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Visual Guide to Options by Jared Levy
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Jared A. Levy
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Library of Congress Cataloging-in-Publication Data:
Levy, Jared, 1976
Visual guide to options/Jared A. Levy.
p. cm. — (Bloomberg press series)
Includes index.
ISBN 978-1-118-19666-3 (pbk.); 978-1-118-22774-9 (ebk); 978-1-118-26531-4 (ebk); 978-1-118-24062-5 (ebk)
1. Options (Finance). I. Title.
HG6024.A3L484 2013
332.64’ 53—dc23
2012030699
Don’t Be Afraid to Take Risks
Load the ship and set out. No one knows for certain whether the vessel will sink or reach the harbor. Cautious people say, “I’ll do nothing until I can be sure.” Merchants know better. If you do nothing, you lose. Don’t be one of those merchants who won’t risk the ocean.
—Rumi
Think Outside the Box
… a new type of thinking is essential if mankind is to survive and move toward higher levels.
—Albert Einstein
Be Prepared
If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle.
—Sun Tzu
Ask Questions
A wise man can learn more from a foolish question than a fool can learn from a wise answer.
—Bruce Lee
Don’t Give Up
The world ain’t all sunshine and rainbows. It’s a very mean and nasty place and I don’t care how tough you are it will beat you to your knees and keep you there permanently if you let it. You, me, or nobody is gonna hit as hard as life. But it ain’t about how hard ya hit. It’s about how hard you can get hit and keep moving forward; how much you can take and keep moving forward. That’s how winning is done!
—Rocky
How to Use This Book
Acknowledgments
Introduction
Chapter 1: The World of Options
Chapter 2: Tools and Knowledge for Trading Options Professionally
Chapter 3: Visualizing the Greeks
Chapter 4: Visualizing Basic Strategies: Trading Calls and Puts
Chapter 5: Visualizing and Trading Vertical Spreads
Chapter 6: Visualizing and Trading Butterflies, Condors, and Complex Spreads
Chapter 7: Managing Your Risk: Tactics, Tips, and Volatility Tricks
Appendix: Bloomberg Functionality Cheat Sheet
About the Author
Index
The Visual Guide series is meant to serve as the all-encompassing, yet easy-to-follow, guide on today’s most relevant finance and trading topics. The content truly lives up to the series name by being highly visual; all charts are in color and presented in a large format for ease of use and readability. Other strong visual attributes include consistent elements that function as additional learning aids for the reader:
Key Points: Primary ideas and takeaways, designed to help the reader skim through definitions and text.
Definitions: Terminology and technical concepts that arise in the discussion.
Step-by-Step: Tutorials designed to ensure that readers understand and can execute each section of a multiphase process.
Do It Yourself: Worksheets, formulas, and calculations.
Bloomberg Functionality Cheat Sheet: For Bloomberg terminal users, a back-of-the-book summary of relevant functions for the topics and tools discussed.
For e-reader users, the Visual Guide series is available as an enhanced e-book and offers special features, like an interactive Test Yourself section where readers can test their newly honed knowledge and skills. The enhanced e-book version also includes video tutorials and special pop-up features. It can be purchased wherever e-books are sold.
Nothing truly meaningful in life is created or even possible if not for the trials and tribulations that shape us as humans.
I’m most gracious to life’s mountains that have stood before me, challenged me, and ultimately given me a chance to get a better view of the beautiful existence I have been fortunate enough to live.
Thank you.
My goal for this guide is to allow you to open to just about any point in the book and find a useful tip, method, or actionable idea that you can apply immediately, without having to go back and read too far.
Most of us believe we are free thinkers, but it’s important to realize that on some level, information flows into our minds through filters or biased channels. The specific publications you read or websites you browse dictate your information sources. As you structure your investment thesis and strategy, don’t ever be afraid to break your normal pattern and look for alternative methods of gathering information, statistics, and strategy.
Depending on your particular exposure or experience with trading options, you are going to have preconceived notions about how useful they are to you. Even if you have been an extremely successful options trader, keep your mind open to looking at the option markets and their risk in a different way. The ideas, techniques, and processes in this book are not the only solution, but they have worked for me for many years and may make a good addition to your existing repertoire. No one has “the secret sauce”; you simply need a viable action plan and a sound risk and psychological management system.
Although there is no perfect way to trade options, there are many wrong ways to do it. I learned some valuable (and costly) lessons along the way; I hope to show you where I screwed it up so that you can avoid the major pitfalls of bad options trading.
This book expands on the focus of my first book, Your Options Handbook, and details more of the nuanced techniques and analysis that professionals use to get an edge on the market. The goal of this text is to help you to truly understand risk, order flow, and volume as well as execution and strategy.
Even with Bloomberg being one of the best information sources out there, don’t be discouraged if you don’t have access to a terminal. The bulk of strategies, tools, and techniques contained in these pages can be utilized and applied in many forms.
Also realize that this book couldn’t possibly contain every single thing you need to know about options, so if you have a question or if you don’t feel completely comfortable with a concept or strategy, be sure to research it further and ask questions! I am available at www.jaredlevy.com if you need a helping hand or if you are looking for further depth on a subject.
There are infinite ways that options can be utilized in your investment portfolio. Whether you are an individual writing covered calls on 200 shares of IBM, a hedge fund manager with billions in assets that need to be protected against volatility or “tail risk,” or anywhere in between, there is a place for options in your account, period.
To get the most from the options markets, it is best to fully understand the underlying securities from which they are valued and then take on the options themselves. The trends, abnormalities, and patterns that emerge in the options markets get their cues from their underlying security. Because of this, you must never look at an option (strategy) in a vacuum.
When I was trading on the floor, I tended to end my trading day delta-neutral—or not having a “directional bet”—going into the next morning. Market makers, like I was, have to deal with a constant flow of orders without preparation. By ending delta-neutral the previous day, I could reset and remain flexible in my strategy.
Option traders tend to have an “if, then” attitude because of our ability to be elastic with our hypothesis and adjust positions as events, news, and data change. This mind-set is usually in stark contrast to a regular stock trader, who needs to be more rigid in predictions and theses. I certainly prefer the flexibility options offer, because I still have yet to meet a person who knows exactly where a stock is going, not to mention that I always like contingency plans. As an option trader you always have the choice of getting or giving odds depending on the situation.
Options traders can use certain strategies to take a neutral position in a stock or can employ protective tactics to increase their probability of becoming profitable, even on the fly.
As a professional with a trained eye I can look at an option chain on just about any security and surmise a general hypothesis about the condition of the stock; but I am learning more and more that it’s actually easier—and more profitable in the long run—to make sense of the nuances of the underlying detail first and use the options markets as your microscope and scalpel as opposed to your looking glass.
But we all get that wild streak from time to time. I remember looking at Apple’s upside call skew in early 2011 (see Exhibit 1.1) and thinking that it might be a good idea to sell some out-of-the-money call spreads because they were so expensive. Little did I know that they had planned a conference call to announce a special dividend and the stock started screaming higher (those calls were pricey for a reason), putting me in an uncomfortable spot; always take time to do your homework!
Exhibit 1.1
I believe that the most effective method of trading starts with a checklist or filter of sorts that gets you to a specific quantitative, objective target on which you can add your subjective twist. Start from the outside (macro) and work inward (details of a stock’s fundamentals and technicals).
Optimally, your checklist should consist of fundamental, technical, and statistical parameters that narrow your potential candidates to a manageable field. Bloomberg’s OSRCH screen is a quick and dirty way to cut through some of the basic fundamental, technical, and statistical noise that exists. Once the noise is out of the way, you can more effectively review only the top contenders without wasting too much time on research and missing your timing.
There are many ways of finding candidates. Running scans and filters at different times will help you to screen for stocks that meet certain criteria. Another method I favor is to form a thesis around a general social, technological, political, or global trend and find the stocks that stand to benefit (or falter) from it. Form a timeline and potential path in your head of how you think these events will unfold and then overlay an option strategy on top of that thesis.
In addition to all this, when you are forming a forward thesis, consider the effects of news, earnings, macroeconomic climate, seasonal effects, and even political developments. I can’t stress this enough! The emotional waves of the masses often override corporate fundamentals and technical formations at least in the short term. Don’t get stuck with blinders on in your own bullish or bearish mind. It’s the worst place to be.
In the longer term, earnings strength and a viable, thriving business structure with a popular good or service is what I believe motivates the markets. Most analysts, especially those using the Discounted Cash Flow (DCF) methodology and the like, agree.
The core of the options universe revolves around volatility and time. Many of the strategies, techniques, and methods I cover in this book are related to volatility/time in some form or fashion. You must understand both the volatility of the stock and the volatility of the option or spread that you are trading. An intimate knowledge of volatility in the underlying asset and subsequent manifestation in the derivative is essential to generating consistent profits and becoming a professional trader.
The checklist is a major step in preventing mistakes and overlooking key information. It also helps with trade consistency and keeps scatterbrains like me focused.
We explore volatility in detail in Chapter 7 and reference it throughout this book. You also see the Bloomberg screens used to analyze it. At the end of the day, everything comes back to volatility; make its comprehension your number one priority. Just when you think you get it, you are just getting started.
The volatility conundrum haunts every good option trader. It is a question that cannot be solved, at least not fully. But you can make “realistic assumptions” about it and often that is good enough.
If you get what I am saying then you probably have some experience under your belt; if you do not, then you have a long journey ahead of you—take it slow.
Exhibit 1.2 shows the growth of puts and calls separately over the last 20 years (calls in yellow).
Options traders are growing in record numbers. Their cumulative experience and growing selection of strategies continue to increase liquidity and flexibility in the option markets, which is beneficial for all of us. See Exhibit 1.3 for totals in annual options volume. It is also the reason why indicators such as the Chicago Board Options Exchange (CBOE) put-call ratio are becoming antiquated and obsolete. I discuss this later.
Don’t be a sucker—learn as much as you can before taking big risks in the option markets.
Exhibit 1.2
Thales of Miletus used options to lock in a low and set price for olive presses ahead of Greek harvests back in 600 BC. In the 1600s, the Dojima Rice exchange, which started on the front lawn of Yodoya Keian, arguably became the world’s first futures exchange.
Even though options in some form or fashion have been around for thousands of years, the modern standardized world of options came about in 1973 when the Chicago Board of Trade (CBOT) gave birth to the CBOE. The CBOE became home to the first equity and index exchange in the United States.
Exhibit 1.3
This was about the time the Black-Scholes model was created as a means of calculating options prices using standardized, measurable, objective integers as opposed to random price quotes that often favored the dealer, not the customer.
Prior to that, the option market was fragmented and if you wanted to buy or sell an option, you went directly to a dealer as opposed to everyone meeting on the exchange to create the most efficient price. Because of this fragmentation, there were major price discrepancies.
You see, without a standard formula there was no accurate way to price an option anyway. It was simply a random price driven market, with little rationale as to the correct price to buy or sell.
When you think about it, the underlying asset has its own set of random forces pushing and pulling on the price. Quantifying and finding a price to buy or sell an asset is hard enough. For a derivative to have no structure, you simply end up magnifying variables and making things more complicated and random.
The underlying securities themselves can also be flawed; think back to the Credit Default Swap (CDS) or Mortgage Backed Securities (MBS) vehicles.
Dealers (called Bucket Shops) would publish static quotes with not only wide bid-ask spreads, but prices that sometimes made no sense compared with today’s pricing systems and models. This is where volatility and time come into play, but back then it didn’t matter because not many people understood this. These shops operated more like horse tracks than financial firms. The dealers had a good idea about what the options were really worth and would “handicap” the prices (odds) many times in their favor. Sure people won some money from time to time, but the dealers were in control.
Jesse Livermore (Reminiscences of a Stock Operator, 1923) made a killing with options because he had the uncommon knowledge about how to derive their value. Perhaps he had a knack for knowing which way the market was moving, too, because the Bucket Shops banned him when he won so much money; he was certainly the exception.
Exhibit 1.4 shows the early twentieth century, which was no doubt the dark ages of the option markets.
But even in the early 1970s, trading and quote technology was still in its infancy. Quotes for options and commodity prices were updates on chalkboards such as the one you see in Exhibit 1.5 in 1971 at the CBOT.
Option prices were still slow to update and the markets were wide and illiquid in many cases.
Fast-forward 40 years and the technology has advanced by an order of magnitude that even Gordon E. Moore could have never imagined. The advantage now lies in knowing behavior and strategy, and having the ability to analyze and execute quickly and efficiently. These tools are at everyone’s disposal.
These strengths can lie in the hands of anyone working from just about anywhere in the world. As a “market taker” (which is what most of you are) you may not get certain small perks that a “market maker” (MM) gets in terms of leverage and rebates on short stock positions, but you are at parity, if not advantaged in comparison. Trust me. (I will explain why, showing how being an MM can leave you exposed to smart money.)
Because options are traded separately from their underliers, there is no need to have both the stock and option trade at the same place or even on the same exchange. Like stocks, options trade on several exchanges, which are somewhat linked together when it comes to disseminating prices.
This can be good and bad when it comes to getting executions in the options that you trade.
One detriment is that exchanges do not share orders with one another! If you send an order to buy calls on the Philadelphia Stock Exchange (PHLX) they are not going to be filled at the International Stock Exchange (ISE) unless PHLX sends the order away. The exchanges do, however, have rules that help ensure the best pricing for the customer. If one exchange is priced better than another, the exchange with the order needs to either fill it at the better price or send it away! See Exhibit 1.6.
Exhibit 1.4
One of the biggest “problems” with completely electronic exchanges is the handling of spread orders. When you send a two-, three-, four- or more legged spread to a certain exchange, it may not be represented in the best way possible to market participants as it would be in a physical crowd. Exchanges like the ISE disseminate data as quickly as possible and market markers use different types of software interfaces to see and trade on that data.
In other words, if you are trying to buy an iron condor that has a market of $1 to $2 and you are bidding $1.80, your order may not be filled, even though it should be. Sometimes you may even bid the full $2 and not see your order filled on the spot, because of the varying prices of each individual option and the way the orders are presented to market makers. In theory, as technology improves so does execution speed and efficiency, but highly efficient markets also mean that the market makers are less willing to make errors themselves or stick their necks out just to get an order completed. So be wary when using AON (all or none) orders or if you need to get into or out of a position in between the markets. There is nothing worse than a partial fill where you tried to save a couple of pennies, but end up losing thousands. It has happened to me many times, trust me.
Exhibit 1.5
Source: Pat Arnow Photography, arnow.org.
Exhibit 1.6
When it comes to executing spreads effectively, there are three things you need:
An understanding of the theoretical value and risk of the options themselves.
The ability to watch the underlying instrument’s price change.
An understanding of how various changes in market conditions are affecting your spread’s value (skew, option pricing model, etc.).
These three things are an integral part of being an effective order execution trader. It can also save you money and reduce risk. See Exhibit 1.7.
Exhibit 1.7
At the end of the twentieth century, the options markets began to change again with the introduction of multiple listings, where a company’s options were now listed on more than one exchange. This enabled investors to trade options just about anywhere they wanted. But more important, this created competition among exchanges to earn business through cheaper transaction prices and tighter bid-ask spreads.
Initially, it was a war over technology and liquidity—who could provide the fastest, most liquid markets with the best price. Exchanges were sometimes paying to have orders routed through their systems. Even today, there are still multiple exchanges trading and flourishing, although many exchanges have either closed for good or have changed the way they conduct business to keep up with the times. There are currently eight exchanges where options can be traded, all of which are fighting for your business. The days of the pit trader (my former profession) are numbered, if not already gone entirely.
Higher volume and concentrated order flow naturally improves prices, so I would expect further consolidation within the exchanges to the extent that the Securities and Exchange Commission (SEC) and other regulatory bodies will allow.
There are agreements that some brokers have with certain exchanges to send them order flow, which may or may not be to your advantage. There is little you need to do as a retail trader to most efficiently execute your orders. As a professional, you may develop relationships with certain exchanges or even specialists to get your orders executed efficiently and at the best price.
Bloomberg has a platform (as do some brokers) that allows you to “shop” off floor liquidity providers for options and spreads if you trade in size. This may help you to execute large trades at one price.
List of Exchanges and Their Acronyms
| AMEX | American Stock Exchange, housed on the NYSE |
| BOX | Boston Stock Exchange |
| CBOE | Chicago Board Options Exchange |
| ISE | International Stock Exchange |
| BATS | BATS Exchange founded in June 2005 as an ECN (electronic communication network) |
| PCST | Pacific Coast Stock Exchange, absorbed by NYSE (see Exhibit 1.8) |
| PHLX | Philadelphia Stock Exchange, part of Nasdaq OMX |
| NASDAQ OMX | Nasdaq Options Market |
As a general rule, your broker will typically route your order to the best-priced exchange, or that exchange will match the best price.
Each of the exchanges disseminates quotes dynamically throughout the day, which are determined both electronically and via open outcry.
Note that some exchanges may have higher bids or lower offers with more or less size (number of contracts). This means that they may be better buyers or sellers at any given moment or that you are seeing standing customer limit orders. This again may also be related to different market maker positions. If the bid or offer size tends to follow the price, it’s most likely a market maker leaning one way or the other. If the size of the market doesn’t move when the price moves, you may have a standing order on the specialist’s books.
Exhibit 1.8
While the option is trading, you have the right to buy or sell it as long as you have the money.
A stock that trades more than 1 million shares a day on average and is a member of the S&P 500 will generally have ample liquidity for you to get into and out of positions up to 50 contracts fairly easily. But there are still many thinly traded securities that you will struggle with to get executed. If you notice bid-ask spreads of $1 or more on a stock that is $50 or less and the stock has volume less than 750,000 shares traded on average a day, it might be best to avoid that all together. See Exhibit 1.9.
Listed options contracts are standardized. If you are buying or selling an option, the Options Clearing Corporation ensures that your counterparty will perform its obligations.
The OCC, along with clearinghouses like Goldman Sachs and even the Chicago Mercantile Exchange (which is both an exchange and a clearinghouse), reduce counterparty risk in options trading.
So if you buy a call and the stock goes up $100, that contract will still be good for sale even though the seller who originally did the trade with you may be in some serious financial pain. Understand that you will seldom be buying an option from and selling it back to the same person; the fluid markets move money around quite efficiently.
Exhibit 1.9
If you buy a put and the stock drops to a nickel from $100, the person who originally sold you that put may have bought it back from someone else when the stock started to drop, or that original trader was short stock and was selling puts to collect some extra income. The bottom line is that as long as the stock is still trading on a major exchange, the options should be trading as well, which means that you can enter or exit your position as you see fit. I will get into what happens during expiration later, because there are nuances to each and every strategy and security that can help or harm you if you don’t know them.
Employee stock options, which you may hear about in the news or even receive from the company you work for, are call options that are not traded on an exchange. There are some similarities, but generally speaking stock options given by a company are illiquid and not tradable or standardized like the equity options listed on exchanges. They can be turned into stock and dilute the outstanding shares of a company.
There are only two types of options: puts and calls. All the spreads and strategies that have ever been created are simply combinations of one, two, or more of these options.
You must thoroughly understand the basic fundamentals, behavioral characteristics, and laws surrounding both types of options. In a perfect world, I would not bend on this. I know that many newbies just learn calls or puts enough to either be dangerous to themselves or slightly successful, but you are doing yourself a great disservice if you don’t understand all the basics of both types.
That includes risk, Greeks, direction, margin requirements, behavior, credit versus debit, and their general behavior in the marketplace.
There are five basic components that make up an options price:
Stock price
Strike price
Interest rate
Dividend
Implied volatility
From these inputs, we can determine an option’s theoretical value at any point in time on any security.
The OVME screen allows you to synthetically value any option on any security by plugging in the factors above.
In a more advanced scenario, this screen can be used to simulate different market changes (like dividends, stock price and volatility) and monetary factors influencing your trade over time, such as changing interest rates. You can also analyze more complicated spreads, which I discuss in later chapters.
In later chapters I also discuss the Greeks, forward prices, different pricing models, and volatility, which all play a role in finding the theoretical value of an option. Many times they can explain any abnormalities you may find when comparing calls and puts in the same class or series.
Here you can see how these factors influence option prices.
Let’s take a look at the basics of pricing, trading, and execution in a real-life scenario. (See Exhibit 1.10.)
The Options Monitor (OMON) is easiest way to view option prices on any option-able security. This screen can be fully customized, so you can view a plethora of data points and measurements. I prefer to keep it limited to the following fields in the option chains (see Exhibit 1.11):
Strike
Bid
Ask
Mark
Theoretical val
Implied vol (theoretical change)
Delta
Gamma
Theta
Vega
Exhibit 1.10
You can also see the basic pricing and analysis I need to begin my study. If I were to buy the IBM December 180 calls, what price would I have to pay? How many contracts could I theoretically buy at that price? What exchange would I get executed on? Who would route my order to the proper exchange?
Make sure that you can answer these questions before moving on!
Remember that puts and calls can be bought or sold, just like stocks. But unlike stocks, the bid-ask spread of an option can and often will be fairly wide, with the average spread coming in around 10 cents ($0.10) or so. High volume, low volatility, and lower priced stocks will generally have tight bid-ask spreads and thinly traded, high volatility, high price stocks will tend to have options with wide spreads, sometimes greater than $1. See Exhibit 1.12.
Exhibit 1.11
To help pinpoint an option’s theoretical value and get a better sense of the true value of a particular option, Bloomberg offers the ThPx column (“calc” mode), which uses Bloomberg’s pricing models to display the theoretical value of an option. You can use this value to shave the bid-ask spread down while increasing your chances of getting filled on your single option or spread orders.
Exhibit 1.12
Essentially it’s like having an inside look at what the market makers are using to find the value of an option. When you know the “market value” of something you will be able to execute your orders more efficiently and at the best price. It’s almost like knowing what a group of people at an auction are willing to pay for your vehicle. If you know that the crowd will pay $10,000 for it, why would you settle for selling it at $9,700? The option world works the same way. Just because an option has a market of $4 bid to $5 ask, doesn’t mean the theoretical value is always $4.50.
An option “series” denotes options with the same strike and expiration date on a particular security, whereas an option “class” includes all the options, strikes, and expirations on a particular security.
Exhibit 1.13 illustrates some SPX (S&P 500 cash index) calls. Notice the ThPx value for the 1265 call. With a theoretical value, you have a guide from which to price your buy and sell orders without getting left in the dust.
Exhibit 1.13
The “Mark” is not the same at the theoretical value. The Mark is generally the midpoint between the bid-ask, and it is what most brokerages use to calculate your profit/loss at the end of each day.
When you buy (to open) an option (paying a debit), you are said to be long that option and have rights as the owner.
When you sell (to open) an option (collecting a credit), you have a short position on or can be “short that option,” and in that case you have obligations, not rights, and typically higher risk.
The scenario or risk graph illustrates the long call in the OVME screen. See Exhibit 1.14.
A call gives the owner (long-call buyer) the right, but not the obligation, to buy 100 shares of a stock at a specified price on or before a specified date.
As a call buyer you will always be bullish on the stock and may realize a profit if the stock rises in value, but not always.
The breakeven of a long call will almost always be greater than the underlying price because of the time value component.
The scenario or risk graph illustrates the long put in the OVME screen. See Exhibit 1.15.
A put gives the owner (long-put buyer) the right, but not the obligation to sell 100 shares of a stock at a specified price on or before a specified date.
Exhibit 1.14
As a put buyer, you will always be bearish on the stock and may realize a profit if the stock falls in value.
The breakeven of a long put will almost always be less than the underlying price because of the time-value component.
In, At, and Out of the Money
In the money
In the money means that the call or put option has intrinsic or real value. In-the-money calls have a strike price that is less than the current stock price; in-the-money puts have a strike price above the current stock price.
Deeper in-the-money calls (those with a delta of 0.70 or greater) tend to behave more like the stock, mimicking its moves with greater accuracy. (See Exhibit 1.16.)
Deep in-the-money puts (those with a delta of –0.70 to –1) tend to behave more like short stock.
Exhibit 1.15
These options provide you with less leverage and cost more than cheaper, lower-delta options. They are a good choice if you believe that the stock will move higher or lower, but you aren’t anticipating a large fast move in the stock.
They also are the least sensitive to changes in time and implied volatility on a percentage basis compared to at-the-money and out-of-the-money options. In-the-money options are more expensive than at- or out-of-the-money options.
At the money
These options have a strike price that is at or very close to the stock price. Typically the delta of these options is around 0.40 to 0.60 or –0.40 to –0.60 for puts. At-the-money options generally have the most amount of time value relative to other options in the chain.
Because of their high level of time value, at-the-money options have the highest time decay, or theta, and the most sensitivity to volatility changes, or vega, as well as changes in time. They also have the most gamma, meaning that the delta will change faster than in- or out-of-the-money options, especially as you come closer to expiration.
Exhibit 1.16
If you feel volatility is low and you believe that the underlying stock is going to make a very fast, big move, at-the-money options can be considered; however, remember that you will be paying the most time value and losing the most theta with these options, so I do not typically recommend that traders buy options at the money.
Out of the money
Out-of-the-money (OTM) options are the cheapest of the three. OTM calls have a strike price that is higher than the stock price. OTM puts have a strike price that’s lower than the stock price. They are comprised completely of time value with no intrinsic value at all.
Out-of-the-money options do have their place in trading and there are certain times when they are appropriate.
Buying them as a hedge, as part of a spread, or as a bonus for “extra upside” are all rationales for purchasing an OTM option.
Since they are lower in delta, OTM options tend to be less correlated with the movements of the underlying. This means that you will have to pay close attention to all the Greeks, especially time decay (theta), if you are buying them.
If you buy a 0.15 delta call, you have a 15 percent shot, statistically, of that option being worth anything at expiration. Anything is the key word; 0.000001 is something, and the delta is telling us that there is a 15 percent shot that this option will be worth less than zero. It is not very promising if you think about it like that. Out-of-the-money options can be used if you have a very strong belief that the stock will move very far, very fast. It helps to have a price target in mind and buy your call accordingly. In other words, if IBM is currently at $120 and you believe that it will be at $135 in two months, then buying the $130 call for $0.60 might be an option for you. However, remember that it is impossible for any person to predict a stock’s movement with accuracy. Just be sure that your price target is realistic, based not only on the stock’s volatility history, but also on an upcoming catalyst of some sort, especially if you are making a short-term trade. (See Exhibit 1.17.)
The options seller is obligated to fulfill the owner’s rights at the strike price of the option. The strike price is also called the exercise price and for the owner is the price at which the owner can purchase (in the case of a call) or sell (in the case of a put) the underlying security or commodity as long as that option has not expired.
There is no absolute when it comes to selecting a strike price. It will vary with the sentiments and needs of the trader. Every thesis you form, combined with the strategy and time horizon you choose will determine what strike price(s) you select. There is no one right answer.
An argument could be made that option sellers are going to be a bit more cautious when it comes to strike selection because the call seller must sell 100 shares of stock (or other security) at the strike price for every contract that is sold on or sometime before expiration.
Exhibit 1.17
The put seller must buy 100 shares of stock (or other security) at the strike price for every contract that is sold on or sometime before expiration.
Generally speaking, when I sell naked options, or options for which I do not own shares of the underlying stock, I am most likely doing so to establish an improved stock position (long or short) in an underlying that has elevated volatility. To sell an option naked I better damn sure have a good reason and firm thesis that backs up my willingness to take on more risk. I may also choose to sell an option naked if I am offsetting risk from another trade.
I almost always sell options with less than 30 days until expiration to limit exposure and collect theta as quickly as possible. You can examine the theta of different months, but you will learn later that time decay is not linear and what looks one way today might be very different in a week or month from now.
All options (and warrants) have an expiration date and a date at which they stop trading; yes, there is a difference between the two and not all securities expire on the same cycles; check CBOE.com for most equity, index, or exchange-traded fund (ETF) product expirations or talk to your broker.
When you are talking options, a trader might reference a “June” option, which would expire the third Friday of June; if it were an October option then it would cease to exist on the third Friday of October, and so on. When an option expires, it is said to be at “parity,” which is essentially what it is really worth or its intrinsic value.
Standard equity options typically cease trading at 4 p.m. Eastern Time on the third Friday of the month and actually expire Saturday, giving you time as the owner to exercise, or if you are a seller, to be assigned. Talk to your brokers about their process and cutoff times for exercise and assignment, as it can vary.
Cash index options will cease trading at 4:15 p.m. on the third Thursday of the month and expire the following morning. Some index ETFs such as the SPY and QQQ trade until 4:15 p.m. on Friday and expire on Saturday.
On expiration, the option cannot be assigned or exercised. The time between when the option stops trading and when the option expires gives the long option holder time to decide to exercise the option.
The value of an option at expiration is determined by the amount it is “in the money.” If it doesn’t have any intrinsic value it will not be worth anything on expiration, but that does not mean that it cannot be exercised.
In essence, an option’s premium can be broken down into two separate values: intrinsic (parity or real value, related to the price of the underlying stock, index, or ETF), and time (volatility) value. Both of these values make up the total price you pay. The total premium is determined by the five factors we discussed earlier in this chapter.
In every trade you do, from the very basic to the very advanced, you will have to consider the risks of the bid-ask spread as part of your analysis. See Exhibit 1.18.
I like to think of the spread as another commission you have to pay to do business in options. Most traders buy on the ask and sell on the bid, which I think is only appropriate when you must get in at that moment in time.
Spreads are usually wide for a reason. Either the stock is thinly traded, it has a high relative volatility, or it is very expensive ($200 or more).
You can always enter a limit order and get filled in between the market, but this is not a guarantee. Think about it like this: If you are trading a put with a bid-ask spread of $1 (yes, there are many of those out there) and you buy just 10 contracts, you are immediately marked at a $1,000 loss (excluding commission). Psychologically, the loss may be a blow for some traders. Now imagine that you bought a –0.70 delta put and the stock falls $1, you may still be at a loss in your trade, which can certainly be disheartening—pay attention to them!
Exhibit 1.18
Volatile and expensive stocks are just fine to trade, but trading stocks with poor volume isn’t the soundest strategy (although some more advanced traders are successful at trading low volume stocks). In my opinion, try to find options with spreads less than $0.20, if possible. You can find these lower spreads in the bigger stock names that trade heavy volume (1mm plus), stocks like AAPL, QQQ (ETF), IBM, and others. Sometimes higher spreads will be inevitable; just be aware of them and be sure to look up and down the option chain to get an idea of the average spread size. Remember, the lower the spread, the less your immediate loss will be in a trade. I prefer to trade options with spreads less than $0.20; however, you can choose a number that you feel comfortable with.
Intrinsic value is more than just a measurement. You can think of it as the only absolute connection that the option has to the underlying. In essence the intrinsic value can be the saving grace for the beginner or a key part of the strategy for the expert.
I am waiting for the stock to rally a bit for the perfect entry, but for demonstration’s sake, I placed a limit order “buy to open” of 10 contracts at $13.50. Remember, placing a limit order allows you to set the purchase or sale price, but not a fill. At the time I placed my bid, the asking price was $14.50, one dollar away from my bid. I was waiting for the stock to rally (put then gets cheaper).
In-the-money options have intrinsic value; out-of-the-money options do not. The amount of intrinsic value in an option is determined by the strike price of the option and the price of the underlying stock price only, plus or minus any dividends until expiration. Nothing else can influence intrinsic value.
So if you have a call option with a strike price of $50 and the stock is at $52, you would have $2 of intrinsic value. Whereas the $50 strike price put with the stock at $52 would have no intrinsic value.
You can customize the OMON screen to display intrinsic value as a column. (I personally like to look at time value on my monitor, but more on that in a minute.) See Exhibit 1.19.
As a novice tactic, if you are not yet comfortable with the Greeks, consider using the intrinsic value of an option compared to its price to help select your strikes.
For example, if a $60 call strike price were trading for 25 cents and I thought for sure the stock would be trading $65 by the time this particular option expired, I might not even care about the other effects that are influencing the price of the option because in my case it’s all about intrinsic value. My ultimate goal is to make $4.75 on this trade. That said, don’t be foolish and buy tons of cheap options thinking that they are going to jump in price.
Exhibit 1.19
Exhibit 1.20
Options will always trade for their intrinsic value plus a certain amount of time value barring any special situations such as a hard-to-borrow stock (big short interest or unshortable), put-call parity not holding up (i.e., VIX options), or in the case of a huge dividend between now and expiration. All of these factors can create a scenario where an option will trade for less than intrinsic value. See Exhibit 1.20.
Anticipating the intrinsic value of an option at expiration based on your forward thesis of the underlying security can help you determine theoretical P&L at that time. Using the Greeks can help quantify the day-to-day influences with accuracy.
The time value of an option is determined both by the amount of time it has until expiration and the volatility of the corresponding underlying, coupled with demand for the option(s) themselves.
All options are losing time value as they approach expiration. The speed at which they decay is not linear and is determined by several forces including changes in time, volatility, and even changes in dividends and interest rates.
Time value should be a focus when you are trading, but it is only a piece of the entire puzzle. Time value and implied volatility go hand in hand. The more volatile a stock is or is going to be, the more time value it will have.
Some beginners may separate intrinsic from time value and/or just focus on the delta of an option. As traders become more advanced they understand the need to focus on the total value of the option and how that value will morph with changes in the marketplace.
An option will typically trade for its intrinsic value, plus an amount of time value. Some options are comprised of completely time value (have no real value) and some may be trading for only their intrinsic value (typically these options are very deep in the money and close to expiration).
Because out-of-the-money options are completely comprised of time value (which will eventually dwindle to zero by expiration) they can only become profitable on expiration if the stock moves above your break-even level, which may be much higher than the current stock price. That’s not to say that they cannot gain value beforehand, but beginners who use the “stock price at expiration” trick to select strikes may find themselves frustrated.
In-the-money options prices are a combination of both intrinsic value plus time value and generally will have lower break-even points than their out-of-the-money counterparts.
The concept of time value is both objective and subjective, with a ton of gray in between. The reality is that it takes a trained eye to spot minute abnormalities in time value and take advantage of it. Time value at that moment is what the market believes that it should be. This doesn’t mean that it’s 100 percent accurate or that it won’t change, because obviously it will.