Replies to post #9 on Ced's High Risk Options

[Stock Lobster]

IBD: How to Invest in Options:

Course IV -- How To Invest In Options

Introduction

An option is a derivative security. Its value is determined by the underlying issue, which for our purposes, we’ll assume is either common stock or an index (a widely followed basket of stocks).

Benefits of Exchange-traded Options

Although the history of options extends several centuries, it was not until 1973 that standardized, exchange-listed and government-regulated options became available. In only a few years, these options virtually displaced the limited trading in over-the-counter options and became an indispensable tool for the securities industry.

Orderly, efficient and liquid markets

Standardized option contracts provide orderly, efficient, and liquid option markets. Except under special circumstances, all stock option contracts are for 100 shares of the underlying security. The strike price of an option is the specified share price at which the shares of stock will be bought or sold if the holder exercises his option. Strike prices are listed in increments of 2 ½, 5, or 10 points, depending on the market price of the underlying security, and only strike prices a few levels above and below the current market price are traded. At any given time a particular option can be bought with one of four expiration dates. As a result of this standardization, option prices can be obtained quickly and easily at any time during trading hours. Additionally, closing option prices (premiums) for exchange-traded options are published daily in IBD as well as many other newspapers. Option prices are set by buyers and sellers on the exchange floor where all trading is conducted in the open, competitive manner of an auction market.

Flexibility

Options are an extremely versatile investment tool. Because of their unique risk/reward structure, options can be used in many combinations with other option contracts and/or other financial instruments to create either a hedged or speculative position. Some basic strategies will be described in options strategies.

Leverage

A stock option allows you to fix the price, for a specific period of time, at which you can purchase or sell 100 shares of stock for a premium, which is only a percentage of what you would pay to own the stock outright. That leverage means that by using options you may be able to increase your potential benefit from a stock’s price movements.

For example, to own 100 shares of a stock trading at $50 per share would cost $5000. On the other hand, owning a $5 call option with a strike price of 50 would give you the right to buy 100 shares of the same stock at any time during the life of the option and would cost only $500. Remember that premiums are quoted on a per share basis; thus a $5 premium represents a premium of $5 * 100, or $500, per option contract. Let’s assume that one month after the option was purchased, the stock price has risen to $55. The gain on the stock investment is $500, or 10%. However, for the same $5 increase in the stock price, the call option premium might increase to $7, for a return of $200, or 40%. Although the dollar amount gained on the stock investment is greater that the option investment, the percentage return is much greater with options than with stock. Leverage also has downside implications. If the stock does not rise as anticipated or falls during the life of the option, leverage will magnify the investment’s percentage loss. For instance, if in the above example the stock had instead fallen to $40, the loss on the stock investment would be $1000 or (20%). For this 10% decrease in stock price, the call option premium might decrease to $2 resulting in a loss of $300 (60%). You should take note, however, that as an option buyer, the most you can lose is the premium amount you paid for the option.

Limited Risk for Buyer

Unlike other investments where risks may have no limit, options offer a known risk to buyers. An option buyer absolutely cannot lose more than the price of the option, the premium. Because the right to buy or sell the underlying security at a specific price expires worthless if the conditions for profitable exercise or sale of the contract are not met by the expiration date. An uncovered option seller, on the other hand, may face unlimited risk.

Guaranteed Contract Performance

The Options Clearing Corporation (OCC) guarantees that the terms of an option contract will be honored.

Prior to the existence of options exchanges and OCC, an option holder who wanted to exercise an option depended on the ethical and financial integrity of the writer or his brokerage firm for performance. Furthermore, there was no convenient means of closing out one’s position prior to the expiration of the contract.

OCC, as the common clearing entity for all SEC-regulated option transactions, resolves these difficulties. Once OCC is satisfied that there are matching orders from a buyer and seller, it severs the link between the parties. In effect, OCC becomes the buyer to the seller and the seller to the buyer, thereby guaranteeing contract performance. As a result, the seller can buy back the same option he has written, closing out the initial transaction and terminating his obligation to deliver the underlying stock or exercise value of the option to the OCC, and this will in no way affect the right of the original buyer to sell, hold or exercise his option. All premium and settlement payments are made to and paid by the OCC.

Further details of Options Trading

Options expire on the Saturday following the third Friday of the expiration month, although the third Friday is the last day of trading.

Option trades have a one-day settlement. The trade settles on the next business day after the trade. Purchases must be paid for in full, and the proceeds from sales are credited to accounts on the settlement day. Some brokerage firms require settlement on the same day as the trade, when trade occurs on the last trading day of an expiration series.

Options are opened for trading in rotation. When the underlying stock opens for trading on any exchange, regional or national, the options on that stock then go into opening rotation on the corresponding option exchange. The rotation system also applies if the underlying stock halts trading and then reopens during a trading day; options on that stock reopen via a rotation.

When the underlying stock splits or pays a stock dividend, terms of its options are adjusted. Such an adjustment may result in fractional striking prices and in options for other than 100 shares per contract.

[Stock Lobster]

IBD: Options Basics

Puts and Calls

Options come in two types, puts and calls. A call option gives the holder the right, not the obligation, to buy 100 shares of the underlying security at a fixed price for a fixed period of time. A put option gives the holder the right, not the obligation, to sell 100 shares of the underlying security for a fixed price for a fixed period of time. If the option is not exercised or sold by expiration, it becomes worthless.

The Four Specifications of an Options Contract

There are four specifications that describe an options contract. They are: the type (put or call), the underlying security, the expiration date, and the striking price. As an example, and option referred to as an “XYZ Jan 40 call” is an option to buy 100 shares of XYZ stock for $40 per share. This option expires on the Saturday after the third Friday in January. The price is quoted on a per-share basis. This means that an option priced at $4 would cost the investor $400 (4 * 100) plus commissions.

The Value of Options

An option is a derivative security. Its value is determined by the underlying stock and will fluctuate as the underlying stock rises and falls. As time passes the options price, the premium, erodes until it ultimately expires worthless. That is why options are referred to as a “wasting asset”. Fortunately, your option can be exercised, invoking the right expressed by the contract, or it can be sold to claim its value.

Options Relative to Price

There are three different terms for describing where an option is trading in relation to the price of the underlying stock. A call option is said to be out-of-the-money if the stock is selling below the strike price of the option. The call option would be in-the-money if the stock were trading above the strike price. An option is at-the-money if the stock price and the strike price are the same.

The intrinsic value of a call option is the amount by which the stock price exceeds the strike price. If the stock price is below the strike, there is no intrinsic value. The time value of an option is the amount by which the option premium itself exceeds the options intrinsic value. Intrinsic value plus time value = the options premium. As an example: Suppose the XYZ Jul 50 Calls are trading at 4 while XYZ is trading at 52. The options intrinsic value is 2 and the time value is 2. An investor is, in effect, paying 2 to see what happens between now and when the option expires in July.

An option normally has the largest amount of time value when the stock price is equal to the strike price. As an option gets further in or out-of-the-money the time value will erode.

Factors influencing the price of an option

There are four major factors that determine the price of an option, and two that contribute to a lesser amount:

The price of the underlying stock.
The strike price of the option itself.
The time remaining until expiration.
The volatility of the underlying stock.
And to a lesser extent:

The current risk free interest rate (usually the 90 day T-bill)
Dividend rate of the underlying stock.
Probably the most important influence on the options price is the stock price and its relation to the strike price. Options very far in or out-of-the-money may have markedly less time value and sell closer to their intrinsic value.

Another important determinant of an option’s premium is the time remaining until expiration. Option time value erodes dramatically as an option approaches its expiration. The rate of decay is related to the square root of the time remaining. Thus a 3-month option decays at twice the rate of a 9-month option (square root of 9=3).

The volatility of the underlying security is another important component of an options price. Volatile stocks make for higher options prices. There are two different kinds of volatility. There is historical volatility and there is implied volatility. Historical volatility estimates volatility based on past price activity. Implied volatility starts with the option price as a given and works backwards to ascertain the theoretical value of volatility equal to the market price minus any intrinsic value. It measures the amount of volatility the market is pricing into the option.

The dividend rate and the 90 day T-bill rate have to do with the cost to carry the contract.