Principal Risks of Option Positions
Here I will discuss the potential risks with options trading. It is very important that you understand all the possible risks before you start options trading!
Biggest Risk – An option holder runs the risk of losing the entire amount paid for the option in a relatively short time – several months or several years. This risk reflects the nature of an option as a wasting agent that expires in a short time and becomes worthless when it expires. An option holder who neither sells his option in the secondary market nor exercises it prior to expiration will necessarily lose his entire investment in the option.
The fact that options become valueless upon expiration means that an option holder must not only be right about the direction (up or down) of an anticipated price change in the underlying stock but must also be right about when the price change will occur. If the price of an underlying stock does not change in the anticipated direction before the option expires to an extent sufficient to cover the cost of the option (premium) the investor will lose all or a significant part of his investment in the option. This contrasts with that investor buys a stock directly and may continue to hold the stock forever hoping it will move in the direction he wants.
The significance of this risk to an option holder depends in large part upon the extent to which he utilizes the leverage of options to control a larger quantity of the underlying stock than he could have purchased directly with the same investment amount. The example below compares the consequences of three different approaches to investing the same of amount of money in stock or options, with each approach involving a different degree of leverage.
Example – Assume that investors A, B, and C each have $5,000 to invest and that each anticipates an increase in the market price of XYZ stock, which is currently $50 a share. Investor A invests is $5,000 in 100 shares of XYZ. Investor B invests $500 in the purchase of XYZ 50 call option (one contract for 100 shares of XYZ at a premium of $5 a share) and invests the remaining $4,500 in relatively risk–free investments such as Treasury Bills. (We'll assume in this example that all of the calls are purchased when they have six months remaining until expiration and that the risk-free investment bears interest at an annual rate of 3.25% - which means that a $4,500 investment will earn approximately $73 and interest over six months). Investor C invests his entire $5,000 in 10 XYZ 50 calls (10 contracts @ $500 each – $5,000).
If each option is held for six months and, if it is profitable, is either sold or exercised immediately before it expires, the following illustrates the dollar and percentage profit or loss that each investor would realize on his $5,000 investment depending upon the price of XYZ stock when the option expires. Increased leverage ($5,000 worth of options controls 10 contracts which controls 1,000 shares) results in greater profit potential on the upside and greater risk of loss on the downside. Investors C, as the most leveraged investor, would realize the highest percentage return if the price of XYZ increased to $62, but would suffer up 20% loss even if XYZ increased to 54 (assuming he did not sell his options while they had significant remaining time value, and would lose all of his investment if the price of XYZ stayed at or below 50.
The more an option is out of the money and the shorter the remaining time to expiration, the greater the risk that an option holder will lose all or part of his investment in the option. The greater the price movement of the underlying interest necessary for the option to become profitable (that is, the more the option is out of the money when purchased and the greater the cost of the option) and the shorter the time within which this price movement must occur, the greater the likelihood that the option holder will realize a loss.
This does not necessarily mean that an option must be worthwhile to exercise in order for a holder to realize a profit. Instead, it may be possible for the holder to realize a profit by selling an option prior to its expiration for more than its original cost even though the option never becomes worthwhile to exercise. (The shorter the time remaining until expiration, the less likely it is that this will be possible – don't expect to make much if you sell your option a day before it expires!
Risks of Option Writers
An option writer may be assigned an exercise at any time during the period the option is exercisable. Starting with the day it is purchased, an option is subject to being exercised by the option holder at any time until the option expires. This means that the option writer is subject to being assigned an exercise at any time after he has written the option until the option expires or until he has closed that his position in a closing transaction.
If an option that is exercisable is in the money, the option writer can anticipate that the option will be exercised, especially as expiration approaches. Once he is assigned an exercise, the assigned writer must deliver (in the case of a call) or purchase (in the case of a put) the underlying stock (or pay the cash settlement amount in the case of an in the money cash–settled option). The consequences of being assigned an exercise depend upon whether the writer of a call is covered or uncovered, as discussed below. We will only use the covered call strategy.
The writer of a covered call forgoes the opportunity to benefit from an increase in the value of the underlying stock above the option price, but continues to bear the risk of a decline in the value of the underlying interest.
Unlike a holder of the underlying stock who has not written a call against it, the covered call writer has (in exchange for the premium) given up the opportunity to profit from an increase in the value of the underlying stock above the exercise price. If he is assigned an exercise, the net proceeds that he realizes from the sale of the underlying stock pursuant to the exercise could be substantially below its prevailing market price.
Example: when XYZ stock was $45.00 a share the investor collected $4 a share premium by writing an XYZ 50 delivery call. As expiration approaches, the stock has risen to $58 a share and he is assigned an exercise. His total return, in addition to any dividends received, will be the $5 per share gain (from $45.00 to $50.00) plus the $4 premium per share collected when the option was written – $8 a share less than the $58 he could've sold the stock for if he had not written the option – but still a very nice profit!
On the other hand, if the value of the underlying stock declined substantially below the exercise price, the call is not likely to be exercised and, depending upon the price paid for the underlying interest, the covered call writer could have an unrealized loss on the underlying stock. AIM would then tell you it's time to buy more shares and you will pocket the option premium paid by the buyer of your option.
Long-Term Options – LEAPs
In addition to normal options, about 10% of optionable stocks also have LEAPs options available for trading. LEAPs is an acronym for Long Term Equity Anticipation Securities. LEAPs are no different from normal options, except their expiration dates are for a much longer time span. All LEAPs are January options which means they expire on the third Friday in January of whatever year they expire. LEAPs are usually available for the January of the following year and maybe the year after that. For example, even as I write this in November 2011, January 2014 LEAPs have been issued on many stocks and more will be issued the rest of this month so you could have a LEAP with a time span of over two years.
Normal options have an expiration date of one to six months at maximum – usually on most options you can get expirations as short as one month on a new option. Like I said above some LEAPs are good for even longer than one year. You can find what stocks have LEAPs by going to http://www.cboe.com and clicking on the top bar I believe you will find a button that will say LEAPs and it will identify all stocks (equities) that have LEAPs from A to Z.
Sometime between the sixth and eighth month point from its expiration date, the LEAP will be converted to a normal option.
Bid and Ask Price
Somebody has to sell you the option and make a market in options. They like to get paid for doing that. They like to get paid very well for doing that. They are paid very well for doing that. So that is why when you see an option quote, notice that there is a bid price as well as an ask price.
So you might see XYZ 50 call June with the bid price of $2 and an ask price of $2.15. The bid price (lower one,) is the price that we can sell our option for. The ask price (the higher one) is the price that we can buy the options for. The difference between the bid and ask prices is called the bid–ask spread. This is how floor traders get rich. This is the (cost of doing business) like commissions, don't worry about it. Look at the option tables and you'll see the differences between bid and ask is now very small – sometimes just a penny. Losing money on the bid and ask difference will not put a dent in your profits.
Volatility of the Stock
Volatility of the stock will be an important factor in our covered call strategy. Options tend to have an amplified impact by the movement of the stock. The more a stock fluctuates, the higher the volatility of that particular stock. A stock can fluctuate both up and down.
Here's an example:
ABC stock moves up and down in the $10 range each day. However, this particular stock closes at or near the same price every day.
XYZ stock moves in a $1 range each day. However at the end of the trading day, the stock moves up $1 dollar each time.
Even though the end-of-day price differences are larger each day for XYZ, the amount of intraday fluctuation is much greater for ABC; therefore ABC tends to have a much higher volatility.
When we use our covered call strategy described later, we want stocks that are very conservative, not volatile. We just want a steady, boring monthly income for our calls that we sell backed up by the stock we own.
The’ Delta’ of Change
There are a lot of good Greek words in investing – beta of a stock means how volatile the stock is. A big beta means big price swings. Here we are concerned with the "Delta" of an option which the rate of change for our option compared to the increase in the stock price.
An example should explain this for you.
Let's say we buy a call option on XYZ stock at the strike price – so if the stock is $80 a share, we buy a $80 strike price call.
If our stock goes to $81, our call was likely to go up $.50 for a Delta of .5.
If our stock goes to $82, our call is more likely to go up $.75 for the $1 stock increase or a Delta of .3.
If our stock goes down to $79, our option is likely to lose $.50 in value for a .5 Delta (or your option value goes from $1.00 to $.50 share or from $100 to $50 per contract.
If our stock goes down to $78, it is likely to lose another $.30 or your option went down to $.20 or each contract is now worth $20.
If our stock goes down to $77, likely to lose another $1.00 or your option goes down to $.10 and each contract is worth $10.
If our stock was down to $76, your option is likely to be worth $.03 or $3 per contract.
Important Points
3 basic trends:
– bullish – stock will go up
– bearish – stock will go down
– stagnant – stock doesn't go up or down, just stays near same price.
A trend is different from a pattern – look for patterns within trends.
Continuation Trend – the Trend is Your Friend
Support and resistance run parallel
Support – price point where stocks stops going down
Resistance – price point where stock stops going up
If bullish – price will go up
If stagnant – price will stay the same
If bearish – price will go lower
To determine what trend is for a stock – look at charts for at least 12 months – what is the stock doing? Going up? Going down? Going sideways? (Stagnant?)
Also look for news about the stock – is it good? Bad? Things happening to the company? Are earnings forecast to go up? Down? Are revenues growing? I may add to my newsletter some recommendations for potential stocks that I feel will work for the option strategy I will give you. And I have started identifying which stocks I am recommending for the month that have LEAPs.
But you really need to learn to do research on your own to make the most profits with options. You really need to be able to give yourself a good reason why you are optioning a particular stock.
Check the sentiment on the stock. Are analysts saying buy, sell? The Standard and Poor Reports are an excellent source for this info. Get familiar with the free research your broker has that you can look at. My broker, TD Waterhouse, has excellent research to let you bring up charts on stocks, look at S&P reports and Reuter reports and many other research tools. The more you know the better you will do with options.
Again check the overall economy, how is the U.S. economy doing, our jobs being created? Maybe they were being created when I first wrote this in the 80s but they sure as hell aren't being created in 2011 as I write this and edit it.
Key to Success
Get core groups of stocks – say 5 – 10
Become intimately familiar with them
Know as much as possible
Then trade them over and over
Change strategy as needed
Keep losses small
Have a plan
Perfect Trading System
Simple
Time efficient
High returns
Low to no risks
Repeatable
Consistent
Low capital (funds) needed
Fun
Low fees
Remember 85% of all options expire worthless – this statistical make you feel good when I explain our covered call strategy.
