| Home | My photos | Forex | My trading | Contacts |
|
|
You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
|
It is one that is so important to the options trader that it requires a thorough understandingUNDERSTANDING OPTION EXPIRATION Although expiration is a relatively straightforward concept, it is one that is so important to the options trader that it requires a thorough understanding. Each option contract has a specific expiration date. After that, the contract ceases to exist. In other words, the option holder no longer has any rights, the seller has no obligations, and the contract has no value. Therefore, to the options trader, it is an extremely important date to understand and remember. Have you ever heard someone say that 90 percent of all options expire worthless? While the percentage is open to debate (the Chicago Board Options Exchange says the figure is closer to 30 percent), the fact is that options do expire. They have a fixed life, which eventually runs out. To understand why, recall what an options contract is: an agreement between a buyer and a seller. Among other things, the two parties agree on a duration for the contract. The duration of the options contract is based on the expiration date. Once the expiration date has passed, the contract no longer exists. It is worthless. The concept is similar to a prospective buyer placing a deposit on a home. In that case, the deposit gives the individual the right to purchase the home. The seller, however, will not want to grant that right forever. For that reason, the deposit gives the owner the right to buy the home, but only for a predetermined period of time. After that time has elapsed, the agreement is void; the seller keeps the deposit, and can then attempt to sell the house to another prospective buyer. While an options contract is an agreement, the two parties involved do not negotiate the expiration dates between themselves. Instead, option contracts are standardized contracts and each option is assigned an expiration cycle. Every option contract, other than long-term equity anticipation securities (LEAPS), is assigned to one of three quarterly cycles: the January cycle, the February cycle, or the March cycle. For example, an option on the January cycle can have options with expiration months of January, April, July, and October. The February cycle includes February, May, August, and November. The March cycle includes March, June, September, and December. In general, at any point in time, a stock option will have contracts with four expiration dates, which include the two near-term months and two further-term months. Therefore, in early January 2005 a contract on XYZ will have options available on the months January, February, April, July and October. Index options often have the first three or four near-term months and then three further-term months. The simplest way to view which months are available is through an option chain (see pp. 58-59). The actual expiration date for a stock option is close of business prior to the Saturday following the third Friday of the expiration month. For instance, expiration for the month of September 2005 is September 17, 2005. That is the last day that the terms of the option contract can be exercised. Therefore, all option holders must express their desire to exercise the contract by that date or they will lose their rights. (Although options that are in-the-money by one-quarter of a point or more will be subject to automatic exercise and the terms of the contract will automatically be fulfilled.) While the last day to exercise an option is the Saturday following the third Friday of the expiration month, the last day to trade the contract is the third Friday. Therefore, an option that has value can be sold on the third Friday of the expiration month. If an option is not sold on that day, it will either be exercised or expire worthless. While the last day to trade stock options is the third Friday of the expiration month, the last trading day for some index options is on a Thursday. For example, the last full day of trading for Standard & Poors 500 ($SPX) options is the Thursday before the third Friday of the month. Why? Because the final settlement value of the option is computed when the 500 stocks that make up the index open on Friday morning. Therefore, when trading indexes, the strategist should not assume that the third Friday of the month is the last trading day. It could be on the Thursday before. According to the Chicago Board Options Exchange, more than 60 percent of all options are closed in the marketplace. That is, buyers sell their options in the market and sellers buy their positions back. Therefore, most option strategists do not hold an options contract for its entire duration. Instead, many either take profits or cut their losses prior to expiration. Nevertheless, expiration dates and cycles are important to understand. They set the terms of the contract and spell the duration of the option holders rights and of the option sellers obligations. SEVEN CHARACTERISTICS OF OPTIONS Options are available on most futures, but not all stocks, indexes, or exchange-traded funds. In order to determine if a stock, index, or exchange traded fund has options available, ask your broker, visit an options symbol directory, or see if an option chain is available. Also, keep in mind that futures and futures options fall under a separate regulatory authority from stocks, stock options, and index options. Therefore, trading futures and options on futures requires separate brokerage accounts when compared to trading stocks and stock options. As a result, a trader might have one brokerage account with a firm that specializes in futures trading and another account with a brokerage firm that trades stocks and stock options. If you are new to trading, determine if you want to specialize in stocks or futures. Then find the best broker to meet your needs. Whether trading futures or stock options, all contracts share the following seven characteristics: 1. Options give you the right to buy or sell an instrument. 2. If you buy an option, you are not obligated to buy or sell the underly ing instrument; you simply have the right to exercise the option. 3. If you sell an option, you are obligated to deliveror to purchase the underlying asset at the predetermined price if the buyer exercises his or her right to take deliveryor to sell. 4. Options are valid for a specified period of time, after which they ex pire and you lose your right to buy or sell the underlying instrument at the specified price. Options expire on the Saturday following the third Friday of the expiration month. 5.Options are bought at a debit to the buyer. So the money is deductedfrom the trading account. 6. Sellers receive credits for selling options. The credit is an amount of money equal to the option premium and it is credited or added to the trading account. 7. Options are available at several strike prices that reflect the price of the underlying security. For example, if XYZ is trading for $50 a share, the options might have strikes of 40, 45, 50, 55, and 60. The number of strike prices will increase as the stock moves dramatically higher or lower. The premium is the total price you have to pay to buy an option or the total credit you receive from selling an option. The premium is, in turn, computed as the current option price times a multiplier. For example, stock options have a multiplier of 100. If a stock option is quoted for $3 a contract, it will cost $300 to purchase the contract. One more note before we begin looking at specific examples of puts and calls: An option does not have to be exercised in order for the owner to make a profit. Instead, an option position can, and often is, closed at a profit (or loss) prior to expiration. Offsetting transactions are used to close option positions. Basically, to offset an open position, the trader must sell an equal number of contracts in the exact same options contract. For example, if I buy 10 XYZ June 50 calls, I close the position by selling 10 XYZ June 50 calls. In the first case, I am buying to open. In the second, I am selling to close. 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 limitedrisk trading strategy. But, before getting into a discussion of more complex strategies that use both puts and calls, lets 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, lets 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 $49.95but 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. Lets 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 stores 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 options 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 (See Table 3.1). 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. 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 inthe-money (ITM) when the price of the underlying instrument is higher than the options 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 securitys 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. Thats why call options that are out-of-the-money by their expiration date expire worthless. Purchasing a call option is probably the simplest form of options trading. A trader who purchases a call is bullish, expecting the underlying asset 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 options 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. Lets 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. 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 ex ample, all of the IBM 80 calls with the same expiration date constitute an option series. |
|
|||||||||||||||
Previous Issues
|
| ©2007 Olesia | Home • My photos • Forex • News • My trading • Contacts |