Welcome to Options

Brad Laidman

7 years ago

Welcome to Options!

Want to know options? I hated the business, but I knew as much as anyone alive, and I taught classes for one of the most successful proprietary trading firms in the world. I’m your guy.

I wrote this around 2007 for the CBOE. They hired me based on it, but couldn’t get their act together to use it. I’m giving it to you for free. It is an excellent introduction to options and all derivatives.

The simplest thing that I can say about options is that they are tools just like a car, a cell phone, or an ax, They are tools. Let’s think about an ax. It can be extremely useful to you if you want to go out and cut down trees. On its face, chopping down a tree seems pretty simple, but it would be a really bad idea to just grab an ax and head out looking for a mighty oak tree to take down without first acquiring some knowledge.

Let’s say that a tree is blocking your view of your town’s beautiful sunsets. You can buy an ax cheaply, but have no idea how to cut down a tree. Cheer up, you have two immediate assets.

You have a goal: Cut down that ugly tree that’s blocking my view!
You have the tool to get it done: The ax.

Now all you need is a little learning and you’re home free.

Are options for you?

This should always be in the back of your mind as you build on your knowledge of options. What can options do for me?

Here’s why I think options are useful.

Options are sort of like custom decorating for the investing world. They can be an extremely powerful way to help you fit your exposure to financial markets to your own personal situation or specifications. For the truly motivated, options might even become an income producing career.

Are options terrifyingly complex?

There is fear involved in learning anything new, but there shouldn’t be. Just be sure of what you do and do not know, and I assure you that you will be better for any knowledge you gain and be fine.

I’ve heard many stock brokers call options complex financial instruments. Some of the brokers might convince you that options are scarier than meeting a really angry mugger in a dark alley. These brokers usually either do not understand options or they make their money selling something different from options, usually both. Imagine what horrible things horse breeders had to say about cars back in the day!

Are they complex? They definitely can be. Intellectuals have written many prize winning dissertations on options. I’ve been working with options for over fifteen years and I continue to learn new things about them.

Should that scare you? Luckily, not at all! A computer is also a complex instrument. My grandmother to her final day was too intimidated to even turn one on, and I could have taught her how to do that in less than 20 seconds!

My grandfather, on the other hand, knew very little about computers, but he was still able to use one to his advantage. He knew how to turn his computer on; he knew how to use a piece of software to play Gin and other card games; he knew how to use it to see where his stocks closed; and he knew how to turn it off.

That’s it. That’s all he knew, and he wasn’t the least bit interested in using it for anything else. He didn’t know how it worked. He wasn’t interested in learning how to use a word processor or a spreadsheet, and he had few people in the world that he felt like talking to much less emailing. There were a ton of things his computer could have done for him, and had he spent the time to learn them he might have found them useful, but he was perfectly happy using it to play Gin and check his stocks.

Options are the same way. There are really simple ways to improve your investment portfolio with options, and if they serve your goals then options are useful to you. A friend of my father’s used to sell options against a certain stock that he owned and did well with this strategy. He had no idea what people at Morgan Stanley or Goldman Sachs were doing with these same options and he had no reason to care. He knew what selling options did for him, and what the risks were for that one basic strategy and that strategy was extremely beneficial to him.

The more you learn about options, the more useful they can be to you. Hopefully, each small thing you find out about options will help you better decide whether trading them is for you. Some of our beginning examples may not be an end point. Do your best to gather the building blocks before reaching a final judgment. Many knowledgeable investors would consider investing without options to be analogous to owning a home without fire insurance.

Treat options like any other tool. You may decide that you want to just play Gin like my grandfather or you may decide that you want to learn how to monitor galaxies with them. It’s up to you and either way is fine.

Treat options just like you treat learning about a computer. What are they and what can they do for ME?

Buying Stock

One of the most common uses of options is to enhance your ability to invest in the stock market. Before introducing calls, it might be useful to quickly review the ups and downs of stock ownership.

Consider a specific stock like IBM. You go to a financial website and you see that it is trading $100 a share.

That’s today! At any given point in the future, IBM can do one of three things:

It can go up
It can go down
It can still be trading $100

Clearly, if you are considering purchasing IBM, you would do so only if you think that IBM is going to go higher. If IBM fell, you would lose money.

Even IBM standing firm at $100 is no good for you.

Imagine buying $10,000 worth of IBM and having the stock just sit there like a rock. That $10,000 could either be earning interest in the bank or perhaps even better yet, you could trade that $10,000 for a top of the line big screen High Definition Plasma TV!

Money is also just a tool that you need to decide how to use.

Whenever you are making any kind of investment in the stock market, you need to assess your goals.

How long do I want to own this stock? A day, a month; a year; until I retire?
Do I want to invest in something with a small amount of risk that will probably yield me a small but consistent return, or have I been saving this money to try and make a big score?

Your investment goal is up to you. IBM is an established company that will probably yield small consistent returns. If instead, you were looking to take on more risk, you could look around for a young company that has a chance of becoming the next IBM. Most investment professionals would suggest doing a little bit of both.

Call Buying Part 1: Comparing 1 Call to 100 Shares of Stock

The Simplest Comparison: Buying stock or buying a call?

A call is one type of option. The other type of option is a put and we will discuss them later. Don’t be intimidated; people traded calls for a number of years before puts were even publicly traded.

I’d consider outright call buying to be a fairly aggressive strategy. I’m starting with it not because it is low on risk, but because it is a relatively simple building block that is very analogous to stock ownership.

Both of the following simple strategies are ways to profit, if you think IBM will go up over the course of the next year.

Choice 1: Buying 100 shares of IBM for $100 and holding on to it for exactly one year

Choice 2: Buying 1 IBM call for $7 that expires in exactly one year with a strike price of $100

Our goal here is to profit if IBM goes up like we think it will. Now we simply need to compare the pros and cons of each strategy the exact same way you would with any other decision.

Sports Car or Utility Vehicle? There is no right or wrong, only what is best for you.

Let’s look at choice 1:

Buying 100 shares of IBM for $100 and holding on to it for exactly one year

How much does this cost?

Without using margin, this will cost you $10,000.

What’s the most I can lose?

IBM can’t go any lower than zero, so the most you can lose is what you paid for it: $10,000.

How can I make money?

IBM could go up significantly in one year. You will make $1 X 100 shares = $100 for every dollar IBM goes up. If IBM goes up to $120, you will have made $2,000. Similarly, if IBM goes down to $80 dollars you will lose $2,000

Net Profit for various IBM outcomes

IBM $10 90 95 100 105 110 115 120
($9000)) ($1,000) ($500) $0 $500 $1,000 $1500 $2000

What will my return be?

1 Year Return = (Profit)/(Investment) X 100%

If you sell IBM for $120 dollars at the end of the year, this would be ($2000)/($10,000) X 100 % = 20%

1 Year Return for various IBM outcomes

What will my return be?

1 Year Return = (Profit)/(Investment) X 100%

If you sell IBM for $120 dollars at the end of the year, this would be ($2000)/($10,000) X 100 % = 20%

1 Year Return for various IBM outcomes

1 Year Return for various IBM outcomes

IBM $10 $80 $90 $95 $100 $105 $107 $110 $115 $120
-90% -20% -10% -5% 0% 5% 7% 10% 15% 20%

On to choice 2:

Buying 1 IBM call for $7 that expires in exactly one year with a strike price of $100

Let’s slowly figure out what that means.

Calls, if you can somehow get them for free, take them!

Calls can never be worth less than 0! It’s like having the option to go swimming when you already have a pool pass. If you really feel like swimming, great – exercise your option to go swimming and have an enjoyable afternoon. If you don’t feel like swimming, nothing ventured, nothing lost.

A call is a lot like a coupon that guarantees you a price. Think about having a gas coupon that lets you buy 20 gallons of gas for $3 a gallon anytime in the next year. If gas never goes higher than $3, you just never use it. If, however, gas surges to $4 a gallon, you’ll be glad to have that coupon!

Consider the above call as nothing more than a coupon letting you buy IBM for $100 a share any time in the next year.

The price that the call (or coupon, if you will) lets you purchase IBM at is called the Strike price. In our example, the Strike price is $100. Strike prices are usually set in increments of $5 (e.g. 90, 95, 100, 105, or 110). Stocks that trade at lower prices may have strike prices for every $2.50.

Calls also have Expiration dates. To start out simply, we’re just going to talk about a call that expires in one year, but later we’ll learn that in the market place specific calls expire on specific dates, and are referred to by the month that they expire.

You may hear the term Underlying. The underlying refers to whatever the call is based on. In this case, it is the stock IBM. Options are often called Derivatives, because they derive their value mostly from the location of their underlying product.

Now that you have the basic idea, here’s the formal definition of a call. A standard equity call option conveys a right, not an obligation, to its holder to purchase 100 shares of the underlying stock, at a specific price per share, for a predetermined amount of time.

Over the course of the next year, you can do whatever you want with your call. Just like a coupon, you can use it any time you wish; you can sell it to someone else before it expires; or in the worst case scenario you might never find a time to do anything with it.

How much does this cost?

This can be a little confusing, so take a deep breath and read the following carefully.

1 IBM call does not correspond to 1 share of IBM stock. When people in the industry refer to 1 call, it’s sort of like how a grocer talks about a carton of eggs.

You understand that a purchasing a carton of eggs for $1.20 means you that are buying 12 eggs all at once for 10 cents each.

1 IBM call gives you the opportunity to buy not one, but 100 shares of IBM for $100.

Here’s where it gets a little dicey. Your broker will tell you that the price of your 1 call is $7. This would be akin to your grocer telling you that a carton of eggs would cost you 10 cents, when what he really meant was 10 cents for each egg in the carton.

Yes, an IBM call, like the one in our example, will cost you $7 for each share of IBM that it represents. So your total expenditure is $700 ($7 X 100 shares).

What’s the most I can lose?

You can’t lose any more than you paid: $700

Here’s a big advantage for the option over buying stock. IBM is probably not going to go to zero in a year, but it could easily go to $80, which would represent a loss almost three times as large ($2,000) as your maximum loss with the option.

That’s the great thing about buying calls instead of stock, limited loss. We’re buying IBM because we think that it is going up. When we buy stock being wrong hurts us, and being really wrong hurts us more and more.

How can I make money?

We’re going to start out as simply as possible by assuming that you do absolutely nothing with your option for exactly one year. This is unrealistic, but a good place to start.

After one year, it’s put up or shut up time.

IBM has to be higher than 100 in one year for my option to be worth anything.

If in one year IBM is trading $95, then your option is worthless. Who wants to buy IBM for $100, if you can buy it for $95?

If in one year IBM is over $100, then you would theoretically exercise your call, which turns it magically into 100 shares of IBM stock. In this case, you would then probably sell your stock in the marketplace for a profit.

Let’s look at an example.

After one year, IBM ends up at $110.

You exercise your call and pay $10,000 for 100 shares of IBM

Then you can sell your 100 shares at $110 in the regular marketplace taking in $11,000.

Your option was worth $11,000 – $10,000 = $1,000 to you.

Don’t forget that you paid $700 for your option, though! So your final profit would be $1000 – $700 = $300

Luckily you really don’t have to go through all that hassle, because you can just sell your option on expiration day for basically the same amount of money in the marketplace. You don’t even ever have to have the $10,000!

Here’s how we figure out what an option is worth at expiration.

Call Value = Price of IBM – Strike Price

So as above, where IBM wound up at $110, let’s see what our call is worth. This is where the confusing practice of quoting a call in terms of its cost per share of stock comes in handy.

We’re going to make the exact same calculation, but in the parlance of the industry.

Call Value (at expiration) = Price of IBM (at time the call expires) – Strike Price

Call Value = $110 – $100 = $10

For the sake of this lesson, assume that you can sell your call for $10 right at the end of expiration day, saving you the hassle of exercising it and then selling your stock out.

This value is usually referred to as the call’s Intrinsic Value or Parity

Profit = Call Value – Price you paid

In this case, we paid $7.

Profit = $10 – $7 = $3 which as above represents 100 shares of stock, so your final profit is $3 X 100 = $300. The same number we got above.

Remember, if the price of IBM at expiration is lower than the Strike Price, you wouldn’t want to use your option. The above formula would give you a negative value, and options are never worth less than 0! Your call has gone out worthless.

Intrinsic Value for various IBM outcomes

IBM $10 $80 $90 $95 $100 $105 $107 $110 $115 $120
Value $0 $0 $0 $0 $0 $5 $7 $10 $15 $20

If you sell IBM for $120 dollars at the end of the year, this would be ($2000)/($10,000) X 100 % = 20%

1 Year Return for various IBM outcomes

IBM	$10	$80	$90	$95	$100	$105	$107	$110	$115	$120
Stock	-90%	-20%	-10%	-5%	0%	5%	7%	10%	15%	20%

Intrinsic Value for various IBM outcomes

IBM	$10	$80	$90	$95	$100	$105	$107	$110	$115	$120
Value	$0	$0	$0	$0	$0	$5	$7	$10	$15	$20

Let’s compare the profits of our choices with some possible outcomes.

IBM	$10	$80	$90	$95	$100	$105	$107	$110	$115	$120
Stock	($9,000)	($2,000)	($1,000)	($500)	$0	$500	$700	$1,000	$1,500	$2,000
Call	($700)	($700)	($700)	($700)	($700)	($200)	$0	$300	$800	$1,300

Some things to notice:

With the call you can not only be wrong, you can be totally wrong! The most you can lose is $700. Buying a call let’s you profit from upside moves in IBM with limited loss!
IBM must go higher than $107 for you to make money on your call. You don’t get anything for free in life. You paid $700 for your limited downside risk. That’s why a lot of people call options insurance.
We never do quite as well in sheer dollar profits with just one call as we do with 100 shares of stock, but we can go to sleep knowing that our losses can only go as high as $700. This can be an especially attractive asset with younger less established companies than IBM where giant moves in either direction are possible!
Here’s something subtle but interesting. Although the call always provides you with at least $700 less profit than the stock purchase, once it starts working for you it starts working just as well as stock. Stock finishing at $115 instead of $110 improves your situation by the same exact amount ($500) in both cases. One call gives you the same upside power that 100 shares of stock does, but it doesn’t cost you $10,000. It only costs you $700!

Let’s look at return

In the above example, where IBM ended up at $110, we made $300 of profit on a $700 investment.

1 Year Return = (Profit) / (Investment) X 100%

1 Year Return = $300/ $700 X 100 % = 43%

Here are the returns associated with some possible outcomes

IBM	$10	$80	$90	$95	$100	$105	$107	$110	$115	$120
Stock	-90%	-20%	-10%	-5%	0%	5%	7%	10%	15%	20%
Call	-100%	-100%	-100%	-100%	-100%	-29%	0%	43%	114%	186%

Remember that we’re comparing an investment of only $700 to one of $10,000.

Some more things to notice

Buying calls can often lead to a loss of your entire investment.
Because options let you take advantage of the upside of a $10,000 investment with only $700, they can offer fantastic returns on your money. Buying one or more calls lets you leverage a small amount of money into generous upside returns with limited downside risk.
Buying a call leaves us with $9300 more to invest any way that we want. One choice might be to purchase more than one IBM call.

The point is that both choices yield certain return characteristics to fit your needs.

Something else about limited loss

Think about this common scenario. You buy IBM at $100 and it immediately falls to $80. You’ve immediately lost $2,000 and suddenly you think to yourself that it’s not very fun owning IBM. Nothing says that IBM will stop going down and perhaps $2,000 is as much as you care to lose. You’d have to sell your IBM stock.

On the other hand with the call, the most you can lose is $700. If stock immediately falls to $80, you’re probably not very happy, but you still have a year for things to improve. It’s gotten about as bad for you as it can get, but you have no real reason to panic about the future, because at this point it can only get better. It’s still possible IBM could still trade up to $120 by the end of the year.

An example where you might consider buying calls instead of stock

Let’s say you do some research on IBM and come to the realization that the coming year is a very important one for the company. IBM is planning to come out with a new product that will be very important to its future, perhaps a home computer that talks to you like a close friend.

You decide that whether this product is successful or not will have a huge impact on the stock. If you think that this new product is a likely success, this would be an ideal circumstance to perhaps purchase some calls especially if you have some money that you are willing to put at risk.

If the product is a flop, your loss is relatively small. If it is a huge success, you can make some excellent returns on your investment with limited dollar risk!

Skill from this less to work on

Understand how to calculate the intrinsic value and net profit for any expired call given the following information