The purpose of this series will be to explain the background of why we do what we do on this site. We will start with the basics and work up. Options enable the trader to play the market in more subtle ways than buying or selling stock straight up allows. On this site we like to trade events. Options are ideal for trading events because they take into account two aspects of stock movement: direction and speed. A trader can make money by predicting the probability of both and be protected even if he or she is only partially right. Options allow us to more specifically define risk, add yield, use leverage or protect a portfolio.
We will give explanations for many of the strategies that we use on the site as well as examples for when the strategy worked and when it did not and why. As with all aspects of the site, we do this not so that you can do as we do exactly, but so that you can optimize your own trading knowledge, goals and decisions. Most of our strategies will involve being flat to long premium, meaning overall we will have bought as many or more options than we’ve sold. Although with an infinite pocket, being short premium can be a winning strategy as volatility is mean reverting, on any particular trade you can lose the house, so for individual traders as opposed to large scale market makers it is not a strategy that we will explore or suggest.
We trade equity and ETF (Exchange Traded Fund) American options so that is what we will be discussing here. An option contract provides the right, but not the obligation, to buy (call) or sell (put) 100 shares of a stock or ETF at the strike price at any time up to the expiration date. If you buy an option you are considered “long” the option and if you sell it (without already being long it) you are considered “short.” As a seller of a call or put you are obliged to either sell or buy the stock respectively at the option’s strike price if the option is exercised at any time up to expiration. Check with your clearance firm, but generally an option is automatically exercised if it finishes $.01 in-the-money at the time of expiration. The expiration date for American stock options is usually the first Saturday after the third Friday of the month. Now that we have weekly options on many stocks it is important to keep in mind that there may be more than one type of expiring option in any month. Also leaps expire in the next calendar year so it is important with January options to make sure you are aware which year they are expiring in. Because of weekly’s we will often include the expiration day number after the month. For example, TRGT Jan21’12 10 call refers to the Target stock call of strike 10 expiring on January 21, 2012.
Some basic terminology. Premium is the price paid for or received for an option contract. Just to relieve my own trauma from my option clerking days where Jimmy yelled it into my head, I will emphasize that you buy “for” and sell “at.” In these days of electronic trading it isn’t so vital, but in case you are on the phone with a broker at any point you won’t sound like an amateur. An in-the-money option has intrinsic value. What does that mean? It means that in the case of a call the strike price is below the currently trading stock price so that you could exercise your call right now and buy stock below the price of the stock. In the case of a put the strike price is higher than the currently trading stock price so that you could exercise your put and sell stock above the current price. Thus these options are worth something right now even if the stock froze until expiration, they have intrinsic value. If the premium equals the intrinsic value, an option is considered to be trading at parity. At-the-money refers to options where the strike price is the closest to the currently trading stock price. Out-of-the-money refers to options whose strike price in the case of calls is above the current trading stock price and for puts below the current trading stock price. You wouldn’t want to pay to buy stock above the currently trading price, nor would you want to pay to sell stock lower than it is currently trading. Thus out-of-the-money options have no intrinsic value. Why would we pay to own them and why is the premium for in-the-money options often more than their intrinsic value? This part of the option price is referred to as time value (although I like the term extrinsic value as there is more than time involved) and is based on a number of factors: time to expiration, implied volatility, dividend, carrying cost and short interest. Extrinsic value is what makes options fun and scares off the faint of heart.
A naked call or put is like a lottery ticket. How much you would pay for a lottery ticket depends on the likelihood of winning. Similarly how much you would sell a lottery ticket for depends on the chance of losing. This is where we will point out that if you buy a lottery ticket you may not win, but you lose only the price of the ticket. If you sell a lottery ticket you can lose much more if someone else happens to win. If a stock is likely to move around, in other words has a high volatility, the options will cost more because it is more likely that a stock might move through out-of-the-money strikes. Similarly, if there is more time to expiration an option will cost more because there is more time opportunity for the stock to move. For example at the time of this writing the BHP Jan21’12 70 calls are $3.25 bid with stock at $69.76 and implied volatility on that call line of 40. The NFLX Jan21’12 70 calls are $6.20 bid with stock at $69.93 and implied volatility on the line of 72. The NFLX Mar17’12 70 calls are $10.50 bid with an implied volatility of 76 (In this case the March calls have not only more time to expiration but a slightly higher implied volatility because March is going into the next quarter’s earning, we will discuss volatility and implied volatility more later.) Dividend and carrying cost are fixed and so although you need to factor them in (well not so much carrying cost in this time of low interest) they are not changing or only discreetly with announcements. Short interest requires a longer discussion which we will put off for later.
This is the first in a running series. All of this educational information will end up in a new section of the site dedicated to options knowledge. The series will start with more basics and move on to more complicated strategies and lessons.