OPTIONS CZAR HELP - BASIC OPTIONS THEORY
The following text provides a short explanation of Options theory. For a deeper understanding of options, we suggest consulting the information available online through the CBOE and/or research the available literature.
Options are financial instruments that provide the buyer the right (but not the obligation) to purchase or sell an underlying asset on a future date. They are different from Futures in that Futures oblige the buyer to buy or sell the underlying asset, while the Option holder may perform the operation with the underlying asset at will.
Options (along with Futures) are called Derivatives because the trader is not working directly with the underlying asset but with an instrument based on the asset. For example, an Option on a common stock (say, AAPL: Apple Computer, Inc.) provides the holder the option to buy or sell (depending on the Option type) an AAPL stock, but the Option holder is not trading with the AAPL stock directly. As a matter of fact, if the Option holder doesn't exercise the Option, then he/she will never see the AAPL stock.
Up to now, we have introduced several terms: Expiration Date, Exercising and Underlying Asset. The former is the date after which the Option is invalid. Exercising the option is the act of performing the operation with the underlying asset, which is the asset on which the Option is based (e.g. if the option is a call, then to exercise the option is to buy the asset at the strike price). Before continuing, it is important to know that the Options that provide the user the right to buy an asset are called Call Options, while Options that provide the right to sell an asset are called Put Options.
Return on Investments in Options
The Strike Price of an option is the agreed price of the underlying asset on which a transaction is to be made. For example, if an investor buys a Call Option with a strike price of US$ 90, then he/she will be able to exercise it (trade it for the underlying asset) when the market price of the asset is equal or greater than the Strike Price of US$ 90. In this case, the profits that are made with this Option transaction will increase with the market price because the investor will always be able to buy the asset at US$ 90 and be able to sell it the market price. The difference between both prices ultimately determines the profits. In the end, the Option price and the trading commissions have to be subtracted from the difference in the Market and Strike prices. If this sounds confusing at first, it is. Therefore, it is better to explain it with a chart.
The example above (an Options Czar screenshot) shows the following: An investor has purchased 10 Call Options with a Strike Price of US$ 40.00 for US$ 370, including commissions equal to $ 120. At the current market price of US$ 36.37, there is no profit (it is within the red zone). However, if the market price increases to US$ 45.22 (as the investor believes) within the expiration period, then he/she will receive a total profit of US$ 4849.67 (including commissions) if the Option is exercised (the investor receives the stock) and the stock is later sold at the market price. The detailed calculation is as follows:
Profit for each Call purchase = Amount of Underlying Shares per Option x (Market Price - Strike Price - Option Premium) - Commissions, or US$ 485 = 100*(45.22 - 40 - 0.25) - 120/10
To summarize what has happened in this operation, the investor received a total of US$ 4849.67 on an investment of US$ 370, a 1311% profit for the time that it took for that to happen (in this case, less than one month). If you think it sounds too good to be true, it's because the market price would have to jump from 36.37 to 45.22 (a 24% jump) within the expiration period, which in this case is between June 22th and July 22nd (roughly 20 trading days).
The main lesson that we can extract from this short example is that the market prices the Options according to what they expect the users can profit from them. If as in the example before, there are slight chances that the buyer will exercise the Option, then the market price will be relatively low. If there are high chances that the investor will exercise the Options, then the price will be relatively high.
The flip side here is that (like for all transactions) for every investor that made a profit of US$ 4849.67, there's another investor (or group of investors) that lost that much. In order for you not to be on the losing side, please read the theory and pay attention to the risks that are mentioned throughout the execution of Options Czar.
Exercising options vs. leaving the position
In the previous example, we explained how a call buyer can make a profit with an American (that allows exercising prior to expiration) option by exercising it once it passes its strike price and the profits are greater than the price that was paid originally.
However, another way to profit from options is to actually trade them: purchase an option and sell it later when the underlying asset price makes it increase in value or short an option and then buy it back when the underlying asset makes its value diminish.
An additional chart in Options Czar shows how the profit/loss curve looks if the investor decides to buy and then sell the call option. Note that the breakeven price is closer to the current price. That's because the Call option doesn't have to be in-the-money for it's price to increase.
Volatility
A high stock volatility (the likeliness of the stock price to change its value in a given period of time) will increase the price of an option. A low volatility will decrease the price of an option. This is because an option is more valuable if the likeliness to reach its strike price is high. Thus the reason why volatility is included in all options pricing calculations since the original Black and Scholes formula. For a good guide to options pricing calculations formulae, we recommend the following book.
In Options Czar and in most options pricing formulae, volatility is expressed as the stock price standard deviation. Options Czar works with volatility over a three month period and uses this value when calculating the effect of time on an Options strategy. For manual operations, and for the strategy maker, volatility will serve as a general guide to the viability of his/her strategy.
Lies, damn lies and stock statistics. This is where we explain the light gray curve that surrounds the current stock price (see screenshots below).
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The screenshots above show the profit/loss charts for the PG (Procter & Gamble) and AAPL (Apple Computer, Inc.) options and stock for a call purchase. The curve that spans from the current price (center line) down to the sides is the normal distribution curve for that stock. What people with a basic knowledge of statistics will tell you is that the greater the standard deviation, the wider the curve. Translated to the graphics above, the Procter & Gamble stock has a lower volatility than the Apple Computer stock. Therefore, the narrower curve. In essence, what the options market is trying to tell you is that the price swings will be greater for AAPL than for PG and that you should take that into account when choosing your options strategies.
Where did Options Czar get the volatility from? Click on the "Options Chain" tab to see all the options in the chain. As we mentioned before, the volatility is included in the options prices. So what the program did was extract it from each option price and calculate the average. From the implied volatilities that appear for each option, the three-month weighted average was used for the normal distribution.
Please remember that the Options (as with the stock market) is made of human beings trading securities and that most opportunities are already priced into these securities. This is why so many books have been written trying to guess what will occur with the markets and that there is no clear unknown method to beat the market. The normal distribution shown above shows what should happen, not necessarily what will happen.
For those not inclined towards statistics, as the curve gets flatter to the sides, the likeliness of occurrence of the stock price is lower.
Using the volatility for Options strategies
The screenshots below show two Options strategies; a long straddle (left) and a short straddle (right), both using the current stock price as the exercise price for the Call and Put options involved.
The lesson here is the following:
- For the Long Straddle (at left), the investor will profit greatly from a non-expected behavior of the stock price. The market figures that the low risk of this strategy is compensated by the likeliness of low profits or losses.
- For the Short Straddle (at right), the investor will obtain a smaller profit if the stock stays about the same (expected for this low-volatility stock) and incur in losses if the stock price swings greatly.
- Note that the normal distribution curve starts and ends at plus or minus 3 times the volatility, respectively. In statistical terms, the area within the curve represents 99.9974% of the possible stock prices. Although this is just statistics and as we said before, securities are traded by human beings, there are slim chances that the stock price will reach any of the limits. Having said that, the investor should recognize what type of Profit/Loss curve is he/she more comfortable with.
When to exercise
In an Options transaction, it is the buyer, not the writer who has the "option" of exercising the security or not. This allows the buyer to have a better control over his/her profits and losses in a more effective manner. The examples below illustrate this point.
An investor buys a Call, which gives him/her the right (but not the obligation) to buy an underlying asset at a certain (strike) price. The Option is an August '06 Ford Motors 7.50 Call at the market price of US$ 0.10 (per share). See chart below.
- The investor is buying an out-of-the-money Option, which means that he/she can't exercise it. An out-of-the-money Option is identifiable in Options Czar because the circle to the left of the Option name is colored orange (as opposed to green).
- The investor's position is called a Long Position because he/she owns the security (the option).
- The investor paid the option premium + the commissions to the broker. All this added up to US$ 49. This is the maximum amount that the investor will lose and it was paid up front.
- If the stock price increases above the Strike Price of US$ 7.50, the investor may choose to exercise it and lose less than the US$ 49 that he/she would have lost.
- If the stock price increases above the breakeven point (here it is US$ 7.76), the investor will start profiting from his/her investment.
- Therefore, the three outcomes of this call investment:
- If the stock price is below the Strike Price, the investor will lose what he/she paid upfront, which was the option premium + commissions. The option is not exercised
- If the stock price is between the Strike Price and the breakeven point, the investor will lose less than what he/she paid upfront. The option should be exercised or sold.
- If the stock price is greater than the breakeven point, the investor will turn a profit (green portion of the chart). The option should be exercised or sold.
- That said, the investor in the Long Position (the one who owns the option) needs to identify the point in which he/she has made a profit and exercise or sell the option prior to the contract expiration. In the example above, if the investor thinks that the stock price will continue increasing, he/she can wait a little longer and obtain a greater profit.
On the opposite side of this equation, another investor sells a Call, which gives another investor the right (but not the obligation) to buy from him/her an underlying asset at a certain (strike) price. The Option is an September '06 Ford Motors 7.50 Call at the market price of US$ 0.15 (per share). See chart below.
- The investor is selling an out-of-the-money Option, which means that the buyer can't exercise it at this point.
- The investor's position is called a Short Position because he/she doesn't own the security (the option).
- The writer received the premium and paid the commissions, which left him with US$ 3. Yes, three dollars, it's just an example. He/she made US$ 15 with the sale but had to pay US$ 12 for commissions. This (US$ 3) is the maximum amount that the investor will receive and will occur if the stock price remains below the strike price as the Option buyer will not exercise.
- If the stock price increases above the Strike Price of US$ 7.50, the options buyer may choose to exercise it, so the options writer will earn less. In this case, since the profit was so slim, the breakeven point is US$ 7.56 (6 cents above the strike price). Technically speaking, if the stock price surpasses the strike price, the writer will start presenting losses.
- If the stock price increases above the breakeven point, the write will continue losing money as a function of the stock price increase. Since the writer doesn't own the option, he/she doesn't have any control on the losses that will occur.
- Building more on this, if there is a one-in-a-lifetime stock price increase due to a breakthrough development at the company (say, Ford developed a flying car) and the stock price increases 33% prior to the options expiration, the writer can lose up to US$ 104 vs. an upside of just US$ 3. Hopefully, this will help illustrate the risks of options writing.
- To summarize, the outcomes of this call sale are:
- If the stock price is below the Strike Price, the investor will earn what was paid upfront by the options buyer.The options buyer will not exercise. In this situation, the writer makes a profit (and the buyer incurs in a loss) by the sale price of the Options security.
- If the stock price increases beyond the strike price, the options writer will begin to incur in losses as a function of the increase in the stock price.The options buyer (or another whom he/she sold the option to) will exercise it and demand the respective cash amount or the stock at the lower strike price. In this situation, the buyer's profit is based on buying the stock at a low price and selling it at a higher market price or being paid that difference by the writer.
Is it possible to never exercise an Option and still make a profit? Yes, as explained before, the higher the stock price, the higher the premium for a Call and the lower the stock price, the higher the premium for a Put. Therefore, if you buy a Put, its value will increase with a decreasing stock price, allowing it to be sold again for a profit. Please note that options contracts lose their value (their price or premium) as the expiration date gets closer.
Expiration dates and CBOE calendar
Options that are traded in the Chicago Board Options Exchange have expiration dates where the months are a function of the cycle that they belong to and the days a function of the CBOE calendar. Please note that the expiration dates that are included in Options Czar are those for equity options, which differ from the expiration dates for other underlying assets.
For example, if you use the June 22, 2006 data for NOK (Nokia) options, you will note that you can purchase options that expire in July, August or October. On the other hand, on June 22 you can buy DELL options that expire in July, August or November. However, no matter what month they expire in, the dates will be the same (July 22, 2006, August 19, 2006, etc.).
This can be better explained through the following chart. Note the dates in red at the bottom of the chart and how the red and green areas are no longer valid beyond the December expiration date. We have repeated throughout this web page that nothing comes for free. Newcomers to options will realize that there are greater chances of achieving the breakeven points for options will later expiration dates than those that expire sooner. Therefore, the market takes care of that and prices the options higher than those with a shorter validity.
The theory that has been outlined here is very basic, so please take the time to review the available online and offline information to learn about concepts such as "in the money", "at the money", "out of the money". Although Options Czar can help you practice Options trading prior to actually executing them, knowledge of Options theory is always important. Options trading involves risks, so please take time to read the Characteristics and Risks of Standardized Options
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