Option Monster Options Basics

8/4/2019 Option Monster Options Basics

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Options involve risk and are not suitable for all investors. For more information, please read the Characteristics and Risks of Standardized Options. Copies may be obtained from The Options Clearing

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tolerance, and liquidity needs. 2011 OptionMonster Holdings, Inc. All Rights Reserved.

Find the trade here. Make it on tradeMONSTER.

OPTIONS BASICS

Would You Like To:

Trading stocks is reasonably easy, at least in theory. If you think a stock is going up, buy it. If you think it is

going down, sell it; or sell it short if you are a real risk-taker. If you think a stock is going nowhere, sell it oravoid it in the rst place. The stock price is what it is and that is what you pay. Things are not so simple withoptions trading. Many factors inuence the value of an option contract. It is for largely that reason that mostretail options traders underestimate the challenge of making money with options.

TABLE OF CONTENTS

Increase your leverage without paying margin rates?

Prot from dropping prices with limited risk?

Generate more income in your account?

Get paid to enter long stock positions?

Insure your positions or even your whole portfolio?

Options are exceptionally versatile. You can do all of the above with the use of options.

What is an Option? ...................................................................................................................................................Option Price and Value .............................................................................................................................................

Buying Calls ................................................................................................................................................................ Exiting Long Calls ......................................................................................................................................................Buying Puts ................................................................................................................................................................Exiting Long Puts .......................................................................................................................................................Rules for Buying .........................................................................................................................................................Selling Calls .................................................................................................................................................................Selling Puts .................................................................................................................................................................Exiting Short Positions ..............................................................................................................................................Rules for Selling .........................................................................................................................................................Review of Basic Strategies with Examples .............................................................................................................Options Terminology ................................................................................................................................................

Options Chains ...........................................................................................................................................................Summary ....................................................................................................................................................................

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Holder (Buyer) Writer (Seller)

Call Option

Put Option

Right to Buy

Right to Sell

Obligation to Sell

Obligation to Buy

What is an Option?

An option is a standardized contract providing for the right but not the obligation to buy or sell anunderlying nancial instrument. In our context, this underlying is a stock or exchange traded fund (ETF).The contract controls 100 shares, and is good until a dened expiration date. The price at which shares canbe bought or sold also is dened by the contract, and is known as the strike price.

There are two types of options: calls and puts. You can buy or sell either type. If you buy an option you arethe holder of the contract and considered to be long, while if you sell an option you are the writer ofthe contract and considered to be short.

The buyer of a call has the right to buy the underlying security (e.g. 100 shares of Google) at the strike

price on or before the expiration date. The seller of a call has the obligation to sell the shares, if asked.

The buyer of a put has the right to sell the underlying security (e.g. 100 shares of Google) at the strike priceon or before the expiration date. The seller of a put has the obligation to buy the shares, if asked.


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Option Price and Value

Premium

In the money (ITM), At the money (ATM), Out of the money (OTM)

In exchange for the right to buy (call) or sell (put) an underlying security on or before the expirationdate, the purchaser of an option pays a premium. The price of the contract is known as the debit, and it isthe purchasers maximum risk. On the other side of the trade, the seller of the option receives the premiumas a credit to his/her brokerage account, but is obligated to buy (in the case of a short put) or sell (in theinstance of a short call) the underlying shares if the purchaser exercises the contract. Brokerages hold cashfrom the premium as a guarantee against short positions.

The strike price, or exercise price, of an option determines whether that contract is in the money, at themoney, or out of the money. If the strike price of a call option is less than the current market price ofthe underlying security, the call is said to be in the money because the holder of the call has the right tobuy the stock at a price which is less than the price he would have to pay to buy the stock in the market.Likewise, if a put option has a strike price that is greater than the current market price of the underlyingsecurity, it is also said to be in the money because the holder of this put has the right to sell the stock at aprice which is greater than the price he would receive in the market. The converse of in the money is, notsurprisingly, out of the money. If the strike price equals the current market price, the option is said to be atthe money.

In The Money (ITM) Strike Price < Stock Price Strike Price > Stock Price

All The Money (ATM) Strike Price = Stock Price Strike Price = Stock Price

Out Of The Money (OTM) Strike Price > Stock Price Strike Price < Stock Price

Call Put


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30 DAYS

Option Price As Time Passes

Intrinsic Value and Time Value

The premium of an option has two components, intrinsic value and time value.

Intrinsic value describes the amount the stock price is above the strike price (for calls), or below the strikeprice (for puts). Therefore the amount by which an option is in the money is intrinsic value. It is also thevalue of the contract at expiration.Time value is dened as the option premium minus the intrinsic value. It is the amount that you pay for thepossibility that it will be worth more in the future. Therefore an at-the money or out-of-the-money optionhas no intrinsic value and only time value.

Intrinsic value is only affected by moves in the underlying security.Time value is subject to several factors, primarily timeto expiration and implied volatility. Implied volatilityis the markets expectation of the future volatility ofthe underlying stock. It is derived from the optionprice itself, and represents demand for the option.The higher the implied volatility, the moreexpectation that the underlying stock will make bigmoves, increasing the options chances of being in themoney. This also means that the options premiums(that is, its time value) are higher. However, the valueof time decays as expiration nears: time decayincreases dramatically in the last 30 days asexpiration approaches.

Intrinsic Value = Stock Price - Strike Price Intrinsic Value = Strike Price - Stock Price

Time Value = Option Price - Intrinsic Value Time Value = Option Price - Intrinsic Value

Calls Puts


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490 call = $25 500 call = $18 510 call = $10

In the money At the money Out of the money

$10 Intrinsic $0 Intrinsic $0 Intrinsic

$15 time value $18 time value $10 time value

Strike Price

Stock Price =$500

Lets consider an example using Google (GOOG). If GOOG were trading at $500 when you bought a 490

strike call option for $25, then $10 of the options value would be intrinsic value.The other $15 would be time value. A 500 call purchased when GOOG is trading for 500 is at the money, butis all time value. It has no intrinsic value.

If the stock were at 500 when you bought a 510 call, the option is again all time value, since it has to rise $10to be in the money.

You want leverage? Buying calls gives you leverage over 100 shares of an underlying stock (or ETF) at thestrike price until the expiration date. Long calls are used to prot from upward moves in the underlying.Again using Google for an example, the GOOG December 500 call option gives you the right to buy 100shares of GOOG for $500 per share up until the expiration date in December. You would do this with theexpectation that the price of the option will rise, usually through the rise in the price of the underlying stock.

Lets say you purchased the GOOG 500 call option for $25 when the stock was trading for $500. If GOOG goesup to $550 before expiration, then your call is worth at least $50. This gives you a 100 percent return on thecall option based on a 10 percent return on the stock. That is the leverage of buying options.

Buying Calls


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Long Call

Stock

475 500 525

Long Call

GOOG

$200

$500

$550

$600

% Return

-100%

-100%

100%

300%

Call P/L

($25)

($25)

-$25

$75

% Return

-60%

0%

10%

20%

Stock P/L

($300)

0

$50

$100

The ip side is that if the stock does not move up, then the option will lose all of its value by expiration. Thisresults from the decay of the value of the options premium, known as time decay. That is the risk of buyingcalls. Since they are expiring assets, they have time value that diminishes over time. But regardless of how farthe stock falls, your risk is limited to the cost of the call.


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GOOG

$400$450

$500

$600

% Return

300%100%

-100%

-100%

Put P/L

$75$25

($25)

($25)

% Return

-20%-10%

0%

20%

Stock P/L

($100)($50)

0

$100

In this case, lets say you were concerned about the downside, so you purchased the GOOG 500 put optionfor $25 when GOOG the stock was trading for $500. If GOOG goes down to $450 before expiration, thenyour put is worth at least $50. This gives you a 100 percent return on the put option with a 10 percent losson the stock.

Buying puts on a stock you own can provide insurance on that position. Index puts can also be used toinsure your entire portfolio. Buying puts is very much like buying insurance: you pick the deductable and

the premiums.

Stock

Long Put

475 500 525

Long Put


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Exiting Long Puts

When a put has been purchased, the position can be closed in one of three ways:

Selling the put Once a put is bought it can be sold at any time, and this is the most commonway of exiting a long position. This is the only way of exiting a long position that captures anyremaining time value in the option.

Letting it expire If a put gets all the way to expiration, it will expire, worthless if it is out ofthe money (when the stock price is above the strike price See Option Pricing). If the stock priceis below the strike price by $.01 or more, it will be automatically exercised and shares will betaken from your brokerage account. Long options are almost always sold before expiring,

as at that point they will have lost all time value.

Exercising the option Utilizing the right to sell that is inherent in the put contract is knownas exercising the option. This delivers shares of the stock from your account at the strike price.Options are rarely bought with the intention of exercising the underlying right. Taking thiscourse also forgoes any remaining time value in the option.

Rules For Buying

Regardless of whether you are buying calls or puts, there are some general rules to follow. One, the expira-

tion should give the option enough time to perform without being overexposed to time decay. Since op-tions have an expiration date, a large part of their value is time value (for more, see our lesson on OptionPricing). This time value will deteriorate as that expiration approaches; time decay increases exponentiallyin the last 30 to 45 days of an options life, so this is usually not the time to own options.

Two, options should generally be bought when the time value primarily inuenced by a factor known asimplied volatility, or the expected price swings of the underlying is expected to stay at or to rise. Buyingoptions is a limited-risk strategy, and all of that risk lies in the premium paid for the option. All else equal,if there is a rise in implied volatility, then there will be a rise in the option premiums. This increase canproduce prots for long options, even if the stock price doesnt move, because the chance of movementhas increased. Conversely, if you buy options when implied volatility and premiums are high, such as before

earnings, then the stock can move in the direction that you want and you can still lose money, becausewith the news out, the implied volatility could fall.


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Finally, when you buy an option, generally you will want to sell it, ideally for a still-greater premium. You

do not want it to expire, since you will receive zero premium, and normally you dont want to exercise yourright to purchase the underlying shares, unless that is your particular strategy (say for tax reasons). In bothof these cases, you lose whatever time value is left in the option. So with future resale value in mind, we cansee why risk management rules are important, such as taking prots when your position doubles or closingout the position when it loses half of their entry value.

Selling Calls

Interested in generating income? When option premiums are high (that is, when implied volatility is high),some traders turn to selling options. Selling naked calls, so called because you do not own the

underlying shares as a hedge in case you are assigned, is a neutral to bearish strategy. You want the marketprice to be below the strike of the call you sold, so that it expires worthless. Selling calls should be done whenyou expect the underlying stock to fall or stay at.

Option buyers have rights, but option sellers have obligations. By selling calls, you are obligating yourself toselling the stock at the strike price when you are assigned. Assignment is the other side of an option beingexercised. If a call buyer decides to exercise the long call, that exercise is put out randomly to a sellerany seller of that call, and the individual is obligated to sell stock to the call buyer.

If you do not own the shares of the stock when assigned, then you will have to come up with them. This isthe reason that brokerages require a margin account for individuals who wish to sell naked calls. It is also the

reason that selling calls is considered the options strategy with the highest risk. Stocks can go up innitely,and so the risk of a naked call is unlimited. Naked calls are the strategy that gives options a bad name amongthe risk averse.

By way of explanation, lets say you sold the GOOG 500 call option for $25 when GOOG was trading for $500.If GOOG is anywhere below 500 at expiration, then you keep your credit of $25. If the stock goes up to $525,however, you will be assigned at expiration, but will come out at since you already pocketed a credit of $25.As the stock price continues upward, your losses mount.










GOOG$300

$500

$550

$700

Call P/L$25

$25

($25)

($175)

% Return-40%

0%

10%

40%

Stock P/L($200)

0

$50

$200

Because of this unlimited risk as the underlying stock price rises, selling calls is rarely done in isolation. In fact,selling calls against stock that you own, known as covered calls or buy-writes, is considered the most

conservative options strategy. (For more, see the lesson on Covered Calls.)

Selling Puts

Want to be paid to buy stock? Many stock investors use limit orders to get into long positions. Anotherway to buy stock for less than the current market price is an options strategy called cash-secured puts. Cashsecured means that you have the cash in your account to buy the stock at the designated strike price. Sellingputs is usually done with options that have high implied volatility. This is a neutral to bullish strategy whichcan be used to generate income, or to enter long stock positions.

Selling puts obligates you to buy the stock when assigned. This strategy brings income into your account,income you keep if the stock is above the strike price at expiration. Traders sell puts if they think the stockis going to stay at or go up slightly, but only if they are willing to buy the stock if assigned. For this reason,selling puts can be an excellent way to initiate long stock positions, and get paid to do so.

Lets say you sold the GOOG 500 put option for $25 when the stock was trading for $500. If GOOG isanywhere above 500 at expiration, then you keep your credit of $25. If the stock is below, you will beassigned, and you will purchase the stock at the strike price. But the trade itself is protable until $475, sinceyou pocketed the $25 credit.










475 500 525

Short Put

GOOG

$300

$450

$500

$700

Put P/L

($175)

($25)

$25

$25

% Return

-40%

0%

10%

40%

Stock P/L

($200)

0

$50

$200

Puts can be sold cash-secured or naked. If they are cash secured, then you have the cash in your account topurchase the stock at the strike price if assigned. If naked, then a lower margin is required. This wouldincrease the return on margin, but also increase the potential risk.










Exiting Short Positions

When an option has been sold, the position can be closed in one of three ways:

Buying back the option After an option is sold, it can be bought back at any time. This is donewhen there is a risk of assignment that the option seller wants to avoid. For instance, if you solda call, the stock went up through your strike, and you do not want to be assigned and forced tosell the stock, you could buy back the option to close the position.

Letting it expire If the option gets all the way to expiration, it will expire, worthless if it is out ofthe money. Typically, this is what you want to have happen with options that you have sold. If itis in the money by $.01, it will be automatically exercised and you will be assigned, automatically

selling stock if you were short a call or buying stock if you were short a put.

Assignment American-style options (all equity and ETF options) can be exercised at any timebefore expiration. So you could be assigned at any time after you have sold an option. Mosttraders view this as a negative, but it is not necessarily so. If you are using cash-secured puts toacquire stock, then assignment means you have achieved your objective at a below-market price.

Rules For Selling

Selling options is best done when implied volatilities, and therefore option premiums, are high and

expected to fall. This is because higher implied volatility brings in more premium income to your account.It isimportant to remember, however, that selling options involves considerable risk, and high impliedvolatility can always go higher.

Since we already know that time decay is greatest in the last 30 to 45 days, this is typically the best time tosell options. Here we the ideal is to have the options expire worthless, and we are not interested in buyingback the options we have sold unless necessary.










Review of Basic Strategies with Examples

Prot from stock price gains with limited risk and lower cost than buying the stock outright

Prot from stock price drops with limited risk and lower cost than shorting the stock

Prot from sideways markets by selling options and generating income

Get paid to buy stock

Protect positions or portfolios

Example: You buy one Intel (INTC) 25 call with the stock at 25, and you pay $1. INTC moves up to $28 and soyour option gains at least $2 in value, giving you a 200% gain versus a 12% increase in the stock.

Example: You buy one Oracle (ORCL) 20 put with ORCL at 21, and you pay $.80. ORCL drops to 18 and youhave a gain of $1.20, which is 150%. The stock lost 10%.

Example: You own 100 shares of General Electric (GE). With the stock at 34, you sell one 35 call for $1.00.If the stock is still at 34 at expiration, the option will expire worthless, and you made a 3% return on yourholdings in a at market.

Example: Apple (AAPL) is trading for 175, a price you like, and you sell an at-the-money put for $9. If thestock is below 175 at expiration, you are assigned, and essentially purchase the shares for $166.

Example: You own 100 shares of AAPL at 190 and want to protect your position, so you buy a 175 put for $1.Should the stock drop to 120, you are protected dollar for dollar from 174 down, and your loss is only $16,not $70.










Option Terminology

Calls.........................................................

Puts.........................................................

Strike Price...........................................

Exercise...................................................

Assignment............................................

Expiration...............................................

In the Money (ITM)...............................

At the Money (ATM).............................

Out of the Money (OTM).....................

American Style.......................................

European Style.......................................

Intrinsic Value........................................

Time Value.............................................

The right, but not the obligation, to buy a specic number of sharesof the underlying security at a dened price, until the expiation date.

The right, but not the obligation, to sell a specic number of sharesof the underlying security at a dened price until the expiration date.

The price at which option holders can exercise their rights.

The process in which the buyer of an option takes, or makes, delivery

of the underlying contract.The process by which the seller of an option is notied that thecontract has been exercised.

The time at which an option can no longer be exercised.

A call (put) option whose strike price is below (above) the stock price.

An option whose strike price is roughly equal to the stock price.

A call (put) option whose strike price is above (below) the stock price.

An option that can be exercised at any time before expiration.

An option that can be exercised only at expiration.(Note: These are mainly index securities.)

The amount that an option is in the money.

The price of an option less the intrinsic value.










Option Chains

For any given option contract, we need to know the most recent prices and other factors. Option chainsshow data for a given underlyings different strike prices and expiration months.

Intel Ord Shs

21.485 +0.105 +0.49% 21.83 21.49 502x45 26.8m

4.55

3.525

2.59

1.67

0.875

0.35

0.12

0.045

0.015

0.01

0.00%

-0.70%

+0.97%

+5.36%

+6.71%

+7.69%

+14.29%

+28.57%

+50.00%

+100.00%

+0.00

-0.025

+0.025

+0.085

+0.055

+0.025

+0.015

+0.001

+0.005

+0.005

4.50

3.45

2.57

1.66

0.87

0.34

0.11

0.04

0.00

0.00

4.60

3.60

2.61

1.68

0.88

0.36

0.13

0.05

0.03

0.02

0

30

225

2.04k

935

1.71k

129

172

0

0

23

192

751

50,992

18,977

74,507

15,808

5,058

7,631

535

4.485

3.485

2.485

1.485

0.485

0.00

0.00

0.00

0.00

0.00

0.065

0.04

0.105

0.185

0.39

0.35

0.12

0.045

0.015

0.01

0.035

0.055

0.095

0.165

0.38

0.855

1.615

2.54

3.50

4.50

0.00%

0.00%

+5.56%

-10.81%

-10.59%

-8.06%

-5.56%

-3.97%

-3.45%

-2.70%

+0.00

+0.00

+0.005

-0.02

-0.045

-0.075

-0.095

-0.105

-0.125

-0.125

0.03

0.05

0.09

0.16

0.37

0.85

1.60

2.52

3.45

4.45

0.04

0.06

0.10

0.17

0.39

0.86

1.63

2.56

3.55

4.55

3

28

373

280

453

108

13

10

0

0

456

4,070

11,700

28,676

18,397

8,025

3,271

1,390

1,044

1,254

0.00

0.00

0.00

0.00

0.00

0.515

1.515

2.515

3.515

4.515

0.035

0.055

0.095

0.165

0.38

0.34

0.10

0.025

0.00

0.00

17

18

19

20

21

22

23

24

25

25

Bid Ask Size Volume

Mark Chg Mark Chg Bid Ask Volume Open Interest Value ValueMark% Intrinsic Extrinsic

Mark Chg Mark Chg Bid Ask Volume Open Interest Value ValueMark% Intrinsic Extrinsic

STRIKES

CALLS PUTS

Feb11 Mar11 Apr11 May11 Jun11 Jul11 Aug11 Sep11

Mar11 (44 Days)

At the top, we have the stock information and then different expiration months. In this case we arelooking at Intel (INTC) March 2011s.

Down the middle are the strike prices. Calls on the left, puts on the right.

Contracts in the money are grey, and out of the money are white.

Each strike lists:

The price between the bid/ask (Mark)

The price at which there are willing buyers (the Bid)

The price at which a contract is offered for sale (the Ask or Offer)

The volume of the days trading (Vol)

The contracts open interest (Open Int), which tells us how many active contracts thereare for a given month and strike.


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High open interest gures, generally near the at-the-money strikes, tell us there are more prospective

trading partners who could accept your price. But note that volume does not equal open interest, sincesome trades are made to close positions.

Summary

Options are used for speculation, income generation, or hedging a position.

Options buyers pay a premium for the right, but not the obligation, to act.

Options sellers (writers) have an obligation (if assigned).

There are four basic positions: buying calls, buying puts, selling calls, selling puts.

Option premiums are made up of intrinsic value and time value.Time value is largely a function of implied volatility.

Option chains are used for valuable trading information.

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