WARNING: Options trading can be
extremely risky! Losses of up to 100% of your trading capital invested in
options is by no means an uncommon event when using and/or actively
trading stock and other types of options. In some cases, it is possible
to lose more than you have invested by writing uncovered call and/or put
options. Please use extreme caution should you decide to trade and/or
invest in options of any kind.
Following is a brief overview of options: what they are and how they
function. Because the use and understanding of options can be fairly
complex and can involve quite high risk, we strongly recommend that you
refer to our book
list for further reading material should you decide to consider the
use of stock options in your trading.
· INFORMATION ABOUT OPTIONS ·
WHAT IS A STOCK OPTION - A stock option
is a contract that gives you the right, but not the obligation, to buy or
sell an underlying stock at a specific price (called the strike price)
during a specific period of time as outlined by the contract. For this
right, you pay the writer of the option contract a premium based on the
option purchased.
The price of an options contract is based on a number of factors,
including volatility of the underlying stock, time left in the contract
and other factors such as the difference in price between the underlying
stock and the price at which the contract allows you to purchase or sell
the stock. This valuation can be dynamically calculated using a
mathematical model called the Black-Scholes Option Pricing Model.
TYPES OF OPTIONS - There are two types
of option contracts: call options, which give you the right to buy a stock
and put options, which give you the right to sell a stock. Just remember the following:
You call a stock to yourself when you buy
You put a stock toward someone else when you sell
A call option would be purchased when you expected the price of the
underlying stock might rise, while a put option would be purchased if you
expected the price of the stock to decline.
If you are correct in your assumption, as the underlying stock changes in
relation to the strike price of the option(s), it creates what is called
"intrinsic" value in the contract. For example, if you have a contract to
buy 100 shares of stock at a fixed price of $50 and the price of the stock
suddenly moves to $65 a share - the value of the contract would be the
difference in price between the stock and the strike price (in this
example $15) plus the time value remaining, multiplied by the number of
shares the contract allows you to purchase at this fixed (and more
favorable) price.
As mentioned above, the strike price is the price specified in the options
agreement or contract which outlines at what price you can purchase or
sell the underlying stock. When the price of the underlying stock is near
or equal to the strike price listed in the options contract, the contract
is said to be "at the money". However, if the price in the options
contract allows you to purchase or sell a stock at a favorable gain, then
the contract is said to be "in the money". For example, in order for a
call option to be "in the money", the price of the actual stock would have
to be greater than the price the option allows you to buy it at.
A stock option is said to be "out of the money", when the price of the stock
is in an unfavorable relationship to the strike price of the option. For
example, on a put option (which gives you the right to sell a stock at a
fixed price) the stock price would have to be higher than the price listed
on the options contract in order for the put option to "out of the money".
THE LEVERAGE POWER OF OPTIONS - One of
the most attractive aspects of options (as well as one of the most
dangerous) is that they can provide you with the ability to greatly
leverage your money. This is because with an options contract, you can -
in effect - control a fairly large amount of stock with a relatively small
amount of capital (at least when compared to the cost involved with buying
the stock outright). The problem (or risk) is not so much this leverage,
but when this leverage is abused.
In fact, when used correctly, options can actually reduce risk. Options
can allow you to control a desired number of shares of stock for a
specific time period with a fixed and completely limited "down side" (i.e.
the price of the options). Trouble arises when investors buy beyond their
means and/or subject all their capital to the risks associated with
options. Namely, the risks associated with their volatility based on the
movement of the underlying issue, as well as the loss of value as the
contract begins to expire. Keep in mind, sometimes as little as a one or
two point move against you in a stock's price will drop the value of an
options contract (at least one that is at the money) as much as 50 to
75 percent in some cases (this is especially true of options with little
time value remaining).
With respect to the actual leverage provided, this ratio can be calculated
by dividing the strike price of the contract by the actual cost of the
contract. Typically, when dealing with stock options the leverage
provided can be as high as to 10 to 1 as compared to buying the stock
itself.
Consider the following example: You purchase a call option on XYZ stock.
XYZ stock is currently trading at $40 a share. Let's assume a one month
call option on this stock with a strike price of $40 is selling at $4 per
option.
Options are sold by number of contracts. A contact by definition is a
group of 100 options. As such, "one contract" would be $4 multiplied by
the number of options in the contract (100) for a price of $400. This
would give you the right to purchase 100 shares of XYZ stock at a fixed
strike price of $40 for the next month regardless of what price the stock
might move to.
Now let's look at how the option price moves in relation to the stock.
Assuming the stock did not move, the option would slowly deteriorate in
price until it was worthless after one month.
However, if the stock were to move to $44 a share before the option began
to significantly deteriorate with regard to remaining time value, we could
see the option value move up to $8 per contract. Only a 10% move in the
stock price itself, however a 100% move in the options contract value.
At this point, assuming the options were selling for roughly $8 each, your
contract would now be worth approximately $800 (note that this example does
not take into account market prices nor specific time valuations).
In fact, on the subject of specific time valuations, let's keep in mind
that if the stock did not move up to $44 a share until the last day of the
option contract, there is a very good chance that the option would drop by
$4 due to expiration of time, while at the same time increasing by $4 due
to the move in the stock - thus the drop in time value and the increase in
intrinsic value would cancel each other out - leaving the option valued at
$4 each.
Finally, let's consider the case where the stock fell to $35 a share.
Certainly, holding a contract that allowed you to purchase the stock at
$40 a share, while at the same time the stock was selling in the open
market at $35 a share would not be a very valuable situation. This would
leave the contract with only time value left, which would most likely not
offset the drastic "out of the money" condition. However, if during the
one month period, the stock returned to $40 or greater, value would
subsequently return in the options and the contract as well.
THE OPTION WRITER - When you purchase an
option on a stock, you are actually purchasing it from another individual
and/or firm on Wall Street that is writing the actual options contract.
If you stop and think about it, this is a somewhat startling fact, since
it means someone is actually betting directly against you being correct in
your assumption of profitability on the final outcome of the option.
While it's true option writers may hedge themselves to limit and/or reduce
risks, at the same time, the basic idea is that you are taking up a
position against someone who is pricing the option in an effort to ensure
you will not take his or her money. When trading options, you need to
always keep this point in mind.
Also understand that while options are traded in a market very similar to
stocks, there is much more latitude as far as how pricing can work between
buyer and seller. The bottom line is that if someone is silly enough to
over pay for an options contract, there will most likely be someone
willing to write that contract and sell it. If you really want to see a
first hand demonstration of this, just place a market order for an option
contract sometime. Look out!
Additionally, spreads between the price which you must pay to open the
position and the price available to you should you decide to close the
position, can be extremely high from a percentage standpoint of view.
When taking up or selling option positions, a good rule of thumb is to
only use limit orders - unless you absolutely need in or out of a position
and are willing to be exposed to a possible big hit by the markets in
the process.
CLOSING YOUR OPTION POSITION - Selling
options is basically very straight forward. Assuming there is value left
in your position and/or it in the money, you have one of two choices.
You can either sell the option to someone else and reap the profit, or you
can exercise the option and take over the stock.
Note that in some cases (generally with very large option positions) you
may not have the cash available in your account to "buy" the stock of the
underlying position. In this case you would typically sell the contract
without exercising it, however, if you run into a situation where there
are no buyers and/or the market does not appear to be favorable for
selling the contracts, you can in fact direct your broker to exercise the
options and then simultaneously flatten the position by selling the stock
at the market. This should not generate a margin or house call in your
account, since you have effectively bought and sold the stock at the same
moment. Normally this is not required, since options generally can be
sold into the market.
OPTIONS EXPIRATION - Options expire on
the 3rd Friday of the month in which the option is written. For
example, a January call option will expire on the 3rd Friday of January.
Technically it expires on Saturday, but Friday is the last day you can
trade it. Note that options which expire with a value of 3/4 of a dollar
or more are automatically executed in your account. Those with a value
less than $0.75 must be manually executed or they will expire worthless.
Options are cleared through the OCC - the Options Clearing Corporation.
Questions regarding the finer points of options can be found at their
website or at the additional links listed at the end of this document.
The OCC's website is located at:
http://www.optionsclearing.com
OPTION TICKER SYMBOL FORMAT - Options
trade under ticker symbols, much like stocks do. However, they use a
somewhat strange notation system which at first glance is a bit confusion
to the novice.
Typically a stock option will have an "options root" associated with it
which identifies the underlying stock. NYSE listed stocks often use the
original ticker symbol, while Nasdaq listed stocks use a root which is
partially derived from the name in most (but not all) cases.
A list of option roots for most stocks can be found at the Chicago Board
of Options Exchange via the following URL and/or at most on-line brokerage
web pages and via most quote services:
http://www.cboe.com/TradTool/Symbols/SymbolDirectory.asp
Finally, a two letter suffix is added to the end of the root to denote the
month of the option and whether it is a call or put, plus the strike price
(respectively). For more information on how option symbols work, be sure
to visit our Option Month & Price Code chart at:
http://www.daytraders.com/option_codes.html
As an example, an IBM November $150 call would be: IBM KJ.
A Microsoft January $70 put would be: MSQ MN
ADDITIONAL RESOURCES FOR OPTIONS -
Following are links to websites that can provide additional information
regarding options. In addition to visiting these sites, we would strongly
recommend reading the book Keys to investing in options and futures
by Nicholas G. Apostolou & Barbara Apostolou. Please visit our book list for more
information on this title.
http://www.cboe.com
http://www.888options.com
http://www.optionsclearing.com
| 
