Make Your Money Work Harder With Options Part 2

Make Your Money Work Harder with Options
Part 2

When the Chicago Board of Options Exchange (CBOE) created the options market, they developed options that were set to expire on the third Saturday of each month.  Always close out options positions prior to market close before expiration to avoid aftermarket risk.  New option expirations dates are created as time passes.  These are known as monthly options and these monthly options were the only way to trade options for many years.  Then in 1990, longer term options were created with expirations dates that would go out at about 3 years.  These options are known as LEAPS options.  In 2005 the CBOE created options that expire every week.  These are known as Weekly options.  And more recently, additional expirations dates of Monday and Wednesday have also been added to the options on the SPY ETF.

All options contracts have a strike price…the price at which the buyer and seller agree to perform under the terms of the contract. The market maker always creates a series of strike prices above, below and close to the current price of the stock.  As the stock moves, additional options contracts are created to make sure there are options below, at, and above the current price of the stock.  These prices are known as “in-the-money,” “out-of-the-money,” and “at-the-money” strike prices.  So far we’ve shared how the market maker creates multiple expiration dates and multiple strike prices which they price using the Black-Scholes formula and list in options chains.  Market makers create these various contract time frames and strike prices as a way to stimulate additional trading volume catering to various investing strategies and also as a way to reduce their risk.  Remember, if they create an option contract, they are legally bound to honor that contract.  So, if a buyer decides they want to sell their contract back into the market (which they can do any time before expiration) the market maker has to buy it back no matter what.

In the real estate world, there is just one type of contract…between the owner of a home who wants to sell their home and the buyer who is interested in obtaining the home.  The options world is a little more complicated.  Option contracts come in two varieties: call options and put options.

Both types of options can be traded either as “buy to open” or “sell to open” orders. Traders who “Buy to open” call positions only make money if the underlying moves up in value just like traders who instead buy the underlying directly.  The difference is options are must less expensive and can therefore be considered inexpensive stock substitutes for trading purposes. On the other hand, traders who “buy to open” put positions only make money if the underlying drops in value.  Put options can be bought to open by those who don’t own the stock or by those who own the stock and who want to purchase “insurance” to protect their holdings from loss.  If the underlying where to drop in value, the option premium would increase in value.

In other words, in a “buy to open” transaction, call options appreciate in value when the underlying goes up and lose value when the underlying goes down…and put options do the opposite.  Put options go up in value when the underlying goes down and lose value when the underlying goes up.

The additional complexity “Puts and Calls” and “sell to open and buy to open orders” add to the options market gives much more flexibility to the individual investor and also reduced risk to the market maker supporting  a much larger and more liquid market.  This additional flexibility provides the individual investor who has taken the time and made the effort to learn about options creative ways to trade these two types of contracts for profit and protection.

There are a great many strategies that have been developed over time to combine options and stocks to profit.  One of those is known as a covered call.  Let’s say you have $400,000 of xyz company stock and it’s time to retire.  Most people believe they will need to cannibalize their retirement account by selling little bits of their xyz stock position each month to sustain their lifestyle.

But instead of simply selling the stock, a person could delay the sale by initiating a “sell to open”  call position instead.  This obligates the person to sell their stock (which they wanted to do anyway) at some point in the future.  In return for this obligation, the person earns a premium which is theirs to keep no matter what.  By delaying the sale of the stock in this way, a person is paid a fee which is like having your account send you a paycheck every week or every month without having to actually sell stock.

This strategy is known as a covered call and is safe enough to do inside a retirement account.  But it’s possible to get more creative too.  It’s possible to initiate a “sell to open position” covered call on other call options which are owned by the trader.  This is a way to generate more leverage and put your money to work even harder.

Where put options differ from call options is what they allow the owner of stock to do.  Let’s say you own stock.  With a call option, you can generate a monthly (or weekly) paycheck from your holdings in return for obligating yourself to sell the stock you own at the contract price and within the contracted time frame.

Put options add another element of choice to the holder of stock who begins to fear the stock they own is about to drop in value.  Instead of selling the stock and incurring a tax consequence, a put option can be purchased instead.  As the stock drops in value, the put would rise in value protecting the investment similar to an insurance policy.

So far we’ve described the options market from the position of a stock owner.  For a stock owner, selling to open a call position is a way to generate cash flow from the market without having to sell any stock.  It’s like renting a house for monthly cash flow…without all the headaches of renting actual real estate.  And for a stock owner, the “buy to open” put position is a way to insure against loss without having to sell stock.

Options can be bought and sold independent of any ownership of stock.  The options speculator can make significantly higher percentage returns on the same move in a stock based on the nature of options pricing.  This module will not discuss the full Black-Scholes formula in detail nor go over the mathematical nature of the different components.

Suffice it to say that an option’s price is generally determined by two things:

  1. Time to expiration and that the value of this time decays with the passing of time.
  2. Intrinsic value which is when the strike price gives the option holder value relative to the current stock price.  Intrinsic value is either positive or zero and is completely dependent on the currently traded price of the underlying.  Intrinsic value is the difference between the current price of the underlying (which changes all the time) and the strike price of the option.

In the list of available strike prices for a stock, the market maker always creates options which are a little above, below, and close to the current price of the stock.  As the stock prices move, additional options are added as needed to be sure there are always options which are above, below and close to the current price of the stock.

These options are known as “in-the-money”; “out-of-the-money” and “at-the-money” options.  For call options, in-the-money options have strike prices lower than the current price of the stock because calls make money when stocks rise in value.  Put options are in the money if the strike price is above the current price of the stock because puts make money when stocks drop in value.

In-the-money options have both intrinsic value and time value added together to determine their price.  The more one pays for intrinsic value, the less one pays for time value as a percentage of the total price of the option.  Out-of-the-money options and options that are exactly “at-the-money’ are priced solely for time as there is no intrinsic value in these options.

Whether an option is in-the-money or out-of-the-money can be confusing when comparing puts and calls in an options chain. The market makers keep it simple by highlighting the in-the-money options a different color than the out-of-the-money options.  The at-the-money option is the strike price closest to the current price of the underlying and is usually either the first one in-the-money or the first one out-of-the-money.

As time passes the value of the time component of an option decays until it reaches zero on expiration.  The intrinsic value of an option goes up or down based on the movement of the underlying equity.

The single biggest risk to an options speculator (someone who “buys to open” a put or a call position) is that the stock doesn’t move enough in the forecasted direction for intrinsic value to make up for the loss of time value so the option expires worthless.  It’s possible to lose 100% of the purchase price of an option if the stock doesn’t move far enough in the forecasted direction before the option contract expires.  An option buyer must choose the right strike price and also the right time frame for the move to profit.

Note that as stocks bounce around in price, their options also move from out-of-the money to in-the-money or vice versa. The best possible profit for an options speculator is to buy an out-of-the-money option which then goes in-the-money before expiration.  This particular strategy is often called a lottery ticket play because of the risk…but the percentage gains in such a play can be phenomenal.

The options market has become a popular place for traders of all kinds (even those with very small accounts) to hedge risk, generate steady cash flow, diversify, or even catch up a retirement with amazing percentage returns.  While it is possible to lose 100% of the investment if the option expires worthless, options cost only a fraction of the underlying equity so the total risk is still less than owning stock.

The options market is more complicated than simply trading stocks.  It trades faster.  There are put and call contracts.  There are “buy to open,” “sell to close” and “sell to open,” “buy to close” orders.  There is intrinsic and time value.  The Black-Scholes mathematical formula.  In-the-money, out-of-the-money and at-the-money contract prices.  Bid and Ask spreads.  In other words, this market contains lots of new jargon and mathematical possibilities.

But despite all these initial headaches and obstacles, the options market is well worth learning to trade.  Options are a trading tool that can supercharge returns, protect accounts and generate steady cash flow, and even do all three at once!  In future classes and modules we’ll show some simple ways anyone can use options to significantly improve their current trading plan.