How-to-use-Options

Options Stuff

Options are a contract that gives you the right to buy (call) or sell (put) a stock at a given price (called the “strike” price) by a given date (expiration date). Options expire on the third Friday of the month, making the third Friday a bit more volatile than other days. You can buy an option with expiration dates many months in advance (over a year, they are called “leaps” Long-term Equity AnticiPation Securities). The standard contract is for a “round lot” of 100 shares for most stocks. This means that an option quoted at $1.20 would cost $120 for the actual contract.

You can buy puts or calls for many different expiration months at many different strike prices. This means that for any given stock there are many different options available. These all have a different ‘ticker symbol’ where the last couple of letters systematically code for put vs call and for the month and strike price. If you really get involved in options, it is worth it to learn that coding; but for occasional purchases, you can just get the symbol from an “options chain” chart.

So if I purchase a “put” on Petrobras at a $35 strike price with a July expiration: That says that I can force someone to buy my Petrobras stock at the price of $35 / share on the third Friday in July. If Petrobras rises in price to $35 (or more) by that date, my option is worth $0.00 because I can sell my stock for the strike price (or more) on the open market. If Petrobras falls to $30, and I can sell it for $35 (via the put) that put is worth $5 since that’s how much more that I can get compared to the open market. (Since the put contract is for 100 shares, that $5 price per share would make the total contract worth $500).

If I purchase a “call” with a $35 strike July expiration that says I can force someone to sell Petrobras to me at $35 a share. If Petrobras rises to $40 a share, my “call” is worth $5 (per share, the total contract would be $500), but if the stock dropped to $35 my call would be worthless since I could buy the stock for the strike price in the open market. (Though ‘worthless’ options will sometimes trade for $0.05 to let folks complete complex strategies that need matching puts and calls, sometimes way ‘out of the money’)

Often times big money players (who are presumed to be smart money players) will buy large blocks of options. For this reason a report of surprisingly high option volume can give a clue as to what is expected to move (up for calls, down for puts) by the “big money” players. Yahoo provides a report of unusually high option volume.

How can I use these things?

Instead of buying 100 shares of Petrobras (PBR) at $35 ($3500) I could buy the call PBRGG for, say,$4.50 ($450 total). If the stock goes up I make a higher percentage gain. If the stock goes down OR just sits still as time passes and my option time value erodes I can lose all my $450. You must watch the time value erosion on options.

As insurance, if I already owned 100 shares of PBR and wanted to put some protection on that value, I could buy a put such as PBRSB ($34 strike July) for about $4.50 (as I write this; $450 total). If PBR drops, the put would rise in value. If PBR increases in price, though, my put would lose value. (But the ‘time value’ would remain, at least for that moment… so the put would not drop to zero at that moment. Look at the chart of option prices to see how price relates to stock price and time). So buying a put for insurance for a short time period is a common strategy. You want to buy a put from a month further away than the nearest month, like 2 or 3 months out, so the time value does not change much during the time you hold the put. Sell (‘sell to close’) the put with a lot of it’s time value still in it (such as at least 1 or 2 months to expiration).

Another approach (often a better approach) is to sell a “covered call”. You own the stock, so the call is “covered” if the option buyer collects the stock at expiration and you didn’t buy the option back before then. The same call ticker PBRGG at $4.50 ($450 total) we talked about as an alternative to buying the stock could instead be sold if you own PBR. Now your PBR has to drop to $30.50 before you start losing more than you gained from selling the option.

What’s the catch? If PBR takes off to the upside, that call means someone else can “call away” your PBR stock at $35 / share so they get the increase in value. You limit your upside potential. This strategy works best if you are pretty sure a rapid rise in stock price is near a peak and is likely to fade or go flat for a while (giving time for the call to expire worthless). For this reason folks often sell the shortest duration contract (called the ‘front month’) where time value evaporates fastest.

It also works well if you want to sell the stock at a given price. Say you would sell PBR at $37.50 and be happy. You could sell the PMJGU $37.50 call for $3.50 (price at the moment with PBR at $35.10 on 4/3/09; it will be different when you read this…). I would get $3.50 for the call and if the price of PBR goes above $37.50 my stock will be “called away”, but I get $37.50 + $3.50 = $41 / share. Not bad for insurance. The stock has to go above $41 / share from $35 for me to have missed out on gain. I would “only” have made $6 on each $35 or about 17% on that move. If instead PBR drops to $30/share the call expires worthless and I keep the $4.50, but lost $5 on my stock, so my net “loss” is $0.50 / share. Not much of a loss. Instead of -14% I have a about a 1% loss. And what if PBR just sits at $35? I still keep that $4.50 for a 13% gain (on a stagnant stock!)

Since almost all options expire worthless, you are better off selling an option (like a covered call) than buying a put unless you are very good at option trading.

To pick a stock and make money, you must get one thing right. The stock has to rise in price someday. You must only get the direction right and wait. To make money buying an option you must get things 3 things right. Direction, Time, Rate of Change. It must rise (or fall, for a put) within the time period of the contract and by an amount more than the option expects. Direction, time, and excessive price change. The option is priced based on the more likely price changes, so you must beat the professional option trader’s estimate of probable stock price change. Are you that good?

Bollinger Bands on a chart can help you decided when to buy vs sell an option. When they are close together options are generally cheaper (so buying makes more sense than selling) when the vertical distance between the two red lines is greatest, prices are moving fastest (so options price in more volatility) and options cost more. That is when it’s best to be selling an option rather than buying one.

What About Leveraged ETFs?

Can I use leveraged ETFs (Exchange Traded Funds – hold some stocks) or ETNs (Exchange Traded Notes – just hold option contracts and related) to reduce the risk of options? Well sort of.

The ETF or ETN does a good job of managing the “roll over” from one option month expiration into another, but it doesn’t change the basic character of an option as a ‘wasting asset’ that will in most cases evaporate into zero value at expiration. An example of this is the FAS / FAZ pair. These are 3x levered ETFs that are a matched set. FAS is 3 times the financial index (XLF or IYF are a close match to the index) while FAZ is 3 times short (i.e. negative 3 times). We would expect to see FAS and FAZ making a set of outside brackets around the XLF. One way above and one way below. You do see some of that from one hour to another, but on the longer 6 month chart, both FAS and FAZ are shown wasting away toward zero.

Some ETFs, like the GLD Gold ETF hold “real stuff” (in the case of GLD they buy physical gold metal) and don’t have this ‘wasting asset’ problem. Others, like some of the oil ETFs (especially the leveraged ones using futures and options contracts) do have this kind of problem. So it’s important to know what kind of ETF you are using. Those with options in them are for very short term trading only (day trades) while those with real assets (stocks, like EWZ or gold, like GLD) can be held for longer periods as an investment vehicle.

Advertisements

About E.M.Smith

A technical managerial sort interested in things from Stonehenge to computer science. My present "hot buttons' are the mythology of Climate Change and ancient metrology; but things change...
This entry was posted in Economics - Trading - and Money and tagged , . Bookmark the permalink.