Understanding Options

Understanding Options, Part 1

A Daily Reckoning Exclusive Report
By Steve Sarnoff

Many people are intimidated by the notion of trading options, fearing that they need to be rocket scientists in order to understand them. There’s no need to be intimidated, because with the right mentor, the basics are easy to understand.

For years, I’ve been helping people make money with options. My weekly Options Hotline e-alert is one of the longest-running option advisory services available, boasting an almost unbeatable track record.

I’m also longtime colleague of the writers of The Daily Reckoning and New York Times’ best-selling authors, Bill Bonner and Addison Wiggin.

The Daily Reckoning weaves information about the financial world, investment opportunities and everyday life into an educational and entertaining e-letter that’s been engaging readers since 1999. It’s fresh, witty and addictive.

I’ve prepared this research report that can help you understand option trading and find out if they are right for you.

Let’s start with the types of options.

An option is the right – but not the obligation – to buy or sell a stock’s index or future at a specific price for a specified amount of time.

The stock, index or future that you buy the option for is known as the underlying instrument. Options are bought and sold to take advantage for the prices movement in the underlying asset.

There are several benefits to buying stock options as opposed to buying the stock outright.  They are relatively inexpensive, particularly when compared to the cost of the underlying instrument. For instance, you might be able to buy stock in XYX Corp. for $1000 per share. Stock is commonly traded in blocks of 100, so you would spend $10,000 for this position.

You can control the same amount of stock for a fraction of that price by buying an option instead. The options might be listed for 8 points. So by purchasing options, you will spend $800 instead of $10,000 to control 100 shares. (Stock options are for 100 shares, so $8 X 100 shares gives you the price of $800, not including your commission.)

Keep in mind, you are NOT buying stock, you are leasing its profit potential for a given amount of time.

The second reason to buy options is because they are flexible. You can profit from options even if the stock goes down. It’s not otherwise possible to do this unless you sell a stock short, a potentially very risky proposition if the stock moves into the opposite direction of your prediction.

The third advantage to buying options, one that I’ll repeat several times, is that you can never lose more than what you paid for the option. Your maximum risk is known and strictly limited. This does not mean that there is no risk, but it is more clearly defined than with stocks with other speculative plays such as buying on margin – buying commodities or stocks with a loan from the broker of up to 50% of the equity’s price.

The fourth benefit to buying options is that they offer superleverage – a concept I’ll describe in greater detail if you become a member of Options Hotline.

A favorable move in a stock of 10-20% can easily translate into profits of 50% to 100% or more on an option purchase.

The final benefit of options is that, like stocks, they are traded on regulated exchanges. This provides a level of protection for you, the option buyer, which my father couldn’t get when he first began trading. You can expect the same rights and privileges of entering order for options as you can for stocks.

The difference between Call and Put Options

Call options give buyers the right to buy a set amount of an underlying instrument (usually 100 shares per contract) at a specified price (the strike price) within a set time (prior to expiration).

Put options give buyers the right to sell a set amount of an underlying instrument (usually 100 shares per contract) at a specified price (the strike price) within a set time (prior to expiration).

Let’s start by looking at calls. Why would you want to buy calls? If you’re bullish on a stock – meaning, you expect the prices to rise- and you don’t want to commit and risk all the capital needed to purchase the stock, then you’d want to buy calls on that stock.

You can learn about buying a call by studying the following example: Let’s say it’s January, and you are considering buying the March Home Depot (HD: NYSE) $40 call for 2.5 (Multiply the points in this example by $100 to get the premium or cost of the basic contract. In this case, it will be $250). Home Depot stock is trading at $38 per share.

In this example, you are considering acquiring the right, but not the obligation, to buy 100 shares of Home Depot (HD: NYSE)stock at $40 per share on or before the third Friday in March for a price of  $250, plus commission.

Let’s look at each part of this typical offering…

The first part of the offering (from left to right) is the expiration date. This is the month in which the option will expire, usually on the third Friday of the month.

For the purpose of this example, think of the third Friday of the expiration month, this last trading date, as your option’s expiration date.

The importance of the expiration date

A stock option usually begins trading about eight months before its expiration date. The exception is LEAPS or long-term options, which I discuss later in this report.  As a result of the sequential nature of the expiration cycles, some option have a life of only one to two months. A stock option trades on one of their expiration cycles. At any given time, an option can be bought or sold with one of four expiration dates as designated in the expiration cycle table. The can be a bit confusing, so remember, if you buy an option, you must pay attention to the expiration date or risk having your option expire worthless.

After the expiration date, you may no longer exercise your rights and the option becomes worthless. For equity options, the expiration date is typically the third Friday in the expiration month (in our example, that month is March). Always be certain of your option’s expirations date because Superleverage instruments die on a certain date.

Be warned: If you don’t exercise your option by the expiration date, you lose all the value you had in the option.

Next, the offering specifies the name of the underlying instrument, the stock, index, or future that the option gives you the right (but not the obligation) to buy. In this case, the underlying instrument is Home Depot (HD: NYSE) stock.

The $40 part of the offering represents the strike price (also known as the exercise price), the price you’ll pay for the stock if you exercise your option to buy the underlying instrument. In this example, you are given the right to buy Home Depot (HD: NYSE) stock at $40 per share.

Exercise means the action taken by a call holder if he wishes to purchase the underlying instrument at the option strike price. If you choose to exercise your option, you are taking a position in the underlying instrument, that is, you are buying the stocks.

The next this is to look at is what type of contract it is, call or put. This is a call (option to buy) option. The final entry is the premium or option price. This is the price you pay for the option. It can be expressed, as it is here in points, i.e. The cost per share of the premium, expressed as dollars. Or it can be expressed as dollar. Or it can be expressed as the cost for an option on 100 shares since option contracts are typically in 100-share lots. In this case, the premium option price would be $250.

You are likely to see the option premium quoted as 2.5 or 2 1/2, especially in the newspaper or on the Internet. To calculate the actual price, simply multiply the points by $100 to get the actual cost of the option contract (2.5 x $100 = $250), excluding brokerage commission.

The options premium is made up of real value and time value.

Real Value is also known as intrinsic value or minimum value. If your call optiongives you the right to buy 100 shares of a stock at $40 per share ad you can sell that stock in the open market at $42 per share, your option has a $2 per share of real value. This works out to  $200 for a 100-share call contract.

Time value is also known as extrinsic value. It is the amount of the option premium over and above the minimum value of the option. Time value is a function of various factors, including time until expiration and the volatility of the underlying instrument. It is calculated using a complex formula that helped win its developers the Nobel Prize in economics.

Let’s return to our example where you bought the March Home Depot (HD: NYSE) $40 call for a price of 2.5 ($250). When the Home Depot (HD: NYSE) stock price rises above $40, the call option with a $40 strike price has real (intrinsic) value. If Home Depot (HD: NYSE) higher and is trading at $50 per share prior to expiration, the $40 call (the right to buy Home Depot (HD: NYSE) at $40) has $10 of intrinsic value.

Your call option gives you the right to buy 100 shares of Home Depot (HD: NYSE) at $40 and be cause the underlying shares are trading at $50, you can sell them for a $10 per share profit.

Multiplying that $1 per share intrinsic value by the 100 shares per option contract gives you an option with $1,000 of real value.

If you would have purchased 100 shares of Home Depot (HD: NYSE) at $38 per share and later sold them at $50, your initial investment would have been $3,800 for a $5,000 gross (a $1,200 profit, or = 32% return, not bad). Remember though, the cost of the call option was only $250 for a $1,000 gross (=300% on a 32% move in the stock).

When you consider that no matter how badly the movement of Home Depot (HD: NYSE) shares goes against you (in this case, assume the price declines and the options expire worthless), the most you could lose is your cost of purchasing the options ($250 each, not counting commission).

Are you beginning to see the powerful leverage provided by options?

That power is only afforded to options buyers. Writers (sellers) of options are obligated to sell you the underlying instrument at a strike price below the current market price. Likewise, seller of puts are obligated to buy back the underlying instrument from the option buyer (you) at a higher prices that it is currently worth on the market.

Sellers of options have a limited return and an unlimited risk. But more people lose money buying options, so you need to find a market analyst who you can trust.

Here is the key point to ponder: Why would you want the right to buy Home Depot (HD: NYSE) at $40 when you can just buy the shares at $38?

You would do it if you anticipate a sharp rise in the price of Home Depot (HD: NYSE) shares. Buying call options can be preferable to purchasing the shares outright, as you’ll soon learn.

With Home Depot (HD: NYSE) at or below $40 the call option has not real value. Its only value is time value – its potential to increase in value over a period of time.

And option like this is said to be out-of-the-money.

Call options whose underlying instrument is below the strike price are called out-of-the-money options.

If the price of the underlying instrument is equal to the strike prices, those calls are at-the-money. Call options whose underlying instrument is trading above the strike price are called in-the-money options.

Farther out-of-the-money options are less expensive to purchase and will outperform when the underlying instrument makes a big move in your favor. They are less expensive. At- or near-the-money options cost more, but they are less risky.

In my next report I will demonstrate how to determine the breakeven point, how to calculate an option’s value, the explanation of puts, LEAPS and more.

This completes the first segment of my research report, Understanding Options.

I’ve covered a great deal with you today… but this is only the beginning, and there is much more to learn. Stayed tuned… Understanding Options, Part 2 will be posted soon.

Happy Trading,
Steve Sarnoff

The Daily Reckoning