Lessons from the Pros


Playing to Win with Options

In last week’s article, which you can read here, I discussed the difference between being the buyer of an option and being the writer, or short seller of that option. Today we’ll continue that discussion.

First, it’s important to realize that the dynamics of the outstanding quantities of options are different than they are for stocks. Taking the simpler picture with regard to stocks first: Apple, for example has about seven billion shares of stock outstanding. These seven billion shares would exist even if there was not one share short anywhere. The shares exist because at one time they were issued by the company itself in exchange for cash. They will remain in existence forever (or at least until Apple goes out of business), unless the Apple management decides to buy some of the shares back in the marketplace, and in effect retires them.

On the other hand, if Apple were to issue some new shares, then the company would have a new net asset total (increased by the amount of cash received for the new shares). That new total value would be spread over the new increased number of shares. If the amount received by the company in exchange for the new shares was not at least as much per share as their pre-issue share price, then we say the stock issue was dilutive to existing stockholders – their stock is now less valuable. This can happen when new stock is issued in connection with an acquisition of another company, for example.

The issuance of new shares as above should not be confused with a stock split, which Apple recently did. In a stock split, all the old shares are in effect retired and exchanged for a larger number of new cheaper shares. In Apple’s recent split, one billion $700 shares became seven billion $100 shares, roughly speaking. In a split, the company itself receives no money, as it would in a new stock issue. No one’s existing interest changes in a split.

With options, it is different. Listed options are generally not issued by the company to whose stock they relate. (There are exceptions – sometimes a company will pay its management partly in stock options, but these are typically a tiny fraction of the total options outstanding. When they do, this is dilutive to all existing shareholders, unless the stock options result in better performance that eventually increases earnings and stock prices more than the amount of the dilution).

Instead, options are created whenever an investor or trader wants to trade one. And yet each new one does not dilute the existing ones, as would be the case with stock. How can this be?

The people doing most of the work of creating option contracts as needed are the option market makers. When an investor or trader places an order to buy an option (the investor is buying to open), there is a good chance that the option sold to the trader by the market maker is one created on the spot for that purpose. Whenever it happens this way, the total number of option contracts outstanding (also called the open interest) expands by the number of contracts sold/purchased.

On the other hand, when a trader wants to sell an option, it is likely that the market maker is the one doing the buying. If so, then this is just the opposite of the case where the trader was buying and the market maker was selling. And yet in this latter case it could still be true that the transaction increases the open interest. How? Say that the selling trader is not selling an option he previously owned, but is instead selling the option short. Perhaps he is selling a call to create a covered call position. He is taking on a short position in the call options. The market maker who is buying that option is doing one of two things: he is either buying the call contract to create (or add to) a long position in that particular option (he is buying to open); or he is buying the call to decrease a short position in that contract (he is buying to close).

If both the option buyer and the option seller are making opening transactions (buy to open on one side and sell to open on the other), then no one is selling an existing contract; so a new contract must be created. The central registry of all options, the options clearing house, records that a new contract has been created, and the identity of the buyer and seller.

If the above sequence of events happened, more options would exist, but their value would not change as a result of the increase. This is because in the creation of the new option, a new valuable asset has also been created. We are not just slicing something thinner; we are creating an entirely new something. What has been created is a new obligation on the part of the option seller.

In fact every single option contract represents an option buyer’s right to buy (calls) or sell (puts) shares of the underlying stock. That right is backed up by the obligation on the part of an option short seller. Every single option outstanding is a long position in one trader’s hands and simultaneously a short position in another trader’s hands. No long option position can exist without a corresponding short position. In this way options are fundamentally different than stock.

In our example above, let’s say it was an investor who sold a call and thereby created a covered call position. The stock owner/call seller has accepted money and given something valuable in return: the right to take the stock away from him at a fixed price. If the call seller owned 100 shares of Apple stock, and sold one September call at the $100 strike price, then he has given the option buyer the right to take the stock away from him and pay a fixed price of $100. This right could turn out to be very valuable indeed, if Apple’s stock soars.

Let’s look further at this particular covered call position. The investor who creates it started with a long position in the stock. Let’s say he bought 100 shares of the stock at $97. The stock position alone had the potential for unlimited gain, or for a loss up to the whole $9700 cost. The investor then sold a September $100 call option at $1.72 per share.

These are the changes to this position as a result of selling the call:

  • The net cost of the position has been reduced by the $172 received for the call.
  • As a result, the break-even price and the maximum loss have been reduced by that same amount.
  • The maximum profit on the trade is no longer unlimited. Since the investor is now obligated to sell the stock at $100, the best he can do is make a $3.00 per share profit on the stock ($100 – $97); plus the $1.72 received for the call; for a total profit of $4.72 per share. Any advance in the stock beyond $100 is of no help to him, since he must sell it at $100.
  • The stock owner is better off with the short call than without it in any case except one: if the stock at the time of the option’s expiration is higher than $100 + $1.72 = $101.72, then the profit from the stock position alone would have been higher. At that price, the profit on the stock is $101.72 – $97.00 = $4.72, the same as the maximum profit on the covered call position.
  • Is the covered call a good deal for the investor?
  • If the following are true, then the covered call was a good deal:
    • Based on his educated analysis, he was neutral to mildly bullish on the stock in the time period until option expiration. (If he were bearish, he shouldn’t have owned the stock at all; and if he were wildly bullish, he shouldn’t have capped his upside with the short call).
    • The money received for the call was sufficient to compensate for the loss of unlimited upside. This needs to be determined by volatility analysis, since option prices are largely a function of implied volatility, or expressed crowd expectations.

If either of these conditions were not met, then this option position would not make sense. In that case there is almost certainly a different option position that would work better, though. It needs to be selected from the dozens of available option strategies based on price and volatility analysis.

So in the end, the assessment of this option position, like all others, boils down to these questions:

  1. What is your expectation for the price movement of the stock?
  2. What is your assessment of the cheapness or expensiveness of the options in terms of volatility?
  3. Which of the available option strategies is likely to work best in this price/volatility environment?

Making these assessments are the skills that are learned through a proper trading education. When mastered, they are the keys to profitable option trading. Sign up for the Professional Options Trader Course at your local center.

For comments or questions on this article, contact me at rallen@tradingacademy.com.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

Join over 170,000 Lessons from the Pros readers. Get new articles delivered to your inbox weekly.