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Up to this point, we have already gone beyond the theoretical mechanics of options that are usually taught in basic options education. Yet, at the risk of slightly overwhelming you, we decided to give you more rather than less because we wanted to answer all of your questions.
Going forward, however, is where the rubber meets the road and we begin practical applications via the use of examples. The most complicated option strategies available are best taught by starting at the most remedial strategy, buying a call or put, and proceeding to basics spreads.[/ezcol_1half_end]
In the back of the text there is a section on the “Bid-Ask Spread” which outlines some basic guidelines on how much you can often save on having to pay the full retail “ask price” of the stock and/options. In order to get through this material without adding more complexity, we will assume that we can buy or sell the instruments at the “mid-price”.
As an example, let’s use the 205 strike call (as seen in Figure 5.1) where the bid price is $2.80 and the ask price is $2.82. Because the middle of this is $2.81, we will use this price for most of this text.
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Naked Long Call or Put
Figure 5.1, is the option chain for International Business Machines (IBM) which is trading at $201.
Market Going Higher
Suppose that you thought that the market was moving up in the near future and you wanted to profit from your research and insight. At this point there are three different strategies which you are prepared to do:
1. Buy the stock
You know how to buy the stock at the current price of $201 and sell it at a future time when it does advance.
2. Buy a call
Buying a call is a bullish position that is going to be considerably less expensive to get into than buying shares. We will start with this.
3. Sell a put
We know that buying a put is a bearish position and gives the owner the right (but not the obligation) to sell stock. The owner wants the stock to decline, but since you are selling the put you want the stock to advance. Therefore selling a put is a bullish position.
Buying a Call
Choosing Which Call
Instead of buying stock, we can purchase the right to buy stock. But, which call do we buy? The answer will be based on many determining factors:
- Time remaining until expiration
- How much you believe the stock will advance
- The cost of each option compared to one another
- How far the option is in or out-of-the-money
Just Picking One
For now we will just pick the first out-of-the-money call. With the stock at $201, the first call that does NOT have intrinsic value in it will be the 205 strike option which is trading for $2.81.
Stock Moves Up $10
Let’s start out by saying that the stock moves up $10 to $211 after you purchased the right to buy the stock at $205. At expiration we know that the 205 strike call will have an intrinsic value of $6 ($211 stock closing price – 205 strike) when there is no time remaining. Because the call is now worth $6 of real value on expiration, we can determine our profit on the trade that cost us $2.81 to purchase.
$6 ending value – $2.81 cost = $3.19 per share profit
At first this may seem like a minuscule profit considering that the stock ran up $10, and had you purchased shares instead of the call, you would have made $10 per share instead of $3.19. Yet, when you calculate the risk of the trade compared to owning shares, you will likely agree that the call purchase was the better choice.
Let’s examine this deeper for a moment. We know that the stock ran higher by $10. Whether that is a big move for the stock or a small one does not matter at this time. What DOES matter is that if a stock can run up $10, it has the same statistical likelihood of falling $10. This means that the stock could have just as easily fallen $10 instead of moving higher as you needed.
Stock Fell $10
Had you owned the actual shares (instead of the option), you would have lost the $10 per share multiplied by the number of shares you owned. Had you owned 100 shares of stock, you would have lost $1,000 (100 shares X $10 move).
Yet if you owned the call and the stock fell $10, the worst thing that could happen is that the call option would lose money, or it would expire worthless if it fell and did not recover by expiration. Because the MOST you can lose on a call (or put) option is what you paid for it, the loss would be the initial investment of $281 – much less than the loss had you owned actual stock shares.
Buying a Put
Buying a put works the same way as buying a call – exactly the same way. The only difference is that you want the market to go down when buying a put, unless you are buying a put to hedge a stock position (which will be described in another chapter).
Let’s assume that we were tired of getting burned by hoping that IBM was going to move higher only to watch it move lower by $10. You finally throw in the bullish opinion towel and say, “Well, if the market is not going to go up, I am going to bet that it is going down.”
So you have to now select which put you are going to purchase. Like the call option you have many choices to make. You can purchase an at-the-money 200 strike put for $4.08 per share ($408 per contract). You can also look at the 195 put which affords less protection, but costs considerably less at $2.43 per share ($243 per contract). People on limited budgets may choose to go even further out-of-the-money and buy the 190 strike put for $1.42. But how do they stack up to one another?
Put Comparison
We will go into a little more detail than we did with the call since we can build upon the knowledge you have already gained. We will show the first purchased OTM put, as well as several different options that could have been chosen. In addition, we will compare what the option looks like after the stock makes an immediate drop once we buy it and what the option looks like should the stock not fall until expiration.
Stock Moves Immediately
Here we see what the various puts look like should the stock immediately drop $10, from $201 to $191, after we purchase them. When we do this we are assuming that, other than the stock falling, nothing else has changed. In other words the time until expiration has not changed, the volatility has not changed, etc. In the previous chart we see that the ATM (at-the-money) 200 strike has the worst percent return on our investment, and it also has the most risk in terms of initial investment that can be lost.
Note:Prices are estimates based on a $10 down move in the stock from $201 to $191
Moves Down $10 on Expiration
Now let’s compare this to the same options; however, we will only look at their values on expiration day when there is no time value left and the option will either have real value or expire worthless.
Note:Prices are based on the stock falling from $201 to $191 on expiration.
On expiration day, an option that does not have the stock fall through the strike price will expire worthless so the 190 and 185 strike puts will have no value (“ending price” column) when the stock closes at $191.
Usually, the 200 strike put seems like the worst selection after an immediate move down. But in this case, if the stock does not fall until expiration day, the 200 strike put is actually the best selection.
So Which Do You Choose?
This is really a matter of your opinion on the stock, how fast this stock moves, the stock’s volatility, any news that may be approaching, the market trend, etc. We will go into more detail on this later.
How Did You Know?
At this point you may be asking yourself, “When you determined what the ending price of the options would be if the stock immediately fell $10, how did you come up with that number?”
There is a very straightforward and accurate way to guess the ending prices of a stock’s option after a move. The limitations to this method are that we have to assume that the stock will move immediately and no other variables will change. Over time, you will learn the more complicated method of using the greeks to determine the price.
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Estimating Option Prices
There is a very simple and straightforward method for determining what an option will be worth after the stock has moved, and doing so with 1 strike price increments is the most accurate. Because the IBM stock trades in $5 strike price increments, a $10 move is a 2 strike movement.
The process is very straightforward, and though it may confuse you at first, it will become instinctual with minimal practice. And since we have never seen this taught at other educational firms, we doubt that there will be other information out there to assist you in learning this.
How It Works
We know that when the stock is at $201, the 200 strike put is $1 out-of-the-money, and should the stock fall $10 to $191, the put will then be $9 ITM. If you want to know what the option will be trading for when it is $9 in-the-money, all you have to do is determine the price of the put that is currently trading $9 in-the-money. Whatever that $9 in-the-money put is trading for should be VERY close to what your put will trade for when it goes ITM.
Figure 5.9 we see that, when the stock is at $201, the 200 strike put is $1 OTM. Then after the stock drops to $191 that same option is $9 ITM. If you want to know what the 200 strike put will look like when it has moved from $1 out-of-the-money to $9 in-the-money, simply look for the option that is currently $9 ITM.
Look at left side of the Figure 5.9. You can see that, when the stock is at $201 at the start, the option that is currently $9 in-the-money is the 210 strike put. So now all we have to do is see what the 210 strike put is trading for and we know that is roughly what the 200 strike option will be trading for should the stock drop.
All we have to do is move the option two strikes further ITM for a move in a favorable direction. Thus if the market instantly falls $10, then we can say with a fair amount of certainty that the put we purchased for $4.08 will move to $10.25.
Note: Of course this procedure will work in the opposite fashion too – you can guess how much you would lose if the market moved in the wrong direction.
For Example
We showed what would happen if we bought a put and the market went down by $10, causing a situation which is favorable for our long put. Thus we know that a move up, by $5 for example, would be unfavorable and we would lose some money on our bearish position after the bullish move. But how much would we lose?
This is easy to determine.
We know that the option started out trading $1 OTM when the stock was at $201. If the stock runs higher by $5 in the opposite direction we need, then the option is getting further OTM and would eventually be $6 OTM. If you want to know what this option would look like when it is $6 OTM, you just look at the option that is currently $6 OTM by moving 1 strike in the opposite direction.
Again, we know that the starting price is $4.08 per share and the ending price will now be $2.43 per share.
Interpolation
You may now be thinking, “So I know how to guesstimate what an option will be trading at should the stock move by a 1 strike price movement. This makes sense (or sort of, but I will understand it eventually). But what if the stock doesn’t move by a whole strike increment ($5 in this example), and moves only $2 instead?”
This is a great question to which there are two answers: use the greeks (delta and gamma) to calculate what the new price will be, or interpolate.
Interpolation is rather easy. Going back to our put example where the stock went in the wrong direction, we know that the put we purchased moved from $4.08 down to $2.43 as the stock moved up $5, resulting in a loss of $1.65.
Since we know there are $5 strike increments and we are looking for what happens after a $2 move, we can divide this $5 by $2 or by an easier amount of $1 increments.
Two Methods
1. Divide the difference between the price of the movement of the option ($1.65) into 2/5 .
We know that the option started out at $4.08 and fell to $2.43, a difference of $1.65 after a $5 point move. Yet we want to know what will happen if the stock falls $2 – not $5.
This is quite straightforward, though people who haven’t used math since high school won’t care for this method. Simply take two-fifths (2/5 or 40%) of the amount the option loses value ($1.65) and subtract that from the starting price ($4.08).
The math looks as Figure 5.12:
Calculations are easier if you take the amount the option changes after a $5 move ($1.65 in this example) and divide it by $5. Once this is done, simply walk the price of the option down by that amount.
We know that taking $1.65 and dividing it by $5 will give us $0.33. Thus, the option will decrease by $0.33 after each dollar move, or by $0.66 after a $2 move.
Naked Short Call or Put
So far we have focused on buying an option since most new traders do this out of fear and conservativeness. Yet the odds are in favor of option sellers most of the time, or can be used in conjunction with stock to enhance profitability. This will be discussed later.
As stated at the beginning of the text, for every person who buys an option, there is someone who sold it. So when someone feels that buying the 205 strike call is a good deal, someone else believes that selling the call is going to make money. An individual may think that they will make money by paying $2.81 for the right to buy the stock at the $205 strike (because the stock is going to move well above the break-even point of $207.81 {strike + call price}). At the same time, someone else may be selling the call because he feels that the stock won’t move that high.
The Figure 5.14 shows that, so long as the stock does not move above $207.81 when it is currently at $201, the seller of the call makes money. If the stock closes at $205 or lower, then the seller of the call keeps the full amount of the sale on expiration.
Review of Naked Option
We have combined the four charts of a long call, short call, long put, and short put so that you can make a comparison in Figure 5.15
So far you have seen how you can make (or lose) money when buying a call or a put with no protection. In many cases, this can be much more favorable to owning stock shares themselves. Yet, this can also be a very risky trade when compared to other strategies.
Naked Long (or short) Option Trade Execution
Once you have found an option that you would like to purchase (or sell short), it is time to place the trade. There are two ways to do this:
- Online execution using an online trading platform that your broker has built to facilitate trading electronically.
- Calling the order in via the telephone.
Both ways work decently, but almost all stock and option transactions are now done through online electronic execution. Electronic execution is faster, (usually) cheaper, gives the trader more information, and allows the trader to time the trade to the exact instant he would like to enter the order.
Since each brokerage firm has their own custom designed trading platform built to what they believe makes the trading a user friendly experience, platforms differ in ergonomics, ease of inputting data, the amount of data, and speed of execution. Who you use is not as important as your comfort and happiness with the trading platform and services being offered.
Figure 5.17 is an example of the general feel most online trade execution platforms possess. Though each platform will differ slightly, you can generally expect to see something similar to this.
