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Understanding Options

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This chapter is from the book

The Options Trader’s Toolbox

Every trader has two goals: make money and manage risk (which might be the same thing). The tools each trader has to achieve these goals guide strategy. The stock trader’s tool is buying assets. Through the purchase of assets, traders seek to make money. Through diversification of assets, traders seeks to diminish volatility in their portfolios. A portfolio of uncorrelated assets takes the sting out of a big downward move in any one asset. Correlations between asset classes can wax and wane pretty quickly. Still, keep in mind that the tool available to a stock trader is buying. If buying is the hammer in the toolbox, assets are the nails. Portfolio theory is all about the nails. It’s all about what kind of nails you deal with and how hard and how deep to hammer them. To extend the analogy a bit further, alluding to the cash available, you get to hammer only a certain number of times.

My father was a mechanic all his life, and it was always a wonder to me to watch him work. I was never my father’s son when it came to being handy. Tools are anathema to me. Growing up in Dallas, I watched my father work on cars in 100-degree summers, trying to loosen bolts that wouldn’t budge or were stripped. If a bolt was stripped, Dad didn’t just keep using the same wrench the same way. He would hammer a smaller wrench over the bolt to give it shape again and then hammer the wrench to loosen it. A wrench alone would not have gotten the job done. I learned many things from him. Know your tools. Don’t blame your tools.

Options are just more tools for the toolbox. Calls do one thing, and puts do another. When you have a set of tools working together, you can accomplish qualitatively different tasks than you can accomplish with individual tools. A piece of wood can only accomplish so much. Find a fulcrum, which also can only do so much, and together you have a lever, which is something completely new and different.

Tools work and interrelate. The relationship might be presented graphically. Most relate to stocks in terms of their price chart, which is fine since charts illustrate risk and reward clearly and succinctly. In addition, computers can graph the math behind complex options trades instantaneously and have transformed the playing field for the average trader who wants to get into options. Imagining how a single option is graphed is pretty easy, but trying to picture a strategy that has four or five moving parts can tax even the most creative mind, especially since volatility can warp the effects of that graph. Figure 1.1 shows an example of a simple chart.

Figure 1.1

Figure 1.1. Apple P&L graph for stock ownership

Source: OptionVue 7

Does this represent only a stock chart? Most people are surprised to learn that you can re-create almost exactly the same chart using options. When you combine buying an at-the-money call option and selling an at-the-money put option, the resulting graph looks just like a stock graph. This is called a synthetic long stock position. Using options, you can create a P&L that mimics the behavior of owning 100 shares of stock without actually owning the stock. Although it mimics the returns and losses of a stock, though, it is still not a stock. There are no dividends. There is a time limit. Why would somebody want to create a synthetic stock position? One reason might be the cost of the trade. The cost of buying the at-the-money call can be almost completely offset by the sale of the at-the-money put. Under the right conditions, you can get paid for that trade if the cost of the put is higher than the cost of the call. Imagine getting into an expensive stock for no cash outlay. But keep in mind that brokerages will require you to have margin collateral to cover the risk behind the naked sale of the at-the-money put. That margin requirement is usually only a fraction of the cost of buying the stock outright.

Figure 1.2 shows an example based on Apple (AAPL). It was selling for $661 a share when this chart was prepared. Therefore, purchasing 100 shares of Apple would cost $66,100. A chart using LEAPS, which are long-dated options, allows you to buy an October 2014 660 call and sell a 660 put with 494 days until expiration.2

Figure 1.2

Figure 1.2. Apple synthetic stock position

Source: OptionVue 7

As you can see in Figure 1.3, the calls cost $99.25, and the puts pay you $104.35. The trade nets a credit of $5.10 before trading costs. However, the margin requirement for placing the trade to cover the naked put is, as per the CBOE, “100% of the option market value plus 20% of the underlying security” which is, in this case, around $22,000.3 Obviously the market value of the option can and will fluctuate and the underlying margin will also move but, in most cases, it will still be cheaper than buying the stock outright.

Figure 1.3

Figure 1.3. AAPL synthetic stock chart

Source: OptionVue 7

The chart of this trade looks familiar (see Figure 1.4).

Figure 1.4

Figure 1.4. AAPL At-the-money covered call position

Source: OptionVue 7

On the surface, the chart in Figure 1.4 looks great, but don’t forget that this trade has the same slope as owning 100 shares of Apple. So the losses in absolute dollar terms will be just as sharp as the gains. Why would anybody do this trade? If, for example, you had a bond portfolio, you could leverage that portfolio to trade the options rather than the stock without exposing yourself to any further risk than just owning the stock. Even though you don’t get dividends through synthetic positions, you have to ask yourself if dividends are worth it. Maybe you’d rather keep more money sitting in a bond portfolio earning interest and use options to create a synthetic portfolio of stocks at a fraction of the cost. You can create an entire stock portfolio using synthetic stock positions, as long as you maintain collateral in your margin account. Just something to think about.

Options Trader’s Toolbox

Stock and its synthetic equivalent can be expressed using a basic formula.4 Owning stock (S+) = buying a call (C+) + selling a put (P-), or

S+=C+ + P-

Using algebra, you can rearrange this formula to get interesting results. For instance, the most advantageous options trade is the covered call. You own the stock, and you sell one call for every 100 shares you hold. The reasoning is that if you lose the bet and the stock price goes up, all you need to do is provide the stock you have to cover the loss. Expressed in notation form, a covered call = S+ +C-.

You can convert this formula to P-=S++ C-. In other words, selling a put is equal to owning the stock and selling a call. Both have the same profile, as shown in Figure 1.5.

Figure 1.5

Figure 1.5. AAPL covered call P&L graph

Source: OptionVue 7

Figure 1.5 shows the trade and a summary of a covered call. The table represents AAPL again, selling one at-the-money call option with 39 days until expiration in tandem with owning 100 shares. You would sell the call for 25.85 a share or a total credit of $2,585. The net cash outflow would be -$63,587.

In Figure 1.6 we examine the case of a naked put strategy. In this example, it sells for a little less than the call. Why? Apple was bullish at this point, and the calls were bidding up. The trade brings in a credit, but the margin requirements are far less than the case required to do the covered call.

Figure 1.6

Figure 1.6. AAPL naked put strategy

Source: OptionVue 7

Figure 1.7 shows what a naked put strategy looks like.

Figure 1.7

Figure 1.7. AAPL naked put P&L graph

Source: OptionVue 7

Figure 1.7 is nearly identical to the covered call graph shown in Figure 1.5. In fact, if you superimposed one of the graphs on the other, you would get the result shown in Figure 1.8.

Figure 1.8

Figure 1.8. AAPL covered call P&L graph combined with naked put P&L graph

Source: OptionVue 7

Gains, losses, and breakevens are almost the same. Most people trade covered calls because they want to leverage their existing stock position to make more money without regard to whether their stocks are good candidates for selling calls based on the prices of the options. What if you didn’t own a stock? Is it better to buy the stock and sell the calls, or is it better to sell naked puts? Many people will tell you that selling naked puts is very dangerous and should be avoided in favor of the safer covered call strategy. This comparison should give you pause before you run to that conclusion.

So which is better: a covered call or selling a naked put? Mostly it depends on the prices for the puts and the calls. You don’t want to undersell in either case. Another consideration, besides taxes, is cash or margin necessary for entering the trade. Owning a stock and selling calls will cost you more than just selling puts. We will revisit the different types of considerations for choosing strategies including covered calls later. Here we just want to introduce you to the terrain.

Synthetic stock positions, covered calls, and naked puts are just some of the combinations that use this formula. Table 1.1 shows the different equivalencies using stocks, calls, and puts.

Table 1.1. Options Trader’s Toolbox

Strategies

Notation

Synthetic stock (at-the-money)

S+ = C+ + P-

Short synthetic stock (at-the-money)

S- = C- + P+

Short put

P- = S+ + C-

Long put

P+ = S- + C+

Long call

C+ = S+ + P+

Short call

C- = S- + P-

Knowing these relationships gives you flexibility in trading. When you own stock, you can create the equivalent of a naked short put position simply by buying a call. If you own stock and buy a put, you have also created the equivalent of owning a call. So you can own stock and leg into different call or put strategies using these equivalences.

You can also layer strategies. If you already own stock and you open a synthetic short stock position, you negate any movement up or down in the stock. However, if you separate the distance between the put you buy and the call you sell, the result is a collar, which is a popular hedging strategy. We will go more into the detail of the mechanics and strategies but it is good to mention that you are already on your way to sophisticated options trades just through the understanding of this Option Traders’ toolbox.

Smart traders want to take steps to limit their risk to the market. Stock traders limit their risks through buying or placing stops. A diversified portfolio is about buying uncorrelated assets so that one moves up when another moves down in order to diminish risk. A stock traders’ toolbox is limited to buying and paying full price each time. By including options in your toolbox, you gain nuanced hedging strategies that were previously unavailable.

An options trader’s toolbox holds more than the tools listed in Table 1.1. A pure options trader might not use stocks at all. They can use combinations of calls and puts. The combinations and strategies are seemingly endless. From an options trader’s perspective, a stock trader’s only tool is a hammer. The stock trader is either hammering a nail in or taking it out. He studies the nail and tries to determine how hard he should hit it. With the plethora of strategies at your disposal, as an options trader, you have a multi-piece toolbox.

The objective of this book is not to create another encyclopedia of options strategies. There are other books for that. The more you understand options and how traders think about them in different situations, the better you’ll be able to understand new strategies and develop your own.

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