Understanding Options and Forex: Part 1
For many newcomers to the stock market, the possibility of making money by trading from the convenience of a laptop is intriguing, dangerous, and exciting. When the markets are closed, take the time to learn the facts presented in this collaboration.
This collaboration specifically tells newcomers to the business how to use and understand option contracts. For those just entering the field, moving into the world of options can be somewhat daunting.
For those coming from a stock background, the most simplistic form of understanding these methods would be “buy low and sell high.” In theory, this idea breaks it down so even the newest members can understand, but that doesn’t mean it is always so simple.
With options, however, there are many working parts which make the machine, as a whole, more difficult to understand, and even harder to master.
That said, trading still invites newcomers to compete along-side lifelong professionals, unlike sports, where, for example, one could not sign up for the Masters after learning a basic golf swing, nor could an individual compete as a professional racecar driver after simply learning how to operate a manual transmission.
If you feel like you’ve just set foot inside the Endeavour spaceship, where hundreds of lights, buttons, and screens blink and beep in your direction, a sense of overwhelming tension can creep up, causing a clear disadvantage in the market.
We overcome this disadvantage with a clear understanding of the market we’re participating in, with a foundational knowledge of how each part works. This foundation begins by understanding what an option contract is, how it works, and how you can implement it into your specific trading techniques.
For those who already feel overwhelmed, remember to take each working part one step at a time, breaking them down into pieces one-by-one, much like learning a dance, step-by-step, slowly mastering the entire process.
An option contract, also known as “an option,” is defined as “a promise that meets the requirements for the formation of a contract.” Essentially, this is a binding contract between two parties.
An option simply means that the buyer has certain rights. The buyer is the optionee, or beneficiary, of the contract. This individual has rights, but not necessary an obligation, to long (or short) a stock from a predetermined price. There is a date until which this contract is good for called an expiration date.
There are two types of options contracts – calls and puts.
Call options give the buyer a guarantee that the person who sold the option, will sell those shares at a predetermined price. That predetermined price is also known as the “strike price.” As a bullish bet, it is likely to go up in value. “Bullish” means that an investor believes a stock price will increase over time; similarly, investors who purchase calls are bullish on the underlying stock. Conversely, “bearish” indicates that an investor believes that the stock will decrease in value.
A call option is a bet that the stock is going to increase in value. For instance, if one predicted that Apple’s stock was on the verge of rising, that person would buy a call option. The higher Apple’s stock climbs, the more the call option appreciates.
The risk with options is that the option could expire worthless. If Apple’s stock were hovering at $500 and one bought a $510 call, it would expire worthless and the premium paid would be lost by that unfortunate investor. What that seller managed to do is called “writing an option.” If a stock were going to go lower, one could sell those options to a third party who believes it will go higher. That is called “writing premium,” or “collecting premium.”
Writing call options is among the riskiest of trade strategies. A particularly unfortunate scenario was illustrated when one individual sold hundreds of a $50 call option for approximately one dollar; when the stock price was $48. The call ended up expiring worthless, but that person had initially thought he would make $25,000 on the trade. The next day he received the news that the stock was up over $50 a share, as it was being bought out. The money he had invested was unable to be recovered. That is the risk associated with writing call options.
When one purchases a call option, it offers the right to buy a given asset at a fixed price, also known as the strike price. If a call option is purchased at $5 and the underlying asset increases in value, the call will increase in value as well. At any time before the specified expiration date, the option writer (namely, the individual who created the option purchased) has a legal obligation to sell the asset at the strike price. Call options that have a strike price below the current market price of the underlying asset are said to be “in
the money.” If Apple were at $500, a $450 call option would be considered to be in the money, while a $550 call option would be out of the money. Those acronyms are common: ITM, OTM, and ATM, or “at the money.” Put options (discussed below) are the inverse of this.
It is also critical to remember that an option price consists of both the intrinsic value and the time value. The former is the amount that the option is in the money. For example, if Apple’s price was at $500 and there was a $490 call, $10 of that option price is intrinsic. Extrinsic (time) value has several variables that create that dollar value.
Buying a call option is the least amount of risk that one could take. Selling a naked call option, on the other hand, is the riskiest endeavor. The downside is essentially unlimited. However, this should not indicate that buying will offer a constant stream of income; if one purchases the wrong stock option, no money shall be made. For instance, if a stock trades at $520 and there are options available at a strike price of $570, this would indicate a tidy profit if the stock were to rise in price. However, the stock could trade sideways, which would leave the trader with nothing as the option expires worthless.
As an example, if Apple’s March $515 call option was priced $23.10. The option buyer had the right to purchase 100 shares of Apple stock at a strike price of $515 per share any time prior to the expiration date. If Apple was at $520 and one bought the $515 call option, and the price might rose to $550. Then an instant profit could be made because the stock is actually trading at $550.
However, there is still the option of buying the stock at the price of $515. Some experts discourage the purchasing (assigning) of stock, which is uncommon but not unheard of. Generally the option is either bought or sold.
Put options are the opposite of call options, and again, one can buy or sell a put option in the same manner as a call option. If Apple’s stock were going to go down, one would buy a put option because as that stock descends, the put option will increase in value. These options give you the right to sell shares at a given strike price.
Selling naked put options is a popular income strategy. For instance, if stocks keep rising, like days when Apple continues to rally, one would sell naked put options. If the stock keeps rallying and the put options expire worthless, the premium received could be kept as income. This is a more conservative option than selling naked call options because a stock can only fall to zero, and the
difference between the option strike and zero would be the maximum loss. One can also mitigate the risk by utilizing credit spreads. (more on this technique later)
As mentioned earlier with an option being in or out of the money, with put options, the inverse holds true: if put options have a strike price above the current market value of the underlying asset, those would be considered to be in the money. If the strike price were below the current market value, those would be out of the money.
The purchase of put contracts gives the buyer a bearish outlook on the market; meaning that they hope the value will actually go down. Therefore, we buy puts when we expect a market to drop and buy calls when we expect it to rise.
While it seems that we could merely buy stocks rather than options, there is one reason why options are so important: leverage.
Leverage means that a small amount of work can move a large force. Imagine using a pulley system to lift a heavy object, or using a crow bar to open a jammed door. Leverage can help small individuals move large objects. The leverage of options can help build a powerful portfolio.
Leverage can actually allow traders with small accounts to grow exponentially while also allowing traders with large accounts to free up excess capital. It is imperative to maintain several different accounts with which to work. Some traders keep multiple accounts, each engineered for different work: short-term, long-term, day trading futures, swing trading options (swing means holding for more than 1 day), among others.
Consider the example of RAX. Currently, RAX is trading for $31.76 in the market. A typical order of RAX may be 100 shares, for a total of $3,176.00.
$31.76 x 100 = $3,176.00
A delta 1.00 call option (delta meaning the rate of change for an options price, relative to a one-unit change in the price of an underlying asset) will give you the exact same price movement as the 100 shares of stock, but it will only cost the buyer $800, rather than a price over three grand. Generally, one should aim for a delta value of 70 or higher. Gamma, additionally, is the rate of change of the delta. (more on this later)