option-trading

This article is a continuation from Introductions to options.

Now that you understand the basics, its time to expand upon the definitions and finer points. This may sound complicated at first, but it will sink in after you read it a few times.

The best thing you could do is start "paper" trading (that is pretend trading) with options, it will all fall into place very quickly!

The following piece comes from r/investing contributor Jartek who was happy to share his thoughts with us here:

Options are good for all sorts of things. To list a few popular ones:

• Hedging, or trying to keep a steady portfolio from crazy market swings. This is what teachers in the beginners course referred to when talking about options as a form of "insurance"

• Trading, or using clever strategies involving various combinations of options and/or stocks

• Speculation aka gambling. This is mainly because options can swing huge amounts of money with a relatively low price (akin to winning scratch-off lottos).

The one thing you'll notice was not on the list was investing. Options are bad at this by nature mainly because investing implies long term stuff, and options all have ticking time limits.

So how do they do all this? First you have to change the way you think of options. You learned that they're a contract between 2 parties to buy/sell something at a certain date and price. But the emphasis that's left out in the beginner's class is that now there's a contract, which previously didn't exist, and that contract is worth money. That contract is an actual commodity, whose value can go up and down as time goes on. And the owner of that contract can sell it whenever they want, in an open market and without ever having to wait 'till expiration to find out if they were right or wrong.

Terms

Few key terms and assumptions (as they come to me and in no particular order).

• Not a definition, but a word of caution. It's easy to get the terms buying and selling mixed up with options, so be mindful when you see those words to make sure to know the context. Here's a quick exercise: "The seller of a put has the obligation to buy stocks where as the buyer of a put has the option to sell stocks. Which is different from calls, where the seller has the obligation to sell and the buyer has the option to buy." If you understood this statement then you're ready to move on.

• "write" an option - this literally means sell an options contract, but what makes it special is that if someone "writes an option" they're literally drafting up a new contract and creating an option which previously didn't exist in the open market and it will remain there until expiration.

• contract - this is the unit of an option. 1 contract means that exactly 100 stocks may be traded upon expiration date.

• bid/ask spread - first, bid is the market price to sell something, and ask is the market price to buy something. And spread is the difference between the two.

THE PRICE

And this is what it all comes down to, the holy grail of options trading. Pricing the contract. Or the fee as I've heard it called.

Options prices are decided similar to everything else in the world, which is the market decides. This means that all you need is for 2 people to agree on a price, then exchange, and then BAM! A new price is set. For example, I'm willing to buy AAPL for $450. But I haven't because that son of a bitch just won't stop going up! (sorry, venting). Anyways, that also means that whoever owns it right now, doesn't want to sell it to me for so cheap and thinks he can sell it for more. Therefore we didn't agree and the price is not $450. But tomorrow, when we wake up and check the price, sure enough the owner will have found someone willing to buy it for like $520 and as soon as they make the exchange, BAM! $520 is the new price tag for it. And that's literally how it works. It's actually just like ebay.

However that introduces a new concept involving market conditions, regarding the number of buyers and sellers at the market. Aka volume, aka liquidity. If you have a market for something with a huge number of buyers and sellers, then it's likely that there's a lot of exchanges which will take place, and competition will be stiff. Think about it, if a seller is trying to rip anybody off, then the buyer will go right next door and buy it for cheaper, and therefore creating a stable price (as the rip off guys either leave or lower their price like). But if there's an imbalance of buyers and sellers, then control of the price will tip in favor of the smaller group. For example, if I tried to sell the one and only mona lisa to the world, and assuming there were many buyers who want it, I would probably get a hefty price because I will only sell it to the person who is willing to give me more money than anybody else in the world. Inversely, if I tried to sell my old XBOX 1 on ebay, I would probably sell it for cheap because in addition to having some competition, I'd also be struggling with finding anyone who even wants one. And finally, if you have a market where there's very few buyers AND sellers, then really strange stuff can happen because every transaction that takes place could literally be decided by who is better at haggling.

Now while this is true with stocks, it plays an especially big role with options because market conditions can affect price and changes of pennies at an options level can easily translate to hundreds of dollars in your loss/return.

INTRODUCTION

Now we know more about how options can be monetized in ways other than exercising - the purchaser/owner of an options contract has the ability to sell it to someone else. So now this raises the question... What is the value of the contract? Can that value change, and if so why?

To answer this question, I'll once again ask you change the way you look at options even further. Rather than thinking of them as instruments that just you buy and then sell in an imaginary store, think of them as instruments that make you want to start your own store so you can sell them to others as well. In other words, consider that sometimes you might benefit from writing an option, giving you the obligation to buy/sell, and giving someone else the option to buy/sell from you. Looking at it that way makes it easier to question the price, since there's two parties which are (hopefully) rational and smart, and both agree on the price of the "bet." Or if you like that analogy, think about it as a sports bet in which the odds even out the expected payout and both parties agree to it.

PREMIUM

Aahh, finally I can say this word. The premium is the proper term that's frequently referred to as the fee, the price, the cost, etc... Although none of the terms are necessarily wrong, but they all carry different implications which can be a source of confusion.

So how do we calculate the premium? Well first there's no one person or organization* decides what premium should be. Remember, the market decides the price and is set by the last people who made a trade.

Lets examine the forces affecting the premium with some exercises:

Assumptions: Facebook (FB) has been public for three months and is currently selling for $50. Today is 2/16/12 and February options expire tomorrow.

• If you bought and owned 1 call (for any amount) to buy FB with strike $48 that expires in Feb (tomorrow). How much would you get if you exercise? $2. And therefore what's the lowest price you would be willing to sell it at? Should be at least $2, right? The "at least $2" part makes up the intrinsic value. Now, using that logic, answer this question again if the strike price was $10, and again if the strike price was $50 (answer is $40 and $0, respectively).

• Now let's assume that tonight after the market closes, FB is going to release their quarterly earnings which will likely tank or skyrocket the price of FB, which means that you either lose $2 or make theoretically infinite (i.e. lose little or win a lot). And it's an all-or-nothing bet because after tomorrow, the option expires and you have no time to let it recover any value. How much would you sell it for now? More than the first question or less? Not sure? To help answer this, let's now assume you don't own any options and instead you decide to write a call and sell it to someone. Now you stand to make $2+ (see above), or you stand to lose theoretically infinite (i.e. win little or lose a lot). How much would you charge for such a huge risk? Hopefully a lot given the expected return. This is an extrinsic value added to the premium. In this case, the uncertainty or implied volatility is driving up the premium.

• Lastly, this one's tricky, assuming you own and want to sell the call OR you feel like writing new one, how much would you expect to sell that option if it expired 1 year from now? Also, because it's a year away, you don't care as much about earnings or other swings since you have an entire year to let the price recover. (Hint: remember the game is no longer about letting options expire, it's about trading the contract for profit, and you have an entire year to wait for the perfect price). Not sure? Well then answer this, would you sell it for more or less than in the first example? Answer should be more, because as time goes on so does the likelihood the price will fluctuate from $48 is high. This extrinsic value is the time component.

DERIVATIVE

Ever wonder why sometimes they call options "derivatives"? In calc, you learn that it means rate of change. And does not care about the actual underlying value in a function, but is interested in how that position will change if the underlying input(s) move. Should sound familiar... And this is also why there are options for $100 stocks going for the same or cheaper than options for $20 stocks.

So in short, we have 3 inputs that actively feed into the premium throughout the life of the contract:

1. Underlying price relative to strike price, and intrinsic. (delta)
2. Uncertainty, or implied volatility, and extrinsic. (vega)
3. Time until expiration, and extrinsic. (theta)

If any/all of these inputs increase, so does the option price. But that also means, that upon expiration extrinsic values (both time and volatility) will be 0, and all we are left with is the intrinsic value / exercise value (which is 0 if you're not ITM). All 3 of these inputs move independently throughout the life of the contract affecting the price. While 2 of the 3 inputs are relatively unpredictable, the one we can depend on is time. The moment you buy an option it starts losing value, and the longer you hold it the more it drops. So unless you're hedging, the game is to throw these options around like hot potato's while they rapidly fluctuate in price. The risk can be contained if you know what you're doing, or it can be disastrous if you don't.

Calculating the intrinsic value is easy, just figure out your profits if you chose to exercise right now, and there you have it. But the problem is how to calculate the value of uncertainty, and time component, since they're somewhat subjective and impossible to measure/valuate. And this has historically been a big problem.

Well, about forty years ago, a couple of Good Will Hunting type guys pretty much figured it all out using complex partial differential equations while trying to find "the perfect hedge." One of them even got a Nobel Prize for it.

But that formula took off, and exploded the options market as we know it today. It's been empirically tested to show impressive accuracy, and has led to an entire science behind options including using "Greeks" which are nothing more than a bunch of metrics.

EXCHANGE

Quick note on this. Unlike stocks which are listed in specific exchanges (like NASDAQ or NYSE), stock options are not bound to a particular exchange since they're essentially just bets. It's worth knowing that the Chicago Board Options Exchange, or CBOE, is the biggest among them (there's like 9 or so other ones) and is home to the all popular VIX (more on this at a later date). But to make things simple when picking an exchange, there's usually a "Best" choice which figures it out for you.

THE MARKET

So, it's finally time to pick some options. Well just like stocks, the first stop is to check out the prices. But now we're going to pay special attention to the market as well, because although market conditions play a part in stocks, they play a crucial role with options. Also, if you're speculating on a price move, the trick is to shop around for opportunities involving various strategies using options and/or stocks, because there are many ways to bet.

Many more than just up or down, that is.

While looking at buying options, a good rule of thumb is to make sure there's healthy (a lot of) volume. Having a liquid market will make sure that there's enough buyers and sellers to get in and back out of the position with relative ease. It's entirely possible that you buy an option and then have nobody to sell it back to (at a half-way reasonable price) when the time is right.

This also tends to tighten up the bid/ask spread (remember: bid is sell price, ask is buy price). This is another big difference with options. Typically when buying stocks, as long as they're somewhat popular, I don't even look at the spread - in fact most popular stock "quoters" won't even show them. But you'll notice that options chains rarely have a single price and instead show you the bid/ask separately. The reason for this is that with options, pennies matter. And the spread will consume into your profits.

Take a look at this chain for LVS with March expiration. You'll see that there are some options with 1 cent spread (green) and others with 15 cent spreads (red). If you were to buy options from the red circle, you're instantly losing $15 dollars PER CONTRACT not to mention commissions. I just checked some AAPL Jan '14 calls and some of them have like a $3 spread. That's $300.00 per contract instantly evaporated!

The 2 factors I can think of that determine liquidity are option popularity (some stocks don't attract options traders) and strike price / expiration date. Even popular stocks lose volume if you look to far ahead or if you pick strike prices that are far from "the money."

Make that 3. Open Interest (or OI or Op Int). This is a metric that you'll typically see in options chains indicating the number of "live contracts" which are out on the market. High OI would imply that there's high volume. The reason why volume and OI are not necessarily the same, is because in practice you can write a contract (create a new one, and adding +1 to the OI tally) and later buy it back (subtracting -1 to OI tally). If this scenario played out in an empty market, the volume would be 2 and OI would be 0.

TIMING

Timing is everything with options. Remember that the moment you buy an option it starts losing extrinsic value from time decay, time decay is not linear. Meaning that stocks won't lose a set amount every day until expiration.

Here's a graph showing what the time decay looks like as dictated by the black-scholes model. You'll notice the drop in price due to time decay exponentially increases at 30 days from expiration.

This doesn't mean options with less than 30 days are no good, but if you buy them it should be part of your strategy (like say, a day trade).

Another important thing to consider is recent news with the underlying stock. Big events can temporarily dislodge prices (which you can also use in your favor, if you want). Announced dividends is a big one. For various reasons, on an ex-dividend date, call prices will go down and put prices will go up. Another big one is earnings releases. You'll notice a huge buildup in premiums (due to implied volatility) as an earnings release approaches, and then a huge drop the day after. This affects calls and puts alike.

LEVERAGE

This is a very important concept which early options traders don't realize right away, and is the reason options can be so powerful and/or dangerous.

Options harness the power of leverage by relying on changes in price to derive their values, and not necessarily the price of the underlying. For example, let's compare MCD and GRPN currently trading at $100 and $20 respectively. If you look at their March expirations options, you'll see that the price for an at-the-money call (strike prices 100 and 20) is about $1.00 for each of them. (And yes, I realize MCD is not quite 100 yet but if you factor out intrinsic and extrinsic values you'll end up about the same).

So for $100, you can buy a call which expires next month for either of these two companies, and you've exposed yourself to 100 shares of said company.

Now ceteris paribus, if the price of both GRPN and MCD went up tomorrow by 5% the price of the MCD call would go up to around $3.50 while the price of GRPN's call would go up to around $1.50. That's the difference between profiting $250 vs $50).

And the reason for this is because if MCD went up by 5% it would be up $5 and if GRPN went up by 5% it would only be up by $1, and the premium only cares about relative price movement, and not necessarily about the underlying's value (this is a simplification).

This is also why expensive stocks like AAPL and GOOG are popular with options gamblers, because as you've already seen here they can have huge swings. And this is also how a lot of people go broke.

THE CHAIN

And finally, the chain. This is just to tie up some of these concepts and you can see what they look like in the real world. At first it can be overwhelming when looking at options chains, but if you know what you're looking for they're not that bad. I'm going to show you what it looks like in OptionsHouse, but most chains will be similar in nature and information.

• Purple circles - calls and related metrics (Bid price, Ask price, Volume and Open Interest)

• Blue circles - puts and related metrics (Bid price, Ask price, Volume and Open Interest)

• Green circles - expiration date

• Cyan circles - strike prices

• Yellow circles - options that are at or very near the money