Options are highly versatile financial instruments that open up a wide range of investment strategies for individual investors. Options have been actively traded on the Chicago Board of Options Exchange (CBOE) since 1973. In essence, an option represents a contract between two parties to buy or sell a financial asset. The contract gives the owner the right to buy the asset (call option) or the right to sell the asset (put option) at a predetermined price and within a predetermined time frame. An option gives its owner the right to do something in the future. The owner of an option has the right but is not obligated to exercise the terms of the contract. If the owner of an option does not exercise this right before the predetermined time frame, then the option and the opportunity to exercise it cease to exist, and the option expires.
Buying a call option for a financial asset is like buying a coupon for something. For example, a coupon for a concert ticket can be thought of as a call option for admission to a concert. Since the price of a concert ticket can go up in the weeks and days before the event, a savvy concert goer might want to lock in a ticket price by spending a little money (a premium) on a coupon that lets him pay a fixed price (the strike price) for a ticket anytime before the concert. Three things can happen to the ticket price in an open market before the concert: the price can go up, it can stay the same, or it can go down. When the ticket price goes up, the coupon owner can buy at a discount because the coupon guarantees a lower price. This is a profitable situation for the coupon owner because he can buy at a discount and immediately sell in the open market at a higher price. When the ticket price stays the same, the coupon owner pays full price, loses the small cost of the coupon, but if tickets are running out before the concert, then the coupon gives him time to buy until the night of the concert. When the price of a concert ticket goes down, maybe because the concert is not that great, the coupon owner may not want to buy a ticket after all, even at a lower price. In this case, a coupon owner loses the small cost of the coupon, but by waiting things out, he doesn't end up spending full price for a ticket up front, only to be stuck with admission to a lousy concert.
Buying a put option for a financial asset is like buying insurance for something. Spending a little money on insurance provides price protection for the thing insured. The value of a ticket can be insured by paying a premium. If the concert ticket price goes up or stays the same, then the insurance is not needed and the money spent on price protection is lost. If the ticket price goes down because the concert is not that great, then this form of insurance guarantees that the ticket holder will get a fixed price for the ticket (a refund), even if the market value of a ticket is much lower. When ticket prices go down, the insurance covers the difference between a fixed, higher price and the current, much lower price, and itself becomes more valuable as people are willing to pay more for greater price protection. When prices go down, the insurance can be sold for more than its original cost. For a small premium, insurance protects the value of the concert ticket if you buy one up front, provides time to make a purchase decision at a fixed price if you want to wait and see what happens to ticket prices until the concert, and increases in value when ticket prices decline.
When you sell something, you get to keep the money collected from the sale, provided that everything goes as expected through the end of a transaction. A ticket coupon seller collects the price of a coupon and expects concert ticket prices to either stay the same or to go down by the night of the concert, in order to keep the price of the coupon as his profit, just as a call option seller typically expects the price of a stock to stay the same or to go down by expiration for the same reason: to keep the premium. The seller of insurance for a concert ticket keeps the premium collected when concert ticket prices stay the same or go up, just as a put option seller collects a premium, and keeps it as a profit when stock prices stay the same or go up.
At a fundamental level, options markets behave like the markets for concert ticket coupons and insurance in these examples: buyers take one side, sellers take the other, and both parties speculate on the price of an underlying asset.
Thursday, January 08, 2015
Why Trade Options?
In an options trade, the seller of an option takes on an obligation, while the buyer purchases a right. The buyer of a call is bullish, thinking the market will move up, while the seller of a call is bearish, thinking it will go down. Conversely, the buyer of a put is bearish while the seller of a put is bullish. Opposing sentiments about the market are implicit in every options trade as traders believe the market will move in a particular direction.
As individual investors, we trade options to get a better ROC (return on capital), to give ourselves better odds of success, to define our risk, and to combine options into profitable trading strategies. We are also interested in trading options to become active participants in the world of finance. Options trading teaches us the language of finance and helps us to develop a financial mind.
As individual investors, we trade options to get a better ROC (return on capital), to give ourselves better odds of success, to define our risk, and to combine options into profitable trading strategies. We are also interested in trading options to become active participants in the world of finance. Options trading teaches us the language of finance and helps us to develop a financial mind.
Buy A Call
A trader who thinks that a stock will go up can buy the right to purchase the stock (a call option) at a fixed price, instead of purchasing the stock itself. If the stock price at expiration is above the strike price by more than the premium paid, then he will make a profit. If the stock price is lower than the strike price, then he will let the option expire worthless, and lose only the amount of the premium.
Example
Suppose MSFT is trading at $46. A call option with a strike price of $46 expiring in a month is priced at $1. A trader’s assumption is that MSFT will rise sharply in the coming weeks and so he pays $100 to purchase a single $46 MSFT call option covering 100 shares ($1 x 100 = $100) with 30 days until expiration.
If the trader’s assumption is correct, and the price of MSFT stock goes up to $50 at option expiration, then he can exercise the call option and buy 100 shares of MSFT at $46. By selling the shares immediately in the open market at $50, the total amount he will profit from the exercise is $4 per share. As each option contract gives him the right to buy 100 shares, the total amount he receives when he sells the shares is $4 x 100 = $400. Since he paid $100 to buy the call option, his net profit for the entire trade is $300.00 ($400 - $100).
If the trader’s assumption is incorrect and the price of MSFT drops to $40 at option expiration, then the call option will expire worthless and his total loss is limited to the $100 paid to purchase the option.
Profit and Loss (P&L) at Expiration
If he had purchased 100 shares of MSFT at $46, that is, if he had purchased the stock outright, then his total investment would have been $4,600. With MSFT trading at $50, the investment would generate a $400 profit ($5,000 - $4,600 = $400). This is an 8.6% return on investment. Purchasing a call option, as detailed above, generates a $300 net profit, on a total investment of $100, or a 300% RoR (return on risk).
Example
Suppose MSFT is trading at $46. A call option with a strike price of $46 expiring in a month is priced at $1. A trader’s assumption is that MSFT will rise sharply in the coming weeks and so he pays $100 to purchase a single $46 MSFT call option covering 100 shares ($1 x 100 = $100) with 30 days until expiration.
If the trader’s assumption is correct, and the price of MSFT stock goes up to $50 at option expiration, then he can exercise the call option and buy 100 shares of MSFT at $46. By selling the shares immediately in the open market at $50, the total amount he will profit from the exercise is $4 per share. As each option contract gives him the right to buy 100 shares, the total amount he receives when he sells the shares is $4 x 100 = $400. Since he paid $100 to buy the call option, his net profit for the entire trade is $300.00 ($400 - $100).
If the trader’s assumption is incorrect and the price of MSFT drops to $40 at option expiration, then the call option will expire worthless and his total loss is limited to the $100 paid to purchase the option.
Profit and Loss (P&L) at Expiration
If he had purchased 100 shares of MSFT at $46, that is, if he had purchased the stock outright, then his total investment would have been $4,600. With MSFT trading at $50, the investment would generate a $400 profit ($5,000 - $4,600 = $400). This is an 8.6% return on investment. Purchasing a call option, as detailed above, generates a $300 net profit, on a total investment of $100, or a 300% RoR (return on risk).
Buy A Put
A trader who thinks that a stock will go down can buy the right to sell the stock (a put option) at a set price. If the stock price at expiration is below the strike price by more than the premium paid, then he will make a profit. If the stock price at expiration is higher than the strike price, then he can let the option expire worthless, and lose only the amount of the premium paid.
Example
Suppose MSFT is trading at $46. A put option with a strike price of $46 expiring in a month is priced at $1. A trader’s assumption is that MSFT will decrease sharply in the coming weeks and so he pays $100 to purchase a single $46 MSFT put option covering 100 shares ($1 x 100 = $100) expiring in 30 days.
If his assumption is correct, and the price of MSFT stock goes down to $40 at option expiration, then he could exercise the put option and sell 100 shares of MSFT at $46. By selling the shares immediately in the open market at $46, the total amount he will profit from the exercise is $6 per share ($46 - $40). As each option contract gives the right to buy 100 shares, the total amount he would receive when he sells the shares is $6 x 100 = $600. Since he paid $100 to buy the call option, his net profit for the entire trade is $500 ($600 - $100).
If his assumption is incorrect and the price of MSFT rallies to $50, then the call option will expire worthless and the total loss of the trade is limited to the $100 paid to purchase the option.
Profit and Loss (P&L) at Expiration
The risk in a long put strategy is limited to the price paid for the put option no matter how high the stock price trades on the expiration date.
Example
Suppose MSFT is trading at $46. A put option with a strike price of $46 expiring in a month is priced at $1. A trader’s assumption is that MSFT will decrease sharply in the coming weeks and so he pays $100 to purchase a single $46 MSFT put option covering 100 shares ($1 x 100 = $100) expiring in 30 days.
If his assumption is correct, and the price of MSFT stock goes down to $40 at option expiration, then he could exercise the put option and sell 100 shares of MSFT at $46. By selling the shares immediately in the open market at $46, the total amount he will profit from the exercise is $6 per share ($46 - $40). As each option contract gives the right to buy 100 shares, the total amount he would receive when he sells the shares is $6 x 100 = $600. Since he paid $100 to buy the call option, his net profit for the entire trade is $500 ($600 - $100).
If his assumption is incorrect and the price of MSFT rallies to $50, then the call option will expire worthless and the total loss of the trade is limited to the $100 paid to purchase the option.
Profit and Loss (P&L) at Expiration
The risk in a long put strategy is limited to the price paid for the put option no matter how high the stock price trades on the expiration date.
Sell A Call
A trader who thinks that a stock price will decrease can sell a call. When a trader sells a call he collects a premium. If the stock price is below the strike price by the expiration date, then the short call expires worthless and the seller keeps the premium. The premium collected is the seller’s profit. Otherwise, if the difference between the stock price and the strike price is greater than the amount collected in premium, then the seller would lose money. Since there is no limit to how high stocks can go, the losses on a trade like this, in theory, are unlimited.
This is also called a naked call. In practice, to sell naked options, a brokerage firm typically requires a seller to deposit funds (margin requirements) sufficient to cover a 2 standard deviation move in the stock price. This trade results in a net credit to the seller, but requires margin to be maintained in the seller’s account until expiration.
Example
Suppose MSFT is trading at $46. A call option with a strike price of $46 expiring in a month is priced at $1. A trader thinks that MSFT will drop below $46 by expiration, so he sells the MSFT 46 call option expiring in 30 days, and receives a $100 credit ($1 x 100 shares). If he’s right, and MSFT drops and stays below $46 by expiration, then he keeps the $100 credit as a profit.
If he’s wrong, and MSFT rallies (goes up) to $50, then the buyer of the option may exercise his right to buy MSFT at the lower price (the strike price of the option), and the difference would be paid by the seller. In this case, the seller would lose:
(Market Price x 100 shares) - (Strike Price x 100 shares)
($50 x 100) - ($46 x 100)
$5,000 - $4,600 = $400
Since the seller collects $100 when the trade is placed, the the net loss is only $300 ($400 - $100).
Profit and Loss (P&L) at Expiration
This is also called a naked call. In practice, to sell naked options, a brokerage firm typically requires a seller to deposit funds (margin requirements) sufficient to cover a 2 standard deviation move in the stock price. This trade results in a net credit to the seller, but requires margin to be maintained in the seller’s account until expiration.
Example
Suppose MSFT is trading at $46. A call option with a strike price of $46 expiring in a month is priced at $1. A trader thinks that MSFT will drop below $46 by expiration, so he sells the MSFT 46 call option expiring in 30 days, and receives a $100 credit ($1 x 100 shares). If he’s right, and MSFT drops and stays below $46 by expiration, then he keeps the $100 credit as a profit.
If he’s wrong, and MSFT rallies (goes up) to $50, then the buyer of the option may exercise his right to buy MSFT at the lower price (the strike price of the option), and the difference would be paid by the seller. In this case, the seller would lose:
(Market Price x 100 shares) - (Strike Price x 100 shares)
($50 x 100) - ($46 x 100)
$5,000 - $4,600 = $400
Since the seller collects $100 when the trade is placed, the the net loss is only $300 ($400 - $100).
Profit and Loss (P&L) at Expiration
Sell A Put
A trader who thinks that a stock will go up can sell a put. When a trader sells a put he collects a premium. If the stock price is above the strike price by the expiration date, then the short put expires worthless and the seller keeps the premium. The premium collected is the seller’s profit. Otherwise, if the stock price is below the strike price by more than the amount collected in premium, then the seller would lose money.
This is also called a naked put. In practice, to sell naked options, a brokerage firm typically requires a seller to deposit funds (margin requirements) sufficient to cover a 2 standard deviation move in the stock price. This trade results in a net credit to the seller, but requires margin to be maintained in the seller’s account until expiration.
Example
Suppose MSFT is trading at $46. A put option with a strike price of $46 expiring in a month is priced at $1. A trader thinks that MSFT will rise above $46 by expiration, so he sells the MSFT 46 put option expiring in 30 days, and receives a $100 credit ($1 x 100 shares). If he’s right, and MSFT stays above $46 by expiration, then he keeps the $100 credit as a profit.
If he’s wrong, and MSFT drops to $40, then the buyer of the option may exercise his right to sell MSFT at the higher price (the strike price of the option), and the difference would be paid by the seller of the option. In this case, the seller would lose:
(Market Price x 100 shares) - (Strike Price x 100 shares)
($40 x 100) - ($46 x 100)
$4,000 - $4,600 = -$600
Since the seller collects $100 when the trade is placed, the net loss is only $500 (-$600 + $100).
Profit and Loss (P&L) at Expiration
This is also called a naked put. In practice, to sell naked options, a brokerage firm typically requires a seller to deposit funds (margin requirements) sufficient to cover a 2 standard deviation move in the stock price. This trade results in a net credit to the seller, but requires margin to be maintained in the seller’s account until expiration.
Example
Suppose MSFT is trading at $46. A put option with a strike price of $46 expiring in a month is priced at $1. A trader thinks that MSFT will rise above $46 by expiration, so he sells the MSFT 46 put option expiring in 30 days, and receives a $100 credit ($1 x 100 shares). If he’s right, and MSFT stays above $46 by expiration, then he keeps the $100 credit as a profit.
If he’s wrong, and MSFT drops to $40, then the buyer of the option may exercise his right to sell MSFT at the higher price (the strike price of the option), and the difference would be paid by the seller of the option. In this case, the seller would lose:
(Market Price x 100 shares) - (Strike Price x 100 shares)
($40 x 100) - ($46 x 100)
$4,000 - $4,600 = -$600
Since the seller collects $100 when the trade is placed, the net loss is only $500 (-$600 + $100).
Profit and Loss (P&L) at Expiration
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