Inside Online Investing: A Stockbroker Tells You What You Really Need to Know

From Chapter 12 – How to Trade Options

What Are Options?

In this chapter, we are referring only to standardized, exchange traded options on shares of common stock, although later we’ll discuss options on market indices. We are not talking about things like employee stock options. An option is a contract that gives its owner the right, but not the obligation, to buy or sell shares of a certain stock at a certain price within a certain time. The stock in question is called the underlying security. Options are traded on about 1,500 stocks. All the terms of each option contract are determined ahead of time. These financial instruments are traded on exchanges, and they are standardized, which means the terms of each contract are kind of cookie-cutter in that they are identical in many ways. That makes them much easier to work with, because we have a very good idea what the variables will be (at least most of the time).

There are five exchanges that trade options. The leading exchange is the Chicago Board Options Exchange (the CBOE, pronounced SEE-bo) which first started traded them in standardized form in 1973. The American, Philadelphia and Pacific stock exchanges also trade options. There is also an all-electronic options exchange called the International Securities Exchange (ISE).

I mentioned that an option gives your the right to buy or sell something. Since there are two actions you can possibly take, there are two types of options:

Calls – Call options give the person who owns them the right to buy shares at a pre-determined price. The call owner can “call shares away” from someone else.
Puts – Put options give the person who owns them the right to sell shares at a pre-determined price. The put owner can “put shares to” someone else.

Contract Specifications

Options are traded in units called contracts, and the minimum investment size is one contract. This makes sense because an option is a binding contract, where one person pays another, who in turn must live up to the terms of that contract when asked. To make the exchange function smoothly, each contract adheres to certain standards.

Size:

Each contract is the right to buy or sell a specific number of shares. The standard option contract covers 100 shares, although there are exceptions.

Date:

Each option contract is only good for a limited period of time, and each contract has an expiration date. Once the expiration date has passed, the option no longer exists. All standardized options expire on the Saturday following the third Friday of the month. As each one expires it’s replaced by a new option according to a set schedule. Every option is dated by the month of expiration, so we say that there are options with expirations in January, February, May, August, etc.

Standard options have expiration dates anywhere from one to nine months forward. At each expiration cycle, the exchange creates new contracts to continually carry the available expiration dates forward. There are always option contracts set to expire in the “current” month (the next time the third Saturday of the month comes up) and in the month after that. After that, each stock has options that expire every three months up to nine months out, depending on a cycle assigned by the options exchange. A stock is assigned to one of three groups. Group One has options that expire on January, April, July and October. Group Two options expire in February, May, August and November. Group Three has expirations in March, June, September and December.

Let’s say it’s the last week of March; the third Saturday has just passed and the March contracts have expired. On Monday, the exchange will create new options that expire in April (the month with the next expiration Saturday) and in May (the month following) assuming that these contracts did not already exist. Any stocks assigned to Group One will already have options with April expirations, and stocks assigned to Group Two will already have options that expire in May. Since stocks assigned to Group Three have their regular March options already come and gone, the exchange will look out nine months forward and begin offering December expiration options. Very important: although options expire on Saturday, the last day to trade or exercise them (more on that later) is the third Friday of the month (or the preceding Thursday if Friday is a holiday) at a cutoff time established by your brokerage firm. Find out what that time is! Don’t call late on Friday thinking you’ve got an extra day.

Price:

Lastly, each option contract specifies the predetermined exercise price or strike price (we can use these terms interchangeably) that its owner has the right to buy or sell at. This simply says “I have the right to buy or sell for $X”. The exchanges create a series of options with strike prices set at regular intervals. A stock trading around $53 will certainly have options available at $50 and $55, and likely at $45 and $60. The more volatile the stock’s price has been, the more strike prices will be issued. Strike prices can be set as low as $5, and then go up in $2.50 in-crements; so they can start at $5, then $7.50, $10, $12.50, etc. up to $25. After that, they go in $5 increments ($25, $30, $35, $40, etc.) up until $200. The most actively traded options may have strike prices at $27.50 and $32.50 but those are rare. After $200, strike prices go in $10 increments.

An option might be immediately profitable, depending on the exercise price compared with the underlying stock’s current market price. Let’s consider a stock trading at $35. Someone who holds a call option with a $30 strike price can buy the stock at $30 and then sell it at $35 for an immediate $5 profit. Someone who holds a put option with a $40 strike price can buy the stock at $35 and exercise the right to sell at $40, also for a $5 profit.

An option with an immediately profitable strike price is said to be in the money. If the option is still unprofitable then it’s out of the money. On those rare occasions when the strike price and the stock price are equal, the option is at the money. Call options go in the money when the stock rises above the strike price. Put options go in the money when the stock price falls below the strike price. This chart can help you figure which one’s which.

Option type

In the money

Out of the money

Call

Stock price above strike price

Stock price below strike price

Put

Stock price below strike price

Stock price above strike price

The Parties Involved

Like any transaction, the process of options trading involves at least two people – one person has to buy the option, another has to sell it. Not too surprising, but they aren’t trading an asset per se; they are trading ownership rights to an asset. Let’s review the role, rights and obligations of each person:

The option buyer, also called the holder, pays a premium to the seller. In return for this payment, the buyer gets the right, but not the obligation, to buy or sell a specified number of shares at a predetermined price within a predetermined time. Instead of buying the stock outright, he buys rights to the stock for a fraction of what the stock would cost. The buyer takes the risk that his option position will be profitable by the time the contract expires. The buyer also has the potential for a very significant return on investment. The buyer has the right and may decide to exercise his option at any time.

The option seller, also called the writer, receives payment from the buyer. In exchange for receiving a premium, the option writer has the obligation to live up to the terms of the contract when and if demanded by the option buyer. When the call writer is exercised, he is obligated to deliver shares since the buyer has the right to buy from him. When the put writer is exercised, he is obligated to deliver cash since the buyer has the right to sell to him.

Here’s a summary of the differences between option holders and writers, and the corresponding opening and closing transactions:

Option Holder
Buys the right to buy or sell a stock at a certain price within a certain time
Pays a cash premium to the option writer
Owns an asset which adds to the value of his or her portfolio, and is said to be “long” the option
Can buy an option to speculate on the direction of the stock, or to hedge against an unexpected loss
Creates the long position by “buying to open”
Closes the position by “selling to close”
Option Writer
Has the obligation to buy or sell a stock at a certain price within a certain time if the option buyer exercises his or her option
Receives a cash premium from the buyer
Has a liability which is subtracted from the value of his or her portfolio, and is said to be “short” the option
Writes (sells) the option to generate income or to speculate on the direction of the stock
Creates the short position by “selling to open”
Closes the position by “buying to close”

Income Producing Strategies – Covered Calls

If you own at least 100 shares of a stock that trades options, you can write covered calls to generate income and lower your cost basis.

In a covered call writing strategy you agree to sell your shares at a pre-determined price within a specified time frame. In exchange for which, you receive a cash premium. Here’s how it works. Let’s say you buy 100 shares of stock at $39.35. You also sell the right to buy that stock from you at $45 anytime over the next three months. A three-month call option with a $45 strike price is bid at $.90. By selling a covered call, you will receive 90 cents per share, times 100 shares per contract that comes to $90 cash in pocket. If the stock is still below $45 in three months when the option expires, you keep the 90-cent premium. If it’s trading above $45, the stock will get called away from you and you’ll sell it at $45 as per the terms of the contract. Of course you still get to keep the 90 cents.

Let’s run the numbers so we can see clearly what’s going on.

Buy 100 shares @ $39.35 ($3,935.00)

Sell 1 3-mo. $45 call @ $.90 $ 90.00

Total cost ($3,845.00)

Covered call writing reduces your out-of-pocket cost, and therefore reduces your risk. In this scenario, your cost is $38.45 a share instead of $39.35, and you still have a profit as long as the stock stays above $38.45. So covered call writing has lowered your break-even point, the price point where you go from losing money to making money. However, the investor has agreed to sell the stock at $45, and that’s the most he can get while the option is in force. The maximum gain, therefore is the difference between the purchase price and the exercise price, plus premium received. Here’s what happens if the option is exercised.

Buy 100 shares @ $39.35 ($3,935.00)

Sell 1 3-mo. $45 call @ $.90 $ 90.00

Sell 100 shares @ $45 $4,500.00

Total Profit: $ 655.00

You can simultaneously buy the stock and write (sell) the covered call. It’s called a buy-write, and you can either place it as a market order (both sides of the order get filled at the prevailing price) or you can place it as a limit order.

The great thing about a buy-write limit order is that instead of saying what you’ll buy the stock for and sell the option for, setting two different prices, you specify your net out-of-pocket cost per share. In the example above, in a market order you would have paid $39.35 for the stock and taken in $.90 on the call so your net would be $38.45 per share. Instead of entering two orders, you may enter one buy-write order at a net debit of $38.45. Like a limit order, you will not spend more than $38.45 per share to get your orders fulfilled. If the brokerage can’t get you what you want for what you want to pay, neither side of this order will be fulfilled and you’ll neither own the stock nor have the covered call.

You can try to hold out for a better price, as well. You could enter a buy-write at a net debit of $38.40, $38.30 or whatever you think you can get. Of course, as your limit price goes further from the current price, it becomes less likely you can get your order fulfilled. Using a net debit, instead of two limit prices, gives your broker must more flexibility in negotiating your trade.

One very popular strategy is to continually write covered calls, letting them expire and then writing another covered calls, collecting premiums all the while. This turns their stock into an income-producing asset. I’ve known people who have written so many covered calls that they have pretty much paid for the cost of the stock.

Now that you know how to get into a buy-write, you should know how to get out of one. To close this position, you must both buy back the call option (with a buy to close order) and then sell the underlying stock. To do them both simultaneously, enter an order called an unwind which you can enter as a market order or at a net credit (since this time you’re collecting more money than you’re spending).