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Part I
Getting Started
Chapter 2
Introducing Options

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In This Chapter

Making sense of an option contract

Discovering an option’s value

Getting reliable option data

Starting out in options trading

There are many forms of options, but this book spends most of its time on listed stock options and listed index options, both of which trade on exchanges. These two distinct types of options function in two ways. First, they can be used to manage your risk by limiting your losses. And they offer you the opportunity for profits when used with the right strategy.

As silly as it may sound, to make the most out of options trading, it’s imperative that you really understand what options are and know the risks and potential rewards associated with them. That’s why this chapter details the information on the individual components of an option and how to recognize them in the market.

Understanding Option Contracts

By learning the basics of options contracts and then being able to compare them to other derivatives, you will be able to get a good working understanding of these securities and how to best use them both for risk reduction and for speculative gains. The next few sections are all about the basic concepts that will get you to a comfortable point in trading options and then lead to a good understanding of the risks and rewards associated with options trading.

Grasping option basics

A financial option is a contractual agreement between two parties. Although some option contracts are over the counter, meaning they are between two parties without going through an exchange, this book is about standardized contracts known as listed options that trade on exchanges. Option contracts give the owner rights and the seller obligations. Here are the key definitions and details:

Call option: A call option gives the owner (seller) the right (obligation) to buy (sell) a specific number of shares of the underlying stock at a specific price by a predetermined date. A call option gives you the opportunity to profit from price gains in the underlying stock at a fraction of the cost of owning the stock.

Put option: Put options give the owner (seller) the right (obligation) to sell (buy) a specific number of shares of the underlying stock at a specific price by a specific date. If you own put options on a stock that you own, and the price of the stock is falling, the put option is gaining in value, thus offsetting the losses on the stock and giving you an opportunity to make decisions about your stock ownership without panicking.

Rights of the owner of an options contract: A call option gives the owner the right to buy a specific number of shares of stock at a predetermined price. A put option gives its owner the right to sell a specific number of shares of stock at a predetermined price.

Obligations of an options seller: Sellers of call options have the obligation to sell a specific number of shares of the underlying stock at a predetermined price. Sellers of put options have the obligation to buy a specific amount of stock at a predetermined price.

In order to maximize your use of options, for both risk management and trading profits, make sure you understand the concepts put forth in each section fully before moving on. Focus on the option, consider how you might use it, and gauge the risk and reward associated with the option and the strategy. If you keep these factors in mind as you study each section, the concepts will be much easier to use as you move on to real time trading.

Use stock options for the following objectives:

✔ To benefit from upside moves for less money

✔ To profit from downside moves in stocks without the risk of short selling

✔ To protect an individual stock position or an entire portfolio during periods of falling prices and market downturns

Always be aware of the risks of trading options. Here are two key concepts:

Option contracts have a limited life. Each contract has an expiration date. That means if the move you anticipate is close to the expiration date, you will lose our entire initial investment. You can figure out how these things happen by paper trading before you do it in real time. You can read more about paper trading in Chapter 7. Paper trading lets you try different options for the underlying stock, accomplishing two things. One is that you can see what happens in real time. Seeing what happens, in turn, lets you figure out how to pick the best option and how to manage the position.

The wrong strategy can lead to disastrous results. If you take more risk than necessary, you will limit your rewards and expose yourself to unlimited losses. This is the same thing that would happen if you sold stocks short, which would defeat the purpose of trading options. Options and specific option strategies let you accomplish the same thing as selling stocks short (profiting from a decrease in prices of the underlying asset) at a fraction of the cost. Chapters 911 give you details on how you can profit from falling markets through options.

Comparing options to other securities

Options are a form of derivative, a type of security that derives its value from an underlying security. Stock options derive their value from the underlying stock. In order to better understand option valuations, it makes sense to know more about other derivatives and exchange traded mutual funds (ETFs), which are quasi-derivatives:

Commodities and futures contracts: Like options, commodity and futures contracts are agreements between two parties. The major difference between a commodity or futures contract and an options contract is that the former obligates you, whereas an options contract gives you rights as an owner. This is because commodities and futures contacts set the price for a predetermined quantity of a physical item to be delivered to a particular location on a predetermined date. Options have no delivery date. On the other hand, commodities and futures contracts are similar to options in that they lock in the price and quantity of an asset. However, in both cases, you can trade away your rights and obligations if you exit the contract before expiration.

Indexes: Think of indexes as collections of assets whose value is pooled together to measure the price of the group. Stocks, commodities, and futures are all index components. Chapter 9 covers index options in detail. Here is the important difference: Indexes are not securities. That means you can’t buy an index directly. Instead, you buy securities that track the value of the index, such as mutual funds that own the stocks in a particular index – for example, Standard & Poor’s 500 Index.

Exchange traded funds (ETFs): ETFs are mutual funds that trade like stocks on an exchange. Most ETFs are designed to track an index or an underlying sector of a particular market. ETFs can be considered quasi-derivatives because they don’t always hold the exact same securities of the index that they track. For example, some leveraged ETFs use more exotic securities known as swaps to mimic the action of the underlying index while adding leverage. Two of the most popular ETFs are the S & P 500 SPDR (SPY) and the Powershares QQQ Trust (QQQ), which tracks the Nasdaq 100 index. These two popular ETFs let you trade their underlying indexes, directly or through options.

Stocks and bonds: Stock ownership gives you part of a company, whereas bond ownership makes you a debt holder. Each dynamic has its own set of risks and rewards. Comparison of the three assets, stocks, bonds, and options, yields a fairly straightforward picture. All three asset classes can lead investors to total loss of their investment. And though stocks give you a piece of the company, and bonds offer you income, options offer you no ownership of any tangible assets. Stocks offer indefinite holding periods, and bonds have a maturity date and options have a limited life.

A swap is an insurance contract whose terms are privately agreed upon by the participants. They can be thought of as non-exchange traded options and they can be used to bet on the direction of just about anything that the two parties agree upon. By design, swaps are very sophisticated securities that are not available to individual investors because of the financial requirements and the specific agreements required to be signed before you trade them. When you own shares in a leveraged ETF, check the prospectus carefully to see if this is what you are buying. We’re not suggesting that you don’t consider leveraged ETFs if they make sense for your portfolio. We use them often in our personal trading. It’s important for you to always know what you are investing in, even if it’s an indirect investment such as an ETF.

When swaps get out of control, the markets can suffer. This is what happened in 2008 as lots of big money players bet (correctly) that subprime mortgage holders would not be able to make their monthly mortgage payments. They were right, and the rest, as they say, is history.

Valuing Options

Part of knowing your risks and rewards results from understanding how an investment derives its value and what affects the rise and fall in its price. In order to value an option, you must know the following:

✔ The type of option (put or call)

✔ The market value of the underlying security

✔ The characteristics of the past trading pattern of the underlying security calm or volatile

✔ The time remaining until the option expires

Knowing your rights and obligations as an options trader

There are two types of options: calls and puts. By owning a call you have the right to buy a certain stock at a pre-specified price by a certain date. Owning a put give you the right to sell a certain stock at a specific price by a certain date. Put option prices go up when the price of the underlying security falls. Call option prices rise when the underlying security’s price rises. When you own options, you can assert your rights at your own discretion. So, between the time you buy an option and its expiration date, you can

✔ Sell the option for a profit.

✔ Sell it for a loss.

✔ Exercise it.

✔ Let it expire with no value (for a loss).

As an option seller, you are obligated to complete a specific set of requirements. In fact, selling options gives you fewer choices, and the actionable choices are heavily influenced by the action in the markets. As the expiration date nears, you can

✔ Buy the option back for a profit.

✔ Buy it back for a loss.

✔ Let the option expire with no value (for a profit).

An easy memory trick to help you keep your rights and obligations in the correct framework is to think about buying the stock as calling it back while selling the option as putting the stock to someone.

Terms of endearment and importance

Here are key terms you have to nail down in order to make good option trading decisions:

Underlying security: The stock that you buy or sell and that determines the value of the option.

Strike price: The price you would pay if you decided to exercise your rights as an option buyer.

Expiration date: The date the option and your rights disappear.

Option package: The number of shares and the name of the underlying security that you can call away or put to someone.

Market quote: The most current price of a security that is being bid on by buyers and offered by sellers of options.

Multiplier: The number used to determine the value of the option and how much money you pay when you call away or put options to someone.

Premium: The total value of the option you buy or sell. The premium is based on the market quote for the option and its multiplier.

Option rights don’t last forever, so it’s important to keep track of how much time you’ve got left in a position before it expires. To figure out how much time you’ve got until the expiration date, identify the expiration date and determine the number of days or months away that date is.

Making Sense of Options Mechanics

Good decisions are only as good as the information you have and how well you understand it. So, whether you trade options without ever considering owning the underlying stock or otherwise, you will need the best data possible in order to assess their value and develop your strategies. Just as important is knowing the basic structure of how options quotes work and how the expiration cycle operates. This section is about deciphering the information you will require to understand your rights and obligations when trading options.

You can gather option market information online, often free of charge, if you are willing to deal with delayed data – typically lagging by 15–20 minutes. A good premium charting service, or your broker’s online trading platform, will usually have excellent real-time data at your finger tips as well. Yahoo! Finance (www.finance.yahoo.com) is a good free site for all kinds of quotes and financial information. You can also find excellent options information at Optionetics (www.optionetics.com).

Identifying options

Although not all stocks have options, those that do feature multiple strike prices and expiration dates. The list of options for a stock is also known as the option chain. When you look through a stock’s option chain you see all the calls and puts available, along with specific data for each listing, including the following:

Open interest: The number of existing contracts for this option

Market quotes: May be delayed or in real time, depending on your data source

Recent trading levels: Current or delayed

Option symbols have been standardized and radically changed since the first edition of this book. The old “root” nomenclature methodology that made it difficult to sometimes identify options for Nasdaq listed stocks with four letter symbols was replaced by the new Options Clearing Corporation (OCC) system. The new symbol system is much easier to decipher and has several components:

✔ The underlying stock or ETF’s symbol

✔ The expiration date, expressed in six digits using the mmddyy format

✔ The option type, P for put, C for call

✔ The strike price × 1000

Mini options are a different type of option. These options are based on smaller amounts of the underlying. They afford you rights and obligations for 10 shares of stock instead of the standard 100 shares feature the number 7 at the end of the symbol to distinguish them from standard listed options. Mini options are aimed at investors who have smaller positions but who want to reduce their risks based on the smaller number of shares in their possession.

Here is an example of the symbol for an Apple Inc. (Nasdaq: AAPL) 76.43 call option that expires on June 13, 2014:

AAPL061314C00076.430

For a mini option of the same underlying stock, expiration date, and striking price, the symbol would be:

AAPL7061314C00076.430

Turning with the expiration cycle

There are three expiration cycles, as listed in Table 2-1. All options feature at least four expiration dates throughout the year based on one of these cycles. Some listed options, such as those linked to important index tracking ETFs, have expiration dates every month. Long-term options (Long-term Equity Anticipation securities, or LEAPs) also have monthly expiration dates.


Table 2-1 Option Expirations by Cycle

Expiration dates are important because as time passes and expiration nears, options lose value. So, in order to manage positions in the best fashion, knowledge of the expiration dates is central.

All options have at least four monthly expiration dates available at all times. Each option features at least the current month and the following month expiration dates. For example, an option that runs with the January cycle also has a February expiration date while the next expiration will be in April, its normal cycle month. This option would also have July available, making four months of expiration dates available for trading. When January expires, February is the near month, so March options become available, along with April and July options. When February expires, October options then come online making four months of expiration dates and rounding out the cycle. The cycle repeats as the near month expires.

When you add LEAPs and mini options to the mix, the number of expiration dates can become confusing. Before you trade, make sure you are very clear on what you are trading and how much time the option has before it expires. Also pay attention to whether you have the type of option, call or put, that you suits your trading objective.

Option strike prices are generally available in increments of 0.50, $1, $2.50, and can be as high as $10, depending on the price of the underlying stock. There are exceptions to this general tendency, which becomes especially noticeable after pricey stocks split. That was the case with Apple in June 2014, which is why the strike price in the earlier example was peculiar. Most of the time, this is not the case.

Options expiration is decision time

If you have an open option position, you should have a good idea about what you will do with it well before it expires. Here are your choices:

Taking advantage of your rights as a contract holder: This means you are exercising the option. It requires contacting your broker and submitting the exercise instructions. Chapter 9 covers this in detail.

Trading out of the option: This means submitting to your broker the instructions required to exit the position.

Option expiration dates fall on Saturday. Because there is no trading on Saturday, you must deliver your instructions or exit the position on the last trading day before expiration, usually a Friday. This is weird and can cost you money. But rejoice. As of February 2015, a transition to Friday expirations begins.

Here are some key details about expiration dates and how to handle them:

Know your last trading day: There is no stock market trading on Saturday, which has been the traditional last trading day. This won’t as be meaningful for options expirations after February 2015, though, when Saturday expirations begin to phase out. Some options, depending on their own particular properties and issue dates, retain the Saturday last trading day date. But over time, they expire, and eventually all options have last trading days on Friday.

Keep up with your last exercise day: The last trading day and the last day to exercise usually fall on the same day. In most cases, you have one hour after the market closes to submit your instructions to your broker. But some brokers may have different rules, thus it’s important to check and know this well before you make any trading or exercise plans.

Detailing your rights

When you buy a call option, you are buying the right, but not the obligation, to buy a specified amount of stock at a certain price (strike price) at any time (just about) before the expiration date. This right lets you either exercise your right or trade out of the position.

When you buy a put option, you are buying the right, but not the obligation, to sell a specific amount of stock at a specific price (strike price) at any point in time (just about) up to the option’s expiration date. During this defined period of time, you can exercise your rights as an option holder or decide to trade out of the position.

It is quite possible that you may never actually exercise an option, as the option position may be part of an overall trading strategy you have devised. That’s the beauty of options, you have rights which give you the choice to act in the way that makes the most sense based on your strategy and market conditions. However, if you decide to exercise an option, here are some advantages:

Exercising a call option: When you exercise a call option, you may benefit from the shareholder rights of the underlying stock. This could mean that you receive cash or a dividend or that you participate in the benefits of other corporate actions such as mergers, acquisitions, and spinoffs.

Exercising a put option: Exercising a put option lets you exit a stock position. This could come in very handy when a company releases bad news after the close of regular trading in the stock market.

Exercising either a call or a put option: This practice may be of help in minimizing commission costs. By selling the option and then buying or selling the stock in the open market, you generate an added commission.

Even though the last bullet sounds confusing, there are times when selling the rights inherent in an option, to buy a stock in the open market, makes sense from a profit and commission savings standpoint. Chapter 9 covers this strategy in detail.

Birthing Option Contracts

There is an important difference between what it takes to issue new shares of stock and how options contracts come to exist. The number of shares available to trade in a particular stock is called the float. If there is a need for more stock to be issued, shareholders vote on whether it is sensible or not to do so, and the company goes through a process of registration before the new shares are offered to the public.

It’s different with options, where the potential number of contracts possible is limitless because options contracts are offered based on demand. The actual number of existing contracts for any option is known as the open interest.

Opening and closing positions

When you enter your order to buy an option, there may or may not be a contract available. But you won’t know that since your demand will create a contract if one isn’t already available. The important factor is how you enter and exit positions. The type of order you enter will lead to the execution of the trade. Attention to detail is very important, so you need to pay close attention to how you enter your order, and that means specifying whether you are opening a new position or closing an existing one. To buy a call option, you would enter the following order:

Buy to Open, 1 XYZ June 21 35.00 strike call option

To exit the position, you would enter the following order:

Sell to Close, 1 XYZ June 21, 35.00 strike call option

The same type of order format applies to opening a position in an option that you don’t own. The important factor is the correct use of language and the specificity of the option you are selling. Use the following to sell an option you don’t own:

Sell to Open, 1 XYZ June 27 42.00 strike call option

Buy to Close, 1 XYZ June 27 42.00 strike call option

When you enter your orders correctly, it allows the exchange and the clearing company to keep accurate track of the number of open contracts, which is also known as the open interest, and to keep tabs on the number of contracts traded on any given day. The open interest number displayed on options contract quotes has a one-day delay, meaning that today’s number is accurate up to the prior day’s action.

If you make a mistake when entering an order, contact your broker immediately. The error should be readily fixable both in your account and at the exchanges.

Selling an option you don’t own

When you sell an option as an opening transaction, you are obligated to sell a stock at the strike price at any time until the option expires. During that period, if a call option holder decides to exercise their rights, you may have to meet your obligation. When this happens, it’s called being assigned the option, and your broker will contact you to inform you about it. When you are assigned on a call option contract, you must weigh two possibilities:

✔ If you own shares of the underlying stock, you must sell the shares and close the stock position.

✔ If you don’t own the shares of the underlying, and you don’t sell the shares, you have created a short position in your account.

The easy part of selling an option that you don’t own is putting in your order. The more important part is understanding the risk of the trade. If you own shares when you sell a call option, it is known as a covered transaction, because the shares cover the short call position. If you don’t own the shares when you sell the call, it’s called a naked call. What makes this strategy most dangerous is that it has the same risk as a stock short position. In other words, your risk of loss is unlimited, given the potential of a stock to continue to rise indefinitely.

When you sell a put option as an opening transaction, you are obligated to buy a specified amount of stock at the predetermined strike price at any point until the option expires. You own this obligation from the time you open the transaction until the expiration weekend and you are require to satisfy the obligation if a put option holder decides to exercise their right. Getting assigned on a short put usually happens when the underlying stock has declined. If assigned you will be buying stock at a higher price than the current market value. Your short put transaction can also be covered or naked.

When you sell a put short, you are under obligation to buy shares, so you cover the position with a short stock position in the underlying. Buying the shares closes the short stock position. If you sold a naked put and you are assigned, you will have a new long position in your account.

Selling puts is a tricky transaction, so it takes a little time to figure it out. Here is why:

✔ When you take on the obligation associated with this transaction, you are no longer making active decisions with regard to the transactions involving the underlying stock.

✔ The risks associated with the short option transactions are very different, depending on whether you have a covered or naked transaction.

I cover the risk reward ratio of transactions more fully in Chapter 4.

Keeping Some Tips in Mind

You not only want to get off on the right foot when you begin trading options, but you also want to keep both feet firmly grounded throughout the process. The following tips should help:

Get approval. When you want to start trading options, you need to get approval from your broker.. the Securities & Exchange Commission (SEC) requires it. They need to make sure that trading these securities is appropriate for your financial situation and goals. It’s part of the process and means you typically get approved for basic option strategies if you haven’t traded them in the past.

Be disciplined. When you enter a trade for a specific reason, such as an earnings announcement, pending economic report or a particular value for an indicator you use, you must exit the trade when conditions change or your original reason for purchasing the security no longer exists. Don’t let a stock or option position you intended to hold for three weeks become part of your long-term portfolio. Being disciplined and following your rules is a must for all traders.

Keep track of the expiration date. Many option chains include the actual expiration date for each month along with the option quote data. The expiration date may also be included with your account position information. Knowing when the option expires is critical to managing the position.

Practice. Always remember that you can paper trade a security that is new to you. Although the emotions you experience trading this way don’t exactly mimic having real money on the line, it helps you get familiar with new types of securities.

Trading Options For Dummies

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