Options

The Essential Guide for Getting Started in Derivatives Trading, Tenth Edition

Michael C Thomsett

• Publisher: De Gruyter
• Year: 2018
• ISBN:
  9781547400119
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

With over 300, 000 copies sold, the new edition of this comprehensive mentoring guide clearly presents all of the essential information needed to learn to trade options.

Whereas most options books focus on profit and loss opportunities, this book addresses the issues of hedging market risks in an equity portfolio head on. The author presents the compelling argument that options should not be thought of as risky stand-alone trading vehicles, but offer greater value as a coordinated strategic methodology for managing equity portfolio risks as presented in numerous examples in this book.

Divided into four parts, Options reflects a guiding standard of the past nine editions and includes:

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• Crystal clear explanations of the attributes and strategies of calls and puts.

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• A chapter on the short life of an option. This, missing in almost every options book, is a key to understanding options trading.

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• Examples in Part 1 showing different trading strategies on both sides of the trade.

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The second part of the book is about closing positions; taking profit, exercising, expirations or rolling forward your position, risk analysis, profit calculations, and the impact of volatility.

The third part simplifies the complex issues of advanced strategies including the various spreads, combining spreads to successfully hedge other positions and how certain strategies work. Each spread is covered in at least one detailed example.

The final part is on evaluating risk. The unquestioned benefits of hedging risk and strategies that are virtually guaranteed to succeed that are generally the domain of the investment giants along with many examples are discussed.

The book's broad coverage makes it an incredibly valuable desk reference to any trader in options. You won't get explanations like these on the internet.

Michael C. Thomsett is a market expert, author, speaker, and coach. His many books include Stock Market Math, Candlestick Charting, The Mathematics of Options, and A Technical Approach to Trend Analysis.

Click here to see an interview with the author.

https://youtu.be/8bgrgLB3Mx4

Part I:The Basics

Chapter 1
Calls and Puts: Defining the Field of Play

Nine-tenths of wisdom is being wise in time.

̶̶ Theodore Roosevelt, speech, June 14, 1917

Options are amazing tools that can help you expand your control over your portfolio, protect positions, reduce market risk, and enhance current income. Some strategies are very high risk, while others are extremely conservative. This is what makes the options market so interesting. The variety of creative uses of options makes it possible to lock in profits in the most uncertain of conditions, to pursue income opportunities, or to hedge risk, without being exposed to volatile markets.

Because the option is an intangible device, its cost—known as the premium—is only a fraction of the stock price. This makes it possible to control shares of stock without assuming the market risks. Each option controls 100 shares, so for between 3 and 10 percent of the cost of buying shares in a company, you can use an option to create the same profit stream. This makes your capital go further while keeping risks very low. The actual percentage of an option’s value depends on its time to expiration, proximity to the underlying price, and level of volatility.

Definition

Premium: The price of an option, expressed in dollars and cents but without dollar signs in hundreds of dollars. For example, if an option has a premium of $200, it is expressed as 2; if an option has a premium of $325, it is expressed as 3.25.

This idea—using intangible contracts to duplicate the returns you expect from wellpicked stocks—is revolutionary to anyone who has never explored options trading. Most people are aware of the two best-known ways to invest money: equity and debt.

Equity Investments

An equity investment is the purchase of a share of stock or many shares of stock, which represents a partial interest in the company itself. Shares are sold through stock exchanges or over the counter (trades made on companies not listed on an exchange). For example, if a company has one million shares outstanding and you buy 100 shares, you own 100/1,000,000ths, or .0001 percent of the company.

Definition

Equity investment: An investment in the form of part ownership, such as the purchase of shares of stock in a corporation.

When you buy 100 shares of stock, you are in complete control over that investment. You decide how long to hold the shares and if or when to sell. Stocks provide you with tangible value, because they represent part ownership in the company. Owning stock entitles you to dividends if they are declared, and gives you the right to vote in elections offered to stockholders (some special nonvoting stock lacks this right). If the stock rises in value, you will gain a profit. If you wish, you can keep the stock for many years, even for your whole life. Stocks are traded over public exchanges and can be used as collateral to borrow money.

Example

An equity investment: You purchase 100 shares at $27 per share, and place $2,700 plus trading fees into your account. You receive notice that the purchase has been completed. This is an equity investment, and you are a stockholder in the corporation.

Example

Part equity, part borrowed: You buy an automobile for $20,000. You put down $6,000 and finance the difference of $14,000. Your equity is limited to your down payment of $6,000. You are the licensed owner, but the financed balance of $14,000 is not part of your equity.

Debt Investments

The second broadly understood form of investing is a debt investment, or debt instrument. This is a loan made by the investor to the company, government, or government agency, which promises to repay the loan plus interest as a contractual obligation. The best-known form of debt instrument is the bond. Corporations, cities and states, the federal government, agencies, and subdivisions finance their operations and projects through bond issues, and investors in bonds are lenders, not stockholders.

When you own a bond, you also own an asset with tangible value, not in stock but in a contractual right with the lender. The bond issuer promises to pay you interest and to repay the amount loaned by a specific date. Like stocks, bonds can be used as collateral to borrow money. They also rise and fall in value based on the interest rate a bond pays compared to current rates in today’s market. In the event an issuer goes broke, bondholders are usually repaid before stockholders as part of their contract, so bonds have priority over stocks.

Example

Lending versus owning: You purchase a bond currently valued at $9,700 from the U.S. government. Although you invest your funds in the same manner as a stockholder, you have become a bondholder; this does not provide you with any equity interest. You are a lender and you own a debt instrument.

Example

Lending to a friend: A good friend wants to buy a car for $20,000, but has only $6,000 in cash. This friend asks you to lend him the balance of $14,000 and offers to pay interest to you. The $14,000 you contribute is a debt investment, and the interest you earn is income on that investment. When you act as a lender, you have made a debt investment.

Investments with No Tangible Value: Options

The third form of investing is less well known. Equity and debt contain a tangible value that we can grasp and visualize. Part ownership in a company and the contractual right for repayment are basic features of equity and debt investments. Not only are these tangible, but they have a specific lifespan as well. Stock ownership lasts as long as you continue to own the stock and cannot be canceled unless the company goes broke; a bond has a contractual repayment schedule and ending date. The third form of investing does not contain these features; it disappears—expires—within a short period of time. You might hesitate at the idea of investing money in a product that evaporates and then ceases to have any value. In fact, there is no tangible value at all.

An option’s value is derived from the underlying security on which it is based. This is why options are also called “derivatives.” Their value is derived from price behavior in an equity position.

Key Point: Options are intangible and have a limited lifespan. The main advantage is that options allow you to control 100 shares of stock without having to buy those shares.

This third type of investment involves no tangible value, and it will be absolutely worthless on its pre-determined expiration date, which can be within a few months. To make this even more perplexing, imagine that the value of this intangible is certain to decline just because time passes by. To confuse the point even further, imagine that these attributes can be an advantage or a disadvantage, depending on how you decide to use these products.

Valuable Resource: For a complete summary of risk, complete with disclosures about the options market, download a copy of the industry prospectus, Characteristics and Risks of Standardized Options at https://www.theocc.com/about/publications/character-risks.jsp

The attributes of options—lack of tangible value, worthlessness in the short term, and declining value over time—make options seem far too risky for most people. But there are good reasons to look beyond these limiting features. Not all methods of investing in options are as risky as they might seem; some are conservative because the features just mentioned can work to your advantage. In whatever way you use options, the many possible strategies make options one of the more interesting avenues for investors. The more you study options, the more you realize that they are flexible; they can be used in numerous situations to create opportunities; and, most intriguing of all, they can be either exceptionally risky or downright conservative.

This makes options both flexible and suitable for a broad range of investors. On one end is the speculator willing to increase risk, and on the other is the conservative investor who seeks ways to reduce risk.

Key Point: Option strategies range from high risk to extremely conservative. The risk features on one end of the spectrum work to your advantage on the other. Options provide you with a rich variety of choices.

The role of options is not without controversy. Citing the potential for manipulation, speculation, and volatility, one paper offers the theory that options trading adds to instability in the markets:

Overall, most economists recognize that derivatives have made a positive contribution to the economy, but since the global crisis of 2007-2010, critics have become much more frequent and virulent and the perception of derivatives has changed quite a lot. Although the usefulness of derivatives is not called into question on the whole, a number of voices have been clamoring about the risks that derivatives place on the stability of financial markets.1

However, manipulation, speculation, and volatility cannot be assigned to options trading exclusively. There have been instances of abuses in all of the publicly traded markets, and these are well-known. But when used to hedge market risk, or when speculation is moderated, the options market is more likely to expand opportunities for trading, rather than harming it. This is accomplished with strategies set up to offset equity risk, or to hedge it. As a starting point in the analysis of the options market, it makes sense to understand not only what options are, but the benefits and risks they provide.

An option is a contract that provides you with the right to execute a stock transaction—that is, to buy or sell 100 shares of stock. (Each option refers to a 100-share unit.) This right includes a specific stock and a specific price per share (strike price) that remains fixed until a known date in the future. When you have an open option position, you do not have any equity in the stock, neither do you have any debt position. You have only a contractual right to buy or to sell 100 shares of the stock at the strike price.

Since you can always buy or sell 100 shares at the current market price, you might ask: “Why do I need to purchase an option to gain that right?” The answer is that the option fixes the price of the stock, and this is the key to an option’s value. This fixed price is known as the strike price, also known as the striking price.

Definition

Strike price: The fixed price to be paid for 100 shares of stock, specified in the option contract; the transaction price per share of stock upon exercise of that option, regardless of the current market value of the stock.

Stock prices may rise or fall, at times significantly. Price movement of the stock is unpredictable, which makes stock market investing interesting and risky. As an option owner, you can buy or sell 100 shares at a price that is frozen for as long as the option remains in effect. So, no matter how much price movement takes place, your price is fixed to the strike price in the event that you decide to purchase or sell 100 shares of that stock. Ultimately, an option’s value is going to be determined by a comparison between the strike price and the stock’s current market price.

A few important restrictions come with options:

1. The right to buy or to sell stock at the strike price is never indefinite; in fact, time is one of the most critical factors because the option exists for a limited time that is unchangeable and defined when the option is created. When the deadline has passed, the option becomes worthless and ceases to exist. Because of this, ...