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Trading Calls & Puts

Options for Beginners

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Struther's Option Report

HOW THE PRO'S MAKE MONEY IN OPTIONS

Part 1

You should go through this report, Part 1 before reading Part 2 on strategies

There is also a couple of good websites you should book mark

The Chicago Board Options Exchange

Also Lawrence McMillan's site

 

The two videos above are good at explaining the basics on Puts and Calls. The one on the right talks prices in rupees - just think dollars instead, same principles

Canadain and U.S. stock options work much the same, but it would also be a good idea to read  the Prospectus from the Options Clearing Corporation and InterContinetal Exchange is a good resource 

OPTIONS, one of the most intriguing, versatile, profitable and misunderstood Investments on the Planet. You probably have heard numerous stories of how Investors made money in Options. Tell me, have you heard the stories how they lost money? Probably not, in general people do not admit to this as often as when they make money. When you scroll through the pages ,contemplating what options to buy, have you ever wondered who is selling these options. I call them the "PRO's" in this report.

The most popular strategy in trading options is to buy. Like many other Investments, the most popular is the most least profitable in general. Now don't get me wrong, I have bought options and have made huge profits and you can too. There are times and places where this is a correct strategy, to make huge profits. The point I want to make is about 90% of those in the option market are losing money trading options and the other 10% are making it.

This report is basically in two parts, the first is an in depth look into the mechanics, the nuts and bolts of the option Markets. I don't know the experience of my subscribers when they sign, so you can use the first part of this report to get an understanding of the nuts and bolts of Options. If you are well experienced you can move on to strategies and refer back if necessary.

Before you start this, I suggest getting onto a website that shows option quotes

OPTION MECHANICS - Part 1

Option Talk-

 

Option - Websters "special right or advantage" In fact an option is a privilege.

Call Option- the privilege to buy a given number of shares of a specific security at a predetermined price for a pre- determined length of time.

Put Option- the privilege to sell a given number of shares of a specific security at a predetermined price for a
predetermined length of time.

Writing Options- this is selling the privilege to buy or sell a given number of shares.

Writing Covered Call Options - selling the privilege to buy the shares of a security you hold.

Writing Naked Call Options - selling the privilege to buy shares which you do not own. High risk

Strike Price - the predetermined price at which you have agreed you may buy or sell the shares within a given time.

Trading Price - the price at which the options themselves are trading on the floor of exchange.

Expiry Date - the predetermined date after which the option or privilege is no longer valid. On the TSE trading
cut-off time is 3 PM., the Friday before the third Saturday of the expiry month.

Open Interest - the net number of option contracts held in a certain share for a particular shrike price and a particular expiry date.

Exercise the Option - to take up your privilege of buying or selling the shares at the strike price and a
particular expiry date.

Intrinsic Value - In 'CALL OPTIONS' the intrinsic value is the amount by which the current share price exceeds
the strike price; if the share price is less than the strike price, the call has no intrinsic value.


In 'PUTS' the intrinsic value is the amount by which the strike price exceeds the current share price; if the
strike price is less than the share price, the put has no intrinsic value.

Time Premium - the amount by which the option trading price exceeds the intrinsic value due to the length of time the option has to run.

 

HOW DOES OPTION TRADING WORK

Options are always expressed according to type, underlying stock, expiration month and strike price.

IBM     October 120    at 4 1/2
IBM p       April 110    at 3

The first listing is for a Call option, the second for a Put (note the p). The Call option is the privilege to buy the shares of IBM at $120 before October and costs $4.50. In fact options only trade in 100's so you would have to pay $450 for the privilege of buying 100 shares of IBM at $120 before the expiry date.

The listing for the Put means that you could trade the privilege to sell shares of IBM at $110 until April expiry date. The cost of this right is $3.00. These also trade only in 100's.

In this example, October and April are the expiry, 120 and 110 the strike prices and 4 1/2 and 3 the trading prices, and IBM is the underlying security.

When you exercise the Call option you must of course pay the strike price of the share regardless of the current market price of the shares. The total cost has thus been the strike price plus the price of buying the option.

When you exercise the Put option you must sell the shares at the strike price regardless of the current market price of the shares. Obviously you will only exercise this option if the market price is less than the strike price.

 Most investors trade their options rather than exercise

Same example as above.


IBM    October 120    at 4 1/2
IBM p April 110             at 3

The writer of an 'exercised Call option' of IBM Oct. 120 must sell the shares to the option buyer for $120 no matter what the market price for the shares. The option price $4 1/2 is the writer's to keep whether or not the option is exercised.

The writer of an ' exercised Put option' of IBM Apr. 110 must buy those shares at 110. The option price of $3 is the writers to keep whether or not the option is exercised.

Note that at the end of each expiry date, if an option has not been exercised or sold in a closing transaction to another holder it becomes 'WORTHLESS'. Consequently options are known as wasting assets and are very speculative.

EXPIRY DATES

Options have a 9 month life (excluding leaps). leaps are options with expiry dates 1 or 2 years out. Each company is assigned a specific cycle of expiry months when its options are first traded.


The 3 possible cycles are:

Cycle 1      Jan.    Apr.,    July,   Oct.,
Cycle 2      Feb.    May      Aug.   Nov.
Cycle 3      Mar    June     Sept.    Dec.

There are 3 cycles in order to spread expiry dates, of heavily capitalized stocks, evenly throughout the year. Some stocks also have expiry dates a few months in a row, like Jan. Feb. and March

LEAPS

Leaps are a relatively new option vehicle of the last few years. The only thing different with Leaps is the expiry date. The expiry date will be in January, one or two years out. This gives the option Buyer more time for the underlying stock to move, but the buyer will pay a higher premium for this right.

STRIKE PRICES

There can be different strike prices for the same month due to the movement in the stock price. On Chicago Board of Exchange, (www.cboe.com), price intervals are $5 for stocks less than $50, $10 for stocks between $50 - $200 and $20 for stocks above $200. In Canada, price intervals are $2 1/2 for stocks below $35, $5 for stocks
between $35 and $100 and $10 intervals for stocks over $100.

In recent years with more volatilty there is often options on stocks under $10, with strike prices below $5

OPTIONS EXCHANGE

The exchange acts as a marketplace to trade options. The exchange also runs the Options Clearing Corporation which guarantees all transactions and frees the original holder and writer from each other. This allows liquidation before expiry date and freedom from the constriction of only dealing with the original/opposite (buyer or seller). This setup allows unlimited buying and selling before an option expirers at prices based on supply and demand and creates a secondary market (the primary market is the original transaction) In the secondary market the original holder can sell his option instead of exercising it and the original writer can buy an offsetting option
instead of exercising.

OPTIONS RISKS/REWARDS

The main advantages to buying options is you have limited risk, you can never lose more than the original cost of the option. You also have greater leverage than owning the stock.

The disadvantage is you have to predict the direction of the market within a limited time span or loose your total investment.

Lets look at some sample comparisons to see how this works.

IBM
Current share price 62 3/4, you buy 100 shares.
Option price - IBM April 65 at 2 1/2, since options trade in 100's
the Call buyer, buys an option for $250.

Ex. #1 IBM closes at April expiration at 62 3/4

                                Call Buyer                                     Stock Buyer
Initial Cost                 (250)                                            (6275)
Proceeds                      0                                                 6275
Profit                         (250)                                                 0
Rate of return            (100%)                                              0%

The stockholder broke even while the Call buyer lost 100%.

Ex. #2 IBM closes at April expiration at 30

                               Call Buyer                                 Stock Buyer
Initial Cost                 (250)                                         (6275)
Proceeds                       0                                            3000
Profit                        (250)                                          (3275)
Rate of return           (100%)                                        (52%)

If the stockholder had not sold his shares his loss would only be on paper and in time the share price may increase, while the option holder loss his entire investment although limited to $250.

Ex. #3 IBM closes at April expiration at $80

                         Call Buyer                                    Stock Buyer
Initial Cost             (250)                                        (6275)
Proceeds              1500                                            8000
Profit                    1250                                           1750
Rate of return        500%                                          27%

If you are willing to take the risk of losing your entire investment in return for the chance at high percentage profits, this type investment may be for you.

WRITING OPTIONS

The advantage of writing Covered Call options (options on shares you already own) is that you receive the money immediately. Your investment in the shares is protected against price declines in the amount of the premium received, you have a profit if the option is exercised.

The disadvantage of writing Covered options are you have no protection against large declines in the stock. You are also not able to participate in a large upward movement in the stock.

You can also write uncovered Call options (you do not own the shares). If the stock is below or at the strike price at expiration the premium will be your profit. However the upside risk is infinite. You must come up with the shares no matter how high the price. This is a very risky action, left mostly to speculators with lots of risk capital.

Before we get into actual strategies, first we will want to know how to value options

VALUING OPTIONS

The price of an option is influenced by several underlying factors

  1. the price of the underlying stock
  2. the volatility of the underlying stock 
  3. the general market environment 
  4. interest rate levels
  5.  the dividend rate of the underlying stock

 

Remember, like any security, prices are set by supply and demand on the exchange floor and the above are merely influencing factors. now lets look more closely at these factors.

Price of the Underlying Security - The option price has two parts, intrinsic value and time premium. Once the intrinsic value is established, time premium may be calculated.

Intrinsic Value - In Call options the intrinsic value is the amount by which the current share price exceeds the strike price. If the share price is less than the strike price, the Call has no intrinsic value. - In Puts the intrinsic value is the amount by which the strike price exceeds the current share price. If the strike price is less than the share price, the Put has no intrinsic value.

The stock price has the most influence on the option's price, because if the stock price is far below or far above the strike price, the other factors have little influence. Obviously, when the price of a stock moves up or down, the value of the options increases or decreases to some degree along with it. When the price of a stock moves above the exercise price of the Call option, it is termed an "in the money" Call option possessing intrinsic value. Of course there are "out of the money" Call options, whose only value comes from a time premium with no
intrinsic value and whose stock price is well below the striking price of the option. Put options work in the converse manner.

Now lets define the pricing terms used in option trading:

Options in the money -the strike price is below the current market price for Calls or above the current market
price for Puts.

Options at the money -the strike price is at the current market price

Options out of the money - the strike price is above the current market price for calls or below the urrent market price for puts.

Example:

IBM is currently trading at $65

CALLS PUTS

In the money IBM Oct. 60 at $11               IBM Oct. 70 at $8

        Time premium of the                        Time premium of the
          call =11+60-65 = 6                    put =8+65-70 = 3
          Intrinsic value = 5                    Intrinsic value = 5

At the money IBM Oct. 65 at $8                  IBM Oct. 65 at $6

               Time premium of the                Time premium of the
                  call =8+65-65 = 8                  put =6+65-65 = 6
                Intrinsic value = 0                    Intrinsic value = 0

 

Out of the money IBM Oct. 70 at $5               IBM Oct. 60 at $3

             Time premium = option               Time premium = option
                      price = 5                                        price = 3
            Intrinsic value = 0                          Intrinsic value = 0

You can see from these examples that "at the money" options and "out of the money" options always have an intrinsic value at 0. Thus the time premium becomes a very important factor.

Volatility of the Underlying Security

The second factor contributing to the value of an option is the volatility of its underlying security. If a stock swings wildly over a $20 price range, then the premium on its option will be much higher than for a stock that stays in approximately the same price range over a period of months.

The Time Until Expiration Date

Time remaining before expiry is an important factor. Consider the purchase of Barrick Gold October 30 in August when the market value of the shares is $30. If the option price is $4, you will make a profit if the stock moves above $34. However, if the expiration date draws closer and the stock has not moved upwards, then the value of the option becomes progressively less because there is less time for the increase to occur.

Thus time constantly works against you. For "in the money" options the premium gradually moves towards the intrinsic value of the option until, on the last day, with no time remaining, the option is worth exactly the intrinsic value.

The decay of the time premium is not steady, but the rate of decay is much more rapid in the weeks immediately before expiration.

The General Market Environment

This can influence the price of the underlying security, a bull market can put upward pressure on the stock, as a bear market or correction can pull the stock down.

Interest Levels

Interest rates can influence the price of stocks paying dividends as well as influence the market in general. High dividend stocks, such as utility stocks will usually track interest rates. These stocks will rise as interest rates fall and move down if rates rise, as the dividend yield is competing with interest rates.

The Dividend Rate of the Underlying Security

Again this can influence the price of the underlying security. A stock may move up in price in advance of a large dividend payment and fall after the stock goes ex-dividend (after the dividend is paid out).

 

Time - the Delta Factor

The price movement of an option is related to the price movement of a stock by the 'delta factor'.

Delta factors are always expressed as the change in price of the option over the change in price of the share. This factor is never greater than 'one' because the option price never rises by more than the amount the stock price
rises.

The rule is that the change in the stock multiplied by the delta equals the change in the option price.

If the options of a stock move up $1 when the share price moves up $2 then the delta factor is 1/2 or 0.5.

We have now looked at how options work and are valued, lets look at some strategies now. On to Part 2.

 

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