Options enable the trader to play the market in more subtle ways than buying or selling stock straight up allows. On this site, we like to trade events. Options are ideal for trading events because they take into account two aspects of stock movement: direction and speed. A trader can make money by predicting the probability of both and be protected even if he or she is only partially right. Options allow us to more specifically define risk, add yield, use leverage or protect a portfolio. In these sections, we will give explanations for many of the strategies that we use on the site as well as some examples for when the strategy worked and when it did not and why. As with all aspects of the site, we do this not so that you can do as we do exactly, but so that you can optimize your own trading knowledge, goals and decisions. Many of our strategies will involve being flat to long premium, unless against existing long stock positions. Although with an infinite pocket, being net short premium can be a winning strategy as volatility is mean reverting, on any particular trade you can lose the house, so for individual traders as opposed to large scale market makers it is not a strategy that we suggest often in its own form. We are here to reduce your market risk and adding yield.
We trade equity and ETF (Exchange Traded Fund) American options so that is what we will be discussing here. An option contract provides the right, but not the obligation, to buy (call) or sell (put) 100 shares of a stock or ETF at the strike price at any time up to the expiration date. If you buy an option you are considered “long” the option and if you sell it (without already being long it) you are considered “short.” If you sell something you already own you are “closing.” As a seller of a call or put, you are obliged to either sell or buy the stock respectively at the option’s strike price if the option is exercised. An option is exercised if it finishes $.01 in-the-money at the time of expiration. The expiration date for American stock options is usually the first Saturday after the third Friday of the month. We also trade/detail weekly options on stocks and we’ll indicate those buy stating the day of expiration and indication ‘weekly’ (e.g. Feb23rd weekly means expiring on Feb 23rd) . Also leaps expire in the next calendar year so it is important with January options to make sure you are aware which year they are expiring. Those will be indicated by a year on their expiration (e.g. Jan’17 regular).
Premium is the price paid for or received for an option contract. When giving an order verbally, you buy “for” and sell “at.” In these days of electronic trading it isn’t so vital, but we try to be consistent on the site with our nomenclature to be redundant.
An in-the-money option has intrinsic value. What does that mean? It means that in the case of a call, the strike price is below the stock price (e.g. stock is trading 55, and the 50 call is $5 in the money). In the case of a put the strike price is higher than the currently trading stock price (e.g. stock is trading 55, and the 60 put is $5 in the money). Thus these options are worth something right now even if the stock froze until expiration, they have intrinsic value. If the premium equals the intrinsic value, an option is considered to be trading at parity.
Out-of-the-money refers to options whose strike price in the case of calls the is above the current trading stock price (e.g. stock is trading 55 and the 60 calls are $5 out of the money) and for puts below the current trading stock price (e.g. the stock is 55 and the 50 puts are $5 out of the money). You wouldn’t want to pay to buy stock above the currently trading price, nor would you want to pay to sell stock lower than it is currently trading. Thus out-of-the-money options have no intrinsic value. But why do in-the-money options often more than their intrinsic value? (e.g. the stock is $55 and the 50 calls trade $6). And why do out of the money options have any value at all? (e.g. the stock is $55 and the 50 puts trade $1) This part of the option price is referred to as time value (although we use the term extrinsic value as there is more than time involved) and is based on a number of factors: time to expiration, implied volatility, dividend, carrying cost and short interest. Extrinsic value is what makes options fun and scares off the faint of heart. But it shouldn’t scare you.
Go back to the example of the stock trading $55 and the 50 calls trading $6 and the 50 puts trading $1. Notice anything? Subtract the $1 puts from the $6 dollar calls and you get $5, the distance (intrinsic value) of that line from where the stock is trading. The put and the call have the same extrinsic premium value ($1), one is added to zero because it is out of the money (the put is intrinsically worth nothing, so nothing +1 equal $1), the other is added to the intrinsic value (the call is intrinsically worth $5, so 5+1 equals $6).
Alot of factors go into the extrinsic premium but it can be boiled down to this. If a stock is likely to move around, in other words has a high volatility, the options will cost more because it is more likely that a stock might move through out-of-the-money strikes. Similarly, if there is more time to expiration an option will cost more because there is more time for the stock to move.