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Option Basics

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Options Basics

To explain how credit spreads work, we need to understand a little about options.

Options, in their most basic form are the right but not the obligation to do buy or sell something at a specific price for a specific period of time.  Options are basically, a paper contract on a real position, and paper is bought and sold in the open market place. Usually the CBOE (Chicago Board of Options Exchange).

Options give us choices in the trading world. Options serve as a contract between two parties: he Buyer and the Seller. The buyer of the options has rights where as the seller has obligations. When an option is purchased, a person is purchasing the right to buy a stock at specific price (Call Option) or sell a stock at a specific price (Put Option).

Let’s break this down a little further. There are two types of options. The first is known as a “call option.” When purchased, it gives the buyer the right to call the stock away from someone else at a specific price and at a specific time in the future.

Let’s demonstrate this using real estate as the example. If you are in the housing market and identify a nice home in a nice area that you think will increase in value in the next year, you can do a couple of things to profit from this movement of perception. Let’s say that you find a home in a rural neighborhood for $250,000 and your analysis predicts that the home is going to go up to $300,000 in the next year. Your first choice open to you would be to just purchase the house outright for the $250,000 and a year later if the house appreciated to $300,000 in value you could sell the house and realize a profit. If you were right on your assessment you would yield a $50,000 profit off of your $250,000 investment, a 20% return.

However, there is also another choice open to in this case. You could approach the homeowner and offer to give him or her 5% of the value of the home or $12,500 to have the right to buy the home for $250,000 sometime in the future. No matter what the market does the homeowner gets to keep the $12,500 and can spend it immediately. Let’s say the home owner gives you one year in which to buy the home for the $250,000. So just like the previous example you have locked in the right to buy the home for $250,000 but in this scenario you only had to put up $12,500 for that right. Should the home appreciate to $300,000 the contract that you have with the homeowner would be worth $50,000. As you can see, by leveraging yourself a little better you allowed yourself to invest $12,500 in order to make $50,000 and gave yourself a 400% return on investment. You bought the right to buy something for an extended period of time and you were willing to give up some money up front to have that right.

However, now let's imagine a scenario in which that same house depreciated by $50,000 instead of appreciating by $50,000. If you had purchasing the home for the full $250,000 you would have lost $50,000 in the value of the home, definitely not a good day at the office. However if you had only purchased an option, you would have put up only $12,500 to have the right to buy the home for $250,000 within the year. Once you had realized a year later the home was now only worth $200,000 you could simply allow our option to purchase the home to simply expire in which you would lose the entire $12,500. While it is still not a great day at the office you did manage to lose a lot less money through the use of an option than you would have by simply purchasing the home. 
This same type of analysis can often be used in the stock market as well. We feel that a stock may appreciate in value and instead of purchasing the stock outright we can often times purchase an option to purchase the stock at fair market value for a later date, for a fraction of the cost.

Let me give you an example: right now, Apple Computers stock is trading at $140.00 per share. If I thought that Apple computers was going to appreciate to $160.00 in the next 2 months I could buy 100 shares for $ 14,000.00 and if it went to $160 I could then sell my shares for $16,000.00 and profit $2,000.00 on the trade for a return of 14% on my initial investment.

My second choice is that I could purchase an option for $600.00 which allows me to purchase 100 shares of Apple for $140.00 in three months. If Apple's stock goes up to $160.00 a share in the next three months then my option will increase to $2,000.00. I could simply sell my option for $2,000.00 leaving me a credit of $1400.00 in the trade or a return on investment of 233%.

By purchasing an option—or to be more specific, a “call option” which gives me the right to call the stock away from the market at $140 per share between now and the next three months—I am allowing myself to profit if the stock appreciates and I have avoided putting up the large sum of money that would have been required for me to purchase the stock initially..
 
The opposite of a call option is a “put option.” If you purchase a put option you are purchasing the right, not the obligation, to “put” the stock to someone else at a specific price and at a specific time in the future. So, when we think something is going to increase in price we want to look at buying call options, and when we think something is going to decrease in price we want to look at put options.

Think of the homeowners insurance you purchase every single month. You buy this insurance to protect you in the case that your house decreases in value due to some catastrophic event. If your home was to burn down then you could simply exercise your insurance policy and “put” your house to your insurance company and they will be obliged to give you the amount that you are insured for. When you purchase homeowners insurance you are buying the right to capture your losses should your home depreciate or go down in value because of some unforeseen catastrophe.

Remember that in the stock market, for every person that thinks something is going up there is someone else with the opposite opinion. It is easy to understand that if you think a stock is going to go up in value you want to buy the stock low and sell it higher. However, let’s talk about what people can do who think that a stock may go down in price and want to profit off of this bearish biased stock. A trader who believes a stock is going to depreciate in value “shorts” the stock at a specific price. This means that they go to their broker and borrow the stock with the promise of repaying it back in the future. They want to sell high and then buy the stock back at a lower price and then give the stock back to the broker allowing them to keep the difference between selling high and buying back at a lower point.

If you were looking at Apple computers which is currently trading at $140 a share and your analysis said that it was going to decrease to $120 a share in the next couple of months, then there are a couple of things that you can do.

Firstly, you could go into your brokerage site and short 100 shares of Apple for $14,000.00.  You are borrowing stock that you do not own with the promise to purchase stock in the future and return it to your brokerage firm at a future date. If Apple goes down to $120.00 a share,  you could purchase 100 shares of Apple a few months later for $12,000.00 and give the shares back to your brokerage firm, thereby closing the trade. Since you sold something for $14,000.00 and purchased it back for $ 12,000.00 you are left with a profit of $2,000.00, a return on investment of 14%.

The second possible scenario is that if you thought Apple's stock, currently trading at $160, was going to decrease in value you could purchase a put option for $600.00 which allows you the right to put the stock (or sell the stock)  to someone else for $160 a share. If after a few months Apple goes down to $140.00 your put option would be worth $2000.00 (since you could purchase 100 shares of Apple at its lower price of $120 a share or 12,000.00 for 100 shares and have the right to sell it for $140 a share or $14,000 for 100 shares). At this time you could sell your put option for the $2,000.00 giving you a profit of $1,400.00, a return on investment of 233%.
As you can see, options lower your cost to get in the trade, thereby lowering your risk. And when the analysis is correct, using options gives you the opportunity to realize a larger return on investment.

Below, are a few further components of options that you should become familiar with:

Strike Prices – The strike price is a fixed price for which an option can be purchased (call option) or sold (put option). Options are available in several different increments ranging from 1 point increments to 25 point increments. For example Apple computer has strike prices starting at 90 and moving in 5 point increments up to 240. Therefore, you the trader could purchase the right to buy (call) or the right to sell (put) Apple Computer stock in a range of anywhere from $90.00 a share to $240.00 a share.

Months of Options – You will have a choice in determining which month of options you would like to use. Months available are classified into one of three cycles. So, if it were June 3rd you would be able to purchase options for June, July, August, or November; and you would also be able to purchase longer term options called “leaps” which are available for Jan of 08, and Jan of 09.

Expiration Date – Every single month, options expire on the third Saturday of the month. Since the market is not open on Saturdays traders use the third Friday of the month as there guideline. There are a few indexes however that expire the Thursday prior to the third Friday of the month. This is why it is essential to understand the vehicles you are trading.

Premium – This is the cost of the option.

Option Greeks – There are four main variables represented by Greeks letters that make up the value of an option. This is not meant to be a thorough evaluation of option Greeks as one could write an entire manual on this subject alone.

Delta – This is the amount the option will increase in value per one point movement of the underlying value. Delta can also be thought of as a probability indicator. An option that has a strike price right where the stock is trading would have a delta close to 50. What this is saying is that the option has a 50 -50 chance of having value at expiration

Gamma – Gamma is the accelerator for Delta. It tells you how much the Delta will change after the first 1 point movement in the underlying.

Theta – Theta is measurement of time decay. It tells you how much value is lost daily based off of the erosion of time.

Vega – Vega is a measure of volatility in the option. The higher the volatility the more expensive an option is. Vega can also be thought of as a fear indicator. When there is uncertainty in the future people are more fearful concerning the outcome and hence, volatility will be higher. Conversely, when fear is low and people feel safe about trading a vehicle, the volatility is lower and the price for the option decreases.

Understanding the basics and effects of each of the Greeks can greatly enhance your trading; however, there are some interrelationships that you need to be aware of:

  1. All of the Greeks except for Delta are the most sensitive to the money.
  2. Gamma responds opposite to Theta (Time Decay). The more positive Gamma is the more negative Theta will be.
  3. As volatility decreases Theta (the value time holds in your options) decreases. As volatility increases Theta (the value of time in the option) increases.

 

Volatility

There are different forms of volatility in the marketplace. Volatility in its most basic form is uncertainty or fear concerning the marketplace. Volatility can be tracked by looking at the Vix, and VXN which measures the volatility in the S&P 500, and the NASDAQ.

optons

The chart above is a chart of an Option Chain. You will see the calls on the left and the puts on the right hand side. This is a chain for Apple Computer when it was trading $139.00 and it was due to expire in 30 days.

Contract – When you are buying options you have to purchase them in units of 100. This is referred to as a “contract.” So, if you see that the price of an option is $3.50, this is the per option price. However, as the trader, you would have to purchase 100 options for $350.00 to buy 1 contract.

Intrinsic and Extrinsic Value – Intrinsic value is the amount of the option that represents real value. So if you are looking at a 135 strike price call option (which would give you the right to buy Apple for $135.00) it is selling for the ask price of $5.40, or $540 dollars to purchase 1 contract. Since Apple is trading in the live market for $139.00 then the 135 call option would have $4.00 dollars of real (intrinsic) value and the other $1.40 would be considered time value or extrinsic value. So to sum it up intrinsic value represents the real value in an option and extrinsic value represents the time value in an option.

ATM – At The Money options are the options that are the closest to where the stock is currently trading. If Apple was trading at 139 then the 140 strike price “call” and “put” would be considered the At The Money Option.

ITM – The In The Money option would be the yellow options shown in the graph above. They represent the options that have real intrinsic Value.

OTM – The Out Of The Money options are the blue options shown in the graph above which signify options that have no real value or intrinsic value.  They only have time value.

The option chain above also has a bid/ask spread. The “bid” price is the lowest price the market makers will consider for the price of the option. The “ask” price is the price the marker maker guarantees to fill you at. The range between the “bid” and “ask” is called the spread.

If you look in the third column you will see a heading called delta. This number tells you how much the option will increase in value per one dollar movement in the underlying. The delta number will increase in value as you go deeper in the money.

While this is a very basic overview of options it should help lay a foundation for the major components of options. We have briefly discussed the benefits of trading options but now let’s focus on just one strategy that a trader can utilize in the marketplace when using options.