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Message from William C. Spaulding on Jan 17 1997 4:47AM EST
A mini-course in options.
Options are contracts that give the contract holder the right to buy or sell
100 shares of stock at a given price, called the strike price. A call option
gives the call holder the right to buy at the strike price and a put gives the holder the
right to sell at the strike price. Options are a form of derivative, because their value
derives from an underlying stock, so they reflect the underlying stock. So if there is a
stock split, then the corresponding options also split: Example for a 2 for 1 stock
split: A Feb 120 call becomes 2 Feb 60 calls. However, a stock option doesn't
pay dividends nor does it give voting rights. Examples of Dell options (all examples
in this post are based on Dell's closing price of 65 1/4):
Option: Feb 65 Call
Option Symbol: DLQBM
Strike Price: 65
Expiration: Feb 22, 1997
Bid/Ask: 4 « / 4 7/8
Option: Feb 65 Put
Option Symbol: DLQNM
Strike Price: 65
Expiration: Feb 22, 1997
Bid/Ask: 4 1/8 / 4 «
To buy one contract of Feb 65 calls would cost $487.50 (4 7/8 X 100).
Buying 100 shares of the stock would cost $6,525.00.
(1) Each stock has a root option symbol that denotes all options on that particular
stock. Dell's root symbol is DLQ.
(2)The next letter denotes both month of expiration and whether it is a call or put.
A-L indicates a call, M-Z, a put. A, the first letter denotes January, E, the fifth letter
denotes the fifth month, May. For a put, M, the first letter in the range M-Z denotes
January, and Q, the fifth letter in the range, denotes May.
(3) The fifth letter indicates the price, but you can't determine the price by looking at
the letter. It simply denotes its position in a series of prices. Thus, the fifth letter in
Feb calls for strike prices 60, 65, 70 are L, M, N. This is complicated by stock
splits, which I won't get into here, but that is the general idea.
(4) For the 65 strike price, a call allows you to buy Dell at 65 regardless of the
stock's market price, and a put allows you to sell at that price.
(5) The expiration date is actually a Saturday, but since the market isn't open then,
you either have sell, or in options parlance, close your position by Friday, or
exercise the option.
(6) The bid/ask spread is usually much larger than the spread between stocks,
because the volume is much lower. However, spreads may narrow on Monday,
January 20 when the new market display rules that the SEC has mandated take
effect. The bid/ask spread is lower with options that are close to expiration because
there is more volume. The commission to open (buy) and close (sell) contracts is
also higher than it is for stocks.
Options have intrinsic value and time value. Intrinsic value is the difference
between the option's strike price and the stock's current market price. Example: A
Feb 60 call has an intrinsic value of 5 1/4, based on Dell's current price of 65
1/4. A stock that has intrinsic value is said to be in the money, if the strike price
equals the stock price, then it is at the money, and if the strike price does not equal
the stock price and has no intrinsic value, then it is out of the money. A call has
intrinsic value if the stock is higher than the strike price, and a put has intrinsic value
if the strike price is higher than the stock. Thus, a Feb 60 call and Feb 70 put for
Dell are both in the money, but a Feb 60 put is out of the money and a Feb 70 call,
likewise. But note that a Feb 70 call still costs you money to buy, because even
though it is out of the money, an option also has time value, also called a premium.
A Feb 70 call would cost you 2 3/4. Thus, its time value is 5 « (70 + 2 3/4 - 65
1/4). The time value for a May 70 call is 11 3/8. This shows that time value declines
as the time left until expiration decreases, explaining why both May calls and puts
are more expensive than Feb calls and puts for the same strike price. The more time
left in the option, the better the chance that the option will become profitable, and
so, it commands a higher premium.
Additional facts about options.
(1) As options become increasingly in the money, they lose more and more of their
premium, and start to track the stock dollar for dollar.
(2) When options are out of or at the money, they increase less on a dollar basis
than the underlying stock, but they increase faster on a percentage basis. Example,
using rough numbers: An Intel Feb 160 call costs $3 / share when Intel was at 138.
Intel rises to 146 in a few days and the call rises to $4 / share. So Intel rises by $8 /
share, but the option rises by only $1, but this $1 / share was 33 1/3% rise in the
option price. If the stock rose by the same amount, it have to go up by $46!
However, if the stock rose to $146 slowly, then the time value might decline faster than the positive
effect of the rising stock price. This is one of the things that makes options tricky.
Profiting with Options. Profits are obviously made by buying low and selling high.
Calls increase in value as the underlying stock price increases. Puts increase in value
as the underlying stock price declines. You would buy a call the same way you buy
the stock: you try to buy it when you think it is at its lowest price. You buy a put
however, when you think the underlying stock is at its highest price, because then
any given put will be at its lowest price.
The advantage of options are numerous.
(1) It is much cheaper buying the option than the stock. Thus, rather than buying
Dell for 65 1/4 per share, you can buy the Feb 65 call for 4 7/8 per share, and the
May 65 call for 8 1/2. Two additional advantages: (a) you can buy stocks that you
wouldn't ordinarily be able to afford, like Intel at 143 per share. (b) You can
diversify more, thereby lowering your risk. This not only includes buying options for
different stocks, but also buying puts and calls. Thus, you could buy calls on strong
stocks and puts on weak stocks. If the market goes up, you make money on your
calls; if the market goes down you make money on your puts. Because options can
appreciate much more than they can decline, the only way you can lose money with
this strategy is if the market stays the same. When does that ever happen?
(2) Your risk is limited. If you buy Dell at 65 1/4, and it declines to 30, then you're
losing 35 1/4 per share. On the other hand, you can't lose anymore than your
investment with options. Thus, you can't lose any more than the 4 7/8 per share you
paid for the Dell Feb 65 call. But herein lies the risk with options. Whereas,
there is little chance that you will lose your entire investment by owning the
actual stock, unless, of course, you bought on margin, you can easily lose your
entire investment! Once an option expires, it becomes completely worthless,
it ceases to exist! The key to lowering risk with options is to not invest
everything you have in options, but just a small part.
(4) The potential for profits is much greater with options than with stocks. The key
to making BIG money in options is to buy cheap and to buy short. I wouldn't buy a
Dell May 65 put, because May is too far off, and therefore would command a high
premium, and a 65 strike price would be too expensive since it is at the money. The
key is to try to determine what you think the stock will go to during the option's
lifetime, and then try to buy at a strike price that is somewhat above that. Example:
CHPS. I only have rough numbers here, but they are good enough to illustrate the
idea. Before CHPS came out with earnings, it was around 21 1/2. When earnings
came out it went down to about 16. When CHPS was above 21, the Jan 17.5 put
for CHPS was probably about 1/16. It was cheap because expiration was so close
and it was way out of the money. However, when the stock declined by more than
$5, the put started to increase in value quickly. If CHPS was 16, the put would
have an intrinsic value of 24/16 (1 1/2), so by closing your contract then, you would
have profited 2400%. A $500 investment would have returned a profit of $11,500
in one day! You could never earn that kind of return on a stock even if you held it
for a whole year! On the other hand, you couldn't lose any more than 100% of your
initial investment, or in this case, $500.
To illustrate how I would use options to make money, let's consider the Dell put.
The first thing that I would consider is, did Dell reach its highest price for the
immediate future, let's say within the next month. Because this earnings time, and
stocks usually do well as earnings are being reported, I would not consider buying a
put now, especially since it will be another month until Dell reports earnings, and it
would probably rise a little more then, so I would wait until then to buy a put. Then I would
project stock prices for the near future. Let's say I think Dell will go to 70 to
75 and then retreat to $55 again. I would wait until the stock reached what I
consider to the maximum price for the next few months, then buy a put for a strike
price of about 60 or 65. I would buy at these strike prices because these puts
would be extremely cheap ($2 or less), and when the stock falls below the strike
price, the value of the put would increase rapidly. So if I buy 65 puts for $2 and it
does go down to $55, then the intrinsic value would have to be at least $10, a
500% increase in my investment, and the option would still have some time value, so
it would actually be worth more yet. If I bought 75 put when the stock was at 74,
then that put would probably cost me about $6, so if it went down to $55, I would
earn more money per share, but since I would have fewer shares for the same
amount of money, the percentage increase would be less. In this case, the intrinsic
value of the put would be about $14, an increase of 233%. Still a nice increase, but
less than I achieved with a cheap put. But, on the other hand, suppose I was wrong
and the stock price only went down to $69. Then I will profit more with the 75 put
than with the 65 put. Note that I didn't specify a month. I would have to buy an
option for the time span that I am considering, but unfortunately there isn't a stock
option that expires for every month. Example: Right now, there are Feb and May
options for Dell, but not March and April. So this is yet another thing that you have
to consider. Since I don't think Dell will decline considerably before Feb expiration,
I wouldn't buy a Feb put.
If I were going to buy a call, I would try to buy right before I think there will be
significant appreciation, like during earnings announcements, for instance, or during
annual meetings, especially if I would buy a cheap call, because if the stock price
rises slowly, then the diminishing time value might be more negative than positive
influence of a rising stock price. Note also, that because of time value, you can make a profit
with a call even if the underlying stock doesn't reach the strike price before expiration,
as long as you sell before then!
So you see, options can be very profitable, but because of the time limitation, they
can be extremely tricky, and that's why they are risky. If you would want to do this,
first of all, read as much as you can to learn options thoroughly. Much of this
reading you can do on the Internet. Some good places:
optionscentral.com and options-iri.com. There are many
other places as well. Use Yahoo or other indexes to find out more.
Most importantly, if you do decide to try options, just buy a few contracts at
a time, and buy cheap contracts. This way you greatly diminish your risk
while testing your ability to make a profit with options. Good Luck. |
