Stock options allow more ways to earn money as well as more ways to lose money. They are elaborate financial instruments that often leave beginner and novice investors scratching their heads when something goes wrong.
1. Published by Moneycation™
Newsletter: May 2014
The maze of stock options
“Risk comes from not knowing what you are doing”
Warren Buffett
Stock options allow more ways to earn money as well as more ways to lose money. They are
elaborate financial instruments that often leave beginner and novice investors scratching their
heads when something goes wrong. The wide range of trading terminology, accurately evaluating
price against potential benefit and uncertainties of forecasting market movements make investing
in these derivatives more like a sophisticated financial dance with each misstep penalizing the
dancers untold amounts of wealth. By comparison, stock trading and investing are more like a 100
yard day trading sprint or a buy-and-hold equity marathon to a finish line. In other words, it takes
flawless execution, advanced skill and comprehensive knowledge to invest in stock options and
win. Nevertheless, navigating the stock options arena is not impossible, but is it worth the risk?
Nathaniel Popper of the New York Times says the following:
“...Academic research suggests that on the whole, options traders do worse than stock
traders, who, in turn, have been shown in many studies to underperform buy-and-hold
investors. The most comprehensive study looked at 68,000 Dutch retail investors. It found
that from 2000 to 2006, retail options traders lost an average of 4.5 percent each month,
while people who just traded stocks lost 1.6 percent.”
A good first question to ask before undertaking options investing is whether or not it fits individual
risk profile. If it does not, a simpler and less complex investment product may be more practical.
However, for the less risk averse, a series of hurdles or obstacles often stand in the way. For
instance, identifying and measuring the kinds of risk involved with options trading is fundamental
to understanding effective risk management. There are several potential pitfalls an investor will be
exposed to when buying or selling stock option contracts; a few of them are listed below:
• Mathematical risk
• Implementation risk
• Market risk
• Liquidity risk
• Knowledge risk
• Price risk
Accurately calculating the most probable outcome of a single stock option in terms of contract
2. price, ideal strike price and time related price decay is a task in and of itself. Even so, stock options
do have a three-fold advantage over traditional investing. Specifically, they have the potential for
lower capital investment and have two ways to earn via underlying stock price movement and the
trading of stock options contracts themselves. In other words, there is greater potential to earn
money if an investor knows how to use them properly.
When stock option contracts are combined with other contracts, stock option techniques are
implemented that attempt to manage risk and maximize gain at the lowest possible cost. This
involves evaluating stock option prices and measures of volatility, momentum, price change and
price sensitivity. These latter metrics are known as “The Greeks”, which include delta, theta, vega,
gamma and rho. Add to this a strong working knowledge of corporate financial statements,
economic assessment and market technical analysis and there is a better chance for financial
success with these financial instruments.
If the above is not a tall enough order, ensuring enough capital to cover naked positions prior to
and upon being exercised is another challenge if an investor decides to sell an uncovered stock
option. In addition, there is the actual act of buying and selling stock options, which involves
thoroughly understanding the trading platform or mechanism through which the contracts are
bought and sold. For example, selling a stock option is called “shorting” whereas buying a stock
option that's underlying stock price is expected to fall is known as a “put”. Infallible understanding
of options trading terms is important to consistent quality stock options trading. The duration of
stock options contracts also vary and this poses another set of risks in terms of pricing and
potential benefits.
So, stock options trading is risky due to the elaborate nature of the financial instruments. This is
not to say they can't be simply understood as much as it is to say, the room for trading error is
easier for brokerages to capitalize on and for investors to trip up on. At the root of any stock
options technique is the basic principle of individual stock, index and market direction; without
knowing that with a high level of probability, the risk of losing money also rises.
Risk management
Buying call options typically risks less capital than buying an equal amount of underlying stock.
For example, if Mr. Gonzalez buys 1,000 shares of XYZ Corporation at $100.00/share and the
price drops by 5% or $5, then Mr. Gonzalez has unrealized losses of $5,000. However, had he
purchased 10 stock option contracts, the only capital risked would be the premium for purchasing
call options.
Thus, in a less than certain bull market, stock options provide a form of capital preservation or risk
management. In addition, stock options contracts can be diversified in a similar way to stock. For
example, to diversify bullish positions, contracts across industries can be purchased to reduce risk
from investing in any one sector. Moreover, if market prices in the technology sector decline, but
those in the biopharmaceuticals industry do not, then purchasing stock option contracts in both
industries lowers risk.
3. Assignment
When writing call options, which are the option for the buyer to purchase X amount of shares at a
specific price, the option contract may or may not be assigned or exercised by a buyer. There is
more risk to writing call options if the stock price goes up than when buying call options. This is
because, selling a call could require the writer to sell the underlying stock at a price below market
value in order for the contract holder to benefit from the difference between market price and strike
price. This incurs a greater loss than letting a call option expire worthless. Thus, writing naked call
options is a greater bullish risk than buying call options. However, this risk can be mitigated by
purchasing call options near the strike price of an equal or similar amount of written call options.
In the case of put options, investors are able to hedge against underlying capital loss if they are
secured by equity positions. However, when selling naked puts there is a higher amount of risk, but
buying puts in the proper way can be used to mitigate risk if used properly.
Timing
Timing is another important element of risk management when investing in stock options. The
reason for this is that unlike stock, options have specific durations ranging from as short as a
month for up to three years in the case of long-term anticipation securities or LEAPS. LEAPS are
also a form of risk management as an investor has a much longer period to work within. In
reference to actual stock option contracts, the concept of time decay generally erodes the price.
Unless the contract price and its resale value increases, then a loss on an un-exercised stock option
is more likely. Also, the Options Industry Council states that in-the-money puts often have a higher
rate of time decay than in-the-money calls.
Costs
Trading options involves commission, premiums or transaction costs, capital losses, taxes on
capital gains and even dividend payments to brokers. That's four to five ways to lose money versus
the potential to gain money from premiums and capital gains. The house always has the advantage,
but the key to effective use of options is to know exactly what you are doing and why it will work
so that advantage is minimized.
A key cost to calculate is the break-even-point of an option contract. For call options this involves
subtracting the contract fee from the sale of stocks bought from an exercised contract's “strike
price”. For example, if Mrs. Smith buys 1 June contract of Coca Cola (KO) with a strike price of
$50 per share for a contract price of .45 x 100 or $45, the stock would have to reach $50.45 to
break even. Moreover, since selling below the strike price of $50 would be out-of-the-money, the
option buyer would lose the value of anything below that break even point. For instance, if the
strike price is $50, the buyer has the option to purchase 100 shares of KO at $50 even if the
underlying stock is valued at $49. This means the unrealized loss is $100 plus the $45 contract fee,
since selling the stock at $49 per share after buying them for $50 per share is a $1 per share loss.
However, since the option to buy does not have to be used, the only money lost would be the $45
contract fee plus any commission.
Prior to expiration, a call option contract's value may be higher than the benefit of selling at the
strike price. In such case, selling the contract rather than letting it expire or exercising it might be a
4. better choice, especially if the option holder does not have enough available money to exercise the
option. This scenario is more likely for in-the-money options. Depending on how in-the-money a
particular stock option's strike price is, the cost of contracts' resale varies.
In some situations, stock option investing only complicates risk management. For instance, in the
case of a bull call spread, a single or multiple call stock options are bought and the same amount
are sold at a higher strike price. While this does allow for leveraged capital investing and lower
upfront costs, the potential benefit is limited and elaborated to a point where the cost advantages
are outweighed by the time it takes to manage and research stock option positions. In other words,
there is sometimes opportunity cost that rises alongside the complexity of any trading technique.
Another cost associated with options trading includes dividends issued during a short-sale period.
Dividends issued by the corporation of the underlying stock are payable by the short-seller to the
broker. This requires stock option buyers to be fully aware of ex-dividend dates and dividend
increases during the time period in which shares have been lent to the short-seller. In the case of
special dividends, a seller is required to deliver the amount of the dividend when the written option
is exercised or assigned. The delivery of a special dividend after a contract is sold may be an
unexpected and costly surprise for the option writer. In addition to dividend cost risk, the broker or
lender of shares for short-sale can recall the shares at any time. If the price of the shares rise before
they are recalled, that's a loss. This represents an uncontrollable risk that may require enough cash
holdings during the short-sale duration, which is an added and potentially unseen opportunity cost.
Offsetting
Suppose the money for naked calls is not available when the option is assigned. This is a serious
problem for the writer. It can be mitigated however, via the purchase of an offsetting call or by
exercising an offsetting call that was purchased at a lower strike price.
Education
Before investing in options it is important to become very familiar with how it all works. Any hole
in individual investor knowledge is a financial weakness that is potentially exploitable by more
savvy investors, brokerages and financial institutions. It is wise to master the following before
engaging in options trading:
• Terminology
• Price forecasting
• Cost evaluation
• Stock option strategies
• Trading process
Trading terms
Trading terms are anything and everything involved in the trading process. They include words and
phrases such as “option chain”, “intrinsic value”, “buy to open” and “stop limit”. Not knowing
exactly what any particular term means when investing money can mean the difference between
5. knowledge and naivety. Trusting the process or trading platform to make decisions for you is a bad
idea as you must know with 100 percent certainty exactly what you are doing as that one word that
may seem irrelevant may be all that is needed for you to lose a lot of money.
Options terminology
In addition to trading terms are the terminology and metrics used in evaluating stock options. For
example, time decay, implied volatility and intrinsic value are all phrases that describe how much a
particular stock option contract is worth. Without understanding the meaning of these terms, an
investor is taking some risk when buying or selling a stock option contract.
The Greeks
Other important terminology used in options trading is known collectively as “the Greeks”. These
are mathematical principles that act and serve as evaluative metrics. In other words, the concepts of
Delta, Gamma, Theta, Vega and Rho help investors evaluate the chances of earning or losing
money when taking specific stock option positions. Understanding what these concepts are and
how to use them is fundamental to having a strong grip on the options trading process and
increasing the probability of success when investing using these financial instruments.
Delta: According to the Nasdaq Stock Exchange, the delta is “the percentage an option will
decrease in value in relation to the price of the underlying stock.” Thus, he higher the delta, the
better the option will match the underlying stock price. Delta is not a fixed value per Trade King;
this is because it changes as the option contract nears expiration and is also linked to the
underlying stock price.
Gamma: Gamma measures how much delta will change. Moreover, while one option may move
from 60% to 50%, another may move from 60% to 40%. Gamma is the calculation that determines
how much an options price will change in proportion to the stock it represents.
Theta: Theta is more specific than Gamma because it measures the amount a stock options price
will deteriorate in relation to its expiration date. In other words, the closer the contract gets to
expiry, the lower the price becomes and Gamma measure the rate at which it lowers. So, a slow
rate of option decay is better than a higher rate.
Vega: Stock option prices are also influenced by the volatility of an underlying stock. Vega
measures how much that volatility will affect price.
Rho: Another variable that influences stock option prices is interest. Rho is a metric that
determines how much a specific stock option's interest rate will influence its price. It is essentially
an interest rate calculation.
To avoid having to calculate all these values by hand, a stock options calculator is helpful. These
calculators can be found for free on the web. One example calculator is Interactive Brokers' stock
options calculator, a link to which is available in the sources section of this newsletter. The Options
Industry Council is also a useful resource and provides a wealth of free information that is
beneficial to those seeking to learn more about options trading. Their free options education
6. program consists of five core levels or mini-courses, each of which has its own lessons with
chapters. There is also a free Virtual Trading System or VTS that simulates the options investment
process and allows investors to practice before investing real dollars in the real world. Similar to
actual brokerage accounts, an approval process is required to make anything other than standard
stock trades using the OIC simulator.
Calculations
In addition to making use of the previous metrics, several additional pricing and profit calculations
are used in options trading. Some of the following calculations are elaborated upon at the Options
Industry Council's online educational program, which helps assess, familiarize and advance
knowledge of options trading. Understanding the meaning of each of the terms prior to making the
calculations helps ensure the best understanding and accuracy of the input and output numbers.
• Break-even profit: Strike price – premium
• Intrinsic call option value: Stock price – strike price
• Intrinsic put option value: Strike price – stock price
• Long call profit: (Intrinsic value – premium) x 100 contract size
• Time value: Total premium – intrinsic value
• Total premium: Intrinsic value + time value
• Put option profit at expiration: Intrinsic value (strike price-stock price) - contract price (Put
price x contract multiplier)
Writing vs. buying options
There are two fundamental ways to make use of stock options. One is to create the stock option by
writing or selling a contract, and the second method is to buy a stock option. Each has its
advantages and disadvantages and both methods can be implemented alongside each other to
reduce risk or hedge positions. Stock options are also tradeable financial instruments in and of
themselves. This means investors can earn or lose money by trading the derivatives without having
to purchase stock. For instance, when share prices for a call option rise, the price of that call option
also rises. This means the investor can sell the call option itself prior to its expiration to earn a
profit. An example of an advantage and disadvantage of each approach to stock options is
described below:
Advantages
If the underlying shares of a company are held by an investor, the potential benefit of holding those
shares can be increased by buying a call option or selling a put option. For example, Mr. Jones
owns 100 shares of Coca Cola (KO) that he paid $42.00/share for, and he writes a single stock put
option, which is the option to sell at a specific price. Since Mr. Jones expects the price of KO to
rise, the put option he has sold may expire “out of the money”, since the buyer of the put will not
make money by exercising the put, he or she loses the premium or contract cost and Mr. Jones
keeps the premium.
7. Depending on the kind of option contract, the financial benefit will vary. Moreover, if Mr. Jones
writes a call option with a strike price of $42.00 per share and he bought the shares for $42.00 per
share; this is a “covered call” because the call option is covered by the actual shares bought.
However, if the option Mr. Jones sold is exercised when the market price of KO is $45 per share ,
then Mr. Jones keeps the premium, but loses the capital appreciation from the underlying stock i.e.
he sells his 100 shares of KO for $42 per share to the option holder for zero profit on the stock.
This transaction demonstrates the insurance value covered calls that are in-the-money have.
Disadvantages
If the share price of Coca Cola goes below $42.00 per share, Mr. Jones incurs an opportunity cost
from not investing his money in a stock or other financial instrument that appreciates in value.
Nevertheless, the contract fee from writing a call option does help mitigate this risk by protecting
against downside loss; dividends also serve a similar function. In the case of naked options, there is
no opportunity cost because money is not invested in underlying stock. However, there is a
substantially more risk if Mr. Jones sells a naked option as he may have topurchase shares at the
market price in order to sell them at the strike price. In such case, the difference may far exceed the
financial benefit of an option contract fee.
Current conditions
Economic and market conditions are also important when evaluating which stock options to buy or
sell. To illustrate, as of the publishing of this newsletter, the monetary stimulus of the Federal
Reserve Bank's asset purchasing program via open market operations has subsided and is expected
to continue to decrease, yet interbank interest rates remain low. However, average 30-yr mortgage
rates have risen approximately 1% over the last year and the housing market is showing signs of
slowing. Economic growth in Q1 was close to zero amid a low inflationary environment, but
economists forecast positive growth going forward. Manufacturing activity is growing slowly per
purchasing managers index data, and actual unemployment and underemployment remains
elevated. So what is a good stock options trading strategy going in to the second half of 2014 or
any other time period? That all depends on how accurate a stock market forecast can be produced.
No matter how well implemented a stock option strategy is, if the market goes a direction that is
not intended or not profitable, then there is little or no financial benefit. A few additional factors to
consider are described as follows:
Federal spending and GDP growth
Another thing to look at is whether or not an increase in national U.S. gross domestic product will
take place during the period for which stock options are invested in. Currently, an important
variable to account for is the decrease in Federal Reserve asset purchases. For instance, if total
economic stimulus for 2013 was $1.01 trillion and total GDP increase was $1.57 trillion, then the
total is $2.58 trillion assuming the two are 100 percent mutually exclusive within GDP calculation.
In 2014, stimulus spending may total approximately $400 billion, so the economy would have to
grow by closer to $2 trillion to make up the difference. If GDP increases by 2 percent in 2014, then
the total annual GDP growth will be closer to $1.6 trillion, still short of the $2 trillion of the 2013
combined stimulus and GDP growth. That's one way of looking at it.
8. Corporate financial fundamentals
Another way of viewing the market is in terms of corporate fundamentals. Are companies listed in
the U.S. stock exchange forecast to experience higher revenue and earnings regardless of analysts
estimates? Analysts estimates are not, or should not be the only or ultimate benchmark for
forecasting stock price based on fundamental financial data; this is partly because they are once
removed from it. Some companies will most likely experience higher revenue and earnings growth,
but others will not. Independent of broader market trends such as the secular bull market, a stock
market correction or the beginning of a bear market, those companies with better forecasts are
more likely to experience share prices rises if they are not already overvalued.
Market trends
The saying “The trend is your friend” is driven by momentum or a kind of market inertia. At
present, the secular bull market has been in effect for some time and that was heavily influenced by
Federal Reserve Bank asset purchases. Since that momentum is waning, the bull market faces a
headwind it did not previously have. The Federal Reserve Bank stimulus provided a wealth effect
in the form of higher 401(k), IRA and other pension values in addition to regular stock accounts. In
turn, consumer spending, which is a large part of economic activity, was probably influenced by
the wealth effect of Federal Reserve stimulus. So that leaves job growth, wage increases and
possibly even inflation to drive consumer spending going forward. Corporations rely on consumer
spending for revenue and profit margin. Domestic companies may consequently have a less rosy
forecast than multi-national corporations that benefit from offshore tax strategies and market
positioning in emerging markets with growing economies.
Techniques
The Options Industry Council recommends first establishing a goal before choosing a stock options
strategy. There are numerous goals that these financial instruments assist with, a few of these are
listed below:
• Position hedging
• Income generation
• Long-term growth
• Stock accumulation
• Investment diversification
Stock options trading strategies form a core part of some investment plans. Since the elaborate
nature of stock options provides more opportunity to make mistakes and lose money, simple
investing techniques are sometimes the better choice, especially for those investors who are not
thoroughly familiar with stock options. Nevertheless, stock options are a financial instrument that
do provide an opportunity to build personal wealth if they are used correctly and provided the right
investing strategy is used. There are several strategies to use with different market forecasts and
risk protection.
Numerous factors influence the decision about which strategy use. After having decided if stock
9. options are a good choice and before investing in them, evaluating which strategy to use is
essential to optimizing the probability of financial success using these financial instruments. Below
are some of the factors that affect the price of underlying stocks and consequently the effectiveness
of any particular stock option method:
• Economic conditions
• Market valuations
• Business cycles
• Corporate fundamentals
• Stock options pricing
There are over 40 stock options strategies or trade positions to choose from. These can be divided
in to bullish, bearish and neutral in terms of market forecasting. For any stock options technique to
work, the underlying accuracy of projected market pricing should be strong, and the cost
calculations and contract metrics should be well defined and carefully evaluated prior to purchase.
Below are a few of the stock option positions and techniques that can be implemented when
market direction is known.
Stock option, cash backed and protected positions
Bullish Neutral Bearish
Long stock Covered call Short stock
Long call Naked call Naked call
Synthetic long stock Naked put Long put
Protective put Cash secured put Short stock
Cash secured put Covered put
Cash backed call Covered call
Naked put Index puts
Stock option trading techniques
Bullish Neutral Bearish
Bull put spread Butterfly Bear call spread
Bull call spread Straddle Bear put spread
Collar Strangle Long butterfly
Synthetic long stock Short butterfly
Synthetic long put
Synthetic short stock
Source: WikiBooks; CC BY-SA 3.0
Cash secured put
Bullish methods
If an investor expects the market to rise, then a bull market strategy is appropriate. Call options are
bullish, but apart from that basic understanding, there are several ways to take advantage of an
upward moving market using stock options. Some key bullish strategies are as follows:
10. Protective put: This is for the cautious bull looking for short-term downside protection. By
purchasing a put option and holding a long stock position, the effect becomes a stop loss on the
long position. The cost of hedging the long position requires a greater upside to price movement to
recoup that expense and secure a capital gain.
Cash secured call: Securing cash in order to exercise a call option should prices rise above the
strike price makes sense if stocks are looking bullish. Otherwise, the cost of the option is lost on a
flat or declining priced stock.
Covered call: A covered call is similar to cash secured call with the exceptions being that a call
option is written rather than purchased and that underlying stock are already purchased. The
advantage of this is that the stock owner earns extra money from the call option fee or premium.
Moreover, should the stock price drop a little, writing the option helps limit the total loss.
Bull call spread: A bull call spread involves buying a call option and selling another at a higher
strike price. It is bullish because the first option makes money if the stock price moves up above
the strike price and the second earns a premium upfront but has a higher strike price requiring it to
climb higher in price to become in-the-money. The bull call spread can be implemented by shorting
a call instead of selling a call. Profit and loss are limited with this method, which makes it a safer
spread to use.
Bull Call Spread
Source: Suicup, GFDL, CC BY-SA 2.0
Neutral methods
Neutral stock options strategies are used when stocks are expected to be volatile or flat, especially
in the short-term. Ideal neutral strategies minimize risk and maximize probability of potential gain
rather than just potential gain.
Bear call spread: This method is for the option writer who believes stock prices will remain low.
The potential loss is limited to the difference between stock sold and purchased at two different
strike prices and the potential gain is limited to the stock option premium.
11. Long straddle: If stock prices are expected to jostle up or down, the long straddle provides limited
risk with unlimited potential gain. The only loss incurred using this method is the loss of premium
should either of two options, one call and one put, expire un-exercised.
Long ratio call spread: This is an attractive method because of the potential upside gain and low
risk. Properly implementing this technique requires a little math to ensure that three separate stock
options are properly priced with the right expirations and strike prices. The goal of this method is
to benefit from an upward movement in stock price.
Bearish methods
Bear call spread: A bear call spread involves two call options, one bought at a higher strike price,
and another sold at a lower strike price. Since the premium is higher for an option that is closer to
being in-the-money, it is a credit spread since the benefit is front loaded. Since the spread limits
potential loss, this is a relatively safe bearish options trading technique with limited upside gain.
Bear put spread: A bear put spread is also called a “debit spread” because the transaction is front
loaded via a higher up front premium. This is because the purchased put has a higher strike price
than the sold put. In other words, the right to sell at a higher price costs more than the premium
received from selling the right to sell at a lower price. Bear put spreads reduce risk of capital loss,
but also limit potential gain.
Bear put spread
Source: Suicup, GFDL, CC BY-SA 3.0
Index puts: Index puts are options against an index or group of stock rather than just a single
corporate stock. They are also settled in cash, but are otherwise similar to regular puts. These are a
bet that market prices will drop below the strike price allowing the buyer to profit from the
difference between the strike price and the market price of the index.
If the above are not confusing enough, Stock options trading techniques get even more complicated
via methods such as the iron condor, double diagonal, calender call spread and short ratio bull
spread.That is not to say these methods of allocating capital or buying and selling financial