The Options Edge

An Intuitive Approach to Generating Consistent Profits for the Novice to the Experienced Practitioner

Michael C. Khouw, Mark W. Guthner

• Editorial: Wiley
• Año: 2016
• ISBN:
  9781119212423
• Edición: 1
• Categoría: Betriebswirtschaft
• Categoría: Investitionen & Wertpapiere

Capture the fortune you're losing with every trade by learning to exploit options

The Options Edge + Free Trial shows you how to capture the fortune you lose out on every day. Buying and selling traditional investments often entails instruments with optionality. Sometimes this optionality is explicit, while other times it is hidden. If you're not leveraging these embedded options to their fullest advantage, you're losing money. Most retail investors don't truly understand the nuances involved in successful options trading and instead rely on more comfortable instruments with fewer complex mechanics. If you're interested in optimizing your portfolio, it's time to step out of your comfort zone and learn what you've been missing. This book gives you the background you need to take full advantage of options in this booming market. The companion website features easy to use analytical tools that help investors find the best opportunities so you can start applying these methods right away. Whether or not you ultimately decide to start actively trading options, the concepts discussed will make you a better all-around trader with greater security in your financial affairs.

Most investors buy and sell options every day without ever knowing it. This book relates stories of those who have leveraged options to make fortunes and those who have lost by not understanding the optionality of their financial endeavors. You must know the fundamentals of options, and then learn to recognize hidden options, in order to improve success in all of your investment activities. After taking these steps, you can go on to:

• Create hidden options at little or no cost
• Structure your finances to reduce risk and increase wealth

• Utilize a practical pricing model for smarter investing

The listed options are currently the only growing exchange traded financial product in the developed markets, with a current average volume of 20 million contracts—equivalent to 2 billion shares—per day. Now is the perfect opportunity to fortify your finances, and The Options Edge + Free Trial gives you the understanding and practical tools you need to optimize your portfolio today.

Chapter 1
What Is an Option, and How Do Options Work?

An option is a contract to buy or sell any specific item, which is referred to as the underlying instrument, asset, or interest. As with all contracts, there are two parties involved. An option contract is an agreement that gives the buyer or owner of the contract the opportunity, but not an obligation, to buy or sell the underlying instrument at their discretion. The seller, on the other hand, has the obligation to perform the seller's end of the bargain should the buyer choose to exercise their right to transact under the terms of the agreement.

The underlying instrument is commonly a financial instrument like a stock, an index of financial instruments, a basket of stocks such as an ETF, a bond or a currency. The underlying instrument does not have to be a financial instrument, however. An option may reference a physical good such as a commodity (oil, gas, gold, silver or copper) or an economic good such as electricity, water, or real estate, and so on. Since investors are interested in options as a means of pursuing certain financial and/or risk management objectives in their investment portfolios, this book will focus on options referencing financial assets, such as stocks and stock indexes. Rest assured that the principles underlying an option contract are universal. It is easy to take the concepts presented and apply them to other aspects of your economic life, be it the purchase or sale of real estate or the management of a business.

The terms and conditions of an option contract must be very precise. The contract defines when, how, and at what price the contract will be executed. For options on financial assets, there are a number of standard terms the buyer and seller must agree upon. Fortunately, options listed on exchanges have standardized terms. This makes financial options liquid and easy to trade. Once you know the basic standardized terms of an option contract, you are good to go. Firstly, an option contract will establish the price of a trade, if a transaction were to occur. A transaction only occurs, if and only if, the owner of the option choses to exercise their right to transact. When an owner of an option exercises their right to transact, they make the demand that the seller of the option perform to the terms and conditions of the option contract. When a contract is exercised, the obligation is fulfilled and the contract is terminated. The price at which a trade occurs is known as the strike price. The contract multiplier defines the amount of stock or commodity transacted under the option agreement. For options on equities, the contract multiplier is typically 100. This means that a single option contract references 100 shares of stock. As a result, when the owner of a call option on a stock exercises their right, the option seller must deliver 100 shares of stock. Options do not last forever. The contract will define the length of time an option will remain effective. Should the buyer choose to exercise their right under the option agreement and transact, the buyer must do so within this window of time. The date upon which an option expires is known as the expiration date. If the buyer of an option chooses not to exercise this right during the life of an option, it simply ceases to exist, and both parties go their merry way.

There are two basic types of options, puts and calls. The type of option the investors select to use is dependent on their investment goals and risk management objectives. Since there are millions of investors employing different strategies trading options, both types are actively traded in the financial markets every day. A call option is a bullish instrument. It gives the buyer the right, but not the obligation, to purchase the underlying instrument at a predetermined price. Investors buy call options with the expectation that the price of the underlying security will rise. The seller of a call does so with the expectation that the price of the underlying instrument will stagnate or fall. Investors might buy a call to manage risk as well. Investors who hold a short position on the underlying instrument, with the expectation the price of that asset will fall, are at risk the price will spike higher. Buying a call allows short sellers to limit their risk by allowing them to buy back their short position at a predefined price. A put option is a bearish instrument. It gives the buyer the right, but not the obligation, to sell the underlying instrument at a predefined price. Investors buy put options with the expectation that the price of the underlying instrument will fall. Like calls, puts can be used for hedging as well. If you are long the underlying stock, you might purchase a put option to limit losses should the price of that stock fall.

How Options Are Created, Extinguished, and Settled

Companies issue a fixed amount of stock, and those shares typically trade on an exchange. While options trade on exchanges much the same way stocks do, there is not a fixed amount of options outstanding. Options differ from stock in that they are created and destroyed as investors take positions during the normal course of trading. If Investor A wants to buy a call option on company XYZ, he instructs his broker to go to the exchange and find someone who wants to sell the same option. If he finds another investor or market maker, call her Investor B, who wants to sell that call with the same terms, and the two parties agree on a price, then a transaction takes place. Since Investor A does not own an option, he will “buy to open” a new position. If Investor B already owns the option she wants to sell, she will sell to close her current holding. In this process, an option is created and one is destroyed, and the total number of options outstanding does not change. If, on the other hand, there are no options outstanding or existing owners of the options do not want to sell, all is not lost. The broker finds a third party or market maker—call him Investor C, who wants to sell a call option he does not already own. Investor C writes a call option that does not currently exist and sells it to Investor A. Since Investor C does not own the option and is creating a new one, he sells to open a new position. Since Investor C sold something he did not own, he is now short an option. The writer of the option now has an obligation to perform against the option written should the buyer of that newly created option wish to exercise. Whenever an investor initiates a new long position while the writer simultaneously sells to open a new position, an option is created and open interest expands.

Just as an option is created when a willing buyer and writer are willing to transact, they can also be destroyed. While there is just one way to create an option, there are two ways for an option to be extinguished. If an owner—say, Investor B—of a call sells the existing position, she “sells to close.” This takes the option out of her portfolio. If Investor C on the other side of the trade wrote the option in question, he “buys to close.” This takes the short position out of his portfolio. With both sides of the agreement now terminated, the option no longer exists. Alternatively, the buyer of the call option can exercise the right to transact. The owner of the call informs the writer of the intention to exercise, and the writer must fulfill the obligation. The writer does so by selling stock to the owner of the call at the previously agreed upon strike price. Once the transaction is consummated, the terms of the option contract are fulfilled and the contract is extinguished. In the case of a put, the put owner could decide to exercise the right to sell at the agreed-on strike price. Once the writer fulfills the obligation to buy the put owner's stock, the option is extinguished.

To get a feel for the market interest and liquidity of a particular option, it is useful to know how many options are outstanding. One can observe how many options exist on exchange-traded options by examining the open interest. The open interest represents the total number of option contracts that are outstanding at any point in time. Open interest increases when options are created, and it falls when options are closed or exercised. The exchanges publish the open interest data for every stock, stock index, ETF, or any other asset underlying those options, parsed by strike price and expiration date.

There is another very important aspect to the mechanics of trading options. When trading a derivative instrument, investors make an agreement to perform some action in the future. In the case of a call option, the writer agrees to sell stock to the call buyer at a predetermined price, if the call buyer wants it. Within this arrangement, there is a risk that the writer may not fulfill their obligation due to financial distress or some other reason. The industry has addressed this risk by forming a nonprofit entity called the Options Clearing Corporation (OCC). The OCC regulates the trading of exchange-traded options and guarantees the performance of those contracts by standing between the buyer and seller of options. In this way, the OCC is the counterparty to all option contracts outstanding. The OCC is well capitalized and has strict collateral requirements investors must adhere to, if they want to write options. These collateral requirements ensure that the option seller will perform as promised. With this discipline, Standard and Poor's and Moody's rate the OCC AAA/Aaa respectively. This is an indication that the chances of a counterparty failure are immeasurably small. Since the OCC is financially strong and maintains an AAA credit rating, investors are assured the terms of their contract will always be fulfilled. If there were not a high-quality counterparty to all option transactions, investors who buy options would have to worry about the financial stability and reputation of their counterparties. Under these conditions, the value of options would be subject to the credit quality of the counterparty and liquidity would be suppressed, as investors would have to find creditworthy counterparties. By having the OCC as the counterparty for all transactions, investors can focus on the investment issues at hand and not counterparty risk. As an aside, financial institutions trade over the counter (OTC) between themselves when they need certain types of customized options. When executing these transactions, counterparty risk is an issue, and option buyers must do in-depth credit analysis to determine if the option writer has the wherewithal to perform as they promise.

Exercising an Option

Investors who trade options do so with the intention of speculating on the price of the underlying security or hedging an existing position. After a trade has matured as intended, the owner of an option has two choices. They can either sell their position at a gain or loss, or they can exercise the option. When call buyers exercise, they do so because they want to take delivery of the underlying instrument to add the position to their portfolio or to cover a short position. Most option traders close out their investment by selling their position prior to expiration. While the owner has the right to exercise, the option contract specifies when they can do so.

The exercise clause of an option contract comes in three basic forms, and they are referred to as the American, the European, and the Bermudan styles. In a European-style option, the owner of a call (put) can only exercise their right to buy (sell) the underlying security on the expiration date of the option. Option writers usually prefer to sell European options as this eliminates the surprise of having to deliver or buy stock when they might not be ready to do so.

At the other end or the spectrum is the American-style option. In an American-style option, the owner of an option has the right to exercise at any time on or before the expiration date. At the extreme, the owner can exercise an American-style option a split second after they buy it. Buyers of options tend to prefer American-style options as it gives them greater flexibility. Options always have value, so it is generally suboptimal to exercise early. There are rare occasions, however, when it is advantageous to do so. For example, a company might issue a large special dividend. Since the owner of a call does not have rights to the dividend, the owner must exercise a call and take delivery of the stock to get it. Since there is more flexibility in an American-style option, its value will always be as high as, or higher than, an equivalent European-style option.

In between the European- and American-style options is the...