Time & Price: Fundamentals of Options Trading

Time is money!

This basic idea lies at the root of options trading. Unlike stocks, which have no real time value, options have a value that is always changing with time. In this Fundamentals class, we explore the nature of options, determined how options are priced, describe how the value of options changes over time, and consider how time is priced in the options market.

First Things First

But first, what is an option? Options are financial instruments that guarantee you the right--but not the obligation--to buy or sell stock (or something else) for a fixed price within a limited time period. They are used in commerce, real estate, and many financial markets such as currencies, commodities and stocks. People use options for many things: to secure property, to secure contracts, to tie up assets for a period of time, or to obtain insurance against loss on purchases. There are two basic kinds:

CALL option the right to BUY at a fixed price within a limited period
PUT option the right to SELL at a fixed price within a limited period

We teach how to trade stock options profitably, although many of the techniques can be applied to these other kinds of markets. In the USA, we American-style options, which can traded or exercised any time up to expiration, not European-style options which can only be exercised one time, at expiration.

Buyers and Sellers of Options

Options buyers obtain control or rights over something for a limited period of time, at an agreed price. A land developer might buy an option on an attractive piece of land to prevent a competitor from obtaining it. Publishing companies or movie producers will purchase options on scripts, hoping to attract money and produce the book or film. These would be a kind of Call options.

Owners of CALLS have the right to purchase stock (but not the obligation)
Owners of PUTS have the right to sell stock (but not the obligation).

Option sellers or "writers" receive money from buyers, and manage their portfolios to avoid having to meet the obligations brought to them by the holders of the options. If this sounds familiar, you may be thinking of your health insurance company, which collects premiums from subscribers and then delays payment. In this case, the insurance company is selling and you are buying protection (Put option) against potential medical expenses, one month at a time. Once the month is up, your insurance premium expires worthless and the company keeps the money. Then you have to buy more insurance to maintain coverage. These are Put-style instruments you are buying from the insurance company, who is the Seller. The whole insurance industry is based on these principles. In another example, a real estate brokerage might enter into a contract securing the right to sell a property they don't own, at market price. This would be a kind of Put option.

Writers/sellers of PUTS have the obligation to purchase stocks
Writers/sellers of CALLS have the obligation to sell stocks.

What are stock options?

Stock options are derivatives of stocks, meaning they are fruits on the tree of particular stocks or stock indexes. There are about 3,700 stocks in the USA market which issue options, and new ones are being issued every week. Many of these will be familiar: Apple, IBM, Priceline, Ford Motors, Facebook, General Electric, Coca Cola, Boeing, American Express, Halliburton. Each contract is worth 100 shares of stock. People make money trading options on stocks just like an orchardist would make money with the fruit on the trees--without selling the trees!

At any time, hundreds of options may be available on each underlying stock, with expirations ranging from a week to a month to a couple of years. They are created according to a schedule and expire weekly, monthly, quarterly or yearly.

Pricing of Options

Options are available at specific price levels known as "strikes" (agreed-upon price), which are simply levels agreed on by a company in consultation with an exchange such as the Chicago Board Options Exchange (CBOE). Option traders use strikes to determine distances from the current price. They can be as narrow as .50 cents and as wide as $20. Strikes which are at-the-money or near the current stock price are almost always closer together.

Here are some recent strikes for SPY (Index of Standard & Poors 500 stocks)

245 246 247 248 249 250 251 252

On the thinkorswim platform, the strikes for any series of options can be found in the center of the Trade/All Products/Underlying. Here is the Option Chain for AMZN expiring November 24, 2017, and showing the price at about $1130.

The location of the strike in relation to the stock price has a dramatic effect on the value of an option. As prices go down, Puts become more valuable. As prices rise, Calls increase in value. This is regardless of the amount of time left to expiration. Notice that the strikes are listed with lowest available strikes at the top. The higher we get from the current price, the cheaper a Call options will be. For example, in the screenshot for AMZN above, the asking price (Ask) for the $1130 Call option is $9.00, the $1132.5 is option worth $8.25 and the 135 is worth $6.80. Similarly, for Puts, the lower the strike, the cheaper the option will be.

The whole display for any expiration is called an option chain. The strikes closest to the current price are the most actively traded. In the example above, notice that the lower priced Call options have lower Volume. Each strike is assigned a value by the computers, based on supply and demand for that particular price. Bid and Ask prices are displayed on the screen, showing the range under negotiation by buyers and sellers.

Sales are negotiated between buyers and sellers via internet-based platforms which place and fill orders. All trading activity is subject to the conditions and permissions of the brokerage houses which collect and distribute profits and losses on each trade.

The cost of an option is called premium. Thus is amount paid by a Buyer to a Seller. We prefer to be Sellers of options than buyers, and use techniques that allow us to be paid our profit upfront rather than waiting.

ATM, ITM, OTM

Moment by moment, the price of the stock affects the values of options. For convenience, we think of three price ranges. If the current price of AMZN is 1129.88, then it is “close to” the 1130 strike, but not very close to the 1100 or 1200 strikes. Those closest to the actual price are called “At The Money” and those further away are either “In The Money” or “Out of The Money”. These three price range have specific definitions.

ATM (At the Money)-- referring to the options Put or Call strikes which are closest to the current price. E.g. if the stock price is $331, then the 330 strike is ATM.
ITM (In the money)--refers to Calls which are BELOW the current price, and Puts which are ABOVE. If the price is $144, then the 125, 130, 135 Calls are ITM, and 145, 150 and 155 Puts are ITM.
OTM (Out of the money)--refers to Calls ABOVE the current price and Puts BELOW the current price. If stock is at $99, then 95, 90 and 85 Puts are OTM. Likewise, 100, 105 and 110 Calls are OTM.

HOMEWORK:

Q: In the SPY example above, if the current price of SPY is 248.75, and strikes are all $1 wide, then what is the ATM Call option? What is the option that is 3 strikes OTM? What is the first OTM Put option?

What goes into the price of an option?

So far, we have considered the price of an option as a whole, However, when the computers calculate the value of an option, they consider four things:

Time ... the more time covered by an option, the more expensive it is.
Intrinsic value ... the more ITM it is, the more expensive it is.
Volatility ... the more volatile the stock or the overall market, the more expensive its options are.
Interest rates ... not an important factor these days, and we will ignore it.

Options and Time Value

Time is a very important part of the price of both Puts and Calls. The amount is measured by the distance from today's date to the the moment of expiration (not from generation). This is part of the extrinsic value of an option. The amount of time involved is reflected in the price, in dollars and cents. The more time, the higher the price for the option.

Options decay in value over time. Once we know when options arise and expire, we are ready to consider what happens to them in the meanwhile. The simple answer is, premium slowly decays in value. timedecay Options are usually worth the most the moment they are first generated. About 70% of all options, both Puts and Calls, expire worthless! This means that, as each day passes. they are worth a little bit less. For most options, this is cents per day, but can be many dollars overall. The drop in value is very gradual at first, as an option with 23 days to expiration is worth almost as much as one with 24 days to expiration. But one with only two days to expiration will be worth a lot less than one with three or four days to go. The actual values can be plotted as an exponential equation on a graph. You will recognize a similar graph as part of our official logo.

So the loss in value of options over time is known as theta. (More about that in a later blog.) We have spoken about time, so let’s consider the other non-time elements in the option price.

Intrinsic and Extrinsic Values

An OTM option has only extrinsic value. But \an option which is ITM has some intrinsic value. You need to count strikes to know the intrinsic value. For example, with the price of AAPL at exactly $115, an 100 strike Call will have $15 of intrinsic value, plus some extrinsic value based on time, for a total of $17. To calculate its strike or “intrinsic” value we simply subtract the strike from the stock price:

Current Price minus Strike of the Option = Current Value

153 - 150 = 3 on a Call

17.50 - 19 = - 1.50 on a Put

For Calls this will always be a positive number, and for Puts a negative number. So, for the AAPL example, we can easily calculate the intrinsic value of the 100 Call and say “$15 in the money”. That means it has $15 of intrinsic value. On the other hand, the 115 Call is “at the money" and has some extrinsic value (based on time and volatility) but zero intrinsic value. Using the same formula for Puts, a 120 Put would have $5 of intrinsic value.

ACTION: Open your TOS platform and locate the "Trade" Tab. Enter the symbol for SPY. Note the exact current price of SPY. Choose the options chain for the next available monthly expiration (white--not the yellow "weeklies" and it will NOT say "weeklies"). Make sure that under SPREAD it says "Single". Look in the middle of the page and find the strike numbers. Locate the Strike closest to the current price. You will note the colors divide (maybe purple or colored for in-the-money and black or white for out-of-the-money strikes). Write down the following prices:

Calls: find the "Ask" price of Calls for the closest ATM strike, for one strike OTM, and for 5 strikes ITM.
Puts: find the "Ask" price of the ATM strike, for two strikes OTM, and 3 strikes ITM.

Repeat the process for one or two other common stocks such as AAPL, AMZN or BIIB

ACTION: Locate the option chains for the SPY for next week. Take the asking price of any deep ITM Call and calculate how much of it is intrinsic, and how much extrinsic. (The formula for the intrinsic value is above.) D0 the same for one other your stock options examples (e.g. AAPL, AMZN or BIIB).

So let’s now look at some of other important things that can be known about stock options.

Implied Volatility, the third element of price, is the expected portion of the options price based on the up and down motion of the underlying stock. If the stock barely moves, the options will reflect a small “implied volatility”. If the stock moves up and down dramatically, the perceived risk is much greater, and so options prices will increase to reflect this increased unpredictability. This is also part of the extrinsic value of an option.

In addition, volatility goes up and down in regular ways, so we can expect option premiums to be higher at certain times than others. (We will spend a whole chapter on this aspect of volatility because it is an important ingredient in the HOT Trading System.)

The Options Life Cycle

Options have a beginning and an end. Its only natural to ask, Where do options come from? The answer is that they are issued by The Options Clearing Corporation (OCC) in consultation with the company underlying the stock, marketed through the Chicago Board Options Exchange (CBOE), and legally regulated by the Securities and Exchange Commission. Options are then placed electronically into the market and made available to traders through brokerage houses such as Fidelity, OptionsExpress or TDAmeritrade. Options for each stock are published and appear on trading platforms as soon as available. The monthlies appear several months in advance on the Monday morning following any expiration date. You can begin trading them within market hours as soon as they appear.

Which brings us to the topic of expiration dates. All Put and Call options have limited shelf life. They may be good for a week, month, or more than year, but sooner or later, they expire. American style options—the only ones we trade—have expirations as follows….

Expirations

Weeklies Close of trading each Friday* or other mid-week day
Monthlies Close of trading third Friday of each month
Quarterlies Close of trading third Friday or last day of third month for each quarter
LEAPS Close of trading third Friday of expiration month

(*Unless that day is a public holiday, in which case expiration falls on the previous day. There are also some options which expire on other days such as Tuesday or Thursday.)

What happens to your options at expiration depends on their final worth. Any options that are ITM by one cent or more will be converted into stock by the brokerage firm, and any OTM options will expire worthless. You can prevent this conversion or assignment of stock by selling off the option anytime before expiration.

[You can skip this next paragraph if you wish.]

The CBOE has a schedule for issuing standard options. This next part is a little complicated as it describes how you can find upcoming options months for particular stocks. (You can skip this paragraph if you wish.) Click Monthly Cycles or go to https://www.cboe.com/TradTool/strikepricecode.aspx . There you will see Cycle guides 1, 2, and 3. A list of "front months" refers to the next expiring monthly options. For January, look at the first line where you will see FEB (in caps), then Apr and July. This means that if January is the current month, then there are options available for Feb, Apr and July. FEB is the most recently added. Each new month added has either 2 or 8 months until expiration. Each new front month appears on the Monday morning after the most monthly recent expiration. Next go to this list at the CBOE which contains every stock and determine which Cycle it belongs to. For example, AAPL and ISRG go by Cycle 1, TUMI goes by Cycle 2, and TSLA and TWTR are Cycle 3.

Front Month Options The next "regular" monthly option is called the front month. If it is early January, before the third Friday, the front month is still January, but if it is now late January, the front month will be February.

Weeklies, Quarterlies and LEAPS Options come out for many stocks each week, quarter and year. On TOS, options expiring weekly show up in yellow. Most expire on Fridays, but an increasing number of mid-week options are being offered on the SPY and other major indexes. You can find currently available weeklies at the CBOE site http://www.cboe.com/micro/weeklys/availableweeklys.aspx

You can see the Calendar of options expirations on the CBOE site http://www.cboe.com/AboutCBOE/xcal2014.pdf

To find the cycles for the Weeklies, Quarterlies and LEAPS go to https://www.cboe.com/TradTool/Symbols/SymbolDirectory.asp

A Recent Example

When the huge Chinese internet company Alibaba (BABA) went public, it had no options. But within a week or two, the CBOE had established an expected price range range for the stock and announced that options would be available on Monday Sep 29, 2014. http://ir.cboe.com/press-releases/2014/sep-16-2014.aspx Today, in the screenshot here, you can find the options chain for BABA on TOS, including weeklies, monthlies and LEAPS all the way out to 2018 and beyond.

ACTION: Using SPY and the same stock symbols as before, locate the furthest out LEAPS for each of three stocks. Does it any have quarterlies? How can you tell the difference between a weekly and a monthly option?

It is better to sell options than buy them.

If options decay over time, starting from their first issue to their expiration, then sellers have an advantage. Buyers of options have time against them, as the decay leaches away profits, but that same leached amount goes to the seller. This is also a core idea for the HOT trading system. We will be covering the strategies and tools for this in a few weeks.

So that’s scoop on Options--what they are, and how to price them--and Time--how it is measured and affects the value of options--in options trading. I will be editing and updating this page in response to questions asked in class, so come back again and re-read it.

Finally, everyone who opens an account and trades should receive and read a booklet entitled Characteristics and Risks of Standardized Options, including the January 2012 Supplement, supplied by their brokerage company. Also available online at http://www.optionsclearing.com/components/docs/riskstoc.pdf

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So now here's your review and homework. Time 1-1.5 hours.

1. Make a list of the key terms in this blog, and write out their definitions. If you are unsure of a meaning of a term, go to Investopedia or check with your text book.

2. Complete the ACTION steps above, located in green.

3. Take the short quiz below. Compare you answers with your buddy or others if you want to. If you think you might have missed an answer, go back over the notes above. [May not be visible on all platforms.]

See you in class!

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