We already discussed what an option is, and how it can help with risk management. When I was talking about risk management, I was talking about how options require a lot less margin to make the same amount of money on a stock. Why wouldn’t everyone do it then? In short, it is because there are three things to consider when investing in options rather than the single variable in stocks. When you master these three variables however, investing in options is the clear superior investment vehicle. I’m sure you have heard of the “Greeks” when dealing with options and their importance. While they are extremely important, they boil down to a measurement of 3 variables. So I will go over those three variables, then explain how the Greeks are derived from them, and how to treat the Greeks in your trading. While looking at these variables, I’m going to have an example option, and bold the significant part of the options as it relates to the variable to help you follow along.
Stock Price – February AAPL $100 call @ $.89 IV 21.20
The first and most obvious variable is the stock price itself. If you buy a call, and the stock goes up, you will make money. While this variable is the easiest to understand, it is the most important. Your thesis determines how well your trade pans out. There is no way to avoid it, if you are wrong in your thesis, you will lose money. No plan will save you.
While that is true, if your plans are well formed you can make money if your thesis is correct only 50% or even 40% of the time. With stocks, you must be right more than half of the time to make significant money. This is reflected in the armies of researchers employed by hedge funds and banks, as knowledge is the traditional edge in the market. Now, markets are driven by speed of trades, liquidity, and pricing inefficiencies. The average retail investor doesn’t have close to the amount of money these hedge funds and banks have. The average retail investor cannot compete with any of that, and is at a major disadvantage in all types of trading because of it. Most retail investors I talk with range between capitulation and treading water when it comes to the market. How can we tip the scales in our favor?
Most of you are aware of this, and rely on theses that try to even the playing field just a little bit. Another way is to have plans that limit losses when wrong and have greater gains when right. Options allow you to do this.
Implied Volatility – February AAPL $100 call @ $.89 IV 21.20
It is catalyst time. You learn that this PDUFA is going to result in a positive outcome. The stock is at $30, you decide to buy a $50 call for $1. This is going to be sweet! Results come in… FDA approval!
You sit down in your desk chair and lean it back resting your feet on the desk. You give your dog a quick pet, you cut your Churchill Romeo y Julieta cigar and light it as you log into your account. The stock is at $45 at 9:45, the option price is…$.75??!!? The stock is up 50% and your option is down 25%? You just got punked by volatility.
Implied volatility is simply the demand for the option itself. This demand is driven by the expected movement in the stock. So naturally when there’s a catalyst or earnings expected, the implied volatility is raised. When that catalyst is over, the expected movement decreases as does the price of the option itself as it relates to the underlying stock’s price. This is no reason to fret, in fact, this is an extremely important variable to understand in order to even help your stock positions. Let’s look at the GILD chart as of 2/1, 2 days after the MRK approval of a competing Hep-C drug.
Let’s say you knew nothing about GILD. This chart is the only information you have. About a week ago, the IV was at 33, but then IV skyrockets to 60! Then the news hits, Zepatier is approved, the GILD goes from $87 to $83. Along with the news, the IV starts its descent. If you didn’t know about Zepatier, you should have known something was brewing when that IV shot up. This should excite you because all those hedge funds who know more than you do just telegraphed their move!
This leads to my number 1 rule for catalyst trading: Always have a short volatility trade (in or out of the money) when the date of it is known. Volatility will always go down when the catalyst is over. This means instead of buying a call when bullish, you sell a put. If you don’t have enough money to sell a put, you can leverage with buying a lower valued put (a strategy called a vertical which I will describe in the next article). There are no exceptions to this rule. When you are selling your house, wouldn’t you rather have 5 people bidding on it than be one of those 5 people doing the bidding?
This leads to another question… why don’t all those banks and hedge funds do the same thing? I have spoken to a couple of portfolio managers about this, and their answer is because generally they use options to hedge their positions. So if someone is bullish on GILD but know the MRK catalyst is coming, they just buy puts to minimize the damage since it costs less margin, which is an effective strategy for them. The same is true for overall market volatility. The VIX is a measurement of option volatility in SPX (not the 'fear' index). Since most portfolios lean long, when there’s a sign of downturn the VIX goes up. This is why in general when the market is down the VIX is up, and vice versa. Now that you understand this important aspect of options, you can use it to your advantage and profit greatly from it.
It is important to mention the effect of time on IV. Because there is more of a chance for bad things to happen the further expiration day is, volatility has a greater impact. This is important for a calendar strategy that I will explain in the next article.
One final small note about IV. The number itself is the relative standard deviation in a monthly move in the underlying. However, when looking at the number I use it on a relative basis. For instance, GILD’s IV at 60 vs. 33 is only good in relation to its historical IV when formulating trades. You need an IV chart like the one above to see if the IV is high or low, and trade accordingly. The option premiums will reflect these numbers, so it is best used when creating strategies to understand how much the underlying has moved historically.
Time - February AAPL $100 call @ $.89 IV 21.20
One interesting aspect of options is the expiration date. For all American-style options, the best possible price to buy an option that is exercised immediately would give a value equal to or less than than the stock price + the premium (or reverse for a put). Otherwise some computer would buy that option, exercise, and sell within a nanosecond. Since there is a deadline to reach the strike price, the extrinsic value decreases as time wears on. Time is also not a variable, it is an exponentially decreasing constant, since it doesn't change.
When you by a call with 15 days left, something big an unexpected had better happen soon, or time will eat at your option value. But if you sold a put instead of buying a call, that curve is in your favor! You want time to go as fast as possible! I call time (or theta) the house advantage. Why wouldn’t you want to be the house? For rangebound trades, you always want to be theta positive.
So now you know all about the three variables of options. The greeks are a measurement of those three variables, and the values are given by the Black-Sholes model.
Congratulations! You now know enough about options to hold your own in a bar conversation. While this seemingly makes options more complicated to trade, it actually makes them a lot more flexible. You can tip the scales of risk to reward in your favor by understanding how stock price, volatility, and time affect your trade, and align your ideas more closely to your thesis.
In the last article, I discussed the basics of options: what they are, their classification, properties, and the different types that exist. I also mentioned how options allow you to speculate on the most expensive stocks at the price of a penny stock. This can make the prudent investor uncomfortable, as penny stocks are classically known as very risky because of the percentage swings and general lack of knowledge about the underlying company. With options the latter issue with penny stocks is solved, because everyone knows who JNJ is, but the swings in market value of options absolutely exist. This article describes how to manage your options to actually control your risk. But before we get there, we will start explaining the pricing of options.
Who determines how much premium an option has?
Ultimately the market does. If there is a high demand for a particular option, it will be more expensive. If there is lower demand, it will be cheaper. The CBOE originates a lot of options, so supply is actually not too much of an issue. The CBOE uses something called the Black-Sholes model to determine their pricing for options. The mathematician in me looked up the formula once and punted. Just know that it is based on historical movement of the underlying, and the volume and open interest just increase the demand for the option (also called implied volatility, or IV for short).
Wait, what is open interest?
My colleague Tony Pelz explained it well a few years ago, and nothing has changed since then. Why reinvent the wheel?
The other basic information included in an Option Chain is Volume and Open Interest. Volume is easy to understand: it represents the total number of options traded for each Strike during a day (just as the volume for a stock represents the total number of shares traded during a day). For example, the SEP 16.0 Strike Call volume as of this day, June 2, was 564 contracts (see Exhibit below). This means that 564 contracts (options) were bought/sold during the day. On the same day the SEP 18.0 Strike Call traded 2,192 contracts, the most active strike for this Series. Volume is a very useful metric as it shows where most of the trading action for the day is occurring. Many possible inferences can be made reading daily volume data.
Exhibit: Option Chain for XYZ Stock
Stock: XYZ @ $16.35
Today: June 2, 2010
BID ASK Volume O.I. STRIKE BID ASK Volume O.I.
2.83 2.88 10 2,114 SEP 14.0 0.59 0.61 455 3,144
2.08 2.13 242 1,071 SEP 15.0 0.83 0.86 247 7,365
1.44 1.48 564 1,389 SEP 16.0 1.19 1.22 306 6,256
0.92 0.96 576 2,267 SEP 17.0 1.68 1.71 1,103 3,633
0.55 0.57 2,192 4,435 SEP 18.0 2.30 2.34 482 1,594
While volume represents the daily activity for each option, Open Interest represents the net increase or decrease in the total number of options traded (opened and closed) since the inception of the Series. For example, the Open Interest for the XYZ SEP 18.0 Strike Calls in the Exhibit is 4,435. This means that a net total of 4,435 option contracts have been opened/remain open since the Series inception.
It is important to note that daily Volume does not always equate to Open Interest – that is, just because a day’s Volume was, for example, 500 contracts, it does not mean that Open Interest will increase by 500 contracts. To expand this point, the Exhibit below shows daily Volume, Open Interest and Net Change for the ABC 5.0 Strike Calls. On Day 1, Open Interest was 10,000 contracts – a net total of 10,000 ABC 5.0 Strike Calls have been opened (and remain open). During Day 1, 500 contracts traded. On Day 2, Open Interest is now 10,500 contracts, which means all of the Volume on Day 1 was from new (initial) contracts. On Day 2, contract Volume is 300. On Day 3, Open Interest is now 10,700, a net increase of 200 contracts. This means that of the 300 contract Volume during Day 2, 100 were closing positions and 200 were opening (initial) positions. During Day 3, 1,500 contracts trade. On Day 4, Open Interest declines by 1,500 contracts, the entire Volume experienced on Day 3.
Exhibit: Open Interest and Volume
ABC 5.0 Strike
Calls Volume Open Interest Net Change
Day 1 (open) – 0 – 10,000
Day 1 (close) 500
Day 2 (open) – 0 – 10,500 (a) +500
Day 2 (close) 300
Day 3 (open) – 0 – 10,700 (b) +200
Day 3 (close) 1,500
Day 4 (open) – 0 – 9,200 (c) -1,500
Open Interest is a very useful metric as it gives you a snapshot into the money flow in the various Strikes of both Puts and Calls. This can at times allow you to gauge general sentiment in the Underlying shares. In some situations, it is extremely important to actively monitor and interpret Open Interest.
I will add to Tony’s description only one more use of Open Interest, and that is to understand the option’s current liquidity state. If an option has an open interest of 0, that doesn’t mean that you cannot trade it; but the only buyer and seller is the CBOE… and they know it.
How do I use this information to manage risk better?
Let’s piggyback off of Tony’s example above. You expect stock XYZ will go up to 18 by the expiration day in September. Currently the price is $16.34. You also notice the SEP $16 Calls @ $1.46 (midpoint is the usual mark). So you are faced with a dilemma. Should I buy the 100 shares of XYZ and pay $1634 total, or should I buy the call for $146?
If you are right, and stock XYZ moves up to $18 at a constant pace (never happens) and ends at expiration at exactly $18… you exercise your options and you just made the same amount of money (minus $146) at a fraction of the margin it took you to just buy the shares.
If you wake up one day and the CEO was arrested overnight spending company funds on hookers and cocaine, your loss was $146 with the call. With the actual stock purchase, you have lost up to the full $1634. It could be less, and probably is, but the risk is disproportionate to the reward. With options, you can greatly manage your risk but not putting up any more money than you are willing to lose while having the ability to make a comparable amount of money as stocks at the expense of a small premium.
Granted, it isn’t as simple as that since there are a few more things to consider with options that will be explained in the next article. But think about this when making a move on catalysts, earnings, technical plays, or even longer term plans. Options greatly increase your available margin and allow you to make more with less.
A quick note about commissions
One other downside to options is that the commission structure is much more expensive than trading stocks. Talking babies peddling E-Trade boast $7 stock trades, while options commission structures look like $10/trade plus $1.50 an option. This can add up really fast, but the returns are worth it. Between trading, exercising, expiration, and settlement, you are getting a lot more service for your trade with an option than you do with stocks, so it does make sense. Personally, my favorite platform is thinkorswim.com, and the cheapest commissions with a decent platform is optionshouse.com.
In 1973, the Chicago Board Options Exchange began to offer what has become the most popular derivative in the world. Their product is called an option, which 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 (Investopedia). From that day on, the face of the trading world changed. It may be difficult for the average retail investor to cobble together $1000 to buy a share of PLCN and expect reasonable gains, but now all of a sudden you can profit from its price action by buying a $75 call! It essentially turns even the largest of companies into a penny stock!
For the classical investor, options can be intimidating. You basically own an agreement to own something, which in itself has little value. In addition, if you don’t understand all the variables that go into understanding what you have, you can easily lose money and become disenchanted. Lucky for you, I’m here to decode this mysterious but highly lucrative product for you.
What is an option's value?
The classic stock option agreement is for 100 shares of a stock at a certain price (called a strike price) by a certain time (expiration date). These options are sold at a price completely determined by the options free market; supply and demand. That price is split into two parts… intrinsic value and extrinsic value. Intrinsic value is the amount the option is worth if exercised immediately, and extrinsic value (also known as premium) is the amount you expect to be realized by the expiration date (otherwise you wouldn’t buy it!). As an example, PCLN is currently trading at $1043. A Feb. $1000 call option is selling for $75. The intrinsic value is $43, the extrinsic value is $32. If an option has any intrinsic value, it is called “in-the-money” (ITM). Without any intrinsic value, it is simply “out-of-the-money” (OTM).
Can I play both directions with options?
Absolutely! You can buy a bullish option known as a call. This would be an agreement to buy 100 shares of a stock at a certain price. You can also buy a bearish option known as a put. This is an agreement to sell 100 shares of a stock at a certain price. Furthermore, you can also sell calls and puts! So selling a call option is a bearish move, and reverse for a put. I will explain the advantages to each of these choices in a later article.
When can I exercise my option?
Exercising an option means to put the agreement into effect. There are two types of exercising options, American style and European style. American style means you can exercise whenever you want, as long as it is before the expiration date. European style options settle on the expiration date no matter what. American style options are done at the buyer’s will, so if you sold a put and the stock is above the strike price, you cannot just “exercise” it and collect your premium before the option is in the money. However, you can sell your obligation at the price the market dictates in the secondary market. This is the route most buyers take. In fact, according to the Options Clearing Corporation (OCC), in 2006 only 17% of options actually were exercised. (see table below). Stock options are typically American style. If you plan on holding options for a long time it would be good to know what kind of option you are holding. The last thing you want is to wake up one Monday short 100 shares of a call option you sold!
When the expiration date comes, ITM options are automatically exercised and OTM options expire worthless. On expiration day, options are either “AM-settled” or “PM-settled”. An AM-settled option’s settlement price is the opening price on the next trading day. PM-settled means the settlement price is the closing price of the stock on expiration day (technically 15 minutes after the close, actually). The typical monthly stock option is “AM-settled” on the third Friday of the month, and weekly stock options are typically “PM-settled” on Friday. Most of the time I don’t advise holding an option until expiration for reasons I’ll discuss in later articles, but this is important to know.
When can I trade my option?
Almost all options are traded during market hours only! This means there is risk in holding options overnight. This is extremely important when trading options, as you could stand to lose a lot of money without the ability to mitigate losses if something happens in the after-market or pre-market.
What is the impact of dividends on my option?
Technically there is no impact of dividends on an option itself. There are some impacts, however. First, theoretically, when an equity goes ex-dividend the stock is supposed to decrease by the amount of the dividend. This is sometimes priced into the options, sometimes it is not.
Further, with American-style options, when holding options in the money, sometimes institutional investors will exercise the options in order to capture the dividend in an arbitrage that is close to risk-free. The moral of that story is, do not hold short ITM calls into an ex-dividend date.
Options are a fantastic vehicle for anyone who wants to trade future movement of stocks, or markets in general. They are tremendously flexible and have the capability to accelerate your gains while controlling your risk. It is important to know what you are buying, and to know what you are getting into.
Hopefully this article helped you understand your option contracts a little better. In future articles, I will talk about risk management with options, the variables involved with options, I’ll introduce you to the “greeks”, and common option strategies. This will lay the groundwork for my mission as The Wizard of Ops, which is to optimize your trading strategy.