Options Education

Options Video Tutorial

 


Introduction

Options EducationNowadays, many investor’s portfolios include investments such as mutual funds, stocks and bonds. But the variety of securities you have at your disposal does not end there. Another type of security, called an option, presents a world of opportunity to sophisticated investors. The power of options lies in their versatility. They enable you to adapt or adjust your position according to any situation that arises. Options can be as speculative or as conservative as you want. This means you can do everything from protecting a position from a decline to outright betting on the movement of a market or index. This versatility, however, does not come without its costs. Options are complex securities and can be extremely risky. This is why, when trading options, you'll see a disclaimer like the following: Options involve risks and are not suitable for everyone.

Option trading can be speculative in nature and carry substantial risk of loss. Only invest with money you can afford to endure a loss with. Despite what anybody tells you, option trading involves risk, especially if you don't know what you are doing. Because of this, many people suggest you steer clear of options and forget their existence. On the other hand, being ignorant of any type of investment places you in a weak position. Perhaps the speculative nature of options doesn't fit your style. No problem - then don't speculate in options. But, before you decide not to invest in options, you should understand them.

Not learning how options function is as dangerous as jumping right in: without knowing about options you would not only forfeit having another item in your investing toolbox but also lose insight into the workings of some of the world's largest corporations. Whether it is to hedge the risk of foreign-exchange transactions or to give employees ownership in the form of stock options, most multi-nationals today use options in some form or another. This tutorial will introduce you to the fundamentals of options. Keep in mind that most options traders have many years of experience, so don't expect to be an expert immediately after reading this tutorial. If you aren't familiar with how the stock market works, please feel free to read through our How to Get Started tutorials.


Options - The Basics

In Australia we talk about Exchange Traded Options (ETO's) that are settled via the OCH (Options Clearing House). However, Options are used across the globe in almost every type of industry and although the exact details are different, the concept remains the same; an option is an agreement between the buyer and a seller of an asset - they agree on a premium paid for the right to transfer the asset. For our purposes we will talk about ETO's. They are used in a variety of different ways.

The main ways of using ETO's are:

  • Acting as insurance for shares;
  • Profiting on Share price movement, and;
  • Fixing a purchase price.

There are two different types of options:

  1. Call option contracts
  2. Put option contracts

You pay a premium for the right, but not the obligation, to buy shares of the Stock at the specified strike price on or before the specified expiration date. After this given date, the option ceases to exist. The seller of an option is, in turn, obligated to sell the shares to you at the specified price when you request. A Put option is the opposite, if you believe the price of the stock is going to fall you would buy puts, they give you the right, but not the obligation, to sell the shares at the specified price. Puts are an excellent way of providing insurance if you hold shares in a stock and want to protect the downside without selling your position, if for example you wanted to retain the stock for dividend or capital gains purposes. The difference between 'right' and 'obligation' is very important. It means that you are able to limit your losses to the amount that you originally spent to purchase the options. Compare this to other forms of leveraged products such as Contracts for difference (CFDs) or margin lending where your exposure is continuous and unlimited until you exit the contract.

With an option, if you are in a losing position the worst case scenario is that you can simply let the option expire 'worthless'. It is also important to note that you do not need to own, nor intend to own, the underlying stock to trade Options. As the options are traded on the exchange there is always a buyer or seller available for the option series. Therefore you can realise gains or losses as long as the market is open. Options contracts are sold in lots of 100 shares (for most of the listed companies) and each contract has a specific strike price (series). For each Call option there is a corresponding Put option.

There are also different series for different months. At the time of writing, BHP has an option series that expires every month whereas a stock such as Rinker Limited (RIN) may only have options every 3 months. If a Stock becomes popular then a new series can be introduced if there is demand. You will also see that on the last Friday of the month there is a spike in the volume of traded shares for those stocks with options series that expired the day before as the contracts are settled. It is worth investigating options to see if they fit within your trading plan. Once you understand the basics, there are numerous trading strategies that can take advantage of the flexibility that ETO's offer.


What are Options?

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties. Still confused?

The idea behind an option is present in many everyday situations. Say, for example, that you discover a house that you'd love to purchase. Unfortunately, you won't have the cash to buy it for another three months. You talk to the owner and negotiate a deal that gives you an option to buy the house in three months for a price of $200,000. The owner agrees, but for this option, you pay a price of $3,000.

Now, consider these theoretical situations that might arise:

First Scenario
It has been discovered that the house is actually the true birthplace of Elvis! As a result, the market value of the house skyrockets to $1 million. Because the owner sold you the option, he is obligated to sell you the house for $200,000. In the end, you stand to make a profit of $797,000 ($1 million - $200,000 - $3,000).

Second Scenario
​While touring the house, you discover not only that the walls are chock-full of asbestos, but also the ghost of Henry VII haunts the master bedroom; furthermore, a family of super-intelligent rats have built a fortress in the basement. Though you originally thought you had found the house of your dreams, you now consider it worthless. On the upside, because you bought an option, you are under no obligation to go through with the sale. Of course, you still lose the $3,000 price of the option. This example demonstrates two very important points. First, when you buy an option, you have a right but not an obligation to do something. You can always let the expiration date go by, at which point the option becomes worthless. If this happens, you lose 100% of your investment, which is the money you used to pay for the option. Second, an option is merely a contract that deals with an underlying asset. For this reason, options are called derivatives, which means an option derives its value from something else. In our example, the house is the underlying asset. Most of the time, the underlying asset is a stock or an index.

Calls and Puts

The two types of options are calls and puts: A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires. A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.

Participants in the Options Market

There are four types of participants in options markets depending on the position they take:

  1. Buyers of calls
  2. Sellers of calls
  3. Buyers of puts
  4. Sellers of puts

People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions.

Here is the important distinction between buyers and sellers:

  • Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose.
  • Call writers and put writers (sellers), however, are obligated to buy or sell. This means that a seller may be required to make good on a promise to buy or sell.

Don't worry if this seems confusing - it is. For this reason we are going to look at options from the point of view of the buyer. Selling options is more complicated and can be even riskier. At this point, it is sufficient to understand that there are two sides of an options contract.

The Lingo

To trade options, you'll have to know the terminology associated with the options market. The price at which an underlying stock can be purchased or sold is called the strike price. This is the price a stock price must go above (for calls) or go below (for puts) before a position can be exercised for a profit.

All of this must occur before the expiration date. An option that is traded on a national options exchange such as the Chicago Board Options Exchange (CBOE) is known as a listed option. These have fixed strike prices and expiration dates. Each listed option represents 100 shares of company stock (known as a contract).

For call options, the option is said to be in-the-money if the share price is above the strike price. A put option is in-the-money when the share price is below the strike price. The amount by which an option is in-the-money is referred to as intrinsic value. The total cost (the price) of an option is called the premium. This price is determined by factors including the stock price, strike price, time remaining until expiration (time value) and volatility. Because of all these factors, determining the premium of an option is complicated and beyond the scope of this tutorial.


Why Use Options

There are two main reasons why an investor would use options:

  1. To speculate;
  2. To hedge.

Speculation

Speculation can be thought of as betting on the movement of a security. The advantage of options is that you aren't limited to making a profit only when the market goes up. Because of the versatility of options, you can also make money when the market goes down or even sideways. Speculation is the territory in which the big money is made - and lost. The use of options in this manner is the reason options have the reputation of being risky. This is because when you buy an option, you have to be correct in determining not only the direction of the stock's movement, but also the magnitude and the timing of this movement. To succeed, you must correctly predict whether a stock will go up or down, and you have to be right about how much the price will change as well as the time frame it will take for all this to happen. And don't forget commissions! The combinations of these factors means the odds are stacked against you. So why do people speculate with options if the odds are so skewed? Aside from versatility, it's all about using leverage. When you are controlling 100 shares with one contract, it doesn't take much of a price movement to generate substantial profits.

Hedging

The other function of options is hedging. Think of this as an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn. Critics of options say that if you are so unsure of your stock pick that you need a hedge, you shouldn't make the investment. On the other hand, there is no doubt that hedging strategies can be useful, especially for large institutions. Even the individual investor can benefit. Imagine that you wanted to take advantage of technology stocks and their upside, but say you also wanted to limit any losses. By using options, you would be able to restrict your downside while enjoying the full upside in a cost-effective way

A Word on Stock Options

Although employee stock options aren't available to everyone, this type of option could, in a way, be classified as a third reason for using options. Many companies use stock options as a way to attract and to keep talented employees, especially management. They are similar to regular stock options in that the holder has the right but not the obligation to purchase company stock. The contract, however, is between the holder and the company, whereas a normal option is a contract between two parties that are completely unrelated to the company. 


How Options Work

Options EducationNow that you know the basics of options, here is an example of how they work. We'll use a fictional firm called Cory's Card Company. Let's say that on May 1, the stock price of Cory's Card Co. is $67 and the premium (cost) is $3.15 for a July 70 Call, which indicates that the expiration is the third Friday of July and the strike price is $70. The total price of the contract is $3.15 x 100 = $315. In reality, you'd also have to take commissions into account, but we'll ignore them for this example. Remember, a stock option contract is the option to buy 100 shares; that's why you must multiply the contract by 100 to get the total price. The strike price of $70 means that the stock price must rise above $70 before the call option is worth anything; furthermore, because the contract is $3.15 per share, the break-even price would be $73.15. If you were to buy the option.

When the stock price is $67, it's less than the $70 strike price, so the option is worthless. But don't forget that you've paid $315 for the option, so you are currently down by this amount. Three weeks later the stock price is $78. The options contract has increased along with the stock price and is now worth $8.25 x 100 = $825. Subtract what you paid for the contract, and your profit is ($8.25 - $3.15) x 100 = $510. You almost doubled our money in just three weeks! You can also your options, which is called "closing your position," and take your profits - unless, of course, you think the stock price will continue to rise. For the sake of this example, let's say we let it ride. By the expiration date, the price drops to $62. Because this is less than our $70 strike price and there is no time left, the option contract is worthless. We are now down to the original investment of $315.

To recap, here is what happened to our option investment:

The price swing for the length of this contract from high to low was $825, which would have given us over double our original investment. This is leverage in action.

Exercising Versus Trading-Out

So far we've talked about options as the right to buy or sell (exercise) the underlying. This is true, but in reality, a majority of options are not actually exercised. In our example, you could make money by exercising at $70 and then selling the stock back in the market at $78 for a profit of $8 a share. You could also keep the stock, knowing you were able to buy it at a discount to the present value. However, the majority of the time holders choose to take their profits by trading out (closing out) their position. This means that holders sell their options in the market, and writers buy their positions back to close.

Intrinsic Value and Time Value

At this point it is worth explaining more about the pricing of options. In our example the premium (price) of the option went from $3.15 to $8.25. These fluctuations can be explained by intrinsic value and time value. Basically, an option's premium is its intrinsic value + time value. Remember, intrinsic value is the amount in-the-money, which, for a call option, means that the price of the stock equals the strike price. Time value represents the possibility of the option increasing in value. So, the price of the option in our example can be thought of as the following: Premium = Intrinsic Value + Time Value $8.25 = $8 + $0.25 In real life options almost always trade above intrinsic value. If you are wondering, we just picked the numbers for this example out of the air to demonstrate how options work.


Options Dictionary A-F

American-Style Option - An option contract that may be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are American-style.

Arbitrage - The process in which professional traders simultaneously buy and sell the same or equivalent securities for a riskless profit. See also Risk Arbitrage.

Ask Price - The price at which a seller is offering to sell an option or stock.

Assignment - The receipt of an exercise notice by an option writer (seller) that obligates him to sell (in the case of a call) or purchase (in the case of a put) the underlying security at the specified strike price.

At-the-money - An option is at-the-money if the strike price of the option is equal to the market price of the underlying security.

Automatic Exercise - A protection procedure whereby the Options Clearing Corporation attempts to protect the holder of an expiring in-the-money option by automatically exercising the option on behalf of the holder.

Average Down - To buy more of a security at a lower price, thereby reducing the holder's average cost. (Average Up: to buy more at a higher price.)

Bearish - An adjective describing an opinion or outlook that expects a decline in price, either by the general market or by an underlying stock, or both. See also Bullish.

Bear Spread - An option strategy that makes its maximum profit when the underlying stock declines and has its maximum risk if the stock rises in price. The strategy can be implemented with either puts or calls. In either case, an option with a higher striking price is purchased and one with a lower striking price is sold, both options generally having the same expiration date. See also Bull Spread.

Beta - A measure of how a stock's movement correlates to the movement of the entire stock market. The Beta is not the same as volatility. See also Standard Deviation and Volatility.

Bid Price - The price at which a buyer is willing to buy an option or stock.

Box Spread - A type of option arbitrage in which both a bull spread and a bear spread are established for a near-riskless position. One spread is established using put options and the other is established using calls. The spread may both be debit spreads (call bull spread vs. put bear spread) or both credit spreads (call bear spread vs. put bull spread). Break-Even Point--the stock price (or prices) at which a particular strategy neither makes nor loses money. It generally pertains to the result at the expiration date of the options involved in the strategy. A "dynamic" break-even point is one that changes as time passes.

Broad-Based - Generally referring to an index, it indicates that the index is composed of a sufficient number of stocks or of stocks in a variety of industry groups. See also Narrow-Based.

Bullish - Describing an opinion or outlook in which one expects a rise in price, either by the general market or by an individual security. See also Bearish.

Bull Spread - An option strategy that achieves its maximum potential if the underlying security rises far enough, and has its maximum risk if the security falls far enough. An option with a lower striking price is bought and one with a higher striking price is sold, both generally having the same expiration date. Either puts or calls may be used for the strategy. See also Bear Spread.

Butterfly Spread - An option strategy that has both limited risk and limited profit potential, constructed by combining a bull spread and a bear spread. Three striking prices are involved, with the lower two being utilized in one spread and the higher two in the opposite spread. The strategy can be established with either puts or calls; there are four different ways of combining options to construct the same basic position.

Buy-write - See also Covered Call.

Calendar Spread - An option strategy in which a short-term option is sold and a longer-term option is bought, both having the same striking price. Either puts or calls may be used.

Calendar Straddle or Combination - See Calendar Spread.

Call - An Option contract that gives the holder the right to buy the underlying security at a specified price for a certain, fixed period of time. See also Put.

Capitalization-Weighted Index - A stock index which is computed by adding the capitalization (float times price) of each individual stock in the index, and then dividing by the divisor. The stocks with the largest market values have the heaviest weighting in the index. See also Float, Divisor.

Capped-Style Option - A capped option is an option with an established profit cap or cap price. The cap price is equal to the option's strike price plus a cap interval for a call option or the strike price minus a cap interval for a put option. A capped option is automatically exercised when the underlying security closes at or above (for a call) or at or below (for a put) the Option's cap price.

Carrying Cost - The interest expense on a debit balance created by establishing a position.

Cash-Based - Referring to an option or future that is settled in cash when exercised or assigned. No physical entity, either stock or commodity, is received or delivered.

Cash Settlement - The process by which the terms of an option contract are fulfilled through the payment or receipt in dollars of the amount by which the option is in-the-money as opposed to delivering or receiving the underlying stock .

CBOE - The Chicago Board Options Exchange; the first national exchange to trade listed stock options.

Class - A term used to refer to all put and call contracts on the same underlying security.

Class of Options - Option contracts of the same type (call or put) and Style (American, European or Capped) that cover the same underlying security.

Closing Purchase - A transaction in which the purchaser's intention is to reduce or eliminate a short position in a given series of options.

Closing Sale - A transaction in which the seller's intention is to reduce or eliminate a long position in a given series of options

Closing Transaction - A trade that reduced an investor's position. Closing buy transactions reduce short positions and closing sell transactions reduce long positions. See also Opening Transaction.

Collateral - The loan value of marginable securities; generally used to finance the writing of uncovered options.

Combination - Any position involving both put and call options that is not a straddle.

Commodities - See Futures Contract.

Contingent Order - An order which can be executed only if another event occurs; i.e. "sell Oct 45 call 7.25 with stock 52 or lower".

Conversion Arbitrage - A riskless transaction in which the arbitrageur buys the underlying security, buys a put, and sells a call. The options have the same terms. See also Reversal Arbitrage.

Conversion Ratio - See Convertible Security.

Converted Put - See Synthetic Put.

Convertible Security - A security that is convertible into another security. Generally, a convertible bond or convertible preferred stock is convertible into the underlying stock of the same corporation. The rate at which the shares of the bond or preferred stock are convertible into the common is called the conversion ratio.

Cover - To buy back as a closing transaction an option that was initially written.

Covered - A written option is considered to be covered if the writer also has an opposing market position on a share-for-share basis in the underlying security. That is, a short call is covered if the underlying stock is owned, and a short put is covered (for margin purposes) if the underlying stock is also short in the account. In addition, a short call is covered if the account is also long another call on the same security, with a striking price equal to or less than the striking price of the short call. A short put is covered if there is also a long put in the account with a striking price equal to or greater than the striking price of the short put.

Covered Call - An option strategy in which a call option is written against long stock on a share-for-share basis.

Covered Call Option Writing - A strategy in which one sells call options while simultaneously owning an equivalent position in the underlying security or strategy in which one sells put options and simultaneously is short an equivalent position in the underlying security.

Covered Put Write - A strategy in which one sells put options and simultaneously is short an equal number of shares of the underlying security.

Covered Straddle - An option strategy in which one call and one put with the same strike price and expiration are written against 100 shares of the underlying stock. In actuality, this is not a "covered" strategy because asignment on the short put would require purchase of stock on margin. This method is also known as a covered combination.

Covered Straddle Write - The term used to describe the strategy in which an investor owns the underlying security and also writes a straddle on that security. This is not really a covered position.

Credit - Money received in an account. A credit transaction is one in which the net sale proceeds are larger than the net buy proceeds (cost), thereby bringing money into the account. See also Debit.

Cycle - The expiration dates applicable to various classes of options. There are three cycles: January/April/July/October, February/May/August November, and March/June/September/ December.

Debit - An expense, or money paid out from an account. A debit transaction is one in which the net cost is greater than the net sale proceeds. See also Credit.

Deliver - To take securities from an individual or firm and transfer them to another individual or firm. A call writer who is assigned must deliver stock to the call holder who exercised. A put holder who exercises must deliver stock to the put writer who is assigned.

Delivery - The process of satisfying an equity call assignment or an equity put exercise. In either case, stock is delivered. For futures, the process of transferring the physical commodity from the seller of the futures contract to the buyer. Equivalent delivery refers to a situation in which delivery may be made in any of various, similar entities that are equivalent to each other (for example, Treasury bonds with differing coupon rates).

Delta - The amount by which an option's price will change for a one-point change in price by the underlying entity. Call options have positive deltas, while put options have negative deltas. Technically, the delta is an instantaneous measure of the option's price change, so that the delta will be altered for even fractional changes by the underlying entity. See also Hedge Ratio.

Delta Spread - A ratio spread that is established as a neutral position by utilizing the deltas of the options involved. The neutral ratio is determined by dividing the delta of the purchased option by the delta of the written option. See also Ratio Spread and Delta.

Depository Trust Corporation (DTC) - A corporation that will hold securities for member institutions. Generally used by option writers, the DTC facilitates and guarantees delivery of underlying securities if assignment is made against securities held in DTC.

Derivative Security - A financial security whose value is determined in part from the value and characteristics of another security, the underlying security.

Diagonal Spread - Any spread in which the purchased options have a longer maturity than do the written options as well as having different striking prices. Typical types of diagonal spreads are diagonal bull spreads, diagonal bear spreads, and diagonal butterfly spreads.

Discount - An option is trading at a discount if it is trading for less than its intrinsic value. A future is trading at a discount if it is trading at a price less than the cash price of its underlying index or commodity. See also Intrinsic Value and Parity.

Discount Arbitrage - A riskless arbitrage in which a discount option is purchased and an opposite position is taken in the underlying security. The arbitrageur may either buy a call at a discount and simultaneously sell the underlying security (basic call arbitrage) or may buy a put at a discount and simultaneously buy the underlying security (basic put arbitrage). See also Discount.

Discretion - Freedom given to the floor broker by an investor to use his judgment regarding the execution of an order. Discretion can be limited, as in the case of a limit order that gives the floor broker.125 or.25 point from the stated limit price to use his judgment in executing the order. Discretion can also be unlimited, as in the case of a market-not-held order. See Limit Order and Market Not Held Order.

Divisor - A mathematical quantity used to compute an index. It is initially an arbitrary number that reduces the index value to a small, workable number. Thereafter, the divisor is adjusted for stock splits (price-weighted index) or additional issues of stock (capitalization-weighted index).

Downside Protection - Generally used in connection with covered call writing, this is the cushion against loss, in case of a price decline by the underlying security, that is afforded by the written call option. Alternatively, it may be expressed in terms of the distance the stock could fall before the total position becomes a loss (an amount equal to the option premium), or it can be expressed as percentage of the current stock price. See also Covered Call Write.

Dynamic - For option strategies, describing analyses made during the course of changing security prices and during the passage of time. This is as opposed to an analysis made at expiration of the options used in the strategy. A dynamic break-even point is one that changes as time passes. A dynamic follow-up action is one that will change as either the security price changes or the option price changes or time passes.

Early Exercise (Assignment) - The exercise or assignment of an option contract before its expiration date.

Escrow Receipt - A receipt issued by a bank in order to verify that a customer (who has written a call) in fact owns the stock and therefore the call is considered covered.

European Exercise - A feature of an option that stipulates that the option may only be exercised at its expiration. Therefore, there can be no early assignment with this type of option.

Ex-Dividend - The process whereby a stock's price is reduced when a dividend is paid. The ex-dividend date (ex-date) is the date on which the price reduction takes place. Investors who own stock on the ex-date will receive the dividend, and those who are short stock must pay out the dividend.

Equity Options - Options on shares of an individual common stock. See also Non-Equity Option.

European-Style Options - An option contract that may be exercised only during a specified period of time just prior to its expiration.

Exercise - To implement the right under which the holder of an option is entitled to buy (in the case of a call) or sell (in the case of a put) the underlying security.

Exercise Limit - The limit on the number of contracts which a holder can exercise in a fixed period of time. Set by the appropriate option exchange, it is designed to prevent an investor or group of investors from "cornering" the market in a stock.

Exercise Price - The price at which the option holder may buy or sell the underlying security, as defined in the terms of his option contract. It is the price at which the call holder may exercise to buy the underlying security or the put holder may exercise to sell the underlying security. For listed options, the exercise price is the same as the Striking Price. See also Exercise.

Exercise Settlement Amount - The difference between the exercise price of the option and the exercise settlement value of the index on the day an exercise notice is tendered, multiplied by the index multiplier.

Expected Return - A rather complex mathematical analysis involving statistical distribution of stock prices, it is the return which an investor might expect to make on an investment if he were to make exactly the same investment many times throughout history.

Expiration Cycle - An expiration cycle relates to the dates on which options on a particular underlying security expire. A given option, other than LEAPS®, will be assigned to one of three cycles, the January cycle, the February cycle or the March cycle.

Expiration Date - The day on which an option contract becomes void. The expiration date for listed stock options is the Saturday after the third Friday of the expiration month. Holders of options should indicate their desire to exercise, if they wish to do so, by this date. See also Expiration Time and Automatic Exercise.

Expiration Time - The time of day by which all exercise notices must be received on the expiration date. Technically, the expiration time is currently 5:00PM on the expiration date, but public holders of option contracts must indicate their desire to exercise no later than 5:30PM on the business day preceding the expiration date. The times are Eastern Time. See also Expiration Date.

Facilitation - The process of providing a market for a security. Normally, this refers to bids and offers made for large blocks of securities, such as those traded by institutions. Listed options may be used to offset part of the risk assumed by the trader who is facilitating the large block order. See also Hedge Ratio.

Fair Value - Normally, a term used to describe the worth of an option or futures contract as determined by a mathematical model. Also sometimes used to indicate intrinsic value. See also Intrinsic Value and Model.

FLEX Options - Exchange traded equity or index options, where the investor can specify within certain limits, the terms of the options, such as exercise price, expiration date, exercise type, and settlement calculation.

Float - The number of shares outstanding of a particular common stock.

Floor Broker - A broker on the exchange floor who executes the orders of public customers or other investors who do not have physical access to the trading area.

Fundamental Analysis - A method of analyzing the prospects of a security by observing accepted accounting measures such as earnings, sales, assets, and so on.

Futures Contract - A standardized contract calling for the delivery of a specified quantity of a commodity at a specified date in the future.


Options Dictionary G-L

Options EducationGamma - The rate of change in an option's delta for a one-unit change in the price of the underlying security. See also Delta.

Good Until Canceled (GTC) - A designation applied to some types of orders, meaning the order remains in effect until it is either filled or canceled. See also Stop Limited and, Trading Limit.

Hedge - A conservative strategy used to limit investment loss by effecting a transaction which offsets an existing position.

Hedge Ratio - The mathematical quantity that is equal to the delta of an option. It is useful in that a theoretically neutral hedge can be established by taking offsetting positions in the underlying stock and its call options. See also Facilitation and Delta.

Holder - The purchaser of an option.

Horizontal Spread - An option strategy in which the options have the same striking price, but different expiration dates.

Implied Volatility - A measure of the volatility of the underlying stock, it is determined by using option prices currently existing in the market at the time rather than using historical data on the price changes of the underlying stock. See also Volatility.

Incremental Return Concept - A strategy of covered call writing in which the investor is striving to earn an additional return from option writing against a stock position which he (she) has targeted to sell -- possibly at substantially higher prices.

Index - A compilation of the prices of several common entities into a single number. See also Price-Weighted Index, Capitalization-Weighted Index.

Index Option - An option whose underlying entity is an index. Most index options are cash-based.

Institution - An organization, probably very large, engaged in professional investing in securities. Normally a bank, insurance company, or mutual fund.

In-the-money - A term describing any option that has intrinsic value. A call option is in-the-money if the underlying security is higher than the striking price of the call. A put option is in-the-money if the security is below the striking price. See also Out-of-the-Money and Intrinsic Value.

Intrinsic Value - The value of an option if it were to expire immediately with the underlying stock at its current price; the amount by which an option is in-the-money. For call options, this is the difference between the stock price and the striking price, if that difference is a positive number, or zero otherwise. For put options it is the difference between the striking price and the stock price, if that difference is positive, and zero otherwise. See also In-the-Money, Time Value Premium and Parity.

Last Trading Day - The very last full day of open trading before an options expiration day, usually the third Friday of the expiration month.

LEAPS - Long-term Equity Anticipation Securities, or LEAPS, are long-term stock or index options. LEAPS, like all options, are available in two types, calls and puts, with expiration dates up to three years in the future.

Leg - A risk-oriented method of establishing a two-sided position. Rather than entering into a simultaneous transaction to establish the position (a spread, for example), the trader first executes one side of the position, hoping to execute the other side at a later time and a better price. The risk materializes from the fact that a better price may never be available, and a worse price must eventually be accepted.

Letter of Guarantee - A letter from a bank to a brokerage firm which states that a customer (who has written a call option) does indeed own the underlying stock and the bank will guarantee delivery if the call is assigned. Thus the call can be considered covered. Not all brokerage firms accept letters of guarantee. Also: letter issued to O.C.C. by member firms covering a guarantee of any trades made by one of its customers, (a trader or broker on the exchange floor).

Leverage - In investments, the attainment of greater percentage profit and risk potential. A call holder has leverage with respect to a stock holder - the former will have greater percentage profits and losses than the latter, for the same movement in the underlying stock.

Limit Order - An order to buy or sell securities at a specified price (the limit). A limit order may also be placed "with discretion". In this case, the floor broker executing the order may use his (her) discretion to buy or sell at a set amount beyond the limit if he (she) feels it is necessary to fill the order.

Listed Option - A put or call option that is traded on a national options exchange. Listed options have fixed striking prices and expiration dates. See also Over-the-Counter Option.

Local - A trader on a futures exchange who buys and sells for his own account and may sometimes also fill public orders.

Lognormal Distribution - A statistical distribution that is often applied to the movement of stock prices. It is a convenient and logical distribution because it implies that stock prices can theoretically rise forever but cannot fall below zero.

Long Position - A position wherein an investor's interest in a particular series of options is as a net holder (i.e., the number of contracts bought exceeds the number of contracts sold).


Options Dictionary M-R

Margin - To buy a security by borrowing funds from a brokerage house. The margin requirement - the maximum percentage of the investment that can be loaned by the brokerage firm -- is set by the Federal Reserve Board.

Margin Requirement (for options) - The amount an uncovered (naked) option writer is required to deposit and maintain to cover a position. The margin requirement is calculated daily.

Mark-To-Market - An accounting process by which the price of securities held in account are valued each day to reflect the last sale price or market quote if the last sale is outside of the market quote. The result of this process is that the equity in an account is updated daily to properly reflect current security prices.

Market Basket - A portfolio of common stocks whose performance is intended to simulate the performance of a specific index. See Index.

Market-Maker - An exchange member whose function is to aid in the making of a market, by making bids and offers for his account in the absence of public buy or sell orders. Several market-makers are normally assigned to a particular security. The market-maker system encompasses the market-makers, floor brokers, and order book officials. See also Order Book Official and Specialist.

Market Not Held Order - Also a market order, but the investor is allowing the floor broker who is executing the order to use his own discretion as to the exact timing of the execution. If the floor broker expects a decline in price and he is holding a "market not held buy order", he (she) may wait to buy, figuring that a better price will soon be available. There is no guarantee that a "market not held order" will be filled.

Market Order - An order to buy or sell securities at the current market. The order will be filled as long as there is a market for the security.

Married Put and Stock - The simultaneous purchase of stock and the corresponding number of put options. This is a limited risk strategy during the life of the puts because the stock can be sold at the strike price of the puts.

Married Put Strategy - A put and stock are considered to be married if they are bought on the same day, and the position is designated at that time as a hedge.

Model - A mathematical formula designed to price an option as a function of certain variables - generally stock price, striking price, volatility, time to expiration, dividends to be paid, and the current risk-free interest rate. The Black-Scholes model is one of the more widely used models.

Naked Option - See Uncovered Option.

Naked writer - See Uncovered call writing and Uncovered put writing.

Narrow-Based - Generally referring to an index, it indicates that the index is composed of only a few stocks, generally in a specific industry group. See also broad-based.

Neutral - Describing an opinion that is neither bearish nor bullish. Neutral option strategies are generally designed to perform best if there is little or no net change in the price of the underlying stock or index. See also Bearish and Bullish.

Non-Equity Option - An option whose underlying entity is not common stock; typically refers to options on physical commodities and index options.

"Not Held" - See Market Not Held Order.

Notice Period - The time during which the buyer of a futures contract can be called upon to accept delivery. Typically, the 3 to 6 weeks preceding the expiration of the contract.

Opening Purchase - A transaction in which the purchaser's intention is to create or increase a long position in a given series of options.

Opening Sale - A transaction in which the seller's intention is to create or increase a short position in a given series of options.

Opening Transaction - A trade which adds to the net position of an investor. An opening buy transaction adds more long securities to the account. An opening sell transaction adds more short securities. See also Closing Transaction.

Open Interest - The number of outstanding option contracts in the exchange market or in a particular class or series.

Option Pricing Curve - A graphical representation of the projected price of an option at a fixed point in time. It reflects the amount of time value premium in the option for various stock prices, as well. The curve is generated by using a mathematical model. The delta (or hedge ratio) is the slope of a tangent line to the curve at a fixed stock price. See also Delta, Hedge Ratio, and Model.

Options Clearing Corporation (OCC) - The issuer of all listed option contracts that are trading on the national option exchanges.

Order Book Official - The exchange employee in charge of keeping a book of public limit orders on exchanges utilizing the "maker-maker" system, as opposed to the "specialist system", of executing orders. See also Market-Maker and Specialist.

Out-of-the-money - A call option is out-of-the-money if the strike price is greater than the market price of the underlying security. A put option is out-of-the-money if the strike price is less than the market price of the underlying security.

Over-the-Counter Option (OTC) - An option traded off-exchange, as opposed to a listed stock option. The OTC option has a direct link between buyer and seller, has no secondary market, and has no standardization of striking prices and expiration dates. See also Listed Stock Option and Secondary Market.

Overvalued - Describing a security trading at a higher price than it logically should. Normally associated with the results of option price predictions by mathematical models. If an option is trading in the market for a higher price than the model indicates, the option is said to be overvalued. See also Fair Value and Undervalued.

Parity - Describing an in-the-money option trading for its intrinsic value; that is, an option trading at parity with the underlying stock. Also used as a point of reference - an option is sometimes said to be trading at a half-point over parity or at a quarter-point under parity. An option trading under parity is a discount option. See also Discount and Intrinsic Value.

Physical Option - An option whose underlying security is a physical commodity that is not stock or futures. The physical commodity itself (a currency, treasury debt issue, commodity) - underlies that option contract. See also equity option, index option.

Position - As a noun, specific securities in an account or strategy. (A covered call writing position might be long 1,000 XYZ and short 10 XYZ January 30 calls). As a verb, to facilitate; to buy or sell - generally a block of securities - thereby establishing a position. See also Facilitation and Strategy.

Position Limit - The maximum number of put or call contracts on the same side of the market that can be held in any one account or group of related accounts. Short puts and long calls are on the same side of the market. Short calls and long puts are on the same side of the market.

Premium - The price of an option contract, determined in the competitive marketplace, which the buyer of the option pays to the option writer for the rights conveyed by the option contract.

Price-Weighted Index - A stock index which is computed by adding the prices of each stock in the index, and then dividing by the divisor. See also Capitalization-weighted index, Divisor.

Payoff Diagram - See Profit Graph.

Profit Graph - A graphical representation of the potential outcomes of a strategy. Dollars of profit or loss are graphed on the vertical axis, and various stock prices are graphed on the horizontal axis. Results may be depicted at any point in time, although the graph usually depicts the results at expiration of the options involved in the strategy.

Profit Range - The range within which a particular position makes a profit. Generally used in reference to strategies that have two break-even points - an upside break-even and a downside break-even. The price range between the two break-even points would be the profit range. See also Break-Even Point.

Profit Table - A table of results of a particular strategy at some point in time. This is usually a tabular compilation of the data drawn on a profit graph. See also Profit Graph.

Protected Strategy - A position that has limited risk. A protected short sale (short stock, long call) has limited risk, as does a protected straddle write (short straddle, long out-of-the-money combination). See also Combination and Straddle.

Public Book (of orders) - The orders to buy or sell, entered by the public, that are generally away from the current market. The order book official or specialist keeps the public book. Market-Makers on the CBOE can see the highest bid and lowest offer at any time. The specialist's book is closed (only he knows at what price and in what quantity the nearest public orders are). See also Order Book Official, Market-Maker, and Specialist.

Put - An option contract that gives the holder the right to sell the underlying security at a specified price for a certain fixed period of time. See also Call.

Ratio Calendar Combination - A strategy consisting of a simultaneous position of a ratio calendar spread using calls and a similar position using puts, where the striking price of the calls is greater than the striking price of the puts.

Ratio Calendar Spread - Selling more near-term options than longer-term ones purchased, all with the same strike; either puts or calls.

Ratio Spread - Constructed with either puts or calls, the strategy consists of buying a certain amount of options and then selling a larger quantity of more out-of-the-money options.

Ratio Strategy - A strategy in which one has an unequal number of long securities and short securities. Normally, it implies a preponderance of short options over either long options or long stock.

Ratio Write - Selling of call options in a ratio higher than 1 to 1 against the stock that is owned.

Resistance - A term in technical analysis indicating a price area higher than the current stock price where an abundance of supply exists for the stock and therefore the stock may have trouble rising through the price. See also Support.

Return (on investment) - The percentage profit that one makes, or might make, on his investment.

Return if Exercised - The return that a covered call writer would make if the underlying stock were called away.

Reversal Arbitrage - A riskless arbitrage that involves selling the stock short, writing a put, and buying a call. The options have the same terms. See also Conversion Arbitrage.

Rho - The expected change in an option is theoretical value for a 1 percent change in interest rates. See also Theoretical Value.

Risk Arbitrage - A form of arbitrage that has some risk associated with it. Commonly refers to potential takeover situations where the arbitrageur buys the stock of the company about to be taken over and sells the stock of the company that is effecting the takeover.

Roll Down - Close out options at one strike and simultaneously open other options at a lower strike.

Roll Forward (Out) - Close-out options at a near-term expiration date and open options at a longer-term expiration date.

Rolling - A follow-up action in which the strategist closes options currently in the position and opens other options with different terms, on the same underlying stock. See also Roll Down, Roll Forward, and Roll Up.

Roll Up - Close out options at a lower strike and open options at a higher strike.


Options Dictionary S-Z

Options EducationSecondary Market - ​A market that provides for the purchase or sale of previously sold or bought options through closing transactions.

Series - ​All option contracts of the same class that also have the same unit of trade, expiration date and strike price.

Settlement Price - ​The official price at the end of a trading session. This price is established by The Options Clearing Corporation and is used to determine changes in account equity, margin requirements, and for other purposes. See also Mark-to-market.

Short Position - ​A position wherein a person's interest in a particular series of options is as a net writer (i.e. the number of contracts sold exceeds the number of contracts bought).

Specialist - ​An exchange member whose function it is to both make markets buy and sell for his own account in the absence of public orders and to keep the book of public orders. Most stock exchanges and some option exchanges utilize the specialist system of trading.

Spread Order - ​An order to simultaneously transact two or more option trades. Typically, one option would be bought while another would simultaneously be sold. Spread orders may be limit orders, not held orders, or orders with discretion. They cannot be stop orders, however.

Spread Strategy - ​Any option position having both long options and short options of the same type on the same underlying security.

Standard Deviation - ​A measure of the volatility of a stock. It is a statistical quantity measuring the magnitude of the daily price changes of that stock.

"Static" Return - ​The return that an investor would make on a particular position if the underlying stock were unchanged in price at the expiration of the options in the position.

Stop-Limit Order - ​Similar to a stop order, the stop-limit order becomes a limit order, rather than a market order, when the security trades at the price specified on the stop. See also Stop Order.

Stop Order - ​An order, placed away from the current market that becomes a market order if the security trades at the price specified on the stop order. Buy stop orders are placed above the market while sell stop orders are placed below.

Straddle - ​The purchase or sale of an equal number of puts and calls having the same terms.

Strategy - ​With respect to option investments, a preconceived, logical plan of position selection and follow-up action.

Strike Price - ​The stated price per share for which the underlying security may be purchased (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract.

Striking Price Interval - ​The distance between striking prices on a particular underlying security. Normally, the interval is 2.50 points for stocks under $25, 5 points for stocks selling over $25 per share, and 10 points (or greater) is acceptable for stocks over $200 per share. There are, however, exceptions to this general guideline.

Sub-Index - ​See narrow-based index.

Suitability - ​A requirement that any investing strategy fall within the financial means and investment objectives of an investor.

Suitable - ​Describing a strategy or trading philosophy in which the investor is operating in accordance with his (her) financial means and investment objectives.

Support - ​A term in technical analysis indicating a price area lower than the current price of the stock, where demand is thought to exist. Thus a stock would stop declining when it reached a support area. See also Resistance.

Synthetic Put - ​A strategy equivalent in risk to purchasing a put option where an investor sells stock short and buys a call.

Synthetic Stock - ​An option strategy that is equivalent to the underlying stock. A long call and a short put is synthetic long stock. A long put and a short call is synthetic short stock.

Technical Analysis - ​The method of predicting future stock price movements based on observation of historical stock price movements.

Terms - ​The collective name denoting the expiration date, striking price, and underlying stock of an option contract.

Theoretical Value - ​The price of an option, or a combination of options, as computed by a mathematical model.

Theta - ​A measure of the rate of change in an option's theoretical value for a one-unit change in time to the option's expiration date. See Time Decay.

Time Decay - ​A term used to describe how the theoretical value of an option "erodes" or reduces with the passage of time. Time decay is especially quantified by Theta.

Time Spread - ​See Calendar Spread.

Time Value - ​The portion of the option premium that is attributable to the amount of time remaining until the expiration of the option contract. Time value is whatever value the option has in addition to its intrinsic value.

Time Value Premium - ​The amount by which an option's total premium exceeds its intrinsic value.

Total Return Concept - ​A covered call writing strategy in which one views the potential profit of the strategy as the sum of capital gains, dividends, and option premium income, rather than viewing each one of the three separately.

Tracking Error - ​The amount of difference between the performance of a specific portfolio of stocks and a broad-based index with which they are being compared. See also market basket.

Trader - ​An investor or professional who makes frequent purchases and sales.

Trading Limit - ​The exchange-imposed maximum daily price change that a futures contract or futures option contract can undergo.

Treasury Bill/Option Strategy - ​(90/10 strategy) a method of investment in which one places approximately 90% of funds in risk-free, interest-bearing assets such as Treasury bills, and buys options with the remainder of his assets.

Type - ​The classification of an option contract as either a put or a call.

Uncovered Call Writing - ​A short call option position in which the writer does not own an equivalent position in the underlying security represented by his option contracts.

Uncovered Option - ​A written option is considered to be uncovered if the investor does not have an offsetting position in the underlying security. See also Covered.

Uncovered Put Writing - ​A short put option position in which the writer does not have a corresponding short position in the underlying security or has not deposited, in a cash account, cash or cash equivalents equal to the exercise value of the put.

Underlying Security - ​The security subject to being purchased or sold upon exercise of the option contract.

Undervalued - ​Describing a security that is trading at a lower price than it logically should. Usually determined by the use of a mathematical model. See also Overvalued and Fair Value.

Unit of Trading - ​The minimum quantity or amount allowed when trading a security. The normal minimum for common stock is 1 round lot or 100 shares. The normal minimum for options is one contract (which normally covers 100 shares of stock).

Variable Ratio Write - ​An option strategy in which the investor owns 100 shares of the underlying security and writes two call options against it, each option having a different striking price.

Vega - ​A measure of the rate of change in an option's theoretical value for a one-unit change in the volatility assumption.

Vertical Spread - ​Most commonly used to describe the purchase of one option and sale of another where both are of the same type and same expiration, but have different strike prices. It is also used to describe a delta-neutral spread in which more options are sold than are purchased.

Volatility - ​A measure of the fluctuation in the market price of the underlying security. Mathematically, volatility is the annualized standard deviation of returns.

Write - ​To sell an option. The investor who sells is called the writer.



Types of Options

There are two main types of options available in Australia:

  1. American options - These can be exercised at any time between the date of purchase and the expiration date. The example about Cory's Card Co. is an example of the use of an American option. Most exchange-traded options are of this type.
  2. European options - These are different from American options in that they can only be exercised at the end of their lives. The distinction between American and European options has nothing to do with geographic location.

Long-Term Options

So far we've only discussed options in a short-term context. There are also options with holding times of one, two or multiple years, which may be more appealing for long-term investors. These options are called long-term equity anticipation securities (LEAPS). By providing opportunities to control and manage risk or even to speculate, LEAPS are virtually identical to regular options. LEAPS, however, provide these opportunities for much longer periods of time. Although they are not available on all stocks, LEAPS are available on most widely held issues.


Exotic Options

The simple calls and puts we've discussed are sometimes referred to as plain vanilla options. Even though the subject of options can be difficult to understand at first, these plain vanilla options are as easy as it gets! Because of the versatility of options, there are many types and variations of options. Anything other than standard options are called exotic options, which are either variations on the payoff profiles of the plain vanilla options or are wholly different products with "option-ality" embedded in them.


Risks

Market Risk - Options are highly speculative and volatile. There are no guarantees or assurances that you will make profits, or not make losses, or that unrealised profits or losses will remain unchanged.

Margining - one could sustain a loss, greater than but not limited to the initial and variation margin that was deposited to establish or maintain a transaction.

Leverage - Leverage can lead to large losses, significantly disproportionate to the initial deposit.

Share Prices - recommends that you obtain independent legal, financial and taxation advice before proceeding with a transaction.


Example of a Put Option on a Stock

I purchase a put option to sell a share in XYZ Corp. on June 1, 2010, for $50. The current price is $55, and I pay a premium of $5. Assume that the XYZ Corp. share price is actually $40 on that day. Then I would exercise my option, by purchasing a share of the stock in the open market (for $40) and then selling it to the counter-party at the strike price of $50. (In practice, the seller of the put option could simply pay me the $10 difference.) My profit would be $10 minus the fee (of $5) that I paid for the option. So I have doubled my money (began with $5 to purchase the put option; ended with $10 in my pocket). If, however, the share price never drops below the strike price (in this case, $50), then I would not exercise the option. (Why sell a stock to someone at $50, the strike price, when it is more valuable in the open market?) My option would be worthless and I would have lost my whole investment, the fee (premium) for the option, $5. Thus, in any future state of the world, my loss is limited to the fee I have paid (in this case $5), while my profit depends on how much the stock price falls (consider, for example, if the stock sold at $20 on the exercise date). This example illustrates that the put option has positive monetary value when the underlying instrument has a spot price (S) below the strike price (K). Since the option will not be exercised unless it is "in-the-money", the payoff for a put option is max[ (K - S) ; 0 ] or formally, (K - S) +

Where:

Prior to exercise, the option value, and therefore price, varies with the underlying price and with time. The put price must reflect the "likelihood" or chance of the option "finishing in-the-money". The price should thus be higher with more time to expiry, and with a more volatile underlying instrument. The science of determining this value is the central tenet of financial mathematics. The most common method is to use the Black-Scholes formula. Whatever the formula used, the buyer and seller must agree this value initially.


Covered Call Writing

An Income Generation Investment Strategy

Options EducationEssentially this is an income-generating strategy. For the novice, the analogy is that of receiving an extra dividend each contract period. In Australia, the majority of the well-known blue chip Australian stocks have monthly or three-monthly contract periods. When purchasing a stock with the intent of writing covered calls as soon as the investor/trader has the buy is confirmed is known as a buy-write Covered Calls are generally considered as a conservative income generating strategy because the potential loss is limited. Covered Call writing involves a call option being sold (or written against a holding of the underlying shares. Writing covered calls gives another party the right to buy the stock at the option strike price. When writing covered calls, the investor/trader is selling the upside potential of a stock to speculators. Since their focus is on monthly income and not long-term capital gain when writing covered calls, it is advantageous if the stock price goes up and the stock gets called away.

When writing Covered calls the investor/trader must be prepared to do one of the following:

  1. Allow the stock to be sold (assigned or called) at the option strike price at any time before the covered calls expire
  2. Buy the covered calls back on the open market before they are exercised
  3. Let the covered calls expire unexercised (on the third Friday of the month)

The Basic Steps To Writing Covered Calls

  1. Have your broker buy the stock you've selected for covered calls in marketable parcels of usually 1,000 shares. (Check with your broker as some stocks require more)
  2. Then have the broker sell the covered calls. If you don't want the stock to be called, you could roll up or roll forward, or roll the covered calls up and forward. You could keep writing covered calls and collecting option premiums each month until the stock is called

This is a good strategy if you have the view that the stock has had a good run and looks likely to plateau for a period of time. In today's market, think of stocks like the banks. They have enjoyed a strong upward momentum over the past few months and seem likely to trade within a band range in the coming months. Writing the call at the top of this range will provide maximum premiums, whilst lowering the probability of your stocks being called away; allowing you to write once again after the contract expires.

The Downside

If the stock pushes up well past the strike price, the investor/trader will not gain the benefit of the capital gain as the stock is called away at the strike price the call is written at. Additionally, selling stock at ad hoc times has tax implications that may not be beneficial to the investor/trader. In theory, if the investor/trader believes the share price has reached a temporary peak, selling covered calls gives them some protection against a pullback in the share price. The premium received compensates for the temporary fall in the price of the share.


Put Options

A graphical interpretation of the payoffs and profits generated by a put option as seen by the purchaser of the option. A lower stock price means a higher profit. Eventually, the price of the underlying (i.e. stock) will be low enough to fully compensate for the price of the option.

Profit is maximized when the option expires worthless (when the price of the underlying exceeds the strike price), and the writer keeps the premium. A put option (sometimes simply called a "put") is a financial contract between two parties, the buyer and the seller of the option. The put allows the buyer the right but not the obligation to sell a commodity or financial instrument (the underlying instrument) to the seller of the option at a certain time for a certain price (the strike price). The seller has the obligation to purchase at that strike price, if the buyer does choose to exercise the option. Note that the seller (the writer) of the option is agreeing to buy the underlying instrument if the buyer of the option so decides!

In exchange for having this option, the buyer pays the seller a fee (the premium). Exact specifications may differ depending on option style. A European put option allows the holder to exercise the put option on the delivery date only. An American put option allows exercise at any time during the life of the option. In general, the buyer of a put option expects the price of stock to fall significantly, but does not want to sell the stock short because that could result in large losses if the stock does go up anyway. (With a put option, the loss is limited to the purchase price of the option.) The seller of the put option generally feels that the stock in question is reasonably priced, and should the price fall, the seller may be willing to become the owner of the stock at a lower price, considering it to be a bargain. (On the other hand, the seller of the put may be merely gambling.)

Put Options As Insurance

The most widely understood example of option buying as insurance is when an investor purchases a put contract to protect a stock that they own. The concept is that the put contract will compensate for some of the monetary loss if the stock value falls. But why bother buying a put? Surely if you were worried about losing money you would simply sell your stock and keep the cash. What the investor is really doing when they buy a protective put is to insure themselves against making the wrong future investment decision. The investor may either inadvertently sell the stock just prior to it rising in value or alternatively, they may simply hold onto the stock as it falls in value. If you protect your position with a put, you can be right either way. Moreover, it is possible to structure your Puts in a way that reflects your market expectations and your analysis of the risk.

Example:

Using BHP on the 9th November 2005; when it was trading around $21.00 per share, the March at-the-money $21.00 strike had an asking price of $1.29; the March in-the-money $21.50 was asking $1.54 and the March out-of-the-money $20.50 put was trading at $1.06. In-the-Money Put. With an in-the-money put you suffer the lowest overall loss if the stock drops sharply, but you also have the lowest gain if the stock rises. This is because it protects the downside more than the other puts, hence you would say that it offers the maximum insurance. But does it? After all, if you just wanted to protect against a loss, your best choice would be to sell the stock and hold cash. But then, of course, you would have given up the chance for any further gains in the stock. At-the-money Put. Buying the at-the-money $21.00 strike put at $1.29 is the maximum insurance. Why? Because if you are uncertain about the direction of the stock, and do not want to be wrong if the stock makes a big move in either direction, then the at-the-money strike put is the insurance you want to buy. With the at-the-money put, if the stock rises $1.00 by the March expiration, to $22.00, with 1000 shares the investor will have participated in all of the $1,000 gain, but will be out of pocket for the $1290.00 paid to purchase the put (your accountant would be able to advise you regarding this amount being tax deductible).

Alternatively, if the stock falls $3.00 to $18.00, the investor can choose to exercise to the $21.00 Put option to sell his/her shares at $21.00 or sell the put option back into the market at a value of around $3.00, giving rise to a gain of $3.00 - $1.29 = $1.71 less the drop in value of the shares. In either scenario all he or she will be out of pocket is $290 (the time value component on the option). Out-of-the-Money; If you are more Bullish then you may decide on the $20.50 out-of-the-money put. Your maximum loss (with 1000 shares) is $606.00, However, if the stock rises instead of declines, your gains will be a lot better than if you hedged by buying the at-the-money put. With an in-the-money put you are moving towards selling off your stock, but insuring yourself against the wrong decision by retaining the right to some upside potential if the stock makes a large upward move.


Pricing and the Market Makers

If you currently trade, or are thinking about trading options, then it is important to understand the way that the options pricing is determined and how you can identify genuine market pricing to maximise your profits (or minimise your losses) When the price of the underlying equity moves up, then it is expected that the price of Call options will rise and the price of Put options will fall. If you study a particular Stock and its option pricing you will notice that there are anomalies in the pricing. Some of this can be explained by volatility and the Delta of the option (sensitivity of the option price in relation to the change in the share price). However, one of the main reasons for the variations is that Options are traded on a separate exchange that is subject to its own supply and demand pricing, much of which is determined by the market makers. Market makers play an important, but anonymous, role in the options market. Under ASX Market Rules they are required to provide quotes in various option series for certain periods of time. Market makers compete against one another while trading on their own account and at their own risk. They can be either individuals or firms and their raison is to make a profit: they are YOUR competition.

There are around 20 market making firms in the ETO market. Companies such as Macquarie, Citigroup, J.B Were are well recognised whilst others such as Optiver, Timber Hill and IMC keep a very low profile, although they are among the largest of the Market Makers. The ASX rules: The ASX specify a maximum spread (the difference between the bid and offer prices) the designated market makers may quote when making a market and the minimum number of contracts for which the market maker must quote a price. The minimum volume requirement is ten contracts for Category 1 Classes and five contracts for Category 2 Classes (Categories basically reflect the price of the option). Watch for the Sting: How do you use this knowledge when trading ETO's? The temptation when trading an option is to pick a mid-point between the bid and ask prices as a 'fair' price. The market makers know this! In their eyes, you (the retail market) are a bit like sheep where you are able to be herded to a point where maximum profit can be extracted. In the table below you can see the pricing for a BHP call (XV) at around 3.50pm. The option had been trading in a range $1.52 - $1.55 with a fairly constant share price. You can see that the last trade was $1.535.

You can also see that a market maker has placed a bid/ask spread of 10c ($1.525 - $1.625) for 10 contracts either side. Fair price is around $1.53. Therefore, anything that you pay above that is basically profit for the market maker. They are hoping that you will be desperate to get into BHP calls and are prepared to pay ~$1.60 - that is an instant 4.6% profit.


Long Straddle Strategy

Continuing on with our insights into Exchange Traded Options (ETO) trading, today we are examining the Long Straddle. The market outlook for this strategy is a strong move in either direction. When an option trader buys either a Call contract or Put contract, they have an expectation of a definite market or share price movement. That is, they believe that the stock price or index has a positive or negative momentum. Often however, the market or an individual share is clouded by a variety of conflicting analysts reports or as disconcerting, too much "news" and not enough concrete information to filter out the future direction of stock prices. Because of this daily market “noise often a good option strategy in this uncertain environment is a long straddle.

The Strategy

The long straddle combines a long put and a long call at the same strike price with the same expiry date. This V-shaped spread generates a return over two ranges of market values: values below the strike price of the put and values above the strike price of the call. To become profitable, the underlying must have a change in price greater than the total cost of the straddle, and the price change must occur prior to expiry. If it doesn't, the straddle expires worthless. Since a straddle can never be worth less than zero, long straddles have limited risk and unlimited profit potential.

However they are expensive to enter as you have to purchase both legs of the strategy. On the graph above, the X-axis is the price level of the underlying stock and the Y-axis represents the profit and loss of the option as the share price moves. More risk-tolerant investors can also take advantage of the opposite situation - a low volatility market - by writing a short straddle, which is the sale of at the money call and put options with the same expiry date and the same exercise price.

Using Straddles

Exchange Traded options (ETO) can offer the trader some flexible trading opportunities, dependent upon your market viewpoint you can structure option strategies that will make the best of any situation, indeed, many strategies can be adjusted as the trade develops over time. Today we will outline a trading strategy called a straddle. The concept being that the trader can generate profits as the stock breaks either up or down. This allows the trader to increase profits by making adjustments during the options lifetime. This is a multiple leg strategy and it is important to accept that one of the legs will lose money, although hopefully the other leg makes more than enough profit to compensate.

A Straddle

A straddle is the simultaneous buying of both a Call and a Put option on the same underlying stock with the same strike price and same expiration date. Straddles allow you to avoid the uncertainty of a stock direction by using stock volatility and option implied volatility of that specific stock, to your benefit. The profit is regardless of stock direction with unlimited potential gain and limited risk. However, there are disadvantages, the strategy depends on volatility in the stock price and is affected by time decay. If you are buying a straddle you are hoping for a very volatile movement and if you are writing a Straddle you are expecting the stock price to travel sideways for an extended period.

Writing a Straddle

This is known as a short straddle and is a high risk strategy, maximum profit, which is the total premium earned from the sale of the options, occurs if the share price is at the strike price at expiry. However, if the share price moves sharply in either direction there is the potential for unlimited losses, whilst the net premium received for selling the straddle provides a small cushion, the stronger the move, the greater this loss will be. It is possible to limit the potential loss by buying a put and a call option with out-of-the-money strike prices. The loss is then limited to the difference between the strike prices. This converts the short straddle into a synthetic version of the long butterfly strategy.

Synthetic Straddles

These are slightly different in that they are a delta neutral strategy (Delta: Change in the price of an option relative to the change of the underlying security) and can be created by using calls or puts. The long synthetic call straddle involves short selling the stock and then purchasing call options to create an overall delta neutral position. When the market goes up, the trader will incur a loss on the underlying stock but would have a bigger profit on the options. When the market goes down, the trader would have a profit on the underlying stock and a smaller loss on the options. No matter the direction, as long as the market moves beyond the breakeven the trader will receive a profit.


The Difference Between Intrinsic and Extrinsic Value

The two main components of an Options value are Intrinsic value and Extrinsic (time) value. It is very useful to be able to determine what component of an options value is Intrinsic and which are time and this lesson will outline how to calculate this proportion. Intrinsic value can be defined as the amount by which the strike price of an option is in-the-money. It is actually the portion of an option's price that is not lost due to the passage of time and it is therefore the minimum value of an option. For call options intrinsic value can be calculated as the Underlying Stock's Current Price minus the Call Strike Price. Therefore the Time Value is the Call Premium minus the Intrinsic Value. For Put Options the Intrinsic value is equal to the Put Strike Price minus the Underlying Stock's Current Price. Again, the Time Value is the Put Premium minus the Intrinsic Value. At the money and out of the money options are purely extrinsic - they don't have any intrinsic value because they do not have any real value, you are simply paying for time and this decreases as the option approaches its expiry date. The more time an option has until expiration, the greater the option's chance of ending up in-the-money. The closer you get to the expiration date, the more money you're going to lose if the Stock price doesn't move. Using BHP as an example, on the 22/11/05, BHP was at $21.67 the call options were priced at; November;

The intrinsic value of an option is the same regardless of how much time is left until expiration. However, since theoretically an option with 1 month till expiration has a better chance of ending up in-the-money than an option expiring in the present month, it is worth more because of the time value component. That's why an out of the money option consists of nothing but time value and the more out-of-the-money an option is, the less it costs. To many traders, this looks good because of the inexpensive price one has to lay out in order to buy such an option. However, the probability that an out of the money option will turn profitable is really quite slim. With the price of BHP at $21.67, a November 21.50 call would cost $0.32. In this case, BHP would have to be at $21.99 in order for the trade to break even. If you were to buy a November $21.00 call and pay $0.73 for it, BHP would only have to be at $21.73 in order to break even. As you can see, the further out an OTM option is, the less chance it has of turning a profit. The deeper in-the-money an option is, the less time value and more intrinsic value it has. That's because the option has more real value and you pay less for time. Therefore, the option moves more like the underlying asset.


Using the Greeks

The Greeks aren't just friendly people with a great Mediterranean lifestyle and millennia of history in arts and literature. In finance, the Greeks are vital tools in risk management that describe the quantities representing the market sensitivities of Exchange Traded Options (ETO) or other derivatives. Each Greek measures how the portfolio's market value should respond to a change in some variable such as the underlying security, implied volatility, interest rates or time. All of the quantities are named after letters in the Greek alphabet (with the exception of Vega, which is named after a star and had previously been known as Kappa) and therefore they are affectionately and collectively called the Greeks;

Delta - The delta of an instrument is the derivative of the value function with respect to the underlying price, delta measures first order (linear) sensitivity to price. Its value will increase if the underlying security increases, and it will decrease if the underlying security decreases.

Gamma - The Gamma is the second derivative of the value function with respect to the underlying price, gamma measures second order (quadratic) sensitivity to price (the curvature of the Delta line).

Vega - The Vega is the derivative of the option value with respect to the volatility of the underlying, Vega measures sensitivity to implied volatility.

Theta - Theta is the derivative of the option value with respect to the amount of time to expiry of the option, theta measures sensitivity to the passage of time while the other four Greeks are risk metrics. Theta is not because the passage of time in certain it involves no risk. Theta can be compared to the accrual of interest.

Rho - The Rho is the derivative of the option value with respect to the risk free rate, rho measures sensitivity to the applicable interest rate.

Lambda - The Lambda is the percentage change in option value per change in the underlying price.


Options Conclusion

We hope this tutorial has given you some insight into the world of options. Once again, we must emphasize that options aren't for all investors. Options are sophisticated trading tools that can be dangerous if you don't educate yourself before using them. Please use this tutorial as it was intended - as a starting point to learning more about options.

Let's recap:

  • An option is a contract giving the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date
  • Options are derivatives because they derive their value from an underlying asset
  • A call gives the holder the right to buy an asset at a certain price within a specific period of time
  • A put gives the holder the right to sell an asset at a certain price within a specific period of time
  • There are four types of participants in options markets: buyers of calls, sellers of calls, buyers of puts, and sellers of puts
  • Buyers are often referred to as holders and sellers are also referred to as writers
  • The price at which an underlying stock can be purchased or sold is called the strike price
  • The total cost of an option is called the premium, which is determined by factors including the stock price, strike price and time remaining until expiration
  • A stock option contract represents 100 shares of the underlying stock
  • Investors use options both to speculate and hedge risk
  • Employee stock options are different from listed options because they are a contract between the company and the holder (Employee stock options do not involve any third parties.)
  • The two main classifications of options are American and European
  • Long term options are known as LEAPS

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