Option Trading College

Subject: The Basics of Trading Call Options
Instructor: The donFranko
Length: 6 sessions

Training  Home

Entry is Key...Exit is Everything! TM

Session 1 – Calls: The Basics

Ah, the Call Option. What excitement if played correctly! What agony if you make a bad choice!

 

Call Options give you the right (but not the obligation) to buy a specific stock at the strike price you choose on or before the expiration day of that option contract.

Q. So what is a contract?

 

A. All options contracts are based on 100 share lots. If you buy, say 10 contracts, then you are controlling the right to buy 1,000 shares of that stock if you actually exercise the option.

 

Q. What is exercising an option mean?

 

A. It's when you decide to actually purchase the stock at the strike price you bought your option at—this is something you will most likely never do because an option trader is not looking to buy stock.

 

The goal of most options investors is to leverage their trading capital by controlling the stock through the option with a fixed amount of risk (the cost of the option); and their primary goal is to sell that option at a profit.

 

Q. Why not buy the stock?

 

A. Buying the stock takes a lot of capital and your risk is 100% of all your capital used. Stocks can and have gone to zero. Options give you the advantage of a fixed amount of capital risk; however, you have limited time to exercise your option contract. The best reason most investors like options is because an option makes a larger profit than a stock does on a percentage basis.

 

Q. How does it do this?

 

A. It does so because of a little thing called implied volatility. Options are derivatives of a stock and are subject to wide price swings based on mathematical calculations called "The Greeks" or better known as: Delta, Gamma, Theta, Vega, Rho. I will cover these in more detail later. These are complicated mathematical calculations based on the Black-Scholes model—a very complex pricing calculator that controls the price swings in options.

 

To really understand call options, you must know how their values are calculated, what makes them move, and how time effects your options price swings. You can read boring information but it will never teach you the valuable lesson that a live trade can and will.

 

I am going to give you a fast track lesson that will save you hours of study, years of learning curve and lots of money trying to figure it out.

 

Let’s use an example from a fast moving stock so you can gain a valuable perspective. The hottest stock right now is Google (GOOG), which, as of this writing, is currently trading around $508.00 per share...gag.

 

You know you want to buy this stock and you have done your research giving you the strong opinion this stock is about to make a big move higher. Now if you want to buy 100 shares of the stock, you have to put on the line $50,000! Well, you just cannot afford that, so you decide to buy 1 contract of a call option.

 

Your first step is to log onto the CBOE website (or your brokers), enter the symbol and pull up some option quotes and, WHAMO! about 100 choices jump up on your screen...YIKES!

 

The options start with the current month and go forward up to 3 years into the future.  Consider the current or next month to be short-term options; three to six months out are mid-term options; and anything longer than that are called long-term options — usually referred to as LEAPS.

 

If you’re buying based on a news story—good news typically lasts 1 to 2 days and bad news can last for months—then consider short-term options. Your goal is to get in and out in as little as a few minutes, hours or a couple of days.

If you’re running with an upwardly trending stock where the 18 day moving average is above the 40 day and both are moving up; and you don’t mind the daily volatility all stocks go through, then mid-term options might be you’re choice.

If you really like a stock for the long-term, and you’re not interested in watching it every minute or day, except for a quick glance every couple of weeks to a month, then long-term options (LEAPS)  are your road to profits.

 

All options have two prices just like stocks. The Bid and Ask are what makes a market and of course what makes a Market Maker rich! One thing you must understand is options carry a time limit and you are always under the gun with time decay. The very second you purchase an option you are immediately at a loss, so it's imperative if you plan to day trade them that you buy in-the-money (ITM) only! If you buy out-of-the-money (OTM) then you are gambling and you better have an iron stomach and fat trading account because 70% of all options bought expire worthless!—The only time I buy OTM options is when I am speculating for one of my Lotto Trades.

 

The hard part of day or short-term trading options is overcoming the spread. Depending on the stock price you play, that spread can fluctuate from .10 - $1.00. This means that once you are filled you are already at a deficit—all the more reason to buy (ITM) options since part of your investment is actually intrinsic value and the Delta is much higher. Fortunately, there is a change coming soon. The NASDAQ is going to start trading options, and their spread will be reduced to penniesthis will make things even more exciting!

 

Too many times, inexperienced traders jump all over the (OTM) options because they perceive them to be cheap. Let me tell you, cheap is a 4 letter word in options trading if you plan to day trade. ONLY a very experienced options trader should attempt to trade (OTM) short term options. I am talking short term in where the options expire in less than two weeks.

 

Look at this way. If you are late to a very important business meeting that will make you rich, and you are driving feverously to get there but coming up is the final intersection to make a left turn and you arrive; however, the left arrow light just turned red what do you do? Looking to your right you see a police car waiting and looking in front you see traffic approaching at 45mph. If you miss this meeting it's going to cost you a lot of money so what would you do? Most people tell me they are going to stop and wait for the green arrow. I ask them why and they say because they do not want to get into an accident.

 

Interestingly enough, they never mention the policeman seeing them run a red light and having to pay a hefty ticket. I further inquire if they stop because they do not want to wreck their car or possibly get injured, maybe even killed. Most people think about their car first...can you believe that?  Your FIRST inclination should always be self-preservation—in other words, protect your trading capital at all costs!

Buying (OTM) short-term options is like running the red light, getting into an accident, getting injured or even killed, and if you manage to squeak through, then you get a very expensive ticket from the policeman!

With that lesson, let's explore the pricing of options and which ones you should start your journey with. Options are based on the value of the strike price you choose. There are three choices:

 

1. At-The-Money (ATM) which means the stock is trading at or near the strike price.

 

2. In-The-Money (ITM) which means the option's strike price is below the stocks current trading price.

 

3. Out-Of-The-Money (OTM) which means the option's strike price is higher than the stocks current price.

Each one carries benefits or risks and this is where many new traders make grave mistakes by not learning the value behind each choice.

Let's look at an example.

 

Say you wanted to purchase Google. Taking a look at the close of trading on 11/23/2006,  the current ask price will cost you a whopping $508.01 per share...ouch! Now you might not have enough money to grab a lot of shares, but your research has led you to believe it will rise significantly in the short-term. How do you control more shares when you do not have enough capital? You choose a "Call Option" as your strategy vs. buying the stock on margin.

 

You have three choices when you decide to purchase an option contract. First off is picking the month of expiration, next is the strike price and finally you must KNOW YOUR EXIT!  

 

Here are the current prices on some call options for Google:

 

GOOG  $508.01 Close

Nov 23, 2006 @ 20:43 ET - Bid 508.00 Ask 508.09

 

 

Lets say you pick the front month and you buy at-the-money (ATM). In this case it would run you around $18.30 cents per contract. Since a contract is equal to 100 shares of stock you would have to put up $1,830.00 per contract in order to control 100 shares of Google. Note: your investment is only $1,830.00 per contract vs. $50,801.00 for the stock. This is the MAXIMUM amount of money you can lose; whereas, the stock could plummet $50, even $100 or more per share on a bad news story and wipe out a significant amount of your trading capital—if you have a stop loss.

 

Stop losses are good if you can watch during the day, but if you are holding overnight and there is a bad news story, you will get a very bad fill because stop-loss orders are typically placed as market orders; however, when you buy a call option, your downside is capped while letting your upside potential become unlimited! If Google rises, then you make a nice profit, but if Google drops significantly, you have capped your loss to the cost of the option contract.

 

Where is the risk? The biggest enemy of options is time decay. If you buy the stock, you have all the time you need to make a profit or recover (potentially) from a bad news story. If you buy the option then you have set the clock running on how long you have to sell/exercise it. This is where many new option traders make two grave mistakes. They do not buy enough time and they buy out-of-the-money (OTM) options. This is why it is critical you do your homework on the stocks you pick. I highly recommend you buy at least two months of time for (OTM) options. Also, make sure the stock is definitely in an uptrend and coming off support.

 

Here is why I say this: If the stock is at or below your chosen strike on expiration, you will lose your $1,830.00 investment because you paid a "premium" for the right to exercise your option. Remember, you paid $18.30 for an ATM call option. This means Google must trade over $518.30 at expiration in order for you to make a profit. Now that is a big move for any stock to make so this is why you need to buy more time. Today is 11/23/2006 and the Jan 2007 $500 strike is trading at $28.50 per contract. The market maker is bumping the premium another $10 for the extra month which translates to Google trading at $528.50 per share by January 2007 expiration. It's a scary thought to risk this much money for only 60 days, but that is what makes the options market so enticing...huge upside potential with capped risk!

Every day that Google moves higher in price, your option premium grows in profits. Well, sort of, because there is a gremlin in the details and that is time decay. In order to maintain a consistent profit, Google must move up every day so your (ATM) or (OTM) option can overcome time decay. If Google whipsaws around, then your option premium will also whipsaw. Many times a stock can go up significantly, then pull back and go up again, but your option premium actually loses value...huh? Yes, I said loses value because, if you remember, you paid $18.30 for an (ATM) option. This means you have that amount of blue sky that can disappear on you. So as long as Google's price stays under your premium + strike price, the Market Maker can manipulate the options value. Of course it's all done mathematically based on the Black Scholes Model, but in reality, the Market Makers have no problem with skewing the math ;-)

How do you minimize this? You buy in-the-money (ITM) options. This way, part of the premium you pay is actually covered in the price of the stock. This is called intrinsic value and it's your best hedge against whipsaw. As the stock moves up in value your option premium will grow faster because you have more "Delta" (see below) working for you; and should the stock get some whipsaw, you have minimized the amount your option decreases in value.

 

For example, the $480 call options are trading at $32.90. It's seems to be a hefty price to pay but you are actually $28.00 (ITM). Your premium for the option is only costing you $4.60 vs. $18.30 for the (ATM) options. The Delta would typically be around $0.50 - $0.75 cents which means that every dollar Google moves up your call options increase by $0.75 cents in value. As the stock does go in your favor your Delta also improves but it's very susceptible to whipsaws and manipulation.

Now look at the (ATM) options. You are paying the FULL $18.30 per contract for what? NOTHING! The delta is barely better than What a difference you pay for time premium for those (ATM) options. Note: At-the-money options are ALWAYS the most expensive options to buy.

 

What about buying out-of-the-money (OTM) options? This is gambling! Many times (if not all the time) new option investors often buy (OTM) options because they are cheaper. Well, they are cheaper for a reason—they have ZERO intrinsic value! You are paying 100% blue sky and hoping the stock goes your way. The reason so many do this is because they can buy more contracts for the same money invested (leverage). The only time this works out (if ever) is because the stock surpasses the (OTM) strike price to give you a profit. Here is what I mean: currently the $520 calls are trading at $8.80. This means Google must close over $528.80 by December expiration for you to be profitable. That means that Google would have to climb $20.59 just so you can break even. Sure, Google can do it, but it can also fall much further too! The delta is typically .25 cent or lower so for every dollar Google does rise, your options only increase by .25 cents. Hmmm, lets see, if I paid $8.80 that means Google has to be trading over $528.80 by December expiration or I lose all my money...$8.80 divided by .25 cents means I would actually need a $35 move just to cover my cost of the option. Are you getting the picture yet? Now you do not actually have to have a move that large because the Delta will adjust higher as the stock does; however, if Google does not get a move on immediately your will NEVER overcome the time decay.

 

Bottom line! Do not buy (ATM) or (OTM) when you are a new options trader. If you do, be ready to take profits sooner if the stock moves up immediately after you buy them. I highly recommend you buy at least two months of time until you are profitable and completely understand how volatility changes options prices. If the stock rises suddenly, but is still out-of-the-money, take your quick profits off the table because it will invariably pull back and your profits will disappear faster than they went up. If you manage the (ATM) or (OTM) trade you can sell for high and re-buy for less as the month moves forward. This takes timing, experience and luck to get it right. I have been trading options for 8+ years and I still struggle with it...so does everyone else! Save yourself a ton of heartache and stress...only buy (ITM) options in front month and when you make a profit take some of that off the table and buy (OTM) options in the next month for the "Lotto" play.

 

Its been said the most options expire worthless. These are true words one must really understand and then prepare for battle when trading options. If you plan on becoming a winner and not a statistic then you have to follow my rules of trading or just buy stock and hold it. Investors who buy call options NEXT-TO-NEVER exercise the option contract. Before you buy anything, you have to know WHY you’re buying and WHAT is you’re objective see controlling losses. The “why” is very simple, you ONLY buy a call option when you, after all your research, feel confident that the stock you picked is going up—and the faster the better.

 

How do you determine that? If you just pick a stock because you "like" it, then jump on a plane and come to Las Vegas because, YOU ARE GAMBLING!

 

The ONLY reason you buy call options is because the stock has

FUTURE COMPELLING NEWS! 

 

The masses (fish) will bid up a stock price when there is something in the future to look forward to. Now do not get me wrong here, I am not talking about some analyst (financial terrorist) coming out with an "upgrade" or "strong buy" rating. This kind of news is after-the-fact and those analysts (more often than not) are selling to the dumb money! You want to buy call options when a stock "pre-announces" news about their: share price, better earnings than projected, 2:1 Stock Splits, etc. These types of news announcements give you something to look forward to. Do not get sucker-punched with an analyst upgrade or downgrade on hype channels like CNBC.

 

 

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Session 2 Surprise Surprise!  

 

Everybody likes to trade the volatile stocks because they think they can make a lot of money. This can be true, but many times, new option traders make very bad choices on strike prices and their timing is off 95% of the time. What do you think is the hottest stock to trade right now? You guessed it...Google!

 

Today is 11/29/2006 and I want to show you how devastating a stock like Google can be to call option prices when it decides to go down rather than up. After the Thanks Giving holiday, Google sold off sharply and managed a slight bounce today. Will it hold? Only time will tell, but I wanted to post the closing prices on the options to show you just how dangerous buying ATM and OTM can be.

 

GOOG  $489.50 Prior Close

Nov 29, 2006 @ 07:37 ET - Bid 491.50 Ask 493.75

 

 

Notice how much of a beating those $500 calls took from a couple of days ago? You would have been stopped out long before this if you had a trading plan, but many times (me included) new options traders buy (OTM) or (ATM) options based on speculation; and when things go bad, like this example clearly shows, you tend to hold on with hope...A VERY BAD IDEA!

 

You may notice that all the option prices, including (ITM), took a beating. This is because Google has a very large amount of premium in the price of all these options; and when the stock takes a large hit, your premium (blue sky) turns into a reality check...kind of reminds me of a certain chicken named Little...;-)

 

This is why you must DO YOUR HOMEWORK and buy more time!

 

Session 3 Example 1...short-term options   

Lets look at an example of a short-term play. Google has been on a tare lately due to great earnings, future growth, hype by many "guru's" and its just a great stock! It's a very expensive stock, so thousands of investors like to play options on this winner and take advantage of the volatility.

Here’s an example of prices from the CBOE.  

GOOG  $484.65 Close  -4.85

Nov 30, 2006 @ 2:25 ET - Bid 484.65 Ask 484.59

 

Take a look at the pricing chart above. These are some of the strike prices available on Google for the front month and the next month. Depending on which one you pick, you will pay a premium for the right but not the obligation to purchase the stock by the expiration date. Option prices are calculated by adding their intrinsic, time and volatility values. Because Google is a large stock (+$200), the options are traded in $10 increments. Stocks that are priced under $200 are traded in $5 increments and under $50 are traded in $2.50 increments.

 

Looking at the $480 strike we see the price is $14.30 (BID) x 14.40 (ASK). With the stock trading at $484.65 you are slightly (ITM) but considered (ATM) for this strike price. If you were to go deeper (ITM) and purchase the $470's, then your price would be $21.30 and this would put you $14.65 (ITM). This translates to the intrinsic portion of the options value; and if you went (OTM) the $490's would cost you $9.50 which is pure time premium or "blue sky" that can evaporate on you.

 

DANGER! DANGER! -- When you buy (ATM) options, you are paying the MOST money, and if you buy (OTM) options in the front month, you are GAMBLING...Vegas Style!!

 

The cost for the $480's is $14.40 which is the ASK. What exactly are you getting for your money? Well, since this strike price is slightly (ITM) you have $4.65 of intrinsic value and $9.75 is time premium or "blue sky" which translates into the volatility. Even though you are slightly (ITM) you can see there is a substantial amount of premium added to this stock. What this means is Google must get moving UP, and the faster the better, or you will be losing money rapidly. Speaking of losing money, you will notice there is a lower price offered. This is called the BID and that is what price your options can be sold for, so you can see the second you are filled, you are already at a slight loss of at least .10 cents; and as the day and stock price fluctuates, the spread can increase depending on the demand and, in my opinion, the particular mood of the Market Maker.

 

My advice is to buy one strike price (ITM) or if you must, one strike price (OTM) only if you are experienced and have a fat bankroll.

 

Session 4 Example 2...OTM options   

 

Next we will look at the (OTM) options. These options are gambling and as you can see by the volume and open interest above there are a lot of gamblers placing bets. Notice the volume and the open interest on the $490's and $500's. Looking at the $500's we see they are trading at $5.90 which appears to be cheap compared to the $480's, right? Not really, because they are cheap for a reason! With this option you are getting zilch for intrinsic value and paying everything for pure time and volatility. It is vital you understand that the stock must get moving up immediately if you stand the slightest chance of making a profit. See my section on a day in the life of an option to really see how the price fluctuates from day-to-day.

 

With today being 11/30/2006, these December options will expire at the close of trading on 12/15/2006. This means that you have two weeks (actually 11 trading days) for this stock to move $21.25 or your options will expire worthless. Are you beginning to understand?

 

Pay attention here!

 

Do you see the closing price of Google in the illustration above? It show's that GOOG moved down -$4.85 today. Now look in the “Net” column for the Dec $500 options. These options actually went DOWN close to 25% in value! You can also see that the $480's dropped more in value, but on a percentage basis you lost less money.

With two weeks left to expiration it's highly speculative that Google price will rise enough to get back to the prices you may have paid pre-holiday. This is why it's extremely dangerous to play big stocks (any stock for that matter) with short-term options. It should only be done by traders with years of experience and a large enough bankroll to absorb the many losses they will take.

Do yourself a favor and learn from my mistakes...only buy (ITM) options for short-term trading.

 

Session 5 Intrinsic Value

GOOG  $484.65 Close  -4.85

Nov 30, 2006 @ 2:25 ET - Bid 484.65 Ask 484.59

 

 

Let's discuss in more detail what Intrinsic Value is. It’s a big college word and can be quite confusing to the new trader. Many people never understand it and unfortunately pay a heavy price when buying (ATM) or (OTM) options.

 

Take a look at the illustration above and you will see Google closed at $484.65 per share. The $480 strike price is (ITM) and the ask is $14.40. Now doing a little math we can see the intrinsic value is $4.65. Next you deduct that from the price from the price of the option and you will discover there is $9.75 of implied volatility or time premium...aka "blue sky!"

 

When you buy the (ITM) option you are actually paying for some of the current stock price and this lessens the amount of premium you pay. Lets say that Google took off and ran up in price all the way to at $505.00 per share by expiration day. You now have choices to make. You can sell your options for a good profit or you can exercise your options and actually purchase the stock. Again we look at the math and find out our option play has a bid of $25.00. The way I know this is because we deduct the last price and our strike price to get the intrinsic value. Since we paid $14.40 for these options we now have a profit of $10.60. WOW! That is over a 73% return on our investment!!! This is why options are so exciting. What if we had purchased the stock instead? We would have made $20.35 which translates into a 4.2% profit. Not bad but certainly not as good as 73+%; and the best part is we risked substantially less money with the options. Of course it could have been a different outcome, but I am illustrating the value of intrinsic value here.

 

What if Google only rose to $490 by expiration? Here is where you get a lesson about implied volatility. If you remember, you already had some intrinsic value when you bought these options, but you also paid a hefty premium. So to estimate your profit and loss potential you have to take the strike price you bought plus the amount you paid for the option; and the stock must be trading higher than that in order for you to be profitable. So, if we add our strike and premium we get $494.40. This means you would lose money on this trade if you held it to expiration. How much you lose is again based on math. We take the closing price of $490 minus our strike of $480 and then deduct that from the premium we paid and the loss would be $4.40.

If you had purchased the (OTM) $500 options you will notice you actually lost even more money than you did with the  (ITM)options. Do not get trapped by cheap options. Many investors buy (OTM) thinking they can capitalize on more contracts and thus make a bigger bang for their buck spent. Yes this is true, but the stock must move up fast and far to effectively give you a handsome profit. In fact, it has to move up past the strike price you bought plus the amount you paid for the option in order for you to be highly profitable. If the stock whipsaws around your chances of making a profit are all but gone.

 

Session 6 Greeks: Delta, Gamma, Theta, Vega, Rho   

 

The Greeks are mathematical variables that effect the way an option price fluctuates. They are complex and take powerful software to figure out. There are services you can subscribe to that will provide nice graphs and give you probabilities, but if you just buy ITM options in upward trending stocks, you will protect your money; and rest assured, you will make money on your options as long as the stock is heading in the direction you chose.

 

Here is a link to test out one of those fancy calculators:

 http://www.cboe.com/LearnCenter/OptionCalculator.aspx

 

Delta - This is the most recognized Greek. It's what determines the movement of the price of an option in relation to the movement of the next dollar of the stock. The further (ITM) you buy the bigger the delta. Delta is very important to making profits when you buy short term options. The typical delta for options two strikes in the money is between $.75 – .85 cents. This means that for every dollar the stock moves up the option will increase by the delta amount. On the same note if you buy two strikes (OTM) the typical delta is only $.15 cents. NOTE: If the stock whipsaws around your delta is dramatically effected.

 

Gamma – This determines how much the delta will move in connection with the movement of a stock. If you buy (OTM) options the delta is so small that time or (gamma) will wipe out your delta fast unless the stock is moving up quickly.

Theta – Represents time decay. Every day you move towards expiration this little Greek is like a Trojan horse.

 

Vega –This Greek represents the rate of change in the option's theoretical value for each 1% change in the volatility.

 

Rho – The expected change in the option's theoretical value for each percentage change in interest rates.

 

Phew! I know it gets confusing and you need a mathematics degree to understand this stuff, so to sum it up, the deeper you buy (ITM) the bigger the delta and your profits as the stock moves up. Of course it works against you on the way down too, that is, unless you have puts!

 

If you buy short term options you need the maximum delta so that would take deep (ITM) options—two or three strike prices. If you buy (OTM) I highly suggest you buy at least two months of time. I have been right many times, but wrong on the time frame only to see an option stopped out at a hefty loss; and even expire worthless because I was just praying the stock would turn around before time ran out. This is called gambling and Vegas will at least give you a few nice buffets, shows and attractions while you lose your money.

 

Option investing is calculated buying/selling with a clearly defined goal in mind. If you want to gamble, take a trip to a casino; otherwise, just buy the stock since time does not matter. Options will eat your lunch and then some if you are not wise in your approach.  

 

 

Profits Up!

The donFranko 

 

 

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