Getting Started in Options

Getting Started in Options is an introduction to options.

I didn't like this book. While the book makes a good job in covering the very basics of options with many examples, it fails to go further. So it completely ignores the Greeks, and hence doesn't enable you to fully understand the data you can find on options on finance sites. Another thing is that the author keeps repeating the same things over and over again. Some repetition is useful, but you can overdo it...

My notes

Introduction: An Investment with Many Faces

The people who get on in this world are the people who get up and look for the circumstances they want, and if they can't find them, make them.

[...] the options market can play an important role in your portfolio in several ways: enhancing profits without a corresponding increase in risk, protecting investments with a form of insurance not otherwise available, and guarding against loss (at least to a degree).

You probably have heard people describe the options market as risky or complicated. Certainly, aspects of option investing fit these descriptions, but so do some aspects of virtually all forms of investing. The truth is, options can take many forms, some high risk and others extremely conservative.

You need to keep in mind as you consider and make decisions about how and where to invest, that the ultimate test of whether or not to proceed should be to question whether it is appropriate, comfortable, and affordable. No one idea works for everyone, and options are no exception. No matter how easy, practical, or foolproof an idea seems in print, and no matter how well it works on paper, placing real money at risk changes everything. Your decision has to feel right to you.

Calls and Puts

I know of no more encouraging fact than the unquestionable ability of man to elevate his life by a conscious endeavor.

An option is a contract that provides you with the right to execute a stock transaction – that is, to buy or sell 100 shares of stock. (Each option always refers to a 100-share unit.) This right includes a specific stock and a specific fixed price per share that remains fixed until a specific date in the future.

The right to buy or to sell stock at the fixed price is never indefinite; in fact, time is the most critical factor because the option exists for only a few months. When the deadline has passed, the option becomes worthless and ceases to exist. Because of this, the option's value is going to fall as the deadline approaches, and in a predictable manner.

There are two types of options. First is the call, which grants its owner the right to buy 100 shares of stock in a company. [...] The second type of option is the put. This is the opposite of a call in the sense that it grants a selling right instead of a purchasing right. The owner of a put contract has the right to sell 100 shares of stock.

The value of an option actually is quite predictable – it is affected by time as well as by the ever-changing value of the stock.

The attributes of calls and puts can be clarified by remembering that either option can be bought or sold. This means there are four possible permutations to options transactions:

• Buy a call (buy the right to buy 100 shares)
• Sell a call (sell the right to someone else to buy 100 shares from you)
• Buy a put (buy the right to sell 100 shares)
• Sell a put (sell the right to someone else to sell 100 shares to you)

Option buyers can profit whether the market rises or falls; the difficult part is knowing ahead of time which direction the market will take.

When it comes to options, you have an additional obstacle besides estimating the direction of price movement: The change has to take place before the deadline that is attached to every option. You might be correct about a stock's long-term prospects and as a stockholder, you have the luxury of being able to wait out long-term change. However, options are always short term. This is the critical point. Options are finite and unlike stocks, they cease to exist and lose all of their value within a relatively short period, usually only a few months.

The market forces affecting the value of stocks in turn affect market values of options. The option itself has no actual fundamental value; its market value is formulated based on the stock's fundamentals.

There are two primary factors affecting the option's value: First is time and second is the market value of the stock. As time passes, the option loses market desirability, because the time approaches after which that option will lose all of its value; and as market value of the stock changes, the option's market value follows suit.

In the event of an increase in the price of the underlying stock, you can take one of two actions. First, you can exercise the [call] option and buy the 100 shares of stock below current market value. Second, if you do not want to own 100 shares of that stock, you can sell the option for a profit.

[The] fixed price in every option contract is called the striking price of the option. Striking price is expressed as a numerical equivalent of the dollar price per share, without dollar signs.

In setting standards for yourself to determine when or if to take profits in an option, be sure to factor in the cost of the transaction.

It often happens that within the relatively short life span of an option, the stock's market value does not change, or changes are too insignificant to create the profit scenario you hope for in buying calls. You have two alternatives in this situation. First, you may sell the call before its expiration date [...]. Second, you may hold onto the option, hoping that the stock's market value will rise before expiration, resulting in a rise in the call's value as well, at the last minute.

If the market value of the stock remains at or below the striking price all the way to expiration, then the premium value – the current market value of the option – will be much less near expiration than it was at the time you purchased it, even if the stock's market value remains the same. The difference reflects the value of time itself. The longer the time until expiration, the more opportunity there is for the stock (and the option) to change in value.

The most significant advantage in speculating in calls is that instead of losing a larger sum in buying 100 shares of stock, the loss is limited to the relatively small premium value. At the same time, you could profit significantly as a call buyer because less money is at risk.

One of the risks in buying stock is the "lost opportunity" risk – capital is committed in a loss situation while other opportunities come and go.

The real advantage in buying calls is that you are not required to tie up a large sum of capital nor to keep it at risk for a long time. Yet, you are able to control 100 shares of stock for each option purchased as though you had bought those shares outright. Losses are limited to the amount of premium you pay.

Because options have no tangible value, becoming an option seller is fairly easy. A call seller grants the right to someone else – a buyer – to buy 100 shares of stock, at a fixed price per share and by a specified expiration date. For granting this right, the call seller is paid a premium. As a call seller you are paid for the sale but you must also be willing to deliver 100 shares of stock if the call buyer exercises the option. This strategy, the exact opposite of buying calls, has a different array of risks from those experienced by the call buyer. The greatest risk is that the option you sell could be exercised, and you would be required to sell 100 shares of stock far below the current market value.

When you operate as an option buyer, the decision to exercise or not is entirely up to you. But as a seller, that decision is always made by someone else.

Call sellers have much less risk when they already own their 100 shares. They can select calls in such a way that in the event of exercise, the stock investment will still be profitable.

In the case where the stock's value remains at or near its value at the time the call is sold, the value of the call will fall over time. [...] While that is a problem for the call buyer, it is a great advantage for the call seller. Time works against the buyer, but it works for the call seller. You have the right to close out your sold call at any time before expiration date. So you can sell a call and see it fall in value; and then buy it at a lower premium, with the difference representing your profit.

Remember three key points as a call seller. First, the transaction takes place in reverse order, with sale occurring before the purchase. Second, when you sell a call, you are paid a premium; in comparison, a call buyer pays the premium at the point of purchase. And third, what is good news for the buyer is bad news for the seller, and vice versa.

When you sell a call option, you are a short seller and that places you into what is called a short position. The sale is the opening transaction, and it can be closed in one of two ways. First, a buy order can be entered, and that closes out the position. Second, you can wait until expiration, after which the option ceases to exist and the position closes automatically.

As a buyer of a put, you hope the underlying stock's value will fall. A put is the opposite of a call and so it acts in the opposite manner as the stock's market value changes. If the stock's market value falls, the put's value rises; and if the stock's market value rises, then the put's value falls.

If the put you sell is exercised, then you end up with overpriced stock, so you need to establish a logical standard for yourself if you sell puts. Never sell a put unless you would be willing to acquire 100 shares of the underlying stock, at the striking price.

Option price behavior is directly affected by the underlying stock and its attributes. So volatile (higher risk) stocks demand higher option premium and tend to experience faster, more severe price changes.

The selection of options cannot be made without also reviewing the attributes of the stock, both fundamental and technical. [...] The need for careful, thorough, and continuing analysis cannot be emphasized too much. So attributes such as financial strength, price stability and volatility, dividend and profit history, and other tests are important, not only to stockholders but to options traders as well.

[...] when the option's striking price is identical to the current market value of the stock – the option is said to be at the money. If the market value per share of stock increases so that the per-share value is above the call's striking price, then the call is said to be in the money. When the price of the stock decreases so that the per-share value is below the option's striking price, then the call is said to be out of the money. These definitions are reversed for puts.

Stock investors tend to view bad news – weakness, negative economic news, overpricing of shares, corporate scandals, and so on – as just bad news. An options trader, though, can use any form of news to make a profitable move in options, even when the news is negative for the company and its stockholders.

Intrinsic value: that portion of an option's current value equal to the number of points that it is in the money.

Any value above the intrinsic value is known as time value. This will decline predictably over time, as expiration nears. [...] if the option is at the money or out of the money, the entire premium is time value. As expiration approaches, time value evaporates at a quickening pace, and at the point of expiration, no time value remains.

Opening, Closing, and Tracking the Option

Every option is characterized by four specific attributes, collectively called the terms of the option. These are striking price, expiration month, type of option (call or put), and the underlying security. These are also alternatively referred to as standardized terms.

It might seem at first glance that, given the behavior of calls and puts when in the money or out of the money, it would make no difference to buy a put or to sell a call. As long as expiration and striking price were identical, what is the difference? In practice, however, significant differences do make these two ideas vastly different in terms of risk profile. When you buy a put, your risk is limited to the amount you pay for premium. When you sell a call, your risk can be far greater because the stock may rise many points, requiring the call seller to deliver 100 shares at a price far below current market value.

All options traded on a specific underlying stock are referred to as a single class of options. Thus, a single stock might be associated with a wide variety of calls and puts with different striking prices and expiration months, but they all belong to the same class. In comparison, all of those options with the same combination of terms – identical striking prices, expiration month, type (call or put), and underlying stock – are considered a single series of options.

An option's expiration takes place on the third Saturday of the expiration month. An order to close an open position has to be placed and executed no later than the last trading day before expiration day; and before the indicated expiration time for the option.

Whenever you have opened an option by buying or selling, the status is called an open position. When you buy, it is described as an opening purchase transaction. And if you start out by selling an option, that is called an opening sale transaction.

Every option will be canceled by an offsetting closing transaction, by exercise, or by expiration.

The Options Clearing Corporation (OCC) has the broad responsibility for orderly settlement of all option contracts [in the USA] [...]. Orderly settlement means, generally, that buyer and seller both trade in confidence knowing that they will be able to execute their orders when they want, finding a ready market and not having to worry about uncertainty. It also means that all terms of the contract are ironclad; exercise price, expiration date, and availability of shares upon exercise are all a part of the orderly settlement.

Assignment: the act of exercise against a seller, done on a random basis or in accordance with orderly procedures developed by the Options Clearing Corporation and brokerage firms.

When a buyer decides to exercise, 100 shares are either purchased ("called from") or sold ("put to") the option seller. [...] The entire process of calling and putting shares of stock upon exercise is broadly referred to as conversion.

Sellers have to be aware that exercise is one possible outcome and that it can occur at any time that the option is in the money. The majority of exercise actions are most likely to occur at or near expiration, so the risk of early exercise is minimal, although it can and does occur.

By the time of expiration, all of the time value will have disappeared from the premium value, and all remaining premium will represent intrinsic value only. This condition is known as parity.

Annualized basis: a method for comparing rates of return for holdings of varying periods, in which all returns are expressed as though investments had been held over a full year.

When you sell calls against stock you own, you need to adjust the comparative analysis to study the possible outcome based on two possible events. The first is called return if exercised. This is the rate of return you will earn if the call you have sold is exercised and 100 shares of stock are called away. It includes both the profit on your option and profit or loss on the stock as well as any dividends you received during the period you owned the stock. The second calculation is called return if unchanged. This is a calculation of the return to be realized if the stock is not called away, and the option is allowed to expire worthless (or it is closed out through a closing purchase transaction).

The purpose in comparing returns on option selling is not to decide which outcome is more desirable, but to decide whether or not to enter into the transaction in the first place.

Buying Calls

If you embark upon a program of buying calls, you take the most speculative position that is possible with options. Since time works against you, substantial change in the underlying stock is required in order to produce a profit.

Before becoming an options buyer, examine all of the risks and become familiar with potential losses as well as potential gains.

Time works against you as a buyer, so the more time value in the option you buy, the more difficult it will be to make a profit.

Leverage: the use of investment capital in a way that a relatively small amount of money enables the investor to control a relatively large value.

Knowing exactly what you are getting into, determining the best strategy, and full comprehension of risk, add up to the definition of your own suitability for a particular investment or strategy. Suitability identifies what is appropriate, given your income, sophistication, experience, understanding of markets and risks, and capital resources. All too often, investors understand the profit potential of a strategy, but not the full extent of risk.

[...] call buyers have to recognize the need for not just price change, but adequate price change to offset declining time value.

Knowing when to take a profit is only a part of the option trader's goal. It is equally important to know when to take a loss.

[...] time to go until expiration, combined with the distance between current market value of the stock and striking price, determine what is a bargain, more than the premium of the call.

Remember that the real leverage value of options takes place when the option is in the money. Then the intrinsic value will change point-for-point with the stock.

[...] whenever a stock is five points or more below the call's striking price, it is described as being deep out of the money. [...] If the stock's market value is five points or more above striking price, it is said to be deep in the money. These definitions are significant to call buyers. A deep out-of-the-money option, because it requires significant price movement just to get to a breakeven point, is a long shot; and a deep in-the-money call is going to demand at least five points of premium just for intrinsic value, in addition to its time value. So the majority of calls buyers will buy within the five point range on either side of the striking price.

Even with the best timing and analysis of the option and the underlying stock, it is very difficult to earn profits consistently by buying calls.

Whatever strategy you employ in your investment portfolio, always be keenly aware of how much price movement is required to create a profit; the risks involved in the strategy required to achieve that profit; and the range of potential losses to which you expose yourself.

Defining breakeven price and profit and loss zones helps you to develop a strategy with complete awareness of the range for potential profit or loss. It also helps to define the range of limited loss in cases such as options buying, so that risk can be quantified more easily.

The option's premium level cannot be used reliably to judge the viability of a buy decision. It can be used to define potential losses, however.

Buying Puts

If you believe the underlying stock's market value will decline in the near future, you can take one of three actions in the market: Sell short on shares of the stock, sell calls, or buy puts. When you buy a put, your desire is that the underlying stock's value will fall below the striking price; the more it falls, the higher your profit.

The short seller's only advantage over the put buyer is that they do not have to be concerned with expiration. Of course, the longer the short seller keeps the position open, the higher the interest cost – not to mention the lost opportunity cost involved with keeping collateral on deposit with the brokerage firm.

Each stock has its own attributes and reacts differently in changing markets. Many issues tend to follow an upward or downward price movement in the larger market, and others do not react to markets as a whole. It is important to study the attributes of the individual stock.

A bargain price might reflect a bargain, or it might reflect a lack of value in the option. Sometimes, real bargains are found in higher-priced options.

You might be right about the general trend in a stock, but not have enough time for your prediction to become true before expiration. With this in mind, it is critical to set goals for yourself, knowing in advance when you will sell a put – based on profit goals as well as loss bailout points.

The further out of the money, the cheaper the premium for the option – and the lower the potential to ever realize a profit.

A very conservative strategy involves buying one put for every 100 shares of the underlying stock owned, to protect yourself against the risk of falling prices. [...] When a put is used in this manner, it is called a married put, since it is tied directly to the underlying stock.

Remember this guideline: As a buyer, don't depend on time value to produce profits between purchase date and expiration, because that is highly unlikely to occur.

Selling Calls

While buyers seek options with the lowest possible time value and with market value within reasonable proximity to striking price, sellers do the opposite. They seek calls with the highest possible time value, preferably as far out of the money as possible. You earn a profit as a call seller due to the decline in time value. That enables you to close out the position by buying the call for a lower premium than you received at the opening sale.

Time is the buyer's enemy, but the opposite is true for the seller. You make your profit as time value evaporates.

If you sell a call but you do not own 100 shares of the underlying stock, the option is classified as a naked option or uncovered option.

Selling uncovered calls is a high-risk idea, because in theory, a stock's price could rise indefinitely. Every point rise in the stock above striking price is $100 more out of the call seller's pocket.

When you enter into an opening sale transaction, you are referred to as a writer.

Exercise does not always mean a loss. The call premium discounts a minimal loss because it is yours to keep, even after exercise.

As a writer, you do not have to wait out expiration; you have another choice. You can close out your short position at any time by purchasing the call.

Because exercise can happen at any time your call is in the money, you need to be aware of your exposure; even early exercise is a possibility. If you sell an in-the-money call, exercise could happen the same day.

By selling a call when you also own 100 shares of the underlying stock, you cover your position. If the option is called away by the buyer, you can meet the obligation simply by delivering shares that you already own.

The disadvantage to covered call selling is found in lost opportunity risk that may or may not materialize. If the stock's market value rises dramatically, your call will be exercised at the specified striking price. If you had not sold the call, you would benefit from higher market value in shares of stock. So covered call sellers trade the certainty for premiums received today, for the potential lost profits in the event of exercise.

Take profits when they can be taken. You cannot count paper profits because they could evaporate and never return.

Never sell a covered call unless you would be satisfied with the outcome in the event of exercise.

If you would be overly concerned about the potential for big gains in the stock, then writing covered calls would not be appropriate for you.

Roll forward: the replacement of one written call with another with the same striking price, but a later expiration date.

The more lots of 100 shares you own of the underlying stock, the greater your flexibility in rolling forward and adding to your option premium profits. Canceling a single call and rolling forward produces a marginal gain; however, if you cancel one call and replace it with two or more later-expiring calls, your gain will be greater. This strategy is called incremental return.

Roll down: the replacement of one written call with another that has a lower striking price.

The roll down is an effective way to offset losses in stock positions in a declining market, as long as the price decline is not severe. Profits in the call premium offset losses, reducing your basis in the stock.

Roll up: the replacement of one written call with another that has a higher striking price.

Rolling techniques can help you to maximize option returns without going through exercise, most of the time. But the wise seller is always prepared to give up shares. That is the nature of seller options.

The key to profiting from rolling forward is in remembering that the longer the time until expiration, the more time value there will be in the call.

Stocks whose options offer greater time value do so for a reason. As a general rule, those stocks are higher-risk investments.

Choosing the Right Stock

If you pick stocks on the basis of rich time value premium, you are likely to end up with a portfolio of high-risk stocks. Thus, if and when the market suffers a downturn – even a temporary one – those stocks are likely to react more strongly than average, and to lose market value quickly.

Value in your portfolio of stocks exists whether or not you sell options. You cannot expect to bail out poorly selected stocks by offsetting stock losses with option profits.

One of the great advantages in selling covered calls is that a minimum profit level is ensured as long as you also remember that the first step always should be proper selection of the stock.

The ideal situation for call writing involves long-term holdings that have appreciated in value well above original basis; that you would not mind selling at a profit; and that you can afford to hold indefinitely, even if primarily to use as cover for written calls. All of these observations assume as well that the stock continues to represent a worthwhile investment on its own merits.

Covered call writing is a conservative strategy, assuming that you first understand how to pick high-quality stocks. First and foremost should be a stock's investment value, meaning that option potential should not be the primary factor in the selection of stocks in your portfolio. [...] If you first analyze the stock for investment value, timeliness, and safety, the option value may then be brought into the picture as yet another means for selecting among otherwise viable investment candidates.

It would be a mistake to continue holding stock because it represents a good candidate for covering call sales, when in fact that stock no longer makes the grade based on analytical tests that you use.

While the fundamentals help you to gain insights into a company's overall financial and capital strength, technical indicators help you to judge market perception about future potential. In this regard, the fundamentals look back at a company's history to estimate the future; and technical indicators are used to make estimates based on current market information.

Investing is more likely to be a successful experience if you employ common sense, backed up with study, analysis, and comparison. If you seek fast riches through easy formulas, you are more likely to lose money than to make money in the stock market. Getting rich without hard work is no easier in the stock market than anywhere else.

Delta: the degree of change in option premium, in relation to changes in the underlying stock.

Open interest: the number of open contracts of a particular option at any given time, which can be used to measure market interest.

Strategies in Volatile Markets

Success in the market should be defined as being right more often than being wrong. Expecting loss is realistic; if a loss takes you by surprise, then you need to take a second look at your expectations.

Options investors will do well to select stocks for long-term investing based on a thorough examination of the fundamentals, and then use technical indicators to time short-term option positions.

Risk tolerance is an ever-changing matter, reflecting your attitude at the moment. It will be different next year and the year after, so you need to review risk tolerance constantly.

LEAPS: Long-term Equity AnticiPation Securities, long-term option contracts that work just like standardized options, but with expiration up to three years.

The LEAPS option removes the most inhibiting factor of the options market, the short-term nature of contracts and ever-looming expiration. A three-year lifespan is an eternity in the options market.

Selling Puts

By and large, a put seller takes a reasonable position in assuming that book value per share is a fair support level, and it is unlikely that the stock's price will fall below that level.

If you are willing to purchase shares of stock at the striking price, then selling puts is a smart strategy. In one regard, there is no actual risk because you think the price is reasonable. Of course, in the event of exercise, you would own 100 shares whose current market value would be lower than your purchase price, and that ties up capital.

Premium value is only half the test of a viable put sale; the other half is careful selection of stocks.

The key to selecting puts should not be the size of the premium, but your willingness to buy the stock at the striking price in the event of exercise.

Combined Techniques

Decision making isn't a matter of arriving at a right or wrong answer; it's a matter of selecting the most effective course of action from among less effective courses of action.

Spread: the simultaneous purchase and sale of options on the same underlying stock, with different striking prices or expiration dates, or both.

When the striking prices are different but the expiration dates are the same, it is called a vertical spread. This is also referred to as a money spread.

Straddle: the simultaneous purchase and sale of the same number of calls and puts with identical striking prices and expiration dates.

A bull spread provides the greatest profit potential if and when the underlying stock's market value rises. With the bull spread, you buy an option with a lower striking price and sell another with a higher striking price.

[...] the bear spread will produce profits if the stock's market value falls. In this variety of the spread, the higher-value option is always bought, and the lower-value option is always sold.

Bear strategies often are overlooked by investors, who tend more often than not to be optimists. Look at all of the possibilities. You can make money when the stock goes down in value, too.

When you open a bull spread and a bear spread at the same time, using options on the same underlying stock, it is called a box spread.

A spread in which more cash is received than paid, is called a credit spread. When the net outcome requires you to make a payment, it is called a debit spread.

Another variation of spread involves simultaneous option transactions with different expiration months. This is called a calendar spread, also called a time spread. The calendar spread can be broken down into two specific variations. Horizontal Spread: In this variation, options have identical striking prices but different expiration dates. Diagonal Spread: In this variation, options have different striking prices and different expiration dates.

The ratio calendar spread involves the employment of a different number of options on each side of the spread, and using different expiration dates as well. The strategy is interesting because it creates two separate profit and loss zone ranges, broadening the opportunity for interim profits.

Whenever options are bought or sold as part of a strategy to protect another open position, the combination of positions represents a hedge. A long hedge protects against price increases. A short hedge protects against price decreases.

Reverse hedge: an extension of a long or short hedge in which more options are opened than the number needed to cover the stock position; this increases profit potential in the event of unfavorable movement in the market value of the underlying stock.

Variable hedge: a hedge involving a long position and a short position in related options, when one side contains a greater number of options than the other. (The desired result is reduction of risks or potentially greater profits)

Another variation of hedging involves cutting partial losses through partial coverage. This strategy is known as a ratio write.

A long straddle involves the purchase of calls and puts at the same striking price and expiration date. Because you pay to create the long positions, the result is a middlezone loss range above and below the striking price; and profit zones above and below that zone. [...] The opposite situation – a middle profit zone – is created through opening a short straddle. This involves selling an identical number of calls and puts on the same underlying stock, with the same striking price and expiration date. If the stock's market price moves beyond the middle profit zone in either direction, this position would result in a loss.

For each and every strategy with limited profit potential, always ask the critical question: Is it worth the risk?

Choosing Your Own Strategy

Establish two price points in every option position: minimum gain and maximum loss. When either point is reached, close the position.

You cannot really know your risk tolerance until you have placed money at risk – no matter how much time you spend on the theory of the market. There is no substitute for experience.