Getting Started With Options

But first, yes, you can lose 100% of your investment. Of course, it is theoretically possible to do this by buying a stock, but it just doesn't happen. Even if you make an incredibly poor choice of equities, you (usually) won't lose all the value in the next month or two. But it is all too easy to buy an option one week that will be worthless the next. However, options can also be conservative, especially when used in conjunction with equities that you already own.

MYRIAD OPTIONS

Many combinations of options go by special names, but basically, there are only two types: puts and calls. Calls are contracts to buy a fixed number of shares of a specified equity (for our purposes, we will use stocks) for a fixed price on or before a fixed date (Figure 1), while puts are contracts to sell a fixed number of shares of a specified equity for a fixed price on or before a fixed date. To exercise an option is the process by which the holder of an option makes or receives delivery of shares of the security. (See Figures 2 and 3.) The fixed price may be above or below the current market price and is referred to as the strike price. The fixed date is the expiration date and is the third Friday of the month.

FIGURE 1: In buying, you pay cash for the right to exercise the option.

FIGURE 2: When you exercise a call, you pay for the stock.

FIGURE 3: When you exercise a put, you get cash for your stock from the put  seller.

If you own a May 120 call on a given stock, you have the right to buy 100 shares of that stock at $120 on or before the third Friday of May. If the current price of that stock is a lot higher than 120, the option will be worth a lot of money. If this is the case, you don't have to exercise the contract (and buy the shares); you could just sell the call contract. Conversely, if the current price is a lot lower than 120, the option will be worth very little. You could sell the option to claim the small value, or you could hold it to expiration and let it expire, worthless.

To complicate matters, you could be long or short the option. If you start out buying a call, then you are long the call. You "bought to open" your position. Then, if you sell the same option (instead of exercising it), you "sell to close" your position. If you started out selling the option, then you are short the contract; you "sold to open" your position. You then "buy to close" if you want to close out your position.
 

The investor who is long the contract is referred to as the holder and that person is the only one to decide if the contract is to be exercised. The person who sold the contract to the holder is known as the writer of the contract, and that person is obligated to fulfill the terms of the contract if the holder decides to exercise it.

ON OPTIONS TERMINOLOGY

We have already covered most of the special terms: call, put, strike, expiration date, holder, writer, buy, sell, long, short. There are only a few others you need to know to get started.

But first, let's review what you do know. If you are long a call, you hold it, and you have the right to buy 100 shares at a fixed price on or before a fixed date. You can remember that the call gives you the right to call a stock away from the writer of the option. Conversely, if you are long a put, you hold the put and you have the right to sell 100 shares at a fixed price on or before a fixed date to the writer of the put. As a simple mnemonic, you can remember that the put gives you the right to put it to the writer by making him buy the stock from you.

The terms holder and writer are used to distinguish who is long and who is short the option. If you hold the option, you bought the contract, and you have the right to decide if the contract is to be exercised. If you hold the option, you don't have to exercise to get your value out; you can sell the contract if it has a value, or you could let it expire if it doesn't (Figure 4).

FIGURE 4: PRICE VS. DAYS TO EXPIRATION. The value of your option declines slowly until the last 30 days, when its time premium plummets.

IN-THE-MONEY, OUT-OF-THE-MONEY, AT-THE-MONEY

These three terms describe the relationship between the strike price and the equity price (Figure 5). If they are the same, the option is said to be at-the money. If you hold a call and could get the stock cheap by exercising the call because the strike price you'd pay is much lower than the equity price, the option is in-the-money. You won't want to exercise an option that is out-of-the-money because it would be cheaper to buy or sell the equity in the market. However, an out-of-the-money option may have a substantial time value that could be realized by selling the option.
 

FIGURE 5: WHERE'S THE MONEY? If you hold the call and could get the stock cheap by exercising the call because the strike price you'd pay is much lower than the equity price, the option is in-the-money. You won't want to exercise an option that is out-of-the-money because it would be cheaper to buy or sell the equity in the market.

A pricing model known as the Black-Scholes model is commonly used to compute the fair price of an option. This model takes into consideration the price of the equity, its volatility, the strike price, and other factors. The formula is complex, but the two major underlying concepts are not.

• Concept 1: The value of an option is made up of two parts: the intrinsic value and the time value (Figure 6). The intrinsic value is the amount that the option would be worth if it expired today -- that is, the amount that the option is in-the-money. The time value is an additional amount related to the probability that the option will be at-the-money at expiration. The time value decreases as the square root of the time remaining because, with less time until expiration, the value of that time decreases. If the time value is $10 with eight weeks to expiration, then the time value will be approximately $7 when four weeks are left (the square root of 4/8 is 0.7). The time value is also related to the volatility of the stock with a highly volatile stock option having more time value initially.

FIGURE 6: TOTAL OPTION VALUE. The value of an option is made up of two parts, the intrinsic value and the time value. The intrinsic value is the amount that the option would be worth if it expired today. The time value is an additional amount related to the probability that the option will be at-the-money at expiration.

• Concept 2: The expected future price of an equity is today's price; small changes in the price are more likely than larger changes; it is as likely that the price will double as halve; the distribution of future prices will be a normal distribution (a bell-shaped curve with the peak at today's price); and future prices will vary as much as they have in the past.

FIGURE 7: TWO OPTIONS' VALUES. Options on a relatively stable-priced equity such as Cigna will have a smaller time value than will options on Ebay, all other conditions being equal.

Now, go back and read the two concepts again; they contain the most important information in this article.

VOLATILITY

Volatility is a measure of how much a stock's price typically changes over a period (Figure 8). It is usually expressed as a percentage number without the percent sign. For example, a stock may have a volatility of 28. This means that the annual variation in stock price is expected to be within 28% of the current price with a probability of about 2/3 (one standard deviation). Subtracting 2/3 chance from one leaves a probability of about 1/6 that the price will be more than 1.28 times today's price and 1/6 that it will be less than 1/1.28 times today's price.

FIGURE 8: STOCK PRICE. Volatility is a measure of how much a stock's price typically changes over a period of time.

If the volatility is 28 for a year, it is about four for a week. (The square root of 52 is about 7; 28/7 is 4.) The annual volatility is normally computed using this square root of time relationship from the daily or weekly volatility.

In addition to computed historical volatility, you will hear of implied volatility. Since the time-value portion of an option price is related to the stock volatility in the pricing model, you could take an actual option price and then work backward to see what volatility is implied by the option's open-outcry price. If this number is higher than the stock's computed volatility, the option is said to be expensive. Stock volatility tends to vary around a long-term average number known as the historical volatility. Unlike prices, which could continue to go up, volatility tends to revert to the long-term average for a stock.

OPTIONS SYMBOLS

The options symbols are more complex than you might think at first. You must remember that you can't or at least shouldn't construct the option symbol; instead, you should look it up. In addition, if you use the symbol for trading (instead of referring to "January 250 call"), you must check that you are trading what you expect to be trading. Most software these days handles the symbol generation for you, but it never hurts to double-check. See sidebar, "Options symbols."

EXPIRATION MONTH

As we've mentioned before, options expire on the third Friday of the month. If a stock is optionable, there will be options available that expire in the current month and the next month and a month further out. After this month's expiration, additional options will become available, but there will always be a near-term option and a longer-term option available. The only difference between long-term equity anticipation securities (LEAPS), which are long-term listed options, with maturities that can be as long as two and a half years, and other options is that LEAPS are generally available for expiration in January of next year and the year after that.

EXPERIENCE IS EXPENSIVE

It will cost you some time to learn about options, but it need not cost much money. There are good but expensive programs available that will help you to screen stocks to find suitable candidates and then screen options and suggest any of a dozen or more option strategies designed to take advantage of circumstances. However, free or inexpensive information is available on the Internet. Go to www.cboe.com/toolbox and download the Options toolbox that teaches about options. On a day-to-day basis, www.BigCharts.com has both symbols and list of options available. Go to www.myTrack.com and download (for free) a program that will provide you a large amount of useful information on stocks and options (also free).

Not only that, on a given equity, you can get quotes, trade volume, price volatility, news, charts, and learn which options are available. Then for each option, you can get quotes, symbols, and trade volume. The myTrack program also allows you to define a portfolio so you can papertrade options. Go to www.theonlineinvestor.com and learn of pending stock splits, brokerage up- and downgrades, and stock-buyback plans. These will help you pick stocks for option consideration.

GETTING STARTED

You've done the homework, so now let's look at a simple example. Suppose you own a stock that is now selling for 101 and it has a volatility of 35. To earn additional money on your position, you want to sell (that is, take in cash) a covered call (that is, you have the stock to deliver if the call is exercised) against your stock about two strike prices above the current price about two months out. An options calculator shows you that in the 52 days to expiration, there is a 25% probability that the option will be in-the-money and that the price of the option should now be about $2.64 if we are buying it or $2.16 if we are selling.

Further, the broker tells you that the option is actually trading for $2.20, making the implied volatility 33.5. The option is a little cheap to buy and slightly bad news if you are selling. The $2.20 that you can get for the option looks pretty good. The probability isn't high that the option will expire in-the-money and have the stock taken away. Even if it does, you will get $110 for the stock plus the $2.20 for the option. And if the option expires worthless, you can do this again in two months.

Meanwhile, if the stock tanks in the next two months, you're partly protected. You'll still suffer the loss from the $101 level, but it will be reduced by the $2.20 (less commissions) you got from selling the call. If it doesn't go below $101 - $2.20 = $98.80, you're still ahead of the game (Figure 9).

There! You've traded an option and it hardly hurt. The simple expedient of selling someone else the right to own your stock at $9 over its current price as a way to improve overall return is probably the most accessible way of using options to your advantage.

Still think options are for the pros? Well, that's true. Are they for you as well?

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OPTIONS SYMBOLS

The symbol for an option may be listed differently, depending on where you look. For example, a May 200 call for IBM may be listed as IBMET (Discover Brokerage), IBM ET (myTrack), -IBMET (Fidelity Brokerage), as well as other variations. What is most important is that the last two symbols represent the expiration month and price; the one, two, or three preceding symbols, the base part of the symbol, represent the equity.

If the equity is traded on the NYSE, the base part of the option symbol may be the same as the one-, two-, or three-character equity symbol. However, it may be different. If the equity is listed on the NASDAQ, the equity symbol is longer than three characters, and therefore, the option symbol base is different from the equity symbol. To add to the complexity, there may be several base symbols for the same equity.

The month character is "A" or "M" to represent January, the former meaning a call and the latter a put. Then the successive months are "B," "C," and so on in the case of calls, and "N," "O," and so on in the case of puts. The price symbol is ambiguous, with an "A" representing $5, $105, or $205. A $150 equity could have options available at $105 and $205 and these would be distinguished by a different option base (first three characters).

All in all, it's best to let software decode the maze the exchanges and datafeeds have created.

--J.D., E.T.

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Joe Demkovich and Gene Theriot are partners in a business of options investing. They can be reached via E-mail at joeandgene@att.net or on the Internet at http://JoeAndGene.home.att.net. Option analysis tools are available for download from their website. This article was originally published in Technical Analysis of STOCKS & COMMODITIES in October 1999.