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The Building Blocks: Puts and Calls
I have a mathematical and analytical type of personality. In fact, that's what attracted me to options trading in the first place. Wait a minute, there's some important options news:
**Options Alert** On November 7th, the NASDAQ announced that it would pay $652 million in cash for the Philadelphia Stock Exchange, the country's oldest stock exchange. It is expected that the NASDAQ exchange will start trading options on Dec. 7, 2007, assuming they receive SEC approval. Also, on Monday of this week, the CBOE announced that it would start publishing a new volatility index, similar to the popular VIX. While the VIX represents a 30 day implied volatility based on the S&P 500, this new index, symbol VXV, will represent a 3 month implied volatility also based on the S&P 500. Details will follow as they become known.
Wow, there's never a dull moment here in options land!
Anyway, back to the beginning. Relative to stocks, options have characteristics that make them more interesting, more fun to trade, and perhaps a better match to my personality. When you're trading stocks, you buy them when you think they're going up and sell them when they're headed south. Of course, that's not always so easy to do. On the other hand, I may buy an option that I'm predicting will go down in value, because at the same time I can sell another option against it, predicting it will go down even more. This is called a spread, but we're getting ahead of ourselves!
Every options position, and all of the funny names that you've heard (straddles, strangles, butterflies, iron butterflies, broken wing butterflies, condors back spreads, vertical spreads, time spreads, need I go on?) are just combinations of Calls, Puts and sometimes Stock. Let's make sure we fully understand what these fundamental building blocks really are. The plan here is to start from basics and build a library of articles so that our options trading is on a firm foundation.
Be aware that there are options on almost every conceivable type of asset that trades: stocks, futures, commodities, Forex, bonds, interest rates, etc. However, for now, we will be discussing options on equities, i.e. Stock Options. So what exactly are they?
A Call (Put) option is a contract that gives the holder the Right, but not the Obligation, to Buy (Sell) an underlying asset, at a certain price, up until a certain date.
That "certain price" is called the Strike price or Exercise price and the "certain date" is called the Expiration date. So,
A Call (Put) option is a contract that gives the holder the Right, but not the Obligation, to Buy (Sell) a Stock at a Strike price, up until the Expiration Date.
You'll probably also hear options referred to as a "wasting asset." All that means is that with all other things being equal, the value of an option will decrease as time goes by. Just the opposite of a fine wine!
Calls and Puts generally represent 100 shares of stock. Be careful, if you want to control 300 shares of stock, you want 3 option contracts, not 300. There are some sad stories regarding people who didn't quite understand that and traded a lot bigger size than they anticipated! There are times when an option contract will represent something other than 100 shares, possibly after a stock split or a merger, or some other corporate reorganization, so if you're not sure, check with your broker or the Options Industry Council.
Options can be classified as either In The Money (ITM), Out of The Money (OTM), or At The Money (ATM). You can determine an options status by comparing the Stock price (S) to the Exercise Price (E) as follows:
| |
If S>X |
If S=X |
If S<X |
| Put is |
OTM |
ATM |
ITM |
| Call is |
ITM |
ATM |
OTM |
So, as an example, with XYZ stock trading at $53, the Dec 50 Call is ITM, and the Dec 50 Put is OTM. In a similar fashion, if the stock was trading at $48, then the Call would be OTM and the Put, ITM. With the stock at $50, both options would be ATM. Even with the stock "slightly" above or below $50, we would still refer to the above options as being ATM.
Options that are ITM also have Intrinsic Value. This Intrinsic Value represents the amount that the option is worth at expiration, and the minimum amount that it is worth prior to expiration. So with XYZ trading at $53 the Dec 50 Call is worth at least $3 because we could exercise the Call, i.e., buy stock for $50, and then sell it in the open market for $53, netting $3. So for Calls, we see that the Intrinsic Value is equal to the difference between S and X. Likewise for Puts, if the stock is trading at $48, the Dec 50 Put has an Intrinsic Value of $2. We can exercise the Put, i.e. sell the stock for $50, and buy it back in the open market for $48. So for Puts, the Intrinsic Value is equal to X – S.
Another way to look at it is that the Intrinsic Value represents the amount that an option is ITM. So you might hear an options trader refer to the above Call as being $3 in the money, or the Put as being $2 in the money. Note that Intrinsic Value cannot be negative and it is zero for ATM and OTM options.
Okay, so how do we know the value of these options? Well, that's the million dollar question and we'll address it in later articles, so keep on reading. What about the price of an option? That's usually called the premium. This premium is the sum of 2 parts, namely; Intrinsic Value and Time Value. If we know the premium that an option is trading for, then we can easily calculate the Time Value by subtracting the Intrinsic Value from the premium.
By the way, we should remember that value and price are different. In fact, we'll end this article quoting the words of Warren Buffet: "Price is what you pay, Value is what you get."
Next time, we'll discuss how we can buy or sell options and learn how to draw profit and loss graphs at expiration of our basic positions. A recent mentoring student of mine mentioned that he had never seen these graphs before and now feels a lot more comfortable knowing how to determine at a glance the profitability of his options positions.
As always, if you have any questions about my articles or have suggestions for future topics, feel free to email me at: SFreifeld@tradingacademy.com or call me at: (888) OTA-2580 ext. 2010.
11. Know Thy Options!
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Stan Freifeld comes to us from the Floor of the American Stock Exchange where he traded options for his own account from 1994-2001. He was a Market Maker for the options on several popular equities including Dupont, Schering Plough, Walgreen's, CBS, U.S. Surgical and Biovail.When he is not trading or thinking about trading, Stan relieves his stress by playing competitive squash, competing in local road rallies with his Ferrari Cabriolet and tutoring local high school students for the SAT's. The bottom line is that Stan, a long time MENSA member, is an engaging teacher with an extraordinary background in options trading and risk management. He is helpful and patient by nature and equally at ease with all levels of traders, from complete novices to advanced pros and academics. He'll be happy to teach you to trade!