What are options?
Options are called derivatives because they are contracts that derive their value from another asset. In the case of equity options, that asset is a stock. In the case of index options, that asset is an index. In futures, the asset is a futures contract.
Options trade on exchanges. The exchange facilitates the transaction and executes the trade. The largest and best known exchange for equity options is the Chicago Board Options Exchange commonly known as the CBOE. In addition there are eleven other options exchanges, up from a total of five exchanges ten years ago.
You never know who specifically you are buying the option from or selling to, it all happens through the exchange which creates bid and ask pricing for the option contract. But the actually middle man is the Options Clearing Corporation (OCC). All option contracts traded on U.S. securities exchanges are issued, guaranteed and cleared by OCC. OCC is a registered clearing corporation with the SEC and has received a ‘AAA’ credit rating from Standard & Poor’s Corporation. The ‘AAA’ credit rating relates to OCC’s ability to fulfill its obligations as counter-party for options trades.
In my trading I focus on standard equity options which are monthly and expire on the thrid Friday of the month. There are also weekly options on some stocks. Weekly options begin on a Thursday and expire 7 trading days later on the following Friday. In addition there are now expanded weeklys that provide addition weeks until expiration.
There are also LEAPS which stands for Long-term Equity AnticiPation Securities. These have time frames of up to 3 years. In addition there are quarterly options on some Index ETFs, Binary Options and Mini-Options.
Again my focus is purely on standard monthly equity options on stocks. I trade equity options because stocks, on which the options are tied to, are more volatile than ETFs or Indices. So when you see my list of stocks they usually have a Beta of 1.5 or higher. A Beta of 1.0 means that the stock is highly correlated with the market. If the S&P 500 goes up 1% that stock should also go up 1%. Therefore high Beta stocks will generate more movement for any given move in the stock market.
There are two basic types of option contracts, Calls and Puts.
A Call gives the purchaser the right, but not the obligation to buy 100 shares of the underlying stock anytime between the time of purchase and the expiration date. Because a Call is tied to the right to buy stock at a specific price, when a stock goes up, the value of the contract also goes up. How much it goes up depends on what Strike Price is designated in the Call contract.
A Put works in reverse. A Put gives the purchaser the right, but not the obligation to sell 100 shares of the underlying stock anytime between the time of purchase and the expiration date. People get confused about this because they think “how could I sell something I don’t own?”
The main point to remember is that you are trading the option contract itself and you don’t have to exercise that right to sell. As the stock drops in value below the strike price of the option, the Put becomes more and more valuable. This is the easy way to “short” a stock without having to borrow shares from a broker. If your analysis tells you the stock is going down then buy a Put and make money as it drops. And remember stocks go down much faster than they go up.
Options Strike Price
The Strike Price is the price in the contract for which you have the right to buy the stock if it is a Call or sell it, if it is a Put. For example if you buy a YHOO December 30 Call, you have the right to buy 100 shares of YHOO at $30 per share anytime between now and the third Friday of December. So as the price of YHOO rises above 30, the contract will become more valuable. Why? Let’s look at an example.
YHOO stock trading at $33 and YHOO Dec. 30 Call priced at $425. There are two components to the price of the Call.
1) Intrinsic value which is value created by the fact that the stock is 3 pts above the strike price of 30. So the Intrinsic Value is $300. If you exercised the contract today, you could buy 100 shares for $30/share and turn around and immediately sell it in the marketplace for $33/share, thereby profiting by $3 X 100 shares = $300.
2) Premium which is the value the marketplace puts on the time remaining in the contract and by the volatility of the stock. The more volatile a stock the higher that premium component will be valued and naturally the more time remaining in the contract the higher the premium component. The closer you get to the expiration date the faster the premium starts to decrease. The premium in our example is $125.
ITM vs OTM Options
If an option has intrinsic value, like in the example above, then it is considered to be In-The-Money (ITM). If it has no intrinsic value and is all premium, then it is called an Out-of-The-Money option. As mentioned above premium decreases the closer you get to expiration. In the last 30 days it starts to drop off dramatically, therefore you have to be careful and have a real good reason for owning OTM options especially as they get into the last month.
When it comes to options, timing is very important. Options are what is called a “wasting asset” in that they lose some part of their value everyday. That is why I chose the “hourglass” as the symbol for my logo. Time is critical. The good news is, options also pack a lot of pricing power into a small amount of dollars.
Option Expiration Date
Equity Option contracts officially expire on the Saturday following the third Friday of the month. In reality you just think of it as the third Friday because trading stops at 3pm CST on Friday. The expiration months are issued in quarterly cycles and specific stocks are tied to a specific quarterly cycle. In addition there will always be options issued for the 2 nearest months.
So again using YHOO as an example you can look at the CBOE symbol directory and see that it has Cycle 1 designation. That means options are issued with January, April, July and October expiration months. YNDX has a Cycle 2 designation so options are issued for February, May, August and November. Facebook (FB) has a Cycle 3 designation so options are issued for March, June, September and December.
And remember that options are issued for the 2 first months also. So today is October 22. October options expired on October 18, so the current front month is November. So YHOO has November, December, January and April options available for trading.
Option Price Quotes and Orders
Option prices are quoted $3.10 bid – $3.20 ask. What this really means is that the value of the contract is $310 bid- $320 ask because we are dealing with 100 share contracts. Option prices < $300 are quoted in $.05 ($5) increments and option prices > $300 are quoted in $0.10 (or $10) increments.
When you place an order with a broker to buy an option, the transaction is a “Buy to Open” a position transaction. When you go to sell your position, it is a “Sell to Close” transaction. This is very important. If you click on a button and it only says “Buy” or “Sell” then you are doing a stock transaction not an option.
When someone “writes” an option, they “Sell to Open” and when that person wants to close out their position, it is “Buy to Close”. The “writer” of the option is the person who is creating the option contract that you are buying, be that a Call or a Put. Usually they have shares that they are writing that contract against.
These are some of the basic facts regarding options. There are many other aspects of options in terms of strategy, the “greeks”, stops, etc. I go into all of this in my course, “Power Swing Trading using Options”.
My eBook, 7 Keys to Successful Option Trading provides some of the lessons I have learned in over 3 decades of option trading.