atility increase in the stock markets. If a stock’s volatility was sitting just below 10, it may increase to 12.5 as a result of the report’s release. You canequate that 2.5 rise to an approximate 8% increase in the price of an option. Optionsoften increase in price when there is a rise in volatility even if the price of the underlying asset doesn’t move at all. As a general rule of thumb, traders buy options inlow volatility and sell them during periods of high volatility.There are two basic kinds of volatility: historical and implied. In basic terms, historical volatility gauges stock price movement in terms of past performance, and impliedvolatility approximates how much the marketplace thinks option prices will move.Historical volatility (also known as statistical volatility) measures a stock’spropensity for movement based on the stock’s past price action during a specifictime period. Historical volatility can be calculated by using the standard deviationof a stock’s price changes from close to close of trading going back 21 to 23 days.Since statistical volatility measures a stock’s propensity for movement, it is an important variable that helps to determine an option’s worth. High or low historicalvolatility also gives traders a clue as to the type of strategy that can best be implemented to optimize profits in a specific market.Historic volatility: A measurement of how much a stock’s price has fluctuatedover a period of time in the past; usually calculated by taking a standard deviation of price changes over a specific time period.
Implied volatility is a computed value that measures an option’s volatility, ratherthan the underlying asset. The fair value of an option is calculated by entering thehistorical volatility of the underlying asset into an option pricing model (Black-
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Scholes for stocks). The computed fair value may differ from the actual marketprice of the option. Implied volatility is the volatility needed to achieve the option’sactual market price.
Implied volatility: Volatility computed using the actual market price of an option and a pricing model (Black-Scholes). For example, if the market price of anoption rises without a change in the price of the underlying stock or future, implied volatility will have risen.
The best thing about implied volatility is that it is very cyclical; that is, it tends tofluctuate within a given range. The key to utilizing implied volatility is in knowingthat when it actually changes direction it often moves quickly in the new direction.Buying options when the implied volatility drops can cause some trades to actuallyend up losing money even when the price of the underlying asset moves in your direction. However, you can take advantage of this situation by selling options, instead of buying them.Volatility not only contributes to the option’s price, it also helps define whichstrategy can be best utilized to take advantage of specific market movement.High-volatility stocks usually have higher-priced options. Low-volatility stockshave lower-priced options; the extrinsic value is lower. There are different strategies that can take advantage of either of these conditions. You can also usevolatility levels to look for skews, or differences, in volatility between higherstrike and lower-strike options of the same underlying stock (or between differentexpiration months).Volatility skews measure and account for the limitation found in most optionpricing models and can be used to give traders an edge in estimating an option’s realworth. Volatility increases the price of a trading instrument. A volatility skew existswhen higher-strike options are overpriced in comparison to the lower-strike optionsor vice versa. A forward volatility skew is found in markets where higher-strike options have high implied volatility and are therefore overpriced, and lower-strike options have low implied volatility and are often underpriced. A reverse volatilityskew is found in markets in which lower-strike options have high implied volatilityand are therefore overpriced, and higher-strike options have low implied volatilityand are often underpriced. There are specific option strategies that take advantageof these kinds of volatility skew scenarios. Skews can also occur between differentmonths.Determining the current volatility level is critical. A basic rule of thumb is to buylow volatility and sell high volatility. If you see that the volatility is high, thatmeans there’s a lot of extrinsic value that somehow has been assigned the option. Agood example of how this happens is when a company makes an announcement ona subject such as earnings. Whether they’re good or bad is immaterial; the news attracts activity, which makes the stock move up or down more than usual, and thismovement attracts the options trader. More trading activity (demand) will naturally
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THE VERSATILITY OF OPTIONS
push the volatility up. So even if the stock doesn’t move, the options may move up.Eventually the buying slows down, and the volatility drops to normal levels again.Two web sites I know of that track and report volatility levels are:Optionetics.com (www.optionetics.com) and Option Club(www.optionclub.com/cgi-bin/longvol.htm). For more information aboutvolatility, Yahoo! Finance has a glossary worth bookmarking(biz.yahoo.com/f/g/bfglosv.html).
OPTION GREEKSThe option Greeks represent a set of measurements that explore the risk exposuresof a specific trade. Options and other trading instruments have a variety of risk exposures that can vary dramatically over time or as markets move. Often, it is notenough to know the total risk associated with an options position. To create a deltaneutral trade, you need to select a calculated ratio of short and long positions thattogether create an overall position delta of zero. To recognize the probabilities ofthe trade making money, it is essential to be able to determine a variety of risk exposure measurements. Changes in the price of the underlying instrument triggerchanges in the delta, which triggers changes in the rest of the Greeks.Each risk measurement is named after a different letter in the Greek alphabet including delta, gamma, theta, and vega (vega is not actually a Greek letter, but isused in this context anyway). In the beginning, comprehending the definition ofeach of the Greeks will give you the tools to decipher option pricing. Each of theterms defined has a specific use in day-to-day trading.• Delta: The change in the price of an option relative to the change of the underlying security. Delta helps you to understand how an option’s premium willrise or fall in comparison to the price of the underlying asset.• Gamma: Change in the delta of an option with respect to the change in priceof its underlying security. Gamma helps you to gauge the change in an option’s delta when the underlying asset moves.• Theta: Change in the price of an option with respect to a change in its time until expiration. Theta measures the amount an option will lose with the passageof one day.• Vega: Change in the price of an option with respect to its change in volatility.Vega measures the amount an option will gain or lose with a 1 percentagepoint change in the implied volatility of the option.The Greeks help us to break option price movement into bite-size pieces thatcan be more easily swallowed and digested. Learning to use them will enhanceyour ability to decide which strategy has the best chance of making money in acertain market. This information can be easily found by visiting the Platinum areaof the Optionetics.com web site. This site is dedicated to empowering investors by
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providing access to a host of additional data and information, as well as a numberof advanced screening techniques.
CALL OPTION BASICSCall options offer an attractive alternative to buying stock by providing the buyerthe right, but not the obligation, to buy an underlying stock at the call’s strike price.Since each option represents 100 shares of the underlying stock, a call option listedas an IBM Aug 2001 115 Call @ 73/4 would give the purchaser the right to buy 100shares of IBM (the underlying asset) at the strike price of $115 per share until theexpiration date of the close of business on the third Friday in August 2001. To acquire this right, an investor would pay a premium of $775 (73/4 × 100 shares = $775)for each call option.Call buyers have unlimited potential to profit from a rise in theprice of an underlying stock; but unlike long stock positions,risk is limited to the premium paid for the option.
Since calls can be purchased at a fraction of the price of buying stock, it is aneconomical way to leverage trading capital in order to participate in market movement without the need for margin. Call options are wasting assets, though, and theirvalue declines as they approach expiration. As they get closer to their expirationdate, the time decay accelerates (see Figure 5.3). This is one of the main reasonspeople lose money on options: they buy them too close to the expiration date, thinking they are cheap and end up getting clobbered.
Figure 5.3
Option Time Decay
134
THE VERSATILITY OF OPTIONSOptions lose the majority of their time valuein the last 30 days before expiration.
Depending on the mood of the market, you may choose to buy (go long) or sell(go short) a call option. The premium of the long call option will show up as a debitin your trading account and is the maximum loss you risk by purchasing the call. Incontrast, the maximum profit of a long call option is unlimited depending on howhigh the underlying instrument rises in price (the upside) above the strike price. Asthe underlying stock rises, the long call increases in value because it gives the optionholder the right to buy the underlying stock at its lower strike price. That’s why youwant to go long a call option on a stock or an index during a rising or bull market.If you choose to buy a call option, you are purchasing the rightto buy the underlying instrument at a specified strikeprice until the third Friday of the expiration month.
If you choose to sell or go short a call option, you are selling the right to buy theunderlying stock at a specific strike price until the third Friday of the expirationmonth. This is called writing an option. The short call strategy should be applied inbearish markets. The call’s premium is the maximum profit available on the position and shows up as a credit in your trading account. The maximum loss, however,is unlimited depending on how high the price of the underlying stock rises to theupside beyond the call’s strike price.If the underlying stock rises above a call’s strike price, the call buyer then has theright to exercise the option. If this happens, the call seller is obligated to deliver 100shares of the underlying stock at the call’s strike price to the option buyer. The option seller still gets to keep the premium received from the short call, which canthen be used to hedge the loss on having to buy the underlying stock at a higherprice to fulfill this obligation. This can be quite expensive, which is why I neverrecommend selling unprotected or naked options. However, experienced traderswho choose to short call options do so in a stable or bear market, because theoretically the call has little chance of being exercised unless a dramatic reversal occurs.Theoretically, the call buyer could exercise the call even if the stock price is belowthe strike price, but that doesn’t make any economic sense and is therefore extremely unlikely.
Long Call ExampleThere are many ways to take advantage of a bullish (rising) market. The simpleststrategy is to buy shares of stock and sell them when the price rises, pocketing thedifference. But even if you buy the shares using a margin account, buying stockmay require a substantial amount of money. Based on the rules of the Securities andExchange Commission (SEC), if you want to purchase stock, margin equals 50% of
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the amount of the trade. For example, if 100 shares of IBM cost a total of $10,000,then you are required to have a minimum of $5,000 on deposit in your margin account. At this rate, margin accounts give traders 2 for 1 buying leverage. If the priceof the stock rises, then everyone wins. If the price of the stock falls below 75% ofthe total value of the investment, the trader receives a margin call from the brokerrequesting additional funds to be placed in the margin account.Instead of buying stock, you may want to consider buying a call option in orderto participate in the bullish movement of a stock with limited downside risk. Along call strategy has many advantages over buying stock. First of all, the premiumof an option is significantly lower than the amount required to purchase a stock.Since the maximum risk on a long call strategy is equal to the premium paid for theoption, buying a call is a limited risk strategy—you know exactly how muchmoney you could potentially lose before entering the trade. Less initial investmentalso means that you can leverage your money a great deal more than the 2 for 1leverage buying stock on margin offers. Perhaps the only drawback is that optionshave a limited time until they expire. But even this disadvantage can be seen as anadvantage if you consider the opportunity cost of waiting months and sometimesyears for a stock that has taken a bearish turn to reverse its direction. A long call isa low-risk strategy that takes advantage of a bullish-performing stock without risking a lot of money.To illustrate the dynamics of a long call trade versus a long stock position, let’screate an example using a fictitious stock with a symbol of XYX. On August 1,XYX is trading at $68 per share. Buying 100 shares would therefore cost a total of$6,800 from a cash account or $3,400 using a margin account. Now, let’s see whatkind of positions we can find using call options. All long call positions offer an unlimited profit potential, and the maximum risk is limited to the price of the premium. In addition, it is very important to calculate the price the underlying stockmust reach for the option position to break even. Figure 5.4 shows various call option premiums for XYX at different strike prices and expirations.For a long call position, the more time an option has until expiration, the betterchance the position has of becoming profitable. Therefore, let’s eliminate the August and September calls from consideration and concentrate on the October andJanuary calls. The calls with strike prices less than 68 are in-the-money and there-
Call Strike Prices and Premiums for XYX @ 68Call Strike Price
August
September
October
January
5560657075
13 3/483/453/427/8
141/21065/8421/8
15 3/8111/281/851/235/8
17 3/4143/4121/891/271/2
Figure 5.4
Call Options and Premiums
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THE VERSATILITY OF OPTIONS
fore come with a higher premium. Since we are hoping to profit from a rise in theprice of XYX, it is important to keep the upside breakeven as low as possible.Let’s take a look at a couple of examples using October and January 65 and 70 calls.Figure 5.5 shows the maximum risk and breakevens for these four long calls. Each option offers its own unique advantages and disadvantages. The October 65 call has thelowest breakeven, but you can lose $812.50 if XYX doesn’t rise above 731/8 by thethird Friday of October. The October 70 call offers a slightly higher breakeven, butwith a lower risk. The January options cost more and have higher breakevens, but theyprovide more time for the option to ripen. Any of these options could conceivably harvest a healthy profit in the event that XYX makes a move to the upside. Since limitingrisk is the name of the game, let’s track the October 70 Call @ 51/2.A month later, let’s say XYX rises 101/2 points to 781/2. There are two ways to takeadvantage of a rise in the price of XYX: exercise or offset. By exercising the October70 call, you will become the owner of 100 shares of XYX at the lower price of $70per share. You can then sell the shares for the current price of $78 per share andpocket the difference of $800. But since you paid $550 for the option, this processreaps only a $250 profit ($800 – $550 = $250). The more profitable technique is tosell the October 70 call for the new premium of 143/4, an increase of 91/4 points. Byselling the October 70 call, you can make a profit of $925 ($1,475 – $550 = $925).Conversely, if you had bought 100 shares of XYX at $68 per share, you wouldhave made a profit of $1,050 (not including commissions) when the stock reached$781/2 per share—an increase of 101/2 points. The profit on the long stock position isslightly higher than the profit on the long call—a big $125. However, the return oninvestment is much higher for the long call position because the initial investmentwas significantly lower than the initial capital needed to buy the stock shares (seeFigure 5.6). Both trades offered profit-making opportunities, but the long call position offered a significantly lower limited risk and the ability to use the rest of theavailable trading capital in other trades. For an initial investment of $3,300, youcould have purchased six call options and made a total profit of $5,550—now, that’sa healthy return.The ability of a call option to be in-the-money by expiration is determinedby the movement of the underlying stock. It is therefore essential to knowhow to analyze stock markets and accurately forecast future priceaction in order to pick the call with the best chance of making aprofit. Understanding market movement is not an easy task.
Call Option
Maximum Risk
Breakeven
October 65October 70January 65January 70
$812.50$550.00$1,212.50$950.00
731/8 (65 + 81/8)751/2 (70 + 51/2)771/8 (65 + 121/8)791/2 (70 + 91/2)
Figure 5.5
Long Call Calculations
RISK PROFILES
137100 Shares of XYX
Oct XYX 70 Call
XYX @ 68 at Trade InitiationPrice per shareMaximum riskBreakeven price
$68$6,800$68
51/2$550751/2
1 Month Later XYX @ 781/2Price per shareProfitReturn on riskFigure 5.6
$781/2$1,05015%
143/4$925168%
Comparison of Long Stock to Long Call Trade
RISK PROFILESAnother way to view the difference between a long stock position and buying a callis to take a look at the risk profiles they present. A risk profile is a graphic representation of the profit/loss of a position in relation to price changes in the underlyingasset. The horizontal numbers at the bottom of the graph read from left to rightshowing the underlying stock’s price. The vertical numbers from top to bottomshow profit and loss. The sloping graph line indicates the theoretical profit and lossof the position at expiration as it corresponds to the price of the underlying stock.By looking at any given market price, you can determine a trade’s correspondingprofit or loss. Risk profiles enable a trader to get a visual feel for the trade’s probability for making a profit. Figures 5.7 and 5.8 provide risk graphs for the long stockand long call examples just discussed. They can help you to visually understandhow the risk differs between a long stock and a long call positions.
Short Call ExampleShorting a call option, or writing an option, can be an extremely risky business. Bywriting a call option, a trader grants someone else the right, but not the obligation,to purchase 100 shares of underlying stock at the option strike price. In exchange,the option writer receives a credit in the amount of the option’s premium. The premium received is the maximum amount of profit that can be made on the short callposition. The risk, however, is unlimited as the price of the underlying stock risesabove the position’s breakeven.Selling a call enables traders to profit from a decrease in the underlying market.If the underlying stock stays below the strike price of the short call until the option’sexpiration, the option expires worthless and the trader gets to keep the credit received. But if the price of the underlying stock rises above the strike price of theshort call before expiration, the call seller’s option has a very good chance of beingassigned to a call buyer. A call buyer (as discussed in the previous section on long
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THE VERSATILITY OF OPTIONS
Figure 5.7
Long Stock Risk Graph
Figure 5.8
Long Call Risk Graph
calls) has the right to buy the underlying asset at the call strike price at any time before expiration by exercising the call. If the call buyer exercises the option, the callis assigned to an option writer who sold an option with the same strike price and expiration date. The option seller then receives notification of assignment and is obligated to deliver 100 shares of the underlying stock to the option buyer at the calloption’s strike price. This entails buying the underlying stock at the higher price anddelivering it to the option buyer at the lower price. The difference between thesetwo prices constitutes the seller’s loss and the buyer’s open position profit.Selling naked calls is not allowed by many brokerages. Others require you to
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have at least $50,000 as a margin deposit. This speaks volumes about just how riskythis strategy can be. However, since a short call is very useful in hedging and combination options strategies, it is important to understand its basic properties.To illustrate the dynamics of a short call option, let’s see what is involved in thesale of 1 September XYX 70 Call @ 4. The key to profiting on a short call is for theunderlying stock to stay below the call strike price so that the option can avoid assignment and expire worthless. Hence, it is best to choose options with less than 45 daystill expiration. An option that expires relatively soon has less time until expiration,and that gives the underlying stock less time to rise above the option’s strike price.Assignment: The decision by an option holder to exercise an option results in anassignment to an option seller. In the case of the assignment of a call, the optionseller must deliver the underlying stock to the option holder at the short call option’s strike price regardless of the current price of the underlying asset. In thecase of assignment of a put, the option seller must buy the underlying stock atthe short put’s option strike price regardless of how low the underlying asset ispriced at that time.Naked option: An option written (sold) without an underlying hedge position.
In this example, the maximum profit is limited to the option’s premium, or $400,which is deposited electronically into your trading account. The breakeven on ashort call position is calculated by adding the premium to the strike price. In this example, the position breaks even when the underlying market rises beyond 74 (70+ 4 = 74). Even if the call is assigned, as long as XYX remains below 74, a smallprofit can be achieved.Let’s take a look at the difference between shorting a call and short selling sharesof stock outright (see Figure 5.9). In a short stock trade, you are borrowing theshares from your brokerage house and selling them at the current price in the hopethat the price will decline (bearish market). You will receive a credit in your accountfor the sales price (minus the commission).The best stock for a short stock trade must be steadily decreasing in price andshow enough liquidity to allow a trader to exit the position when necessary. Sellingstock comes with unlimited risk as the price of the underlying stock rises above theinitial cost of the shares—there is no limit to how much you can lose. In addition, ashort stock position requires at least 11/2 times the total cost of the shares as marginin your account to execute the trade. If the price of the stock starts to rise, you willbe required to post additional margin funds.The main differences between short stock and short call positions are the profitpotentials, and breakevens. The profit on a short stock is limited to the price of thestock as it falls all the way to zero. The profit on a short call is limited to the premium received when the trade is placed. However, the breakeven on a short call isoffset by the premium of the option and is therefore higher than that of a shortstock—the price of the position at trade entry. This relationship can also be exploited by a well-used strategy known as a covered call.
$300[(68 – 65) × 100= $300]
Call expiresworthless
$400
Profit/loss of100 sharesof XYX @ 68
Procedure
Profit/loss of70 calloption
$400
Call expiresworthless
–$200[(68 – 70) × 100= – $200]
Buy sharesback for a loss
XYX @ 70
XYX @ 74
–$400[(68 – 72) × 100 =– $400]
Buy sharesback for a loss–$600[(68 – 74) × 100 =– $600]
Buy shares back for aloss
Profit/Loss of 100 Short Shares of XYX @ 68
XYX @ 72
$200[4 – (72 – 70) × 100= $200]
Call is assigned, sellermust buy 100 shares @72 and deliver tobuyer @ 70
0[4 – (74 – 70) × 100 = 0]
Call is assigned, sellermust buy 100 shares @74 and deliver tobuyer @ 70
Profit/Loss of 1 Short September XYX 70 Call @ 4
Short Stock versus Short Call Comparison
Buy sharesback for a profit
Procedure
Figure 5.9
XYX @ 65
Price of XYXat Expiration
Short Stock versus Short Call
– $600[4 – (80 – 70) × 100 =– $600]
Call is assigned, sellermust buy 100 shares @80 and deliver tobuyer @ 70
–$1,200[(68 – 80) × 100 =– $1,200]
Buy shares back for aloss
XYX @ 80
PUT OPTION BASICS
141
Covered call: A short call position sold as a hedge against a long stock position.
Figure 5.10 shows the risk profile of the short stock position. The risk curvefalls from the upper left-hand corner to the lower right-hand corner—when thestock price falls, you make money; when it rises, you lose money. Figure 5.11shows the risk profile of the short call position. Notice how the line slants upwardfrom right to left providing insight as to its bearish nature. When the underlying
Figure 5.10
Figure 5.11
Short Stock Risk Graph
Short Call Risk Graph
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THE VERSATILITY OF OPTIONS
stock reaches a price of 70, the position’s profit hits a maximum profit of $400.The call’s potential loss continues to increase as the price of the underlying assetrises above the breakeven.
PUT OPTION BASICSA put option gives the buyer the right, but not the obligation, to sell 100 shares of anunderlying stock at a fixed price until the option’s expiration date. Just like call options, put options come in various strike prices with a variety of expiration dates.However, unlike call options, if you are bearish (expect market prices to fall), youmight consider going long a put option. If you were bullish (expect the market torise), you might (theoretically) consider shorting a put option.Buying a put option is a welcome alternative to short selling stock.Although both strategies offer traders the chance to profit from adecrease in a market, only put buying does so with limited risk.
If you choose to buy or go long a put option, you are purchasing the right to sellthe underlying instrument at a specific strike price of your choice until the date ofthe expiration of your choice. The premium of the long put option will show up as adebit in your trading account. The cost of the premium is the maximum loss at riskfrom purchasing a put option. The maximum profit occurs if the stock drops to zero(although this is unlikely to happen). As the underlying stock falls, the long put becomes more valuable because it gives you the right to sell the underlying stock atthe put option’s higher strike price. So instead of incurring a much higher risk byshorting a stock, you reduce your exposure by buying a put.If you choose to sell or go short a put option, you are selling the right to sell theunderlying instrument at a specific strike price from the time the position is established until the expiration date. However, shorting a put option also comes with anobligation to buy 100 shares of the underlying stock if an assigned option holderexercises the option. No matter what, you get to keep the premium paid for theshort put; the premium of the short put will show up as a credit in your trading account. The cost of the premium is the maximum credit you receive by selling a putoption. However, the maximum loss is virtually unlimited; it depends, naturally, onhow low the price of the underlying stock falls. In most cases, you are anticipatingthat the short put option will simply expire before the expiration date, enabling youto keep the premium received. However, if your put option is assigned and exercised, you are obligated to purchase 100 shares of the underlying stock from thebuyer of your put at the option’s strike price. Experienced traders who choose togo short put options do so in a stable or bull market because the put will not be exercised unless the market falls.
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Long Put ExampleIn a long put trade, you are purchasing the right, but not the obligation, to sell theunderlying stock at the put strike price until the option expires. A long put strategyshould be used when you anticipate a fall in the price of the underlying market. Thisstrategy provides unlimited profit potential with limited risk. The most you can loseis the price of the option, regardless of how high the underlying stock rises. Profitoccurs as the price of the underlying stock falls below the breakeven.Buying a put is a limited risk bearish strategy thatcan be used instead of shorting stock.
Let’s create an example of a long put strategy with XYX trading at 69 3/8 using thepremiums in Figure 5.12. Time is one of the more important contributing variables inan option’s premium. Therefore, the further away the expiration date, the higher thepremium. But the cost that time contributes to a put’s premium must be balanced outby the need for sufficient time until expiration. Profit on a long put position dependson the underlying stock moving below the put breakeven. The breakeven on a longput is derived by subtracting the put premium from the option strike price. Hence,the higher the premium, the lower the breakeven, and this means the underlyingstock has to move lower for the long put position to make a profit.Looking at the values in Figure 5.12, which option seems to have the best balance between maximum risk and breakeven? As with most trading decisions, thequestion is subjective at best. It depends on a variety of factors from when the earnings report will be released to interest rates. If you anticipate a big move in the nearfuture, you may want to buy a September 70 Put @ 47/8. The maximum risk on thisposition is $487.50 and the breakeven is 657/8 (see Figure 5.13). If you think youneed more time, you could buy an October XYX 75 call @ 91/8 for a maximum risk$912.50 and a breakeven of 657/8. In this case, a decrease of 31/2 points will start toinitiate a profit and you have more than 60 days for XYX