the lower strike price or, since the value of the option has increased, sell (to close) the option at a profit. 

Hence, purchasing a call option has a limited risk because the most you stand to lose is the premium paid for the option plus commissions paid to the broker. Let’s review the basic fundamental structure of buying a standard call on shares using IBM. If you buy a call option for 100 shares of IBM, you get the right, but not the obligation, to buy 100 shares at a certain price. The certain price is called the strike price. Your right is good for a certain amount of time. You lose your right to buy the shares at the strike price on the expiration date of the call option.

Generally, calls are available at several strike prices, which usually come in increments of five. In addition, there normally is a choice of several different expiration dates for each strike price. Just pick up the financial pages of a good newspaper and find the options for IBM. Looking at this example, you will see the strike prices, expiration months, and the closing call option prices of the underlying shares, IBM.

                                                           Price of IBM = 80

             Strike Price                   January                       April                        July
                     75                                       6.40                              7.50                          8.30
                     80                                      2.00                              3.90                          4.80
                     85                                         .40                              1.60                          2.80

The numbers in the first column are the strike prices of the IBM calls. The months across the top are the expiration months. The numbers inside the table are the option premiums. For example, the premium of an IBM January 75 call is 6.40. Each $1 in premium is equal to $100 per contract (i.e., the multiplier is equal to 100) because each option contract controls 100 shares. Looking at the IBM January 75 call option, a premium of 6.40 indicates that one contract trades for $640: (6.40 × $100 = $640).

The table also shows that the January 80 calls are priced at a premium of $2. Since a call option controls 100 shares, you would have to pay $200 plus brokerage commissions to buy one IBM January 80 call: (2 × $100 = $200). A July 75 call trading at 8.30 would cost $830: (8.30 × $100) plus commissions:

  • Cost of January IBM 80 call = 2 × $100 = $200 + commissions.
  • Cost of July IBM 75 call = 8.30 × $100 = $830 + commissions.

All the options of one type (put or call) that have the same underlying security are called a class of options. For example, all the calls on IBM constitute an option class. All the options that are in one class and have the same strike price and expiration are called a series of options. For example, all of the IBM 80 calls with the same expiration date constitute an option series.

Put Options

Put options give the buyer the right, but not the obligation, to sell the underlying stock, index, or futures contract. A put option increases in value when the underlying asset falls in price and loses value when the underlying asset rises in price. Thus, the purchase of a put option is a bearish strategy. That is, the put option increases in value when the price of an underlying asset falls. Let’s review the following analogy to become more familiar with the basics of put options.

You’ve decided to set up a small cottage industry manufacturing ski jackets. Your first product is a long-sleeved jacket complete with embroidered logos of the respective ski resorts placing the orders. The manager of the pro shop at a local ski resort agrees to purchase 1,000 jackets for $40 each, if you can deliver them by November. In effect, you’ve been given a put option. The cost of producing each jacket is $25, which gives you a $15 profit on each item. You have therefore locked in a guaranteed profit of $15,000 for your initial period of operation.

This guaranteed order from the resort is an in-the-money put option. You have the right to sell a specific number of jackets at a fixed price (strike price) by a certain time (expiration date). Just as November rolls around, you find out that a large manufacturer is creating very similar products for ski resorts for $30 each. If you didn’t have a put option agreement, you would have to drop your price to meet the competition’s price, and thereby lose a significant amount of profit. Luckily, you exercise your right to sell your jackets for $40 each and enjoy a prosperous Christmas season. Your competitor made it advantageous for you to sell your jackets for $40 using the put option because it was in-the-money.

In a different scenario, you get a call from another ski resort that has just been featured in a major magazine. The resort needs 1,000 jackets by the beginning of November to fulfill obligations to its marketing team and is willing to pay you $50 per jacket. Even though it goes against your grain to disappoint your first customer, the new market price of your product is $10 higher than your put option price. Since the put option does not obligate you to sell the jackets for $40, you elect to sell them for the higher market price to garner an even bigger profit.

These examples demonstrate the basic nature of a put option. Put options give you the right, but not the obligation, to sell something at a specific price for a fixed amount of time. Put options give the buyer of puts the right to “go short the market” (sell shares). If bearish (you believe the market will drop), then you could go short the market by buying puts. If you buy a put option, your maximum risk is the money paid for the option (the premium) and brokerage commissions.

Theoretically, if bullish (you believe the market will rise), then you could “go long the market” by selling puts—but make no mistake, this comes with high risk! If you sell a put option, your risk is unlimited until the underlying asset reaches zero because, if the stock falls precipitously and the short option is assigned, you will be forced to buy the stock at the previously higher strike price. You can then either hold it or sell it back into the market at a significantly lower price.

Put Option Moneyness:


A put option is in-the-money (ITM) when the price of the underlying instrument is lower than the option’s strike price. For example, a put option that gives the buyer of the put the right to sell 100 shares of IBM for $80 each is in-the-money when the current price of IBM is less than $80, because the option can be used to sell the shares for more than the current market price. A put option is at-the-money (ATM) when the price of the underlying shares is equal to its strike price. 

For example, an IBM put option with a strike price of $80 is at-the-money when IBM can be purchased for $80. A put option is out-of-the-money (OTM) when the underlying security’s market value is greater than the strike price. For example, an IBM put option with an $80 strike price is out-of-the-money when the current price of IBM is more than $80. No one would want to exercise an option to sell IBM at $80 if it can be sold directly for more. That’s why put options that are out-of-the-money by their expiration date expire worthless.

                                                              Price of IBM = 80

                   Strike Price                         Put Option                      Option Premium
                          100                                             ITM                                           20.80
                            95                                             ITM                                            17.50
                            90                                             ITM                                            13.80
                            85                                             ITM                                            10.00
                            80                                            ATM                                             6.50
                            75                                             OTM                                            4.75
                            70                                             OTM                                            2.30
                            65                                             OTM                                            1.00
                            60                                             OTM                                              .50

Purchasing put options is generally a bearish move. A holder who has purchased a put option benefits when there is a decrease in the price of the underlying asset. This enables the holder to buy the underlying asset at a lower price on the open market and sell it back at a higher price to the writer of the put option. A decrease in the underlying asset’s price also promotes an increase in the value of the put option so that it can be sold for a higher price than was originally paid for it. The purchase of a put option provides unlimited profit potential (to the point where the underlying asset reaches zero). The maximum risk of the put option is limited to the put premium plus commissions to the broker placing the trade.

LEAPS

The acronym LEAPS stands for long-term equity anticipation securities. While the name seems somewhat arcane, LEAPS are nothing more than long-term options. Some investors incorrectly view these long-term options as a separate asset class. But in fact, the only real difference between LEAPS and conventional stock options is the time left until expiration. That is, while short-term options expire within a maximum of eight months, LEAPS can have terms lasting more than two and a half years. At the same time, however, while the only real distinction between conventional options and LEAPS is the time left until expiration, there are important differences to consider when implementing trading strategies with long-term equity anticipation securities. One of the most important factors is the impact of time decay.

The Chicago Board Options Exchange (CBOE) first listed LEAPS in 1990. The goal was to provide those investors who have longer-term time horizons with opportunities to trade options. Prior to that, only short-term options with a maximum expiration of eight months were available. The exchange labeled the new securities as long-term equity anticipation securities in order to differentiate between the new contracts and already existing short-term contracts. According to the exchange, “the name is not important. It is the flexibility that long-term options can add to a portfolio that is important.”

In order to add flexibility to your portfolio using LEAPS, there are a number of important factors to consider. First, like conventional options, these options represent the right to buy (for calls) or sell (for puts) an underlying asset for a specific price (the strike price) until expiration. Each option contract represents the right to buy or sell 100 shares of stock. All LEAPS have January expirations, and new years are added as time passes. For example, the year 2007 LEAPS were created after the expiration of the May 2004 contract. Approximately one-third of the stocks that already had LEAPS were issued the 2007 LEAPS after the May expiration. The remaining two-thirds will be listed when June and July option contracts expire.

Not all stocks, however, will be assigned long-term options. In order to have long-term options, the stock must already have listed short-term options. In addition, according to the CBOE, long-term options are listed only on large, well-capitalized companies with significant trading volume in both their stock and their short-term options. In order to find out if a given stock has LEAPS, simply pull up an option chain see if the stock has options expiring in January 2006 or January 2007. If so, the stock does indeed have long-term options available. When long-term options become short-term options, they are subject to a process known as melding. During that time, the terms of the option contract (the strike price, the unit of trade, expiration date, etc.) do not change. 

The symbol assigned to the contract is the only thing that changes during the melding phase. The exchanges generally assign different trading symbols to long-term options to distinguish between the LEAPS and the short-term contracts. Therefore, for bookkeeping purposes, the long-term option is converted to a short-term option and the symbol changes from the LEAPS symbol to the symbol assigned to the conventional options. This melding process occurs after either the May, June, or July expiration that precedes the first LEAPS expiration. After that, the LEAPS status and special symbol are removed and the options begin trading like regular short-term options. In sum, the terms of the options contract such as the unit of trading, strike price, and expiration date do not change when LEAPS become short-term contracts. 

Therefore, neither will the option’s price. It is merely a cosmetic change. In trading, LEAPS can provide several advantages over short-term options. For example, when protecting a stock holding through the use of puts, the investor can purchase the options and not worry about adjusting the position for up to two and a half years—which means less in commissions. At the same time, bullish trades such as long calls and bull call spreads can be established using out-of-the-money LEAPS. Doing so can provide the investor a long-term operating framework similar to the traditional buy-and-hold stock investor, but without committing as much trading capital to the investment.

Another difference between long-term and short-term options will be the impact of time decay, which refers to the fact that options lose value as time passes and as expiration approaches. The process is not linear, however. Instead, time decay becomes greater as the option’s expiration approaches. Therefore, all else being equal, an option with two years until expiration will experience a slower rate of decay than an option with two months until expiration. As a result, LEAPS can offer better risk/reward ratios when implementing strategies that require holding long-term options, such as calendar spreads or debit spreads, but not strategies that attempt to benefit from the impact of time decay—like the covered call.

I love LEAPS! Remember that these options are nothing more than stock or index options with very distant expiration dates. These long-term options are available on the most actively traded contracts like Microsoft, General Electric, and IBM. They allow traders more time for trades to work in their favor and have become among my favorite ways to play the long-term trends in the stock market. Bottom line: Don’t overlook the power of LEAPS.

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