Options are derivative securities, meaning that their value is derived from other underlying securities (stocks, futures, etc). While they can be extremely volatile, they can also be extremely versatile, helping traders capitalize on the market and leverage current positions. Options trade in contracts with specific terms. They give buyers the right to buy or sell a particular security at a fixed (strike) price, on or before a specific date. One option usually represents rights on 100 shares of underlying stock, and they typically expire on the third Friday of each month. For example, ABC Oct 30 Call gives the buyer the right to purchase 100 shares of ABC at $30 up until the third Friday in October.
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Long Calls |
A call option gives the buyer the right to purchase shares of an underlying security. Purchasing calls is a bullish strategy; the buyer expects that the price of the underlying stock is going to increase. Hopefully, as the price of the underlying security increases, so will the value of the option. While the profit potential for a long call is unlimited, potential loss is fixed at the option’s purchase price. If the underlying stock price falls to zero, the option will simply expire worthless.
The strike price of a call, relative to the price of its underlying stock, determines whether it is "in-the-money" or not. If the current stock price is above a call’s strike (plus premium), it is considered in-the-money; the holder can exercise the call and purchase stock shares below current market price. If the stock price is below the call’s strike, the option is out-of-the-money. No one will exercise ABC 30 call when ABC is trading at $20, or pay much for the option. Keep in mind that any premium paid for options must also be considered when determining whether a position is profitable or not.
The three main factors that affect the price of a call option are:
- The underlying security price in relation to the strike price
- The time remaining until the option contract expires
- The volatility of the underlying security
Long calls that are already in the money command a higher price than those whose strike is well above current market price. Also, as the calendar date approaches the expiration date of an option (the third Friday of each month), the time value of the contract will decrease. Finally, the more fluctuation there is in a stock’s price, the more likely it is that its options will fluctuate; the less a security fluctuates, the less movement there will be in the price of its calls.
In-the-money option owners have the choice of selling their calls or exercising them. In some cases, if a call is far enough in the money (3/4 of a point or more on expiration day), it will be exercised automatically. Selling a long call (selling to close) renders one flat in the position. Owners can also exercise their options and take possession of the stock at their strike price. (Note that funds must be on hand to cover the full purchase amount of the stock.) This strategy might prove beneficial if the owner wishes to hold onto the shares, expecting the stock price to increase. The owner may also have the shares delivered into his/her account and sold immediately. Some traders sell in-the-money call option contracts, and then rollover the profit into another call option contract at a higher strike price. Of course, this trader would still have to feel bullish about the underlying security.
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Long Puts |
A put option gives the buyer the right to sell shares of an underlying security. Buying puts is a bearish strategy; the buyer expects that the underlying stock’s price is going to drop. As the price of the underlying security decreases, the value of the put will most likely increase. The potential profit on long puts is limited (since the stock can only drop to zero), and the potential loss is fixed at the option’s purchase price.
The strike price of a put, relative to the price of its underlying stock, determines whether it is in-the-money or not. If the current stock price is below the put's strike, it is considered in-the-money. If the strike is below current market, the put is out-of-the-money.
The three main factors that affect the price of a put option are:
- The underlying security price in relation to the strike price
- The time remaining until the option contract expires
- The volatility of the underlying security
As the underlying security price decreases, the value
of the put will increase. If the underlying security price
increases, the price of the put option will decrease. As the
current calendar date approaches the expiration date, the
time value of the option contract will decrease. Finally,
the more fluctuation there is in a stock’s price, the more
likely it is that its puts
will trade at a premium; the less a security fluctuates, the
less movement there will be in the price of its puts.
Put holders have the option of selling their puts or exercising them. Selling a long put (selling to close) makes the position flat. Owners can exercise their puts if they are also long the underlying stock. They "put" their shares to the market, receiving payment at the strike price. Traders who are long a security sometimes employ this strategy, utilizing puts as a hedge. In some cases, if a put is far enough in the money (3/4 of a point or more on expiration day), it will be exercised automatically.
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Writing Covered Calls |
Writing covered calls is the sale of a call while holding shares of the underlying stock. The writer of a covered call is bullish on the long term prospects of the security but bearish on the short term prospects. The covered is also used to generate income on the stock by collecting premiums on the sale of out of the money calls The call is not considered short since the underlying security serves as collateral, and will be tendered should the option be exercised. If a covered call writer wishes to retain the stock, the calls can be bought back. (Provided this is done prior to exercise.)
Example:A trader owns 100 shares of XYZ stock, which currently trades at 57. The trader decides that XYZ is going to trade flat or perhaps drop a bit, so decides to sell one XYZ 60 call at 2.25. The net profit is $225. If XYZ closes at 60 or lower upon expiration, the covered call will expire worthless and the trader will pocket the $225. If XYZ closes above 60, the call might be exercised, and the trader will need to deliver 100 shares of stock at the strike price. (If the trader initially purchased the shares of the stock below 60, this would be a profitable strategy in two ways: the profit on the call, and the profit on the stock.)
The above example does not include commission charges that could significantly decrease the above profits or increase the loss.
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Complex Option Strategies |
| Several option strategies involving simultaneous trades of two or more options do exist. These are employed by experienced options traders for profit or to hedge on specific market situations. You must be approved to use these strategies.
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Call Debit Spread |
A call debit spread consists of the purchase of a call
and the sale of another call at a higher strike price. A very
aggressive spread would establish an out-of-the-money call
for each leg of the spread. A less aggressive strategy would
establish the lower call in the money and the higher call
out-of-the-money. The least aggressive strategy would establish
both legs of the spread in the money.
Example:
A trader buys an ABC July 55 call for 3.50 and sells an ABC July 60 call for 1.75. ABC is currently trading at 56. This trade results in a debit of 1.75. If ABC closes above 56.75 at expiration, the spread is in the money, since the debit was 1.75. The maximum profit occurs when ABC closes at 60 upon expiration; the long call is worth 5 and the short call expires worthless, realizing a profit of 1.75 on the sale of the call.
The maximum profit = the higher strike price minus the lower strike price minus net debit of the spread
The maximum loss = the net debit of the spread
The breakeven point = lower strike price plus the net debit of the spread
The above example does not include commission charges that could significantly decrease the above profits or increase the loss.
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Call Credit Spread |
This strategy involves the purchase of a call and the sale of another call at a lower strike price. The net amount of the two premiums results in a credit. The strategy behind this spread is for both options to expire worthless. It becomes profitable if the short call’s (the one that is sold) strike is above the stock price upon expiration.
Example:
A trader purchases a DEF July 100 call at 1.75 and sells a DEF July 95 call at 3.50. The net credit of the two premiums is 1.75, which is also the maximum profit on this spread. The maximum loss in this strategy is the difference between the two strike prices, less the net credit received. Overall, this strategy is very aggressive, since the short call has a lower strike price than the long call.
The maximum profit = the initial credit
The maximum loss = higher strike price minus lower strike price minus net credit
The breakeven point = lower strike price plus initial credit
The above example does not include commission charges that could significantly decrease the above profits or increase the loss.
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Long Straddle |
This strategy is generally used when a trader expects strong volatility in the underlying security but is not sure which direction it will go. The long straddle is a simultaneous purchase of a long call and a long put. Both options are on the same security, and have the same strike price and expiration date.
Example:
A trader purchases a JKL November 30 call at 3 and a JKL November 30 put at 2.50. This results in a net debit of 5.50. If JKL closes above 35.50, the call will be profitable. If JKL closes below 24.50 at expiration, the put will be profitable. Maximum loss occurs if JKL closes at 30, because the options would expire worthless and both premiums would be lost.
The maximum profit = Unlimited
The maximum loss = the initial debit
The breakeven point = exercise price plus and minus the combined premium
The above example does not include commission charges that could significantly decrease the above profits or increase the loss.
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Long Strangle |
The long strangle is a simultaneous purchase of a long call and a long put that have the same expiration date on the same underlying security. However, the strike prices are not the same.
Example:
A trader buys a JKL November 40 call and a JKL November 30 put. Both options carry a premium of $1 for a total cost of $2. The underlying security price is $35. Both options are out of the money and will require a greater amount of volatility than the Long Straddle for either of the strike prices to be surpassed. If JKL closes at $35 upon expiration, maximum loss (the total amount of the premiums) occurs. In order for this strategy to be profitable, JKL must close below 28 or above 42 at expiration.
The maximum profit = Unlimited
The maximum loss = the initial premiums
The breakeven point = exercise price plus and minus the combined premium
The above example does not include commission charges that could significantly decrease the above profits or increase the loss.
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Long Butterfly |
Essentially, the long butterfly is a simultaneous purchase of a bull call spread and a bear call spread. One call is bought at the lowest strike price, and one call is bought at the highest strike price. Two calls are sold at a middle strike price. The Long Butterfly can be described as "buying the wings and selling the middle."
Example:
A trader buys one August ABC 80 call at $2 and one August 60 call at $6.50, and sells two August ABC 70 calls at $3.50. The net debit is $150. Ideally, the current price of the underlying security should be close to the middle strike price (the short calls).
The maximum risk = the net debit of the butterfly
The maximum profit = the distance between the strikes minus the net debit
Downside breakeven point = lowest strike price plus the net debit
Upside breakeven point = highest strike price less the net debit
The above example does not include commission charges that could significantly decrease the above profits or increase the loss.
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Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies of this document are available from Terra Nova Financial, LLC, 100 S. Wacker Drive, Suite 1550, Chicago, IL 60606. A prospectus, which discusses the role of The Options Clearing Corporation, is also available on request for no charge. Contact The Options Clearing Corporation, 440 S. LaSalle Street, 24th Floor, Chicago, IL 60605. The documents available discuss exchange-traded options issued by The Options Clearing Corporation and are intended for educational purposes. No statement in the documents should be construed as a recommendation to buy or sell a security or to provide investment advice.
Options are not suitable for all investors and you must balance the opportunities of options trading with the corresponding risks involved. You should discuss tax treatment of the possible options strategies with your tax advisers prior to undertaking such transactions. Exercise and/or closing transactions are subject to commission charges. Interest charges are incurred where the underlying securities are purchased on margin.
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