Option Basics

In the context of reintroducing option related strategies here at Evil Speculator I find it important that we establish a baseline of fundamental option related concepts for everyone. Perhaps you’ve never traded options before or maybe you’re just a bit rusty and could use a refresher. So let’s start with the very basics:

What Is An Option And What Does It Do?

So basically the stock, index or future that you buy the option for is known as the underlying instrument asset. Options are bought and sold to take advantage of price movements in the underlying. There are several benefits to buying stock or index options for example as opposed to buying the underlying outright. For one options are relatively inexpensive, particularly when compared to the cost of the underlying instrument. Right now today as I’m typing this you or I can buy 100 shares of the Spiders for roughly $206 per share. That means buying 100 shares of SPY will set you back a princely $20,600 plus commission.

Affordability

Instead of doing that you could just buy an option instead and control the same 100 shares for a fraction of the price. The SPY June option trading at-the-money (ATM) at the 206 strike price right now runs about 5.16 points. So by purchasing one single option you spend only $516 plus commission instead of over $25k to control 100 shares of the Spiders. However keep in mind that you are not buying the Spiders, you are merely leasing their profit potential for a given amount of time. And that privilege expires the very same day your option does.

Flexibility

The second reason to buy options is because they are very flexible. By purchasing a put you can easily profit from options even if the stock goes down. And doing that is a lot easier/quicker than borrowing and selling shares in order to establish a short position, which also is a potentially very risky proposition if Yellen for some reason once more surprises the market with even more dovish monetary policies.

Limited Risk

The third advantage to buying an option is that you can never ever lose more than what you paid for that option – period. Your maximum risk exposure is clearly defined and represents the premium you paid when you purchased your option. This does not mean that there is no risk in trading options at all. If you are writing (i.e. selling) naked options then you are in fact assuming unlimited risk, which is why I strongly advice anyone against doing that. For mere mortals like us writing options is tantamount to picking up pennies in front of a steamroller. It works fine for a long time until you accidentally trip one day and watch your account being flattened in mere moments. So leave selling options to the professionals – you’ll sleep a lot better knowing that are not risking your entire account over one open position.

Leverage

The fourth benefit to buying options is that they offer a lot of leverage. Should the Spiders continue to appreciate then my measly $516 could easily multiply by a factor of two or more. But beyond mere profit potential there is a more subtle advantage to option leverage that many retail traders have a hard time grasping – position sizing. On the futures or forex side for instance I rarely devote more than 1% of my account principal to one single position. As a matter of fact we employ risk calculators for both forex and the futures to ensure that our campaign’s stops limit us to as close to the desired R size as possible. The concept of R is explained here and I strongly suggest you understand absorb it before reading on.

Position Sizing

The fifth benefit to trading options is more subtle and one many retail traders are blissfully unaware of. When buying or selling shares of a stock I am facing a liquidity problem. Stock is commonly traded in blocks of 100, so if I want to buy 100 shares of IBM at $50 then I will need to devote $5,000 of my assets for that position. Of course that $5,000 does only theoretically represent my full risk. In my time as a trader I have seen stock shares drop all the way to zero, but outside of 6 sigma events my stop loss is hopefully going to kick in way before that. But the main issue that remains is that of availability of trading assets. I may only have $50k in my account and that means that a full 10% of my assets will now be locked into one single position. That affects my ability to devote funds to other campaigns and also implicitly impairs my ability to diversify across various asset classes or markets.

The Case Against Naked Options

So clearly there are many good reasons for buying an option, however there also some against it. As you already learned options are a wasting assets, which means that from the day you buy one it will slowly lose some of its time value until expiration. Time value is represented by theta – one of the famed option greeks.

Now the option’s time value is equal to its premium (i.e. the cost of the option) minus its intrinsic value which is the difference between the strike price and the price of the underlying instrument. I just glanced at the option chains and the Spiders are currently selling for 216.31 which that means my 216 June option I mentioned above at $516 has an intrinsic value of exactly 0.31 points or 31 Dollars! If I deduct that from the full premium of $516 I arrive at $485 and that, as you probably guessed it, is the time (or extrinsic) value of my option. The further price moves above my call’s strike price the higher the option’s intrinsic value and the lower its time value.

As a rough guide – the maximum time value of an option is when it’s trading ATM, above and below its option chain time value gradually decreases each strike. The more time that remains until expiration, the greater the time value of the option.Time value decreases over time, eventually decaying to zero at expiration, a phenomenon known as time decay. This is because traders are willing to pay a higher premium for more time since the contract will have longer to become profitable due to a favorable move in the underlying.

Now loss of time value is the main reason why a significant number of options expire worthless. Here are some recent statistics I lifted off of the CBOE:

• 10% of option contracts are exercised.
• 55% – 60% of option contracts are closed out prior to expiration.
• 30% – 35% of option contracts expire worthless.

Now that’s quite a lot less than some people claim but if you look beneath the numbers you must also recognize the fact that many people buy options not just for speculation but for protection/hedging. If you’re holding 100,000 shares of IBM then buying 1000 puts to ahead of an anticipated volatile move makes complete sense. And that put can easily be sold again a day or two later once markets have quiet down a little again. It will have lost a bit of time value but that’s a small price to pay for downside insurance. [caveat: selling your puts into falling vega (i.e. volatility) may cost you a pretty penny and we’ll be covering that in the future in some detail.]

Some people actually speculate doing the inverse – they may sell 1000 calls against their 100,000 shares which is called writing a covered call. It’s not something I do but investors often use it for generating a bit of extra income. It’s basically a way of locking in your existing profits, but we’ll cover that another time.

Option Strategies

Now the reason why I mentioned the statistics above is that there is another way to trade options which has better much odds but retains our ability to limit our risk. And that, as you may have guessed already, is via the trading option strategies, which involves the simultaneous buying and/or selling of one or more options.

Options strategies not only allow you to profit from bullish or bearish price swings, but they also enable you to profit in sideways tape. One way of doing that is in leveraging volatility – expressed as Vega in our options greeks. Neutral strategies can be further be classified into those which are bullish on volatility and those that are bearish on volatility. Traders can also profit off time decay when the stock market have low volatility as well usually measured by the greek called Theta.

Option strategies is where the real fun begins but in order to use them effectively it is important that we understand them thoroughly in order to anticipate the impact of market moves on our profitability as well as our risk exposure. We will be covering that in much detail in further installments of this series.

So I hope to catch you next time when we’ll dive right into the most basic option strategies, the Bull Call Spread and the Bear Put Spread.