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FIGURE 3.11 ETF with Volume Chart (Source: www.ProﬁtSource.com)
declining volume on down days. During a bearish trend, volume tends toincrease on the down days.
CONCLUSIONFinancial markets move in trends. Some trends are short and last only afew days, but others unfold over several years or even decades. Thelonger the trend, the more powerful the price moves and the greater potential for profits. Indexes, along with the other tools presented in thischapter, can help traders identify and move with the trends.Importantly, all trends eventually reach an end. When it happens,much of the investment community is caught by surprise because reversals often occur when the majority least expects it. So, while trends areimportant, identifying turning points is also important. Indeed, trends andreversals are extremely important to trading not just indexes, but anymarkets. This chapter focuses on trends; later chapters help identify reversals. Up next, however, is our first discussion of options and the basicsof trading puts and calls in the index market.
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UnderstandingOptions
I
ndexes serve two purposes. First, an index can provide a tool for gauging the price changes in a group or basket of stocks. The Dow Jones Industrial Average ($INDU) and the NASDAQ Composite Index ($COMPQ)are mentioned frequently in the business news. These two barometers forthe performance of the U.S. stock market are examples of market indexes. Meanwhile, as we saw in Chapter 3, sector indexes are used togauge the performance of specific industry groups, such as biotechnology,semiconductor, or energy stocks.Indexes can also be used as trading vehicles. For example, optionsand futures on the S&P 500 Index are among the most actively tradedfinancial derivatives today. In addition, many sector indexes andexchange-traded funds have options linked to their performance. However, before implementing strategies using options based on indexes orETFs, traders need to develop a solid understanding of option contractbasics.
HISTORY OF OPTIONSThe history of organized options trading in the United States dates backroughly 30 years. Its roots can be traced to the founding of the ChicagoBoard Options Exchange in 1973. By the end of that year, options hadtraded on a total of 32 different issues and a little more than 1,000,000contracts had traded hands.47
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In 1975, roughly two years after the founding of the first U.S.–basedoptions exchange, the Securities and Exchange Commission (SEC) approved the Options Clearing Corporation (OCC). The OCC was created asthe clearing agent for all U.S.–based options exchanges and still performsthat role today. As clearing agent, the OCC facilitates execution of optionstrades by transferring funds, assigning deliveries of derivatives contractsand guaranteeing the performance of obligations.The early 1970s also witnessed other important events related to optionstrading. In 1973, Fischer Black and Myron Scholes wrote a research paperoutlining an analytic model that could determine the fair market value of calloptions. The findings were published in the Journal of Political Economyand the model became known as the Black-Scholes Options Pricing Model.It is still the options pricing model used most widely by traders today.As options trading grew in popularity, other exchanges started tradingthese investment vehicles. In 1975, both the Philadelphia Stock Exchange(PHLX) and the American Stock Exchange (AMEX) began trading stockoptions. In 1976, the Pacific Stock Exchange (PCX) entered the optionstrading scene. All three became members of the OCC, and all three stilltrade options today. In addition, in 1977, the SEC permitted the trading ofput options for the first time. In 1975, 18 million option contracts weretraded. By 1978, the number had soared to nearly 60 million. The 1980salso saw an explosion in the use of options, which eventually peaked withthe stock market crash of 1987.The CBOE launched the first index options in the early 1980s. In 1983,the exchange began trading options on the S&P 100 Index ($OEX); thiswas the first index to have listed options. In 1993, the CBOE Volatility Index ($VIX) was derived from OEX option prices. The VIX became the market’s first real-time volatility index. Today, the CBOE Volatility Indexmeasures the implied volatility of S&P 500 Index options. When it rises,traders are becoming more bearish and are worried about future marketvolatility. For that reason, VIX is sometimes called the “fear gauge.” LowVIX readings are a sign of bullishness or complacency among traders.The early 1980s saw a growing interest in both stock and index options. From 1980 until 1987, annual options volume rose from just under100 million contracts to just over 300 million. After the market crash inOctober 1987, however, investor enthusiasm for options trading wanedand less than 200 million contracts traded in the year 1991, or roughlytwo-thirds of the peak levels witnessed in 1987.Throughout most of the 1990s, trading activity in the options marketimproved. In 1990, long-term equity anticipation securities (LEAPS) wereintroduced; these are option contracts that expire in years instead ofmonths. The OCC and the options exchanges created the Options IndustryCouncil (OIC) in 1992. The OIC is a nonprofit association created to
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educate the investing public and brokers about the benefits and risks ofexchange-traded options.LEAPS: Long-term equity anticipation securities, or LEAPS, are longterm options contracts, either puts or calls, with expirations up tothree years in the future. LEAPS are available on the more activelytraded stocks, ETFs, and indexes. Note, the minimum amount of timefor a LEAP option is 9 months.
In 1998, the options industry celebrated its 25th anniversary. In 1999,the AMEX began trading options on the NASDAQ 100 Index Trust(QQQQ)—an exchange-traded fund that is among the most actively tradedin the marketplace today. That same year, total options volume surpasseda half-billion contracts for the first time ever.In the year 2000, a new options exchange arrived on the scene. OnMay 26, 2000, the International Securities Exchange (ISE) opened forbusiness. It was the first new U.S. exchange in 27 years. In addition, theISE became the first all-electronic U.S. options exchange. In 2001, the options exchanges followed suit with equities trading and converted pricesfrom fractions to decimals.Another player entered into the options trading foray in February2004. The Boston Options Exchange (“the BOX”) received regulatory approval and started trading puts and calls. The entity was formed by a jointventure among the Boston Stock Exchange, the Montreal Exchange, andInteractive Brokers. The BOX became the sixth U.S. options exchange.A great deal has changed in the options market during the past fewdecades. Not only are there six U.S. exchanges today versus only one 30years ago, but a variety of different products including options on indexesand exchange-traded funds have also become available. Although the firstindex option began trading in 1983, it was not until 1999 that options began trading on exchange-traded funds. Today, index and exchange-tradedfunds represent a sizeable portion of the total options market.Stocks versus Exchange-Traded FundsStock represents ownership of shares in a corporation. When companiesare publicly traded, shares of stock are listed on one of the exchangessuch as the New York Stock Exchange or the NASDAQ Stock Market. Pricesare quoted throughout the day, and investors buy and sell shares on anongoing basis. An investor who buys shares is taking an equity position inthe company and becomes one of its owners. If the company performs(Continued)
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Stocks versus Exchange-Traded Funds (Continued)well, the stock price can go up and yield proﬁts to the stockholder. Indexestrack the prices of a group of stocks.Exchange-traded funds are pools of money that hold baskets of stocksand issue shares to the public. Therefore, shares of ETFs also trade on theexchanges like stock. Options trade on stocks, exchange-traded funds, andequity indexes, and are called stock options and index options.
WHAT IS AN OPTION?Since the four books that preceded The Index Trading Course coveredoptions extensively, we don’t want to spend a lot of time rehashing the basics of options contracts. Readers needing an in-depth discussion of options are encouraged to pick up a copy of any of our previous books (TheOptions Course, The Stock Market Course, Trade Options Online, or TheVolatility Course) or visit us online at Optionetics.com. Nevertheless, inorder to understand the trading techniques discussed later in this text, abasic understanding of options is in order and the next few pages servethis purpose.Options come in two flavors: puts and calls. Both types of option canbe purchased or sold. If an investor buys a call, he/she has entered into acontract that gives him/her a right to buy a stock (futures contract, ETF,etc.) at a predetermined price known as the strike price. The contract isvalid for a specific period of time, until the expiration date. After the timehas lapsed, the option expires. So if you buy a June 50 call option on Microsoft, it gives you the right to buy (or call) the stock (100 shares forevery call contract) at a specific price ($50 a share) for a specific period oftime (until June expiration).An investor who sells an option must honor the terms of the contract.Hence, a call seller, or writer, has the obligation—if the option is assigned—to deliver the underlying security at a specific price until the option’s expiration. The seller has no choice. So if you sell (write) a June 50call on Microsoft, you are agreeing to deliver the stock to the assigned option buyer at $50 a share—regardless of Microsoft’s current marketprice—if the option is assigned. Assignment occurs when an option buyerexercises his/her option by delivering a notice to the option seller, requesting the option seller to fulfill the terms of the options contract. Thisincludes delivering the underlying security (for a call writer) or acceptingdelivery of the underlying asset (for the put seller).A put option can also be bought or sold. A put buyer enters into an
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agreement that gives him/her the right to sell (put) the underlying asset ata specific price for a predetermined period of time. If I buy a MicrosoftJune 50 put option, I have the right to sell shares of Microsoft (100 sharesper each contract) for $50 per share from now until the option expires inJune—regardless of the current price for Microsoft.A put seller, on the other hand, takes on the obligation to buy the underlying asset at a specific price, known as the strike price, for a predetermined period of time. A trader who writes a Microsoft 50 put has entereda contract that obligates him/her to buy the stock at $50 per share—again,regardless of the current price of Microsoft.
Put option: An option contract that gives the owner the right, butnot the obligation, to sell, or put, the underlying asset at a speciﬁcprice—called the strike price—for a speciﬁc period of time, known asthe expiration date.Call option: An option contract that gives the owner the right, butnot the obligation, to buy, or call, the underlying asset at a speciﬁcprice—called the strike price—for a speciﬁc period of time, known asthe expiration date.
OPTION MECHANICSEach options contract can be described using the following four factors:1. The name of the underlying security2. The type (put or call)3. The strike price4. The expiration date
When discussing options, the four variables provided are used to identify the specific contract. For example, the “$SPX June 1500 call” describes a call option on the S&P 500 Index, a cash index, that expires inJune and has a strike price of 1,500. The “QQQQ October 30 put” is a putoption contract on QQQQ—an ETF—that expires in October and has astrike price of 30.The price of an option is quoted in dollars and cents like the price of astock. For example, a QQQQ October 30 Call might trade for $3.00, with abid price of $2.90 and an ask price of $3.00. Therefore, it costs $3.00 to buythat contract and it can be sold for $2.90. The difference between the bidand the ask (offer) is known as the spread. It’s important to note that thecash required to buy one QQQQ October 30 call in this example would be
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$300 because each options contract contains 100 shares. Therefore, in order to determine the cost of an options contract, one must take the valueof the option in the market and multiply it by 100. The cost of an optionscontract is also known as the premium.
KEY DETERMINANTS OF OPTION PRICESOptions are often called “wasting assets” because their values decline astime passes. This phenomenon is known as time decay. All else beingequal, an option that is valid for the next six months is worth more than anidentical option that has only one month left until expiration. You have theright to exercise the former option for five months longer! However, whiletime is a key element in determining the value of an options contract, it isnot the most important factor.
Price of UnderlyingThe price of the underlying security is the most important factor in determining the value of an option. Most of us learn this early on in our tradingcareers. For example, we buy calls on XYZ stock because we expect XYZto move higher. The call option gives us leverage. It will increase in valueas XYZ moves northward, but the small cost translates into a large percentage return.In order to really understand how option prices work, however, it is important to understand that the value of an option is determined largely by therelationship between its strike price and the price of the underlying asset. Infact, the difference between the strike price and the price of the underlyingasset plays the most important role in determining the value of the contract.The relationship between the price of the underlying asset and thestrike price of the option is known as moneyness. The terms in-themoney (ITM), at-the-money (ATM), and out-of-the-money (OTM) are usedin this context. For example, a call option is in-the-money if the strikeprice of the option is below the price of the underlying asset, and out-ofthe-money if the strike price is above the price of the underlying security.So a call can move from OTM to ITM as the stock price moves higher. Onthe other hand, a put option is in-the-money if the strike price is greaterthan the price of the underlying security, and out-of-the-money if thestrike price is below the price of underlying security. So a put can movefrom OTM to ITM as the price of the underlying security moves lower (seeTable 4.1). A call or put option is at- or near-the-money if the strike price isthe same as, or close to, the price of the underlying security.
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TABLE 4.1 Option MoneynessPrice of XYZ = $100Strike Price
Call Option
Put Option
120
OTM
ITM
110
OTM
ITM
100
ATM
ATM
90
ITM
OTM
80
ITM
OTM
Table 4.1 summarizes moneyness with a hypothetical example. If thecurrent price of XYZ is $100, both the 100 put and the 100 call are at-themoney. However, the 120 put is in-the-money and the 120 call is out-ofthe-money.The higher the asset price relative to the call option’s strike price, themore the call option is in-the-money. The difference between the strikeprice and the underlying asset’s price is known as intrinsic value. Whencall options have a large amount of intrinsic value, or the asset price isconsiderably above the strike price, it is said to be deep-in-the-money. Theopposite holds true for put options—that is, when the price of the underlying asset is below the strike price the put option has intrinsic value; it isin-the-money. If the price of the underlying is much lower than the strikeprice, the put option is deep-in-the-money.An out-of-the-money call option will have a strike price above the underlying stock’s price and an out-of-the-money put will have a strike pricebelow the stock price. Out-of-the-money options have zero intrinsic value.When the strike price of a call option is considerably above the stockprice, it is considered deep-out-of-the-money. Similarly, when the strikeprice on a put option is considerably below the underlying asset’s price,the option is considered deep-out-of-the-money.Knowing whether an option is in-the-money, at-the-money, or out-ofthe-money will help you determine whether the option is likely to be exercised. Exercise occurs when the call option owner decides to buy thestock in accordance with the rights under the call option contract, orwhen the put owner sells the stock in accordance with the rights underthe put option contract.Near expiration, an option that is in-the-money will have a greaterchance of being exercised. For instance, suppose a strategist buys sharesof XYZ stock for $50 a share and sells the December 50 calls—a strategyknown as a covered call. If at expiration (the Saturday following the third
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Friday in December) the stock climbed to $55 a share, the call would havean intrinsic value of $5.00. It is likely to be exercised and the stock will becalled away from the option writer for $50.00. Exercise is all but assuredwhen an option is in-the-money at expiration. In fact, the OCC automatically exercises any option that has intrinsic value of 0.25 or more at expiration—whether the option holder requests it or not.What happens to in-the-money options before expiration? When thereis a considerable amount of time left before the option expires, chancesare less that an in-the-money option will be exercised. The reason that anoption with intrinsic value will probably not be exercised ahead of expiration is due to the fact that the option also has a different type of value—i.e., time value. The time value of an in-the-money call is computed asfollows:Call time value = (Call option price + Strike price) – Stock price= Call option price – Intrinsic value
TimeTime is the second most important factor in determining an option’s value.The greater the amount of time value in the option’s premium, the lesslikely the option will be exercised. But time value decreases as timepasses. Importantly, time value decreases at an accelerating rate. As a result, an option with only one month of life remaining will see time valueerode faster than an options contract with six months remaining until itexpires. At expiration, time value will equal zero. At that time, if there isno intrinsic value (i.e., the option is not in-the-money), it becomes worthless and will not be exercised. Therefore, the odds of exercise increase as(1) the option becomes in-the-money, and (2) the time value of the optiondiminishes.As noted earlier, the amount of time left until an option expires has animportant influence on the option’s value. Specifically, all else being equal,the more time left until an option expires, the greater the value of theoptions contract. As time passes, the value of an option will decline. It isimportant to understand the impact of time decay on a position.
DividendsThe dividend is another determinant of a stock option’s price. A dividendis a payment from a corporation to a shareholder. Dividends are oftenpaid quarterly and represent a distribution of profits to stockholders.These payments will lower the value of the stock price after the dividendis paid. Hence, dividends also affect the prices of stock options.
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Obviously, if the stock pays no dividend or if we are dealing with a futures contract or index, the dividend makes no difference. However, a dividend will lower the value of a call option and increase the value of the putoption. In addition, the larger the dividend, the larger an impact it has onthe price of the corresponding call option. Therefore, stocks with high dividends will have low call option premiums and higher put premiums.
Interest RatesChanges in interest rates can also have an impact on option prices throughout the entire market. Higher interest rates lead to somewhat higher option prices, and lower interest rates result in lower option premiums. Theextent of the impact of interest rates on the value of an option is subjectto debate, but it is considered one of the determinants throughout most ofthe options-trading community.
VolatilityVolatility is an extremely important factor in determining the value of anoptions contract—so important that we have written an entire book onthe subject! The Volatility Course outlines and defines various measuresof volatility and also how to trade volatility using options contracts.Why is volatility so important? All else being equal, the greater an underlying asset’s volatility, the higher the option premium. To understandwhy, consider buying a call option on XYZ with a strike price of 50 and expiration in July (the XYZ July 50 call). The call is purchased in January. Ifthe stock has been trading between $40.00 and $45 for the past six years,the odds of the option rising above $50 by July are relatively slim. As a result, the XYZ July 50 call option will not carry much value because theodds of the stock moving up to $50.00 are statistically small. However,suppose the stock has been trading between $40 and $80 during the pastsix months and sometimes jumps $15 in a single day. In that case, XYZ hasexhibited relatively high volatility and, therefore, the stock has a betterchance of rising above $50 by July.Basically, an option, or the right to buy or sell the stock at $50 a share,will have better odds of being in-the-money at expiration when volatilityof the asset is high. As a result, the options will command a higher price ifthe stock has been exhibiting higher levels of volatility. Buyers will bewilling to pay higher prices for the right to buy or sell the underlying asset,and sellers will want a greater premium to take on the obligation relatedto assignment of the option.All else being equal, indexes and exchange-traded funds often havelower premiums than stocks for the same reason. Since indexes and
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exchange-traded funds consist of many stocks, there is more diversification and consequently less volatility. Stated differently, indexes areless likely to see dramatic one-day moves than are individual stocks.The options market recognizes this fact; therefore, the premiums arepriced accordingly.
STANDARD CHARACTERISTICS OF OPTIONS CONTRACTSWhether trading futures or stock options, all contracts share certain basiccharacteristics. For example, all call options give the owner the right tobuy a specific asset at a specific price for a predetermined period of time.This is true of stocks, indexes, or exchange-traded funds. All options contracts share the following seven characteristics.1. Options give the right to buy or sell an instrument.2. Option buyers or owners are not obligated to buy or sell the underly-
ing instrument; they simply have the choice or option to do so.3. An option seller (or writer) is obligated to deliver (when selling a call)or to purchase (when selling a put) the underlying asset at the predetermined price if the assigned option buyer exercises his or her rightto take delivery (or to sell).4. Options are valid for a specified period of time, after which they expire and the contracts cease to exist. Options expire on the Saturdayfollowing the third Friday of the expiration month.5. Options are bought at a debit to the buyer. The cost is deducted fromthe trader’s trading account.6. Sellers receive credits for selling options. The credit is an amount ofmoney equal to the option’s premium and it is credited (added) to thetrading account.7. The strike price available for an options contract reflects the price ofthe underlying security. For example, if XYZ is trading for $50 a share,the options might have strikes of 40, 45, 50, 55, and 60. The number ofstrike prices will increase as the stock moves higher or lower.An important note: Exercising an option is not the only way to bank aprofit or close the position. Instead, an option position can, and often is,closed at a profit (or loss) prior to expiration through offsetting transactions. To offset an open long position, the trader sells an equal number ofcontracts in the exact same options contract. For example, an accountthat is long 10 XYZ June 50 calls can close that position by selling 10 XYZ
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June 50 calls. When the trade is established, it is an opening transaction.The offsetting transaction is a closing trade. In this example, the traderbuys to open and sells to close. It is also possible to sell an option as anopening transaction and then buy to close the position.A trader might choose to exercise an option rather than offset it for avariety of reasons. Exercising closes an open call option position by taking ownership of the underlying stock. If a trader wants to exercise a long(bought) stock option, the broker is notified, who then notifies the OCC.By the next business day, the account will own (if exercising calls) orhave sold (if exercising puts) the corresponding shares of underlying asset or, in the case of index options, will transfer cash.An option seller cannot exercise an option. By selling an option, thetrader is taking the risk of having an assigned buyer exercise the option. The OCC randomly matches or assigns buyers and sellers to oneanother. If there is an excess of sellers by expiration, all open-positionITM short options are automatically exercised by the OCC. In order toavoid being assigned, short option holders can offset or close theiroptions instead.
ANTICIPATING ASSIGNMENTSelling puts or calls involves significant risks. However, some strategiescarry relatively low risk, but also involve selling options. For example, astrategist might buy a call and sell another call with a higher strike price—a position known as a bull call spread. In that trade, which is discussed inmore detail in Chapter 5, the long call covers the short call. That is, if theshort call is assigned, the long call can be exercised to satisfy assignment.Sometimes we want to sell options. But if an option is sold, how doesone determine if there is a risk of assignment? While there is no way toknow for certain if and when assignment will occur, there are ways toanticipate it before it happens.Recall that sellers take on an obligation to honor the option contract.Therefore, a call writer agrees to sell the stock at a predetermined priceuntil the option expires. Similarly, the put seller has the obligation to buythe stock (or have it “put” to him/her) at the option’s strike price until theoption expires.When a writer fulfills the obligation to buy or sell a stock, s/he hasbeen assigned. Assignment is the process of buying or selling the underlying asset in accordance with the terms of the options contract. For stocksand ETFs, this involves the transfer of shares. For indexes, assignment involves cash. Once assigned, the option seller has no choice but to honor
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the contract. It is too late to try to buy the option contract back and closethe position.Although option sellers have an obligation to buy or sell a stock at apredetermined price, assignment will only take place under certain circumstances. How do you know if you are at risk of being assigned? First,exercise generally takes place only with in-the-money options. Recall thata call option that has a strike price below the price of the underlying indexis ITM. If an ETF is currently trading near $55, the March 50 call optionswill have an intrinsic value of $5 because the option buyer can exercisethe option, buy shares for $50, immediately sell them in the market for$55, and realize a $5 profit. A put option, by contrast, will be ITM when thestock price is below the strike price.It is rare for assignment to take place when options are not ITM. Asnoted earlier, if an option is in-the-money at expiration, assignment is allbut assured. In fact, the OCC automatically exercises any option contractthat is ITM at expiration. That is, options that are in-the-money by 0.25 ormore are subject to “auto-exercise.”The second important factor to consider when assessing the probability of assignment is the amount of time value left in the option. When anoption is exercised before expiration, it is known as early exercise. Ingeneral, if there is sufficient time value (i.e., 0.25 or more) left in the option, the option will usually not be exercised.Option sellers can expect assignment when the option has little to notime value remaining. Since the time value of an option decreases as timepasses, the probability of early exercise increases as the expiration dateapproaches. To determine the amount of time value remaining in a call orput option, traders can use the following formula:Call time value = (Call strike price + Call option price) – Stock pricePut time value = (Stock price + Put option price) – Strike priceFinally, this discussion of assignment applies to American-styleoptions. American-style options can be exercised at any time prior to expiration.