USING LISTED OPTIONS IN YOUR TRADING
USING LISTED OPTIONS IN YOUR TRADING
Introduction
In today's ever changing markets, one wants to ensure that his investments will perform no matter what scenario the markets may bring. When trading only stocks or futures, this can sometimes be a difficult task to accomplish. However, option trading offers many solutions to such problems. Options are financial instruments that can provide the investor or trader with tremendous profit potential, limited risk, and the flexibility needed to take advantage of almost any investment situation one might encounter. Whether the market outlook is bullish, bearish, choppy, or quiet, option trading can significantly increase one's profitable trading opportunities.
- The listing of options on an exchange standardized striking prices and expiration dates - and that standardization cleared the way for the growth that has followed.
Option Basics: Terms and Definitions
UNDERLYING INSTRUMENTS
Before even getting into what an option is, we should have some idea of the kinds of things that have options. The simplest underlying instrument is common stock. Options that give the investor the right to buy or sell common stock are called stock options or equity options. Exchange traded funds (ETF's) also fall into this category.
Another very popular type of underlying instrument is an index. The best known indices are the Dow?Jones Industrial Average and the S&P 500 Index, but there are indices of many other groups of stocks. Options on these indices are called index options.
Finally, the third broad category of underlying instrument is futures. Some people mistakenly think options and futures are nearly the same thing. Nothing could be further from the truth. In reality, owning a futures contract is very much like owning stock with an expiration date. Thus, futures contracts can climb in price infinitely, just as stocks can, and they could theoretically trade all the way down to zero, just as stocks can. Options, however, have striking prices and buyers have predefined, fixed risk. As might be suspected, options on futures contracts are called futures options.
OPTION TERMS
An option is the right to buy or sell a particular underlying security at a specific price, and that right is only good for a certain period of time. The specific items in that definition of an option are as follows:
Type. Type describes whether we are talking about a call option or a put option. A call options gives its owner the right to buy the underlying, while a put option gives him the right to sell it. While it is possible to use options in many ways, if we are merely talking about buying options, then a call option purchase is bullish-we want the underlying to increase in price-and a put option purchase is bearish-we want the underlying to decline.
Underlying Security. Underlying security is what specifically can be bought or sold by the option holder. In the case of stock options, it's the actual stock that can be bought or sold (IBM, for example). The typical stock or index option is for 100 shares of the underlying. For futures, the option is usually for one futures contract.
Strike Price. The strike price is the price at which the underlying security can be bought (call option) or sold (put option).
Expiration Date. The expiration date is the date by which the option must either be liquidated (i.e., sold in the open market) or exercised (converted into the physical instrument that underlies the option contract?stock, index, or futures). Expiration dates were standardized with the listing of options on exchanges. For stock options and most index options, this date is the Saturday following the third Friday of the expiration month (which by default, makes the third Friday of the month the last trading day). However, for futures options, these dates vary widely.
These four terms combine to uniquely describe any option contract. It is common to describe the option by stating the terms in this order: underlying, expiration date, strike, and type. For example, an option described as an IBM July 120 call completely describes the fact that this option gives you the right to buy IBM at a price of 120, up until the expiration date in July. Similarly, a futures option described as the Dec US Bond 98 put gives you the right to sell the underlying 30?year U.S. Government Bond futures contract at a price of 98, up until the expiration of the December options.
THE COST OF AN OPTION
The cost of an option is, of course, called the price, but it is also referred to as the premium. If someone tells you that the XYZ July 50 call is trading at 3 (and we know that the option is for 100 shares of XYZ), then the actual cost of the option is $300. Thus, one option trading at 3 costs $300 and "controls" 100 shares of XYZ until the expiration date.
The cost-in U.S. dollars-of any particular futures option depends, of course, on how much of the commodity the futures control. We have already said that a futures option "controls" one futures contract. But each futures contract is somewhat different. For example, soybean futures and options are worth $50 per point. So if someone says that a July Soybean 600 put is selling for12, then it would cost $600 (12x $50) to buy that option. However, S&P 500 futures and options are worth $250 per point, so if a Dec S&P 1500 call is selling for 7, then you have to pay $1, 750 (7 x $250) to buy it.
IN-THE-MONEY, OUT-OF-THE-MONEY
An option is said to have intrinsic value when the stock price is above the strike price of a call or below the strike price of a put. Another term that describes the situation where an option has intrinsic value is to say that the option is in?the?money. If the option has no intrinsic value, it is said to be out?of?the?money. For calls, this would mean that the underlying's price is currently below the striking price of the call, and for puts it would mean that the underlying's price is above the strike price of the put.
Another related definition that is important is that of parity. Any derivative security that is trading with no time value premium is said to be trading at parity. Sometimes parity is used as a sort of measuring stick. One may say that an option is trading at 20 cents or 50 cents above parity.
Example: XYZ is 53.
- July 40 call: l2.80 20 cents below parity
July 45 call: 8 Exactly at parity
- July 50 call: 3.25 25 cents above parity
The price of an option is composed of two parts - intrinsic value (if there is any) and what is called "time value" - which pertains to the rest of the option price. These examples illustrate the concept:
Suppose that XYZ is trading at 42:
Option Option Intrinsic Time
Terms Price Value Value
- July 40 call 3.50 2.00 1.50
- July 45 call 1.00 0.00 1.00
EXERCISE AND ASSIGNMENT
Ultimately, one of two things happens to an option as it reaches expiration: it is exercised or it expires worthless. The owner of an out?of?the?money option will let it expire worthless. This is any call where the stock, index, or futures price is below the strike price at expiration. In the same manner, he will let a put expire worthless if the underlying price is higher than the strike price at expiration. For example, if one owned the IBM July 120 call and IBM was trading at 115 at expiration, why would you want to exercise your call to buy 100 shares of IBM at 120 when you can just go to the stock market and buy 100 shares of IBM for 115? You wouldn't, of course.
If the option is in?the?money at expiration - that is, the price of the underlying is higher than the strike price of a call - then the owner of the call will exercise it at expiration because it has value. If you own the IBM July 110 call and IBM is selling at 115 at expiration, then you would exercise the call because you can buy IBM at 110 via your call exercise, whereas you would have to pay 115 to buy IBM in the open market. Conversely a put holder would exercise his put if it is in?the?money, that is, if the underlying's current price were below the strike price, because the put gives him the right to sell at the higher price, the strike.
Note that during the life of an option (that is, prior to expiration), it is highly unlikely that an option will be exercised, even if it is in?the?money, because - in doing so - the owner of the option would be throwing away any excess value (time value premium) in the option.. Only options that lose all of their time value premium are subject to early exercise.
INFLUENCES ON AN OPTION'S PRICE
There are six factors that influence the price of an option. These are not necessarily listed in the order of importance.
1. Price of the underlying instrument.
2. Striking price of the option.
3. Amount of time remaining until expiration.
4. Volatility of the underlying instrument.
5. Short?term interest rates, generally defined as the 90?day T?bill rate.
6. Dividends (if applicable).
Each of these six factors has an influence on the price of an option. In fact, each has a direct effect, causing the option to become more or less expensive as the factor itself increases. An easy one to discern is that the more time remaining until expiration, the more expensive the options will be. Conversely, as time decreases, so do option prices. Thus, option prices are directly related to the time remaining, as one factor. Interest rates also work in a more complicated manner, although that is not quite as obvious.
Sometimes the factors affect calls differently than puts. For example, as the underlying's price increases, calls get more expensive while puts get cheaper. Dividends, also, have opposite effects on puts and calls. If a company increases its dividend, calls will be cheaper and puts will get more expensive. This is because the listed options do not have any right to the dividend. The options' prices merely reflect what the stock price will do, and if the dividend is increased, it will drop farther when it goes ex?dividend; thus, puts increase in value to account for the expected ex?dividend drop in stock price, and calls get cheaper.
Volatility
Volatility is a measure of how fast the underlying changes in price. If the underlying stock or future has the potential to change in price by a great deal in a short amount of time, then we say that the underlying is volatile. For example, over?the?counter biotech stocks are volatile stocks; orange juice futures in winter or soybean futures in summer are volatile as well.
There are two types of volatility that are pertinent to the discussion of option pricing. One is historical volatility, which is a statistical measure of how fast the underlying security has been changing in price. Historical volatility is quantifiable, that is, it's calculated by a standard formula, although some mathematicians disagree as to the best exact formula for calculating historical volatility. The other type of volatility is implied volatility. This is the volatility that is "implied" for future time periods, and the things that are doing the implying are the listed options.
Implied volatility is perhaps the most important factor influencing the price of an option. In fact, the term "time value premium" is a misnomer, for often the major factor in determining how much an option trades above its intrinsic value is implied volatility.
You might think that it should be a fairly easy matter to determine the "fair" value of an option, given that the price is only dependent on the six factors listed earlier. Five of the six factors are known for certain at any one time. We certainly know the price of the underlying, and of course we know what the strike price is. We also know how much time is left until expiration of the option. Moreover, it is a simple matter to find out where short?term interest rates are. And, if there are any dividends, it is an easy task to find the amount and timing of the dividend. The one factor that we can't quantify with any certainty is volatility, especially the volatility in future time periods. This, then, is the "rub" in determining the fair or theoretical value of an option. If we don't know how volatile the underlying security is going to be-that is, we don't know how much the underlying is going to change in price and how fast it's going to do it-then how can we possibly decide how much to pay for the option? The answer to this question is not simple, for forecasting volatility is difficult - as we saw in the financial meltdown of 2008.
To read the rest of this article, refer to the chapter by Lawrence G McMillian in the free e-book Slipstream Wealth. Read the full chapter at http://www.slipstreamwealth.com
Lawrence G. McMillan
known as the author of Options As a Strategic Investment, the best-selling work on stock and index options strategies, which has sold over 200, 000 copies. An active trader of his own account, he also manages option-oriented accounts for certain individuals. Read his full article at http://www.slipstreamwealth.com
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