Option Education

[leemalone2k3]

Basics

An option is a contract that gives the owner the right, but not the obligation, to buy or sell a stock at a set price by a set date.
An option is a piece of paper that allows you if you own the contract to buy or sell a stock at a set price before the contract expires, or to buy or sell the contract at any time prior to expiration..

a Purchased Call option gives you the right to buy a stock a t a set price for a set period of time.
A Purchased Put option gives you the right to SELL a stock at a certain price by a set date.
Option carry the risk of total loss of your investment.
Options have leverage. When you buy 1 contract, you control 100 shares of the stock at a fraction of the price
5 Ingredients to Option Pricing
The current stock price.
The strike price you are trading.
The time till the option expires.
The cost of the money.
The stocks volatility.
Every Option has 2 Parts
Intrinsic vale
Value if the current value of the opt if it were to be exercised today.
Time value
Value if the amount you pay to exercise your contract within the next few months.
Time Value(TV) is the additional amount the MM's add to the premium, it's like a car dealers mark up price.
Example
a. Intrinsic value + Time value = option price
b. Stock=$26
c. I want to buy the $25 calls
d. The intrinsic value = $1 (26-25)
e. If the option quote price of the $25 call is 2.50, then the time value is $1.50 (see F)
f. 2.50-1.00=1.50
g. If stock is $27, Intrinsic Value=$2.00
h. Option Quote - Intrinsic Value = Time Value

Theoretical Value
1. Is the fair value of an option.
2. It not only tells us if the stock is overvalued or undervalued, but it also tells us exactly what price we should be paying for an option.
3. This T-value is derived from the Black Scholes Calculator.
Example
a. Lets say we are looking at a 60.00 stock and the Tval is listed at .65.
b. Ask price for the strike price and the exp month is .70 for the Nov 60.00 call option.
c. If we pay .70 to buy the option and the Tval is .65 we will pay 7.6% more than we should.
d. There is a normal premium built into most options as the MM's will try to see how much more you are willing to pay.
e. As a general rule of thumb, make sure the ask price of an option is not trading more than 20% premium of the T-Val.


Decision Factors
A huge factor in deciding whether or not to purchase an option rests in the expected volatility (price movement) vs. the stock's historical volatility.
Volatility = magnitude of a stock move, this can be up or down.
If stock has low historical volatility, that means investors are willing to hold the stock and not trade it.
This usually indicates the stock will see low volatility in the future.
The 12m calculation for historical volatility is a good indicator.
Implied volatility measures the current expected volatility of the stock.
When we measure the historic against the implied, we can see if the stock's expected (implied) volatility is above or below normal historical volatility.
If implied volatility is higher than historic volatility, the option is overvalued.
If implied volatility is lower than historic volatility, the option is undervalued.
If implied volatility is close to the historic volatility, the option is fair valued.
All of this is done for you with a calculator called the Black Shoales Calculator.
The BSC allows you to project the future value of an option by allowing you to manually change the Strike price, share price , time to expiration, volatility, annual interest rate.
http://www.blobek.com/black-scholes.html.
Forecasting
Each time you invest, you must choose a strategy that takes advantage of your forecast for the market or a particular stock.
This is a tremendous challenge and is impossible to be right 100% of the time.
To make a forecast, use the best available info and tools and then apply your individual; interpretation of them.
Always forecast before making a trade. Most option traders focus on short time frames for their forecasting (generally 3 months or less).
As option traders we try to use the leverage of an option to profit from a short term move in the market or individual stock.
Rules
The Trend is your friend. Never buck the trend or you lose.
Spot trend of the major indexes first: DOW<S&P500,NASDAQ.
Keep in mind that the trend tells you WHAT to do, and the Indicator tells you WHEN to do it.
ALWAYS - check the trend before you check the indicator.