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I returned to the futures market with a more disciplined approach that included trading optionsOption Basics After I was introduced to the futures market I saw how, with a small amount of capital, I could increase my leverage and control much more of a particular commodity using less money. What I did not fully understand was the potential risk. Shortly into my futures trading career, it became evident to me exactly what could happen to an account when one was on the wrong side of the futures market. This resulted in a temporary setback referred to by many in the business as a margin call, which requires a trader to provide additional money to the broker as a guarantee to stay in the trade. Later that year, I returned to the futures market with a more disciplined approach that included trading options. As a trader, I find options to be the most effective way to maintain consistent trading profits. They have become vitally important tools in my trading toolbox. However, like any tool, they are most effective when used properly and dangerous if not respected. Theres an adage among savvy traders that says, Options dont lose money; people do. Most of my favorite trading strategies use put and call options to act as insurance policies in a wide variety of trading scenarios. You probably have insurance on your car or house because it is the responsible and safe thing to do. Options provide the same kind of safety net for your trades. They also allow you to control more shares of a certain stock without tying up a large amount of capital in your account. In order to grasp the complex nature of trading options, it is important to build a solid foundation in option basics. In Chapter 2, we started building that foundation with a brief introduction to various financial markets and trading instruments. Now lets continue our discussion, but narrow our focus to the fascinating world of options. WHAT IS AN OPTION? Outside in the world beyond finance, an option is merely a choice. There is an infinite number of examples of options. Perhaps you are looking for a house to rent, but you are also interested in buying a house in the future. Lets say I have a house for rent and would be willing to sell the house. A 12-month lease agreement with an option to buy the house at $100,000 is written. As the seller, I may charge you $1,000 extra just for that 12-month option to buy the house. You now have 12 months in which to decide whether to buy the house for the agreed price. You have purchased a call option, which gives you the right to buy the house for $100,000, although you are in no way obligated to do so. A variety of factors may help you decide whether to buy the house, including appreciation of the property, transportation, climate, local schools, and the cost of repairs and general upkeep. Housing prices may rise or fall during the lease period, which could also be a determining factor in your decision. Once the lease is up, you lose the option to buy the house at the agreed price. If you decide to buy the house, you are exercising your right granted by the terms of our contract. Thats basically how a call option works. So, in the options market, a call gives the owner the right to buy a stock (or index, futures contract, index, etc.) at a predetermined price for a specific period of time. The call owner could elect not to exercise the right and could let the option expire worthless. He or she might also sell the call at a later point in time and close the position. Regardless of what the owner decides to do, the call option represents an option to its owner. Throughout the rest of this book, out discussion of options deals with the types of contracts that are traded on the organized options exchanges. Each day, millions of these contracts are bought and sold. Each contract can in turn be described using four factors: 1. The name of the underlying stock (or future, index, exchange-traded fund, etc.). 2. The expiration date. 3. The strike price. 4. Whether it is a put or call. Therefore, when discussing an option, the contract can be described using the four variables alone. For example, IBM June 50 Call describes the call option on shares of International Business Machines (IBM) that expires in June and has a strike price of 50. The QQQ October 30 Put is the put option contract on the Nasdaq 100 QQQ that expires in October and has a strike price of 30. DETERMINANTS OF OPTION PRICES Options are sometimes called wasting assets because they lose value as time passes. This makes sense because, all else being equal, an option to buy or sell a stock that is valid for the next six months would be worth more than the same option that has only one month left until expiration. You have the right to exercise that option for five months longer! However, time is not the most important factor that will determine the value of an options contract. The price of the underlying security is the most important factor in determining the value of an option. This is often the first thing new options traders learn. For example, they might buy calls on XYZ stock because they expect XYZ to move higher. In order to really understand how option prices work, however, it is important to understand that the value of a contract will be determined largely by the relationship between its strike price and the price of the underlying asset. It is the difference between the strike price and the price of the underlying asset that plays the most important role in determining the value of an option. This relationship is known as moneyness. The terms in-the-money (ITM), at-the-money (ATM), and out-of-the money (OTM) are used with reference to an options moneyness. A call option is in-the-money if the strike price of the option is below where the underlying security is trading and out-of-the-money if the strike price is above the price of the underlying security. A put option is in-the-money if the strike price is greater than the price of the underlying security and out-of-the-money if the strike price is below the price of the underlying security. A call or put option is at-the-money or near-the-money if the strike price is the same as or close to the price of the underlying security. As noted earlier, the amount of time left until an option expires will also have an important influence on the value of an option. All else being equal, the more time left until an option expires, the greater the worth. As time passes, the value of an option will diminish. The phenomenon is known as time decay, and that is why options are often called wasting assets. It is important to understand the impact of time decay on a position. In fact, time is the second most important factor in determining an options value. The dividend is also one of the determinants of a stock options price. (Obviously, if the stock pays no dividend, or if we are dealing with a futures contract or index, the question of a dividend makes no difference.) A dividend will lower the value of a call option. In addition, the larger the dividend, the lower the price of the corresponding call options. Therefore, stocks with high dividends will have low call option premiums. Changes in interest rates can also have an impact on option prices throughout the entire market. Higher interest rates lead to somewhat higher option prices, and lower interest rates result in lower option premiums. The extent of the impact of interest rates on the value of an option is subject to debate; but it is considered one of the determinants throughout most of the options-trading community. The volatility of the underlying asset will have considerable influence on the price of an option. All else being equal, the greater an underlying assets volatility, the higher the option premium. To understand why, consider buying a call option on XYZ with a strike price of 50 and expiration in July (the XYZ July 50 call) during the month of January. If the stock has been trading between $40 and $45 for the past six years, the odds of its price rising above $50 by July are relatively slim. As a result, the XYZ July 50 call option will not carry much value because the odds of the stock moving up to $50 are statistically small. Suppose, though, the stock has been trading between $40 and $80 during the past six months and sometimes jumps $15 in a single day. In that case, XYZ has exhibited relatively high volatility and, therefore, the stock has a better chance of rising above $50 by July. The call option, or the right to buy the stock at $50 a share, will have better odds of being in-the-money at expiration and, as a result, will command a higher price since the stock has been exhibiting higher levels of volatility. Understanding the Option Premium New option traders are often confused about what an options premium is and what it represents. Lets delve into the total concept of options premium and hopefully demystify it once and for all. The meaning of the word premium takes on its own distinction within the options world. It represents an options price, and is comparable to an insurance premium. If you are buying a put or a call option, you are paying the option writer a price for this privilege. This best explains why so often the terms price and premium are used interchangeably. One of the most common analogies made for options is that they act like insurance policies, particularly the premium concept. For example, as a writer of an option, you are offering a price guarantee to the option buyer. Further, the writer plays the role of the insurer, assuming the risk of a stock price move that would trigger a claim. And just like an insurance underwriter, the option writer charges a premium that is nonrefundable, whether the contract is ever exercised. From the moment an option is first opened, its premium is set by competing bids and offers in the open market. The price remains exposed to fluctuations according to market supply and demand until the option stops trading. Stock market investors are well aware that influences that cannot be quantified or predicted may have a major impact on the market price of an asset. These influences can come from a variety of areas such as market psychology, breaking news events, and/or heightened interest in a particular industry. And these are just three illustrations where unexpected shifts in market valuations sometimes occur. Although market forces set option prices, it does not follow that premiums are completely random or arbitrary. An option pricing model applies a mathematical formula to calculate an options theoretical value based on a range of real-life variables. Many trading professionals and options strategists rely on such models as an essential guide to valuing their positions and managing risk. However, if no pricing model can reliably predict how option prices will behave, why should an individual investor care about the principles of theoretical option pricing? The primary reason is that understanding the key price influences is the simplest method to establish realistic expectations for how an option position is likely to behave under a variety of conditions. These models can serve as tools for interpreting market prices. They may explain price relationships between options, raise suspicions about suspect prices, and indicate the markets current outlook for this security. Floor traders often use the models as a decision-making guide, and their valuations play a role in the market prices you observe as an investor. Investors who are serious about achieving long-term success with options find it instrumental to understand the impact of the six principal variables in the theoretical establishment of an options premium: 1. Price of underlying security. 2. Moneyness. 3. Time to expiration. 4. Dividend. 5. Change in interest rates. 6. Volatility. |
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