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Understanding Options: Strategies for effective options plays

Posted April 9, 2008

A TFN Research Report:

“Stocks are fine for long-term investors. But traders need high-powered precision instruments to reap short-term profits. By speculating with options, you have the potential to make triple-digit returns in a matter of months, weeks or even days. Of course, this type of profit opportunity doesn’t come without risks. But by carefully constructing options positions, you can significantly reduce those risks.” – Stephen Oakes & Ian Cooper

Today’s Financial News feed provides an independent and practical perspective on the U.S. and global investment markets.
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by Stephen Oakes, editor of Jutia Group & Ian Cooper, editor of Pure Energy Trader

Baltimore — (TFN): Before you read on, keep in mind that while we may mention specific stocks in our report, we are not recommending that you buy any specific options trades. Whenever possible, we use fictitious stocks to avoid confusion. Examples drawn from real stocks are used to show the real potential for profits and losses.

Options 101

An option is a type of derivative security, i.e. one that derives its value from another asset. Options are agreements to buy or sell an asset called the underlying security at an agreed-upon price some time in the future. There are options in stocks, stock indices, commodities, and currencies.

The seller (or writer ) of an option is obligated to buy or sell a predetermined amount of the underlying security at the agreed-upon price, or strike price. The buyer of an option has the right, but not the obligation, to buy or sell the underlying security at the strike price.

A call option gives you the right to buy. Buy a call option and you acquire the right to buy at a fixed price. Sell a call option and you give someone else the right to buy from you at a fixed price.

A put option gives you the right to sell. Buy a put option and you acquire the right to sell at a fixed price.Sell a put option and you give someone else the right to sell to you at a fixed price.

Options have limited lifetimes. At expiration, options cease to exist. If you buy an option, you either exercise it (buy or sell the underlying security) or it will expire worthless. If you sell an option, you want it to expire worthless.

The price of an option is called the premium. The premium is the cost of buying the option, or how much you get for writing it. You find the dollar value of an option by multiplying the premium by the multiplier. A stock option represents 100 shares. For example, a Telmex US$35 November call gives you the right to buy 100 shares of Telmex at US$35 until late November, regardless of Telmexs share price at the time.

(Keep in mind: For the sake of simplicity, we are ignoring commissions in our discussion of options. Commissions on options trades tend to be higher than on stocks. Your return can be negatively affected by high commission rates.)

How to value options

Option premiums can be broken down into two components: intrinsic value and time value. Intrinsic value represents how much the option is worth if you exercise it right now. You can find intrinsic value by comparing the strike price to the market price of the underlying security. An option with intrinsic value is in-the-money.

In the case of a call, if the price of the underlying stock is above the strike price, the call is in-the-money. If Telmex is trading at US$40, and you have a US$35 call, you can buy the stock at US$5 less than everybody else. This is the call’s intrinsic value.

In the case of a put, the opposite is true. A put is in-the-money when the strike price is above the market price of the stock. If you own a Telmex US$35 November put, and Telmex is trading around US$30, you are US$5 in-the-money. This represents the intrinsic value of the put.

If the strike price of a call is above the price of the stock, the call is out-of-the-money. If you own a K-Mart November US$10 call when K-Mart is at US$8, there s no reason to exercise it, since you would automatically lose US$2. If the strike price of the call is equal to the price of the stock, the call is at-the-money. In both cases, you don t gain anything by exercising the call. The call lacks intrinsic value.

A put is out-of-the-money if the strike price is below the price of the underlying security. A Microsoft US$80 put is US$12 out-of-the-money when Microsoft is at US$92. If the strike price is equal to the price of the underlying security, the put is at-the-money.

Out-of-the-money options aren’t free. While they lack intrinsic value, they still have time value. Time value is a reflection of the time left until expiration. A call might be out-of-the-money with the stock trading at current levels. However, the stock might climb above the strike price before the call expires.

Longer-dated options have a higher premium. You have to pay for more time. With an in-the-money option, you can subtract the option’s intrinsic value from the premium to find time value. The premium of an out-of-the-money option consists entirely of time value.

As an option approaches expiration, time value falls. This is known as time decay. At expiration, an out-of-the-money option is totally worthless. Options are wasting assets. The longer you hold an option, the less it is worth in terms of time value.

Again, if you write an option, you want it to expire worthless.

Volatile stocks tend to have high options premiums. The more a stock swings up and down, the more likely an option based on it is to expire in-the-money. The time value of options on a volatile stock is different than the time value of options on a quiet, dead stock. Options on a stock that swings up and down 10% every three months are more likely to expire in-the-money than options on a stock that swings up and down 5% every three months.

Volatility

In the general market, volatility means price movement. A market is called volatile when prices are making big swings higher and lower. But volatility has a special meaning for options.

The Chicago Board Options Exchange (CBOE) maintains two volatility indices, the VIX and the VXN. The VIX measures the amount of premium put buyers are willing to pay on S&P 500 stocks. The VXN measures the premium in NASDAQ 100 put options.

As stocks fall in price, volatility rises because more people are buying puts. The general rule for trading is, when the VIX is high it’s time to buy, when the VIX is low it’s time to go.

This rule is very good contrarian indicator. When put buying reaches a crescendo, it’s usually after stocks have been falling for a while. By the time the majority of investors are comfortable with the downtrend, it’s usually about time for a reversal. And when no one is buying puts because stocks keep going up, it’s a good sign that a top is near.

Typically, every bear market rally coincides with high volatility readings.

Buy low. Sell high. How does this basic rule of trading apply to options?

Let’s say a speculator buys a Microsoft March US$100 call for US$2. Microsoft hits US$102. The speculator wants to exercise the call. While the speculator can purchase 100 shares for US$2 under the market, he paid US$2.25 for this right. His break-even point is US$102.25. Every tick above US$102.25 is pure profit. The more you pay for a call, the higher the stock has to go above the strike price for you to break even.

Call writers want the stock to fall below the strike price. Since all call writers receive the premium up front for selling the call, their break-even level is the same as the call buyer’s, but in the other direction. The call writer breaks even when the stock is below the strike plus the premium. If you sell the Microsoft US$100 call for US$2, your break-even level is US$102. When Microsoft is at US$102, you’re breaking even. Above US$102, you’re loosing money. Below US$102, you’re making money.

Break-even levels are reversed for puts. The stock has to decline far enough below the strike price to cover the premium. If you bought an IBM US$110 March put for US$8 and IBM is at US$109, you haven’t broken even yet, even though the option is in-the-money. The break-even level is US$102. Put sellers are in the black above US$102. Put buyers are in the black below US$102.

Whatever you do, never confuse break-even levels with in-the-money options. Options are either in-the-money or not-in-the-money. It doesn’t matter whether you bought or sold an option, or how much premium you paid or received. Break-even levels are different for each buyer or seller. Pay close attention to break-even levels. An options strategy might look profitable until you factor them in.

The secret of options: Leverage

How do options let you leverage your money? A US$5 premium on a Gillette call will let you control 100 shares of a US$60 stock (US$6,000 worth of stock) for US$500 (US$5 premium per share multiplied by 100 shares). You only have to put 8.4% down. This means you can double or triple your money on a premium while the stock only goes up 10 or 15 points.

Options premiums and stock prices are tied together through delta.

If you’re a mathematician or just like to mess around with figures, you can calculate delta based on the underlying security s value. Delta is the amount by which an option’s price will change for a one-point change in the price of the underlying asset. Call options have positive deltas, while put options have negative deltas. A 0.75 delta means that for every US$1 gain in the stock, a call option gains US$0.75 in premium. A -0.75 delta means that for every US$1 loss in the stock, a put option gains US$0.75 in premium. Deep in-the-money options have deltas close to 1 (or -1 for puts).

Let’s say you buy a 50 call on a US$50 stock. You pay a US$2 premium for an option with a 0.50 delta. Your friend likes the stock, but instead of buying the call, he buys 100 shares of the stock itself at US$50. If the stock goes up to US$52, your friend make a US$200 profit, or a 4% gain. The call gained US$1 (0.50 delta multiplied by the US$2 stock gain). This leaves you with a profit of 50% on the call.

Unless you’re trading several hundred thousand dollars worth of options, you don’t have to worry about delta. (If you don’t believe me, just ask your broker what delta is. He’ll probably tell you it’s an airline). But you need to understand how options work. While options pricing involves fairly complicated mathematics, you don’t have to be a scientist to hedge with options. By knowing the tricks of the trade, you can turn the odds in your favor.

For the options buyer, risk is limited to the premium paid. In the worst-case scenario, the option expires worthless. If you write an option, you have to put 20% of the market value of the underlying security down as margin (plus the proceeds of the sale). Since you’re selling options for the premium, you’re risking that the option will expire in-the-money. Your loss might exceed the premium you initially received many times over.

Since options are leveraged financial instruments, you have to trade them in a special margin account. You’ll have to sign an options account agreement and a risk disclosure document. Your broker is supposed to make sure you have the financial sophistication to trade options. The minimum account for options trading is usually between US$5,000 and US$10,000.

Style

There are two styles of options. American-style options can be exercised by the options holder any time before expiration. All stock options are American-style. If you hold a Merck US$60 March call, you can buy 100 shares of Merck at US$60 at any time before it expires in March.

European-style options can only be exercised during a specific period of time immediately before expiration. For example, S&P 500 index options can only be exercised on the last business day before expiration. Most stock index options are European-style. Index options allow you to trade in a particular market or industry. That way, you don’t have to buy all of the stocks individually.

Stock options usually begin trading eight months before expiration. There are three expiration cycles: January, February, and March. You should be familiar with the different expiration cycles so that you can select the right option. In any given month, there are four available expiration months.

Expiration for stock options is on the Saturday following the third Friday of the expiration month. This is critical for the options investor. If the option is out-of-the-money on the last Friday before expiration, the options buyer forfeits the premium while the options writer gets to keep the premium. On the other hand, if the option is in-the-money, the options holder may choose to exercise the option, forcing the options writer to deliver the underlying security at a loss.

Long-term Equity Anticipation Securities, or LEAPS, are long-term options with expiration dates up to three years out. All equity LEAPS expire in January. Stock index LEAPS have monthly expiration cycles. LEAPS let you take long-term options positions in a stock.

Options strategies can get extremely complex. But basic options trading is simple.

If you think a stock is going up, you could buy the stock. Your profit potential is unlimited, since the stock could keep going higher. But your risk is 100% of the capital you invest. Theoretically, a stock could fall to zero, although most legitimate companies with real assets will be bought out at some point if their share price falls ridiculously low.

Or, instead of buying the actual stock, you could buy a call option. Your profit potential is unlimited. While the dollar gains on the stock will generally be greater than the dollar gains on the option’s premium, the gains in premium will represent a much larger percentage gain. Your risks are limited to the price paid for the call. While this represents 100% of the premium, it is a smaller dollar amount than you’d be risking with the actual stock.

Let’s say you expect a US$50 stock to make a run up to US$65 in three months. It’s March. The August US$60 call has a US$1-7/8 premium. You have US$10,000 to invest. What’s the best way to profit from your forecast?

You could buy 200 shares and wait for the stock to hit US$65 to liquidate. If the stock hits US$65, you will make US$3,000 on the trade, or 30%. That is an acceptable return, but you’re taking the risk that the stock will drop before you sell it. A few years ago, the stock peaked out at US$60 and dropped to US$30, so you assume that the worst-case scenario is a 40% drop from current levels which would be a US$4,000 blow to your portfolio.

As an alternative, you could buy two August US$60 calls for US$375. If the stock climbs to US$65 before expiration in the third week of August, your calls will have a premium of at least US$6. Your call position is now worth US$1,200. You only made 12% on your US$10,000, but your maximum loss was only US$375, or 3.75%. Buying calls instead of shares actually reduces your risk.

Now, 12% is a nice return when you are only risking 3.75%. But it’s not enough. You want to make real money. By buying the stock, you figure at most you are risking 40% of your investment capital. So let’s say that you’re willing to risk up to US$4,000 buying calls.

You buy 21 August US$60 calls at US$1-7/8 for a net US$3,937.50. In the worst-case scenario, the calls expire worthless, leaving you with a loss of US$3,937.50. But say the stock, as forecast, makes a run up to US$65 by July. The August US$60 calls are now worth US$6. Your options position is now worth US$12,600. The total value of your account is now US$22,600. Your options trade left you with a 126% profit.

Let’s say that you’re even more aggressive. You’re willing to blow US$10,000. You load up on US$60 calls. Luckily, your forecast turns out to be accurate. Your 53 US$60 calls are now worth US$31,800. The return on your extremely leveraged trade is 318%.

If you manage your risk properly, you’ll find that the average stock investor is risking more in dollar terms than the options speculators. Using leverage, the aggressive speculator can more than double his account while taking the same -40% risk the average investor takes by owning the stock. The only advantage of owning stocks is that stocks don’t expire. In this respect, stocks are superior to options over the long term. For short-term trading, options are superior. Phenomenal returns are possible, while risk can be precisely defined in advance.

Deeper out-of-the-money options are cheaper. The more the stock has to travel for the option to be in-the-money, the less the option is worth. Aggressive speculators can take advantage of this by buying more options with a given amount of capital. However, you are taking more risk. While deep out-of-the-money options are usually dirt-cheap, they often have little chance of expiring in-the-money. Don’t buy deep out-of-the-money options unless you are 99.9% certain that you will make money or 100% resigned to the possibility of a total loss of the premium.

How to speculate with puts

Puts let you profit from bearish markets. If you think a stock is going to decline, you could take a position in the market by buying a put. By purchasing a put, you acquire the right to sell the underlying security at a fixed price within a specified time period. As the underlying security falls below the strike price, the holder of the put makes money.

Without options, you would have to short sell the stock to profit from declining prices. Short selling is the opposite of buying, or going long. To short a stock, you borrow shares through your broker and sell them immediately. Eventually, you have to buy back the shares to return them to your broker. If the stock declines, you can close out your short position by buying back your shares at a cheaper price. The difference is your profit.

Sounds great, right? But there’s a drawback to shorting — your potential losses are infinite. If a stock climbs to US$80 after you shorted 1,000 shares at US$20, you have to cover a US$60,000 loss on a US$20,000 investment. If a short position moves against you, your broker will issue a margin call. Margin calls are issued when losses in a margin account exceed 75% of an account’s available equity. If you don’t meet a margin call, your position will be liquidated possibly leaving a deficit in your account.

You can avoid margin calls altogether. By shorting with puts, you can limit your losses to a predetermined amount. And you can make just as much money by correctly forecasting declining prices. By buying out-of-the-money puts, you can increase your leverage. Federal law allows you to leverage 50% of the market value of stock. With puts, you could short the stock on a margin of up to 100%.

Dance with wolves

Short selling can be a dangerous game. If a stock seems overvalued and ripe for shorting, you should think twice before calling your broker. Don’t get caught in a short squeeze. The problem with shorting a stock that is already heavily shorted is that all the shorts eventually have to be covered. While the shorts are selling, professional traders and market makers load up on shares.

In a thin (weakly traded) market, you have to short naked, which means that you have to short without actually borrowing the stock certificate. The lenders can force the shorts to produce stock certificates. Once liquidity dries up, the professional traders step in, jacking up the price. Since the shorts are margined, they will tend to panic and buy back the stock if it starts moving up. The naked shorts are forced to pay exorbitant prices to buy back the stock. The market makers unload their shares to panicked short sellers, pocketing a quick profit.

As a put buyer, on the other hand, you only risk the premium. If the stock doesn’t decline, your put will expire worthless. You can’t lose more than your initial investment. Ironically, puts give you staying power even though they expire. You can’t get squeezed out of a short position or get wiped out on margin.

Let’s say that you have found a heavily promoted stock that has made a run up from US$25 to US$75 in the last three months. It’s trading at 400 times next year’s estimated earnings. The company doesn’t produce anything or have any real assets. You check the paper. It’s not heavily shorted. You think the stock will collapse to US$25 from current levels in the next few months.

What’s the best way to short a stock?

Never try to short a stock on a shoestring.

Say you have US$10,000 in your account. You could short 133 shares at US$75. Borrowing the shares from your broker, you sell the shares immediately for US$9,975. Under current margin requirements, you need to put at least 50% of the US$9,975 down to hold the short. But you don’t want to get a margin call, so you keep US$10,000 in the account. If the stock falls to US$25 as you expected, you’ll make US$50 per share, or US$6,650 a 66.5% profit.

If the stock goes up to US$150, you’ll be completely wiped out. Sound crazy? Plenty of investors tried to short Netscape at its high of US$74 (it later split 2:1) on the day of its initial public offering (IPO). The company had never earned a dime, was hyped by the mass media, and had an IPO price of US$28 — the perfect candidate for a short sell. Only one problem: Netscape went up to US$175, wiping out all the short sellers.

Back to our example. If you were more aggressive, you could short 266 shares on a 50% margin. The shares you borrowed initially have a market value of US$19,950. If everything turns out as expected, the stock would fall to US$25. But if the market value of the shares you borrowed rose to US$112.50, your US$US10,000 would be wiped out. As the stock approached US$112.50, you would get a margin call. If the stock ran up to US$150 before your broker liquidated the position, you would be liable for a US$9,975 loss. If you can’t come up with the cash, your broker can put a lien on your personal property.

Heads you win, tails you lose

So instead of shorting the stock, you buy puts. You could control 200 shares with two puts. Since you are forecasting a large move, you can buy cheap out-of-the-money options. The August US$50 puts are trading for US$0.50. For US$100, you can still profit from the stock’s collapse. If the stock falls to US$25, your US$50 puts will be worth at least US$25 on top of any remaining time value. Your profit would be US$5,000. By purchasing the puts, you’re only risking US$100.

You could buy more puts. If you are willing to risk US$10,000, you could buy 200 August US$50 puts. You will lose the entire US$10,000 if the stock stays where it is or moves higher. But if the stock drops to US$25, your puts will be worth US$500,000.

Clearly, buying puts is superior to shorting the stock. Your risk is limited, while your profit potential is unlimited. Keep in mind that you have to pay interest on the value of the shares you borrow when you short. Brokerage houses lend out securities to short sellers to generate free income on their stocks.

When you are thinking about shorting a stock, buy puts instead. For the same dollar risk, you’ll make a lot more money. Unfortunately, you can’t find options on every stock. Only liquid stocks have options written on them. If you want to short a thinly traded small-cap stock, you’ll have to short the stock outright.

Sleeping like a baby

You have now learned the basics of speculating with options. As a speculator, you need to look at losses before considering profits. How much are you willing to lose? Once you know that, you can leverage your money to the hilt with options. While average investors risk US$5,000 to make US$500, you’re using the same US$5,000 to make US$10,000 or even US$50,000.

By combining different options on the same underlying security, you can create reduced-risk trades. Reduced-risk trading is different from hedging. Reduced-risk trading still involves assuming risk. Using the following options techniques, you’re taking risks — just less so than you would without options. With options, you can precisely control risk and maximize the profitability of an accurate forecast.

Speculating with index options

Index options work just like stock options. The only difference is that index options are settled in cash. To speculate directly on the overall market, use index options. Every stock options strategy can be applied to index options. Since there’s no actual delivery involved, index options are simpler than stock options.

By itself, an index is just a number. With index options, you multiply the index by a dollar multiplier (usually US$100) to find the value of the index. At 970, the S&P 500 is worth US$97,000. A move from 900 to 970 is worth 70 points or US$7,000. At expiration, your profit or loss will be settled in cash based on the difference between the strike price and the current index.

There are options on almost any index. You can trade on the S&P 500 (SPX), Dow Industrials (DJX), the NASDAQ 100 (NDX), as well as a biotech index (BTX), the Philadelphia Semiconductor Index (SOX), and other specialized indices. Certain foreign markets such as the Nikkei also have active options markets.

Let’s say you are bullish on US stocks. Buy an out-of-the-money S&P 500 call three months out. The S&P 500 is at 960. You buy the three-month-out 970 call for US$12, or US$1,200. Say the S&P rallies to 1,015. Rather than exercise the option, you sell it. The premium has risen to US$47. You net US$3,500.

Index LEAPS let you take positions several years out. But be careful buying index LEAPS. You have to cough up a year or two in time premium. Far-dated options have higher premiums because they have a lot more risk.

Staying alive

Never risk what you can’t afford to lose. Sound obvious? Large banks have been toppled by losses on options and other derivatives. Individual investors venturing into options have gotten crushed like deer under a Mack truck.

Separate yourself from the masses. Don’t get into options trades thinking about how much you’ll make. Think about how much you could lose. Options are designed to let you control risk. You can risk as much or as little money as you wish.

Taking too much risk will eventually blow up in your face. Don’t trust your luck. If an options trade backfires, get out. Consider liquidating unprofitable long options positions to get back the remaining time premium. But when an option is ripe for a quick trade, go in with both guns blazing, looking for a quick kill.

Today’s Financial News feed provides an independent and practical perspective on the U.S. and global investment markets.

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