WHAT ARE YOUR
OPTIONS?
By
TEO B P Terence
Essential Guide
On
Options & Option Strategies
2011
(Edition 1)
Knowledge Creates Wealth (Vol. 2)
Copyright 2011 by TEO B P
Terence
Published at Smashwords
Dedicated to my lovely wife, Pey Chin
TABLE OF CONTENTS
Copyright
&
Terms of Use
PREFACE
PROLOGUE
AN
OVERVIEW – THE RAW BASICS
VANILLA
OPTIONS – CALLs & PUTs
LONG
CALL OPTION
LONG
PUT OPTION
SHORT
CALL OPTION
Briefly
About Covered Call
SHORT
PUT OPTION
An
Application of naked SHORT Put
MONEY-ness
OVERVIEW
OF OPTION STRATEGIES
BASIC
OPTION STRATEGY – VERTICAL SPREADS
LONG
CALL SPREAD (Bullish Spread)
SHORT
CALL SPREAD (Bearish Spread)
LONG
PUT SPREAD (Bearish Spread)
SHORT
PUT SPREAD (Bullish Spread)
OPTION
STRATEGY – LONG RATIO SPREADS
LONG
OTM Call Ratio Spread (“Bullish” Spread)
LONG
OTM Put Ratio Spread (“Bearish” Spread)
OPTION
VALUE
ADVANCE
OPTION STRATEGY – LONG BUTTERFLY
LONG
OTM Call Butterfly (Bull’s Eye Spread)
LONG
OTM Put Butterfly (Bearish Spread)
LONG
ATM Call/Put Butterfly (Non-Volatile Spread)
ADVANCE
OPTION STRATEGY – LONG CONDOR
BULLISH
BIAS LONG CONDOR
LONG
OTM Call Condor (Bullish Bias)
BEARISH
BIAS LONG CONDOR
LONG
OTM Put Condor (Bearish Bias)
NON-VOLATILE
BIAS LONG CONDOR
OPTION
GREEKS
DELTA
GAMMA
THETA
VEGA
RHO
EPILOGUE
ABOUT
The AUTHOR
COPYRIGHT &
TERMS OF USE
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Copyright © 2011 by TEO, BP Terence. All rights reserved.
No part of this publication may be reproduced in any media or form without the expressed permission of the author in writing. Requests should be made to the author whose email is located at the epilogue section.
This publication is designed to provide accurate and authoritative information in regard the subject matter covered. It is sold with the understanding that the publisher/author is not engaged in rendering professional and/or financial services. If professional or financial advice is required, the services of a competent financial/professional person should be sought.
The publisher/author is entirely not liable for any damages arising from the use of the information in this book.
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What Are Your Options? -Essential Guide On Options & Profitable Option Strategies is a practical guide on options and profitable option strategies. The theories and practical applications of Options are discussed in this book, in an easy to understand manner.
There is no shortage of books written on Options and Options trading. So why add on to the already crowded collection of literature on this topic? This is what you can expect to take away by the end of What Are Your Options?
What
You Can Expect Of This Book
Firstly,
What
Are Your Options? -Essential Guide On Options & Profitable Option
Strategies
provides readers with concise explanations of options and its
terminologies and suggestions on profitable option strategies.
I recall my own initial foray into learning about options and how flabbergasted I was when faced with complex terminologies found in many, supposedly, basic options books. I spent more time deciphering the meanings of these alien terms than I did on options concepts. This book is aimed at sparing you this very agony. Whenever options jargons arise, these will be clearly explained.
What Are Your Options? -Essential Guide On Options & Profitable Option Strategies hopes to motivate the beginner option students and encourage further pursuit of options knowledge. The contents are also structured to serve as a concise revision for the intermediate options traders. What Are Your Options? -Essential Guide On Options & Profitable Option Strategies focuses on fundamental principles of options and options trading. Every effort has been put into keeping the materials logically organized.
Secondly, this book aims to drive-in a crucial fact about options trading; that having a good theoretical understanding of options is of utmost importance before actually commencing options trading. Trading options without first attaining a firm grasp of key options concepts is tantamount to committing financial suicide and the market is filled with the carcasses of overly eager novice options traders.
What Are Your Options? -Essential Guide On Options & Profitable Option Strategies is the springboard from which readers will discover more in-depth knowledge about options and options trading. This book will be mentally stimulating and highly rewarding to the beginner, intermediate and even advance options traders seeking information about Options and its profitable strategies.
Thirdly, this book includes practical examples of various option strategies using real data and prices, accompanied by Profit/Loss and Risk/Reward profiles that are graphically represented. It is carefully written in progressive complexity, with each succeeding section building on the knowledge of the previous, ensuring a logical and methodical learning process. These will help readers visualize trades.
Provided you pay attention to the details of this material, by the end of this book, you will attain some very useful knowledge about options and profitable option strategies.
~ Author – TEO B P Terence
ACKNOWLEDGEMENT
To God and His amazing Grace.
To my mother and wife, for their unparalleled patience, moral support and unconditional love.
A very special thanks to my friend, Ginny, who generously proof read and edited this manuscript.
How
This Book Is Structured
To
reap maximum benefits, readers are encouraged to leaf through these
pages sequentially, as the logic of options and discussions are
arranged with increasing complexity. However, the individual sections
can be read in silo without compromising on the full knowledge of
that section. It might just be a little harder, especially for the
beginner student, to grasp all of the concepts if readers impatiently
skip sections.
The
following are the main sections of this book:
AN OVERVIEW –
OPTIONS BASICS
What are Options? Why are they considered financial
leveraged derivatives? What are the different kinds of Options? What
components make up the option value? What are contract sizes, strike
prices and expirations? These and other elementary concepts are
presented in this section, offering an overall macro picture, and
will lead us logically into the succeeding sections.
VANILLA
OPTIONS – CALLS AND PUTS
Call and Put options, by themselves,
are known as Vanilla options. The profit and loss profiles of buying
and selling vanilla options are explained with highlights on the
pitfalls of naked vanilla SHORT options.
”MONEY-ness”
– ITM/ATM/OTM
What makes an option In-The-Money, At-The-Money or
Out-of-The-Money is determined by the relationship of strike price to
the underlying asset price. Why do traders choose certain
“money-ness” options over others? These are explained here.
OVERVIEW
OF OPTION STRATEGIES
Vanilla options can be purposefully combined
to form option strategies. This section broadly explores these
strategies.
BASIC
OPTION STRATEGIES
- Vertical Spreads
- LONG Ratio
Spreads
Option strategies are constructed to achieve some specific
trading objectives. These may be to limit risk exposures, increase
the chances of success or to hedge risk exposures. Vertical spreads,
such as LONG Call/Put spreads, offer traders the chance of profiting
without the worry about huge risks. Ratio spreads are made up of
vanilla options and can be structured to offer potentially higher
chances of profiting, but they come at a price.
OPTIONS
VALUE
How do options derive their values? In a gist, options
values are a function of several key variables, such as options
strike price, time to expiration and others. This section gives the
details.
ADVANCE
OPTION STRATEGIES
- LONG Butterfly
- LONG Condor
Butterflies,
often referred in abbreviation as “flies” and condors are
slightly more advance option strategies that are characterized by
their limited profit potential and limited liability. This section
shows the use of ITM/ATM/OTM options to create directional and/or
non-directional bias option strategies.
OPTION
GREEKS
Option Greeks are parameters with values assigned to
individual option. This section offers concise explanations of the
key option Greeks that every options student and trader must
comprehend. Delta, Gamma, Theta, Vega and Rho, the common option
greeks, affect the choices of which options to trade.
In case you were looking for a “get rich quick” book, this is not it. Options trading is never a way to instant riches. If it was, everyone would be trading options by now and you certainly will not be reading its “secrets” from me or anyone else. Nothing quite useful can be achieved without the accompanying effort to learn and this book offers that education.
Some
Qualifying Assumptions
Categorically, options stated herein are
American style(explanations will be made in the relevant section) and
only pertain specifically to equities as the underlying asset.
European style options(again, this will be defined later in this
book) and options on other underlying assets, such as Futures,
Commodities, Exchange Traded Funds (ETFs), Indexes and others will
not be discussed in detail in this book. However, there are
occasional references made to European style Options, for purposes of
comparing and contrasting.
For simplicity, all risk/reward calculations omit trading commissions/fees. Readers are advised to remember that such commissions/fees do form part of the costs of trading options. While online brokerages, these days, do offer competitive services at rock bottom fees, over trading can quickly generate sizeable trade commissions and make your brokerage a very happy service provider.
AN OVERVIEW –
THE RAW BASICS
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Every day, people from all walks of life are trying to increase wealth through financial investments. Corporate CFOs, bankers, insurance companies, sovereign wealth funds managers, professional equities/bonds/commodities/futures and retail traders and many others go through each business day competing against one another in the world wide financial markets to profit through their various investment instruments, with one overriding objective – to generate profits. Such financial activities keep the money engine fuelling our global economies, corporate bottom lines and individual wealth.
For some to win, inevitably, some must lose. It should not come as a surprise that the consistent winners of these gladiatorial and global financial games are those with specific knowledge, financial muscles and a very good management of the accompanying risks to these investments. However, this not to suggest that retail investors do not stand the chance to win. To be successful, non-institutional traders need to be informed and more than sufficiently educated in their fields of investments. What Are Your Options? –Essential Guide On Options & Option Strategies will start you off in the right direction.
The very first lesson every trader must learn is, that every form of investment always involves risk. There must be risks before any rewards can be had. The key is to learn how to identify those risks and manage them accordingly.
Any investment that promises to yield higher capital returns is always matched with higher risks. Conversely, lower risk propositions usually only offer smaller profit potential.
If you should ever encounter sales pitches professing to multiply your investment capital in a very short timeframe, aka a “free lunch”, it would be wise of you to immediately walk away. There are no “free lunches” in the financial world. Those who are ill informed and poorly educated ARE the “lunches” preyed upon by the better prepared traders.
Throughout history, unscrupulous people have hustled the uninformed and preyed on the greedy. Sadly, in the global financial meltdown of 2008, millions of pensioners all over the world lost their retirement funds to superlatively high yielding toxic asset-backed securities, credit default swaps and the likes, conjured up by Wall Street “geniuses”. The world’s economy may have recovered in the following years(as of this writing in July 2011), but the painful repercussions are still starkly felt by many of these unfortunate investors, many of whom are the ordinary folks who fell victim to either ignorance or greed or sheer bad luck. Their wounds are still very raw.
So, let’s be very cognizant that all forms of investments are never full proof in generating profits. Options as an investment instrument, is not exempt from such financial risks. It is a class of financial derivative, a financial investment instrument by which wealth can be created or lost.
In principal, options trading is not unlike investing in shares, exchange traded funds, unit trusts, bonds, commodities, live stocks, crude oil, precious metals, or simply purchasing properties, when it pertains to the generally accompanying risks and potential for rewards associated with any forms of investments. The risks and rewards specific to options trading are quite thoroughly discussed throughout this read.
In the remaining of this section, we will briefly explore various characteristics pertaining to options. Details will follow in the later sections of this book.
Let us begin this incredible journey of learning and discovery.
What
are Options?
Fundamentally,
an option can either be a Call or a Put. It is a class of financial
derivative because its existence is solely dependent on an underlying
asset. Options are used as a financial instrument to generate and/or
protect wealth.
Most of us would have unknowingly transacted in options. Some do so more often than others, but most of us would have experienced using options at some point.
For example, when you place a monetary deposit to the seller of a property, indicating your interest in purchasing that property, you are in fact engaging in options. This deposit gives you the right to purchase that property at any time before a stipulated deadline at a predetermined price. In other words, by paying upfront a sum of money, as the deposit, you have purchased the right, but not the obligation, to buy that property at an agreed price, within a stipulated period of time.
The seller, having accepted your deposit, is bound by contractual obligation to withdraw the sale of his property from the sale market, while awaiting, up to that specified date, your optional decision to make that purchase. If you should indeed decide to exercise your right to purchase the property, you will need to do so before the expiration of this option and pay the agreed price. But if for any reasons, you should decide against the purchase, the seller will get to keep that paid deposit. There will be no refunding of the deposit. If you remain undecided past the agreed deadline, your option to purchase expires, thereby also forfeiting your deposit paid to the seller.
From a technical view point, such a deposit paid, called an option fee, is exchanged for the right to purchase an asset at an agreed price by a certain time. This specific form of option is known as a CALL Option.
Thus
to the BUYER of the CALL Option:
It is the contractual right, but
not the obligation, to buy an asset at a predetermined price, at any
time before or on expiration date.
And
to the SELLER of the CALL Option:
It is the contractual
obligation, and with no right to refuse, on demand to sell the asset
at a predetermined price, at any time before or on expiration date.
A less common example of when you might have engaged in options is suppose you decide to sell your property, not immediately but, sometime in the future. Say you were expatriated and purchased a property to stay in. Towards the end of your work tenure, some four months in advance, you approach a credible local real estate dealer and propose to pay them $10,000, if they grant you the option to sell your property to them at $360,000 any time within the next four months. Assuming that this local realtor accepts your proposition and payment of $10,000, which is the option fee, an option contract is established between you and the realtor.
As the four months comes up, you check the property market and are likely do one of two things. If you are able to find another buyer willing to pay you more than $360,000 for your property, you will gladly sell it at this higher price and ignore the earlier option contract you established with the estate dealer and forfeit that $10,000 option fee paid to them. That option will automatically expire at the end of the four month period. The real estate dealer will pocket that $10,000. And that will be the end of this option contract; ie, this option contract expires.
If, however, no one is willing buy your property for above $360,000, you now turn to the real estate dealer and demand he purchased it as previously agreed at $360,000. That is, you exercise your option to sell your property to the estate dealer, who is contractually obligated to buy it from you at $360,000, the agreed price. Effectively, you would have received a gross sum of $350,000 (before any other related taxes, handling fees, etc) since you had earlier paid out $10,000.
In this transaction, you were a BUYER of a PUT Option and the realtor was a SELLER of that PUT Option.
To
you, a BUYER of a PUT Option:
It is your contractual right, but
not obligation, to sell your asset(property) at a predetermined
price($360,000), on or before the expiration of that option(four
months).
To
this real estate dealer, a SELLER of a PUT Option:
It is the
contractual obligation, with no right to refuse, upon demand to buy
your asset at a predetermined price, on or before the expiration of
that option.
In the financial world, there exists willing buyers and sellers of options, whether CALL or PUT options, so long as paying or receiving those option fees(“deposit”) makes financial sense to the buyers/sellers of Calls/Puts. In the previous example, the real estate dealer was willing to assume the obligation to buy the asset at $360,000 because he felt the upfront receipt of a $10,000 option fee to establish this contract makes good financial sense. Perhaps, the realtor thought that the property market would remain stagnant at the end of four months, and so whilst he would be “forced” to buy the property for $360,000, he could quickly turn around and sell it for the same price. Although, no capital gains are made from this transaction, the realtor nevertheless profits a gross sum of $10,000 option fee it received earlier. Or perhaps, the estate dealer thought that the property market will spike up in the next four months and chances are good that you will be able to find another buyer willing to pay more than $360,000. In this case, the estate dealer merrily pockets the $10,000 option fee you paid him. Of course, there is no way for the real estate dealer to predict the future with any accuracy and it is a risk he was willing to assume because the $10,000 deposit was sufficient for him to sell you the Put option. This illustrates the risk undertaken by the real estate agency for the potential to earn $10,000.
The
Power of Financial Leverage
Options
are well known for their leveraging capacity. Let me illustrate this
concept using the following example.
Suppose you wish to own 100 shares of XYZ stock that is listed at NYSE at $10/share. This purchase will cost you $1000 in total capital outlay. You could instead buy a Call option on XYZ stocks and still be accorded the right, though not the obligation, to purchase 100 shares of XYZ and pay only a fraction of $1000 for those options, hypothetically $100 or just 10% of $1000.
If XYZ share price moves up to $11 within a month, those XYZ options could be worth $200 or more. This represents gains of at least 100% of the initial investment. Whereas, those 100 shares of XYZ would only generate 10% profit at $11(this will be clearer as we get into the specifics in the later sections).
The ability of options trading to amplify profits is known as financial leveraging.
It is not surprising that many have been and are still quickly lured by such financial leveraging characteristic of options trading, but it would be remiss not to mention that such seeming advantage of leveraging is not without its dangers. For one, leveraging is a double-edged sword. As much as winnings can be multiplied, losses too can be amplified many folds. Readers will soon discover later in this book that such financial leverage is “paid for” in one form or another.
What
Are Option Strategies
Options
trading is fundamentally about buying and/or selling of CALL and/or
PUT options. When Calls and/or Puts are bought and/or sold
singularly, they are widely referred to as vanilla options.
Complex option strategies are formed by the combination of vanilla options. In other words, specific LONG and/or SHORT vanilla options positions combined in specific structures produce more complex options such as Call and Put Spreads, Butterflies, Ratios, Condors, Straddles, Strangles, Ladders, Conversions, Reversions, etc. Several of these option strategies are expounded in this book.
Types
of Options
Options
of different underlying assets possess different contractual
obligations and specifications that bind buyers and sellers. These
contractual specifications include dictating the contract size of the
underlying asset, the option expiration date of the week/month/year,
the method of acceptance/delivery of assets, the quality/shape/size
of the asset, whether it is a cash settlement, etc. For example, the
contractual specifications of options on Gold surely are different
than those contractual specifications of options on Citibank shares.
Different types of Options are traded on the various Stock and Commodities Exchanges; such as the New York Stock Exchange(NYSE), Chicago Board of Exchange(CBOE), Chicago Mercantile Exchange(CME), NYSE ARCA, Philadelphia Exchange(PHLX), BATS Global Exchange, and many others. These various exchanges offer options on different underlying assets and their contractual specifications
There are options on shares(equities), options on market indexes(indexes), options on futures, options on commodities, options on precious metals, options on softs/grains/pork bellies, etc. There are even exotic options such as Rainbows and Swaptions. Thus, we not only have options on Citibank shares, various stock and commodities exchanges also offer options on gold and silver, options on wheat, options on SP500 index, options on light sweet crude, options on interest rates, options on currencies, and even options on options.
However, in all of our discussions in this book, we will restrict our focus primarily on options on equities since most are familiar with stock investment. Understanding options on equities is a good springboard to explore other types of options once readers become more familiar with this financial instrument.
Options
Style
All
Options discussed in this book will be American (style) options.
There are also European (style) Options. The vast majority of options
traded on the popular exchanges fall into these two categories. Their
primary difference is highlighted here:
An
American style option may be exercised at any time before and up to
the option expiration date.
A European style option may be
exercised only at the option expiry date, i.e. at a single
pre-defined point in time and not any earlier.
All options on equities traded on North American exchanges are usually American options. But readers must be very careful to identify the “style” of options when trading options on indexes, such as SP500 (SPX), and especially over-the-counter options, for these are usually European options and as such, have different contractual terms than the American ones. The fact that European options cannot be exercised earlier than their expiration date, are attractive to sellers of these options knowing they cannot be “demanded” to fulfil their contractual obligations any earlier than a fixed date.
Different types of options(options on equities or indexes) and styles(american or european) have different characteristics that affect how they are traded. It is imperative that you first ascertain the type and style of options, fully understand its terms of contract, before trading them. It is very dangerous to assume, so do not.
Note that from henceforth, options referred in this book shall be American options on equities, unless otherwise stated.
Format
Of An Option Position
Options
trades are generally displayed in the following format:
<N>
<LONG/SHORT> <XYZ> <Expiration Month/Year> <Strike
Price> <CALL/PUT>
<N> = size of option
contract
<LONG/SHORT> = corresponding to Buy/Sell
<XYZ>
= the exchange ticker of the underlying equity
< Expiration
Month/Year> = in which month and year( YY format), the option
contract will expire
<Strike Price> = the agreed price at
which the underlying equity is to be transacted(exercised)
<CALL/PUT>
= denoting the option as a CALL or PUT
Examples:
1
LONG AAPL Jun11 360CALL means a purchase of one contract of Apple
Inc. Call option of strike price $360, which will expire on the 3rd
Friday of June 2011. Monthly options on equities effectively always
expire on the 3rd Friday of the month.
10 SHORT C Aug11 40PUT means a sale of ten contracts of Citibank Put options of strike price $40 which will effectively expire on the 3rd Friday of August 2011.
Increasingly, weekly options are becoming popular among retail options traders. These options expire on the Friday of that week. Note that weekly options are not always offered on all equities. The only difference in format between a weekly and monthly option is the additional (W) shown below:
<N>
<LONG/SHORT> <XYZ> <Expiration Month(W)/Year>
<Strike Price> <CALL/PUT>
(W)= corresponds to the
specific week of the month and is denoted numerically
Eg, 8 LONG C JUN2 11 42CALL
This above trade is a purchase of eight contracts of Citibank Call options with strike price $42 which will expire on the Friday of the 2nd week of Jun 2011
Option
Contract Size
The
numeric value <N> displayed at the start of each option format
represents the contract size. An option with the contract size of “1”
represents the ability to control 100 shares of the underlying
equity. Thus, a 5 LONG AMGN Jun11 60CALL, will grant the option
holder the right to purchase 500 of Amgen Inc.shares at $60/share on
or before 3rd Friday of June 2011.
Suppose you had previously purchased 1 LONG AMGN Jun11 60CALL option and paid a total premium of $50 (option fee). It is now before the Jun 2011 option expiration date, and AGMN shares are traded at $65. You, as a buyer of this Call option, have the right to purchase 100 AGMN shares at $60/share. If you exercise this Call option right, you will pay up $6000 ($60x100 shares) and immediately sell off your 100 AGMN shares in the open exchange and receive $6500, resulting in a net profit of $450 ($6500-$6000-$50) after accounting for the $50 of paid option fee.
In this hypothetical scenario, you would have made 900%(100x450/50) returns on your investment. This is to demonstrate the seductiveness of financial leveraging that is found in derivative options trading. However, do not be misled into believing that such a scenario happens frequently. In fact, my trading experience tells me otherwise. For many options traders, this unlikely scenario of paying little and winning aplenty may never occur throughout their options trading career.
Expiration
Date
All
options have expiration dates, some as soon as a day and others
within a week, a month, months or a year, and still other options can
possess specifically tailored expiration dates years ahead. Whatever
the length of time to expiration, every option will eventually
expire. On expiration date, some options will be worth substantial
amounts of money while others will be worthless.
Some options have very long expiration dates, perhaps 2 or more years. These are referred to as Long Term Equities AnticiPation Securities or LEAPS. Most retail investors do not participate in LEAPS, but instead buy options that have expirations within one year as LEAPS have higher option fees, thus requiring more capital outlay. Also, they are not commonly available to retail players and so are not as widely traded.
The widely traded options on equities, with monthly expirations, will always effectively expire on the 3rd Friday of that indicated month. It is therefore very important for options traders to be mindful of such expiration dates, as under certain circumstances, especially options sellers may be contractually obligated to buy equities they never intended to purchase or forced to sell equities they do not originally possess, as dictated by the terms of those option contracts.
Strike
Price
Besides
having an expiration date, every option also bears a Strike Price.
This strike price is the agreed price between the buyer and seller of
the option at which to transact that underlying asset. Recall the
example of the expatriate having the option to sell his property to
the realtor at $360,000, which is the strike price of this option
contract. Every option contract will have at least one stipulated
strike price. Vanilla options trades have one strike price and
complex options positions possess more than one strike price.
Option
Premium/Fee
Every
option has a price at which it is traded on the open exchange. This
price is the option premium. The total amount paid or received on the
options transaction is the option fee.
Options
Value
Options
are classified as derivatives because they are created out of the
underlying assets. So, take away the assets, there would be no
options to speak of. If Citibank shares get delisted from the stock
exchange, then all of its options will also be delisted. Hence,
naturally, option values are derived from the underlying equity
price. However, equity price is not the sle determinant of options
values. Other variables also affect an option value. Briefly, an
option value is a function of six variables.
Option Value = f ( Equity spot price, Strike Price, Time to Expiration, Implied Volatility, “Risk Free” Interest Rate and Dividend Payout)
Understanding how option values are affected by these variables is a crucial knowledge because there will come a time when all option traders will be faced with the decision of choosing one option over others to purchase or sell, based not just on the underlying equity spot price but also the choice of strike price, option expiration month, on price volatility, interest rate outlook and the prospect of stock dividend payout.
All these variables combined result in an option value, its premium. Some options of the same underlying equity have “higher” premiums compared to others. Traders are always confronted with the choice of which options to purchase, sometimes influenced simply by the cost of those option premiums. Yet, to decide which option to purchase solely based on its premium is not the correct approach to options trading. There are good reasons for “cheaper” options not to be the most ideal choice. In other words, “cheaper” does not equate inexpensive.
The later sections will help readers to understand the various considerations in buying and/or selling options.
Options
Modelling
The
Black-Scholes model, which is a widely accepted mathematical options
model, in essence uses the six mentioned variables as key inputs into
their Nobel Prize winning mathematical formula that churns out an
option value of equity, which is generally considered to be the fair
value.
The resulting values are the option prices we see displayed on the exchange boards and on our computer screens. There are other mathematical models, such as the Binary Model, that are also in use today in deriving fair option values. Each mathematical model carries flawed assumptions and therefore none is perfect. This is not as important as the fact that all options traders generally accept that the option prices traded on the major exchanges is as close to the real fair value as they should be, even though we are aware these ”fair” are being generated by imperfect mathematical models. As of now, we simply have to accept these options models as the best that we intellectually are capable of engineering, to produce close to fair option values. This is sufficient for the options markets to function.
Debating over whether the Black-Scholes model is superior or inferior to the Binary model should best be left to the academics.
Options
Greeks
Understanding
options Greeks, is by far, for most students, one of the most
challenging aspects of learning options. This is also usually the
stage at which many tend to give up due to the perceived complexity.
Readers with some foundation in statistics and calculus will find it easier to understand option greeks. But it is not an absolute pre-requisite. It will just be slightly harder, but not impossible, for someone with lesser mathematical inclination to fully grasp why and by how much option values change over time. I have made extra effort in making this topic as easily comprehensible as possible.
We already have some idea of how option values are derived. One deriving variable is equity spot price. This means, when the equity price moves, its options values will also change accordingly. For example, if the equity price moves up, all Call options will gain in value. But some Call options will gain more than others. Why?
To be able to understand this phenomenon, we find the explanations in the section on Option Greeks.
Briefly, option greeks are parameters assigned to each option. These parameters change option values under specific circumstances, such as with the passing of time or when the underlying equity price moves. The amount of changes to option premiums are determined by the sensitivity of those assigned option greeks, which are Delta(Δ), Gamma(Γ), Theta(Θ), Vega(ν) and Rho(ρ). These are the common, but not exhaustive list of, option Greeks.
VANILLA OPTIONS
– CALLs & PUTs
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A LONG Call is established by buying a Call option. A SHORT Put position is established by selling a Put option.
LONG Call, SHORT Call, LONG Put and SHORT Put options are termed as vanilla options. The term vanilla connotes “plain”, “simple”, “uncomplicated”, which is what all singular option positions are.
LONG CALL
Option
What
is a LONG Call Option?
A LONG Call option confers the buyer of a
CALL option the right, but not the obligation, to purchase the
underlying equity at a predetermined price at any time before or at
its expiration date.
When
to establish LONG Call options?
LONG Call options are purchased
when the trader has a bullish outlook on the price of the underlying
equity.
LONG
Call Illustration
In
May 2011, AMGN stocks are traded at about $60/share. John, a
fictitious trader, forms an opinion, after a thorough study of AMGN’s
business through fundamental and/or technical analyses, that the
price of AMGN shares will likely rise sharply beyond $60/share in the
future.
Instead
of forking out $6000 to purchase 100 shares of AMGN, John instead
buys AMGN options to execute his bullish investment plan. He looks at
the various AMGN Call option chains to decide which Call option that
he can buy into.
An option chain is a tabulation of various
options of different strike prices of the same expiration date.Every
option is priced at a premium.
Table 1 shows two AMGN option chains. These options will expire on the 3rd Fridays of Jun 2011 and Oct 2011 respectively. Within each options chain, there are many more available Call options of other strike prices. There are also many other options chains of different expiration months that are available to John.
Popular stocks which are usually more liquid, a term to mean highly transacted, tend to have more options chains. Less liquid stocks usually present fewer options chains to traders to choose their options from. For example, Citibank shares have available options chains expiring in Dec11, Jan12, Feb12, Mar12, May12, Jun12 and Sep12 as compared to Simpson Manufacturing Company, Inc, which lists options chains expiring on Dec11, Jan12, Mar12 and Jun12.
In this simple illustration, only three Call strike prices are presented in each options chain. In reality, John has a wide choice of many other Call strike prices within each options chain, ranging between 27.50 and 80 and with a $2.50 gap between the strike prices. This gap is known as a “spread”. For AMGN options, the spread is $2.50 apart, but for Hewlett Packard, it is currently a $1 spread. Thus, spreads between option strike prices vary for different underlying equities trading at different prices. Generally, the tighter the spread, the easier it is to trade them.
Which
Option to Choose?
How does John decide which options to choose
from the AMGN options chain? He has quite a few choices. Let’s just
suppose he chooses to buy one contract of Jun 11 expiration with a
strike price 60. This will cost him $100 of option fee to secure the
right, but not the obligation, to purchase 100 AMGN shares at
$60/share before or on 3rd Friday in Jun 2011.
His
position is shown as:
1 LONG AMGN Jun11 60Call
1 LONG AMGN option contract represents the right to buy 100 AMGN shares. Thus a single option premium of $1.00 translates to a cost of $100($1.00x100) in total option fee. This is a significantly smaller capital outlay compared to $6000 required to purchase 100 AMG shares upfront.
However, should John decide to purchase 1 contract of Call option of the same strike price of 60 from within the Oct11 option chain, he will need to pay $315($3.15x100). This is 3.15 times more capital outlay than his earlier choice. However, this gives John four extra months of right, but not the obligation, to purchase 100 AGMN shares at $60/share before or on the 3rd Friday of Oct 2011. This is because those Oct 11 options have four extra months of lifespan compared to those Jun 11 options.
By paying more for the further dated Oct11 Call option, John buys himself more time for AMGN share price to rise. He pays more for an increased chance of winning on his trade because with more time, AMGN share price has greater opportunity to go higher. This is one reason that John might be willing to pay more and purchase the Oct Call option instead of the Jun option.
Profit/Loss Profiles of 1 LONG AMGN Jun11 60Call & 1 LONG AMGN Oct11 60Call
Graphically,
all LONG Call options have similar P/L profiles as shown in figure 1.
Review
of LONG Jun11 60Call and LONG Oct11 60Call
Both
LONG Jun11 60Call and LONG Oct11 60Call have a limited loss
liability, which is equal to their respective option fee paid.
If AMGN share price does not rise as John had expected but instead falls below $60 by their respective option expiry dates, then either of John’s LONG Call options will become worthless. Recall that a LONG Call option conveys the right to purchase the underlying equity. But why would John want to exercise his LONG AMGN 60Call to buy AMGN shares at $60/share when they can be bought for less? Consequently, these 60Call options become junk.
Therefore, if AMGN shares trade below $60 at option expiration date, John would suffer a maximum loss of $100 if he had bought the LONG Jun11 60Call or $315 if he had purchased the LONG Oct11 60Call for the simple reason that those options are now worthless; ie., $0. As a consolation, John knows that he will not lose a penny more than the option fee he paid to establish either of the trade. This knowledge that his risk exposure is known in advance and limited is crucial in risk management.
That is, all LONG Call options have limited potential losses, otherwise known as limited risks, and they can be predetermined at the time these are bought.
Suppose John had purchased AMGN shares instead. Is this a limited risk investment? Well, it is if you consider that the stock price cannot go below $0, as a form of limitation. Recall Bear Stearns’ shares were trading at a 52 week high of $133.20 before it collapsed in 2008. Although under normal circumstances, chances are slim for a stock to hit $0 value, but evidently, this unlikely scenario does happen. So, the risk of purchasing shares is arguably “unlimited”, especially when the equity price is high in absolute terms. Suppose you purchased Google shares at $520/share or Berkshire Hathaway shares at $111,500/share in Jun 2011 and the worst nightmare happens and those shares collapse to $0. Granted this is rather unlikely, but if they did, your losses would be catastrophic.
On the other hand, if AMGN share price gaps up, perhaps due to some unexpected Food and Drug Administration approval on their latest trial drug, then John stands to make a fortune as LONG Calls have unlimited profit potential as shown in figure 1. If as the result of some positive news announcements, AMGN share price shoots to $200/share by the option expiry date, that LONG Oct11 60Call could profit John some $13,685. Not bad for an initial capital outlay of just $315 in the form of option fee paid(more of the detailed calculations later).
The higher AGMN shares climb in value, the more John will profit. Literally, the sky is the limit.
That is, all LONG Call options have unlimited profit potential.
Due to such unlimited profit potential and limited loss characteristics, many options traders start off buying vanilla LONG Call options. It is simple to understand and easy to establish. However, readers should take note that “simple” and “easy” do not always equal successful trades. And as you progress patiently through this book, you will discover why.
Breakeven
Point
Points A and B shown in figure 1 are the respective
breakeven points of LONG Jun11 60Call and LONG Oct11 60Call trades
respectively. Remember that John has to pay an option fee to
establish either of these LONG Call options. That option fee paid
represents the cost of “doing business”. Before John can profit
from either of his LONG Call positions, he must first recoup the cost
of establishing his LONG Call position. The breakeven point is the
price level that AMGN shares must first rise to in order for John to
recoup the option fee. Every LONG Call option position has a
breakeven point. It is only when the equity price settles higher than
such breakeven points that Long Call positions produce net profits.
In other words, for 1 LONG Jun11 60Call to generate a net profit for John, AMGN price must settle higher than $61 at the option expiration date or higher than $63.15 for the 1 LONG Oct11 60Call position(trade commissions, which also add to the cost of business, are omitted for simplicity).
Every option trade has at least one breakeven point. The way to calculate the breakeven point, for LONG Call positions, is as follows:
Breakeven Point = Strike Price + Option Premium (you do not really have to commit this to memory as long as you understand the logic behind this)
In this example, the 1 LONG Jun11 60Call has a breakeven point of $61 ($60+$1) because John paid $1 premium to buy the Jun11 60Call. The breakeven point for 1 LONG Oct11 60Call is $63.15 ($60+$3.15) because he paid $3.15 premium for the Oct11 60Call option.
We know John chose to buy a Call option on AMGN shares because he expects AMGN share price to rise in the near future. But we have yet to address what motivates John to choose between the Jun 60Call and Oct 60Call to purchase. So the question begging to be asked is, how should John decide which Call option to purchase? If it were just down to comparing premium fees, it would be easy. But it is not that straight forward.
Although LONG Jun11 60Call has a lower premium of $1 and so a lower breakeven point of $61, this option position has only one month of lifespan. This trade accords AMGN shares one month of time to rise in value. Is it realistic of John to expect AMGN share price to rise sharply and beyond $61 in just one month? Only John can make that decision. In other words, a trader must decide on his level of conviction of his trade opinion.
By choosing the LONG Oct11 60Call option, John is giving his trade position more time, some five months from May, or four more months compared to purchasing a LONG Jun11 60Call, for AMGN price to rally and perhaps to realize a bigger profit potential. With more time, it also gives John’s trade a higher probability of success because if AMGN share price were to dip immediately after John buys the LONG Oct11 60Call option, AMGN price has many months to recover from any correction and move back up. Not so, if he bought the nearer dated Jun11 60Call option, as there could be insufficient time for AMGN price to rise before those options expire. But for this advantage of additional time, John has to pay 3.15 times more in option fee
Thus, for options of the same underlying equity, of the same strike price, those further out (longer dated) options will always cost more than their nearer dated counterparts. You literally pay for time. As the saying goes, time is money. It is very aptly applied here.
And John has to decide on this trade off; ie., paying a lower option fee gives him less time and paying a higher one gives him more time. This is a constant conundrum that confronts every option trader. Whichever option John chooses to purchase is ultimately determined solely by his outlook for AMGN share price movement and his level of conviction on his market outlook. If he thinks AMGN price will shoot up aggressively very soon, then perhaps buying the LONG Jun11 60Call is a good choice but it’s not a good choice if he is not sure if AMGN price will rise immediately.
What John should not do, is to let his pocket size determine which of the options to buy. Many traders make this basic error. You should avoid falling into this trap. If you cannot afford to buy the option that best suits your trade outlook, you should not settle for something “cheaper” that could well lose you money, just for the excitement of being in the game. Do not get into the habit of buying “lottery tickets”, so named because these options require small capital outlay and have remote chances of winning.
Possible
Outcomes of 1 LONG AMGN Oct11 60Call
Let’s
review the possible outcomes of John’s 1 LONG Oct11 60call position
come the 3rd Friday of Oct 2011:
1)
If AMGN share price is below $60
John’s
LONG Oct 60Call option becomes valueless because it is not logical
for him to exercise his 60Call option given right to buy 100 AMGN
shares at $60 when the market is selling them for less than $60.
There will be no market interest in this option and so these 60Call
options become worthless. Consequently, the entire $315 option fee
that John paid to buy this 60Call is lost on this trade. The good
news is, no matter how low AMGN share price might settle below $60,
even if it was $0.10, John will not suffer anything more than $315 in
losses. This limited loss characteristic is one major advantage of
vanilla LONG Call positions.
2)
If AMGN shares trades between $60 and $63.15
Even
though AGMN price rallied, John would still make a loss, but less
than the maximum amount of $315, if AMGN share price settles between
$60 and $63.15 at option expiration date. Within this price
settlement range, John’s LONG 60Call will possess some value,
called the intrinsic value.
Suppose AMGN shares settle at $62,
this LONG 60Call will have an intrinsic value of $2 ($62-$60) and is
worth $200($2x100). Consequently, John loses $115 ($200-$315). So the
closer to $63.15 that AMGN price settles at option expiration date,
the smaller will be John’s loss. At $63.15, John breaks even on his
LONG Oct11 60Call trade, since it would produce
$315{($63.15-$63)x100} of gross profit, which offsets his paid option
fee.
3)
If AMGN price is above $63.15
This
option trade is profitable because John’s initial bullish bias
outlook is proven absolutely correct. The higher AMGN price settles
beyond $63.15 at option expiration date, the higher will be John’s
profit. If AMGN shares are at $100, then John will see a profit of
$3685{($100-$63.15)x100}.
Review
of Possible Outcomes of 1 LONG AMGN Jun11 60 Call
For
completeness, we shall review the possible outcomes of John’s 1
LONG Jun11 60Call trade on expiration date. With the same logic as
before:
A)
If AMGN price < $60
This
LONG Jun11 60Call option becomes worthless for the very same reason
that nobody will want it and so, its premium tumbles from $1 to $0.
John loses $100 consequently. But this is the maximum amount he will
ever lose on this trade. Not a penny more.
B)
AMGN price is between $60 and $61
John
still loses some money on this trade but the amount is less than
$100, even though John is correct in his trade opinion that AGMN
price will rally. The closer towards $61 the share price settles on
option expiration, the lower the loss. This is because that 60Call
option will have gained some intrinsic value as soon as AMGN price
rises past $60(strike price). At $61, John breaks even on his trade
because the $100{100x($61-$60)} gross profit generated by his LONG
Jun11 60Call merely recoups the $100 in paid option fee.
C)
If AMGN price > $61
This
Call option becomes a winner because AMGN share price rose as John
had expected. The higher the AMGN price settles at expiration date,
the higher John’s profit which can theoretically be infinite.
Although all LONG Call positions can theoretically generate infinite profits, how often have you witnessed a stock price rallying infinitely within a very short time frame? Can you name one in recent history? Even if you could, that would be just one stock among a stable of thousands of stocks listed in a stock exchange. You would have to be very blessed to have spotted this opportunity. Thus, the theory that LONG Call options can generate infinite profits remains just that, a theory in most instances. Still, it is a very enticing proposition for most novice options traders.
LONG PUT
Option
What
is a LONG Put option?
A Put option gives the buyer the right, but
not the obligation, to sell the underlying equity at an agreed price
on or before option expiration date.
When
to establish LONG Put options?
A LONG Put option can be
established, when the trader has a bearish outlook on the underlying
equity price.
LONG Put Illustration
After studying Research in Motion Limited’s (RIMM) business model, John is of the opinion that over the next few months, possibly by Sept 2011, RIMM price will fall substantially from its current $43 level in May2011.
To implement his bearish opinion, John could sell RIMM shares he does not own. This transaction is known as a naked SHORT stock. If he does so, he will need to put up a considerable sum of money as capital margin required by his brokerage in order to establish this naked Short stock position. He is also liable for any dividend payouts that RIMM may declare during the entire period that John has this naked SHORT stock position in place. For whatever reasons, if and when demanded, John is also fully obligated to deliver RIMM shares to the buyer. Since he does not actually own these shares he sold, he would need to buy them in the open market at whatever prevailing price, even if that meant absorbing a loss. More crucially, John is exposed to the enormous risks of losing an infinitely large sum of money if RIMM shares became very bullish and spiked up aggressively. Theoretically, naked SHORT stock positions have unlimited potential losses. Therefore, John must weigh these various considerations before establishing such naked SHORT stock positions.
Fortunately for John, he has the choice of buying Put options on RIMM shares . Purchasing these Put options represent an alternative investment vehicle for John to trade RIMM shares to the downside without all the shortcomings and risks of naked SHORT stock positions described earlier.
RIMM
trading at $43 in May2011
These two options chains are just a subset of several Put options chains of different expiration months. Within each options chain are many Put options of different strike prices ranging from 22.50 to 100 that are available for purchase. These subsets are selected for illustration purposes.
To express his bearish view that RIMM shares will take a huge tumble in the very near future, John chooses to buy 1 contract of Put option that will expire in June 2011 of strike price 42.50 and pays a $190 (100x$1.90) option fee. His position is represented in this format:
1 LONG RIMM Jun11 42.50Put
John could have chosen any one of the other Put options. His decision to purchase the Jun11 42.50Put option is based purely on his very bearish bias outlook on RIMM share price. He also believes that RIMM shares price will collapse imminently. His specific trade opinion compels him to choose the LONG Jun11 42.50Put instead of LONG Sept11 42.50Put option. This choice is not made because the former costs less.
In other words, John chose not to buy any of the Sept11 Put options because he believed RIMM price would plunge below its current $43 level within a month. His action is motivated by trade opinion. This is an appropriate move.
Note : when the capital outlay required to pay for an option fee is lower , it does not mean it is cheaper than another that requires more capital outlay. You will soon learn that certain options can be costlier to purchase, in terms of capital outlay, but are in fact cheaper because they have less extrinsic value.
Whether John is right or wrong with his very bearish outlook on RIMM price is not the topic of debate here. Rather, it is whether he acted correctly in his selection of Put option to purchase based on his view of RIMM price movement. In this regard, John’s decision to buy the less capital intensive Jun11 42.50Put rather than the LONG Oct11 42.50Put option is an acceptable course of action. He chooses to purchase LONG Jun11 42.50Put option not because he is restricted by his available trading funds. Doing so would be a wrong approach to options trading.
Profit/Loss
Profile of 1 LONG RIMM Jun11 42.50Put
Graphically,
all LONG Put options have similar P/L profiles as figure 2.
Risk/Reward
Profile
Maximum
Potential Profit = $4060 {($42.50-$0)x100-$190}
Maximum Potential
Loss = $190 (Total Option Fee Paid)
Breakeven Point = $40.60
($42.5 –$1.90)
Possible
Profit/Loss Outcomes of 1 LONG RIMM Jun11 42.50Put
At
option expiration date, John will profit or lose depending on where
RIMM price settles at.
1)
If RIMM settles higher than $42.50
John
is punished for his erroneous trade opinion that RIMM share price
will fall and fall imminently. Owners of 42.50Put option will not
exercise the right to sell RIMM shares at $42.50 when the stock can
be sold for higher than $42.50 in the open market, making those
42.50Put options worthless. The 1 LONG Jun11 42.50Put which used to
be worth $190 is now zero value. As a result, John loses $190 in
option fees. The good news is that John’s losses will be capped at
$190 no matter how high RIMM shares settle beyond $42.50 at
expiration date. This limited loss characteristic is a significant
advantage of buying LONG Puts. Had John naked SHORT sold RIMM stocks
instead of buying this put option, he would most certainly be in a
really messy situation.
2)
If RIMM trades settles below $40.60
If
John is right in his initial assessment and RIMM share price falls
sharply below $40.60, then his LONG Jun11 42.50Put trade will reward
him handsomely. In the best case scenario, should RIMM suddenly
declare chapter 11 and its shares tank to $0, John would stand to
earn a maximum of $4,060($42.50x100-$190).
Readers should not
think that listed companies frequently go bust.