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Lets discuss one more basic element of the options market: the option symbolOPTION SYMBOLS Before we move on to the next chapter and the discussion of actual trading strategies, lets discuss one more basic element of the options market: the option symbol. In the stock market, stocks on the New York Stock Exchange and American Stock Exchange usually have symbols consisting of one, two, or three letters. For example, the symbol for Sears is simply S, Coca-Cola has the symbol KO, and International Business Machines is easy to rememberIBM. Nasdaq-listed stocks have symbols with four (and on rare occasions five or six) letters. Thats why some traders refer to Nasdaq stocks as the four-letter stocks. Option contracts are a bit more complicated than stocks, however, and the ticker symbols include three pieces of information. The first part of an option symbol describes the underlying stock. It is known as the root symbol and is often similar to the actual ticker of the stock. For instance, the root symbol for International Business Machines is straightforward. It is the same as the stock symbol: IBM. Four-letter stocks, however, always have root symbols different from their stock symbols. For instance, while the stock symbol for Microsoft is MSFT, the option symbol is MSQ. Option root symbols can have one, two, or three letters, but never four. In the case of a stock price that has moved dramatically higher or lower, there may be two or more root symbols. For example, referring back to the option chain for Microsoft, we can see that it shows root symbols of MQF and MSQ. The second part of an option symbol represents the month and defines whether the option is a put or a call. For example, a January call uses the letter A after the root symbol. Therefore, the IBM January call will have the root symbol IBM and then A, or IBMA. The February call is B, March C, and so on until December, which is the letter L (the twelfth letter in the alphabet). The expiration months for puts begin at the letter M. For instance, the IBM February put will have the letter N following the root symbol, or IBMN. Table 3.3 provides the symbol letter for each month. The final element to an option symbol reflects the strike price. Generally, the number 5 is assigned the letter A, 10 to the letter B, 15 the letter C, and so on until 100, which is given the letter T. Therefore, the IBM January 95 call will have the symbol IBMAS. Table 3.3 provides the letters assigned to each strike price. In conclusion, the symbol for any option contract will consist of three pieces of information. The first is the root symbol. It is often similar to the ticker symbol of the underlying stock, but not always. The root symbol can also vary based on the strike prices available for the option; whether it is a one-, two-, three-, or four-letter stock; and if it is a LEAPS or not. The second part of the symbol simply defines the expiration month. The final element indicates the strike price of the option. Taken together the three pieces of information define the option symbol, which is used to pull up quotes and place orders. EXPIRATION CYCLES REVISITED Not all stocks have options available to trade. Among other rules, newly public companieslow-priced stocks and firms that do not have much trading volume in their stockwill not have options. Tradable options, those listed on the exchanges, are solely the creations of the exchanges. Companies have no ability to either create or eliminate options for their firms. Firms do create unique options as incentives for their key employees and sometimes as sweeteners or bonuses for the purchase of stock. Such options, which are issued by companies to their employees, are different from the options discussed throughout this book. Instead, we are talking about options that trade on the organized options exchanges and can be bought and sold through a brokerage firm. The standard, tradable options on the options exchanges are all created by the exchanges themselves. To determine whether options exist for the stock you are contemplating trading, you can check out numerous web sites (including www.optionetics.com or the Chicago Board Options Exchange site, www.cboe.com); look in the option tables of the newspaper; or call your broker. Once you have determined that options are available, you can retrieve a quote or an option chain (see Figure 3.2). Lets review this now and consider the six issues that define an option. 1. Contract size. 2. Month of expiration. 3. Underlying stock. 4. Strike price. 5. Type of option (put or call). 6. Bid and ask price of the option. The distinguishing factor of options is that they expire; unlike equities, options have a finite life. Thus, knowing the expiration date is critical. One of the great keys to the success of tradable options is the standardization of expiration dates. All stock options officially expire at 10:59 P.M. Central time on the Saturday following the third Friday of the designated month. However, for all practical purposes, the options expire at the close of business on the third Friday of the month because that is usually the last time to trade them. The final accounting (except for rare errors) is completed early Saturday morning. As previously mentioned, optionable stocks are assigned to one of three expiration cycles (January, February, or March) by the exchange when the options are first created for the firm. The cycles, and their standard expiration months, are listed in Table 3.4. All stocks with options have active options for the current month, the next month out, and then the next two cycle months. For instance, on March 30, a stock in each of the cycles would have options expiring on the third Friday of the months in Table 3.5. In addition to the four months listed in Table 3.5 for all optionable stocks, the most active stocks also have LEAPS that will expire on January of the next two years. Those LEAPS become regular options when the January date is within nine months of expiration. A new LEAPS option is created each May, June, or July, depending on which cycle the particular stock is located in, for the subsequent year out. To further complicate matters, a given stock may not have options created if there will be some dramatic change in the stock that is known by the exchanges. For instance, if the firm is about to be acquired or delisted, the exchange may not create a particular set of options for the next normal month, awaiting events. In all cases, check with your broker, the CBOE, or even the Optionetics.com web site to be sure that a particular option exists. The strike price, or exercise price, is designed to provide options that will attract trading volume. Thus, options are created that closely surround the current stock price. The norm is to set the strike prices in the following increments: For stock prices under $25, strikes will be $2.50 apart, starting at $5 (5, 7.5, 10, etc.). For stock prices between $25 and $200, strikes will be $5 apart (25, 30, 35, etc.). For stock prices greater than $200, strikes will be $10 apart (200, 210, 220, etc.). In 2003, options with one-point increments between strike prices started trading on some actively traded low-priced stocks. For example, a $5 stock might have strike prices of 5, 6, 7, and so on. As the stock price moves up or down, new options are created around the new stock prices. However, the old options will remain in effect until expiration (they are not eliminated just because the stock price has moved). As with most things in life, these rules are not absolute. Stock splits, for instance, can cause some strange strikes. If a company institutes a split, the option prices and numbers of contracts will also be affected. A 2for-1 split would cause an option with a strike of 85 to turn into two options with a strike of 42.50. Similarly, a 3-for-1 split would cause the same option to become three options, each with a strike of 28.33. Also, for stocks that move rapidly up and down, like the volatile technology stocks, there are often options only at 10-point increments, even though the stock is selling well under $200. This is particularly true of options that are several months from expiration. The reasoning is that with rapid stock price movements, if options were created for every standard strike, there could easily be 30 or 40 strikes for both puts and calls on that stock for each expiration month. The problem is that every time the stock price moves each of those options must be repriced, and the calculations and tracking required become humongous. Likewise, with a given volume of option trading for a particular stock, the more option choices available, the less volume any one option will likely have, resulting, of course, in decreased liquidity. INTRINSIC VALUE AND TIME VALUE Intrinsic value is defined as the amount by which the strike price of an option is in-the-money. It is a very important value to determine, since it is the portion of an options price that is not lost due to the passage of time. For a call option, intrinsic value is equal to the current price of the underlying asset minus the strike price of the call option. For a put option, intrinsic value is equal to the strike price of the option minus the current price of the underlying asset. If a call or put option is at-the-money, the intrinsic value would equal zero. Likewise, an out-of-the-money call or put option has no intrinsic value. The intrinsic value of an option does not depend on how much time is left until expiration. It simply tells you how much real value you are paying for. If an option has no intrinsic value, then all it really has is time value, which decreases as an option approaches expiration. Time value (theta) can be defined as the amount by which the price of an option exceeds its intrinsic value. Also referred to as extrinsic value, the time value of an option is directly related to how much time the option has until expiration. Theta decays over time. For example, if a call costs $5 and its intrinsic value is $1, the time value would be $5 - $1 = $4. Lets use the following table to calculate the intrinsic value and time value of a few options. Here are the calculations for the IBM February 85 calls if IBM is now trading at $86: Intrinsic value = underlying asset price minus strike price: $86 - $85 = $1. Time value = call premium minus intrinsic value: $3.90 - $1 = $2.90. Now lets look at the intrinsic value of each option relative to its time value. The January 80 call has a minimum value of 6; therefore, you are pay ing .40 point of time value for the option (6.40 - 6 = .40). The February 80 call has a minimum value of 6; therefore, you are paying 1.50 points of time value for this option (7.50 - 6 = 1.50). The May 80 call has a minimum value of 6; therefore, you are paying 2.25 points of time value for this option (8.25 - 6 = 2.25). As you can see, the intrinsic value of an option is the same, no matter what time is left until expiration. Now lets look at some options within the same month, but with different strike prices: Price of IBM = 86 The January 70 call has 16 points of intrinsic value (86 - 70 = 16) and .25 points of time value (16.25 - 16 = .25). The January 75 call has 11 points of intrinsic value (86 - 75 = 11) and .50 points of time value (11.50 - 11 = .50). The January 80 call has 6 points of intrinsic value (86 - 80 = 6) and .40 points of time value (6.40 - 6 = .40). Obviously, an option with three months till expiration is worth more than an option that expires this month. Theoretically, the option with three months till expiration has a better chance of ending up in-themoney than the option expiring this month. Thats why an OTM option consists of nothing but time value. The more out-of-the-money an option is, the less it costs. However, since it has no real (intrinsic) value, all you are paying for is time value (i.e., the time to let your OTM option become profitable due to a swing in the market). The probability that an extremely OTM option will turn profitable is quite slim. To confirm this, just go to your local library and look up some options prices in previous copies of a financial newspaper, such as Investors Business Daily. Compare the present-day price of a particular option to prices in back issues of the same publication. Since you can exercise an American-style call option anytime you want, its price should not be less than its intrinsic value. An options intrinsic value is also called the minimum value primarily because it tells you the minimum the option should be selling for (i.e., exactly what you are paying for and how much time value you have left). What does this mean? Most importantly, it means that the cheaper the option, the less real value you are buying. Intrinsic value acts a lot like car insurance. If you buy a zero-deductible policy and you have an accident, even a fender bender, youre covered. You pay less for a $500-deductible policy, but if you have an accident the total damage must exceed $500 before the insurance company will pay for the remainder of the damages. The prices of OTM options are low, and get even lower further out-of-the-money. To many traders, this inexpensive price looks good. Unfortunately, OTM options have only a slim probability that they will turn profitable. The following table demonstrates this slim chance of profitability. With the price of XYZ at 86, a January 90 call would have a price (premium) of 3. To be 3 points above the strike price, XYZ has to rise 7 points to 93 in order for you to break even. If you were to buy a January 75 call and pay 13.50 for it, XYZ would have to rise to 88.50 in order to break even (75 + 13.50 = 88.50). As you can see, the further out-of-the-money an option is, the less chance it has of turning a profit. Theta (time value) correlates the change in the price of the option with respect to the time left until expiration. The passage of time has a snowball effect as well. If youve ever bought options and sat on them until the last couple of weeks before expiration, you might have noticed that at a certain point the market seems to stop moving anywhere. Option prices are exponentialthe closer you get to expiration, the more money youre going to lose if the market doesnt move. On the expiration day, an options worth is its intrinsic value. Its either in-the-money or it isnt. Early in my options career, I realized that as you go deeper in-themoney with calls or puts, the options have less time value and more intrinsic value. This means that you are paying less for time; therefore, the option moves more like the underlying asset. This is referred to as the delta of an option. The delta is the key to creating delta neutral strategies and we will delve deeply into its properties and functions as we explore more advanced trading techniques throughout this book. Lets now explore various strike price trends. Looking at the expiration months for XYZ, notice that in the January column, the price (premium) of a call is higher for lower strike prices. For example, the price of an XYZ January 45 call (6.40) is higher than the price of the XYZ January 50 call (2.30). That makes sense since the XYZ January 45 call allows you to buy a $50 stock (XYZ) for $45 per share, while the XYZ January 50 call allows you to buy it for $50. Also notice that the price of a call is lower for closer expirations. For example, the price of the XYZ May 50 call (4.75) is higher than the price of the XYZ January 50 call (2.30). This makes sense since the May 50 call allows you to buy XYZ at $50 until close of business prior to the third Saturday of May (a period of about four months from January). With the XYZ January 50 call, your right expires at close of business prior to the third Saturday of January. The only difference between these options is the amount of time the trader has to make a decision on the option and its probability of closing in-the-money. The same principle applies to puts. Less time to expiration means lower prices. The buyer has less time for the put to move in-the-money or to decide what to do with the option. |
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