Chapter 1
Calls and Puts: Defining the Field of Play
Nine-tenths of wisdom is being wise in time.
—Theodore Roosevelt, speech, June 14, 1917
Options are amazing tools that can help you expand your control over your portfolio, protect positions, reduce market risk, and enhance current income. Some strategies are very high risk, but others are extremely conservative. This is what makes the options market so interesting. The variety of creative uses of options makes it possible to tie in profits in the most uncertain of conditions, or to pursue income opportunities without being exposed to even the most volatile markets.
Because the option is an intangible device, its cost is only a fraction of stock prices. This makes it possible to control shares of stock without assuming the market risks. Each option controls 100 shares, so for approximately 10 percent of the cost of buying shares in a company, you can use options to create the same profit stream. This makes your capital go farther while keeping risks very low.
This idea—using intangible contracts to duplicate the returns you expect from well-picked stocks—is revolutionary to anyone who has never explored options trading. Most people are aware of the two best-known ways to invest money: equity and debt. An equity investment is the purchase of a share of stock or many shares of stock, which represents a partial interest in the company itself. Shares are sold through stock exchanges or over the counter (trades made on companies not listed on an exchange). For example, if a company has one million shares outstanding and you buy 100 shares, you own 100/1,000,000ths, or .0001 percent of the company.
equity investment
an investment in the form of part ownership, such as the purchase of shares of stock in a corporation.
share
a unit of ownership in the capital of a corporation.
When you buy 100 shares of stock, you are in complete control over that investment. You decide how long to hold the shares and when to sell. Stocks provide you with tangible value, because they represent part ownership in the company. Owning stock entitles you to dividends if they are declared, and gives you the right to vote in elections offered to stockholders. (Some special nonvoting stock lacks this right.) If the stock rises in value, you will gain a profit. If you wish, you can keep the stock for many years, even for your whole life. Stocks, because they have tangible value, can be traded over public exchanges, or they can be used as collateral to borrow money.
Example
Equity for Cash: You purchase 100 shares at $27 per share, and place $2,700 plus trading fees into your account. You receive notice that the purchase has been completed. This is an equity investment, and you are a stockholder in the corporation.
Example
Partway There: You buy an automobile for $10,000. You put down $3,000 and finance the difference of $7,000. Your equity is limited to your down payment of $3,000. You are the licensed owner, but the financed balance of $7,000 is not part of your equity.
debt investment
an investment in the form of a loan made to earn interest, such as the purchase of a bond.
The second broadly understood form is a debt investment, also called a debt instrument. This is a loan made by the investor to the company, government, or government agency, which promises to repay the loan plus interest, as a contractual obligation. The best-known form of debt instrument is the bond. Corporations, cities and states, the federal government, agencies, and subdivisions finance their operations and projects through bond issues, and investors in bonds are lenders, not stockholders.
When you own a bond, you also own a tangible value, not in stock but in a contractual right with the lender. The bond issuer promises to pay you interest and to repay the amount loaned by a specific date. Like stocks, bonds can be used as collateral to borrow money. They also rise and fall in value based on the interest rate a bond pays compared to current rates in today’s market. In the event an issuer goes broke, bondholders are usually repaid before stockholders as part of their contract, so bonds have that advantage over stocks.
Example
Lending Your Money: You purchase a bond currently valued at $9,700 from the U.S. government. Although you invest your funds in the same manner as a stockholder, you have become a bondholder; this does not provide any equity interest to you. You are a lender and you own a debt instrument.
Example
Helping a Friend: A good friend wants to buy a car for $10,000, but has only $3,000 in cash. This friend asks you to lend him the balance of $7,000 and offers to pay interest to you. The $7,000 you contribute is a debt investment, and the interest you earn is income on that investment. When you act as lender, you have made a debt investment.
The third form of investing is less well known. Equity and debt contain a tangible value that we can grasp and visualize. Part ownership in a company and the contractual right for repayment are basic features of equity and debt investments. Not only are these tangible, but they have a specific life span as well. Stock ownership lasts as long as you continue to own the stock and cannot be canceled unless the company goes broke; a bond has a contractual repayment schedule and ending date. The third form of investing does not contain these features; it disappears—expires—within a short period of time. You might hesitate at the idea of investing money in a product that evaporates and then ceases to have any value. In fact, there is no tangible value at all.
Smart Investor Tip
Options are intangible and have a limited life span. The main advantage is that options allow you to control 100 shares of stock without having to buy those shares.
So we’re talking about investing money in something with no tangible value, which will be absolutely worthless within a few months. To make this even more perplexing, imagine that the value of this intangible is certain to decline just because time passes by. To confuse the point even further, imagine that these attributes can be an advantage or a disadvantage, depending on how you decide to use these products.
These are some of the features of options. Taken alone (and out of context), these attributes certainly do not make this market seem very appealing. These attributes—lack of tangible value, worthlessness in the short term, and decline in value itself—make options seem far too risky for most people. But there are good reasons for you to read on. Not all methods of investing in options are as risky as they might seem; some are quite conservative because the features just mentioned can work to your advantage. In whatever way you might use options, the many strategies that can be applied make options one of the more interesting avenues for investors. The more you study options, the more you realize that they are flexible; they can be used in numerous situations and to create numerous opportunities; and, most intriguing of all, they can be either exceptionally risky or downright conservative.
Smart Investor Tip
Option strategies range from high risk to extremely conservative. The risk features on one end of the spectrum work to your advantage on the other. Options provide you with a rich variety of choices.
option
the right to buy or to sell 100 shares of stock at a specified, fixed price and by a specified date in the future.
An option is a contract that provides you with the right to execute a stock transaction—that is, to buy or sell 100 shares of stock. (Each option always refers to a 100-share unit.) This right includes a specific stock and a specific fixed price per share that remains fixed until a specific date in the future. When you have an open option position, you do not have any equity in the stock, and neither do you have any debt position. You have only a contractual right to buy or to sell 100 shares of the stock at the fixed price.
Since you can always buy or sell 100 shares at the current market price, you might ask: “Why do I need to purchase an option to gain that right?” The answer is that the option fixes the price of stock, and this is the key to an option’s value. Stock prices may rise or fall, at times significantly. Price movement of the stock is unpredictable, which makes stock market investing interesting and also defines the risk to the market itself. As an option owner, the stock price you can apply to buy or sell 100 shares is frozen for as long as the option remains in effect. So no matter how much price movement takes place, your price is fixed should you decide to purchase or sell 100 shares of that stock. Ultimately, an option’s value is going to be determined by a comparison between the fixed price and the stock’s current market price.
A few important restrictions come with options:
round lot
a lot of 100 shares of stock or of higher numbers divisible by 100, the usual trading unit on the public exchanges.
• The right to buy or to sell stock at the fixed price is never indefinite; in fact, time is the most critical factor because the option exists for a specific time only. When the deadline has passed, the option becomes worthless and ceases to exist. Because of this, the option’s value is going to fall as the deadline approaches, and in a predictable manner.
• Each option also applies only to one specific stock and cannot be transferred.
• Finally, each option applies to exactly 100 shares of stock, no more and no less.
odd lot
a lot of shares that contains fewer than the more typical round lot trading unit of 100 shares.
Stock transactions commonly occur in blocks divisible by 100, called a round lot, which has become a standard trading unit on the public exchanges. In the market, you have the right to buy or sell an unlimited number of shares, assuming that they are available for sale and that you are willing to pay the seller’s price. However, if you buy fewer than 100 shares in a single transaction, you will be charged a higher trading fee. An odd-numbered grouping of shares is called an odd lot .
call
an option acquired by a buyer or granted by a seller to buy 100 shares of stock at a fixed price within a specified time period.
So each option applies to 100 shares, conforming to the commonly traded lot, whether you are operating as a buyer or as a seller. There are two types of options. First is the call, which grants its owner the right to buy 100 shares of stock in a company. When you buy a call, it is as though the seller is saying to you, “I will allow you to buy 100 shares of this company’s stock, at a specified price, at any time between now and a specified date in the future. For that privilege, I expect you to pay me the current call’s price.”
Each option’s value changes according to changes in the price of the stock. If the stock’s value rises, the value of the call option will follow suit and rise as well. And if the stock’s market price falls, the call option will react in the same manner. When an investor buys a call and the stock’s market value rises after the purchase, the investor profits because the call becomes more valuable. The value of an option actually is quite predictable—it is affected by the passage of time as well as by the ever-changing value of the stock.
Smart Investor Tip
Changes in the stock’s value affect the value of the option directly, because while the stock’s market price changes, the option’s specified price per share remains the same. The changes in value are predictable; option valuation is no mystery.
put
an option acquired by a buyer or granted by a seller to sell 100 shares of stock at a fixed price within a specified time period.
The second type of option is the put . This is the opposite of a call in the sense that it grants a selling right instead of a purchasing right. The owner of a put contract has the right to sell 100 shares of stock. When you buy a put, it is as though the seller were saying to you, “I will allow you to sell me 100 shares of a specific company’s stock, at a specified price per share, at any time between now and a specific date in the future. For that privilege, I expect you to pay me the current put’s price.”
The attributes of calls and puts can be clarified by remembering that either option can be bought or sold. This means there are four possible permutations to option transactions:
1. Buy a call (buy the right to buy 100 shares).
2. Sell a call (sell to someone else the right to buy 100 shares from you).
3. Buy a put (buy the right to sell 100 shares).
4. Sell a put (sell to someone else the right to sell 100 shares to you).
Another way to keep the distinction clear is to remember these qualifications: A call buyer believes and hopes that the stock’s value will rise, but a put buyer is looking for the price per share to fall. If the belief is right in either case, then a profit may occur.
The opposite is true for sellers of options. A call seller hopes that the stock price will remain the same or fall, and a put seller hopes the price of the stock will rise. (The seller profits if the option’s value falls—more on this later.)
Smart Investor Tip
Option buyers can profit whether the market rises or falls; the trick is knowing ahead of time which direction the market will take.
If an option buyer—dealing either in calls or in puts—is correct in predicting the price movement in the stock’s market value, then the action of buying the option will be profitable. Market value is the price value agreed upon by both buyer and seller, and is the common determining factor in the auction marketplace. However, when it comes to options, you have an additional obstacle besides estimating the direction of price movement: The change has to take place before the deadline that is attached to every option. You might be correct about a stock’s long-term prospects, and as a stockholder you have the luxury of being able to wait out long-term change. However, this luxury is not available to option buyers. This is the critical point. Options are finite and, unlike stocks, they cease to exist and lose all of their value within a relatively short period of time—within a few months for every listed option . (Long-term options last up to three years; more on these later.) Because of this daunting limitation to options trading, time is one important factor in determining whether an option buyer is able to earn a profit.
market value
the value of an investment at any given time or date; the amount a buyer is willing to pay to acquire an investment and what a seller is also willing to receive to transfer the same investment.
listed option
an option traded on a public exchange and listed in the published reports in the financial press.
Smart Investor Tip
It is not enough to accurately predict the direction of a stock’s price movement. For option buyers, that movement has to occur quickly enough for that profit to materialize while the option still exists.
Why does the option’s market value change when the stock’s price moves up or down? First of all, the option is an intangible right, a contract lacking the kind of value associated, for example, with shares of stock. The option is an agreement relating to 100 shares of a specific stock and to a specific price per share. Consequently, if the buyer’s timing is poor—meaning the stock’s movement doesn’t occur or is not substantial enough by the deadline—then the buyer will not realize a profit.
When you buy a call, it is as though you are saying, “I am willing to pay the price being asked to acquire a contractual right. That right provides that I may buy 100 shares of stock at the specified fixed price per share, and this right exists to buy those shares at any time between my option purchase date and the specified deadline.” If the stock’s market price rises above the fixed price indicated in the option agreement, the call becomes more valuable. Imagine that you buy a call option granting you the right to buy 100 shares at the price of $80 per share. Before the deadline, though, the stock’s market price rises to $95 per share. As the owner of a call option, you have the right to buy 100 shares at $80, or 15 points below the current market value. This is the purchaser’s advantage in the scenario described, when market value exceeds the fixed contractual price indicated in the call’s contract. In that instance, you as buyer would have the right to buy 100 shares 15 points below current market value. You own the right, but you are not obligated to follow through. For example, if your call granted you the right to buy 100 shares at $80 per share but the stock’s market price fell to $70, you would not have to buy shares at the fixed price of $80; you could elect to take no action.
contract
a single option, the agreement providing the buyer with the terms that option grants. Those terms include identification of the stock, the cost of the option, the date the option will expire, and the fixed price per share of the stock to be bought or sold under the rights of the option.
The same scenario applies to buying puts, but with the stock moving in the opposite direction. When you buy a put, it is as though you are saying, “I am willing to pay the asked price to buy a contractual right. That right provides that I may sell 100 shares of the specified stock at the indicated price per share, at any time between my option purchase date and the specified deadline.” If the stock’s price falls below that level, you will be able to sell 100 shares above current market value. For example, let’s say that you buy a put option providing you with the right to sell 100 shares at $80 per share. Before the deadline, the stock’s market value falls to $70 per share. As the owner of a put, you have the right to sell 100 shares at the fixed price of $80, which is $10 per share above the current market value. You own the right but you are not obligated. For example, if your put granted you the right to sell 100 shares at $70 but the stock’s market price rose to $85 per share, you would not be required to sell at the fixed price. You could sell at the higher market price, which would be more profitable. The potential advantage to option buyers is found in the contractual rights that they acquire. These rights are central to the nature of options, and each option bought or sold is referred to as a contract.
The Call Option
A call is the right to buy 100 shares of stock at a fixed price per share, at any time between the purchase of the call and the specified future deadline. This time is limited. As a call
buyer, you acquire the right, and as a call
seller, you grant the right of the option to someone else. (See
Figure 1.1.)
Let’s walk through an illustration and apply both buying and selling as they relate to the call option.
•
Buyer of a call: When you buy a call, you hope that the stock will rise in value, because that will result in a corresponding increase in value for the call. This will create higher market value in the call, which can be sold and closed at a profit; or the stock can be bought at a fixed price lower than the current market value.
buyer
an investor who purchases a call or a put option; the buyer realizes a profit if the value of stock moves above the specified price (call) or below the specified price (put).
seller
an investor who grants a right in an option to someone else; the seller realizes a profit if the value of the stock moves below the specified price (call) or above the specified price (put).
• Seller of a call: When you sell a call, you hope that the stock will fall in value, because that will result in a corresponding decrease in value for the call. This will create lower market value for the call, which can then be purchased and closed at a profit; or the stock can be sold to the buyer at a price above current market value. The order is the reverse from the better-known buyer’s position. The call seller will first sell and then, later on, will close the transaction with a buy order. (More information on selling calls is presented in Chapter 5.)
The backwards sequence used by call sellers is often difficult to grasp for anyone accustomed to the more traditional buy-hold-sell pattern. The seller’s approach is to sell-hold-buy. Remembering that time is running for every option contract, the seller, by reversing the sequence, has a distinct advantage over the buyer. Time is on the seller’s side.
Smart Investor Tip
Option sellers reverse the sequence by selling first and buying later. This strategy has many advantages, especially considering the restriction of time unique to the option contract. Time benefits the seller.
supply and demand
the market forces that determine the current value for stocks. The number of buyers represents demand for shares, and the number of sellers represents supply. The price of stocks rises as demand increases, and falls as supply increases.
Prices of listed options—those traded publicly on exchanges like the New York, Chicago, and Philadelphia stock exchanges—are established strictly through supply and demand. Those are the forces that dictate whether market prices rise or fall for stocks. As more buyers want stocks, prices are driven upward by their demand; and as more sellers want to sell shares of stock, prices decline due to increased supply. The supply and demand for stocks, in turn, affect the market value of options. The option itself has no direct fundamental value or underlying financial reasons for rising or falling; its market value is a by-product of the fundamental and technical changes in the stock.
Smart Investor Tip
The market forces affecting the value of stocks in turn affect market values of options. The option itself has no actual fundamental value; its market value is formulated based on the stock’s fundamentals.
The orderly process of buying and selling stocks, which establishes stock price values, takes place on the exchanges through trading available to the general public. This overall public trading activity, in which prices are being established through ever-changing supply and demand, is called the auction market, because value is not controlled by any forces other than the market itself. These forces include economic news and perceptions, earnings of listed companies, news and events affecting products and services, competitive forces, and Wall Street events, both positive and negative. Individual stock prices also rise or fall based on index motion.
Stocks issued by corporations are limited in number, but the exchanges will allow investors to buy or sell as many options as they want. The number of active options is unlimited. However, the values in option contracts respond directly to changes in the stock’s value. The two primary factors affecting an option’s value are time and the market value of the stock.
auction market
the public exchanges in which stocks, bonds, options, and other products are traded publicly, and in which values are established by ever-changing supply and demand on the part of buyers and sellers.
Smart Investor Tip
Option value is affected by movement in the price of the stock and by the passage of time. Supply and demand affect option valuation only indirectly.
The owner of a call enjoys an important benefit in the auction market. There is always a ready market for the option at the current market price. That means that the owner of an option never has a problem selling that option.
ready market
a liquid market, one in which buyers can easily sell their holdings, or in which sellers can easily find buyers, at current market prices.
This feature is of critical importance. For example, if there were constantly more buyers than sellers of options, then market value would be distorted beyond reason. To some degree, distortions do occur on the basis of rumor or speculation, usually in the short term. But by and large, option values are directly formulated on the basis of stock prices and time until the option will cease to exist. If buyers had to scramble to find a limited number of willing sellers, the market would not work efficiently. Demand between buyers and sellers in options is rarely equal because options do not possess supply-and-demand features of their own. So the Options Clearing Corporation (OCC) acts as the seller to every buyer, and as the buyer to every seller.
Smart Investor Tip
Learn more about the Options Clearing Corporation (OCC) at their web site,
www.optionsclearing.com. This page includes current market information, resources for options trading, and a link to the options prospectus, “Characteristics and Risks of Standardized Options.” The prospectus can also be viewed at the Chicago Board Options Exchange (CBOE) web site,
www.cboe.com/Resources/intro.aspx.
How Call Buying Works
expiration date
the date on which an option becomes worthless, which is specified in the option contract.
underlying stock
the stock on which the option grants the right to buy or sell, which is specified in every option contract.
When you buy a call, you are not required to buy the 100 shares of stock. You have the right, but not the obligation. In fact, the vast majority of call buyers do not actually buy 100 shares of stock. Most buyers are speculating on the price movement of the stock, hoping to sell their options at a profit rather than buy 100 shares of stock. As a buyer, you have until the expiration date to decide what action to take, if any. You have several choices, and the best one to make depends entirely on what happens to the market price of the underlying stock, and on how much time remains in the option period.
Using calls to illustrate, there are three scenarios relating to the price of the underlying stock, and several choices for action within each.
1.
The market value of the underlying stock rises. In the event of an increase in the price of the underlying stock, you may take one of two actions. First, you may
exercise the call and buy the 100 shares of stock below current market value. Second, if you do not want to own 100 shares of that stock, you may sell the option for a profit.
Every option has a fixed value at which exercise takes place. Whenever an option is exercised, the purchase price of 100 shares of stock takes place at that fixed price, which is called the striking price of the option. Striking price is expressed as a numerical equivalent of the dollar price per share, without dollar signs. The striking price is normally divisible by 5, as options are established with striking prices at five-dollar price intervals for stocks selling between $30 and $200 per share. Stocks selling under $30 have options trading at 2.5-point intervals; and stocks trading above $200 per share have options trading at $10 intervals. When a stock splits, new striking price levels may also be introduced. For example, if a stock is split 2-for-1 and it has a current option at 35, the post-split levels would be adjusted to 17½. (In cases of splits, the number of shares and options are adjusted so that the ratio of one option per 100 shares of stock remains constant. In a 2-for-1 split, 100 shares become 200 shares at half the value; and each outstanding option becomes two options worth half the pre-split value.)
exercise
the act of buying stock under the terms of the call option or selling stock under the terms of the put option, at the price per share specified in the option contract.
striking price
the fixed price to be paid for 100 shares of stock, specified in the option contract; the transaction price per share of stock upon exercise of that option, regardless of the current market value of the stock.
Example
Profitable Decisions: You decided two months ago to buy a call. You paid the option price of $200, which entitled you to buy 100 shares of a particular stock at $55 per share. The striking price is 55. The option will expire later this month. The stock currently is selling for $60 per share, and the option’s current value is 6 ($600). You have a choice to make: You may exercise the call and buy 100 shares at the contractual price of $55 per share, which is $5 per share below current market value; or you may sell the call and realize a profit of $400 on the investment, consisting of current market value of the option of $600, less the original price of $200. (This example does not include an adjustment for trading costs, so in applying this and other examples, remember that it will cost you a fee each time you enter an option transaction and each time you leave one. This should be factored into any calculation of profit or loss on an option trade.)
wasting asset
any asset that declines in value over time. An option is an example of a wasting asset because it exists only until expiration, after which it becomes worthless.
premium value
the current price of an option, which a buyer pays and a seller receives at the time of the transaction. The amount of premium is expressed as the dollar value of the option, but without dollar signs; for example, stating that an option is “at 3” means its current market value is $300.
2.
The market value of the underlying stock does not change. It often happens that within the life span of an option, the stock’s market value does not change, or changes are too insignificant to create the profit scenario you hope for when you buy calls. You have two alternatives in this situation. First, you may sell the call at a loss before its expiration date (after which the call becomes worthless). Second, you may hold on to the option, hoping that the stock’s market value will rise before expiration, which would create a rise in the call’s value as well, at the last minute. The first choice, selling at a loss, is advisable when it appears there is no hope of a last-minute surge in the stock’s market value. Taking some money out and reducing your loss may be wiser than waiting for the option to lose even more value. Remember, after expiration date, the option is worthless. An option is a
wasting asset, because it is designed to lose all of its value after expiration. By its limited life attribute, it is expected to decline in value as time passes. If the market value of the stock remains at or below the striking price all the way to expiration, then the
premium value—the current market value of the option—will be much less near expiration than at the time you purchased it, even if the stock’s market value remains the same. The difference reflects the value of time itself. The longer the time until expiration, the more opportunity there is for the stock (and the option) to change in value.
Smart Investor Tip
In setting standards for yourself to determine when or if to take profits in an option, be sure to factor in the cost of the transaction. Brokerage fees and charges vary widely, so shop around for the best option deal based on the volume of trading you undertake.
Example
Best Laid Plans: You purchased a call a few months ago “at 5.” (This means you paid a premium of $500). You hoped that the underlying stock would increase in market value, causing the option also to rise in value. The call will expire later this month, but contrary to your expectations, the stock’s price has not changed. The option’s value has declined to $100. You have the choice of selling it now and taking a $400 loss; or you may hold the option, hoping for a last-minute increas in the stock’s value. Either way, you will need to sell the option before expiration, after which it will become worthless.
Smart Investor Tip
The options market is characterized by a series of choices, some more difficult than others. It requires discipline to apply a formula so that you make the best decision given the circumstances, rather than acting on impulse. That is the key to succeeding with options.
3.
The market value of the underlying stock falls. As the underlying stock’s market value falls, the value of all related calls will fall as well. The value of the option is always related to the value of the underlying stock. If the stock’s market price falls significantly, your call will show very little in the way of market value. You may sell and accept the loss or, if the option is worth nearly nothing, you may simply allow it to expire and take a full loss on the transaction.
This example demonstrates that buying calls is risky. The last-minute rescue of an option by a sudden increase in the value of the underlying stock can and does happen, but usually it does not. The limited life of the option works against the call buyer, so that the entire amount invested could be lost. The most significant advantage in speculating in calls is that instead of losing a larger sum in buying 100 shares of stock, the loss is limited to the relatively small premium value. At the same time, you could profit significantly as a call buyer because less money is at risk. The stockholder, in comparison, has the advantage of being able to hold stock indefinitely, without having to worry about expiration date. For stockholders, patience is always possible, and it might take many months or even years for growth in value to occur. The stockholder is under no pressure to act because stock does not expire as options do.
Example
Dashed Hopes: You bought a call four months ago and paid 3 (a premium of $300). You were hoping that the stock’s market value would rise, also causing a rise in the value of the call. Instead, the stock’s market value fell, and the option followed suit. It is now worth only 1 ($100). You have a choice: You may sell the call for 1 and accept a loss of $200; or you may hold on to the call until near expiration. The stock could rise in value at the last minute, which has been known to happen. However, by continuing to hold the call, you risk further deterioration in the call premium value. If you wait until expiration occurs, the call will be worthless.
Example
Limiting Risk: You bought a call last month for 1 (premium of $100). The current price of the stock is $80 per share. For your $100 investment, you have a degree of control over 100 shares, without having to invest $8,000. Your risk is limited to the $100 investment; if the stock’s market value falls, you cannot lose more than the $100, no matter what. In comparison, if you paid $8,000 to acquire 100 shares of stock, you could afford to wait indefinitely for a profit to appear, but you would have to tie up $8,000. You could also lose much more; if the stock’s market value falls to $50 per share, your investment will have lost $3,000 in market value.
Smart Investor Tip
For anyone speculating over the short term, option buying is an excellent method of controlling large blocks of stock with minor commitments of capital.
In some respects, the preceding example defines the difference between investing and speculating. The very idea of investing usually indicates a long-term mentality and perspective. Because stock does not expire, investors enjoy the luxury of being able to wait out short-term market conditions, hoping that over several years that company’s fortunes will lead to profits—not to mention continuing dividends and ever-higher market value for the stock. There is no denying that stockholders enjoy clear advantages over option buyers. They can wait indefinitely for the market to go their way. They earn dividend income. And stock can be used as collateral for buying or financing other assets. Speculators, in comparison, risk losing all of their investment, while also being exposed to the opportunity for spectacular gains. Rather than considering one method as being better than the other, think of options as yet another way to use investment capital. Option buyers know that their risk/reward scenario is characterized by the ever-looming expiration date. To understand how the speculative nature of call buying affects you, consider the following two examples.
Smart Investor Tip
The limited life of options defines the risk/reward scenario, and option players recognize this as part of their strategy. The risk is accepted because the opportunity is there, too.
Example
Rising Hopes . . . and Prices: You buy an 80 call for 2 ($200), which provides you with the right to buy 100 shares of stock for $80 per share. If the stock’s value rises above $80, your call will rise in value dollar for dollar along with the stock. So if the stock goes up $4 per share to $84, the option will also rise four points, or $400 in value. You would earn a profit of $200 if you were to sell the call at that point (four points of value less the purchase price of 2). That would be the same amount of profit you would realize by purchasing 100 shares of stock at $8,000 and selling those shares for $8,200. (Again, this example does not take into account any brokerage and trading costs. Chances are that fees for the stock trade would be higher than for an option trade because more money is being exchanged.)
Example
Falling Expectations: You buy an 80 call for 2 ($200), which gives you the right to buy 100 shares of stock at $80 per share. By the call’s expiration date, the stock has fallen to $68 per share. You lose the entire $200 investment as the call becomes worthless. However, if you had purchased 100 shares of stock and paid $8,000, your loss at this point would be $1,200 ($80 per share at purchase, less current market value of $68 per share). Your choice, then, would be to sell the stock and take the loss or continue to keep your capital tied up, hoping its value will eventually rebound. Compared to buying stock directly, the option risks are limited. Stockholders can wait out a temporary drop in price, even indefinitely. However, the stockholder has no way of knowing when the stock’s price will rebound, or even if it ever will do so. As an option buyer, you are at risk for only a few months at the most. One of the risks in buying stock is the lost opportunity risk—capital is committed in a loss situation while other opportunities come and go.
lost opportunity risk (stock)
the risk stockholders experience in tying up capital over the long term, causing lost opportunities that could be taken if capital were available.
In situations where an investment in stock loses value, stockholders can wait for a rebound. During that time, they are entitled to continue receiving dividends, so their investment is not entirely in limbo. If you are seeking long-term gains, then a temporary drop in market value is not catastrophic as long as you continue to believe that the company remains a viable long-term “hold” candidate; market fluctuations might even be expected. Some investors would see such a drop as a buying opportunity and pick up even more shares. The effect of this move is to lower the overall basis in the stock, so that a rebound creates even greater returns later on.
Smart Investor Tip
A long-term investor can hold stock indefinitely and does not have to worry about expiration. Option buyers have to worry continually about expiration date.
The advantage in buying calls is that you are not required to tie up a large sum of capital nor to keep it at risk for a long time. Yet you are able to control 100 shares of stock for each option purchased as though you had bought those shares outright. Losses are limited to the amount of premium you pay.
The Long-Term Call Option
The greatest inhibiting factor in evaluating calls is time. As a call buyer, you need to continually be aware that expiration forces a decision point; profits have to materialize before expiration, or the call buyer loses money.
The listed option has a life span of only a few months, normally eight or so; the price movement of the stock has to be substantial enough to overcome this time factor. For many buyers, the short life span of calls makes them impractical as a speculative position. To overcome this problem, call buyers may also consider using long-term options. These work just like listed options in every respect, with one exception: their life span lasts up to three years.
A long-term equity anticipation security (LEAPS) is a long-term option that can be used to solve the problem of time. Unlike the relatively short-lived listed option, LEAPS can be used to expand many strategies that would otherwise be impractical, given the time factor.
The long-term option, because of its extended life, can be employed for some strategies that are not practical with shorter-expiration contracts. LEAPS can be used as an alternative to buying stock and placing large sums of capital at risk. This could change the way that you invest in volatile market conditions. They can also be used to protect paper profits over a period of time, in combination with other strategies, and for speculative or conservative strategies. The choice of using listed options or LEAPS options expands the range of strategies and makes the entire field of options far more flexible; options traders can look beyond the eight-month range that is typical for listed options and achieve far more with a greater amount of time in play.
LEAPS
Long-term equity anticipation security, long-term option contracts that work just like standardized options, but with expiration up to three years.
In considering calls and reviewing the broad range of risk levels, you can consider both short-term and long-term options in developing investment standards. Throughout the remainder of this book, many examples will employ listed options as well as LEAPS options to illustrate how strategies can be used in a number of different ways.
Investment Standards for Call Buyers
Whether using shorter-term listed options or LEAPS calls, you need to not only be aware of risk levels, but also to establish a clear investment standard for yourself. This means much more than merely taking the advice of a stockbroker or financial planner; it means considering a range of ideas and choosing standards that fit well for you, individually.
People who work in the stock market—including brokers who help investors to decide what to buy and sell—regularly offer advice on stocks. If a stockbroker, analyst, or financial planner is qualified, he or she may also offer advice on trading in options. Three important points should be kept in mind when working with a broker, especially where option buying is involved.
1. You need to develop your own expertise. The broker might not know as much about the market as you do. Just because someone has a license does not mean that he or she is an expert on all types of investments. In fact, due to the nature of the options market, you may want to become proficient at making your own options-related decisions. In this case, you may wish to continue employing outside help for stock-related decisions, but maintain direct control over options trading.
2. You cannot expect on-the-job training as an options investor. Don’t expect a broker to train you. Remember, brokers earn their living on commissions and placement of orders. That means their primary motive is to get clients to buy and to sell. Here again, you may depend on a broker’s expertise when it comes to stocks; but you should not assume that the same broker is knowledgeable about options strategies or risks.
3. There are no guarantees. Risk is found everywhere and in all markets. While it is true that call buying involves specific risk, this does not mean that buying stock is safe in comparison. You need to distinguish between risk levels for stocks and options. For stocks, your broker should be aware of how volatility in stocks matches with your risk levels; but options change the overall picture, and you need to separate stock and options risks, ignoring the tendency to think that there are any risk-free investments using stocks, options, or the two together. The fact is, once you become comfortable with options trading, you are going to be less likely to depend on a broker for any advice. Options traders tend to think for themselves, and come to realize that they can operate without the services that come with paying full-price commissions.
Smart Investor Tip
Anyone who wants to be involved with options will eventually realize that a broker’s advice is unnecessary and could even get in the way of an efficient trading program.
Some traders continue using brokers due to personal loyalty or a track record of exceptional advice. Whether you are seeking a broker or using one already, that broker should not give the same recommendations to everyone; advice should be matched to specific risk levels and experience. Brokers are required by law to ensure that you are qualified to invest in options. That means that you should have at least a minimal understanding of market risks, procedures, and terminology, and that you understand the risks associated with options. Brokers are required to apply a rule called know your customer. The brokerage firm has to ask you to complete a form that documents your knowledge or experience with options; firms also give out a prospectus, which is a document explaining all of the risks of option investing.
The investment standard for buying calls includes the requirement that you know how the market works and that you invest only funds that you can afford to have at risk. Beyond that, you have every right to decide for yourself how much risk you want to take. Ultimately, you are responsible for your own profits and losses in the market. The role of the broker is to document the fact that the right questions were asked before your money was taken and placed into the option. One of the most common mistakes made, especially by inexperienced investors, is to believe that brokers are responsible for providing guidance. They are not. However, they are required to make sure you know what you’re doing before you proceed.
know your customer
a rule requiring brokers to be aware of the risk, knowledge level, and capital profile of each client, designed to ensure that recommendations are suitable for each individual.
prospectus
a document designed to disclose all of the risk characteristics associated with a particular investment.
How Call Selling Works
Buying calls is similar to buying stock, at least regarding the sequence of events. You invest money and, after some time has passed, you make the decision to sell. The transaction takes place in a predictable order. Call selling doesn’t work that way. A seller begins by selling a call, and later on buys the same call to close out the transaction.
Many people have trouble grasping the idea of selling before buying. A common reaction is, “Are you sure? Is that legal?” or “How can you sell something that you don’t own?” It is legal, and you can sell something before you buy it.
short selling
a strategy in the stock market in which shares of stock are first sold, creating a short position for the investor, and later bought in a closing purchase transaction.
This is done all the time in the stock market through a strategy known as short selling. An investor sells stock that he or she does not own, and later places a “buy” order, which closes the position.
The same technique is used in the options market and is far less complicated than selling stock short. Because options have no tangible value, becoming an option seller is fairly easy. A call seller grants the right to someone else—a buyer—to buy 100 shares of stock, at a fixed price per share and by a specified expiration date. For granting this right, the call seller is paid a premium. As a call seller, you are paid for the sale but you must also be willing to deliver 100 shares of stock if the call buyer exercises the option. This strategy, the exact opposite of buying calls, has a different array of risks than those experienced by the call buyer. The greatest risk is that the option you sell could be exercised, and you would be required to sell 100 shares of stock far below the current market value.
When you operate as an option buyer, the decision to exercise or not is entirely up to you. But as a seller, that decision is always made by someone else. As an option seller, you can make or lose money in three different ways:
1.
The market value of the underlying stock rises. In this instance, the value of the call rises as well. For a buyer, this is good news. But for the seller, the opposite is true. If the buyer exercises the call, the 100 shares of stock have to be delivered by the option seller. In practice, this means you are required to pay the difference between the option’s striking price and the stock’s current market value. As a seller, this means you lose money. Remember, the option will be exercised only if the stock’s current market value is higher than the striking price of the option.
Example
Called Away: You sell a call with a striking price of $40 per share. You happen to own 100 shares of the underlying stock, so you consider your risks to be minimal in selling a call. (If the buyer exercises the call, you already own the shares and would be willing to sell them at the striking price.) In addition, the call is worth $200, and that amount is paid to you for selling the call. One month later, the stock’s market value has risen to $46 per share and the buyer exercises the call. You are obligated to deliver the 100 shares of stock at $40 per share. This is $6 per share below current market value. Although you received a premium of $200 for selling the call, you lose the increased market value in the stock, which is $600. Your net loss in this case is $400.
The loss in this example would be viewed based on your original cost of the stock. A call seller selects striking prices based on the original cost of the stock. So if you originally paid $42 per share for the stock and it is called away at $40, you break even before trading costs. (A $2-per-share loss is offset by the premium you were paid for selling the call.) However, if your original cost of the stock was $35 per share, your overall net profit would be $700—a $500 capital gain on the stock plus $200 in option premium.
Example
More Risk, More Loss: Given the same conditions as the preceding example, let’s now assume that you did not own 100 shares of stock. What happens if the option is exercised? In this case, you are still required to deliver 100 shares at $40 per share. Current market value is $46, so you are required to buy the shares at that price and then sell them at $40, a net loss of $400. ($600 difference in values, less $200 you received for selling the call.) In practice, you would be required to pay the difference rather than physically buying and then selling 100 shares.
Smart Investor Tip
Call sellers have much less risk when they already own their 100 shares. They can select calls in such a way that in the event of exercise, the stock investment will still be profitable.
The difference between these two examples is that in the first case, you owned the shares and could deliver them if the option were exercised. There is even the possibility that you originally purchased those shares below the $40 per share value. So in effect, you exchanged potential gain in the stock for the value of the call premium you received. In the second example, it is all loss because you have to buy the shares at current market value and sell them for less.
When the call is exercised, it doesn’t always translate to a loss. If you received enough premium for selling the call, you could still make a profit.
Example
The LEAPS Call Alternative: You sold a LEAPS call with 30 months until expiration. Because that is a long time away, you were paid a much higher premium than you would have received for selling a shorter-term listed option. You were paid 12 ($1,200) when you sold the call. A few months later, the stock is four points higher than the striking price, and your broker notifies you that your option has been called. You are required to pay the difference between current market value and striking price, which is $400. The net effect is a profit of $800 (before considering trading costs). When using a LEAPS call in a short sale, a higher premium grants you more cushion.
2.
The market value of the stock does not change. In the case where the stock’s value remains at or near the price level when the call was sold, the value of the call will decline over time. Remember, the call is a wasting asset. While that is a problem for the call buyer, it is a great advantage for the call seller. Time works against the buyer, but it works for the call seller. You have the right to close out your short call at any time before expiration date. So you may sell a call and hope that it declines in value; and then buy it to close the position at a lower premium, with the difference representing your profit.
Example
Profiting from Inertia: You sell a call for a premium of 4 ($400). Two months later, the stock’s market value is about the same as it was when you sold the call. The option’s premium value has fallen to 1 ($100). You cancel your position by buying the call at 1, realizing a profit of $300.
3.
The market value of the stock falls. In this case, the option will also fall in value. This provides you with an advantage as a call seller. Remember, you are
Example
Profits from Falling Prices: You sell a LEAPS call and receive a premium of 12 ($1,200). The stock’s market value later falls far below the striking price of the option and, in your opinion, a recovery is not likely. As long as the market value of the stock is at or below the striking price at expiration, the option will not be exercised. By allowing the option to expire in this situation, the entire $1,200 you received is profit. paid a premium at the time you sell the call. You want to close out your position at a later date, or wait for the call to expire worthless. You may do either in this case. Because time works against the buyer, it would take a considerable change in the stock’s market value to change your profitable position in the sold option.
Remember three key points as a call seller. First, the transaction takes place in reverse order, with sale occurring before the purchase. Second, when you sell a call, you are paid a premium; in comparison, a call buyer pays the premium at the point of purchase. Third, what is good news for the buyer is bad news for the seller, and vice versa.
When you sell a call option, you are a short seller and that places you into what is called a short position . The sale is the opening transaction, and it can be closed in one of two ways. First, a buy order can be entered, and that closes out the position. Second, you may wait until expiration, after which the option ceases to exist and the position closes automatically. In comparison, the better-known “buy first, sell later” approach is called a long position. The long position is also closed in one of two ways. Either the buyer enters a sell order, closing the position, or the option expires worthless, so that the buyer loses the entire premium value.
short position
the status assumed by investors when they enter a sale order in advance of entering a buy order. The short position is closed by later entering a buy order, or through expiration.
long position
the status assumed by investors when they enter a buy order in advance of entering a sell order. The long position is closed by later entering a sell order, or through expiration.
The Put Option
A put is the opposite of a call. It is a contract granting the right to
sell 100 shares of stock at a fixed price per share and by a specified expiration date in the future. As a put buyer, you acquire the right to sell 100 shares of stock; and as a put seller, you grant that right to the buyer. (See
Figure 1.2.)
Buying and Selling Puts
As a buyer of a put, you hope the underlying stock’s value will fall. A put is the opposite of a call and so it acts in the opposite manner as the stock’s market value changes. If the stock’s market value falls, the put’s value rises; and if the stock’s market value rises, then the put’s value falls. There are three possible outcomes when you buy puts.
1.
The market value of the stock rises. In this case, the put’s value falls in response. Thus, you may sell the put for a price below the price you paid and take a loss; or you may hold on to the put, hoping that the stock’s market value will fall before the expiration date.
Example
Turning It Upside Down: You bought a put two months ago, paying a premium of 2 ($200). You expected the stock’s market price to fall, in which case the value of the put would have risen. Instead, the stock’s market value rose, so the put’s value fell. It is now worth only 0.25, or $25. You have a choice: Sell the put and take a $175 loss, or hold on to the put, hoping the stock will fall before the expiration date. If you hold the put beyond expiration, it will be worthless and your loss will be the full $200.
This example demonstrates the need to assess risks. For example, with the put currently worth only $25—nearly nothing—there is very little value remaining, so you might consider it too late to cut your losses in this case. Considering that there is only $25 at stake, it might be worth the long shot of holding the put until expiration. If the stock’s price does fall between now and then, you stand the chance of recovering your investment and, perhaps, even earning a profit.
Smart Investor Tip
Option traders constantly calculate risk and reward, and often make decisions based not upon how they hoped prices would change, but upon how an unexpected change has affected their position.
2.
The market value of the stock does not change. If the stock does not move significantly enough to alter the value of the put, then the put’s value will still fall. The put, like the call, is a wasting asset; so the more time that passes and the closer the expiration date becomes, the less value will remain in the put. In this situation, you may sell the put and accept a loss, or hold on to it, hoping that the stock’s market price will fall before the put’s expiration.
Example
Choosing between Bad and Worse: You bought a LEAPS put several months ago and paid a premium of 7 ($700). You had expected the stock’s market value to fall, in which case the put’s value would have risen. Expiration comes up later this month. Unfortunately, the stock’s market value is about the same as it was when you bought the LEAPS put, but that put is now worth only $100. Your choices: Sell the put for $100 and accept the $600 loss, or hold on to the put on the chance that the stock’s value will fall before expiration.
The choice comes down to a matter of timing and an awareness of how much price change is required to produce a breakeven point or a profit. In the preceding example, the stock would have to fall at least seven points below the put’s striking price just to create a breakeven outcome (before trading costs). In this case, even utilizing a longer-term LEAPS put, the option profit simply did not materialize before expiration. If you have more time, your choice would be easier because you could defer your decision to either take a loss or just wait out the price movement of the stock. You can afford to adopt a wait-and-see attitude with a long time to go before expiration, which makes the LEAPS a more flexible choice than shorter-term listed options. The value of any option tends to fall slowly at first, and then more rapidly as expiration approaches.
3. The market value of the stock falls. In this case, the put’s value will rise. You have three alternatives. First, you may hold the put in the hope that the stock’s market value will decline even more, increasing your profit. Second, you may sell the put and take your profit now. Third, you may exercise the put and sell 100 shares of the underlying stock at the striking price. That price will be above current market value, so you will profit from exercise by selling at the higher striking price.
Example
Having It Both Ways: You own 100 shares of stock that you bought last year for $38 per share, and the price later rose above $40. You were worried about the threat of a falling market; however, you also wanted to hold on to your stock as a long-term investment. To protect yourself against the possibility of a price decline in your stock, you bought a put, paying a premium of 0.50, or $50. This guarantees you the right to sell 100 shares for $40 per share. Recently, the price of your stock fell to $33 per share. The value of the put increased to $750, offsetting your loss in the stock.
You can make a choice given the preceding example. You may sell the put and realize a profit of $700, which offsets the loss in the stock. This choice is appealing because you can take a profit in the put, but you continue to own the stock. So if the stock’s price rebounds, you will benefit twice.
A second alternative is to exercise the put and sell the 100 shares at $40 per share (the striking price of the option), which is $7 per share above current market value (but only $2 per share above the price you paid originally for the stock). This choice could be appealing if you believe that circumstances have changed and that it was a mistake to buy the stock as a long-term investment. By getting out now with a profit instead of a loss, you recover your full investment even though the stock’s market value has fallen. This alternative makes sense if and when you would prefer to get out of the stock position; with the put investment, you can make that choice profitably, even though the stock’s market value has fallen.
A third choice is to hold off taking any immediate action. The put acts as a form of insurance to protect your investment in the stock against further price declines. That’s because at this point, for every drop in the stock’s price, the option’s value will offset that drop, point for point. If the stock’s value increases, the option’s value will decline dollar for dollar. So the two positions offset one another. As long as you take action before the put’s expiration, your risk is virtually eliminated.
Smart Investor Tip
At times, inaction is the smartest choice. Depending on the circumstances, you could be better off patiently waiting out price movements until the day before expiration.
While you may buy puts believing the stock’s market value will fall, or to protect your stock position, you may also sell puts. As a put seller, you grant someone else the right to sell 100 shares of stock to you at a fixed price. If the put is exercised, you will be required to buy 100 shares of the stock at the striking price, which would be above the market value of the stock. For taking this risk, you are paid a premium when you sell the put. Like the call seller, put sellers do not control the outcome of their position as much as buyers do, since it is the buyer who has the right to exercise at any time.
Example
Waiting It Out: Last month, you sold a put with a striking price of $50 per share. The premium was $250, which was paid to you at the time of the sale. Since then, the stock’s market value has remained in a narrow range between $48 and $53 per share. Currently, the price is at $51. You do not expect the stock’s price to fall below the striking price of 50. As long as the market value of the underlying stock remains at or above that level, the put will not be exercised. (The buyer will not exercise, meaning that you will not be required to buy 100 shares of stock.) If your prediction turns out to be correct, you can make a profit by selling the put once its value has declined.
Your risk in this example is that the stock’s market price could decline below $50 per share before expiration, meaning that upon exercise you would be required to buy 100 shares at $50 per share. To avoid that risk, you have the right to cancel the position by buying the put at current market value. The closer you are to expiration (and as long as the stock’s market value is above the striking price), the lower the market value of the put—and the greater your profit.
Put selling also makes sense if you believe that the striking price represents a fair price for the stock. In the worst case, you will be required to buy 100 shares at a price above current market value. If you are right, though, and the striking price is a fair price, then the stock’s market value will eventually rebound to that price or above. In addition, to calculate the real loss on buying, overpriced stock has to be discounted for the premium you received.
Selling puts is a vastly different strategy from buying puts, because it places you on the opposite side of the transaction. The risk profile is different as well. If the put you sell is exercised, then you end up with overpriced stock, so you need to establish a logical standard for yourself if you sell puts. Never sell a put unless you are willing to acquire 100 shares of the underlying stock at the striking price.
One advantage for put sellers is that time works for you and against the buyer. As expiration approaches, the put loses value. However, if movement in the underlying stock is opposite the movement you expected, you could end up taking a loss or having to buy 100 shares of stock for each put you sell. Sudden and unexpected changes in the stock’s market value can occur at any time. The more volatile a stock’s price movement, the greater your risk as a seller. You might also notice as you observe the pricing of options that, due to higher risks, options on volatile stocks tend to hold higher premium values than those on more predictable, lower volatility issues.
Smart Investor Tip
Option price behavior is directly affected by the underlying stock and its attributes. So volatile (higher risk) stocks demand higher option premiums and tend to experience faster, more severe price changes.
Put selling strategies can be more flexible when employing LEAPS. Because there is greater time to go until expiration, the LEAPS put seller has two advantages. First, the potential decline in stock price is limited in comparison to the potential rise in the case of using short calls; and second, the premium is likely to be higher than for shorter-term listed puts.
The potential decline in stock price is limited in two ways. First, the difference between the striking price and zero is a known quantity. Second and more realistically, the price of stock is not likely to fall below tangible book value per share. So risks in short-selling of puts is limited. You will recall that short selling of calls is far riskier because, in theory at least, a stock’s price could rise indefinitely.
The second factor—the LEAPS premium—makes put selling practical due to the cushion that premium provides. However, the larger premium also reflects a longer time period that LEAPS put sellers remain at risk; so offsetting the advantage, there is also the disadvantage of having to wait longer for those profits to materialize.
Example
The Premium Cushion: You believe that a particular stock is likely to rise in value. It is currently selling at $41 per share. The 30-month LEAPS puts at a striking price of 40 are available at 9 ($900). You sell a LEAPS put and receive payment of $900.
If the stock’s value falls as low as $31 per share, you have downside protection (before trading costs are calculated) due to the nine points you were paid in premium. However, even if that put were to be exercised, you consider $40 per share a reasonable price to pay for the stock. You believe its long-term prospects are strong, so you would not mind picking up shares at that price level. Considering the payment of $900 for the LEAPS put, your net basis in stock upon exercise would be only $31 per share.
Option Valuation
Option values change in direct proportion to the changing market value of the underlying stock. Every option is associated specifically with the stock of a single corporation and cannot be interchanged with others. How you fare in your option positions depends on how the stock’s value changes in the immediate future.
The question of selecting stocks is more involved and complex than the method of picking an option. For options, the selection has to do with risk assessment, current value, time until expiration, and your own risk tolerance level; in addition, numerous strategies you may employ will affect the ultimate decision. But option selection is formulated predictably. In comparison, stock selection involves no precise formula that works in every case. Price movement in the stock itself cannot be known in advance, whereas the reaction of option premium value is completely predictable, based on the way the stock’s price changes.
The selection of a stock is the critical decision point that determines whether you will succeed with options. This observation applies for buying or selling stock, and also applies when you never intend to own the stock at all but only want to deal with options themselves. It is a mistake to pick options based only on current value and time, hoping to succeed, without also thinking about the particulars of the stock—volatility, relation to striking price of the option, and much more. Of course, to some degree, the features of the option can be used to calculate likely outcomes, but that is only a part of the whole picture. Because option value is tied to stock price and volatility, you also need to develop a dependable method for evaluation of the underlying stock.
fundamental analysis
a study of financial information and attributes of a company’s management and competitive position, as a means for selecting stocks.
technical analysis
a study of trends and patterns of price movement in stocks, including price per share, the shape of price movements on charts, high and low ranges, and trends in pricing over time.
You may pick stocks strictly on the basis of fundamental analysis. This includes a study of financial statements, dividends paid to stockholders, management, the company’s position within its industry, capitalization, product or service, and other financial information.
The importance of the fundamentals cannot be emphasized too much, as they define a company’s long-term growth prospects, ability to produce consistent profits, and ability to demonstrate market strength over time. However, remember that the fundamentals are historical and have little to do with short-term price changes in the company’s stock. It is that very thing—short-term price change—that determines whether a particular option strategy will succeed or fail. While the fundamentals are essential for long-term stock selection, short-term price movement is affected more by perception of value. Indicators involving market price and perception are broadly classified under the umbrella of technical analysis.
Both fundamental and technical indicators have something to offer, and you can use elements of both to study and identify stocks for option trading. The distinctions should be kept in mind, however, including both advantages and disadvantages of each method.
The selection of options cannot be made without also reviewing the attributes of the stock, both fundamental and technical. Whether you treat options only as a form of speculative side bet or as an important aspect associated with being in the market, the judgment you use in selection has to apply to the characteristics and values of both the option and the stock. Criteria for the selection of high-value stocks are at the heart of smart stock market investing. The need for careful, thorough, and continuing analysis cannot be emphasized too much. So attributes such as financial strength, price stability and volatility, dividend and profit history, and others are important, not only to stockholders but to options traders as well. Picking worthwhile options trades depends on your awareness of fundamental and technical indicators for the stock, even while you recognize that short-term indicators may not be reliable.
TABLE 1.1 Price Movement in the Underlying Security
Smart Investor Tip
In the stock market, the perception of value is of far greater interest in stock valuation than is the actual fundamental value. Perception in the market carries far more weight than even fact itself.
The analysis of stock values for the purpose of determining whether to buy stock is a complex science. When options are added to the equation, it becomes even more complicated. As shown in
Table 1.1, you would consider stock price movement to be either a plus or a minus depending on whether you are planning to operate as a seller or buyer, and whether you plan to utilize calls or puts.
Example
All Around the Money: Two months ago, you bought a call and paid a premium of $300. The striking price was $40 per share. At that time, the underlying stock’s price was at $40 per share. In this condition—when the call’s striking price is identical to the current market value of the stock—the call is said to be at the money. If the market value per share of stock increases so that the per-share value is above the call’s striking price, then the call is said to be in the money. When the price of the stock decreases so that the per-share value is below the call’s striking price, then the call is said to be out of the money.
These definitions are reversed for puts; “in” and “out of ” the money occur in the opposite directions.
Figure 1.3 shows the price ranges that represent in the money, at the money, and out of the money for a call.
at the money
the status of an option when the underlying stock’s value is identical to the option’s striking price.
FIGURE 1.3 Market value of the underlying stock in relation to striking price of a call.
in the money
the status of a call option when the underlying stock’s market value is higher than the option’s striking price, or of a put option when the underlying stock’s market value is lower than the option’s striking price.
out of the money
the status of a call option when the underlying stock’s market value is lower than the option’s striking price, or of a put option when the underlying stock’s market value is higher than the option’s striking price.
The dollar-for-dollar price movement of an option’s value occurs whenever an option is in the money. The tendency will be for the option’s value to mirror price movement in the stock, going up or down to the same degree as the stock’s market price. These price movements will not always be identical because, as expiration nears, the time factor also affects the option’s value.
In the preceding example, a significant change would occur if the stock’s market price continued to fall below the striking price. Once in the money, the put’s value would rise one dollar for each dollar of decline in the stock’s market value (not considering the time factor).
Example
Staying Out of the Money: You bought a put last month with a striking price of 30 and you paid 2. (The striking price is $30 per share and you paid $200 for the put.) At that time, the stock’s market value was $34 per share, so the option was four points out of the money. More recently, the stock price has fallen to $31 per share; however, the put’s premium remains at 2. Because the put remains out of the money, its premium value cannot be expected to change just because of stock movement—at least not until or unless the stock’s market value falls so that the put is in the money.
The value of options that are in the money relates to the underlying stock’s current market value. But in the stock market, value also depends on two additional factors. First is the stock’s volatility, the tendency to trade within a narrow range (low volatility) or a broad range (high volatility). The degree of volatility will, of course, also affect valuation of the option, as will the time element. But value is also affected by volume—the level of trading activity in the stock and in the option, or in the market as a whole. The level of volume in a stock might have a similar effect on option value, or option volume could be affected by entirely different factors. Options traders look for clues to explain circumstances when option volume increases but no corresponding increase is seen in the stock. That could indicate that other factors, not yet widely recognized in the market, are distorting the option’s value or the stock’s value, or that other factors (such as unfounded rumors) are causing distortions in both the stock and the option.
volatility
an indicator of the degree of change in a stock’s market value, measured over a 12-month period and stated as a percentage. To measure volatility, subtract the lowest 12-month price from the highest 12-month price, and divide the answer by the 12-month lowest price.
volume
the level of trading activity in a stock, an option, or the market as a whole.
Pick the Right Stock
The usual assumption in using any form of analysis is that you identify stocks you would want to buy or hold, and when the news turns bad, you then want to sell shares. With options, however, a stock that shows inherent weaknesses can also signal the time to use options in a different way. For example, if you are convinced that a stock is overpriced and susceptible to price decline, one reaction would be to buy puts. If you’re right and the price falls, your puts will increase in value. Thus, the difference between stock investors and options traders is the reaction to news. Stock investors tend to view bad news—price weakness, negative economic news, overpricing of shares, corporate scandals, and so on—as just bad news. An options trader, though, can use any form of news to make a profitable move in options, even when the news is negative for the company and its stockholders.
Smart Investor Tip
Selecting options wisely depends on also identifying or picking stocks using logical criteria. Using options without also analyzing stocks is a big mistake.
Chapter 7 provides a more in-depth study of stock selection criteria. For now, be aware that checking the facts by reviewing corporate information is a smart starting point. A lot of information can be obtained free to let you begin reviewing a corporation’s financial strength. You can get current information about any listed company from a number of sources on the Internet. These include several free services allowing downloads of corporate annual reports in addition to direct contact with the companies themselves.
Another source for information concerning stocks is one of several subscription services. Using either online or mail-oriented services, check out Value Line and Standard & Poor’s, both of which offer nicely detailed analytical services for investors.
Intrinsic Value and Time Value
Once you become comfortable with methods of stock selection, you will be ready to use that knowledge to study the options market. Remember that options themselves change in value based on movement in the underlying stock. Because option valuation is inescapably tied to stock value and market conditions, options do not possess any fundamental value of their own. By definition, the fundamentals are the financial condition and results of the corporation; an option is related to the stock’s market value and exists only for a brief period of time. Every listed option and its pricing structure are more easily comprehended by a study of valuation, which has two parts.
The first of the two segments of value is called intrinsic value, which is that part of an option’s premium equal to the number of points it is in the money. Intrinsic value, for example, is three points for a call that is three points above striking price, or for a put that is three points below striking price.
Any option premium above the intrinsic value is known as time value. This will decline predictably over time, as expiration nears. With many months before expiration, time value can be substantial; if the option is at the money or out of the money, the entire premium is time value. As expiration approaches, time value evaporates at a quickening pace, and at the point of expiration, no time value remains. Time value also tends to fall away when the option is substantially out of the money. In other words, an option that is 2 points out of the money will be likely to have greater time value than one with the same time until expiration, but 15 points out of the money.
Option valuation can be summed up in this statement: the relative degree of intrinsic value and time value is determined by the distance between striking price and current market value of stock, adjusted by the time remaining until expiration of the option.
intrinsic value
that portion of an option’s current value equal to the number of points that it is in the money. One points equals one dollar of value per share, so 35 points equals $35 per share.
time value
that portion of an option’s current premium above intrinsic value.
TABLE 1.2 The Declining Time Value of an Option
Example
Value, but No Real Value: A 45 call is valued currently at 3 ($300 premium value on a $45 striking price). The underlying stock’s market value is currently $45 per share. Because the option is at the money, it has no intrinsic value. The entire premium represents time value alone. You know that by expiration, the time value will disappear completely, so it will be necessary for the stock to increase in value at least three points for you to break even were you to buy the call (and without considering transaction fees). The stock will need to rise beyond the three-point level before expiration if you are to earn a profit.
A comparison between option premium and market value of the underlying stock is presented in
Table 1.2. Using a call as an example, this table demonstrates the direct relationship between intrinsic value, market value of the underlying stock, and time value of the option. If the option were a put, intrinsic value would be represented by the degree to which the stock’s market value was
below striking price.
FIGURE 1.4 Time and intrinsic values of underlying stock and options.
Another helpful illustration is shown in
Figure 1.4. This summarizes movement in the underlying stock (top graph) and option values (bottom graph). Note that intrinsic value (black portion) is identical to stock price movement in the money, and that time value moves independently, gradually dissolving as expiration approaches. From this illustration, you can see how the two forms of value act independently from one another, because different influences—stock price versus time—affect the two segments of the option premium.
The total amount of option premium can be expected to vary greatly between two different stocks at the same price level and identical option features, due to other influences. These include the perception of value, the stock’s price history and volatility, stock trading volume, financial status and trends, interest in options among buyers and sellers, and dozens of other possible influences. For example, two stocks at the same current price may have options at 35 and identical expiration dates. But even given identical features, the option premium could be different for each.
Differences in option value are caused solely by changes in nonintrinsic value. The intrinsic value is always equal to the number of points an option is in the money, and any additional premium is generally classified as time value. (This distinction is a bit more complex, due to the additional value-based elements explained later.)
The non-intrinsic value of an option premium is where all of the differences exist. Because intrinsic value is entirely predictable and tied to the difference between stock price and option striking price, it is not difficult to predict at all. Beyond intrinsic value, premium will vary because of the stock’s volatility, market perceptions of market risk, and any other market factors that make future price changes uncertain. The uncertainty factor, more than anything else, is the feature of option value that is the most appealing. So the so-called “time value” premium is where analysis and study will be focused.
sector
a specific segment of the market defined by product or service offered by a company. Factors affecting value (cyclical, economic, or market-based) make each sector distinct and different from other sectors, also affecting option valuation.
In fact, time value is not solely affected by time. It also changes due to the degree of price movement in the stock and, more specifically, based on perceptions about stock price movement. Time value also varies to some degree due to outside influences, like the market sector of the stock. For example, information technology stocks might be more volatile as a group than pharmaceutical or retail stocks; as a result, time value might also be more volatile for options on those stocks.
Because time value is not defined entirely by time, it can be further broken down into two primary parts. Time value—the portion affected strictly by time—is generally quite predictable. As time until expiration approaches, time value declines on an accelerated basis. And the farther out of the money the option is, the more rapid the decline in time value. But actual volatility in the stock also determines the nonintrinsic option value, and this portion is distinguished from pure time value and is called extrinsic value.
So time value itself becomes quite unpredictable and inconsistent due to extrinsic value. If an option is out of the money, there is no intrinsic value involved; but when an option is in the money, premium contains three parts:
1. Intrinsic value is equal to the number of points between current striking price and current stock price.
2. Time value refers to all nonintrinsic value in most discussions. However, in a strict sense, “time value” is that portion of premium affected by the passage of time and the time remaining until expiration.
3. Extrinsic value is the premium value within time value caused by nontime sources. These include perceived potential for price changes, volatility in the stock, and other external causes.
extrinsic value
the portion of an option’s premium generated from volatility in the underlying stock and from market perception of potential price changes until expiration date; a nonintrinsic portion of the premium value not specifically caused by the element of time.
Throughout the rest of this book, the use of the term time value refers to the entire nonintrinsic premium and includes both time and extrinsic value. The term can be confusing because in some options writings, extrinsic value is used as a substitute for time value. For example, Investopedia defines extrinsic value as “the difference between an option’s price and the intrinsic value.” While this is not entirely accurate, it does agree with a popular definition but makes no distinction between the attributes of time and nontime segments.
Option buyers, as a rule, will be willing to pay more for options when they perceive a greater than normal potential for price movement. Higher levels of volatility increase risks all around, but also increase potential for bigger profits in option speculation. Of course, low-volatility stocks are going to be far less interesting to would-be option buyers, because little price change is expected in the stock. The same arguments apply to sellers; higher-volatility stocks are accompanied by options with higher time value and more potential for profits from selling options (as well as greater risks for exercise).
You can recognize time value easily by comparing the stock’s current value to the option’s premium. For example, a stock currently priced at $47 per share may have an option valued at 3 and a striking price of 45. To break down the total option premium, subtract striking price from the current market value; the difference is intrinsic value. Then subtract intrinsic value from total premium to find time value. If premium value is at or below striking price (for a call) or above striking price (for a put), there is no intrinsic value. The preceding example is summarized as follows:
Stock Price
Option Premium
In the next chapter, several important features of options—striking price, expiration date, and exercise—are more fully explored, especially in light of how these features affect your personal options strategy.
