Option Basics for Newbie Traders

09/28/2012 7:00 am EST

Focus: OPTIONS

Russ Allen of Online Trading Academy outlines the basics of options for new traders.

Options are by far the most versatile trading instrument. There is a lot of money to be made with them, if you do it right. They can be used like an insurance policy, like a lottery ticket, like a bank CD, and many other things besides. And unlike anything else, used in a certain way they can make money from an absence of price movement. But the learning curve can be daunting. If you’ve never traded them, where do you start?

Every week in this space, our instructors give you solid, actionable information designed to help you make more money with options. That information ranges from the basic through intermediate to advanced, as do the experience levels of our readers.

As a long-time instructor for Online Trading Academy, one of my specialties is explaining complex subjects to new traders in understandable terms. As adults with money to trade or invest, almost all of us have come from other fields where we are experts.  But trading is a whole new world. That is especially true for options, with all their moving parts.

Since I came into trading a few years ago as a nearly complete beginner after many years in another career, I have first-hand experience of what that’s like. So for those of you who are new to options, or who have never really thought about trading them before, I want to help give you a starting point. Over the next few weeks, on alternate weeks, I’m going to go through the subject in the most basic way. Even if you’re a veteran, these articles may give you a deeper understanding of some aspects of options than you had before.

There are a few oversimplifications as each topic is introduced for the sake of clarity, but we’ll clean these up as we go along.

Profit is made by selling something for more than its cost; if sold for less, there is a loss. That simple statement describes every possible monetary transaction.

We enter into many monetary transactions every day of our lives, whether we are working, playing or sitting still.  We buy things, including food and utilities, every single day. Those things are sold to us by others. If those sellers paid less than the amounts they collect from us, they make a profit; if not, they have a loss. The same holds in reverse when we are the sellers. Pretty simple.

In our business or employment, we sell our time for more money than the cost of going to work.

Everyone understands this in the context of merchandise or services. Financial markets are fundamentally no different: to make a profit, we must buy something for a lower price, and sell it at a higher price. Buy low, sell high.

Options give us unique ways to do this.

Call options or “Calls” give their owners the right to buy something at a certain price – that is, if things work out right, to buy low. The thing they have the right to buy is called the underlying asset, or just the underlying for short. The underlying can be a stock or something else. For our examples below, we’ll assume that the underlying is a stock.

Put options or “Puts” give their owners the right to sell an underlying asset at a certain price – hopefully, to sell high. The owners of puts do not actually have to own the underlying asset that they have the right to sell. They can plan to buy the underlying later after the price has gone down (buy low).

NEXT: Trading Options on Apple

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Let’s look at an example using call options – in particular, call options for a stock.

On the day I’m writing this, August 29, 2012, the stock of Apple Computer (the underlying) closed at $673.40 per share. There are available Call options that give their owners the right to buy Apple shares (in 100-share lots), for $650 per share. This $650 price is called the strike price or just the strike. These rights expire in 23 days. That date, 23 days out, is the expiration date for these particular options. There are other dates, both sooner and later, for which options are available. More about all that later. For these options, that $650 strike price is a discount of $23.40 per share from today’s price of $673.40. Now that’s buying low! What do we have to do to get this deal?

We have to pay for the option – to be exact, as of the time of this writing, at the close we’d have to pay $27.60 per share for the option. (Option prices are listed just like stock prices, and today the price is $27.60. Much more about pricing later in the series). Since each option covers 100 shares, we’d have to pay a minimum of $27.60 X 100 = $2,760 to play. It would be another $2,760 per hundred for larger quantities.

So we have to pay $27.60 today to get a discount of $23.40. What’s the extra $4.20 for? That can’t be right. Who would buy these things?

Well, on this day alone 1743 of those particular September $650 Call options changed hands (so 1743 is the volume); and as of the end of the day a total of 12,889 of them are outstanding. (That number, 12,889 is called the open interest for those options). At 100 shares per, these calls represent 1,288,900 shares. Those shares are worth altogether about $868 million. Somebody believes those options are a good deal. Almost a billion dollars’ worth of somebodies, in fact. What are they thinking?

They’re thinking that in the 23 days remaining before those options expire, the price of Apple could go higher. They’re paying that “extra” $4.20 for what could happen to the price of Apple stock in the remaining time before expiration of the options. They’re putting a value of $4.20 on that time.

In fact, that’s what we call that extra amount – time value. It also has another name, which is extrinsic value. By either name, that $4.20 portion of the option’s value exists only because there is some time remaining in the option’s life, during which the price of Apple could go higher.

The rest of the option’s value, $23.40, represents an actual discount (the amount by which we could buy low) compared to today’s Apple price. We call this discount amount the option’s intrinsic value. If the price of Apple were to go below $650, then these options would have no intrinsic value.

Let’s say Apple were to make another new all-time high (which it did), and end up 23 days out $30 higher at $703.40. The call options at the $650 strike would then provide a discount (that is, has an intrinsic value) of $703.40 – $650, or $53.40 per share. Anybody who owned a $650 Apple call at that time could exercise it – that is, in effect turn it in to their broker, along with $65,000, and receive the hundred shares of stock. They could then immediately sell those hundred shares for $70,340. Let’s see, buy for $65,000 and sell at $70,340. That’s a gross profit of $5,340. From that we have to subtract what we paid for the option, which was $2,760; leaving a net profit of $2,580. Ignoring commissions (which in this case would take a dollar or so out of our $2580), that’s about a 94% profit (2580 on 2760) in 23 days. This on a stock that itself increased only 4.5% (from $673.40 to $703.40). That magnification of the profit (from 4.5% to 94%) is what we call leverage, and it’s one of the main attractions of options.

By the way, because we could exercise the options like this, doesn’t mean that we’d have to in order to realize our profit. We don’t need to suffer the inconvenience of parting with $65,000, even temporarily, if we don’t want to. Those options can be bought or sold online instantly with a few mouse clicks. Since anybody who owned that option could use it to get that $53.40 per share discount, we knew there would be people bidding just a few cents less than that amount at the close of business on expiration day. That few cents is a risk-free profit to them. So we could just sell our option to one of them for $5,340 less a few dollars, and be done with it, profit in hand.

Sounds great, but what else could have happened?

NEXT: Exiting our position on Apple

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Let’s say Apple had stayed right where it was for the next 23 days, so just before the close of the market on expiration day, the stock was still $673.40. The options would still give their owners the right to buy Apple at $650, which would still be a discount of $23.40. But that’s as good as it could ever get – there’d be no time left for things to improve. As on any expiration day, since there is no time left, there is no time value. At expiration, all  options, including these, are worth exactly their intrinsic value – the actual discount they provide, if any. In this case that’s still $23.40 per share. The option owners could have sold them for this amount and recouped the $23.40, so they’d be out the $4.20 they paid for the time value. Remember – when there is no time, there is no time value.
Not too bad – but how bad can it get?

What if some unimaginable disaster happens and Apple goes out of business in the next 23 days – its stock is worth nothing. In that case our right to buy nothing is worth nothing, so we will have lost the $2760 we paid for the option. Not good, but not as bad as if we had owned the $63,740 worth of stock itself. Our loss is only a small fraction of that – at worst; we can never lose more than we paid for the option. So the good news about owning options is that our loss is limited. The bad news – what it’s limited to is 100% of what we paid for the options.

By the way, Apple doesn’t have to go to zero for call option owners to lose 100% of what they paid. All that needs to happen is for the stock to end up at expiration below the strike price ($650 here). In that case the right to buy something for $650, that is only worth $650, or $649.99, or any price at all less than $650, is worth nothing. If you had a coupon to buy toilet paper for $6.50, but the price on the shelf was $6.40, would you turn the coupon in? No, you’d just throw it away and pay the $6.40 For the same reason the option to buy at $650 would be worth nothing if the stock were at $640, with no time left for that to change. In that case anyone who had paid $2760 for the option would lose the entire $2760. Remember the leverage? Here it’s worked against us. A drop in the underlying from $673.40 to $650, or just 3.5%, would cost us 100% of our investment. That is, if we waited that long. We don’t have to, as we’ll discuss later.

So if we were to lose our $2760, where would it go? The answer is that it would have gone to the person who originally sold us the calls, when we paid for them in the first place. In this case our loss would be their gain. If we had made money, they would have lost. In future articles we’ll describe this zero-sum-game aspect of options in detail. One key to making money in options is deciding whether to make the bet or take the bet – whether to buy options or to sell them. Another is knowing which bet. That’s where we’re heading.

Russ Allen can be found at Online Trading Academy.

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