Making Money with Option Strategies: Powerful Hedging Ideas for the Serious Investor to Reduce Portfolio Risks
352
Making Money with Option Strategies: Powerful Hedging Ideas for the Serious Investor to Reduce Portfolio Risks
352eBook
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Overview
There are many options books available already, and they fall into two major categories: basic primers limited to explaining the terminology and market of options; and more advanced books discussing theory and pricing models of options.
None of these books addresses the largest audience of all—those who know the basics but are not interested in theories and pricing models. They want clear, practical ways to apply these principles to make money and reduce their risks. Making Money With Option Strategies is designed for this market.
Michael has traded options since the mid-1970s and is the best-selling options author in the United States. His best-selling Getting Started in Options, a beginner’s book now in its ninth edition, has sold more than 300,000 copies since 1986.
Many people view options as exotic, complex, and high-risk beasts. They are not. If your portfolio risk keeps you up at night, adding carefully designed option strategies to hedge risks will help you get a good night’s sleep.
Product Details
| ISBN-13: | 9781632659521 |
|---|---|
| Publisher: | Red Wheel/Weiser |
| Publication date: | 08/22/2016 |
| Sold by: | Barnes & Noble |
| Format: | eBook |
| Pages: | 352 |
| File size: | 7 MB |
About the Author
Read an Excerpt
CHAPTER 1
The Basics of Options
The options market is characterized by specialized jargon and terminology. This chapter explains all of the terms used and places them in context for you, as an investor. Beyond definitions, you also need to grasp the essential trading rules and to be able to read options listings found online or in the financial press.
This chapter presents a broad overview of the options market as a starting point for folding an options strategy into an equity portfolio; identifying specific risks; and understanding how to mitigate or remove an equity-based market risk.
Attributes of the Option Contract
Options are intangible contracts, granting their buyers specific rights (and imposing obligations on sellers). The amazing attribute of options is that they can be used in many ways, covering the spectrum from highly speculative to highly conservative. Most investors cannot be classified as strictly speculative or conservative, but tend to operate within a range of risk levels. These levels change based on the circumstances, including market conditions, stock prices, and the amount of cash in a trading account.
With these variations in mind, options are perfect vehicles due to their flexibility. The degree of risk you can undertake based on how you use options is not fixed any more than your risk tolerance. The leverage of options is very attractive as well. However, depending on how that leverage is applied, it can increase or decrease your risk.
For example, options typically cost 3% to 5% of 100 shares of stock. So buying a single option is a highly leveraged way to benefit from favorable stock price movement — or to suffer the risk of unfavorable movement. The percentage of option cost varies due to the specific terms of that option.
The flexibility of options is one of the primary attractions among investors. In addition to the pure speculator, many conservative investors with a buy-and-hold portfolio will trade options with a small portion of capital, as a form of "side bet" on the market. This not only brings up the chance for added profits, but also allows investors to take advantage of price movement in their stocks. Rather than sell to take profits, options can be used to capture those profits without giving up stock. And when a stock price is likely to decline, options can also be used to limit risks. In other words, options are flexible enough to allow you to manage portfolio risks while continuing to hold stocks in your portfolio.
The Leverage Benefit (and Risk)
Because option values are determined by price movement in the stock itself, the skillful use of options as a leverage tool presents many opportunities. For many, the option is an alternative to actually owning stock, so as a purely speculative tool, the leverage appeals to this group of traders. However, leverage also provides hedging value by setting up risk limitation as well as alternative forms of profit creation based on portfolio positions.
Leverage is normally associated with borrowing and, in that regard, most forms of leverage are also high-risk investing strategies. Borrowing money to invest does not seem to most people like a prudent decision. However, even the most conservative investors trade on margin, meaning they can buy 100 shares of stock with 50% cash and 50% leverage. So even when you consider yourself very conservative, you might be using risky leverage in your own margin account.
This means that every investor trading in a margin account is exposed to the risk of leverage through borrowing. This approach might seem wise. You can buy 100 shares of a $50 stock for only $25 per share; as the stock price rises, the return on your $2,500 cash investment is twice as much as it would be when paying all cash. However, if the stock price declines, the loss also is accelerated. So if the $50 stock falls to $42, you lose $800, or 32% of the $2,500 you put at risk. However, you still owe your broker $2,500. Your leveraged debt is $2,500, but the cash portion of your investment has dropped to $1,700.
This demonstrates that leverage based on borrowing money means that both profits and losses are accelerated. So leverage (meaning borrowing money) can represent considerable risks. These risks are removed when you trade options as hedges against your portfolio. You can pay cash to buy options at a small percentage of the cost of 100 shares, and the most you can lose is the amount you pay, never any more.
Terms of Options
To completely understand how options provide hedging benefits, you need to master the jargon of this industry. Every option is uniquely defined by its four standardized terms. These terms define the option and always work in the same way, meaning all of the terms apply to all listed options (thus, they are standardized). So when you buy or sell an option, you know exactly what your contractual terms are for that asset.
The four terms are:
1. Type of option. There are two, and only two, "types" of options: calls and puts. A call grants its owner the right, but not the obligation, to buy 100 shares of stock, at a fixed strike price and by or before its expiration. A put grants its owner the right, but not the obligation, to sell 100 shares of stock, at a fixed strike price and by or before its expiration.
2. Strike price. This is the fixed price at which a call or a put can be traded. This price remains fixed for the entire life of the option regardless of the stock's price.
3. Underlying security. Every option is tied to a specific stock or other security (such as a stock index or exchange-traded fund, for example). This cannot be changed during the limited lifetime of the option.
4. Expiration date. This is the month and date when each option ceases to exist. Every option is identified by expiration month. In addition, listed options expire on the third Saturday of that month, and the last trading day is the third Friday.
Expression of an option is quite specific and is based on these four standardized terms. Here are two examples:
JNJ Oct 95 c (Johnson & Johnson, call with a 95 strike price, expiring in October)
MCD Mar 100 p (McDonald's, put with a 100 strike price, expiring in March)
The stock symbol for each stock (JNJ or MCD, for example) is used in an options listing or description. The expiration month is normally reduced to a three-digit summary without a period. The strike is always expressed at the price per share but without dollar signs.
If the option is not a round dollar per share value, it is expressed as dollars and cents to two digits, also without dollar signs. So if the strike is 99.50, that means the strike is equal to $99.50 per share. In describing options and stocks, the use of dollar signs is always used to explain the price per share of stock, but never options. So a 99.50 option on a stock currently priced at $99.75 is how the situation is expressed.
The Price of Options
The price of each option is called its premium and it is always written as the price per share. So if the premium of a 99 call is $215, it is expressed as 2.15. Expanding the listing of an option to include the premium value, the following examples include premium:
JNJ Oct 95 c @ 1.40 (Johnson & Johnson, call with a 95 strike price, expiring in October, with current premium value of 1.40, or $140)
MCD Mar 100 p @ 7 (McDonald's, put with a 100 strike price, expiring in March, with current premium value of 7, or $700)
Like most securities, options also are expressed at both bid and ask prices. The ask is the price you pay to buy the option, and the bid is the price you receive for selling the option. For example, the JNJ Oct 95 c @ 1.40 is the bid price for that option, or what a seller receives. And the MCD Mar 100 p @ 7 describes a put worth $700.
Long and Short Positions
Expanding beyond the listing, every option can be either bought or sold. The bid price (what sellers receive) and the ask price (what buyers pay) are included in every options listing. When you buy an option, you are long; when you sell, you are short. The distinction is one of sequence. A long position is the well-known "buy-hold-sell" sequence. The short position is the opposite, or "sell-hold-buy."
This reversal of the sequence is confusing for many investors accustomed to first buying a security and then later selling. However, you can open a position that is either long or short with options, and the risks are different for each. Just as a buyer has the right to buy or sell 100 shares, the seller is exposed to the possibility of exercise, meaning a call owner will "call" 100 shares and the seller is required to deliver those shares at the strike, even when the market value is much higher. It also means a put owner will "put" 100 shares to the seller, meaning the seller is required to accept 100 shares at the strike, even when the market value is much lower.
The buyer of an option enters an opening trade, called "buy to open," and a later a closing trade, called "sell to close." Everyone who has bought and sold stock is familiar with these definitions. However, for those who enter a short position by opening with a sale, the opening trade is called "sell to open" and the closing trade is called "buy to close." These distinctions are important because the distinctions — buy versus sell and open versus close — define the action you take each time you trade an option. Many traders describe the closing of a short option as "buying back" the option. This is misleading and confusing, because the buy to close occurs based on the initial opening of a short position. There is no "buying back" action because the trader never owned the position to begin with.
To compare buying and selling consider the important differences between calls and puts and between long and short, illustrated in Table 1.1.
Where This Gets Confusing
Anyone new to jargon is going to struggle to grasp the concepts. With options, the opposites — call versus put, long versus short, buy versus sell — can be very difficult to put into context. To aid in clarifying these differences, keep in mind that:
• A call is the right to buy, and the put is the right to sell.
• Buyers of calls and puts gain the right to buy or sell, and sellers have an obligation to accept exercise if and when it happens.
• A long position starts with a "buy" order and ends with a "sell" order.
• A short position starts with a "sell" order and ends with a "buy" order.
These definitions are of crucial importance in developing an understanding of the many potential hedging strategies you can apply to your portfolio. Among the difficulties faced by those new to options is the concept of profiting from a price decline. Most investors grasp the idea that investment is profitable when prices rise. However, thinking of the put as the opposite of a call, it becomes clearer why the put becomes profitable when the stock price falls.
The difficulty of jargon becomes clearer when specific strategies are introduced and aided by examples of outcomes. Price direction defines risk. So options working as hedges for portfolio positions (usually meaning long stock held in the portfolio) can involve either calls or puts, opened as either long or short trades.
The Option Premium's Three Types of Value
Every stockholder understands that stock has a single value: the price per share. This changes daily based on many influencing factors, but the value of a share of stock is universally agreed upon. With options, however, it is not as simple.
There are three distinct and separate types of value that make up the total premium of the option. Once you understand how these values interact, you will have a clearer understanding of why option-based hedging works so well. The influences on changing option value are not based only on movement of the underlying stock, but also on volatility and time.
Volatility of stock is often represented by ITLβITL, a measurement of how a stock's price follows or responds to the larger market. This comparison is made between the stock and a benchmark index like the S&P 500. A beta of 1.0 indicates that the stock will rise and fall at 100% of the rise or fall in the benchmark. A higher beta equals higher volatility, and a lower beta equals less responsiveness or lower volatility.
This is all relevant to option premium because the underlying stock's volatility (called historical volatility) is going to show up in the option as well. Whereas volatility is a clear factor in levels of option value, proximity between the option's strike and the underlying stock's price is another factor. So there are three key factors adding to value of the option: volatility, time, and proximity (between strike of the option and price of the stock). This proximity is called the moneyness of an option.
Every option may be in the money (when the stock price is higher than a call's strike or lower than a put's strike); at the money (when the stock price is exactly the same as the option's strike); or out of the money (when the stock price is lower than a call's strike or higher than a put's strike). Figure 1.2 illustrates the moneyness of options.
The chart demonstrates the moneyness of calls and puts. With strikes of 95, calls and puts are at the money (ATM) when the underlying stock is worth $95 per share. The in-the-money (ITM) and out-of-the-money (OTM) status are opposite for calls and puts.
With moneyness of options, it is easy to determine whether an option is in or out of the money. This leads to the definition of the first type of option premium: intrinsic value.
This value is easy to identify. For example, with a strike of 45, a call is 3 points in the money when the stock price is $48 per share. So the call has 3 points ($300) of intrinsic value. If the stock price is $45, the call is at the money; and any price below $45 per share means the 45 call is out of the money and has no intrinsic value.
For puts, the same rules apply but in the opposite direction. A 45 put is in the money by 2 points if the stock price is $43 per share. At a stock price of $45 per share, the put is at the money. And any time the stock price is higher than $45, the 45 put is out of the money and has no intrinsic value.
In trading options, the moneyness demonstrates that when proximity is close, there tends to be a more immediate reaction between overall option pricing and stock movement. When an option is in the money, intrinsic value changes point for point with movement in the stock. However, this does not mean the overall premium value tracks the stock precisely. The two other forms of option premium, time value and volatility, work together to also adjust the premium levels of options. With time value, increases in intrinsic value may be offset with a decrease, so the overall premium is not entirely responsive to stock movement. And volatility value also affects premium in either direction, depending on proximity and time.
Time value is the portion of an option's premium directly related to the time remaining until expiration. It declines over the lifetime of the option, reaching zero by expiration day. As expiration approaches, the decline in time value (called time decay) accelerates as well.
Time value (like intrinsic value) is completely predictable. The curve of time decay increases toward the end of the option's life cycle, taking time value down to zero on the last trading day. This is shown in Figure 1.3.
Time value affects overall premium in predictable ways, and you can see this effect in a study of an option's listing. For example, On October 1, 2015, IBM was trading at $142.64 per share. At that time calls and puts with three different expirations were trading at the following prices, as Table 1.2 indicates.
(Continues…)
Excerpted from "Making Money With Option Strategies"
by .
Copyright © 2016 Michael C. Thomsett.
Excerpted by permission of Red Wheel/Weiser, LLC.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.
Table of Contents
Introduction: Solving the Time and Proximity Issues,
1: The Basics of Options,
2: The Hedging Concept and Its Application,
3: Option Valuation and Portfolio Risk,
4: Speculation With Options vs. Conservative Strategies,
5: Charting and Trade Timing,
6: The Basic Covered Call,
7: The Uncovered Put: Alternative to Covered Calls With Less Risk,
8: Hedging With Spreads,
9: The Butterfly and Condor,
10: Collars and Synthetic Stock,
11: Straddles Hedged,
12: Rolling and Recovery Strategies,
13: Avoiding Early Exercise of Short Options,
14: Collateral and Tax Rules for Options Trading,
15: The Final Twist: Proximity,
Glossary,
Bibliography,
Index,
About the Author,