TheoTrade
TheoTrade
TheRebel’sGuidetoTradingOptions
HowtoProtect&ProfitinAnyMarket
©Copyright2015-2016TheoTrade,LLC.Allrightsreserved.
EditionV2
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Disclaimer and Waiver of Claims
WeAreNotFinancialAdvisorsoraBroker/Dealer:NeitherTheoTrade®noranyofitsofficers,
employees,representatives,agents,orindependentcontractorsare,insuchcapacities,licensed
financial advisors, registered investment advisers, or registered broker-dealers. TheoTrade ®
doesnotprovideinvestmentorfinancialadviceormakeinvestmentrecommendations,norisit
in the business of transacting trades, nor does it direct client commodity accounts or give
commoditytradingadvicetailoredtoanyparticularclient’ssituation.Nothingcontainedinthis
communicationconstitutesasolicitation,recommendation,promotion,endorsement,oroffer
byTheoTrade®ofanyparticularsecurity,transaction,orinvestment.
SecuritiesUsedasExamples:Thesecurityusedinthisexampleisusedforillustrativepurposes
only. TheoTrade ® is not recommending that you buy or sell this security. Past performance
showninexamplesmaynotbeindicativeoffutureperformance.
Return on Investment “ROI” Examples: The security used in this example is for illustrative
purposes only. The calculation used to determine the return on investment “ROI” does not
include the number of trades, commissions, or any other factors used to determine ROI. The
ROI calculation measures the profitability of investment and, as such, there are alternate
methodstocalculate/expressit.Allinformationprovidedisforeducationalpurposesonlyand
doesnotimply,express,orguaranteefuturereturns.Pastperformanceshowninexamplesmay
notbeindicativeoffutureperformance.
Investing Risk: Trading securities can involve high risk and the loss of any funds invested.
Investment information provided may not be appropriate for all investors and is provided
withoutrespecttoindividualinvestorfinancialsophistication,financialsituation,investingtime
horizon,orrisktolerance.
Options Trading Risk: Options trading is generally more complex than stock trading and may
not be suitable for some investors. Granting options and some other options strategies can
resultinthelossofmorethantheoriginalamountinvested.Beforetradingoptions,aperson
shouldreviewthedocumentCharacteristicsandRisksofStandardizedOptions,availablefrom
yourbrokeroranyexchangeonwhichoptionsaretraded.
Nopartofthispresentationmaybecopied,recorded,orrebroadcastinanyformwithoutthe
priorwrittenconsentofTheoTrade®.
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Contents.
TheoTradeMission.........................................................................................................................6
Introduction...................................................................................................................................7
TheoTradePrinciples..................................................................................................................7
IntroductiontoOptions..............................................................................................................8
TheoTradeMantra......................................................................................................................9
TheoTradeCharacteristicsofTraders..........................................................................................10
UnderstandingOptions................................................................................................................11
AncientRootsofOptionContracts...........................................................................................11
Definition..................................................................................................................................11
OptionAdvantages...................................................................................................................12
OptionsDisadvantages.............................................................................................................12
OptionBuyer’sRightsandOptionSeller’sObligations.............................................................12
OptionParticulars.....................................................................................................................14
UnderstandingOptionPremium..............................................................................................18
IntrinsicValueFormula.............................................................................................................19
RelationshipofStockPricetoOptionPrice..................................................................................21
The“Money”isthestockprice................................................................................................21
IntrinsicValueofanOptionWhentheStockisat$50.............................................................21
TimeValue(ExtrinsicValue).....................................................................................................23
FactorsthatInfluenceTimeValue............................................................................................24
ATMOptionshavethemosttimevalue...................................................................................25
Volatility...................................................................................................................................26
OptionPositions.......................................................................................................................28
ClosingOptionPositions...........................................................................................................37
ExercisingOptions....................................................................................................................38
EnhancingReturnsandManagingRiskwithOptions...................................................................40
HedgingYourLongTermPortfoliowithPutOptions...............................................................40
UsingOptionstoBenefitfromPriceMovements(Speculating)...............................................43
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Risk-RewardAnalysisofOptionsversusStocks........................................................................43
TradingwithSpreads................................................................................................................44
StockandATMOptionEquivalentsandRelatedRisks.................................................................46
StockMarketTerminology...........................................................................................................48
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TheoTrade Mission.
Youwanttolearnaboutthemarketsandthat'swhatgetsusupinthemorningatTheoTrade.
We do it for the love of the trade. Forget what you think stocks are going to do and start
focusingontherighttradeswiththerighttradelogic.Wearenotsomerunofthemilltalking
heads,wetrade,andwedothistoevokechangeintheflawedrealityofclassicalWallStreet
finance. Step up to the plate, commit yourself to learning the markets from our experience,
andjoinusinourpursuitoffinancialrevolution.
DonKaufman
Co-FounderTheoTrade
Learn.Chat.Trade.
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Introduction.
Congratulations on beginning your journey towards learning the options markets with
TheoTrade!Youareabouttoembarkonalearningexperiencethatwillteachyouriskaverse
concepts for trading known and used by less than 1% of the people in the stock market. To
beginweshallintroducetheTheoTradePrinciples:
TheoTrade Principles
1. TradeLogic
2. CapitalAllocation
3. DirectionalBias
TradeLogic
AtTheoTradeweputyourstrategyandtradelogicfirst.Thevastmajorityofpeopleinvolvedin
markets are infatuated with market direction, attempting to predict the next move a stock is
goingtomake.Thereality,whatyou“think”astockisgoingtododoesnotalwaystranslate
into profits. Many investors and traders alike place far too much emphasis on being right or
picking the next move a stock might make. Our veteran traders dictate the right strategy
coupled with established entry and exit criteria you do not need to be “right” in picking a
directioninastockorthemarketsinordertobeprofitable.
CapitalAllocation
Howandwhereyouallocatecapitalshouldbestronglyconsideredasaviableportionofyour
tradingmethodology.AtTheoTradeCapitalAllocationtakesprecedenceoverbeing“right”in
the markets. Why you ask? Experience and watching order flow for decades has taught us
invaluablelessons.Haveyoueverbeenstoppedoutofatradeorbailedoutofapositiononly
to see the markets turn around shortly thereafter? How and where you allocate capital can
definenotonlylossesbutitcanbethedefiningfactorinyouroverallsuccessorfailureinthe
markets.Ourwarcryis“durationoverdirection”,youneedtobecapableofsustainingtrades
longenoughtobeprofitable.
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DirectionalBias
We are not anti-charts. Rather we recognize where you “think” a stock might go does not
always mean the markets will agree with your sentiments. Being right directionally cannot
defineusasinvestorsortradersforwemaynotbe“right”oftenenough.AtTheoTradeweare
realistsofthemarketplaceandwemustplaceourcapitalatriskONLYwiththecorrecttrade
logicandacomfortableallocation.
Introduction to Options
ThisTheoTradeIntroductiontoOptionsisdesignedhelpyoubecomefamiliarwithsomebasic
WallStreetconceptsandthefundamentalsofcallandputoptions.Understandinghowoptions
work is paramount to becoming a more effective trader. The fact that options are widely
regardedasriskyisironic,asoptionswereoriginallydesignedasriskmanagementtools.Like
any tools one must learn how to use options. A power saw has many advantages over a
handsawforcuttingwood.However,ifyoudon’tlearnhowtouseapowersaw,youcancut
yourfingersoff.Similarlytoapowersaw,thosewithoutanunderstandingofoptionscanput
themselves at risk. For the most part, brokers are right in advising their clients to stay away
fromoptions.Theyknowmostwillwanttograbholdofthe“saw”withoutlearninghowtouse
it.However,onceapersonisproperlyeducatedontheproperuseoftheseriskmanagement
tools,optionscanbethequickest,easiest,andsafestroutetofinancialsuccessinthefinancial
markets.
The strategies taught in our online classes, chat rooms, and workshops are used by trading
professionalsaroundtheworld.Andyouwillbelearningfromsomeofthebesttradersinthe
world. Our instructors have a minimum of 15 years’ experience working within the finance
industryastraders,marketmakers,orbrokers.Theywillteachyouhowtohedgeyourstocks
andmutualfundstoenhanceyourreturnsandminimizelossesonmajordownturns.Youwill
learnhowtoplacetradesthatcanproducelargemonthlyreturnswithverysmallmovesina
stock.Allthiscanbedonewithminimalcapitalandinonlyafewhoursperweek.AtTheoTrade
ourcoursesandcoachingwillprovideyouwithstep-by-stepcriteriaforeachstrategythatwill
helpyouselectandvalidatecandidates,establishlosslimitsandprofitgoals,andenterandexit
each trade. You’ll learn in a very short time what takes most traders many years to discover
throughtrialanderror.Thegreatestexperienceisothertrader’sknowledgeandlearningfrom
theirmistakes.
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Ifyouhavelittleornoexperiencewithoptions,someofthematerialinthisstudyguidemaybe
difficulttograspatfirst.Don’tletthatworryyou.Itisourjobthroughonlineclasses,coaching,
andworkshops tohelp youunderstandtheconcepts. Ifyoumerelybecomefamiliarwiththe
materialitwillhelpshortenyourlearningcurve.
TheoTrade Mantra
Traders,speculators,andinvestorswhodonotutilizerisk-managementtechniquesareatthe
mercyofthemarket.Theymayfallvictimtomarketcorrectionsandreversals.Thebesttraders
--theonesthatlast--utilizestrategiesdesignedtoreducerisksandprotectcapital.
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TheoTrade Characteristics
of Traders
WeatTheoTrade:
§
haterisk.
§
useanytoolavailabletoreducerisk.
§
useoptionstoreduceriskandenhancereturns.
§
neverputallourmoneyononetrade.
§
nevertradeontips.
§
sleepatnightbecauseourpositionsarecovered.
§
doourhomeworkbeforeexecutinganytrade.
§
usemarginonlywhentheyarehedged.
§
buyonweaknessandsellonstrength.
§
aredisciplined.
§
Planourstrategies.
§
arealwayspreparedtoexecuteourplan.
§
stickwithourplan;wedon’tpanic.
§
knowwhentoexit.
§
thriveonchaos.It’stheirmanna.
§
identifyourmaximumlossbeforeenteringatrade.
§
factorincommissionsandinterestwhenevaluatingreturns
§
arealwaysreadytopounceonvolatilityandopportunity.
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Understanding Options.
Note:Payparticularattentiontothissectiononoptions.Youwillneedtounderstandhowto
useoptionstotradeinthemarketwithreducedrisk.Itisnotunusualtobeconfusedbythis
material.Theconceptsareabstractandhardtograspatfirst.Thegoodnewsisthatthisisas
difficult as it gets! And we will lead you into a fuller understanding at the TheoTrade classes.
Themorefamiliaryouarewiththissectionattheoutset,themorequicklyyouwillmasterour
coursesatTheoTrade.
Ancient Roots of Option Contracts
Although many believe options are a recent innovation, they actually date back thousands of
yearsasoptionsoriginatedasrisk-managementtools.Evidencethattheuseofoptioncontracts
wasstandardinancienttimesappearsduringtheGreekcivilization.
All option contracts that trade on U.S. exchanges are issued, guaranteed, and cleared by the
OptionsClearingCorporation(OCC).Foundedin1973,OCCisastand-aloneclearinghousethat
issuesandclearsoptionsandfuturesoncommonstocks,indices,currencies,andinterestrate
compositeslistedon12participatingexchanges,ofwhichfiveareshareholders.SinceJuly18,
2012, and as part of the Dodd-Frank financial overhaul, OCC was designated a systemically
importantfinancialmarketutility.Assuch,theFederalReservehasbecomeathirdregulator,
along with the Commodity Futures Trading Commission and the Securities and Exchange
Commission,withsomeformofsupervisoryrole.
Definition
A stock option is a contract that gives the holder the right to buy (a call) or sell (a put) on a
particularstock,atapredeterminedprice(thestrike price),onorbeforeaparticulardate(the
expiration date). For everyone who buys stock, there is someone who sells it. Likewise, for
everyoption(callorput)buyer,thereisanoptionseller.
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Option Advantages
§
Optionsgivetheholdertheopportunityofmaximumgainthroughleverage.
§
Optionscanbeusedasrisk-managementandloss-preventiontools.
§
Optionscanbesoldtoearnpremiumsandcreatecashflow.
Options Disadvantages
§
Thebuyer/ownercanlosehisorherentireinvestment.
§
Thelimitedlifeofanoptionisadouble-edgedsword:adisadvantageifyou’reabuyer,
butadistinctadvantageifyou’reaseller.
Option Buyer’s Rights and Option
Seller’s Obligations
Calls
Thebuyerorholderofacalloptionpaysapremiumfortheright,butnottheobligation,tobuy
aparticularstockatthestrikepricepriortoexpiration.Hemayalsochoosetoselltheoption
purchased at any time prior to expiration or let it expire worthless. The call buyer wants the
stocktogoup.
Buyingacallissimilartohavinganoptiontobuyahouse.Ifthehousegoesupinvalueyoucan
eitherexerciseyourrighttobuythehouseorsellyouroptiontosomeoneelsewhowouldlike
the right to buy the house. If expiration approaches and the house has gone down in value,
below your agreed to right to purchase, you can let the option expire with no obligation to
purchasethehouse.Yourlossislimitedtothepremiumyoupaidfortheoption.
Youcouldbuyacallforspeculationhopingtomakeaprofitbysellingthecallataprofitshould
thestockgoup.Callscanalsobeusedtohedgeashortsale.Theriskofsellingshortisthatthe
stockcouldgoup.However,owningacallwouldlimityourpricetobuythestockatthestrike
pricepriortoexpiration,regardlessofhowhighthestockwouldgo.
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Thesellerorwriterofacalloptioncollectsthepremiumandisobligated,ifcalleduponpriorto
expiration,tosellaparticularstockatthestrikeprice.Thisislikelytohappeniftheoptionis“in
themoney”(i.e.,ifthestockpriceishigherthanthestrikeprice)atexpiration.He/shemaybuy
thecallbacktopreventthisfromhappening.Ifthestockstaysbelowthecallstrikeprice,the
callwillexpireworthlessandthesellerofthecallwillkeeptheentirepremiumreceived.The
callsellerwantsthestocktogodown.
Thesellerofthecallislikesomeonewhohassoldyouanoptiontobuyahouse.Heorsheis
obligatedtosellyouthehouseanytimeyouexerciseyourright.Ifthehousegoesdowninvalue
andyoudon’texerciseyourrighttobuythehouse,thecallsellerkeepsthepremium.However,
ifyouexerciseyouroptiontobuythehouse,heisobligatedtosellittoyouattheagreed-to
price.
Onedoesnotneedtoownthestocktosellacalloption.Thiswouldbereferredtoassellingan
uncoveredcall(alsofrequentlyreferredtoas“sellingnaked”)andtheriskcanbeunlimited.If
thecallisexercised,thecallsellerwouldhavetobuythestockatthecurrentpriceandresellit
at the strike price to the call buyer. If a trader has sold a call on a house and expiration
approachesandthehousehasgonedowninvalue,belowyouragreedtorighttopurchase,you
canlettheoptionexpirewithnoobligationtopurchasethehouse.Yourlossislimitedtothe
premiumyoupaidfortheoption.
Youcouldbuyacallforspeculationhopingtomakeaprofitbysellingthecallataprofitshould
thestockgoup.Callscanalsobeusedtohedgeashortsale.Theriskofsellingshortisthatthe
stockcouldgoup.However,owningacallwouldlimityourpricetobuythestockatthestrike
pricepriortoexpiration,regardlessofhowhighthestockwouldgo.
Puts
Thebuyerorownerofaputoptionpaysapremiumfortheright,butnottheobligation,tosell
aparticularstockatthestrikepricepriortoexpiration.Hemaychoosetoselltheoptionprior
toexpirationorsimplyletitexpireworthless.Theputbuyerwantsthestocktogodown.
Thinkofbuyingaputlikebuyinginsuranceonacar.Ifthecarisdamaged,youhavetherightto
fileaclaim.Theinsurancecompanyistheselleroftheput.Ifyouexerciseyourrighttosell,the
selleroftheputisobligatedtobuythestockattheagreed-toprice,evenifthestockshouldgo
tozero.Justthesame,theinsurancecompanymustgiveyouthedollarvalueofyourcarevenif
it is demolished and worthless. Of course, the insurance company is hoping you never wreck
yourcarsotheycankeepthepremium.Likewise,theputsellersishopingthestockstaysabove
the strike price of the put so you never exercise your right to sell the stock and the put
eventuallyexpiresworthless.Insuchcases,theputsellerwillkeepthepremiumreceived.
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Youcouldbuyputsforspeculationhopingthatastockgoesdownandtheputsgoupinvalue.
Orputscanbeusedtohedgeastockposition,givingyoutherighttosellthestockatthestrike
priceregardlessofhowlowastockshouldgo.
Thesellerorwriterofaputoptioncollectsthepremiumandisobligated,ifcalleduponprior
toexpiration,tobuyaparticularstockatthestrikeprice.Thisislikelytohappeniftheoption
is“inthemoney”(i.e.,ifthestockpriceislowerthanthestrikeprice)atexpiration.Hecould
buy back the put to prevent this. If the stock stays above the strike price, the put will expire
worthless and the put seller will keep the entire premium received. The put seller wants the
stocktogoup.
OptionBuyer(Holder) Buysoptioncontracts Call=righttobuy Put=righttosell Paysthepremium OptionSeller(Writer)
Sellsoptioncontracts
Call=obligatedtosell
Put=obligatedtobuy
Receivesthepremium
Option Particulars
OptionHoldersandWriters
Thebuyerofanoptionisreferredtoastheoptionholder.Thesellerofanoptionisreferredto
astheoptionwriter.
OptionContract
Options Trade in Contract and not shares. All option contracts are bought and sold in onehundred-sharelotsonly.One call or one put is a contract to buy (a call) or sell (a put) one
hundred shares of an underlying stock.Onecallistherighttobuy100shares;twocalls,200
shares;threecalls,300shares;etc.Note:arecentinnovationinmarketsareMinioptions.Mini
Optionsareoptioncontractswheretheunderlyingsecurityis10sharesofastock.Thisisthe
main difference between mini options and standard options, which have 100 shares as the
underlyingsecurity.
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OptionPremium
Thepremiumisthepricethatthebuyer/holderofanoptionpaysandtheseller/writerofan
option receives for the rights conveyed by the option. It is the price set by the holder and
writer,ortheirbrokers,inatransactioninanoptionsmarketwheretheoptionistraded.The
premiumdoesnotconstituteadownpaymentoracredittowardsthepurchaseofastock;itis
simply a nonrefundable payment in full from the option holder (buyer) to the option writer
(seller)fortherightsconveyedbytheoption.
Thepremiumisalwaysquotedonaper-sharebasis.Ifthe120strikepricecallsaretradingat
$5,thismeans$5pershare.Sinceonecallcoversonehundredshares,onecalloptionwould
thereforecost$5x100or$500.
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StrikePrice
Thestrikepriceisthepriceatwhichtheoptionallowstheholdertobuyorthewritertosell
theunderlyingstock.Thestrikepriceisnotnegotiable.Toestablishamoreorderlyandliquid
market,strikepricesarefixedin$.50,$1,$2.50,$5,or$10increments.IndexProducts,ETF’s,
andStockswithheavyvolume(liquidity)oftenoffermovestrikepricevariety.Everythingfrom
$.50 increment strike prices are now available on hundreds of liquid products. Below is an
exampleofstrikepriceincrementsfromDecember2015expirationinaprominentETFproduct.
Expiration
StrikePrice
December2015
205
December2015
205.5
December2015
206
December2015
206.5
December2015
207
December2015
207.5
December2015
208
December2015
208.5
December2015
209
Exceptionstotherule:Optionsonstocksthatsplitmaytradeinvariousincrementstoaccount
forthesplit.(Forexample,one,95calltradingfor$4,willbecometwo,$47.50callstradingfor
$2ona2:1stocksplit.)
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Expiration
Equity(Stock)OptionsexpiretheSaturdayfollowingthe3rdFridayofthemonth.Theclosing
price of the stock on the 3rd Friday of the month at 4:00 Eastern Standard Time is used to
determine whether an option has value or not at expiration. Effectively therefore, equity
optionsexpireat4:00p.m.,EasternStandardTime,onthe3rdFridayofthemonth.Inaddition,
Weekly Options or “Weekly’s” are now available on over 400+ underlying’s and offer
expirations every Friday! Weekly’s should be regarded as options with shorter lifespans but
similarattributes.
OpenInterest
Openinterestreferstothenumberofoutstandingoptioncontractsofaparticularstrikeprice
andexpirationdatethathavebeenboughtorsoldtoopenapositionIforwhenanoptionis
boughttoopenaposition,theopeninterestincreasesbyone.Iforwhenthatoptionissoldto
closetheposition,theopeninterestdecreasesbyone.Likewise,ifanoptionissoldtoopena
position,theopeninterestincreasesbyone.Whenitisboughtback,openinterestdecreases
by one. Open interest is calculated at the end of each business day. Open interest is an
indicatoroftheliquidityofaparticularoption.
OptionVolume
Option volume is the number of option contracts that have been bought or sold within a
particulartimeperiod.Volumeisdisseminatedonarealtimebasis.
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Understanding Option Premium
Thepremiumismadeupofintrinsicvalueandtimevalue.
Premium=IntrinsicValue+TimeValue
IntrinsicValue
IntrinsicValue=Premium-TimeValue
Theintrinsicvalueisthevalueoftheoptionwithnoconsiderationfortime.Itisthevalueof
theoptionatexpiration.Therefore,itisthevalueoftheoptionwhenthereisnotime.Itis
theREALVALUEofanoptionscontract.Itreflectstheamount,ifany,bywhichanoptionis“in
themoney.”Theintrinsicvalueisusuallytheminimumvalueanoptionwillhaveasanoption
willrarelytradebelowitsintrinsicvalue.
Tounderstandintrinsicvalue,thinkofhavinganaccidentinsurancepolicy(aput)onyourcar.
Youpaidapremiumof$3,000toinsureyour$50,000autoforoneyear.Ifyouweretosellyour
carwithintheyearyoucouldgetarefundonpartofthepremiumbecauseyoudidnotuseall
ofthetime.(Theputwouldstillhavesometimevalueinit.)However,pretendonthedayyour
policyexpires,youtotalyourcarandyouareunconsciousforaweek.Whenyouwakeupyou
findoutthatyourcarwastotaled.Eventhoughthepolicyexpiredaweekearlierandthereis
notimevalueleftinit,youarestillcovered.Thisisbecausetheaccidenthappenedbeforethe
policyexpired.Yourpolicyexpiredwithanintrinsicvalueof$50,000.Youcanstillfileaclaim
andreceivethefulldifferencebetweenthefacevalueofthepolicyandthecurrentvalueofthe
car.Inthisexample,youhada$50,000policyandtheautowastotaled.Therefore,youwill
receive $50,000. This is the policy’s (the put’s) intrinsic value and it does not go away even
thoughthepolicyhasexpired.
If,atexpiration,anoptionisin-the-money,thatis,hasintrinsicvalue,equaltoorgreaterthan
one penny per share ($.01 in the money), then the Options Clearing Corporation (OCC) will
automatically exercise that option on behalf of the option buyer. To determine the intrinsic
valueofanoption,usethefollowingformula:
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Intrinsic Value Formula
Whatistherighttobuy/sell_________
CallPutCompany
for/at$________worth,atexpiration,
StrikePrice
whenitscurrentmarketpriceis_______?
StockPrice
Forexample,todeterminetheintrinsicvalueofthe$50strikepricecallwhenXYZstockisat
$52, we would ask ourselves, “What is the right to buy XYZ for $50 worth, when its current
marketpriceis$52?”Itisworth$2.Therighttobuythestockfor$50whenthestockisat52
savesus$2.Withthe50call,wecouldbuythestockfor$50andimmediatelysellitfor$52and
makeaprofitof$2.Therefore,the50callhasanintrinsicvalueof$2.
Therighttobuythestockfor$50whenitscurrentmarketpriceis$49wouldbeworthnothing!
Whypayfortherighttobuyat$50whenyoucanbuyfor$49.
Now, let’s determine the intrinsic value of the 50 put when XYZ is trading for $52. Using the
formula above we would say, “What is the right to sell XYZ at $50 worth, when its current
marketpriceis$52?”Itisworthnothing.Thestockistradingfor$52,sowhypayfortheright
to get only $50? However, if the stock was at $49, the $50 put would be worth at least $1
intrinsicallyandevenmore,iftherewastimesometimevalueleft.
Theintrinsicvalueofacalloptionequalsthestockpricelessthestrikeprice.However,itcan
neverhaveanegativevalue.Anoptioneitherhasvalueornot.
Intrinsicvaluecannotgobelow0.
StockPrice $52
$53
- StrikePrice -$50
-$55
Call’sI.V. $2
$0
Theintrinsicvalueofaputoptionequalsthestrikepricelessthestockprice.
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The intrinsic value of the 55 put when the stock is trading at $57 is 0, not -2. Intrinsic value
cannotgobelow0.The55putwiththestockat57wouldbe$2out-of-the-money.Whenthe
stockisat$53,theintrinsicvalueofthe55putwouldbe$2.The55putwiththestockat$53
wouldbe$2in-the-money.
StrikePrice
- StockPrice
Put’sI.V. www.TheoTrade.com
$50
-$52
$0$2
$55
-$53
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Relationship of Stock
Price to Option Price.
The “Money” is the stock price.
At-the-Money (ATM) Call or Put: The stock’s price is the same as the strike price. Intrinsic
valueiszero.
Out-of-the-Money (OTM) Call: The stock’s price is below the strike price. Intrinsic value is
zero.
Out-of-the-Money (OTM) Put: The stock’s price is above the strike price. Intrinsic value is
zero.
In-the-Money (ITM) Call:Thestock’spriceisabovethestrikeprice.Intrinsicvalueispositive.
In-the-Money (ITM) Put:Thestock’spriceisbelowthestrikeprice.Intrinsicvalueispositive.
Intrinsic Value of an Option When the
Stock is at $50
Strike IntrinsicValueIntrinsicValue
Price ofaCall
ofaPut
65
0 (15 OTM)
15 ITM
60
0 (10 OTM)
10 ITM
55
0 (5 OTM)
5 ITM
50
0 ATM
0 ATM
45
5 ITM
0 (5 OTM)
40
10 ITM
0 (10 OTM)
35
15 ITM
0 (15 OTM)
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ITM=inthemoney,OTM=outofthemoney,ATM=atthemoney
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Time Value (Extrinsic Value)
Thetimevalueofanoptionisthatportionoftheoptionpremiumoverandaboveitsintrinsic
value. Generally speaking, the more time before expiration and/or the more volatile the
underlyingstock,thehigherthetimepremiumwillbe.Suchfactorsincreasetheprobabilityofa
stockreachingacertainpricepoint.Thus,timevaluewillbehigherwhentheoptionisfurther
fromexpirationandwilldecreaseastheoptiongetsclosertoexpiration.AMayoptionwillcost
morethananApriloptionbecausethereismoretimeforthestocktoreachorgobeyondthe
strikeprice.Out-of-the-moneyoptionscarryonlytimevalue,iftheyhaveanyvalueatall.Time
valuecanbedeterminedbysubtractingtheintrinsicvalueofanoptionfromthepremium.
Time Value = Option Premium - Intrinsic Value
Ifthereissometimeleftbeforeexpirationanoptionmaybeworthmorethanitsintrinsicvalue
byanamountequaltoitstimevalue.Anoptionthatstillhastimevalueleftpriortoexpiration
willrarelybeexercised,asitwillbringtheholderagreatervaluebysimplysellingit.
Forexample,let’ssayXYZstockistradingat52withaweekleftuntilexpiration.The50callis
trading at $2.50 because it has $2 of intrinsic value and $.50 of time value. If one were to
exercisethecallandbuythestockfor50andthenimmediatelysellthestockat52,hewould
realize$2.00.However,ifhesimplysoldthecall,hewouldrealize$2.50.Evenifthecallholder
wantedtoownthestock,hewouldbebetteroffsellingthecallandthenbuyingthestock.By
doingsohewouldbeabletobuythestockforfiftycentslesspershare.Thisiswhyanoption
thatstillhastimevalueremainingisrarelyexercised.
Atexpirationallthetimevaluegoesawayandonlyintrinsicvalueremains.Timevalueusually
diminishes as an option goes further ITM or OTM or, as it moves closer to expiration, to the
point where it will eventually be reduced to nothing. If, prior to expiration, an option has
intrinsicvalue(ITM)andthereislittleornotimevalueremaining,thereisahighlikelihoodit
could be exercised.Such an option is now trading at “parity.” An option is trading at parity
withitsstockifitisin-the-moneyandhasnotimevalue.
Forexample,ifthe50callwastradingfor$2withthestockat52itwouldbetradingatparity.If
the option holder wanted to own the stock, he/she would exercise his option as there is no
advantage in selling the call when there is no time value remaining. However, if he/she was
merelyspeculatingwiththeoptionanddidnotwanttoownthestock,he/shewouldstillsell
the option to avoid being automatically exercised and owning it. Remember, if an option
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expires with intrinsic value equal to or greater than one penny per share ($.01) it will be
automatically exercised by the Options Clearing Corporation (OCC). If a long call is exercised,
theoptionholderwillnowhavealongstockposition.Ifhewantstoavoidthis,hewillsellthe
put,evenifthereisnotimevalueremaining.
Factors that Influence Time Value
The primary factors that influence time value are the length of time remaining until
expiration,theunderlyingstock’svolatility,andanoption’ssupplyanddemand.
TimeDecay
Justlikethepremiumwouldbemoretoinsureacarfortwomonthsthanonemonth,sotoo,
thetimevalueofaMayoptionwillbemorethananApril.Thetimevalueisawastingasset.
Otherfactorsbeingequal,thetimevaluedecreasesastheoptionapproachesexpiration.
Thisdecreaseacceleratesinanonlinearfashiontheclosertheoptiongetstoexpirationasthe
followingtimegraphillustrates.Thisprocessisreferredtoas“timedecay.”Atexpirationonly
thoseoptionsthatarein-the-moneywillhaveanyintrinsicvalueremaining(Rememberintrinsic
value does not change with time,) but no options will have any time value remaining. If the
optionis“out-of-the-money”andisnotsoldorexercisedpriortoitsexpiration,itwillbecome
worthless.
Timedecayisadvantageoustosellersofoptionsandadisadvantagetobuyersofoptions.For
example,thesellerofacalloptionmay,duetotimedecay,beabletobuybacktheoptionata
lower price than he originally sold it for, even if the stock does not drop in value. In such
situations,theoptionsellercanmakeaprofitandeliminatetheriskofbeing“assigned”.Ifthe
option is well OTM, the seller may allow the option to expire worthless and keep the entire
premium.WhenhesellsanOTMoption,anoptionselleriscollectingmoneyfortime,asthere
isnointrinsicvalue.Shouldthestockatexpirationbebelowthestrikeprice,ifitisacall,or
abovethestrikeprice,ifitisaput,thesellerwillretaintheentirepremium.
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Timedecayisdisadvantageoustoanoptionbuyerbecausehenowownsawastingordecaying
asset.Evenifthestockdoesn’tmove,theoptionwilldecreaseinvalueeverydayduetotime
decay.Theoptionbuyerishopingthestockmovesupquicklysohecanretainasmuchtime
valueaspossible.
ATM Options have the most time
value.
Anoptionwhosestrikepriceisat-the-money(ATM)willhavemoretimevaluethantheother
strike prices because there is more uncertainty as to its closing in-the-money or out-of-themoneyatexpiration.Thisuncertaintydiminishesastheoptionmovesmoreintoorout-of-themoney.Anoptionthatisalreadyinorout-of-the-moneyhasagreaterprobabilityofremaining
so then one that is at-the-money. The time value will be approximately the same for options
equaldistanceITMandOTMbecausetheyhaverelativelythesameamountofuncertainty.
In the following table notice for example that the 120 call, that is five dollars OTM, has the
sametimevalue($3)asthe110calls,whichisfivedollarsITM.However,the110callhasatotal
premium value of 8 because it also has 5 dollars of intrinsic value. As the following table
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illustrates,thetimevalueforoptionsequaldistanceinorout-of-the-moneyonthesamestock
willbeapproximatelythesame.
CallPremium30daysPriortoExpirationwithStockat$115
StrikePrice
premium
intrinsicvalue
timevalue
95
20.375
20
0.375
100
15.75
15
0.75
105
11.5
10
1.5
110
8
5
3
115
5
0
5
120
3
0
3
125
1.5
0
1.5
130
0.75
0
0.75
Volatility
Volatilityisthemeasurementoftheamountbywhichthepriceoftheunderlyingsecurityis
expected to fluctuate over a given period of time. Generally speaking, stocks that fluctuate
over a wide price range have more volatility. Typically, with all other factors being equal, an
option’stimevaluewillbehigheronastockwithgreatervolatility.Earthquakeinsurancewill
cost more in San Francisco than in Chicago, because San Francisco can “move” more. For
example,taketwostockstradingat100.The105Maycallsonbothstocksare$5out-of-themoney and therefore have no intrinsic value, just time value. The premium for the 105 May
calls is at $1 for Stock A and $2 for Stock B. Even though both options have the same time
remaining,StockB’scallsaretrading$1higherthanStockA’s.ThisisbecauseStockBismore
volatile.ThemarketissayingthatStockBhasagreaterchanceofmovingto105thanStockA.
Therefore,StockBdemandsahigherpremium.
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HistoricalVolatility
Historicalvolatilityisastatisticalmeasurementofastock’spricemovementsbasedonhistory.
Typically,itiscalculatedbytakingthestandarddeviationofthestock’sdailyclosingpriceover
thepast21tradingdays.
ImpliedVolatility
Impliedvolatilityisthevolatilityderivedfromlookingatthecurrentmarketpriceofanoption.
Option prices don’t imply a direction of movement for the stock. They only imply a probable
distributionorvolatility.Increasedvolatilityincreasestheexpectedvalueofanoption,butnot
theexpectedvalueofastock.
Although there are more technical methods of measuring volatility, it is a general rule that if
thestockisflat,volatilityshouldbelow.Ifthestockisfluctuatinggreatly,volatilityshouldbe
high. The higher the volatility, the higher the risk, and thus option sellers will demand more
Optionpremium.
The market ultimately determines an options price. The “market” includes market makers,
liquidityproviders,hedgefunds,institutionalinvestors,thepublic,andevenYOU.Remember,
theintrinsicorrealvalueofanoptionwillalwaysbeconstant.Theintrinsicvalueofthe50call
withthestockat51willalwaysbe$1.00.However,theoptionswillmostlikelybetradingfor
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morethan$1duetoitstimevalue.Thetimevalueisdeterminedprimarilybythedistancethe
option’s strike price is to the stock price, the stock’s volatility, the current demand for the
option, and the volatility of the stock. The more a stock can move in price the more money
optionsellerswillwanttoreceiveandthemoreoptionbuyerswillhavetopayforanoption.
Themarketplace,whichfactorsinallthesevariables,determinesatwhatpricewecanbuyor
sellanoptionforinthesamefashionitestablishesstockprices.
Option Positions
BuyingNakedCalls
Onewhobuysacalltoopenaposition(goeslong)wantstheunderlyingstocktogoup.This
willtypicallyincreasetheoption’spremium.Ifthestockpricegoesabovethestrikeprice,the
callbuyercaneitherexercisetheoptiontobuythestockorsimplyselltheoption.Hisriskis
limitedtowhathepaidfortheoption,pluscommission.
The following graph illustrates the value, at expiration, of a 30 call bought for $3. The graph
illustrates a worst case scenario, as the option will usually be worth more prior to expiration
when there is some time value remaining. The stock must go to $33 at expiration, to breakeven, and the call position begins making money above $33. The potential profit is unlimited
(minusthepremiumpaid);alossislimitedto$3ashare.
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SellingNakedCalls
Whenonesellsacalloption(short)toopenaposition,withoutowningtheunderlyingstock
or another call (long) on the same security, it is called a naked or uncovered short call
position.Itiscalleduncoveredbecausethesellerhasnoprotectioniftheunderlyingsecurity
rises in price. When you sell (go short) a call, you are giving someone the right to buy the
underlyingstockatthestrikepriceinreturnforthepremium.
Onewhosellsacall(toopenaposition)wantstheunderlyingstocktogodown.Theseller
collects the premium and realizes maximum profit at the time of sale. Typically, if the stock
pricestaysthesameorgoesdown,thevalueofthecallwillbereduced.Thecallsellercanthen
closeouthispositionbybuyingbackthecallatareducedprice.Theprofitisthenthedifference
between what was originally received for selling the call less the price paid to buy it back.
Alternatively, if the stock price is below the strike price at expiration, the seller can let the
option expire worthless and keep the entire premium. However, should the stock price rise
abovethestrikeprice,thesellerrunstheriskofbeingexercisedandhavingtodeliverthestock
atthestrikeprice.
Thefollowinggraphillustratesthevalue,atexpiration,ofthe30callsoldfor$3.Ifthestockis
at$30orbelow,thecallsellerwillkeeptheentirepremiumreceived.Maximumprofitislimited
to $3 per share. However, if the stock goes above $30, the seller begins giving back the
premiumandbreaksevenat$33.Alossisincurredasthestockclosesabove$33,anditcan
becomeunlimited.Sellingcallsnakedcancauseextremerisk;TheoTradeadvisesclientelehave
extensiveexperiencepriortosellingcallsnaked.
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SellingCoveredCalls
Whenonesellsacalloptiontoopenaposition,andownstheunderlyingstock,onehassolda
covered call. The risk of owning a short call, as shown above, is covered by the underlying
stockposition.Intheeventthestockgoesabovethestrikepriceofthecall,onewouldmost
likelybecalledtodeliverthestockatthestrikepriceofthecallsold.Ratherthanbeingforced
tobuythestockatahigherpriceandsellanddeliverthestockatthestrikeprice,onesimply
stockequaltothestrikepriceofthecall.Whenonesellsacoveredcall,he/shelimitstheupside
on the stock, while only slightly reducing the downside risk of owning the stock. In various
TheoTradeclassesyouwilllearnhowtoreducetheriskofcoveredcallstrategy.
BuyingNakedPuts
Onewhobuysaputwantsthestocktogodown,whichusuallyincreasesthepriceoftheput.
Thebuyer’sgoalistoselltheputataprofitorexercisehisrighttosellthestock.
Thefollowinggraphillustratesthevalue,atexpiration,ofthe30putboughtfor$2.Tobreakeven, the stock must go to $28. Below $28, the put increases in value dollar-for-dollar with
everydollardropinthepriceofthestock;thiscancontinueallthewaytozero.However,aloss
is realized at expiration if the stock stays above $28. The maximum loss of $2 per share is
realizedat$30orabove.
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SellingNakedPuts
Whenonesellsaputoptiontoopenaposition,withoutbeingshorttheunderlyingstockor
longanotherputoptiononthesamesecurity,itiscalledanakedoruncoveredshortput.The
put seller wants the stock to go up so he can keep all or part of the premium. However, the
potentialriskishigh.Thepotentiallossisthedifferencebetweenthevalueoftheunderlying
stock(whichcouldgotozero)andthestrikeprice,lesswhatwasoriginallyreceivedforthesale
oftheput,pluscommission.
Onewhosellsaput(toopenaposition)wantsthestocktogoup.Thesellerrealizesmaximum
profitatthetimehesellstheput.He/shewillretainmaximumprofitifthestockclosesator
abovethestrikepriceatexpiration.Shouldthestockgobelowtheputstrikeprice,theseller
could be obligated to buy the stock at the strike price, if exercised. Typically, he/she will buy
backtheputpriortoexpirationtoavoidthis.
Thefollowinggraphshowsthevalue,atexpiration,ofthe30putsoldat$2.Amaximumprofit
of$2pershareisrealizedifthestockisat$30oraboveatexpiration.Break-evenisat$28.The
putsellercouldloseupto$28shouldthestockgotozeroatexpiration.
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SellingCoveredPuts
Whenonesellsaputoptiontoopenapositionandisshorttheunderlyingstock,he/shehas
soldacoveredput.Also,ifoneownsaputandsellsanotherputonthesamestock;heisno
longernakedbuthedged.
VerticalSpreads
Averticalspreadisonestrategytousewhenyouareconfidentastockwillmoveinacertain
direction.Itdoesnotemploytheuseofstock,onlyoptions,makingthisarelativelyinexpensive
methodtobenefitfromstockmovement.Theyarecalled“vertical”becausetheyemploystrike
prices of the same month that are higher or lower than each other vertically. With vertical
spreads, you are paying a premium to buy one option, while at the same time collecting a
premiumbysellinganotheroption.Withaverticalcallspread,youbuyacallatonestrikeprice
andsellanothercallatadifferentstrikeprice.Withaverticalputspread,youbuyaputatone
strikepriceandsellanotherputatadifferentstrikeprice.
VerticalSpreadFormula:
§
Buyonestrikeoption
§
Sellanotherstrikeoption
§
Sameseries(callswithcallsorputswithputs)
§
Sameexpirationmonth
§
Sameunderlyingasset(stock,index,ETF)
A vertical spread is an alternative strategy to a costly or risky naked long or short option
position.Theprofitpotentialremainsrelativelyhighwhileriskisdramaticallyreduced.Buyinga
nakedcallorputcanbeexpensive.Theverticalspreadreducescostbysellinganotheroption.
Sellinganakedcallorputtoopenapositioncanbeanextremelyhighriskstrategy.However
thesaleofverticalspreadtoopenisamuchlessriskystrategy.Ratherthanbeingnakedshorta
callorput,onesimultaneouslybuysafurtherout-of-the-moneycallorputtoreducetherisk.
These positions are called spreads because the risk is “spread out”, instead of being
concentratedononenakedlongorshortposition.
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Averticalspread’smaximumvalue,whetheritisacalloraputspread,canonlygoashighor
lowasthedifferencebetweenthetwostrikepricesused.Therefore:
Maximumvaluea2.50spread(i.e.,17.50-20)couldgotois2.50,or$250perspread.
Maximumvaluea5spread(i.e.,25-30)couldgotois5,or$500perspread.
Maximumvaluea10spread(i.e.,75-85)couldgotois10,or$1,000perspread.
Maximumvaluea15spread(i.e.,75-90)couldgotois15,or$1,500perspread.
Profitorlosswhenbuyingaverticalspreadtoopen:
Whenbuyingaverticalspreadtoopenaposition,maximumprofitislimitedtothedifference
betweenthestrikepricesoftheoptionsboughtandsold,lessthecostofthespread.Maximum
lossislimitedtowhatyoupayforthespread.Thatis,thepremiumoftheoptionbought,less
thepremiumoftheonesold.
MaximumPROFITwhenBUYINGaVerticalSpread
Maximumprofit=Diff.betweenstrikes-costofspread
MaximumLOSSwhenBUYINGaVerticalSpread
Maximumloss=Netcostofspread
BuyingtheVerticalCallSpread(BullCallSpread)
Thisisabullishplay.Bydefinition,youwanttheunderlyingstocktogoup.
Formula:buynear-the-moneycalls(lowerstrikeprice)andsellanequalnumberofcallsfurther
outofthemoney(higherstrikeprice)inthesameexpirationmonth.
MaximumRisk:thecostofthespread.
MaximumProfit:thedifferencebetweenthetwostrikes,lessthecostofthespread.Ifyoupay
$1forthe30-35callspread,yourmaximumprofitis5-1=4.
Break-EvenatExpiration:thestockmustgoabovethelowerstrikepricebyanamountequalto
the cost of the spread. If you paid $1 for the 30-35 call spread, the stock must go to $31 at
expirationtobreak-even.Asthestockincreasesinvaluefromthatpoint,youmakemoney.
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Example:
XYZstockistradingat$28.TheAug30callis$2,andtheAug35callis$1.Ifyoubuyone,Aug
30callsandsellone,Aug35calls,thespreadcosts$100.
-$200
+$100
- $100
PaidforAug30call
ReceivedforAug35call
Totalcost(beforecommissions)
Youarerisking$100foranopportunitytomakeupto$400,a400%returnoninvestment.The
followingchartshowstheprofitorlossonthistradeatexpiration.Ofcourse,thispositioncan
beclosedatanytimepriortoexpiration.Toclosethisposition,youwouldsellthecallsthatyou
bought,andbuybackthecallsthatyousold.
Valueof30-35CallSpreadatExpiration
Toopentheposition,buythe30callandsellthe35call.
Toclose,sellthe30callandbuybackthe35call.
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Stock Sell BuyDebitLess
Price 30C 35CCreditCost
290 0 0 -1
300 0 0 -1
311 0 1 -1
322 0 2 -1
333 0 3 -1
344 0 4 -1
355 0 5 -1
4010 -5 5 -1
Gain 1x%
Loss $__Return
-1-100-100
-1 -100-100
0 00
1 100100
2 200 200
3 300 300
4 400 400
4 400 400
BuyingtheVerticalPutSpread(BearPutSpread)
Thisisabearishplay.Executeitwhenyouexpectastocktogodowninprice.
Formula:buyaputatornearthestockprice(higherstrikeprice),andsellanequalnumberof
further-out-of-the-money(lowerstrikeprice)putsinthesameexpirationmonth.
MaximumRisk:thecostofthespread.
MaximumProfit:thedifferencebetweenthetwostrikeprices,lessthecostofthespread.For
example,ifyoupay$1forthe30-35putspread,yourmaximumprofitis
5-1=4.
Break-EvenatExpiration:stockmustgobelowthehigherstrikepricebythecostofthespread.
Ifyoupaid$1forthe30-35putspread,thestockmustgoto$34atexpirationtobreak-even.
Example:
XYZ is trading at $37. The April 35 put is trading at $4.50, and the April 30 put is trading at
$3.50.IfyoubuytheApril35putandselltheApril30put,youarepaying$1forthespread.
-$450
+350
-$100
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BuyoneApril35putfor4.50
SelloneApril30putat3.50
Costofthespread=-$1
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Thefollowingchartshowstheprofitorlossyouwouldrealizeifyouweretoclosethisposition
atexpiration.Toclosethisposition,youwouldselltheputsthatyoubought,andbuybackthe
putsthatyousold.
Valueof30-35PutSpreadatExpiration
Toopentheposition,buythe35putandsellthe30put.
Toclose,sellthe35putandbuybackthe30put.
Stock Sell
Price 35P
36
0
35
0
34
1
33
2
32
3
31
4
30
5
25
10
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Buy Debit Less Gain 1x
%
30P Credit Cost Loss
$ Return
0
0
-1
-1 -100 -100
0
0
-1
-1 -100 -100
0
1
-1
0
0
0
0
2
-1
1
100 100
0
3
-1
2
200 200
0
4
-1
3
300 300
0
5
-1
4
400 400
-5
5
-1
4
400 400
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Closing Option Positions
Buyers and sellers of option contracts may close out their positions in one of the following
ways:
1. Lettheoptionexpireifitisout-of-the-moneyandworthless.
2. Offsettheoptionbydoingoneofthefollowing:
a.Buyingbacktheoptionsthatweresoldwhenopeningtheposition.
b.Sellingtheoptionsthatwereboughtwhenopeningtheposition.
3. Exercisetheoptionifitisin-the-money.
4. Automatic exercise. If, at expiration, an option is in-the-money, that is, has intrinsic
value, equal to or greater than one penny per share, then the Options Clearing
Corporation(OCC)willautomaticallyexercisethatoptiononbehalfoftheoptionbuyer.
Ifacallisautomaticallyexercised,onthenextbusinessdayafterexpiration(usuallyMonday,
afterexpirationFriday),thecallholderwillnowhavealongstockpositionandwillberequired
to pay for the stock at the strike price of the call purchased by the close of business day.
Alternatively,theholdercouldelecttosellthestocktopayforit.Theholdergetstokeepany
ormustmakeupanylossresultingfromastockmovementbetweenexpirationandthetime
thestockissold.Ifaputisautomaticallyexercised,onthenextbusinessdayafterexpiration
(usuallyMonday,afterexpirationFriday),theputholderwillnowhaveashortstockposition
andwillberequiredtodepositthemarginrequirementforashortstockpositionbythecloseof
thebusinessday.Alternatively,theholdercouldbuythestockbacktoclosetheshortposition.
Theholderkeepsanyprofitsorwillhavetomakeupanydeficit.
Mostoptionsareeitheroffsetorexpireworthlessatexpirationandarenotexercised.Thevast
majorityofoptionsexercisedaredonesoontheexpirationdate.Theriskofanoptionbeing
exercisedpriortoexpirationisminimizedwhenthereistimevaluestillleftinitspremium.This
is because one would receive more by simply selling the option to retain the time value. For
example,saythe50callistradingat$3.50withthestockat$53.Ifyousellthecall,youreceive
$3.50.Ifyouexercisethecall,youbuythestockat$50andsellitfor$53,thusnettingonly$3.
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Inthisexample,ifthecallbuyerwantedtoownthestock,hewouldbebetteroffsellingthecall
andusingtheadditional50centspersharetobuymorestockortoreducehisbasisinit.Thus,
itisrareforanoptiontobeexercisedwhenitstillhastimevalueremaining.Conversely,when
anoptionistradingatparitywithnotimevalue,itrunsahigherriskofbeingexercisedpriorto
expiration.
Options may be offset (sold if they were bought and bought back if they were sold) at any
timepriortoexpiration.Let’srepeatthissentence.Optionsmaybeoffsetorclosedoutat
anytimepriortoexpiration.Typically,anoptionwillbeoffsetwhenaprofitcanbemadeorto
reducealoss.Note:theprudentinvestoralwaysmakenoteofexpirationdatessohe/shecan
avoidleavinganyprofitsatexpiration.
Exercising Options
Buyersofoptioncontractshavetherighttoexercisetheiroptionpriortoexpiration.Sellersof
optioncontractsareobligatedtodeliverthestock(callseller)ortoacceptdeliveryofthestock
(putseller)ifcalledupon(assigned)priortoexpiration.
ExercisingCalls
Whenyouownorholdalong(buy)callposition,youhavetherighttoexerciseyouroptionto
buythestockpriortoexpiration.If,forexample,youown1IBMJan85calloption,youmay
choose to exercise your option to buy 100 shares of IBM stock at $85 per share plus
commission.IfyouareaselleroftheIBMJan85call,theOCC(OptionsClearingCorporation)
maycalluponyoutodeliverthestock.Astherecipientofanexercise,youareassigned.
If you have sold the call without owning the underlying stock, you are what is referred to as
nakedshortthecall(i.e.,uncovered).Youarenowshortthestock(naked),andwillhavetobuy
itatthecurrentpricetodeliverit.Youwilllosethedifferencebetweenwhatyouareforcedto
payforthestockandthestrikepriceofthecall,lessthepremiumreceivedwhenyousoldthe
call.Ifyouhavesoldthecallandown(long)thestock(covered),yourstockisnowgone.Thisis
commonlyreferredtoashavingthestockcalledaway.Ithasbeendeliveredtothecallowner
whoexercisedhiscall.
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ExercisingPuts
Thissameprocessworksforputs.Ifyouarelong(bought)1IBMOct95put,youmaychooseto
exercise your right to sell IBM at 95. You tell your broker to exercise the put, he in turn,
instructstheOCC.TheOCCthenmakesarandomselectionfromitslistofsellersoftheIBMOct
95 puts and informs that person to take delivery of 100 shares of IBM at $95 per share. The
following morning you have a sell transaction for 100 shares of IBM at $95 per share in your
account(i.e.,$9,500lesscommissions).Becauseyouexercisedyourput,yourpositionofbeing
long 1 IBM Oct 95 put is now eliminated. If you own the stock and choose to exercise your
optiontosell,youareforcingtheselleroftheputcontracttoacceptdeliveryofthestockyou
ownattheagreeduponstrikeprice.
Ifyouaretheseller(short)ofa95put,youmaybecalledupontoacceptdeliveryofIBMstock
at$95pershare.Astherecipientofanexercise,youareassigned.Whenyouareassigned,you
becometheowner(long)ofthestock.Thisiscommonlyreferredtoashavingthestockputto
you.Youmusthaveallthemoneyinyouraccountthenextdaytopayforthestock.Youare
nowflatifyouwereshortthestock(i.e.,acoveredput)whenyouhadthestockputtoyou.
TransactionCosts
Thetransactioncostsofoptionsinvestingconsistprimarilyofcommissions(whichareimposed
in opening, closing, exercise and assignment transactions), but may also include margin and
interestcostsinparticulartransactions.
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TheoTrade
Enhancing Returns and
Managing Risk with
Options.
Hedging Your Long Term Portfolio
with Put Options
Would you drive a car without insurance? Would you even think of owning a home without
insurance?Mostpeoplebuyinsurancetoprotecttheirinvestmentsfromloss.Oneneverwants
to collect on a policy, but buying insurance is prudent, regardless. Options, like insurance
policies,canbeusedtolimitrisk.
Professionalsbelievethattheonlywayonecansafelybeinthemarketforthelonghaulisby
beinghedged.Putoptionscanbeusedasaninsurancepolicytoprotectstockormutualfund
holdings.Asagoodrule-of-thumb,whenyoubuystockormutualfunds,youshouldbuyputs.
Buyingputstohedgeastockpositionisreferredtobytheprofessionalsas“marriedputs.”You
willlearnatTheoTradehowtohedgeamutualfundbyusingindexoptions.Amutualfundisa
basketofstocks,asisanindex.Youshouldbuyenoughputstocoveryourlongstockposition.
(Remember, one put contract gives the holder the right to sell 100 shares of the underlying
stock, at the strike price, before the expiration date.) By purchasing puts, you minimize the
potentiallossonastockormutualfund,shoulditdeclineinprice.
For Example: You buy or own 1,000 shares of XYZ at $31 and ten 30 strike puts, one month
from expiration, at $1. By purchasing the put, you have increased your investment in XYZ to
$32.(TheoTradephilosophy:Ifthestockisnotworth$32withprotection,itisnotworthpaying
$31without.YouarebuyingXYZbecauseyouthinkthestockisgoingup.Ifyoudon’tbelieve
thestockormutualfundwillgoupbyatleastthecostoftheputinthetimeremaininguntil
expiration,it’snotworthowning!)
Buying puts for protection is obviously a bullish strategy. If you thought a stock was going
down, why own it. However, you don’t mind paying insurance for something you feel will
continuetogoupinvalue.Therefore,itisimportanttounderstandthatbuyingmarriedputsis
not a cure for poor performing stocks. If you own a stock that is not going up, why do you
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continuetoownit?Sellit,andbuyoneyouareconfidentwillgoup,alongwithamarriedput,
incaseyou’rewrong!Withmarriedputs,youshouldbeconfidentthatthestockwillincreasein
priceandalsobewillingtogiveupalittleupsideprofittooffsetyourdownsideriskprotection.
Bypurchasingputs,yousetthemaximumlossonthestockattheputstrikeprice,lessthecost
oftheput.Inourexample,youareguaranteed$29forthestock(theputstrikeof30,lessthe
$1premiumpaidfortheput)evenifitgoestozeropriortoexpiration.
Theadvantageofbuyingputsoverstop-lossorders:
Stop loss orders are poor protection against sudden downturns in a stock. Bad news, poor
earnings, political problems, and many other factors can cause a stock to gap down. In our
example,shouldthestockgapdownfrom31to20,a30stoplossorderwouldsellthestock
near20notat30sincethestockneverhitapricebetween30and20.Ifyouhavea30stop
orderoncethestockhits30orbelow,thestockisimmediatelysoldatthemarketprice.Ifyou
hada“stoplimitorder”at30,youwouldn’tbesolduntilthestockgoesbackto30.However,
the stock could continue to drop. Stop and stop limit orders, therefore, provide very little
protection.But,ifyouownthe30strikeput,youhavetherighttosellthestockat30anytime
priortotheoption’sexpiration.Astop-lossordercanalsoforceanuntimelysale.Whenastock
pricereachesthestop,itissoldautomatically;therebyeliminatingthechanceofparticipating
inupwardmovementsshouldthestockturnaround.Owningtheputsallowstheholdertoride
outthesedownturns.
The options of the married-put holder: Should your stock decline in price, you have two
optionsasamarried-putholder:
1. Youcanexerciseyourrighttosellthestockattheputstrikeprice.
2. You can sell the put option and keep the stock and then re-hedge the position with
another put. You will then own the stock at the current price, but the sale of the put
optionwillgiveyouthedifferencebetweentheputstrikepriceandthecurrentpriceof
thestock,plusanyremainingtimevalueintheput.Thefollowingtablewillshowyou
thevalueoftheputoptionatexpirationbasedonvariousstockprices.Noticethatifyou
keepthestockyouwillownthestockatthecurrentprice,plushavecashequaltothe
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intrinsicvalueoftheoption.Addingthetwotogether,yournetlossinthisexamplewill
neverbemorethan$2,nomatterhowlowthestockgoes.
Profit or Loss on XYZ stock bought for $31 with 30 strike put purchased for $1 for a total
investmentof$32.
StockPrice+30PutValue
$40 $0 $35 $0 $32 $0 $28 $2 $20 $10
$15 $15
$5 $25
$0 $30
-Cost=NetGain/Loss
$32 $8
$32 $3
$32 $0
$32 -$2
$32 -$2
$32 -$2
$32 -$2
$32 -$2
MaximumLoss:Thedifferencebetweenthepriceyoupaidforthestock,lessthestrikepriceof
theput,plusthecostoftheputandcommission.
Whenyoubuyaput,youarebuyingtherighttosellthestockatthestrikeprice,lessthecostof
theput.Ifyourstockdeclines,youcanselltheputandbuyalower-strike-priceputforthenext
month.Ifthestockmovesup,youcanlock-inprofitsbypurchasingahigherstrikeput.
AttheTheoTradeyouwilllearnspecificcriteriaonwhatstrikepriceputandexpirationmonth
topurchasetoproperlyhedgeyourstocksormutualfunds.Thenyouwilllearnspecificcriteria
forre-hedgingthepositiontolockinprofitsshouldthestockormutualfundincreaseinpriceor
minimizelossesshouldthestockormutualfunddropinprice.TheoTradeemphasizes“Trade
Criteria”andisworththeinvestmentinourcoursematerials.
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TheoTrade
Using Options to Benefit from Price
Movements (Speculating)
Traders can use options to benefit from price movements in underlying stocks without the
expenseorriskofowningorshortingstock.
SupposeABCistradingat$98,andyoubuyone100strikepricecallforapremiumof$4.Since
onecallisanoptiontobuy100shares,yourtotalinvestmentwouldbe$400(4x100).Ifthe
stockweretogoto$105priortoexpiration,the100callwouldbeworthatleast$5pershare,
or$500percontract.Sellingthecallwouldresultina$100profit,earning25%returnona$400
investment. By comparison, the stock owner would have realized only $700 on a $9,800
investment. This is only a 7% return for the same movement in the stock. The stock owner
couldloseupto$98pershare,foratotalof$9,800,shouldthestockdeclineinvalue!Thecall
holder’slossislimitedto$4pershare,or$400foronecontract,regardlessofhowfarthestock
declines.
Risk-Reward Analysis of Options
versus Stocks
Buy100sharesABC@$98=$9,800or
Buy1ABC$100call@$4=$400
Thestockdropsto$80:
Thestockownerloses18%,or$1,800
Theoptionownerloses100%,or$400
Thestockgoesto$105:
Thestockownergains7%,or$700
Theoptionownergains25%,or$100
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TheoTrade
Trading with Spreads
Although options can be purchased naked for speculation, TheoTrade believes that most
tradesshouldbehedged.Ratherthanbeingnakedlongorshortanoption,TheoTradeprefers
toloweryourriskbyusingacombinationofoptionsinoneposition.These“spreads”,asthey
arecalled,canbeusedtoestablishlower-risktrades.AVerticalSpread,forexample,iscreated
bysimultaneouslybuyingoneoptionandsellinganotheroptionofthesamestockatadifferent
strikeprice.
Suppose,inourpreviousexample,withABCstockat$98,threeandahalfweeks
from expiration, you buy ten near-month 100 calls for $4 and simultaneously sell ten nearmonth105callsat$2.25.YounowhavetheABC100-105aVerticalCallSpreadforanetcostof
$1.75,or$1,750fortenspreads:
Buy(Open)100-105VerticalCallSpreadwithStockat$98:
Buy100callfor
Sell105callat
CostofSpread
-4.00 - 10(4x100)=-4,000
2.25 10(2.25x100)=2,250
-1.75 - 10(1.75x100)=-1,750
Valueof100-105CallSpreadatExpirationwithStockat$105:
Sell100callfor Buy105callat SaleofSpread LessSpreadcost GrossProfit 5 - 10(5x100) -0 10(0x100) 5 10(5x100) -1.75-10(1.75x100)
3.25 10(3x100) =5,000
=-0
=5,000
=-1,750
=3,250
Younowowntherighttobuythestockfor$100andhavesoldsomeoneelsetherighttobuy
thestockfor$105.Ifthestockisclosetoorabove$105atexpiration,youcouldberequiredto
sellthestockfor$105.However,youcouldexerciseyourrighttobuythestockfor$100,thus
receiving$5pershare,foratotalof$5,000onthetenspreads.
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TheoTrade
Alternatively, you might also receive close to $5,000 by simply selling the spread at or near
expiration.Whenyousubtractthe$1,750youpaidforthespread,youareleftwitha$3,250
profit.Thatisa185%returnfora7%moveinthestock!Inaddition,youhavelimitedyourrisk
toonly$1.75pershare,or$1,750fortenspreads,pluscommissions.
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TheoTrade
Stock and ATM Option
Equivalents and Related
Risks.
The following compares 4 bullish and 4 bearish positions and the associated risk with each
position. You should note the risk of owning stock and selling stock or options short in
comparisontothelimitedriskofspreadsandbuyingoptions.
BullishPositions
Trade
Type
BuyStock@ Sell100Put
100
@3
Buy100
Call@3
Buy100-105Call
Spreadfor1.50
Risk/share
$100
$97
$3
$1.50
StockBreakEven
100
97
103
101.50
MaxProfit/share
Unlimited
$3
Unlimited
$3.50
TheoTradewillcoveranumberofstockandoptioncombinationstrategiesdesignedtolimit
riskandincreaseprofitpotentialinbullish,bearish,volatile,orneutralmarketsincluding:
§
Straddles
§
Strangles
§
VerticalBullCallSpreads
§
VerticalBearCallSpreads
§
VerticalBearPutSpreads
§
VerticalBullPutSpreads
§
IronCondors
§
CalendarBullCallSpreads
§
CalendarNeutralCallSpreads
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TheRebel’sGuidetoTradingOptions
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TheoTrade
§
CalendarBearPutSpreads
§
CalendarNeutralPutSpreads
§
HedgingStockwithMarriedPuts
§
HedgingaMutualFundorPortfolio
§
Collars
§
WritingCoveredCalls
§
HedgingaShortSale
§
LockinginStockPrices
§
LockinginStockProfits
§
UsingOptionstoBuyStock
§
UsingOptionstoSellStock
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TheoTrade
Stock Market Terminology.
The following are some of the most common terms used in trading that will be used
throughout this manual and Theotrade course materials. Your familiarity with these terms
willbehelpful.
§
Bull/Bullish:Movingup.
§
Bear/Bearish:Movingdown.
§
Bid:Thehighestpriceabuyeriswillingtopayforastockoroption.
§
Ask:Thelowestpriceaselleriswillingtosellastockoroption.
§
Price Spread: The difference between the bid and ask. For example if the bid price is
2.50andtheaskpriceis2.75,thepricespreadis.25.
§
MarketOrder:Anordertobuyorsellatthecurrentmarketprice.
§
LimitOrder:Anordertobuyorsellataspecifiedpricelimit.
§
DayOrder:Abuyorsellorderthatisgoodonlyforthedayandifnotfilled,canceled.
Typically,buyorsellordersareconsidereddayordersunlessotherwisespecified.
§
GTC:Anorderthatis“GoodTillCanceled”.
§
StopOrder:Anorderusedtolimitloss.Whenastockreachesthespecified“stop”price,
thestockissoldatthemarketprice.
§
StopLimitOrder:Anorderalsousedtolimitloss,exceptthestockwillbesoldatthe
limitprice.
§
OCOOrder:OneOrderCancelsOther.
§
OpeningTransaction:Theoriginalorderplacedwithabrokertobuyorsell.
§
ClosingTransaction:Anorderthatclosesthetransactionbysellingsomethingboughtor
buyingbacksomethingsold.
§
Offset:Theactionofsellingsomethingoriginallyboughttoopenatransactionorbuying
backsomethingoriginallysoldtoopenatransaction.
§
Long:Ownorboughtstocksoroptions.
§
Short:Soldstocksoroptions.
§
Write:Tosellanoption.Theselleriscalledthe“writer.”
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TheRebel’sGuidetoTradingOptions
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TheoTrade
§
SellingShort:Sellingastockwithoutowningit.
§
Naked:Apositionwhentheoptionsellerorbuyerdoesn’towntheunderlyingstockor
anotheroptiononthesamestock.
§
Covered: A position when the option seller or buyer owns the underlying stock or
anotheroptiononthesamestock.
§
Call:Anoptionthegivessomeonetherighttobuyastock.
§
Put:Anoptionthatgivesontherighttosellastock.
Thefollowingwilldescribethedifferencebetweengoinglongandsellingshort:
LONG SHORT
BuyOpeningTransaction Sell
Sell(offset) ClosingTransaction Buy(offset)
Longreferstoapositionwhereonebuysastockoranoptionasanopeningtransaction.Heis
now long that particular stock or option. He offsets or closes this long position by selling the
stockoroption.Thinkofbeinglongasanautodealerwhobuysacarwiththeintentionofone
day selling it at a profit. He is now long a car. He will eventually offset this long position by
sellingthecar.
Shortreferstoapositionwhereonesellsastockoranoptionthathedoesnotown.Thesellis
theopeningtransaction.Heisnowshortthatparticularstockoroption.Heoffsetsorclosesthis
short position by buying the stock or option. An auto dealer who receives payment (or a
deposit)foracarthathedoesn’thaveinstockisnowshortacar.Hehassoldthecarandhopes
to buy one at a lower price than he has sold it for to fulfill the order. He will later offset his
shortpositionbybuyingthecaranddeliveringit.
Technicallyspeaking,whenastockissoldshort,thebrokerhasalreadydeliveredthestockto
thebuyer.Theshortsellernowowesthestocktohisbroker.Themoneyreceivedforthestock
remainsinhismarginaccountandcannotbewithdrawnuntilthestockisboughttoreplacethe
stockthebrokerhasloaned.Theriskisthatthestockgoesup.Ifso,theshortsellermustbring
inmoremoney(amargincall)sothatthereisenoughtobuythestockatitscurrentprice.As
long as there is enough money in the account to buy the stock at its current price one can
remainshortindefinitely.
“Naked long” refers to a position where one is long (buy to open) with no protection. For
example,theriskinbeingnakedlongstockisthatyoucouldloseallofyourinvestment.When
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TheoTrade
youbuyaprotectiveputyouarenow“hedged.”Withoutfireinsuranceonyourhome,youare
naked,noprotection.Howeverifyoubuyafireinsurancepolicy,youarenowprotectedagainst
loss.
“Naked short” refers to having a short position (sell to open) without protection. If you are
nakedshortstockyourriskisunlimited,asthestockhasnolimitastohowhighitcango.When
youbuyaprotectivecall,youarenowhedged.Thecalllimitsthepriceyouwouldhavetopay
forthestock.
TheoTradeContinuedEducation
Ourfirstrecommendationwouldbetoshutoffallthenoise.WhileDonKaufmanwasatTD
Ameritradetheywouldrunstudiesonthe100softhousandsofthemostactiveaccounts.They
foundoutwhatworksandwhatdoesn'twork.Ifyou'resubscribedtoanyotherservice-cancel
immediately.Stopgivingthemmoneytoentertainyouandthenturnarounduseyourmoney
torefundtheirowntradingaccounts.Iknowit'sbrutallyhonest,butsadlytheso-calledtrading
educationcommunityisnothingbutsalesmen.TheoTradehasanall-inclusivemembership
meaningyouhaveaccesstoalloureducators,indicators,andscanners.Wedon'thave8
differentsubscriptionsforyoutogetandyou'llneverfindussellingsomefancyindicator.
TheoTradeisallyouneedsosaveyourmoneyfortrading.:-)
Weknowtherearealotofservicesoutthere.TheInternethasmadeitsothatanyonewithan
Internetconnectionandsomesalesabilitycanthrowupawebsitetoconvincepeoplethey're
traders(oranythingelse).Thetruthismanyoftheseso-calledexpertsarejustshowmen.They
showyouonlytheirwinningtrades,theyputonbothsidesofatradeandshowyouonlythe
tradesthatworked,ortheytakescreenshotsatonlythemostconvenienttimes.DonKaufman
istheonlyoneouttherewith15yearsinthebrokerageindustrywholedtheentireeducation
team in a $20 billion firm. He was the guy this firm sent out to train fund managers and
professionalinvestorsandhecantrainyoutoo!
TheoTradeRecommendedBroker
OpenanewaccountwithTDAmeritradeandget90daysoffreetradingclickingthelinkbelow:
https://theotrade.com/tdameritrade
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TheRebel’sGuidetoTradingOptions
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TheoTrade
TheoTradeandTDAmeritrade’sthinkorswim®Software
PriortoTheoTrade,DonKaufmanspenttheprevious15yearsofhiscareerworkingfor,trading
on,andbuildingfeaturesforthinkorswim®Youwanttolearnthenuancesofthethinkorswim®
tradingapplication,wellthatispreciselywhatwearegoingtodo.Watchthemostrevealing90minuteonlineseminaronhowtousetheindustry’sleadingtradingapplicationfromsomeone
whohelpedcreateit!
https://theotrade.com/thinkorswim-tutorial/
Duringthisfreeonlineseminaryouwilllearn:
*Charting-DiscoverhowtobuildCustomChartsandtoolsforyourtradingneeds.Sureanyone
canbuildachartandplaceastudyonachartbutcanyoudoitwithoneclick?Ican,andwill
showyouhowtousethisfeature!Loaddozensofchartsandstudiessimultaneouslywith1
click.
*Scanningtechnology-Learntoharnessthepowerofthethinkorswim®scanning.Whenyou
arereadytostepupyourtradinggameallowmetointroduceyoutothinkorswim’sscanning
capabilities.Whateveryouarelookingforonachartorinoptions,wellthe
thinkorswim®scannercanfindinunder1second.
*AdvancedOrderTypes.Justwhenyouthoughtyouknewhowtobuildanadvancedtrade…
well,Icanshowyouhowtobuildcomplexorderswithinsecondsandusetherighttoolsin
attempttobetteryourexecutionpricesonallyourtrades.
*Tradingonthinkorswim®-InsighttoalittleknownOptionAnalyticalToolfoundonTOS.You
haveplayedwithprobabilityoftouching;nowlearnwhatit’sallabout!
*AnalyzeTab-TheAnalyzetab,fearedbythosewhodonotknowofitsstrengthsandrevered
bythosethatdo.FearNOTtheanalyzetabforIshalltakeyouintothedepthsfromwhichthere
isnoreturn.Youwilllearnmoreaboutoptionsandanalyticsthanyoubargainedfor!
https://theotrade.com/thinkorswim-tutorial/
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TheoTrade
TheoTrade’sRevolutionaryIndicators
Yes,weshareallourindicatorsatTheoTrade.Allindicatorsarebasedonfreemarketdata.The
abilitytodevelopcoolbellsandwhistlesisacommodity.Neverpaygoodmoneyforan
indicator.Letmeputittoyouthisway.Brokeragefirmsthatareworth10sofbillionsofdollars
wantyoutotrademore,right?Iftherewasastudy,indicator,orscannerouttherethatmade
youabettertraderdon’tyouthinkthesefirmswouldpaytopdollarforthemandmakethem
availabletoyou?Ofcoursetheywould!Thereforesaveyourmoneyfortrading!
Thedirtysecretintheinvestmenteducationworldistheremanyunscrupulouspeoplewillput
onbothsidesofatradebasedonamagicalindicatorandthenonlyshowyouthewinning
trade.Thensellyouthemagicalindicatortorefundtheirowntradingaccount.Don’tfallvictim
tothis!
Everytrader’sdreamistopickthetop&bottomofthestockmarket.Withtheseindicatorsyou
finallycan!Withouttheseindicatorsyoumightaswellbegamblingwithyourmoney.Ifyou
wanttogamblegotoLasVegas.Ifyouwanttolearnhowtopicktops&bottomswatchthis
freeonlineseminar.Theindicatorisavailableforfreeforthinkorswim®users.Theindicatoris
postedonthepagebelow.Don'tworry,weincludedstep-by-stepdirectionsonhowtoinstall
theindicatorsonyourthinkorswim®platform.It'seasy!
https://theotrade.com/revolutionary-indicators-replay/
TheoTradersareNOTgamblers!That'swhyI'mmakingourTheoTradeindicatorsavailableto
youatabsolutelyZEROcost.AtTheoTradewearenotabouttonickelanddimeyou!Weare
aboutcreatingresults.Makesureyougettheseindicatorsonyourchartssoyoucanlearnthe
bestwaytousetheminthisfreeonlineseminar.
https://theotrade.com/revolutionary-indicators-replay/
TheoTradeCommitmenttoYou
Ourcommitmenttoyouistocreatethesinglemostsupportiveenvironmentforyour
investmentandtradingeducation,barnone.Yoursuccessinfinancialmarketsisourhighest
priority;ifyouhaveaquestion,aconcern,orevenarandomthought,contactus.
Email:[email protected]
Phone:1-800-256-8876
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