A while back, I posted a series of articles looking at the basics and various aspects of the Forex market. I thought today would be a good time to revisit another article that was written dealing with some of the basics of the derivatives or options market. Enjoy....
~Duane Gott
Options or derivatives as they are sometimes called, are a complex, yet highly profitable trading instrument available in many of today’s stock and commodity markets. Options can be traded through a variety of structured strategies that minimize risk and can lead to eye-popping gains. Before we get too far along, let’s take a look at the basics.
What is an option?
Simply put, an option is a trading instrument that is derived from a stock, future or currency cross-rate. One of the clearest ways to illustrate how an option works is by thinking about supermarket coupons.
A 12-pack of Coca Cola is regularly priced at $4. However, you have a coupon that allows you to purchase the Coca Cola for $2.50. This coupon expires at the end of the month and beyond that, it is deemed worthless. Now, you can either choose to buy the Coca Cola with the coupon for a discount, or you can sell the coupon to another consumer. The coupon basically guarantees that you have the right to purchase the 12-pack of Coke at $2.50 before the expiration date. Knowing this, let’s say that a change in the soft drink market dramatically sent the cost of a 12 pack of Coca Cola from $4 to $6.50. The coupon that the person now holds becomes more valuable as it still guarantees the right to buy the 12-pack of Coke at $2.50 where the actual asset is now selling for $6.50. This coupon guarantees the right to buy the Coca Cola at over a 50% discount. Not only can the consumer exercise the coupon and buy the Coca Cola outright, but they can sell the coupon to another consumer. Because the market value of a 12-pack of Coca Cola has gone up significantly, the coupon is now worth more because of the increased discount it offers.
Thinking about this analogy, the options market works in the exact same way. Let’s equate our example to see how it works with equities. We’ll use the stock MSFT as our example. MSFT stock is represented by the 12-pack of Coca Cola, also known as the underlying asset. The selling price of $4 for a 12-pack of Coca Cola represents the current market value of MSFT. The coupon to buy the Coca Cola at $2.50 represents an option to buy MSFT stock at a discount from the current market value. In the options world, the $2.50 coupon would represent what is called the strike price. As MSFT goes up in price, the option becomes more valuable because it guarantees the trader a discount compared to the current market value of the stock.
Types of Options
There are two primary types of options, calls and puts. Let’s define each one…
A Call option is a trading instrument that allows the trader to speculate that the current market value of a stock or commodity is headed up. A Put option is a trading instrument that allows the trader to speculate that the current market value of a stock or commodity is headed down. Just like when we “short” the market, we can use options to make money regardless of whether a stock is headed up or down. Keep in mind that not all stocks have options. A stock must be liquid enough to absorb any fallout from options traders for it to be optionable.
Strategies & Nuances
The outlined example of a how an option is traded is a basic explanation that can become extremely complex depending on how a trader wishes to position themselves around a particular stock or commodity. Let’s take a look at some of the details that surround the options market.
There are three basic conditions that can be discussed when we talk about options. Let’s define each of these…
* In The Money: Situation in which an option's strike price is below the current market price of the underlier (for a call option) or above the current market price of the underlier (for a put option). Such an option has intrinsic value.
* Near The Money: An option contract for which the strike price is close to the current market price of the underlying security.
* Out of the Money: A call option whose strike price is higher than the market price of the underlying security, or a put option whose strike price is lower than the market price of the underlying security.
Time Decay: Just like our coupon example, every option has an expiration date. Unlike stocks that can be held indefinitely, options have a limited shelf life. Every month, new options are brought to the market while others expire. Because options are technically working against the clock, they have what is called Time Decay. Time Decay slowly erodes the underlying strength of the option as it gets closer to the expiration date. The ratio of the change between an options value and the amount of time left until expiration is the Time Decay or what is also called the Theta.
* Intrinsic Value: The amount by which a call option is in the money, calculated by taking the difference between the strike price and the market price of the underlying asset. For example, if a call option for 100 shares has a strike price of $35 and the stock is trading at $50 a share then the call option has an intrinsic value of $15 per share, or $1500. If the stock price is less than the strike price the call option has no intrinsic value.
There are many other components that are taken into consideration when we talk about the way options are traded. Some of these factors include items such as implied volatility, Delta, Gamma, Open Interest, theoretical value, Rho and the premium. Most of these terms and corresponding concepts are beyond the scope of this introduction, but will be explained at a later time.
If you are interested in learning more about Options and the way they are structured, I would recommend reading “The Complete Option Player” by Kenneth Trester. This book covers not only the basics of the options market but also expands on complex theories and trading strategies implemented by professional option traders.
Trade Smart....
~Duane Gott
I would recommend McMillan on Options and Options as a Strategic Investment both by Larry McMillan as resources. They will help you see a variety of possibilities which in many cases are not closely linked to price movement. I subscribe to his service and have had good results. I take his speculative trades with a grain of salt unless backed up by AGet confirmation but his volatility plays have treated me quite well
Posted by: Donnie V | September 05, 2008 at 11:23 AM
I agree Don. Larry McMillan is one of the option greats. It's not hard to find value in any of his books.
Posted by: Duane Gott | September 05, 2008 at 03:34 PM