Mastering Option Part 2

Time Value & Intrinsic Value

An option's premium, the amount you pay, can be broken down into two component parts: time value and intrinsic value. It is important to know how to break an option's price into these two components as well as understand the interpretation if you want to become better at trading options.

In-the-money versus out-of-the-money

Before you can break an option's premium into time and intrinsic values, you need to understand the terms in-the-money and out-of-the-money, also called the moneyness of an option.

An option is in-the-money if the stock price is higher than the strike for calls and lower than the strike for puts. If a stock is trading for $100, a $90 call is in-the-money and a $90 put is out-of-the-money. The following chart may help:

	Calls	Puts
Stock price ABOVE strike	In-the-money	Out-of-the-money
Stock price BELOW strike	Out-of-the-money	In-the-money

An option that is exactly at the strike price is said to be at-the-money. Now, it's rare to find a stock trading exactly at the strike price, so it is customary to call the nearest strike (whether in or out-of-the-money) the at-the-money strike. For example, if a stock were trading at $99-1/2, most traders would consider the $100 strike at-the-money even though the strike is slightly out-of-the-money. Likewise, if the stock were slightly higher, say $100-1/4, most would call the $100 strike at-the-money even though it is slightly in-the-money.

Intrinsic value

If an option is in-the-money, it is said to have intrinsic value. This is the value of the option if you were to immediately exercise -- the difference between the stock price and the strike. For example, if the stock is trading for $101 and you hold the $100 call, you could realize a $1 point gain by exercising the call option; you would receive stock worth $101, but pay only $100*.

*Generally a trader should never exercise a call option early. Please see our section on "Early Exercise" for more information. The value you could gain by exercising early is purely a definition of intrinsic value.

Another way to view intrinsic value is to calculate the value of the option if it were to expire immediately. Using the above example, if the $100 call option expired, it would be worth $1, the same value as if you exercised early. Why will it be worth $1? If it is trading for less than that, say $1/2, arbitrageurs will correct for it by buying the option for $1/2 and selling the stock for $101, for a net credit of $100-1/2. By immediately exercising, they can cover the short position by paying only $100, the strike, for an arbitrage profit of $1/2. This would continue until the option is priced at a minimum of $1 (please see our section under "Basic Options Pricing").

For puts, the idea of intrinsic value is the same but in the other direction. If the stock were trading for $99, the $100 put would have an intrinsic value of $1. The holder of the put could exercise and sell stock worth $99 but receive $100 -- a $1 gain.

Also, if the put option expired immediately, it would be worth $1. If it is worth less than this, say $1/2, arbitrageurs will buy the put for $1/2 and buy the stock for $99, for a total purchase price of $99-1/2. Then they would immediately exercise it, sell the stock for $100, and capture a $1/2 arbitrage profit. This would continue until the option is priced at a minimum of $1.

Probably the easiest way to understand intrinsic value is to think of it as the number of points the stock is in your favor in relation to the strike price. For example, if you are long a call, you are bullish and want the stock to go up. If you have the $100 strike call with the stock at $103, then your option is 3 points in-the-money; the stock is trading $3 points to the bullish side (above) of your option. If you are long the $105 put, you are bearish and want the stock to fall. With the stock at $103, the stock is two points to the bearish side (below) of your strike.

Time value

Time value (or time premium) is easy to calculate. It's what is left over after accounting for intrinsic value. Assume a $100 call is trading for a premium of $3. If the stock is trading for $101 then the $100 call has intrinsic value of $1; the remaining $2 is called time premium. The following formula may help:

Premium - intrinsic value = time value

What if the stock were trading at $100? Now, the $100 call is at-the-money and has no intrinsic value. With the option trading for $3, the entire premium is all time premium. This would be true for any stock price at or below $100; the option would be comprised entirely of time premium.

For puts, let's assume the stock is $98 and you are holding the $100 put, which is trading for $5. The option has $2 intrinsic value and therefore has $3 time value.

Examples:

Call option premium	Stock	Intrinsic Value	Time value
$50 call = $3	$52	$2	$1
$100 call = $7	$105	$5	$2
$80 call = $5 1/2	$79	$0	$5 1/2
$75 call = $4 3/4	$77	$2	$2 3/4
Put option premium
$100 put = $5	$97	$3	$2
$75 put = $2 3/4	$77	$0	$2 3/4
$40 put = $3	$38 1/2	$1 1/2	$1 1/2
$85 put = $6 1/2	$79	$6	$1/2
Notice in the above examples that the intrinsic value plus the time value equals the total price (premium) of the option.

How much time premium do options have?

Generally there will always be some time premium on an option, even if only a small amount. With all else constant, the longer the maturity of the option or the more volatile the option, the more you will pay in time premium. Why? With all else constant, investors will prefer to buy longer-term options, as they will have more time for it to gain intrinsic value. Likewise, investors will prefer more volatile options, as they have a greater chance of making bigger moves, thereby giving the option more intrinsic value.

Also, the deeper-in-the-money you go, the more time premium will decrease. So if the stock is $100, the $80 call will have less time premium than the $85 call, and the $85 will have less than the $90, etc. If the option is deep enough in the money, the time premium will equal the risk-free rate. Why? If the stock is at $100 and the $80 call is sufficiently in-the-money, investors can buy the stock and sell the $80 call (covered call position) thereby "guaranteeing" them $80 at expiration. As with any guaranteed trade, the interest rate will be the risk-free rate. Now, it should be mentioned that a covered call is never truly guaranteed, as it is always possible for the stock to fall below the strike price of the short call. However, if it is sufficiently deep-in-the-money where the markets perceive it to be guaranteed, then the market will only reward you the risk-free rate for that trade. The important point to understand is that as you move to lower and lower strikes for calls (higher strikes for puts), they become more and more likely to have intrinsic value. Because of this, they will have correspondingly lower amounts of time premium.

Parity

If there is no time premium on an option, it is said to be trading at parity. For example, with the stock at $103, a $100 call trading for $3 would be trading at parity; there is no time premium on this option. Usually, the only time you will see an option trading at parity is at expiration with options that are fairly deep-in-the-money.

How do i use this information to trade?

We said earlier that it is important to understand time value and intrinsic value in order to understand what you're getting into with a particular option. Any option that has high time premium is risky (in trading terms, it will have a high gamma value). The reason it is risky is because the underlying stock must move, in the proper direction, enough to make up for the time premium. If it does not, you will end up with a losing trade.

For example, if you buy a $100 call option for $10 with the stock at $100, the stock must get to $110 (stock price plus time premium) in order to break even. If the stock moves to $108 at expiration, the $100 call will be worth $8, yet you paid $10 for a $2 loss.

Now compare this to the trader who may have purchased the $80 call, which may have been trading for $21 ($20 intrinsic + $1 time premium). With the stock at $110 at expiration, the $80 call will be worth $30. This trader bought for $21 and sold for $30 -- a profit of $9, which is certainly different from the $2 loss taken with the $100 call (for more on this, please see "Deltas and Gammas" during week 5).

If you are looking for very quick moves in the underlying, you can afford to buy options with higher time premium. However, if you are only interested in speculating on the direction of the underlying stock, you should consider deeper-in-the-money options to avoid the high risk associated with high time premium options.

But avoiding the speed game is not for free. If you buy a deep-in-the-money option, you will pay more in total dollars (more intrinsic value and less time value). By doing so, you now have more money at risk if the stock should move against you. In addition, if the stock should fall, the deep-in-the-money option will fall nearly point-for-point through a certain range of stock prices before slowing. It is a delicate balancing act to find the appropriate option that suits your needs.

Option trading mistakes

One of the biggest mistakes new option traders make is to buy an option just because it is "cheap." The inexperienced trader will usually look to out-of-the-money options because they can buy more contracts for a fixed dollar investment, or similarly, pay less money for a given number of contracts. For example, if a stock is trading at $50, a new trader who is bullish on the stock will usually look at a $55 strike or higher. They often wonder why one should buy an in-the-money option as the stock has already exceeded the strike price. They feel they are "wasting" money by paying for the intrinsic value.

Usually cheap options are composed entirely of time premium and can also be far-out-of-the-money. Make sure you know where your break-even points are and that it matches your sentiment with the underlying. For example, if the stock is $100 and you want to buy the $115 option for $2, that stock will have to move to $117 by expiration in order to break even on the trade. If you do not think this is likely, you should probably consider another option. A deeper-in-the-money option will be more costly but have less time premium; it will not need to move as far to break even.

Many strategies rely on the behavior of time premium. If you plan to increase your trading knowledge of options, you need to have a solid understanding of time and intrinsic values.

Types of Orders

Even if you have the winning stock and matching option strategy, you still need to get the order in correctly to carry out your intentions. There is a whole list of terms, restrictions, and general market lingo you will need to know in order to maximize your use of options. Whether you are new or experienced with options, this section will greatly help with your trading.

This is especially important with Web trading. Most firms offer great incentives to place your orders over the Web. However, you are now at risk by checking off the wrong box or entering the wrong amount. You will be given many choices when placing trades over the Web, so you need to be aware of what these terms mean.

Opening and closing transactions

The first thing you need to understand regarding an option order is that you must specify whether you are opening or closing the position. For example, if you want to be long a call option, you will need to place the order as "buy calls to open." This is very different from a stock trade where you just designate the order as either buy or sell. The reason the options markets need to know if you are opening or closing the position is so the OCC (Options Clearing Corporation) can account for the open interest. For example, you may be buying the call to open and the person on the other side of the trade is selling to close their position. In this case, there is no net change on open interest, as one party is opening and the other is closing (please see our section "Open Interest" for more information). The OCC must track open interest, as there is no limit to the number of contracts that can be traded on any individual stock or index as with stocks. With stocks, you can only buy or sell up to the available number of shares outstanding.

Basically, if you are initiating a position for the first time, you are opening. If you are getting out of a position, you are closing.

There is a common mistake new traders make when selling covered calls: They often feel they must designate the order as some type of buy. This mistake usually stems from the fact that most other financial instruments (stocks, bonds, mutual funds, etc.) are initiated with a buy. Remember, you are selling the call and opening the position, so your first transaction would be "sell calls to open," then you would "buy calls to close" if you want to undo the position.

Always check with a broker if you are unsure. There is nothing worse than being on the wrong side of the market because of a mistake on the order. I have seen this result in very costly mistakes!

Market versus limit orders

The next thing your broker will want to know is whether you are buying at market or at a limit.

A market order guarantees the execution but not the price.

In fact, a market order is the only way to make certain you will get the trade (the only exception is with a "short sale" on stock which must be executed on an uptick). However, in order to do that, you must be willing to accept the best available price at the time your order hits the floor. So, while you may see an option quoting $5 - $5-1/2, placing a buy order at market does not guarantee you the asking price of $5-1/2 as many people think. It's entirely possibly for the stock to be in a fast market (which means the quotes are not accurate due to delays in processing orders), and you find yourself being filled at something like $7. In most cases, this is unlikely, but just be aware that with a market order, you are saying that you are willing to pay any price. You will have no recourse with your broker by placing a market order and being filled at a higher price with a buy order, or a lower price with a sell order.

With a limit order, you tell your broker that you are willing to buy or sell, but only at a certain price called the limit price. If you say, "buy calls to open" at a limit of $6, this means your order will only be filled if it can be filled for $6 or less. Of course, your risk is that your order will never get filled. If you are selling at a limit of $6, your order can be filled only at $6 or higher.

Limit orders guarantee the price but not the execution.

Also, a limit order may be filled in part unlike a market order. For example, if you place an order to buy 30 contracts at a limit of $6, it's possible that you get filled on 20 contracts or some other number less than 30. What you are really telling your broker is that you are willing to buy up to 30 contracts. If you only want all 30 or nothing at all, you will need to use an "all-or-none" restriction discussed later.

When placing an order, you need to figure out which is more important -- making sure it is filled (market orders), or making sure you get a certain price (limit orders). There is no way to guarantee the execution and price -- you get one or the other.

By the way, if you are placing a limit order on options, you need to be aware of the following rule: Options quoted at $3 or less may be entered in 1/16ths and options quoted above $3 must be entered in minimums of 1/8ths. So, if you see an option quoting $3-1/2 to $3-3/4, do not send in a limit order at $3-9/16; the floor will return your order to be re-entered in 1/8ths. Under decimalization, the new MPV's (Minimum Price Variations) are as follows: options under $3 may be entered in .05 increments while options over $3 must be entered in .10 increments.

Or-better orders

There is a type of limit order which sort of blends a market and limit order, called an "or better" condition.

With an or-better order, you place buy orders above the current asking price, and sell orders below the current bid price.

Say an option is $5 on the ask. You can tell your broker to buy at a limit of $5-1/2 or better, for example. Now, when your order hits the floor, you will be filled as long as it doesn't exceed $5-1/2. Some people think this is a recipe for ruin as the floor will probably fill you at the higher $5-1/2 price. This is not true, as the traders are bound by time-and-sales, which reflect the current prices at the time your order was received. With or-better orders, your order is still not guaranteed to fill, but the odds are much higher compared to a straight limit order. I would almost always use "or better" orders if the underlying stock is moving quickly.

Day, good-until-cancelled, immediate-or-cancel, fill-or-kill

If you use a limit order or an or-better order, you must also specify a time period that the order is to remain open. Technically there are four different time designations: day, good-until-cancelled, immediate-or-cancel, and fill-or-kill. By far, most trades are entered as either day or good-until-cancelled, but we will go over each so you understand them all.

Remember: a limit order is not guaranteed to fill, so your broker will need to know if you want the order cancelled at the end of the day (day order), or cancelled after a much longer period (up to six months) with a good-'til-cancelled order, also called GTC. The New York Stock Exchange allows firms to keep the orders on the books for up to six months. However, individual firms are free to make the requirements stricter. They may, for example, only hold a GTC order for two months. Check with your broker as to their firm's policy on GTC orders.

Be careful with GTC orders, though -- especially when buying! There have been many cases where people place GTC buy orders and then forget about them. Weeks later they see an option position in the account trading for a huge loss and wonder how it got there. It's probably not a good idea to use GTC buy orders on options for this very reason unless you actively monitor your account.

However, using GTC sell orders can be a very good portfolio management tool. For example, say you buy an option at $5 and are willing to sell it for $8. By placing a GTC order to sell it at $8, you now never have to worry about not being at your computer to place the order if it trades that high -- the computer will take care of it for you. Further, you will not be tempted to hang on hoping for more if you see it trade at $8, as the computer will automatically sell it. Using GTC sell orders can be a great tool for disciplined trading.

Instead of day or GTC, you can elect your timeframe to be immediate-or-cancel or fill-or-kill also known as IOC and FOK orders respectively. Both orders are asking for an immediate execution or cancellation of the order. The difference is that immediate-or-cancel orders allow for partial fills while fill-or-kill orders must be filled in entirety.

For example, if you enter an order to sell 50 contracts at $7 immediate-or-cancel, the market maker may fill a portion of that order at $7 or higher; they are not required to fill the entire 50 lot order. A fill-or-kill order would require that they fill the entire 50 contracts immediately, or none at all. These orders are often used to pressure the market makers into making a decision, and consequently, are usually cancelled! It is recommended that you do not use these orders. Any trader who gets filled by using them probably would have been filled with a day or good-til-cancelled order as well. There is not a big advantage to the immediate-or-cancel or fill-or-kill orders, and there's a great chance it may hurt the execution.

Why don't you use day, GTC, IOC, or FOK time frames with market orders? Remember, market orders are guaranteed to execute, so they will default to a day order and normally be filled within seconds.

All-or-none

If you place a limit order, for example, to buy 30 contracts at a limit of $5, it is possible to get filled on only a portion, say 20 contracts. With a limit order, you are telling your broker to buy up to the amount designated (30 contracts in this example). If, however, you want to insure that you get all 30 contracts or nothing at all, you need to use an "all-or-none" restriction, also designated AON. If you use this restriction, you are telling the floor to fill the entire order, or nothing at all.

There is a big danger in using all-or-none orders! Any order marked all-or-none goes to the back of the line (for listed stocks), or is held in the back pocket of a trader for options. This means that it is possible you'll never get an execution, even though many traded at your price or better, and you cannot hold the exchange to time and sales! The trader can always come back and say that all contracts could never be filled at once and you will have no recourse against your broker or the exchange.

Also, all option quotes are good for at least 20 contracts. So, if you are placing option orders for 20 contracts or less, you will be doing yourself a huge disservice by placing all-or-none restrictions on these orders.

Minimums and minimum lots

If you don't like the idea of all-or-none restrictions, you can opt for a minimum. For example, say you are selling 50 contracts but want at least 30 or nothing at all. You can place the order to sell 50 with a minimum of 30.

Further, if you only want your trade filled in minimums of 5 contracts thereafter, you can tell your broker "minimum lots" of 5. So the order would look like "sell 50 contracts, minimum 30, and minimum lots 5." Now the order must be filled with at least 30 initially, and in 5 lot increments thereafter, such as 35, 40, etc. up to 50.

Minimums and minimum lots are a nice alternative to all-or-none orders.

Market on close

There is a really nice tool that's not widely used by most traders. It's called a market-on-close order or MOC. With an MOC order, you try to buy or sell your contracts at a limit price during the trading day. If it is not filled, it converts to a market order within the last five or so minutes of the trading day. For example, say you bought 10 contracts at $2 and they are now selling for $10. The market looks really strong and there is a possibility it could trade much higher. However, you don't want to lose your profit.

You could place an order to sell your 10 contracts at a limit of $12 MOC. Now, if the option trades at $12 or higher, you will be filled. But, if it doesn't trade that high, you will be sold very close to the closing price of the day. Keep in mind this could be much less than you anticipated! But MOC orders can be a great tool, as they allow you to try for better prices during the day, but get you executed by the end of the day regardless.

Net credits and net debits

Net credits and net debits are types of limit orders, but are used for multiple option orders. For example, you may enter a buy-write, which allows you to simultaneously buy stock and sell a call against it (please see our section on "Buy-Writes" for more information). If the stock is trading for $50 and the call is trading for $3, you can enter the buy-write for a net debit of $47. This tells your broker that you are willing to buy the stock and sell the call as long as the net charge to you does not exceed $47. The floor could fill the stock purchase price at $50-1/2 but would have to fill the call for $3-1/2 or any other combination that nets a $47 debit. Often, traders will try to "negotiate" a better deal, and may enter the above order for a net debit of $46-1/2 for example.

Net credit orders are just the reverse of net debits. Say you bought the above buy-write for $46-1/2 debit and it is now trading for $48-1/2. You could enter the reverse of this trade, called an "unwind," which sells the stock and buys the call for a net credit of $48-1/2. Now the order cannot be filled unless the net proceeds to you are $48-1/2 or higher.

Stop orders

Stop orders can be a great risk-management tool. They can also cause great losses is you're not sure how they work.

If you are planning to use stop orders on your option trades, make sure you understand this section.

How do stop orders work?

There are two basic types of stop orders: stop orders and stop limit orders. There are very important difference between the two, so we'll look at them individually.

First, the basics of stop orders are the same for stocks and options. There is one major difference with options though, and we'll look at that at the end. For now, we'll just concentrate on how basic stop and stop limits work with stocks.

Stop order

A stop order is a conditional order to buy or sell at market. You specify a price at which point the trade is "triggered" and becomes a market order to either buy or sell.

For example, say you paid $30 for a stock and it is now $50. You feel it could climb much higher so would like to keep holding it, but at the same time, you do not want to see it fall back to $30. You could place an order to sell your shares at a stop price of $45, for example. When you specify a stop price, that is the "trigger price," and is not necessarily the price you will get for your shares. So if the stock trades at $45, your order is triggered and becomes a market order, which will be filled at the next best available price.

It is very important to note that the stock needs to trade at or through your price in order to become triggered. Here is where a lot of traders get themselves in trouble. Using the above example, say the trader places a stop at $45 and the stock closes that day at $45-1/2. The order is not triggered, so the trader at this point still has his shares. However, the first trade the following morning is $38 on bad news. Because the last trade is through the stop price of $45, this trader will be filled at market -- around $38, which is very different from the stop price of $45.

Remember, the stop price is only a trigger point -- the point where the order is activated. It is not the price you will necessarily receive!

Stop orders used to be called "stop loss" orders until the Securities and Exchange Commission ruled to change the name because it was misleading. It sounds like the order will prevent a loss, which is definitely not true.

Trading Case One of the worst cases I can remember was with a trader who had 3,000 shares of one of the "dot com" stocks back when they were hot. This person paid around $100 per share, so he had a decent profit with the stock trading around $120. He placed an order to sell the shares at a stop price of $110. The stock started to fall radically with every couple of trades decreasing the stock by a point or so. The stock traded at $110 and continued to fall. The customer was impatiently calling to find out where he finally sold his stock. After all, a price of $110 was still a nice profit for him. The confirmation came back with all shares being sold at $87. This fill was deemed good by time and sales; that was the fair price when his order hit the market maker. Stop orders do not prevent losses!

Stop limit orders

The trader in our first example was hoping to get around $45 per share if the stock fell. Under normal circumstances, if the stock falls slowly, stop orders work great. It's only when you see the large gaps down where the prices can be very different.

What if the above trader would rather hold the stock instead of selling it at $38? Is there a way to prevent the sale? Yes, and that is done with a stop limit order.

With a stop limit order, you specify two prices. One is the trigger point and the other is the sell limit price. The above trader could have placed a stop limit order by telling his broker to sell at a stop price of $45 and a stop limit of $45. If the stock trades at $45 or below (the stop price) the order will be activated as with a regular stop order. However, instead of becoming a market order, a stop limit order becomes a limit order to sell. This order is saying to activate it at $45 (the stop price), but do not sell for anything less than $45 (the limit price). The limit price can be equal to or less than the stop price.

In the above example, when the stock opened at $38, the trader with the stop limit order would also have their order activated. However, they will still hold the shares because they could not be sold for $45 or higher. If the stock does rise to that price during the day (or later if a good-til-cancelled order), the stock will be sold. If you do not want this to happen, you need to cancel the order.

Notice again that the stop limit order did not prevent a loss either. This trader still has the shares!

Buy stops

Buy stops work the same as sell stops but just in the other direction. Usually they are used by short sellers -- those who borrow shares to sell hoping to buy them back cheaper at a later time. In order to prevent the stock from getting away from them to the upside, these traders often place buy stops.

For example, say a trader shorts shares at $100. The risk to this trader is if the stock moves higher. In order to make sure the stock doesn't get away from him, he may place a buy stop at $110. This is saying to buy the shares at market if the stock trades at $110 or higher. Again, this is not necessarily the price he will pay.

If the trader does not want to pay more than a certain price, he can elect to place a buy stop limit. As an example, he could say buy the shares at a stop price of $110 with a stop limit of $111. If the stock trades at $110, the order will be activated, but will only fill if the shares can be purchased for $111 or lower.

Traders also use buy stops to buy stocks on momentum. For example, say a stock has been sitting flat for a very long time at $30. The rumor is that a new product is expected to be released that could send it into the hundreds of dollars per share. Rather than buy it now and possibly wait a long time for that day to come, traders may put in a buy stop order at $35, for example. Now, the only time the trader will be filled is if the stock is trading at $35 or higher. In effect, the trader is buying the stock only if it appears the market is starting to rally the stock.

Incidentally, it is possible to be filled at a higher price on a stop or stop limit order. This is fairly uncommon, but if the stock bounces at the time your order is triggered, it may be trading at a higher price when the market maker fills it.

Stop orders on options

Stop orders on options work about the same as for stocks with one big exception. With stocks, the last trade will trigger a stop order. With options, the asking price will trigger the order and you will be sold at the bid.

A sell stop will be triggered on the ask and sold at the bid; a buy stop will be triggered on the bid and purchased on the ask.

This is very important for option traders due to the leverage in options. Gains can quickly become losses if you are not careful.

For example, say a stock is trading at $100, and a $100 call is bid $7 and offered at $7-1/2. A trader bought 10 contracts earlier for $5 and now places a stop order at $6. To the novice option trader, this trade seems nearly risk-free as the trader paid $5 and will get out at $6 (less some commissions) if the stock should fall. The stock starts to fall but there are no trades on the option; however, the quotes on the option will change as the stock falls. Eventually, the option quote is bid $5-1/2 and offered at $6. Now the stop order is triggered because the offering price is $6, but the trader is sold at the bid price of $5-1/2. That little 1/2 point spread cost the trader an additional $500 on top of the commissions.

Time stops

Another stop order many option traders use is that of "time stops." A time stop is more of a mental stop order that the trader keeps in his head; it is not one that can be placed with your broker.

Say a trader buys a 6-month option for $10 and is hoping to sell for $15 before expiration. The trader may set a time stop and sell the option if it has not hit $15 by a certain day. The reason traders do this is to prevent holding the option too close to expiration day and seeing the entire premium fall to zero from time decay.

Stop orders can be great tools when used under the right circumstances. Be sure you thoroughly understand the mechanics before using them, as the results can be upsetting if your expectations are not realistic.

There are many other types of orders and restrictions but these will be the majority of the terms you will come in contact with. Always check with your broker with specific questions, as individual firms can have different policies. Keep in mind that these orders were developed for various reasons, each with its own set of benefits and drawbacks. If you learn the different types of orders, you will become more flexible in your option strategies.

Buy or Sell

Better to buy or sell options?

There are a number of investors who adamantly believe you are better off selling options as opposed to buying. They reason that since most buyers lose money, it must be better to be a seller. While this may make sense on the surface, it completely neglects other factors of option trading. With a little effort, we will show you that neither the buyer nor the seller has a long-term advantage.

This is not to say that, under certain conditions, a buyer or seller cannot have a theoretical edge on the trade. That happens all the time. We are talking about making an unconditional statement that one side has an advantage over the other.

Equilibrium -- the efficient markets theory

Is it better to own a Porsche Boxster or a Ford Taurus?

Many people are tempted to answer that the Porsche is clearly the better choice.

What if the Ford Taurus and Porsche Boxster are both priced the same? With both cars priced the same, most would agree that you are better off with the Porsche. If so, people will buy the Porsche over the Taurus. This will put buying pressure on the Porsche and raise its price relative to the Taurus. Say the Porsche is now bid up to a price $3,000 above the Taurus. Most would agree that it is still a better deal and continue to buy it. This action will continue until the markets are not so sure that an additional $1 is worth jumping from the Taurus to the Boxster. If it were worth it, they would do it.

While it may seem counterintuitive, as long as there is no net bidding up or down of prices between the two cars, you are equally well off with either one. While the Porsche may be faster and have higher quality and resale value (not to mention it just looks cooler), it also comes with higher repair bills, insurance rates, and theft occurrences. The car market will reflect all pros and cons in the prices of the two cars.

Similarly, the financial markets will price all assets to reflect their risks. Quality assets are bid up and riskier assets are sold off. This is why a government T-bill yielding 5% is equal to a more risky bond priced to yield 10%. The government bond is higher quality but also has a lower yield. The markets realize that, all else constant, you are better off with the T-bill so it will continue to bid that price up until there is no net difference between the two bonds. If there were an advantage, the markets would continue taking action and reflect it in the price.

In more technical terms, the market's action in the above examples is a form of the efficient market theory (called the semi-strong form), which states that all publicly available information is priced into the asset. The markets will price all assets so that the risk-reward ratios are equal across the board.

So is it better to be a seller of options as opposed to a buyer? Now you should know that, on average, there is no difference between the two choices. The markets will reflect the risk in the prices. If it were always true that, say, sellers of call options were better off, the market would continue to sell calls and drive down their price. The price will stop falling when buyers purchase all that is for sale and there is no net selling. At that point, equilibrium is reached and the assets are priced fairly.

Do not be lured into strategies that claim you are always better off as a buyer of this or a seller of that. If you do, you may encounter a very expensive understanding of efficient markets.

Fair Value

Futures Markets

You may have heard financial sources, such as CNBC, talk about the futures quotes prior to the market open. Advanced market participants will watch the futures trading to get an idea of where the market will open. However, even advanced traders get confused as to exactly what this means. Often they associate the change in futures prices as the indication. For example, if the futures are trading up 20, many mistakenly believe this mean a positive indication for the open. Likewise, they feel if the futures are trading down 10, that the markets will open negatively.

While it may appear to make sense, this interpretation can get you into trouble especially if you are trading in pre-market based on the indication. In order to understand how to interpret the quote, you need to understand a concept called "fair value."

Before we can talk about fair value, we need to understand some basic mechanics of the futures markets. When you buy a futures contract, you are entering into an agreement to buy and take delivery of a commodity (or financial future) at a future date. This sometimes confuses people who are new to futures but you've probably entered into similar agreements although not specifically futures contracts. For example, if you have a contractor build a house or a car dealer order a car. You agree to take delivery at a future date and exchange cash at that time. The important thing to keep in mind is that, with futures contracts, the buys and sells are locked in! This is very different from the options market where the buyer has the right, but not the obligation to purchase. If you buy a futures contract, you must purchase the goods. If you sell a futures contract, you must deliver the goods. Of course, if you do want to get out of your obligation, you can execute a reversing contract just like in the options market.

Futures markets are used as hedging tools for both buyers and sellers. For example, a farmer would probably be a seller of wheat futures. He can grow the crops today and know in advance what his price will be at harvest. Likewise, Kellogg would probably be a buyer of wheat futures to lock in their purchase price of wheat for use in cereal.

The financial futures (SPX and NDX among others) are used for similar purposes. They allow fund managers to hedge portfolios. There are four contract months, each is the last month of the quarter. So, the contracts are March (represented by the letter "H"), June (M), September (U) and December (Z). Whenever you hear CNBC quoting fair value, they are always talking about the near-term contract.

Fair Value Review

Fair value is the relationship between the index (also called the "spot") and the corresponding futures contract. It has nothing to do with the fundamental value of the companies representing the index. Fair value tells us what the value of a futures contract "should be." But, because futures trade on separate markets from the spot market, they are subjected to their own sets of supply and demand so may wander off in different directions from the stock market. In fact, the futures trade all night long on GLOBEX, from 4:45pm until 9:15 am EST. But, if the futures get too far out of line, the arbitrageurs will correct for that prior to the opening bell.

Definition: Fair value is nothing more than the cost to carry the index to delivery to the future. What do we mean by cost of carry? It is the interest that could be earned on money in a risk-free asset such as a money market or T-bill. So, if you have an asset that costs $100 and must carry it for one year, your cost would be $10 if interest rates were 10%; this is the amount of money forgone by not having the money in the risk-free asset.

To simplify things, let's look at a simple commodity such as gold and assume the following:

Gold price: $200
Interest rate: 10%
1-year futures contract: $250

If you buy this futures contract, you are saying you will buy gold for $250 per ounce in one year. The person who sells this contract is saying they will sell gold for $250 per ounce in one year. Of course, as things change (i.e., supply and demand for gold, time remaining on contract etc.) so will the price of this contract.

Fair value to carry the gold is $200 * (1.10) = $220.

If you borrowed $200 to buy the gold, it would cost you $20 in interest; if you bought it with your own money, you would miss out on $20 in interest. So, either way you look at it, there is a $20 cost to buy the gold and hold for one year.

Because the 1-year futures contract is above the fair value, arbitrage is possible.

Note: In order for a transaction to qualify as arbitrage, two conditions must be met: (1) The transactions must guarantee a profit (2) there can be no initial cash outlay. The second condition is necessary otherwise the straight purchase of a government bond would qualify as arbitrage since profit is guaranteed.

With the fair value above the spot price, arbitrageurs will take the following strategy:

Today
Borrow $200: +$200
Buy gold in spot market: -$200
Sell the futures contract: $0
Net cash outlay: $0

1 year later
Deliver the gold against futures contract and receive: +$250
Pay the interest from loan ($200 + 10%) -$220
for an arbitrage profit of $30. $30

This is an arbitrage profit because there was no initial cash outlay to acquire the asset but we guaranteed our selling price by selling the futures contract.

Traders will buy the spot and carry it to the future thus creating their own futures contract. This is called "cash and carry" arbitrage. These actions will put buying pressure on the spot price and selling pressure on the futures contract, which will eventually eliminate the arbitrage opportunity.

In a perfect market, any futures price above $220 will result in cash and carry arbitrage.

What if the futures price is too low? Assume the following prices:

Spot price: $230 Interest rate: 10%
1-year futures contract: $250

Fair value = $230 * (1.10) = $253

In this case, the futures contract is below fair value. It "should be" priced at $253 but is only $250 so arbitrageurs will do the following strategy:

Today
Sell short gold: +$230
Lend proceeds at 10%: -$230
Buy the futures: $0

1 year later
Take delivery of the spot through futures
contract and cover short position: -$250
Collect proceeds from loan: +$253
For arbitrage profit of $3

Notice that this is arbitrage because there was no cash outlay at beginning. We guaranteed the profit with the purchase of the futures contract. These actions should put buying pressure on the futures contract and selling pressure on the spot market, which will eventually eliminate the arbitrage opportunity.

In a perfect market, any futures price below fair value will result in this "reverse cash and carry arbitrage."

Remember, if the futures price is above fair value, arbitrageurs will buy the spot. If the futures price is below fair value, they will sell the spot.

We have seen how traders can arbitrage when futures are too high or too low. The only time they cannot arbitrage is when the futures contract is priced at the cost of carry -- the fair value!

Market Imperfections

We just showed that arbitrage is theoretically possible if the futures contract is either above or below fair value. However, in the real world, there are many imperfections that make arbitrage impossible even though the futures contract may be higher or lower than fair value. Some of these imperfections are:

1) Transaction Costs
2) Bid/Ask spreads
3) Restrictions on short sales
4) Different borrowing/lending rates
5) Execution risk
6) Lack of storability (for non-financial commodities)

Because of these imperfections, arbitrage may disappear even though the futures are not priced at their fair value.

For example, assume the following but with a 3% transaction cost:
Gold price: $200
Interest rate: 10%
1-year futures contract: $225
Transaction costs: 3%

We know that fair value is $200 * (1.10) = $220 and the futures price is $225 so it appears that arbitrage is possible. Let's see if it is:

Today
Borrow $206 +$206
Buy gold in spot market ($200 + 3%) -$206
Sell the futures contract: $0
Net cash outlay: $0

1 year later
Deliver the gold to make delivery of futures contract: +$225.00
Pay the interest from loan ($206 + 10%) -$226.60
For net loss -$1.60

Now, because of transaction costs, the arbitrage situation is eliminated. In this example, the futures would have to be priced at $226.60 or higher to execute a "cash and carry" arbitrage.

Using the above example but with futures priced too low, what happens with a 3% transaction cost?

Gold price: $200
Interest rate: 10%
1-year futures contract: $215
Transaction costs: 3%

We know that fair value is $200 * (1.10) = $220 so it appears the futures contract is priced too low at $215. Arbitrageurs will attempt to arbitrage by executing a reverse cash and carry.

Today
Sell short gold: +$194 (sell at $200 less a 3% transaction cost)
Lend at 10%: -$194
Buy the $215 futures: $0
Net cash outlay $0

1 year later
Take delivery of the spot through
futures contract and cover short position: -$215.00
Collect proceeds from loan: +$213.40
For net loss: -$1.60

With the spot at $200, the futures contract would have to trade below $200*(0.97)*(1.1) = $213.40 before arbitrage could be implemented. So, with 3% transaction costs, the futures must trade in the range of $213.40 and $226.60 before arbitrage can be successful.

Any futures price inside this range results in NO arbitrage.

An easier way to state this is that if the spread (the difference between the futures and spot) is above $26.60 or below $13.40 then arbitrage will occur.

For instance, using the above example with the spot at $200 and the futures at $215, the spread would be $215 - $200 = $15. Because $15 lies between the "no arbitrage" bounds of $13.40 and $26.60, then no arbitrage can occur.

Often you will hear sources refer to "buy and sell program" values. This is exactly what the buy and sell programs tell us. If an index has buy programs at $26.60 and sell programs at $13.40, then if the spread (the difference between the futures and spot) rises above $26.60 the arbitrageurs will buy the index and sell the futures for a guaranteed profit. This creates buying pressure on the index, which is why it is labeled as "buy." If the spread falls below $13.40, then arbitrageurs will short the index and buy the futures for a guaranteed profit. This causes selling pressure on the index and is therefore labeled "sell."

So, the futures are allowed to wander within an "invisible fence" around the fair value as shown in the chart below. The fence is created by the transaction costs and other market imperfections listed above. Again, any spread within this fence results in no arbitrage.

Also notice that the number of points above and below fair value is the same. In the above example, fair value is $220 with buy programs at $26.60 and sell at $13.40. This is 6.6 points above and below the $20 fair value. Assuming equal transaction costs on the buy and sell programs, the number of points above and below fair value will always be equal.

It is important to keep in mind that it is the spread (the difference between the futures and spot) that counts.

In the above example, the spread must expand to $26.60 or higher before the sell programs start. The spread can increase by several cases such as: (1) the futures can increase while the spot stays the same (2) the spot can decrease while futures stays same (3) futures rise and spot falls (4) futures and spot rise but futures rise at a faster rate.

This shows that program trading (arbitrage) does not necessarily guarantee a correction toward fair value. If the futures and spot are both rising, but the futures is rising at a faster rate then the index may stay in sell territory for extended periods of time, possibly the entire day. As long as the spread remains outside the upper arbitrage bounds, sell programs will continue. In a similar but opposite way, buy programs can exist for extended times. If the spread shrinks (i.e., the spot market is falling faster than the futures), then buy programs will continue.

How Is Fair Value Calculated?

Now that you understand that fair value is nothing more than the cost of carry of the underlying asset, there is just one adjustment you need to make to fully understand how fair value is calculated for the S&P 500 (SPX) or Nasdaq (NDX) futures.

If you buy all the stocks in the index on margin and carry them to the future (cash and carry arbitrage) you will receive some dividends, which offsets your cost of carry. So, if the risk-free rate is 5% and you receive 3% in dividends, effectively your cost of carry is (5%-3%) = 2%.

Futures contract * (1+ (interest - dividends) ) ^ days/360

And that is the formula for Fair Value!

Example: Say the NDX index closed last night at 3465. The futures closed at 3490. However, the futures traded throughout the night and are now trading at 3550. Also assume that fair value calculations put fair value at 3550. What does this imply for the opening of the Nasdaq market?

The futures are currently 3550 but closed at 3490 so the futures will be indicating UP 60 points (3550 - 3490). But, the fair value formula says the futures "should be" trading at 3550 so they are, in essence, priced fairly. This is actually a neutral or flat indication for the opening even though the futures are up. The futures may be up from their closing price the day before, but they are currently trading for fair value.

Most Important Concept!

Here is where most people get tripped up when looking at futures quotes. Say we use the same example above but now, instead, the futures are trading for 3495. Here, the futures closed at 3490 but are now trading for 3495 so the quote will show the futures up 5.

KEY POINT: If you get nothing else from all this, please understand that just because the futures are UP that this, in itself, does not tell you the indication for the opening of the market. You need to know where fair value is.

Likewise, just because the futures quote is down does not mean that it is a negative indication for the market.

In this second example, the futures are trading for 3495 but "should be," based on the fair value calculation, trading for 3500. In essence, they are still cheap even though their price increased overnight. Arbitrageurs will buy the futures and sell the spot. So, even though the futures are up, in this case, it is actually a negative indication for the market!

The concept of fair value is of little use for retail investors other than to satisfy their curiosity as to the direction of the market at the opening bell. Where many investors get in trouble is to either buy or sell in the pre-market (such as selectnet) based on the futures quote. Before you base your decisions on the futures quote, make sure you know where it is in relation to fair value. It is only then that you will truly know the expectation of the market on the opening bell.

Put-Call Ratio

Technical analysis is quickly becoming widespread as an active trader tool. Used only by professionals just a few years ago, this same information is available to nearly everybody through the World Wide Web.

Technical indicators try to predict market turns; that is, at what point a stock or index will rise or fall. If we knew these points, the gains could be unimaginable so the incentive is certainly there for investors to try to figure out where these points are.

Of all technical indicators, the put-call ratio is probably the most recognized that uses options as its focal point.

From a mathematical standpoint, the calculation of the put-call ratio is very easy. It is the total volume for all put contracts divided by the total volume of call contracts traded on the Chicago Board Options Exchange (CBOE).

Put-call ratio = Total CBOE put volume / Total CBOE call volume

The indicator suggests that a market downturn is threatening when the put-call ratio hits a low level and vice versa. The rationale is quite simple: most speculators of options are unsophisticated and typically will be lured to buy calls when the market is at a top, and buy puts when the market is at a bottom.

If speculators start to buy a high number of call options relative to puts, the indicator decreases (because you are dividing by a larger number) and it is read as a negative indicator. Likewise, if speculators are loading up on puts, the ratio increases and it becomes a bullish reading. Because the put-call indicator works in a backward fashion (bullish indicator when markets bearish and vice versa), it is called a contrarian indicator.

Where these "high" and "low" points are is a matter of debate. There are many interpretations and many traders and technical analysis firms that make small modifications to the formula to meet their specific needs. But as a general rule, a level of 80 is bullish and 45 is bearish.

Keep in mind that no technical indicator is perfect by any means! So do not speculate just because the indicator is giving a particular reading. Use it in conjunction with other information and your own opinions.

There are two important points to remember when using the put-call ratio. First, remember it is a contrarian indicator. There are many novice traders who have been burned by buying puts just because the indicator was high; they should have been buying calls.

Second, put-call ratio is much harder to interpret now with sophisticated traders and the use of synthetics. If a trader buys a put, it will get calculated as a bearish position by the put-call ratio. But what if the trader is buying a put as protection for a long stock position? Now he is certainly bullish and should be counted as so. Likewise, someone selling puts would be counted towards the bullish side (selling puts by themselves is bullish). But if this investor were selling puts against short stock, they should be counted as bearish because they are now synthetic short calls. So in theory, the indicator may be of significance. The reality is, unless you know how the investor is using the put or call, the indicator is highly uncertain.

Percent To Double

Investors are constantly coming up with tools to find the ideal option trade. In essence, they are looking for ways to beat the market. Of course, many businesses are willing to sell those products to them, and one of the most pointless is the analytic tool called "percent to double" (there is a similar indicator called price-to-double which is the same information, just expressed in prices and not percentages).

I'll show you the basic idea of percent to double and you will immediately see why it's of no value. Be wary of brokers who tell you they add value to your option trades because they have access to percent-to-double values.

Here is the idea behind percent-to-double. Say a stock is trading for $100 and a $100 call option is trading for $5. Percent-to-double is supposed to tell you what percent the underlying stock needs to move in order for the option price to double. For example, a broker may tell you an option has a percent-to-double of 20%. This means that if the stock moves up 20%, the call price will double from its current price.

On the surface, it sounds like it may be of value since a lot of option traders will close positions when they double their money. So it would be nice to know just how much the stock needs to move in order to reach that point.

Here's why it does not work. Say the above $100 call is priced at $5 with delta of 1/2. In order for the option to double, it would have to be trading for $10. Now, how many points does the stock need to move to create a 5-point move in the option? With a delta of 1/2, it may seem that the stock would have to move 10 points. However, delta is accurate for sudden, small changes in the stock price. If this stock were to move 10 points, you can be assured the delta will no longer be 1/2; it will be something much higher. So dividing the number of point movement required in the stock by delta will not work.

Further, we need to know how long it will take the stock to move. If you are told your option has a percent-to-double of 20%, we really need to know over what time period. Does that mean the stock must move 20% immediately, sometime today, next week or next month? Every single moment in time will produce a different percent-to-double figure. To complicate that even more, you have implied volatilities that are constantly changing, too. If the stock does move that high but implied volatility drops, your option will not double.

Another problem is that as the stock moves higher and the option becomes more in-the-money, the bid-ask spreads become very wide. So even if percent-to-double forecasted correctly, it would be in reference to the asking price and not the bid price, which is what you will receive for selling the option.

If you are still not convinced, use percent-to-double for your next hundred or so option trades -- you will not see one time that it forecasts correctly. There are just too many variables that affect the option's price.

The only time percent-to-double will work is at expiration. With the above $100 call trading at $5, we do know that the call will double in price if the stock closes at $110. With the stock at $110, the $100 call will be trading for $10 (the intrinsic amount) -- exactly double the price. But notice that in order for it to work, we had to wait until expiration -- and then it is too late.

Even if percent-to-double did work, there is just no value to the information. The markets already have that information priced into the option. It may seem that a percent-to-double of 1% is much better than 20%. However, think about this example: Say there are two stocks, A and B. Stock A is $100 and hardly moves, and the $100 call is $1/2. Stock B is a high-flying tech stock capable of moving several points in a day. It is priced at $50 with the $50 call at $5. Stock A has an at-expiration percent-to-double of 1%, and B has one of 20%. It should now be apparent why there is a difference. Stock B is much more likely to move, so the markets will bid it's option price up; that's why its price is $5 while A's is only $1/2. You have no added value by knowing the percent-to-double.

Unless you are familiar with option pricing, be careful with software that tries to pick out the "best" trades for you. Remember, the markets will always price in the proper risk-reward ratios. Using some of these tools can lead to a false sense of security and disappointing trades.

Hedging

Did you hold your tech stocks last month hoping for an upside bounce? YES! Are you now wishing you had sold instead? YES! Well, now you can reap the benefits of both.

Here's how...

Portfolio insurance is nothing new to professional traders yet unknown to most retail investors. Before you say, "I don't need any insurance," think about this: Many investors' homes and cars are insured, yet valued less than their stock portfolio. In addition, we have recently seen some of the bluest of blue-chips such as Proctor and Gamble, Home Depot, Eli Lilly and Hewlett-Packard lose over twenty-five percent of their value in a single day. Don't think it can't happen to the tech stocks you hold. If you are not familiar with portfolio insurance, read on and find out how the professionals take the emotions out of investing.

It is often said that knowing when to sell is the most difficult part of investing. This is because of the two most significant factors that drive the markets: greed and fear. When stocks are flying, we hang on hoping for more. When they fall, we sell the shares out of fear, often forgetting about the long-term reasons we bought them in the first place. We are afraid to take profits yet quick to take losses, which is not a very good formula for making money in the markets!

Now, we are not advocating short-term trading. After all, the stock market has a very long history of an upward bias, and statistically speaking, you are better off buying and holding. But the emotional side of the investor rarely allows this strategy to work. The roller coaster starts, your profits become losses, and there you are selling at a loss again. Is there a better way to trade?

In certain circumstances, you may want to consider portfolio insurance. Basically, portfolio insurance can be defined as an added asset to your portfolio that will increase in value as a particular stock or index falls in value. Financial professionals call this a hedge, and we will look at many ways to place a hedge in your portfolio, some without any out-of-pocket expense!

To understand hedging, you need to understand some basics of the options markets, as this is one of the primary tools used for hedging. Options were created as a way for investors to buy and sell risk, and while this may seem unusual, it actually occurs in many ways in our everyday lives. For example, driving a car involves the risk of wrecks, injury, and theft. You do not want this risk, but for a fee, your auto insurance company does. You have, in fact, transferred the risk to them. When you buy a one-year magazine subscription, you are transferring risk. The magazine company is at risk if the price of its magazines goes way up. Of course, you are at risk if the price stays the same or falls. But for the up-front fee, you both consider the risks mutually beneficial. Out of economic necessity, the options markets were created in 1973 as a standardized way for the financial markets to transfer risk.

In most cases, options can be purchased through most brokerage firms with just as much ease as a stock. Usually, you will need to fill out an options application and wait a few days to get approval. Do not worry if you do not get approved or are not comfortable with options, as we have another way for you to hedge yourself that will be discussed later.

More about options

What exactly is an option? Options are assets that give owners the right, but not the obligation, to buy or sell certain securities (or indexes) at a fixed price over a given amount of time. Since the owner has the "right, but not the obligation," this means that the owner of an option chooses whether or not to buy or sell -- it is their option to do so, hence the name.

There are two basic types of options; calls and puts. Call options give the owner the right to buy the stock (or "call" it away from the owner), while put options give the owner the right to sell the stock (or "put" it back to the seller). This is a contractual obligation, controlled through a clearing firm (called the Options Clearing Corp. or OCC), so there is no need to worry about a defaulting party on the other side of the transaction. Because they are contractual obligations, options are traded in units called contracts, just as stock is traded in shares, with one contract usually representing 100 shares of stock.

Options are standardized meaning there are only certain prices at which you can agree to buy/sell stock as well as specific time frames. The prices are set by the exchange at fixed intervals and are known as strikes, because that is the price where the contract is struck. As for the time frames, you will always find at least four different months being traded for stock options. There will always be the current month, the following month, and at least two additional months. Also, there may be longer-term options that can go as long as three years. Options do have a specified expiration date which, for trading purposes, is the third Friday of the month.

That's a lot of information, so an example should make things clear. Let's say it is October and you are bullish on XYZ stock trading at $50. You could purchase a January $50 call option that gives you the right, but not the obligation, to purchase XYZ for a price of $50 through expiration in January. Now, of course, there is a fee for this, called the premium, and let's say it is $5. This means that you are paying $5 per share, but remember, each contract controls 100 shares so the total purchase price for one contract would be $500 plus commissions. Now, you have the right to buy the stock at $50 per share at any time through expiration. If XYZ is trading for $70 when the option expires, the call option must be worth $20 (the difference between the stock price and strike). However, if XYZ is trading at $70 before expiration, then the option will be worth at least $20 as there will still be time remaining on the option and investors are willing to pay for time. How much they pay is up to the market and determined solely by supply and demand for the option. Of course, if the stock closes below $50, the option expires worthless so the most you can lose is the amount paid, in this case, $500.

You may be thinking, "Hey, wait a minute, how do I know the market makers won't try to rip me off and only offer me $15 for the call when I decide to sell?"

If XYZ is trading at $70 and the market makers are bidding $15 for the $50 call, then the arbitrageurs will step in and come to your rescue! These are people who watch for price discrepancies in the market and are able to make riskless transactions for guaranteed profits. These transactions happen at lightning speeds and do not last for long. Arbitrageurs will buy the call for $15, sell short the stock, and receive $70 for a net credit of $55. They will then exercise the option (use it to buy stock) for $50 and keep the $5 profit -- exactly the amount the market maker, in this example, was trying to steal! This process will continue until it disappears, at which point, the option will be trading for $20. So have no fear, the market makers cannot steal the intrinsic value (the difference between the stock and strike) of your option!

What if you were bearish on XYZ? Well, you could instead buy a January $50 put. Now you have the right, but not the obligation, to sell your stock for $50 per share through expiration in January. If XYZ is trading for $40 at option expiration, the put must be worth $10 (the difference between the strike and the stock price). If XYZ is trading at $40 before expiration, the put must be worth at least $10, as there will still be time remaining. If a market maker decided to only bid $8 for the put, arbitrageurs will buy the put for $8, buy the stock for $40 (far a net debit of $48), exercise the put and sell the stock for $50 for a guaranteed profit of $2. Again, this process (which would be measured in seconds) will continue until the put is priced fairly at $10.

So far, we have only considered the owners or buyers of calls and puts. What about the person who sold them? Well, the seller of any option has an obligation to perform. If you sell a call, you must sell your stock if and when the owner of the call chooses to buy it. If you sell a put, you must buy the stock if and when the owner of the put chooses to sell it. It is only the owner (the long position) who has the right; the seller (short position) has an obligation.

Hedging your portfolio

Now that you have the basics of options, let's look at ways to hedge and see if hedging sounds like a good idea to you!

Assume we are back in late May and you bought Intel (INTC) at $55. Later, in mid July it's trading above $70 and you decide to hedge by buying a January $70 put trading for $10.

By placing this trade, you have guaranteed yourself a profit of at least $5 per share through expiration in January. This is because you can always sell your shares for $70 but it cost you $10 for a net of $60. Because you paid $55 for the stock, the put guarantees you $5 per share profit.

Now consider the advantages of this trade. If the stock continues to move higher, we still participate in the upside (less our $10 premium). But if the stock starts to fall, as it did in mid-July when we bought our put (see chart above), we now have removed the emotional side out from our trading! The put allows us to focus on fundamental values in the company, and not the short-term downtrend. We can hold the stock, hoping for an upturn, yet never regret it as we have locked in a profit. There's also no fear of a maintenance call (for those who trade on margin). Best of all, it's easy to sleep at night knowing you never have to look back thinking "I should have sold that back when it was $70" because now you have the option to do so! It's not a bad deal if you think about it -- guaranteed profit of at least $5, with no limit to the upside, and we have all the way until January reap our rewards.

Some people think the "downside" to this trade is if the stock continues to run higher and you "wasted" your $10 on the put. However, is your home insurance a waste just because it never caught fire? Of course not, and you shouldn't feel that way about the put either. In fact, because you still participate in all of the upside movement of the stock, the best thing to happen is for the stock to climb higher, leaving your put worthless.

Let's look at our profit and loss profile (at option expiration) on the trade above with and without the put.

Stock Price	Profit/Loss for long stock @ $55	Profit/Loss for long stock @ $55 + long $70 put @ $10
100	+ $45	+ $35
90	+ $35	+ $25
80	+ $25	+ $15
70	+ $15	+ $5
60	+ $5	+ $5
50	- $5	+ $5
40	- $15	+ $5
30	- $25	+ $5

It is easy to see the value of the protection here. Look at the profit/loss for the two positions in the table above. If the stock closes at $100, the long stock position will have a gain of $45 points ($100 minus the $55 cost), while the long stock/long put position will have a gain of $35 (this is due to the $10 spent on the put). There will always be a $10 difference between the two positions for all stock prices at $70 or above. So the investor that hedged the portfolio will only be off by $10 in terms of profit and loss to the upside, but look at the difference to the downside!

For any stock price below $60, the hedged portfolio dominates. For example, say the stock closes at $40. The investor who bought the shares at $55 is down $15 points. The investor who hedged is also down $15 on the stock but the $70 put must be worth at least $30 points (the difference between the strike and the stock price). This gives a profit of $15; however, we must subtract out the $10 cost of the put, which gives us a total profit of $5. This $5 profit will hold for all stock prices below the $70 strike of the put. This is exactly what happens in a fully hedged position. The loss on the stock is exactly offset by the gain in the option.

Options can be very versatile and there is no need to necessarily have hedged our imaginary position above at $70. If you are willing to take a $5 point "deductible," you could have elected to purchase a $65 put which would be cheaper than the $70 for exactly the same reason your auto insurance is cheaper when you assume some of the risk through a deductible. The options market will always give less value to a put with a lower strike with all other factors being the same. So the choice is yours...do you want more protection or cheaper cost?

Hedging with no out-of-pocket expense

There is another hedging technique that may be interesting to you. This one allows you to hedge all the downside risk, as above, but without paying for it! Of course, nothing is free in the financial markets, so what's the catch? The catch is that you must be willing to give up some or all of your upside potential in the stock. We do this by selling call options against the stock and then using that money to buy the puts. Remember that when we sell an option we have an obligation. So if the person who buys the call from us elects to buy our shares, we must sell. This hedging strategy is sometimes called a collar.

Let's run through an example with the same INTC trade above. Again, we bought shares at $55 and the stock is now $70. The $70 put is trading for $10. We could sell the $75 call option and buy the $70 put. Depending on where they are trading, this trade may result in only a slight debit instead of the $10 we paid before. Or we could buy the $65 put and sell the $75 call for a credit of about one. That's right, depending on which options we choose, we can actually get paid to put on the hedge. But be careful, the only way to get a credit is to allow for a bigger downside loss. It doesn't mean that it's necessarily a bad trade, it's just that the credit doesn't come for free.

For example, say we sell the $75 call and buy the $65 put for a net credit of $1. This means we actually get paid $100 per contract. Now, what does the profit and loss look like at option expiration?

Stock Price	Profit/Loss for long stock @ $55	Profit/Loss for long stock @ $55 + long $65 put + short $75 call for credit of $1
100	+ $45	+ $21
90	+ $35	+ $21
80	+ $25	+ $21
70	+ $15	+ $16
60	+ $5	+ $11
50	- $5	+ $11
40	- $15	+ $11
30	- $25	+ $11

Now compare this profit/loss (at expiration) table to the previous one. We can easily see that we have sacrificed upside potential, as our max gain with the collar is only $21 regardless of how high the stock goes. However, because we didn't pay $10 for the put, our downside is much higher with a credit of $11 instead of $5.

To recap, hedging is a method of maintaining upside potential, whether limited or unlimited, and reducing our downside loss. Hopefully, it is now apparent that hedging can be beneficial!

Hedging without options

There is a really nice way to hedge your portfolio without the use of options. Through the use of "bear" mutual funds, mutual funds that go up in price as the market falls, one can easily hedge a portfolio. However, some funds are better than others for hedging. One that we like to utilize from time to time is the ProFunds UltraShort OTC Fund (USPIX). This fund is unique in that it produces double the inverse of the Nasdaq 100 (NDX), the most volatile of all indices. So if the NDX is down 5%, this fund will be up 10%. Of course, the reverse is true too; if the NDX is up 5%, the fund will be down 10%. Further benefits are that you are not on margin, as would normally be the case to produce a 2:1 performance ratio. Also, you do not need options approval and there is no expiration as with options. You are also not exposed to "time decay" which is the portion of the option premium that erodes with the passage of time. On the downside, mutual funds only trade at one time -- in the evening after the close -- so you cannot trade them intra-day. But if you have a heavily laden tech portfolio and are looking for a relatively cheap way to hedge, USPIX is tough to beat!

These are just the basics of options and hedging, and are intended to show the benefits of hedging, which can be very important at certain times in the market.

We will be recommending various hedges for winning positions and we want you to be aware of the idea and philosophy behind them. Please understand that these are just the basics; there are numerous factors to consider before placing a hedge. Some of the factors are the deltas and gammas (options sensitivity measures) as well as implied and historical volatilities. Sometimes we will utilize roll-up or roll-down strategies as well as dollar-cost or constant-dollar methods. But that's what we are here for. As a subscriber, you can be assured that we look at all relevant factors, combine them with a lot of research and expertise, and relay the information to you as quickly as possible to insure winning trades.

Remember, in a bear market, the money returns to its rightful owner. Hedging can keep you from giving it back!

Options Expiration Cycles

You may have noticed that not all stocks have the same months available for options. For example, it is now October and MRVC has April options, but SCMR does not. Why is that? When will April options become available for SCMR? In order to answer these questions, you need to understand option expiration cycles.

When options first started trading in 1973, the Chicago Board Options Exchange (CBOE) decided that there would only be four months of equity options traded at any given time. Later, with the advent of LEAPS (Long Term Equity Anticipation Securities) more than four months could be traded, at least for the more popular securities. Your local newspaper probably only prints three of these months, to conserve space, but understand that there are always at least four different months traded at any given time (more if LEAPS are available).

Originally, stocks were assigned to one of three cycles, either a January, February, or March cycle. The assignment had nothing to do with earnings cycles of a company or any other deep-seated reason; it was purely a random assignment.

Option cycles

A January cycle meant that options would be traded on the first month of each quarter. So if a stock were assigned a January cycle under the original rules, options could only be traded in the following months:

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

A February cycle could only trade on the middle months of each quarter:

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

And of course, the March cycle would be traded on the end-months: March, June, September, and December.

Because of these positions, sometimes you will hear the cycles referred to as front-month (January), mid-month (February) or end-month (March) cycles.

As options gained in popularity, investors and floor-traders alike were looking for ways to trade or hedge for shorter terms. So around 1984, the CBOE decided to always trade the current month, the following month (called the near-term contract), and an additional two months from the original cycle. This can get a little confusing, so it is best to explain with an example.

Example:

Say it is now January and we are looking at a stock that trades options on a January cycle. Which months will be traded?

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Looking at the above diagram may help. Remember, under the new rules, the CBOE decided that there would always be the current month plus the following month available. Because it is January in our example, then January and February will be available. Because four months must trade, the remaining two months will be from the original cycle, which would be April and July.

What happens when January expires?

When January expires, then the current contract will be February so we would see the following:

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

When February expires, March will be the current contract so we will see:

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

However, notice now that only three contracts are traded and we need four!

Because a fourth contract must now be made available, October will be added because it is the next month available on the January cycle so, when February expires, we will see:

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

A commonly asked question is, continuing with the above example, "When will, say, November contracts be traded"?

This is easy once you understand option cycles. The first thing you want to ask is this: Is November part of the January cycle? No, it is part of the February cycle. Because it is not on the same cycle, the only time it will become available will be when the September contract expires. When September expires, October will be the current contract and November will start trading.

Ok, here's where it gets a little tricky. See if you can answer the following question using the diagram below, still assuming a January cycle.

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

It is now April and we have April, May, July, and October trading as shown above. When will the January contracts start trading?

Because we're wondering about a month that does in fact fall on the January cycle, this one may open for trading months in advance.

If you run through the steps above, you will see that the January contract will start trading when May expires. Once May is expired, June will become the current month, so there will be a June, July and October for a total of three months. The fourth month will be the addition of January.

LEAPS

As mentioned earlier, there are always at least four contracts trading at all times. If a stock has LEAPS traded, then more than four months will be available. Once you understand the basic option cycle, adding LEAPS is not too difficult.

LEAPS are long-term options that usually trade in January for a maximum of three years out, although there are exceptions. If a stock trades LEAPS, then new LEAPS will be issued in May, June, or July, depending on the cycle. When January month is "hit" in the normal rotation (other than by default as the current or near-term contract), a new LEAP will be added. The January option will become a normal option and the root symbol will change.

Again, this is difficult to explain without the use of examples so let's look at INTC options.

It is currently November and INTC has the following months trading:

Month	Root Symbol
November	INQ
December	INQ
April	INQ
January '01	INQ
January '02	WNL
January '03	VNL

From what we learned earlier, we know there must be a November and December contract and we see that there is. You can never tell which cycle a particular stock is on just by looking at the first two months; remember, all options will have these months being traded.

We see that January '01 is the next contract traded. Normally, this would tell us that this stock is on a January cycle. However, INTC has LEAPS, too which means there will always be a January option traded so we still cannot be sure which cycle it is on just because we see January next in line. Looking out to the next month, we see April is trading. Because April is part of the January cycle, we can now be certain that INTC trades on a January cycle.

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Based on what we know, the four months highlighted above should be trading for INTC, and we see they are when compared to the above table. When November expires, December and January become the current and near-term months respectively, and July will be added.

In this case, no LEAPS will be added because the LEAPS are currently out three years to '03.

However, when May expiration comes around, June, July, October will be trading and January will be added. At this point, the '02 LEAPS will have their root symbol changed to INQ and the '04 LEAPS will be added.

So depending on which cycle your stock is on, look for new LEAPS to be added sometime in late May, June, or July. Otherwise, the basic option expiration cycle applies.

Let's go back to the questions asked at the very beginning and see if we can find out the answers:

It is now October and MRVC has April options but SCMR does not.

1) Why is that?

2) When will April options become available for SCMR?

Looking at the options for MRVC there are:

November, December, January, April

For SCMR:

November, December, March, June

It is evident there are no LEAPS as there are only four contract months trading. We know there will be November and December for each. For MRVC, the next month is January so it is on a January cycle and SCMR is on a March cycle.

When will April options become available for SCMR?

Because April is not part of the March cycle, the only time April options will become available will be when February expires. At that time, March will be the current month and April will be the near-term contract.

Option expiration cycles can be a little confusing if you are new to them. With a little work, they will become second nature. They are important to know because many strategies require some type of position management during the holding period, yet the proper contracts may not exist. Understanding these cycles can give you an added edge in option trading!

Additional questions:

1) It is now August and your stock trades on a March cycle. Which months should you expect to see trading?

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

We will see the current and near-term months trading, which will be August and September. In addition, we will see two contracts from the original March cycle, which will be December and March.

2) When will the May contracts start trading?

Because May is not part of the March cycle, the only time they could trade is when March contracts expire. At that time, April will be the current month and May will be the near-term.

3) When will the June contracts begin trading?

Since June is part of the March cycle, it could start trading months in advance, so we need to be careful here. Run through them step-by-step.

When August expires, we will have September, October, December and March for a total of four contracts so no June contracts, will trade at this point.

When September expires, we will see October, November, December and March, so June still will not trade.

When October expires, we will have November, December and March for a total of three. At this time, June contracts will be rolled out.