Chapter 20
Simple Options Strategies
I attended a 3-day investing seminar in February 2006 and learned some very simple options strategies that I am adding to my AIM strategy. Options offer excellent ways to vastly increase your profits while you wait for your stocks to rise and make you profits using AIM. First I want to give you the basics about options. I strongly recommend you go to Amazon or eBay and buy a couple of basic books on options. Options and knowledge of trading them is the key to wealth.
Two books I recommend:
Getting Started in Options by Michael C. Thomsett
Options Trading for the Conservative Investor by Michael C. Thompson
I will start with some basic information so you will have an idea of what I'm talking about later.
Options: An option is a contract (each contract = 100 shares of the stock) between a buyer (option holder) and the seller (option writer) that gives the buyer the right, but not the obligation, to buy (call) or to sell (put) specific stock at a specific price on or before a specific date in exchange for a market premium. If you buy or sell 10 contracts then you control 1,000 shares of a specific stock for a limited period.
Option Holder; Option Writer – The option holder is the person who buys the right conveyed by the option. The holder of a cash settled option has the right to receive an amount of cash equal to the cash settlement amount upon exercise prior to the expiration of the option. The option writer sells the option to the option holder.
Cash Settlement Amount – The cash settlement amount is the amount of cash that the holder of the cash–settled option is entitled to receive upon exercise of the option. It is the amount by which the exercise settlement value of the underlying interest of the cash–settled call exceeds the exercise price of a cash–settled call, or the amount by which the exercise price of a cash–settled put exceeds the exercise settlement value of the underlying interest, multiplied by the multiplier for the option.
Here's an example of the cash settlement amount:
Assume that the holder of a cash–settled option on XYZ stock that has an exercise price of 80 exercises it when the exercise settlement value of the stock is 85. If the multiplier for XYZ stock is 100 (1 contract), the assigned writer would be obligated to pay, and the exercising holder would be entitled to receive, the cash-settled amount of $500 ($85 minus $80 multiplied by 100 = $500).
Exercise Price – The exercise price, also called the "strike price" is the price at which the option holder has the right either to purchase or to see the underlying stock.
For example: A physical delivery XYZ 40 call gives the option holder the right to purchase 100 shares of XYZ stock at an exercise price of $40 a share. A physical delivery XYZ 40 put option gives the option holder the right to sell 100 shares of XYZ stock at an exercise price of $40 a share. The exercise price of a cash–settled option is the base for the determination of the amount of cash, if any, that the option holder is entitled to receive upon exercise.
Expiration Date – This is the date on which the option expires. If an option has not been exercised prior to its expiration, it's worthless – that is the option holder no longer has any rights and the option no longer has any value. The expiration dates are fixed by the options market on which the series trades. Very important you know and understand what the expiration date is for any options you buy.
When you look options up on the on the web, and again Yahoo Finance is a great place to find all the information you need on options such as the expiration date current price etc. For example you might see XYZ stock options with March, April, July dates listed. These are the months when the option expires. Almost all options expire on the third Friday of the month listed as the expiration month. For regular options normally there are monthly expiration dates extending out for five or six months. You will see later on that our strategy is very concerned with the month our options expire in.
Unit of Trading, Contract Size – The unit of trading, also called the contract, of a physical delivery option is the amount of the underlying interest that is subject to being purchased or sold on the exercise of a single option contract.
For example: a physical delivery XYZ 50 call will give its holder the right upon exercise to purchase 100 shares of XYZ at $50 per share. If the option is trading at a premium (profit) of say, $4 per share, then the aggregate premium for a single option contract would be $400, 100 shares X $4 a share.
Multiplier – The multiplier determines the aggregate value of each point (dollar) of the difference between the exercise price of the option and the exercise settlement value of the underlying interest. Almost all of our multipliers will be 100 because each contract contains 100 shares. So a multiplier of 100 means that for each point or dollar by which a cash–settled option is in the money upon exercise, there is a $100 increase in the cash settlement amount. So for example, if an option with a multiplier of 100 is trading at a premium of say $4, then the aggregate premium for single option contract would be $400.
Exercise – If the holder of a physical delivery option wishes to buy (in the case of a call) or sell (in the case of a put) the underlying interest at the exercise price – or, in the case of the cash-settled option, to receive the cash settlement amount, he must exercise his option. To exercise an option, option’s holders usually give exercise instructions to their brokerage firm in accordance with the firm's policy.
Premium – The premium is the price that the holder of an option pays and the writer of an option receives for the rights conveyed by the option. It is a price set by the holder and writer, or their brokers, in a transaction in an options market when the option is traded. The premium is not a down payment. It is simply an entirely nonrefundable payment in full – from the option holder to the option writer. The holder pays the writer of the right to hold the option for a specific period of time.
Just like with stocks, the premium trades after the initial sale – it can go up or down based on what XYZ stock is doing. The factors that mostly generally affect the pricing of an option include such variables as the current value of the underlying interest (current XYZ stock price) and the relationship between that value and the exercise price, the current value of related interests (e. g. futures on the underlying XYZ stock or interest related to XYZ stock) the style of the option, the individual estimates of market traders on the future volatility of XYZ stock, the historical volatility of XYZ stock, the amount of time remaining until the option expires, cash dividends payable on the underlying stock, exchange-rate in the case of foreign stocks, current interest rates.
You see that many factors can affect your option – but don't worry about this too much. We will be using simple option strategies that don't require us to look at these many factors. The above explanation covers all options strategies – we are just concerned about three options strategies.
Opening Transaction – This is the purchase or sell transaction which opens our position or increases our position in the call or put option.
Closing Transaction – This is the transaction we make at some time prior to the expiration of our call or put option. Here's what we do: we make an offsetting sale of an identical option, or the option writer makes an offsetting purchase of an identical option. A closing transaction in an option reduces or eliminates an investor's previous position as the holder or the writer of that option.
For example: in June an investor buys December XYZ 50 call at an aggregate premium of $500. By September the market price of the option has increased to $700. To gain his $200 profit, the investor can direct his broker to do an offsetting December XYZ 50 call in the closing transaction. On the other hand, if by September the market price of the option has decreased to $300, the investor might still decide to see the option in a closing transaction thereby limiting his loss to $200. Remember the option will expire the third Friday of December – on that date the option is worthless.
Although option holders have the right to exercise at any time before expiration, holders frequently elect to realize their profits or losses by making closing transactions because the transaction costs (commissions) of the closing transactions may be lower than the transaction costs associated with exercises, and because closing transactions may provide an opportunity for an option holder to realize the remaining time value (described below) of the option that would be lost in an exercise (why wait until December when you can sell and buy or sell another option in September and start making money with that option!)
Combination; Spreads and Straddles – Combination positions are positions in more than one option at the same time. Spreads and straddles are two types of combination positions. A spread involves being both the buyer and writer of the same type of option (puts or calls) on the same stock, with the options having different exercise prices and/or expiration dates.
Covered Call Writer – If the writer of a physical delivery call option owns or acquires the amount of the underlying stock that is deliverable upon exercise of the call, he is said to be a covered call writer. This is one of the simple option strategies I will teach you! You will use this with one or more of your stocks. You will use this only on stocks that show little bullish or bearish movement, basically the price is staying around the same amount.
For example: an investor owns 100 shares of XYZ, stock. If he writes one physical delivery XYZ call option – giving the call holder the right to purchase his 100 shares at a specified price – this would be a covered call. Unless you're an expert, NEVER do "naked calls" – that means an investor who writes a call but does not own the stock – if you are wrong you could lose a lot of money!!
At the Money – This term means that the current market value of the stock is the same as the exercise price of the option. If the stock is selling for $25 a share in the exercise price of the option is 25 that stock is "at the money".
In the Money – A call option is said to be "in the money" if the current value of the underlying stock is above the exercise price of the option. A put option is said to be "in the money" if the current market value of the underlying interest is below the exercise price of the option.
For example: if XYZ stock is selling at $43, a XYZ 40 call would be in the money by $3. If X YZ stock was selling at $37, a XYZ 40 puts would be in the money by $3.
Out of the Money - If the exercise price of a call is higher than the current value of the underlying stock or the exercise price of the put is below the current market value of the underlying stock, the option is said to be "out of the money".
For example: with a current market price of XYZ stock at $40, a call with an exercise price of $45 would be out of money by $5. With the current market price of $35, a put with an exercise price of $30 would be out of the money by $5.
Intrinsic Value and Time Value – It is sometimes useful to consider the premium of an option as consisting of two components: intrinsic value and time value. Intrinsic value reflects the amount, if any, by which an option is in the money. In the examples, the call options had an intrinsic value of $5
Time value is whatever the premium of the option is in addition to its intrinsic value – this is the "emotions" in the market – based on what people emotionally think the stock will do. And option will normally never be expected to trade for less than its intrinsic value prior to expiration, although occasionally this would happen.
Here's an example of a call with intrinsic value: when the current market price of XYZ stock is $46 a share, a XYZ 40 call would have an intrinsic value of $6 a share for each contract or each contract (100 shares) has an intrinsic value of $600. If the market price of the stock were to decline to $44, the intrinsic value of the call would be only $4 a share or $400 per contract. Should the stock dropped below $40, the call would have no intrinsic value.
Here's an example of a put with intrinsic value: When the current market price of XYZ stock is $46 a share, a XYZ 50 put would have an intrinsic value of $4 a share or $400 per contract. The price of the stock climbed above $50 share, the put would have no intrinsic value.
Example of Time Value – When XYZ stock is $40 a share, XYZ call may have a current market value of say, $2 a share or $200 per contract. This is entirely time value – someone out there wants the right to be able to buy XYZ stock at $40 a share say any time in the next three months because he or she thinks XYZ stock will go up and they will make a profit.
An option with intrinsic value may often also have some time value as well – that is, the market price of the option may be greater than its intrinsic value. This could occur with both a call and put option.
For example: the market price of XYZ stock at $45 a share, a XYZ 40 call may have a current value price of $6 a share ($600 per contract), reflecting an intrinsic value of $5 a share and a time value of $1 share.
An option’s time value is influenced by several factors (as described under "premium") including the length of time remaining until expiration. And option is a "wasting" asset; if it is not sold or exercise prior to its expiration, it will become worthless.
From the little bit of glancing I've done looking at options, I'd say that emotion rules and you will find plenty of options that you can buy that could be traded and are a good choice. We will look for these kinds of options in using our covered call strategy.
Transaction costs – The transaction costs of options investing consists primarily of commissions (which are charged for opening and closing transactions just as with stocks. If you are a riskier trader and use margin (borrow money from your broker) then you will incur interest costs as well. I am NOT recommending anyone use margin until they feel very comfortable using option strategies. And even then I think it's a bad idea. Always realize options are riskier than buying stocks – don't get in over your head until you are an expert swimmer!!