option basics

Profits from stock trading come by buying low and selling high.  Profits fuel capitalism.  Profits built America.  Corporate profits come from buying low and selling high.  Every successful business is based on this simple concept.

The main difference between corporate profits and investing profits is, the adding of value.  McDonalds buys potatoes low and sells them high.  They add value by peeling, cutting and frying these potatoes; then selling them as french-fries.  The basic concept remains buy low/sell high.

Investors don’t add value.  They can’t dip their stock certificates in chocolate and have fancier more valuable shares.  A share is a share, is a share.  All shares are equal.

Buying low and selling high requires valuations.  How else would you know if something is high or low.  You can’t trade using 20/20 hindsight.  You need to know what something is worth and what it should be worth.  Not just stock or option valuations, but for anything.

There are rules of thumb for everything.  Example, something is only worth what someone is willing to sell it at or pay for it.  Price measures value.  To measure the value of a stock at any time look at the last price traded.  It is the most current match of a willing buyer and a willing seller.  Trades require buyers and sellers.  With every trade, you truly have both opinions.  Prices move based on supply and demand.  More buyers cause increasing prices, more sellers and prices decline.

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Free Appraisals

Antique dealers earn their living through their knowledge.  Buying and selling provides their income, but their knowledge allows their transactions.  They need to verify authenticity, rate condition, know market values and marketability.  They use this insight to buy low/sell high.

Many antique dealers supplement their antique trading profits by offering appraisals.  Often before insuring certain items, insurance policies will require professional written appraisals stating value.  In the worse case scenario of a claim, a written appraisal saves untold amounts of grief.

Some antiques are too large or delicate to transit, so the appraiser must travel to inspect them.  Time cost money.  The appraisers need to charge for their time.  None of this is done for free, well almost nothing.  Many people seeking appraisals are doing so to value their item for sale.  Loss leader appraisal services generate antiques coming through the doors.  Many dealers offer appraisal services as a means to buy.

An antique dealer friend of mine told me a story of a client who didn’t want to pay for his services, but wanted them just the same.  He explained how this person had a “valuable” piece of antique furniture.  When told of the cost of the appraisal, including the travel time to come look at it, the client asked for a free appraisal over the phone.  The antique dealer was used to people trying to avoid paying for his services and played a little game with any skin-flints.

Hold It Up To The Phone

He told them to bring the phone near the piece to be able to better describe it.  Then he asked to have the phone held closer so he could see the item better.  He asked to have the phone moved around the piece very systematically.  The phone was placed inside every nook and cranny.  Upon completion, the antique dealer announced the piece looked counterfeit.  The person became so concerned.  Was he sure?  Well only in person could he know.

Knowledge also provides professional stock traders with their living.  And unlike antique dealers, they give free appraisals.  Every time they buy or sell, they state their opinion on what that particular stock is worth at that very moment.

The last trade gives the universally accepted valuation of a stock.  Whether one share or one million shares exchanged hands, the last recorded trade sets the value of all existing shares.  This skew allows profit potential.  Volume is a key to stock and option traders.  Price movements on low volume don’t confirm valuation changes as well as large volume moves.

The market capitalization of a company is figured by multiplying the number of shares outstanding by the current price of the stock.  Theoretically, if a stock trades millions of shares at a level, then trades one last share at a much different level, the market cap is based on this last share.

This is the problem with after hours trading.  The spreads are wide, with volume low.  Valuations swing wildly as trades take place from low bids to outrageous offers.  The willing buyers want to steal stock.  The willing sellers want a small fortune.  Until after hours trading gets tight bid/ask spreads, think of it like unscrupulous antique dealers trying to underpay ignorant owners or overcharge non-knowledgeable collectors.

Unlike businesses that add value, traders need to mine equity.  Investors need to use knowledge, experience and research to find gold mine stocks.  Not literal gold mining companies, but value waiting to be pulled out.  Gold in the ground is worthless until someone stakes a claim, commits resources to extract the value.

In business, the key is not to be part of the crowd, but to know the direction of the crowd.  Don’t be a follower; try to be a leader.  If you can’t beat ‘em, DON’T join ‘em!  You should watch the crowd.  Don’t join in their herd mind-set, least you join a band of lemmings parading over a cliff.  Crowds may be right in the middle, but they’re wrong at the ends.  They buy high and sell low, the exact opposite of successful trading.

The crowd watches CNBC and so do the experts.  Go into most brokerage offices and/or trading rooms across this country and chances are they will have a TV tuned to CNBC.  Not because it’s their best source of information on the market, but because it’s their best source of info on the trading public.

CNBC only reports the news they don’t make it, or do they?  They have no bearing on prices, or do they?  Have you heard of the “CNBC Effect?”  The “CNBC Effect” takes place when the crowd reacts to the information shared with them via CNBC.  Viewers watch and listen for tidbits of information, any tip construed or otherwise, any reason to buy or sell.

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If you watched long enough, you’ve seen a CEO give a stellar interview.  Soon on the streaming ticker tape flowing across the bottom of the screen, you see the stock increase in frequency and price.  Or you might have seen a CFO stutter when asked about future earnings or worse still, accounting irregularities.  Shortly there after that stock may trade much lower in price on higher volume.

Can option traders use CNBC to their advantage?  The answer is yes!  But you need the big picture.  Some of the details may seem old hat or trivial.  When finished looping off in opposite directions, it ties nice and neatly into a bow.

Stocks are one-dimensional; price.  Options have many components: price, time and potential.  Compared to potential, price and time are easy math. Potential is a difficult concept to understand.  (Older Options 101 columns go into option pricing in greater detail.)

Volatility measures potential.  Higher potential moves in either direction produce higher Volatility.  Higher Volatility equals higher option prices.  Higher option prices mean higher potential moves, or so the formula says.  In actuality, higher option prices indicate higher Implied Volatility, but not greater potential.

Volatility comes in four different flavors.  Implied Volatility gives novice option traders a sour taste.  Another way to look at Implied Volatility is to consider it as supply and demand.  More buyers, Implied Volatility increases.  Fewer buyers and/or more sellers, Implied Volatility drops.  True potential has nothing to do with it.  There is a skew between actual and assumed probabilities, a mathematical edge. 

Option traders don’t need stock prices to move if they have correctly bet on option pricing components.  The “CNBC Effect” can and does often change Implied Volatility without ever changing stock prices.  Do not assume the additional exposure of stocks featured on CNBC will increase their Implied Volatility!  But don’t be surprised if it happens.

Being aware of the trading environment transforms option trading from betting to investing.  Anticipating future changes based on previous tendencies increases profitability.  Knowing what to expect and not being blind-sided decreases losses.  Avoiding crowds help avoid stampede disease, being trampled.

We’re not talking Bikinis, we mean highs and lows.  Not as in buy low-sell high, but as in trends and chart patterns.

A stock industry maxim reads, “The public is right in the middle, but wrong on the ends.”  Spelled out, many fortunes will be lost by buying when one should ultimately be selling, or by selling when one should buy.

Many analysts try to predict tops and bottoms with price targets.  Their predictions may pan out with amazing accuracy.  Some well-followed analysts’ predictions become self-fulfilling prophecies.

Have you ever bought a stock at the bottom?  Or better still, sold at the top?  How did you know at the time it was one of the extremes?  Luck or genius?  If someone bought at the bottom, then someone sold to them.  For every seller at the top, there was an unlucky buyer.  Have you ever been on the wrong side of a transaction at either end?  Misfortune or ignorance?

Buying near the bottom is easier than selling at the top.  An absolute bottom exists, zero.  The ultimate top is unknown.  Theoretically a stock could trade to infinity.  Although I’ve never seen infinity on a chart.

Honestly, you could sell at the top.  As an example; selling into a merger or takeover.  When a company tries to take over another company, they have to pay above the then current market price to motivate shareholders to approve the sale.  If they don’t offer enough, they don’t get the votes.  Typically, a buy out offer will be the highest price in a specific time period.  Creating a top.

Some people trade blindly, others with blinders on, still others just need a different pair of glasses.  If you look at things in a different light, you should become better traders.

An old adage claims, “He who defines the terms, wins the argument.”  So don’t send me an e-mail disagreeing.  Some of this will be completely new.

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No one can buy bottoms or sell tops.  Transactions require two parties, buyers and sellers.  There has to be someone on the other side of a trade.  Without a willing seller, a buyer keeps his money.  Without a buyer, no sale takes place.  Tops and bottoms have only one willing party.

Commonly known as the bottom, it should truly be known as the lowest price.  The highest price is not the top, but just the highest price.  Bottoms are lows that don’t go lower.  Tops are highs that don’t trade higher.  They can only be confirmed after the fact.  Not during or before, but after.

Prices decline because of concentrated selling with scattered buying.  Translated, more sellers than buyers.  Prices fall with lower sellers; a rush to the exit.  To fall further it needs a seller at a lower price.  If a seller at a lower price doesn’t exist, the decline will stop.  Even with ready and willing buyers, no transaction will take place without sellers. The absence of sellers indicates the bottom, a theoretical point just after the lowest price.

Until prices increase a bottom hasn’t been made, only a new low.  The price may stay flat, forming a solid bottom to rise from.  Only after the prices rise can one look back and see the bottom.  It must turn back upward.

Trying to buy a bottom is like “trying to catch a falling knife”.  More often than not, you’ll injure yourself.  Often a stock that you thought was trading near a bottom will fall even further.  Stocks bottom out when there is no one left to sell any lower.  You will be a better trader if you let the stock turn to the upside before buying.  Don’t get greedy.

The opposite extreme to the bottom is the top.  If prices decline because of selling pressure, then prices rise due to buying pressure.  Concentrated buying with scattered selling, more buyers than sellers.  A high is only a high until replaced with a new higher high.  A high becomes a top after it peaks and turns down.  A top is the absence of buyers.  No one to pay more.  Without buyers, sellers can not trade.

You may trade at the ultimate extremes in price, but you can not trade at the tops or bottoms.  There’s no one to take the opposite side.  If you traded at the extremes it’s not because of genius or stupidity, it’s because of luck.  Good or bad.  The good news is, you can create luck with knowledge and technical analysis.

All investments have risk.  Real estate, stocks, and mutual funds have risk, and of course options have risk.  But have you ever considered the risk of cash?  Not the risk of someone breaking into your house and stealing the money under your mattress, but the risk your money in the bank doesn’t retain buying power.

This week we’ll discuss option trading accounts and how brokerages look at them.  If you lack an option trading account, knowing almost everything about them won’t help you make any money.  This will not be a recommendation to any specific broker or brokerage.  Its an individual decision, like picking a favorite flavor of ice cream, my favorite flavor shouldn’t be yours, no matter how much I know about ice cream.

You shouldn’t chose a broker by low commission rates, but the trading authority they will allow.  If you have a more complicated or “more risky” strategy that consistently has made money in the past and your broker won’t let you trade it, you need a new broker.  In defense of the broker, if you’re consistently betting the milk money on “long shot losers”, he doesn’t need the risk of a lawsuit for allowing you to speculate away your grocery money.  Don’t laugh, brokers get sued all the time.  Good brokers don’t want the label of a churn and burner, using tactics making more commissions than profits.  Brokerage won’t allow everyone shovels to dig themselves holes they can’t get out.

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By reading these articles, many of you will know more about options than your broker.  If they won’t allow you to trade strategies they don’t understand, no matter how much you understand, consider changing.

Different brokerage firms might have different rules and requirements, but this is as close to industry standard as it gets.  There are five levels of option trading authority.  These levels are based on risk and complications.  Risk to you the trader, but more important the perceived risk to the broker.  Some strategies are complicated, both to the investor and the broker.

The five levels are:

Level One; selling covered calls.
Level Two; buying puts and calls.
Level Three; spreads.
Level Four; selling uncovered (naked) puts.
Level Five; selling uncovered (naked) calls.

Options are a contract between two parties.  The buyer has rights, the seller has obligations.  Call options give the buyer the right to buy a stock at a predetermined price (the strike price) within a predetermined time period (the expiration date).  The seller, also known as the writer, is obligated to deliver the stock if the buyer exercises his right.

Most investors should easily attain Level One trading authority. Considered so safe a strategy, the IRS allows it in IRA accounts.  When a investor owns stock, he may sell a call, giving the buyer the right to purchase the stock.  The brokerage liens the stock, they won’t allow you to dispose of it since it guarantees your ability to perform your part of the contract.  Think of it this way, the broker is covered.  The chain of events flows.  If the call buyer exercises his right, the broker doesn’t have to contact you.  The stock is sold automatically.  The broker takes it out of your account, and puts in money.  If the call buyer doesn’t exercise his rights before the call expires, the lien disappears.  You’re free to sell the stock, or another covered call.  Pretty safe, pretty simple.  Covered calls have two risks, both related to market fluctuations.  First, like owning stock, you run the risk of the stock price declining.  You also run the risk of not participating if the stock makes a major upward move.

Level Two is buying options.  The option purchaser pays the option premium hoping for a favorable move in the underlying stock.  The investor actually speculates the value of the option will rise.  It’s not a complicated scenario, try to buy low, sell high.  Buying options is less complex and less commission intensive than covered calls.  The pitfall requires risking entire amount ventured.  If an option runs out of time and has no intrinsic value then it’s worthless.  Zip, Zero!  Because of the possibility of total loss, not everyone will be allowed Level Two authority.  Not difficult to get, but with few exceptions not allowed in retirement accounts.  The determining factor generally is account size.  It’s the grocery money issue.

Levels Three through Five require a margin account.

Level Three:  spreads.  In my opinion, the least risky, but most complex of all transactions.  A brief explanation; a spread is a position with two or more components.  Simultaneously buying or selling two different options changes the risk/reward curve.  Spreads can have predetermined risk with predetermined reward, but done right, unlimited possibility!  My attempt, this week, is not to teach spreads, but to help you know about setting up your account.  I would encourage all option investors to have spread writing authorization.  Make it a goal.  If you don’t have it set up, find out what it takes for approval.  Be aware, many brokerages require one year prior account activity before okaying spreads.  If your broker demands more time than your account has been open don’t fret, you’ll be given the tools to profitable trade until such time.

Level Four, selling uncovered (naked) puts.  Think of it this way, the seller acts as the insurance company, the buyer is the policy holder, the put sold the policy, the strike price equals policy value, and the option premium collected the insurance premium.  The policy states that if on or before expiration the stock price is below the strike price, the policy holder may sell the stock at policy value, regardless the actual market value.  The put seller obligates himself to buy the stock no matter how low the price drops.

A funny thing about Level Four naked puts, without margin, the risks are identical to Level One covered calls.  Think about it, in both, if the stock price is above the strike price the option seller won’t own the stock.  If the stock price is below the strike price, the covered call writer keeps his stock; the naked put writer is obligated to buy the stock.  The reality is naked puts have lower margin requirements, and therefore higher leveraged potential returns.  Everybody knows with higher rewards, there must be higher risk.  I like naked put selling, but I feel the same high returns are available, with less danger with put spreads (Level Three).

Level Five, selling uncovered (naked) calls.  Only money guarantees your ability to deliver the stock, and it takes a lot!  Technically this strategy has unlimited risk.  The sky is the limit.  The seller is obligated to deliver stock he doesn’t own.  Unless you have a lot of experience and a ton of money, your broker won’t allow you to sell naked calls.  Don’t ask.  The bright side is, I only know one circumstance worth considering using Level Five authority.  If you have a calendar spread on expiration Friday, with the short option out of the money, consider selling the next month’s call without waiting until the following Monday.  You won’t lose two days of time decay nor have unknown market exposure.  You’re entering into a new spread without closing the old one.

Often out of the money options have too much value on the ask side on expiration day.  Market makers know most option traders can’t sell uncovered options, and to keep a spread hedged over the weekend following expiration Friday, option traders need to buy back their short position to close.  Hence, they overcharge for them.  Market makers are not stupid.

If you can’t understand this situation, don’t worry, you don’t want Level Five authority, nor will your broker approve.

Episode I.

Is there a Trekkie out there who can help me out?  I understand the Black-Scholes option pricing formula, but I just can’t comprehend Star Wars.

People with tents sleeping in line waiting to buy tickets to a movie.  Not just any movie, but a movie that’s playing everywhere.  Multiple theaters, gobs of seats, and plenty of screenings.

I have a few thoughts as to why anyone would go through all the trouble to be among Star War’s first viewers.

Crowd Mentality!  The media hypes the movie, and a feeding frenzy begins.

Bad Math Skills!  Until there’s a scarcity of theaters, there’s no scarcity of seats.  Each theater has hundreds of seats, one per person.  Don’t forget they empty the theater and show the movie again.  Over and over, infinitum.

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Bragging Rights!  Every time a day one viewer watches the video, he will remember he’s able to tell his grand kids he saw the movie on May 19th not May 20th.

Bad Business Skills!  Who is smarter?  The guy in a tent for a week, or his buddy who pays him $20 to buy an $8 movie ticket?

Too Much Free Time!  Hello, don’t people have anything better to do than wait days to buy a ticket to a movie?

Am I missing something?  I just don’t get it.  While you’re at it, explain to me how Episode One can come 20 years after the first movie.

I haven’t seen the movie yet, was it worth the hype?  Was the expectation greater than the event?

What does this have to do with option pricing?

I get e-mails from many mathematically challenged, crowd following option traders who don’t know the value of time and can’t brag about good trades.  Besides, even I have to jump on a bandwagon every once in a while.

Don’t forget the suspense.  Our last column ended in a cliff hanger.  Will the sequel be worth the hype?  Does understanding Implied Volatility and Vega help traders to win more often and lose less frequently?

Enough excitement, back to option pricing.

In mathematical equations you solve for the unknown.  Two plus two equals what number?  That’s too easy.  Let’s use multiplication instead of addition.  Two times two equals?  Still too simple, how about option pricing?  Without going into tremendous detail of option pricing formulas, here’s the gist.

The price of the stock compared with the strike price has a value.  The amount of time to expiration is easily calculated.  As are interest rates and dividends.  You take all these components plus the expected volatility, plug them into the pricing formula, and solve for the unknown; the option’s price.  Actually the option’s theoretical price.

While mathematical formulas determine theoretical value of options, market forces determine the price at which options trade.  The market consists of buyers and sellers.  Supply and demand.

More buyers equals higher prices.  You can’t pitch a tent to be one of the lucky, you need to write a check.  On the flip side of the coin, excessive sellers and/or insufficient buyers drive prices lower.

Market Makers estimate with formulas.  Charging according to whatever the traffic will bear.  If the market won’t support higher prices, it drops.

The Dark Side of the Force.

Back to our make believe world, where nothing changes unless we allow it.  Without any movement to the stock price, interest rate, dividend, and time to expiration; the price of an option can still vary.

The funny thing about all our previous make believe examples, this one might not be so made up.  In reality, an option’s price may fluctuate without any other circumstantial difference.  This situation can happen.

A rumor may spread about a take over possibility.  The interest rates and dividends could certainly remain the same before and after the rumor.  The stock price might not move.  In no time at all the price of the options could sky rocket.  The hype could end just as sudden and the stock price not falter, but the option price melts.  Could it be, the expectation was greater than the event?

What about earnings reports?  After the announcement, there is no guess work, no unknown, no expectation.  Option prices tend to drop, the sizzle is gone and all that is left is steak, or gristle.  Don’t fuel the fire by over paying for options.

Comparing Implied Volatility to Expected Volatility tells if an option is fairly valued.  If the Implied Volatility is less than Expected Volatility the option is said to be undervalued.  If Implied Volatility is greater than Expected Volatility the option is overvalued.

Vega measures option price changes based on volatility.  Although Vega is considered one of the “Greeks,” it’s not actually Greek.  It’s Spanish.  Or as most would say, A foreign language.

“May the Implied Volatility be with you.”

 

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