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Options Lab Part 1: Why Options? Why Not?

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September 1, 2013
Options Lab Part 1: Why Options? Why Not?

There’s only so much about the markets you can learn from books, right? At some point you have to jump in. Experiment. Struggle. Learn. Tinker. And, ultimately, grow more confident in adding options to your investing mix. That’s our goal here with a series of brief, instructional articles that start at the beginning and build to combining and applying basic principles in more complex (complex, sure, but also more versatile) strategies, including spreads. Now options trading isn't for everyone, but we’ll toss in links to archived The Ticker Tape articles and blogs on options that will appeal to traders of all grade levels.

Finding an awesome lab partner for you? That’s out of our scope. But we can say this: options trading (like all trading) is an increasingly social endeavor. We invite you to share and learn in a chat room such as myTrade. Or, follow the Twitter pages of the always-exploring, always-experimenting members of the TD Ameritrade trading team, Joe “JJ” Kinahan and Nicole Sherrod. Email the editors options article and blog topics you’d like to see.

Virtual Lab

paperMoney® gives you real market experience without real dough on the line. At the thinkorswim login screen, select paperMoney before signing in.

Practice helps traders evolve. But so does testing your market mettle in your live account. paperMoney is designed to help get you trading for real.    

First, a little textbook time. Options are primarily used three ways:

  1. Speculation: Aiming to make money when an asset appreciates
    When you invest, you’re simply trying to anticipate the price move of a stock, bond, or other asset, often over a particular time frame. That makes you a speculator, friend. Options can help speculators adjust the amount of time that they’re exposed to market moves and the capital they’re fronting to fund the trade.
     
  2. Income: Generating revenue by holding an asset
    Selling options while using the stocks in your portfolio as collateral is one way to potentially increase earned income. It’s a little like “renting out” property you own.

    . However, the strategy will limit the upside potential of the underlying equity position, as the stock would likely be called away in the event of substantial stock price increase. 

     

  3. Protection: Hedging an asset
    You buy insurance to protect your home, car, and health. Similarly, you might buy options contracts to “insure” your portfolio for a set period of time. But after that period of time, should the option expire worthless, the entire investment the option position would be lost.

Calls and Puts: Key Elements

Calls are options to buy an “underlying” asset, like a stock. The buyer obtains the right (but not the obligation) to purchase the underlying stock at a pre-set time and price. The seller of a call assumes the obligation to supply the underlying asset if the call contract is “exercised.”

Puts, then, are options to sell a stock. The buyer obtains the right (but not the obligation) to sell the underlying stock. The seller of a put assumes the obligation to purchase an underlying asset if the put contract is exercised.    

Consider four basic option positions:

  • Buy a call (long call)
  • Sell a call (short call)
  • Buy a put (long put)
  • Sell a put (short put)

There are trade-offs between potential risk, the probability of realizing profit, and the size of that potential profit. Generally speaking, the lower the risk or the higher the probability of profit from a given trade, the smaller the potential percentage profit.

Part of your challenge is to balance these trade-offs. For example, an option’s value is continuously whittled down by time. Because of this, there’s a constant tug back and forth. On the one hand, you have the option’s value eroding as time passes. On the other hand, you may be waiting for a favorable move in the underlying stock price or an increase in implied volatility (more on this below) that will raise the value of the option. Therefore, you need to consider the timing and the magnitude of the anticipated rise in a stock price. When you trade options, you accept the interplay of these decisions as a form of speculation.

Learn More

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Understanding Options Pricing

At expiration, an option can be worth whatever its intrinsic or in-the-money (actual) value is. It can also be worth nothing. In general terms, option values depend on the stock price, the option’s strike price, the stock price’s implied (or estimated) volatility, time to expiration, interest rates, and any dividends on the stock payable before the option’s expiration.

Pricing can’t be discussed without first taking on “volatility.” Accept it: volatility—the magnitude of price changes in a stock or index—happens. The rate of change might seem high or low (strong or weak). But no matter what volatility has done, will do, or is doing right now, trade through. Imagine you’re shooting an arrow at a target. The wind might push the arrow a little bit to the left or the right. To compensate, you aim the arrow a little bit left or right to account for the wind’s velocity affecting your arrow’s path to the target. Trading in the context, and presence, of volatility means you may need to adjust your trading strategy like you did with the wind.

Rules of thumb: The higher the volatility, the more expensive the option. The more days until expiration, the more expensive the option. Dividends reduce the value of calls and increase the value of puts. An increase in interest rates increases the value of calls and decreases the value of puts.

Today’s take-home: Remember that whenever an option trade occurs, the buyer thinks the option is too cheap and the seller thinks it’s too expensive. The fact that people disagree on value is why any trading occurs at all. Rather than worrying about an option’s value, you might concentrate on the trade’s risk/reward and your investment needs. Something to think about.

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