Mastering Option Part 1

What's The Best Option Strategy?

You've probably heard many opinions as to which option strategies are the best: Covered calls are best because they reduce the risk but still allow for a profit. Naked puts are the best because you're getting paid to buy stock. Straddles are the best because they allow you to make money whether the market is going up or down.

If you've been trading options for a while, you no doubt have heard many others. But, when you hear comments such as these, all you're hearing are opinions of one trader's preference for a particular risk-reward profile. In order to really understand option trading, you need to understand that all option strategies come with their own sets of risks and rewards and the market will price them accordingly. Be careful of anyone telling you that a particular strategy is superior to another; they either do not fully understand options or are trying to sell you something.

Traders who tout superior option strategies focus on one aspect of the strategy -- either the risk or reward side -- and completely neglect the counterpart. They will make comments such as, "Calls are superior to stock because the return on investment is much higher." It's easy to make them consider the risk side by replying, "Sure, but lottery tickets are superior to calls because the return on investment is even higher!"

The best option strategy is the one that directly matches your set of risk and reward tolerances for a given outlook on the underlying. This is the level of option trading you want to achieve. Learn to dissect a position into its component parts and see if you are willing to accept the associated risks. Learn the various strategies and how to further tailor them to match your needs better. Don't spend your time looking for the superior option strategy. It doesn't exist.

Understanding risk and reward

To fully understand the relationships between risk and reward with options, we need to look at profit and loss diagrams. We will show you in detail how to construct and read them in the next section)

If you compare the profit and loss diagrams of any two strategies, there will always be a part of the diagram where each strategy dominates.

For example, let's revisit the earlier comment. Are call options superior to stock? Assume one investor buys stock for $50 and another buys the $50 call for $5.

We can plot the profit and loss at expiration for each position, and we will get the following diagram:

For example, the trader who buys stock at $50 will make $5 profit if the stock is trading for $55. If you look at the above chart, you can see that the profit and loss line (red) crosses the $5 profit line for a stock price of $55. Likewise, if the stock is trading for $45, the trader will incur a $5 loss.

The diagram also shows that the long $50 call buyer (blue) will lose $5 if the stock is $50 or below and will break even if the stock is $55. At a stock price of $60, the $50 call buyer will make $5 profit (the call option will be worth $10 but the trader paid $5)

Notice the profit and loss diagram for stock (red). It is superior to (lies above) the profit and loss line for the long call (blue) for all stock prices above $45. This is because the call option buyer is effectively paying $55 for the stock ($50 strike for a cost of $5). If the stock stays above $45, the long stock position is the better strategy (the red line is above the blue line). But if the stock falls below $45, the call option becomes the better strategy (the blue line is above the red line), as the most the long call will lose is the premium. It should be evident that one strategy is not better than the other; it depends on your outlook of the stock and the amount of risk you are willing to accept.

An investor who believes the stock will stay above $50 is better off buying stock. Of course, there is a tradeoff of accepting a potential $50 maximum loss. Conversely, an investor who believes the stock is heading higher but doesn't want the exposure to the downside is better off buying the call. The tradeoff is that he will pay $55 for the stock instead of $50, but in return, only be subjected to a $5 maximum loss.

If traders are more concerned with the downside risk, they will bid up the price of the call. If they feel the price of the call is too high relative to the stock, they will sell the call (either naked or covered). These actions will price the call fairly with respect to investors' opinions, and neither strategy will be superior to the other.

What about naked puts? They must be better than stock because you are actually getting paid to buy the stock, right?

Let's look at the profit and loss diagram between stock purchased for $50 and a naked $50 put sold for $5:

Again, in some areas of the chart the long stock position dominates, and in others it does not. The long stock position is better for stock prices above $55. With the stock above $55, the long stock investor will realize unlimited profits, while the naked put will profit only by the premium received from the sale of the put.

However, if the stock is below $55, the naked put is the better strategy. Below a $50 stock price, both investors lose but the naked put seller is ahead by the premium.

Maybe a long call is better than a naked put? Some may reason that the long call position makes more money than the short put if the stock rises and loses less if it falls, so it is a better strategy. Let's assume a long $50 call and short $50 put are each traded for $5:

Looking at the above chart we see that the long call position (red) does dominate for all stock prices above $60 and below $40. But if the stock stays between these prices, the naked put is clearly the better choice. Your outlook on the stock and tolerance for risk will determine which strategy is best for you.

Pick any two strategies and look at their profit and loss diagrams. You will always see that each strategy will dominate over a given range of stock prices. Try switching one position from long to short. Try changing strike prices. You will soon see that it does not matter; one strategy cannot dominate another for all stock prices.

Strategies come in all shapes and sizes. Now you should have a better understanding why. Different strategies alter the risk-reward relationships and it is up to you, the trader, to decide which is best. Do not be afraid to alter the strategy to meet your taste -- that is what option trading is all about. If you accept somebody's strategy as the "best," you are, by default, accepting his or her risk tolerances too. If those tolerances are not in line with yours, you will eventually learn, the expensive way, that no strategy is superior to another.

Open Interest

You will often hear the term "open interest" in option trading. It can be very helpful to understand what this means, and how the number is either increased or decreased.

Because of the way options are traded, the Options Clearing Corporation (OCC) must account for the total number of outstanding contracts. To do so, one could either tally all long positions or all short positions and get the total number of outstanding contracts. This is because each contract has a buyer and a seller (a long and a short position). Some people mistakenly believe that the open interest is the total number of long and short positions. However, this would double count the actual number of open contracts.

For example, say there are currently no contracts at all trading on a particular stock. If Larry decides to buy 10 contracts, he must find someone who is willing to sell 10 contracts. If Moe would like to sell them, then a buyer and seller can be matched and the total open interest is now 10 contracts.

Notice how open interest is not the total long and short positions. If we count all longs and shorts using the above example, we have 10 contracts long and 10 short, which give us a total of 20 -- exactly double the correct answer.

Now say another trader, Curly, wants to buy 10 contracts. If he "buys to open" and Larry "sells to close," then, in effect, all that has happened is that Larry and Curly have switched places and there are still only 10 contracts outstanding. Why? Because Larry originally "bought to open" and then "sold to close," so he's out of the picture altogether. Now Moe and Curly are effectively matched.

Whenever one party is opening a position and the other party is closing a position, open interest remains unchanged.

Should Moe be concerned that Larry is not on the other side of the trade anymore? No, because technically, OCC acts as a middleman and is the buyer to every seller and the seller to every buyer. The trades are all guaranteed (for contract performance, not profit!) by the OCC.

Let's say Larry wants back in the action and "buys to open," but this time, another trader "sells to open." Assuming this trade was also for 10 contracts, the total open interest is now 20 contracts.

Whenever both parties are opening positions, open interest will increase by the amount of the contracts traded.

In the above example, Moe and Curly have open positions and are accounting for 10 of the 20 contracts in open interest. If Moe "buys to close" and Curly "sells to close," the total open interest will fall to 10.

Whenever both parties are closing, open interest will decrease by the amount of the contracts.

New traders are often confused with situations similar to this: Say a new trader "buys to open" 10 contracts on an option that has no other volume for the day, and the option had 100 open interest yesterday. The next day, open interest still shows 100. The new trader often thinks that a mistake has been made because they "bought to open" 10 contracts, so the open interest must surely be 110 now. Hopefully it is evident to you now why this may happen -- the other side of the transaction must have been "selling to close" keeping the open interest unchanged.

How to read the open interest numbers

The open interest figures for a particular contract are counted as round lots of 100 -- just like the option contracts. So if you see open interest of 250, this really means that a total of 250 *100 (or the equivalent of 25,000 shares) is being traded in this option.

This is important to understand for trading purposes, especially if you are placing large dollar amounts in a particular option. Say an option shows 3,500 contracts open interest (or a total of 350,000 shares) being represented. On the surface, there appears to be a lot of liquidity in this option. However, a better method is to take the 350,000 shares and multiply it by the market price of the option. Whether you use the bid, ask, or last trade usually won't make a huge difference unless there is a very high bid-ask spread. Let's say the last trade was 1/8. In terms of total dollars in the contract, that's only $43,700, which by market standards, is not too liquid.

Conversely, the Nasdaq 100 Index (NDX) is currently trading around 3,320 with the Nov $3,350 call trading about $186 (yes, this index is extremely expensive due to the volatility!). There are "only" 558 open interest, which doesn't appear to be too liquid. But if we take 558 * 100 * $186, we see there is over $10,000,000 in liquidity.

Before you place relatively large option orders, check the liquidity by calculating the total dollars in open interest in that option.

Example:

You are bullish on MRVC trading around $38-1/2. You want to "buy to open" 30 contracts of the Dec $30. Are there potential liquidity problems?

Checking open interest we see there are only 8 contracts for a total of 800 shares represented by this contract. The price is $12-1/4, which is 800 * $12-1/4 = $9,800 dollars being represented. This appears to be a potential liquidity problem at this point. This is not to say that things cannot change as December expiration approaches, as they certainly can. However, it is important to make your decisions with all available relevant information. Would you feel comfortable with a trade this large and only $9,800 worth of liquidity?

If not, it may be best to spread your risk through other strikes or expirations.

Profit And Loss Diagrams

As the saying goes, a picture is worth a thousand words. This is so true when it comes to profit and loss diagrams on options. By looking at a picture, you can immediately see where your max profit and loss is, feel how the position will behave, and know where the danger zones are for any strategy.

Unfortunately, there are basically two types of option investors. Those who can read profit and loss diagrams, and those who can't!

Being able to read and understand the profit and loss diagram is critical for understanding options.

Important Note: Before we get started, there is one very important point that needs to be made here. When we speak of profit and loss diagrams, we are talking about the profit and losses at expiration of the option. Prior to expiration, it is very difficult to say what the profit/loss diagrams will look like because of the many factors that affect an option's price.

So what exactly is a profit and loss diagram? Let's start with the simplest one -- a long stock position.

If you are long stock (meaning you own it), you will make one point of profit for every point increase in the stock above your cost basis. Likewise, for every point drop below your cost, you will lose exactly one point. This is easy to show on a spreadsheet. Assume we buy 1 share of stock at a price of $50:

If the stock price is:	Your profit/loss will be
$45	-$5
$46	-$4
$47	-$3
$48	-$2
$49	-$1
$50	$0 (the break-even point)
$51	+$1
$52	+$2
$53	+$3
$54	+$4
$55	+$5

Assuming you paid $50 for the stock, this table shows that you will have a loss of $5 if the stock is trading at $45. If the stock is trading for say, $53, you will have a profit of $3 per share. If the stock is trading for $50, you will have no profit and no loss -- you are just breaking even.

You must admit, even though this is a relatively simple position, it's not readily apparent as to the behavior. So let's take the above numbers and put them in a picture -- a profit and loss diagram. All we have to do is plot the stock prices from the table above on the horizontal axis (the x-axis) and the profit/loss numbers on the vertical axis (the y-axis). Once we do, we get the following picture:

How do you read the chart? Using the chart below, look at any stock price along the horizontal axis such as $53, for example. Now trace a line to the profit/loss line (blue) and see where that point lines up with the vertical axis to the left. It lines up with $3 profit, which is exactly what we calculated in the spreadsheet previously. At a stock price of $46, we see the profit/loss line shows a $4 loss.

It should be evident that it is much easier to look at the picture rather than the spreadsheet to see how a long stock position, at $50, will behave. We know immediately that the break-even point is at $50 -- the point where the profit/loss line crosses zero on the horizontal axis. We can also immediately see that there is unlimited loss (at least all the way down to a stock price of zero since you can never lose more than what you paid) and an unlimited upside potential as the line continues up to the right without bounds.

What if you are short the stock? Shorting stock involves borrowing the shares and selling them with the intent of buying them later at a cheaper price. You are, in essence, doing the reverse of the traditional "buy low - sell high" strategy. You are trying to "sell high - buy low." The profit and loss diagram for short stock looks like this:

A short position will always behave the opposite of the corresponding long position. In this case, we see that profit is made as the stock falls and unlimited losses occur as the stock rises. The unlimited loss part is what makes the short stock position so dangerous!

Got the hang of it? Ok, let's try something a little more complicated and see what a long call position looks like.

Long call position

A long $50 call gives the owner the right, but not the obligation to buy stock at a price of $50 over a specified amount of time. The trader, in this case, paid $3 per share for that right and, consequently, that is all that can be lost. So, no matter how low the stock falls, this trader's maximum loss is just the premium of $3.

Looking at the chart below, we see the call option trader has, in effect, limited the downside risk below $50, as compared to the long stock position, but still retained all of the upside potential. Of course, this does not come for free. If you notice, the break-even has been moved upward by $3, the price of the call option, to $53. This is the most powerful benefit of options; they allow you to custom-tailor the profit/loss profiles to exactly suit your needs.

Short Call

Let's see what a short call looks like. Remember, we said at the beginning that a short position would be exactly the opposite of the corresponding long position.

The profit/loss diagram for the short call (red line) is telling us that the maximum profit is $3, the amount of the premium. This will be made for any stock price (at expiration) below $50. Because the $50 call will be worthless to the owner (the long position) at expiration, the short position will profit by the entire premium of $3.

Notice how this short call is the mirror image of the long call position (blue line). For the long call, $3 is the maximum loss; this is the amount of the short call's maximum gain. The short call's break-even point is at $53, because at this point at expiration, the option will be trading for $3, (remember, this is the profit for the long position). The short's position will be worth -$3 and this is the amount for which the call was sold for a net profit/loss of zero. If the stock moves above $53, unlimited losses will occur for the short call beyond this point. Because of the high leveraged nature of options, the short call (also called a naked or uncovered call) position is the riskiest of all! Why? Because you can only make a limited gain on the position, but are assuming an unlimited risk to do so.

An interesting point should be made here. Look again at the above chart with the long call and short call positions. Because they are mirror images of each other, this shows that no net flow of cash is created from the options markets. In other words, any option trader's gain is exactly somebody else's loss; the money merely changes hands. The financial press is often known for making the statement that the options markets should not exist for this very reason. This is a big misconception. The options markets were created as a way to hedge risk; it is a way for hedgers to meet speculators. So the next time you hear about a devastating loss due to derivatives, remember, the trader/traders on the other side of the trade made exactly that amount of a gain.

Okay, let's work one backwards. I'll show you the profit/loss chart and see if you can identify it:

Look at the chart and try to read it: The trader in the diagram can only lose $5, no matter how high the stock goes. But, an unlimited amount (down to a zero stock price) can be made if the stock falls below $50. Which option position has these characteristics?

If you said a long $50 strike put, you're right! A long put is a bearish position; you make money if the stock falls (assuming it falls far enough to offset the premium). A short stock position, as we saw earlier, is bearish too. But, the long put position is not exposed to the unlimited upside risk as the stock moves higher. Again, this does not come for free. The long put position, in this example, must have the stock fall below $45 before money is made. The short stock position will make money for any fall in the stock below $50.

Okay, just to make sure you have it, let's look at a short put, which remember, should be the mirror image of the long put above.

And we see that it is. It is easy to see from the profit and loss diagram that a short put is bullish, as maximum profit is made when the stock is above $50. The trader is exposed to unlimited losses (down to a stock price of zero). This short put position will break-even at a stock price of $45, since the put will be worth -$5 at expiration, which is exactly the amount of the premium collected.

Combination Strategies

The above strategies are relatively simple, but are intended to teach you the basics in reading a profit and loss diagram. Now we will get a little more complicated and really see their value when we look at combination strategies. These are strategies that combine two or more positions to really custom tailor those risk-reward profiles you may be seeking but were unable to do with stock alone.

For starters, let's view the profit/loss diagram for a covered call position, which is one of the most popular strategies in options. The covered call is a strategy in which the investor buys the stock and sells (or writes) the call against that stock. The investor will take in some money for doing so, which in effect, provides a small downside hedge -- it lowers the break-even point. However, the investor also gives up some of the upside potential in the stock.

Let's piece the two positions together. Remember that the profit/loss for long stock looks like this (assuming that $50 is paid per share):

Now let's add the covered call. Say the investor sells a $60 call against the stock for a premium of $5. This means the investor will receive $5 per share but may have to sell the stock at $60. On the surface, it doesn't seem like a bad deal as you are getting paid to sell your stock at a profit. As we will soon see, with the help of our profit/loss diagram, there is a price to pay.

By selling the $60 call, the investor "gives up" any appreciation in the stock above $60; he has sold those rights to somebody else -- the person who bought the call. But the investor also reduces the downside risk, slightly, in exchange. The total covered call position now looks like the red line below:

The red line is our profit and loss diagram for the covered call position. We see that the break-even has now been reduced to $45 because of the $5 premium received from the call. However, for any stock price above $60, there is no more appreciation in the position as there is for the long stock position. The maximum that can be made, in this example, is $15. How? If the stock is $60, we make $10 on our stock because we paid $50, but also made $5 from the call for a total of $15. If the stock is higher than $60, it does not matter; we are under contract to sell it for $60, so our profit is still $15.

Now here is the price you pay for entering into a covered call position. YOU are holding ALL of the downside risk! You cannot sell your stock until expiration of the call unless you are willing to buy the call back, which could be a loss. Otherwise, you must wait for expiration in order to fully profit by the $5 premium.

The Myth Of Covered Calls There is a lot of bad information floating around out there about covered calls. If you ask most people, brokers included, you will hear that the "risk" of a covered call position is that you may have to sell your stock for a price below market. In other words, the stock may be trading at $100 but you have to sell it for $60. Look at all of the points on the above chart at $60 or above -- the points where you will likely be assigned on the option and must sell your stock. Is this the "risky" area of the chart? NO! It is our maximum profit zone, exactly the points where you want to be. There are a lot of professionals and academic journals that surprisingly make this mistake. It is a huge myth in the marketplace. The risk of any position is not missing out on some reward. If you are really sharp, you may have noticed that the covered call profit/loss diagram is exactly the same shape as that for the short put shown earlier. These are called "synthetic equivalents" (and will be discussed in detail at a later time). Covered calls are often considered among the "safest" strategies while naked puts are considered to be one of the riskiest. Covered calls and naked puts are, incorrectly, considered by many to be polar opposites in terms of risk. Even option approval levels with your broker will usually require the lowest level for covered calls and the highest level for naked puts. Yet, from a profit and loss standpoint, they are exactly the same strategies. Now you should understand the beauty of profit/loss diagrams. They can help uncover the myths. The risk with the covered call is the same as with the naked put. The risk is that the stock goes down.

So who should enter into a covered call position? If you write calls against stock you would hold regardless, then writing calls can be a great strategy because you were willing to assume the risk with or without the covered call.

But if you are buying the stock because of the premium, then you should strongly reconsider your strategy. People who do this are known as premium-seekers, as they seek out the very high premiums on the options, then buy the stock just to gain the premium. I have witnessed, on more than one occasion, million dollar accounts becoming virtually worthless doing nothing but covered calls using this method.

Long straddles

The long straddle is a position where the trader buys a call and a put with same strikes and expiration. The idea behind the strategy is that a large move is expected but the trader is unsure about which direction. Usually, this strategy is used prior to an earnings report, FDA approval for a drug company or some other big announcement. If the report is favorable, the stock may run wild to the upside; if not, it may tank. So the strategy plays both sides.

We will be discussing straddles in detail at a later time, but we do want to make the point that playing straddles solely for news announcements is usually not a good strategy, as the price of the calls and puts will already factor in the expected rise or fall of the stock. This means that it will usually be difficult to get out of the straddle for a profit. A bigger reason to play straddles is if you think the market has underestimated the volatility.

Say a trader buys a $50 call for $5 and a $50 put for $3 for a total of $8. What does its profit/loss diagram look like:

It is easy to see now where your profit zones are. This trader will need to see the stock go above $58 (the strike plus both premiums) or below $42 (the strike minus both premiums). If the stock stays between these two points, at expiration, the trader will lose a maximum of $8.

Be aware of seminars or books that announce, "We'll show you how to make money regardless of where the stock moves" as they are usually talking about straddles.

The downside to the straddle is that you are basically buying a very expensive call and a very expensive put. In effect, you are buying the call for the price of a call and a put. You are also buying a put for the price of a call and a put. This is because you must buy both options to complete the straddle yet only one will be in-the-money at expiration (unless the stock closes exactly at $50 or under a rare partial tender offer where both options can expire in-the-money). This makes the straddle very tough to profit from unless you get a tremendous move in the stock. So, while you may "make money" on either leg of the spread, that's not necessarily the same as being profitable.

Okay, ready for one more?

Ratio spread

Let's look at a more complicated position -- the ratio spread. I am only showing this to demonstrate the power of the profit and loss diagrams and why you should learn to use them. I will not even discuss the strategy (although it will be available in another section), but instead, I want to see if you can identify the critical points.

First of all, let's say a trader buys 10 $50 strike calls for $5 and sells 35 $65 strike calls for $1-3/4. That's a ratio spread, or ratio-write with calls.

Now, think about this for a minute. Just by looking at the above ratio spread, can you tell what the trader wants the stock to do? Where the maximum profit and loss is? Where the danger zones are?

It's pretty tough, isn't it?

Now let's use the profit and loss diagram for the ratio spread described and see if we can answer the questions a little easier:

Much easier, isn't it? We can now see that the trader will make money if the stock either collapses below $50 or rises up to $65, which is the point of maximum profit. After $65, the trader starts to lose some profits and will reach a break-even point around $73. Beyond $73, unlimited losses will occur.

Would you have been able to analyze the trade in this way just knowing that the trader bought 10 $50 calls at $5 and sold 35 $65 strikes at $1-3/4? Don't feel bad, most people can't. But that's what profit and loss diagrams are for.

Learn to use them, as they will greatly help your understanding of option strategies!

Large Bid-Ask Spreads

Often when you are trading options, you will notice that the bid-ask spreads can become quite large -- as much as three or four points and more for some of the more volatile indices. These large spreads are usually found for deep in-the-money options and long term LEAPS.

Understanding why this happens will help you with trading as well as understanding the importance of not placing market orders for options that fall into these categories.

To start, you need to understand how prices are determined.

How prices are determined

All prices are determined by equating supply and demand. Although there are substantial differences in the way various securities markets go about equating these two forces, the basic idea applies. For example, option equilibrium is determined in the opening rotation, by the specialist for the New York Stock Exchange and by numerous market makers for the Nasdaq market. All methods have their own benefits and drawbacks but the effects are the same -- they try to determine the fair price of the security.

Let's start with a simple example of how prices are determined, then include the assumption of a bid-ask spread later.

Say there are 11 people who are bidding (wanting to buy) for a particular option and 11 people offering to sell. The following chart shows their bid and offer limit orders. Also, to make things easier, we will assume all participants are placing equal numbers of contracts.

Bids	Offers
7 1/8	5 7/8
7	6
6 7/8	6 1/8
6 3/4	6 1/4
6 5/8	6 3/8
6 1/2	6 1/2
6 3/8	6 5/8
6 1/4	6 3/4
6 1/8	6 7/8
6	7
5 7/8	7 1/8

Keep in mind that a bid of $7-1/8, for example, means that is the highest price that person is willing to pay; they will gladly pay less, just no higher. An asking price (or offer) of $7-1/8 is the lowest for which that person is willing to sell; they will surely sell for more, just not less.

The question now is what is the fair price for the option? Again, to make things a little easier, we will assume no bid-ask spreads at this point.

Say the option opens up with a price of $7-1/8, the highest bid. Because we are assuming there is no bid or ask spread, any buyer can buy for $7-1/8 and any seller may sell for the same price. What will happen? If you look closely at the above chart, you will see that there is only one buyer (the one bidding $7-1/8) but 11 sellers. Why 11 sellers? Obviously, the lowest offer of $5-7/8 will certainly be willing to sell for $7-1/8. So all 11 offers will want to sell, but only one person is willing to buy -- you have unequal supply and demand.

What happens if you have unequal supply and demand numbers? If you have unequal numbers, in this case more sellers than buyers, the sellers will start competing for that buyer's business and the price will fall. In order to keep buying or selling pressure from being prevalent, there must be equal numbers of buyers and sellers. It can also be shown, although we will not do it here, that when the numbers are equal, that will be the point of maximum profit for the market makers, so they have great incentive to find this point.

Back to the example, what if the option price opens at $6? Now there will be 10 buyers; all of them will buy except for the person who bid $5-7/8. For the sellers, only two people will sell: the person who is willing to sell for $5-7/8 and the one willing at $6. Again, we have unequal balance between supply and demand except, this time, there are more buyers. The buyers will start to compete for the business of the two people willing to sell and the price will be bid up.

The price where there is no imbalance is $6-1/2. If the option's price is $6-1/2, you will have 6 buyers and 6 sellers.

Looking at our bids and offers in the above chart graphically:

We see that at a price of $6-1/2, we can exactly clear the market; there is a buyer for every seller at that price.

However, because of the nature of the markets, market-makers will put in bid-ask spreads as a profit margin for matching buyers and sellers. So they may post this option as bid $6-3/8 and offered at $6-5/8. Now, because of the bid-ask spread, we have three forms of inefficiencies, and investors must now:

1) Pay a higher price ($6- 5/8 vs. $6-1/2)
2) Sell for a lower price ($6-3/8 vs. $6-1/2)
3) Have less volume (5 instead of 6)

These are the three inefficiencies created by bid-ask spreads.

Now, think about this: What would happen if the volume were reduced to only four buyers and sellers?

If the volume is reduced to four contracts, the bid-ask spread will widen as shown by the dotted gray line above. Notice how much wider the dotted line is compared to the red line that represented the initial bid-ask spread (shown in red).

Often you will hear that the large spreads are a result of market-makers "playing games," or trying to cheat you on your order. Bear in mind that the only way they make money is to fill orders, not just produce quotes. If the spreads are too wide, investors will not be attracted to the security and will produce no volume. In addition, if the spreads are unfairly too wide, you can be assured another market maker will compete for the business and narrow the spread. Market makers are reflecting the liquidity risks by the bid-ask spreads and their ability to spread the risk by hedging the position. If you feel a bid-ask spread is too wide, remember, you are always free to "tighten the spread" by either bidding higher or selling for less (please see our section on "Show or Fill Rule".)

So, what you want to get from all this is that the market determines the bid-ask spread--not the market-makers. So if you see an option (or stock, for that matter) with a large bid-ask spread, just understand that this is the sign of a potential liquidity problem. If placing orders in these securities, it is generally advisable to consider going "in between" the bid-ask spreads to improve your trading results.

For example, say the quote is bid $6-1/4 and ask $6-3/4. If you want to buy, you can buy at the asking price and pay $6-3/4. Or you can put in a bid above the current bid of $6-1/4. Say you put in a bid of $6-1/2. The quote will now jump to bid $6-1/2 and ask $6-3/4. Notice that your higher bid has tightened the spread. There is now a higher bidder on the market (that's you) at $6-1/2, which gives a seller incentive to sell because of the higher price. The reverse holds true for sellers. If a seller places an offer below the $6 3/4 quote, say $6-5/8, the quote will now become bid $6-1/2 and ask $6-5/8. The new lower asking price will give another investor incentive to buy. Notice how the spread has been further narrowed from the original 1/2 point spread (bid $6 1/4 and ask $6-3/4) to a 1/8th point spread (bid $6-1/2 and ask $6-5/8).

Large bid-ask spreads can be frustrating, especially when using options, because of the leverage. Use this information before entering into the position and do not be afraid to compete for a better price (unless there is some reason you absolutely must have the trade). If you do not get the option, this only represents a lost opportunity, which is usually better than a lost profit from being forced to exit a position that holds large bid-ask spreads.

Measuring The Leverage Of Options

You have probably heard that one of the biggest advantages of trading options is leverage. By leverage we mean that for a given percentage change in the stock, the option will increase by a larger percentage, thus leveraging, or magnifying, the return on investment.

For example, say a stock is trading for $100 and a $100 call is trading for $5. If the stock closes at $115 at expiration, a 15% move, the option will be worth $15, a 200% move.

One way to view this leverage is to realize that the option trader, in this example, has leveraged the returns by a factor of twenty. In other words, for every 100 shares the stock investor buys ($10,000 worth), the option buyer can buy 20 contracts ($10,000 / $500 per option = 20).

If the stock trader invested $10,000, it would grow by 15% to a value of $10,000 * (1.15) = $11,500, or a profit of $1,500. The option trader's account will be worth $10,000 x 200% increase= $30,000. If we multiply the profit of the stock trader, $1,500, by 20, we end up with $30,000, which is the value of the option trader's position. In this example, the option trader's total account value will always be worth 20 times the stock trader's profit, assuming the $100 call option has intrinsic value.

Gearing

The leverage described above is known as gearing, and is actually just an old British term that means leverage. It is not uniquely defined, but the two most common definitions are (1) The stock price divided by the option price or (2) The strike price, divided by the option price.

Using definition 1, the way to find it is to simply divide the stock price by the option price:

Gearing = stock price / option price

In our example, the stock was $100 and the option was $5, so $100/$5 = 20.

This is just another way of saying the stock trader required twenty times the amount of capital to control the same amount of shares.

Using the second definition, gearing would be:

Gearing = strike price / option price

This gives the same answer of 20. But what if the strike was $110? Now the gearing is $110/$5 = 22. In this way, the option trader may pay $110 for the stock but is controlling it for $5, so is leveraged by a factor of 22.

Omega

There is another term you may encounter that describes leverage and is called omega. Omega measures the relative percentage changes between the stock and the option -- called an elasticity measure. For instance, assume the call in the above example has a delta of 1/2. With the stock at $100 and the call at $5, if the stock were to move $1 (a 1% move) the call will move roughly 1/2 point for a 10% increase. Because the option moved 10 times faster relative to the stock (10% compared to 1%), the elasticity, or omega, is 10.

Omega = Delta / option price
1 / stock price

This can also be written: (stock price / option price) * delta

Using the above formula in our example, we have a $100 stock price divided by a $5 call option with delta of 1/2, so:

$100/$5 * 1/2 = 10

Regardless of which measure you use, the higher the leverage the more speculative the position.

It should also be noted that option traders should invest in the equivalent share amount as they would a stock purchase, and not the equivalent dollar amount. For example, the trader above invested $10,000 on 100 shares. If he elected to use the call option instead, it is advisable to purchase one contract representing 100 shares as opposed to buying $10,000 worth of the $5 option or 20 contracts.

The reason is due to the leverage. If a trader is not used to dealing in 2,000 share orders (20 contracts), the leverage and losses can become too great too fast. By using share equivalents, the stock and option positions will behave similarly and not leave the trader with losses he was not prepared to take.

Leverage can be a very powerful -- and destructive -- tool. If you understand the various ways to measure leverage, it will make you more comfortable with your option picks and strategies!

Are Options Good For The Market?

Many times I am asked if options are good for the market. After all, there is no new equity created as when new shares of stock are issued. What seems to be happening is that we are allowing a legalized gambling arena. At least, this is what the popular financial press would have us believe.

Further, we saw Baring's Bank, a 233-year old institution that helped finance the Napoleonic Wars, brought down single-handedly by an options trader. Certainly options cannot be good for anybody, right?

Before you take that view, let me show you why options were created and why they are actually good for the market. Options were created out of economic necessity, and are a logical extension of a well-developed financial market.

To help you understand, assume that there are no options and only stocks. Say you want to buy shares of ABC stock, trading for $100, and you're a long-term investor -- none of this short-term speculative stuff for you! When you decide to purchase shares for your long-term hold, what's better for you, one seller or two? Obviously, two sellers are better, as they will compete for your business and help to lower your purchase price. Likewise, when you sell your stock, would you prefer one buyer or two? Again, you should prefer two, as they will compete for your business and help to raise your selling price.

In other words, the more market participants you have, the better off you are whether buying or selling. Another way to say this is that the bid-ask spreads will be narrowed, causing more stock to transact -- and more wealth to be created. The spreads will narrow because the buyers will compete by raising the bid price (giving incentive for sellers to enter the market), and the sellers will compete by lowering the asking price (giving incentive for buyers to enter the market). The financial markets always benefit from narrow spreads.

Notice in the following diagram how the bid-ask spreads (red-dotted line) cause less shares to be sold (122,000 instead of 128,000) when compared to no spread (solid blue line).

Now, back to the buying of your stock. At this time there is only one seller, who also is a long-term player and has held this stock for ten years. Notice the nice, neat, clean market we have here with no speculators. However, with only one seller, this is certainly not a good situation for you.

Now let's meet Sam Speculator. Sam likes to speculate on market direction. He's willing to take big risks and gamble for big profits. Long-term investing for him is measured in hours. He just happens to think ABC stock will fall a few points. He would short the shares (which would be good for you since you'd have another seller), but he's very afraid to because of the recent volatility in ABC. He doesn't want to take the risk of the stock moving higher. So he sits on the sideline, leaving you with just the one seller.

Now let's enter the options market. Call options give market participants a way to purchase stock, while put options provide a way to sell stock for a fraction of the cost of the stock. In addition, the owner of a call or put option has risk that is limited to the amount paid for the option. This idea gets Sam's attention. He puts in a bid to buy 10 of the $100 strike puts for a price of $5 1/2.

The market maker sees this order and wants to fill it, as this is how he makes money. He will create a synthetic put by selling stock and buying a call. In other words, the market maker must "manufacture" the long put option that Sam wants. But where will the market maker be able to buy the call? He doesn't know either, so he puts in a bid to buy one for, say, $5-1/4.

Another investor, Conservative Connie, also hates the idea of speculation in the markets. However, she will gladly sell someone a call option against stock in her IRA account, as it will give her income without the need for selling her shares. She happens to own ABC stock, so she sells the market maker the call and pockets the $5-1/4 per share. She's willing to assume the downside risk on ABC (if she wasn't, she wouldn't own it). Connie doesn't think the stock will fall; Sam thinks it will. Together, they bring more stock to the market.

Notice what's happened. The market maker shorts stock, which is really what Sam wanted to do but was afraid of the risk. The market maker then protected himself with the purchase of a call and sold that package (a synthetic put) as a long put to Sam.

You wanted to buy shares of ABC but now have two sellers instead of one. The market maker, in essence, has partitioned his risk between two other players. Together, Sam and Connie hold the synthetic short position (Sam is long the put and Connie is short the call). Because those two participants were willing to accept the associated risks, the market maker was able to short the stock, thus lowering the asking price of the stock you're interested in buying!

Options, in this example, gave us an arena in which to meet speculators. It doesn't matter where they live or what they want to use the option for. In this example, Connie was willing to assume the downside risk of the stock if she could get paid for it. Sam was willing to pay for that. Unfortunately, Sam doesn't know Connie. But, through the options market, Sam and Connie are matched.

Ultimately, the options markets bring in more participants, making the spreads narrower for all. So speculators are actually a necessary part of financial markets, and although it's sometimes difficult to see, they make the markets better and more efficient.

If you're still not convinced, think about the bond market. Bonds are almost always associated with conservative investing. If you buy a bond, you may see yourself as a responsible, conservative investor. In fact, you may even hate the idea of borrowing! No credit cards or debts of any kind for you. Now for the hidden truth. Who do you think is on the other side of that bond trade? A borrower -- a speculator -- hoping to make a profit by earning more with the borrowed funds than they will owe in interest. If you love the idea of loaning money, be glad there are speculators in the world. No speculators, no bond market.

Speculators are an essential part of any well-functioning market. While it is a tragedy that Nick Leeson single-handedly brought down Barings Bank with options, that is the fault of the user and not of the options market.

Keep in mind there were also investors on the other side of those trades, and for every option trade there is a winner for every loser, as shown in the following chart:

Notice how the profit and loss diagrams are mirror images for the long and short positions. Money merely changes hands from one person to the other. In this way, options can be viewed as a "bet" between two people, but that should not trick you into believing that's why they were created.

Somewhere in the world, a conservative mutual fund manager may have desired puts as a hedge for his mutual fund, and bought the puts that Nick was selling. Options are about transferring risk. Nick Leeson was selling straddles on a Japanese index speculating on a quiet market; he was accepting the risk the mutual fund manager wanted to hedge.

Because of this, that mutual fund may have had a great year and provided for a new home for someone or protected their IRA account. The fund may have sent someone to college who, otherwise, never would have had a chance. But we will never know the name of this person as we know Nick Leeson's. We will never know, because that is not horrific news, so it just vanishes into the background. It's easy to overlook what you cannot see. But they are there every time another loses on an option trade.

Options are good for the market. They create narrower spreads and provide excellent hedges for conservative investors. They are also excellent speculating tools for those who use them responsibly.