| Home | My photos | Forex | My trading | Contacts |
|
|
You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
|
Put options give the buyer the right, but not the obligationPut 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. Lets review the following analogy to become more familiar with the basics of put options. Youve 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, youve 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 didnt have a put option agreement, you would have to drop your price to meet the competitions 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. could go long the market by selling putsbut 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. A put option is in-the-money (ITM) when the price of the underlying instrument is lower than the options strike price (see Table 3.2). 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 securitys market value is greater than the strike price. For example, an IBM put option with an $80 strike price is out-ofthe-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. Thats why put options that are out-of-the-money by their expiration date expire worthless. 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 assets 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 shortterm 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 on the Optionetics.com web sites home page and 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 longterm 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 options 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 yearswhich 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 options 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 decaylike 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: Dont overlook the power of LEAPS. OPTION CHAINS In order to view the various option prices at any given point in time, traders often use a tool known as option chains. Not only do option chains offer the current market prices for a series of options, they also tell of an options liquidity, the available strike prices for the option contract, and the expiration months. In fact, option chains are so important that many brokerage firms offer them to their clients with real-time updates. At the same time, while chains can be extremely helpful tools to the options trader, they are also fairly easy to understand and use. Today, option chains are readily found. Not long ago, they were available mostly to brokerage firms and other professional investors. Now, however, individual investors can go to a number of web sites and find option chains. Most online brokerage firms provide them, as do several options-related web sites. For instance, at the Optionetics.com home page, pulling up an option chain for any given stock is simply a matter of entering the stock ticker symbol in the quote box at the top of the screen and selecting chain. An example of an option chain from Optionetics.com appears in Figure 3.1. It is a snapshot of some of the Microsoft (MSFT) options with February 2004 expirations. It is not a complete list of all the options available at that time on MSFT. In fact, it is only a small fraction. Listing all of MSFT options would take more than 100 rows and a couple of pages. Option chains like this one are split in two right down the middle. On the left side we have calls and on the right we see puts. On the left side of the table, each row lists a call option contract for MSFT, and on the right side each row reflects a different put option. Separating the puts and calls, we have a column with the heading strike. This tells us the strike price of both the puts and calls. For example, in the first row, we have the February 2004 options with the strike price of 20. In this case, the strikes occur at 2.5-point increments. So, as we move down the rows, we see the strike prices of 22.5, 25, 27.5, and so on. Once we reach the end of the February 2004 strike prices, the March 2004 options would appear next on the chain. Each column within the figure provides a different piece of information. On each side of the figure (call and put), the first column lists the options symbol. For example, on the left half of the figure, the first row shows the February 20 call, which has the ticker symbol MQFBD (we will see how to create options symbols shortly). As with stocks, options have a bid price and an ask price, which appear in columns two and three. The bid is the current price at which the market will buy the option, and the ask is the price at which the option can be bought. The next column indicates the options open interest. Open interest is the total number of contracts that have been opened and not yet closed out. For instance, if an option trader buys (as an initial transaction) five February 25 calls, the open interest will increase by five. When he or she later sells those five calls (to close the transaction), open interest will decrease by five. Generally, the more open interest, the greater the trading activity associated with that particular option and, hence, the better the liquidity. Open interest is updated only once a day. The information included in an option chain will differ somewhat depending on the source, but the variables in Figure 3.1 are usually found. Some chains will include the last price, the days volume, or other bits of trading data. Regardless of the source, chains are important. They allow traders to see a variety of different contracts simultaneously, which can help the trader sort through and identify the option contract with the most appropriate strike, expiration month, and market price for any specific strategy. |
|
|||||||||||||||
Previous Issues
|
| ©2007 Olesia | Home • My photos • Forex • News • My trading • Contacts |