It is debated amongst different markets that the options markets are more efficient than the stock markets.  The CBOE has a couple of markets makers in each optionable stock.  Their sole function is to buy and sell options out of their own accounts to set the bid and ask prices for options in that category.  They cannot make the market by taking public orders, and thus if you place a market order it is never a market maker that takes the other side of that transaction.  There is another fundermentalist in Options, being the ‘board broker’.  The CBOE board broker does not actually trade as such, but rather just collects all the buy and sell orders and tallies them up and matches the orders amongst traders.

Option market opening and closing and settlement

Options markets open at 9:00 each morning Monday to Friday.  They open in rotation from market to market immediatly following the opening of the underlying security or stock.  This rotational opening system can pose an issue for options prices when an underlying security experiences extreme volatility during the open.  It can result is some very unfavourable prices for your options contracts if the underlying stock moves too fast during this opening rotation.  For this very reason it is unadvisable to trade during the opening rotation at all… and if you do decide to trade.  i.e  by putting an order together the night before opening, then make sure that the type of order you place is a limit order, thus dictating to the market the exact price that you are filling to pay for that particular contract.  Generally speaking, market orders are fine if you would like to get filled fast during the course of the day, but NEVER the night before the market opens due to this rotational opening system.

The markets close at 4:00 Monday to Friday.  During the last 5 minutes of trading, the options market generally has a huge spike of activitiy.  and for this reason, it is usually best to steer clear of trading during this time, especially if you are trying to exit a position that is in-the-money and going to be exercised.  Sometimes, even market orders fail to get filled during this time, so just avoid it if at all possible, and if you do put an order together make the order expire if unfulfilled at the end of the day…  Good till cancelled orders may be a source of trouble for you if you forget to cancel your unfillilled order at the end of the day.

All options contracts are settled the fiollowing day.  Some brokers require you to fulfill your contracts the same day, however, the CBOE doesn’t settle till the following day.  that is the day that you need to be able to have funds to cover any filled position or assignment.  And all options that expire on a given month cease trading on the 3rd Friday of that month and are settled on the following Saturday.

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So the mechanics of assignment is simple due to the governing body of options called the Options Clearing Corporation (OCC).  The OCC is the issuer of all listed options contracts, thus it controls all listed option assignments and exercises.

So how do you exercise your option?  – simple, you instruct your broker to do so.  Your broker will notify the OCC that they wish to exercise a contract of the underlying stock.  Now the OCC springs into action and selects “AT RANDOM” a holder of the contract who is SHORT that contract (meaning they have sold that contract) and then the OCC will notify that person that they have been Assigned.

So the selection of the person being assigned is really quite simple:

1. random selection
2. First in/first out basis
3. any other systematic selection criteria that the OCC deems fair

Now that you have been assigned

You must deliver the stock…  and…  you have no choice in the matter.  Now it is too late in the piece to try buying the option back, and if you’re short naked (meaning you have no covering position)  then your situation might look quite bleak indeed.  However, all is not so bad as you have a couple of choices as to how you go about fulfilling your obligation to deliver the nominated number of underlying contracts.  you can;

1. deliver the stock from your own reserves (assuming you own the stock)
2. purchase the stock in the open market to deliver them to the assignor
3. ask your brokerage to go short and deliver the stock (this requires you to have a short account with your brokarage firm…  most brokerage firms do not let nocive traders short sell, and require a minimum account value of a few hundred thousand dollars.

Margin Calls

Sometimes during assignment the process of purchasing the stock to cover your position and fulfill your obligation might result in a margin call.  A margin call is where you have insufficient funds to cover your position.  This is not relevant so much today as most brokerages (all that I know of anyway) only require you to have the marginal difference between the exercise price of an option and the price of the option itself.

When can you be Assigned?

Assignment can take at anytime throughout the duration of the options contract.  Generally speaking, if you are the seller of the option and the option goes into the money you always run the risk of early assignment.  This is called early or premature assignment.  Otherwise, options are always certainly exercized if they are in the money at expiration.  Assignment is generally something you’d normally avoid, so it is always advisable to cover your postion by buying back the inthe money option before or on expiration day.

The option reason for early asignment could be due to an impending dividend payout.  Generally the stock price will go down by the value of the dividend payout and so exercise can occur so that the position of the holder of an option is not diluted due to the divend.  By exercising their rights and taking hold of the stock they effectievly have a net $0 postion by taking the dividend payment.  Quite obsucre is this situation, but it does happen.

1. Price of the underlying stock  (more expensive stocks like GOOG, RUT, SPX, CME tend to have very expensive options)
2. The strike price of the option itself
3. time until expiration of the option
4. volatility of the underlying stock
5. interest rate, (risk free interest rate exactly, so usually gauged on the 90 day T-Bill)
6. Dividend rate of the underlying stock

The actual method of valuing the options is commonly based on the mathematical formula called the Black-Scholes.  It’s a complicated formula, so i wouldn’t bother trying to learn it (unless you think the markets and formula are inefficient and thus provide a basis for Arbitrage strategies).

The first four items on the above list are the most important determinants of price.

Stock price is the utmost important factor.

If the option strike price is out of the money then the other factors have no real value at all.  The other thing about options is that they are wasting assets.  On the day of their expiration the only determining factor of value or price of an option is it’s intrinsic value.  That is, is it In-the-money or not…  if it is not in the money then it has no value at all at expiration date.

The call option price curve shows the relationship with time and profit.  As the underlying asset increases in value, so too does the value of the call.  The downside (risk) is limted to the premium that you paid for the call contract.

Sound simple?  well it is…  A call contract is therefore better than owning the asset itself as the risk is limited but the upside profit potential is unlimited!  -  this is stated in theory, but in reality, when you purchase a call option and you lose, you lose 100% of all the money you used to purchase that call option!  Remember that options are wasting assets too, so you’re going to be either right and win, or wrong and lose and all be taken or lost at the expiration date!  You don’t run that risk with stocks, if the stock goes down in value then you do have the option of holding the stock as long as the stock doesn’t go down to $0.

So how much is a call option worth before expiration?

When a call option has time still remaining to expiration its total price is the sum of its intrinsic value plus the time value premium.  Therefore the call option price curve looks like an inverted arch that stretches along the stock price axis.

1. The time value premium is greatest when the stock price and the strike price are equal
2. If the stock price rises well above or below (deep in or deep out of the money) the strike price the option sells for nearly a 1-1 parity value to it’s intrinsic value…  meaning, for every $1 increase of decrease of the underlying stock, the option will also take that value of a $1 increase of decrease…  this is a really good example that illustrates the profit power of options.

Imagine this scenario: Stock ABC is trading for $30, the equivalent call option with a strke price of $30 and a couple of months to expiration is selling for $3 per share. (1 options contract controls 100 shares, so the total value of the options contract is $3 x 100 = $300).  So for an investment of $300 we now control 100 shares of ABC.  to purchase the ABC shares outright would have cost us $30 x 100 = $3,000.

The stock then rises throughout the month as it trades on favourable news of a new drug that has been approved by the FDA.  by the end of the month the stock is now trading at $50!  At this price, our options contract with a strike of $30 would trade at close to 1 – 1 parity with the movement of the stock price.

If we sold the shares at $50 we would realise a gain of $20 per share.  A total profit of $20 x 100 = $2,000.  or more importantly, a return on our investment of 67%.

Now our options have also increased.  most likely, our options contracts will be worth approx $20 each!!! that’s an increase of $17 per share.

If we sold our options at $20 we would realise a gain of $17 per options contract.  A total profit of $17 x 100 = $1,700.  or more importanty, a return on our initial investment of 566%.

This is the power of options…  massive upside potential with very little of no risk.

How about an adverse situation?  we see we can make massive upside?  does that mean we can lose like that too?  well no!  the most you can ever lose is 100% of your initial investment, so what are the risks if we lose?

Shortly after purchasing ABC shares for $50 so adverse news hits the markets and the shares plummet to $30 within the month.  so now our total lose is $20 x $100 = $2,000 or more importantly a total of  40% of our intestment.

Now, the same situation but with options.  we purchase the initial strike $50 call option for $2.20.  so our total investment is $2.20 x 100 = $220 and we have 60 days to expiration.  During the month the shares plummet and our option contract is now worth a pultry $0.05.  the the total amount we have lost is $215.

If I was a totally impartial person looking at these equations side by side… this is what I see:

OPTIONS PROVIDE MUCH BETTER RISK TO REWARD RATIO’S HOWEVER RUN THE RISK OF LOOSING 100% OF YOUR INITIAL INVESTMENT!

this is so super important to understand.  when you get this, you realize that using options as a wealth creation tool will therefore require you to have VERY VERY GOOD money management strategies, verves of steel, and an apt ability to calculate risk and rewards

So to just recap:  By purchasing a CALL contract you have the rights to “Purchase a stock at a predetermined price on or before a predefined date” for a PUT Contract, you the the rights to “Sell a stock at a predetermined price on or before a predefined date“.

make sense?  here’s an easy way to remember it:

CALL up,  PUT down…

If you’re going to buy a call, you expect the stock price to go up in the future.

If you are purchasing a put contract, you expect the stock price to go down in the future.

Now that is the easy part… now, not all options contracts are equal…

Contracts can have 3 status’s…  they can be In the money, At the Money, or Out of the Money.  The further in the money the options are (meaning their strike price is in the money), then the more expensive the option is.  The other element or force that determines the options value is it’s time value, or time to expiration)…

lets explore each of these elements in more detail:

Imagine a game of throwing a ball through a basketball hoop.  If you stand Underneath the hoop you have almost a certain chance of scoring.  But the value of that score very small.

Take a few steps back, and imagine now you score a little more, but your chances of scoring reduce slightly.

now step back a few steps more, once again your chances of scoring diminish, but your reward increases for when you score

Options trading take on a very similar risk to reward ratio as our game of shooting hoops…  the further in the money your options are, the more likely they are to expire ‘In the money’ and successful for you… HOWEVER the rewards for these options are very low, and for deep in the money options, your reward is basically wiped out by brokers fees…  so we basically NEVER BUY deep in the money options.  The only ‘In the money’ options that you should ever buy are SLIGHTLY IN THE MONEY options.  so we can maintain an acceptable reward.

Conversely, if you go for Deep out of the money options, you’ll be standing over the 1/2 way line trying to shoot hoops.  how likely is it that you will make a score from the 1/2 way point?  not likely?  so too are you to be not very likely with purchasing deep out of the money options.  However, if you do and you are successful, then your reward will be great.

For this reason, to take an acceptable risk reward ratio with every position, you should concentrate on AT THE MONEY options.. they are options that have a stike price that is as close to the underlying asset price as possible.

In the money options:

an in-the-money option is the most expensvie option.  the more ‘in the money’ it is, the more expensive the option becomes..  so much so that an option will have a 1 to 1 ratio value for each dollar that it is in the money.

At the money options:

these are the most popular options to purchase. they are either slightly in the money or slightly out of the money options.  They have all the characteristics of the underlying asset however do not posses any significant costs and provide the best risk / reward ratio of all of the options.  You can gett a deeper understanding of why when you discover the ‘greeks’.

Out of the money options:

Out of the money options are for the true gamblers.  the ones that chase the massive returns with little or no chance of ever realizing a profit.  I would consider these to be too much of a gamble to be traded actively by seasoned traders, however, there are strategies and circumstances that can bring these option types to life!

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The stock itself is called the Underlying Security.

A Call Option gives the owner of the contract the right to buy the underlying security.

A Put Option gives the holder of the contract the right to sell the underlying security.

The exercise price is the price at which the stock can be bought or sold for… (also called the Strike Price).

Because of the finite and known lifetime of an option, the date that you can exercise your right is called the expiration date.

So there are 4 key elements to an options contract:
1. The type (put or call)
2. The underlying stock
3. The expiration date of a stock
4. The strike price of a stock

Laymans Example:
I’ll use the example of buying a property, as that is an example that we’ll all be familiar already.
Lets say that we want to buy a house. Except, instead of purchasing the house we decide to enter into a contract with the owner of the house. (this is the option contract). The house is currently valued at $500,000

So we draft a contract with the owner with the following terms:

1.  We agree to buy the house off the off the owner (this is a call contract)

2.  We agree on the predetermined price that I will purchase the house for as being $550,000 (this is the strike price)

3.  We agree that I have the right to purchase the house at any stage within 1 year.  in 1 years time the option will expire worthless. (the expiration date)

4.  As this is a contract, we have to pay the premium to give us the right to buy the house.  it is agreed that we will pay $10,000 right now to give me the right to purchase the house at any stage within 1 year off the owner for $550,000 (this is the premium)

so in a nut shell, we have agreed to purchase the house for $550,000 at any stage within 1 year and up to 1 year and it cost me $10,000 for the right to do so.  So now the existing owner of the house has an obligation to sell me the house for $550,000 at any stage should I decide to exercise my rights to purchase the property.

Now, there are a few things that can happen throughout the year.  lets explore each of them.

The house price increases in value to $600,000

The price we have the right to buy the house for is $550,000, so we exercise our right to purchase the house for this price, and we then realise a profit of $50,000.  However, we already paid $10,000 for the rights, so we deduct that and we have made a net profit of $40,000 on the purchase of this property.

Note however – in an options world, because the options contracts are traded actively on a secondary market we could have sold the options contract and never actually taken possession of the house itself!  this is important to understand, as most often options traders are speculative in nature, therefore not really interested in owning the underlying asset, but rather just controlling it and profiting from its price movements.

The house price stays the same value $500,000

In this exapmle, quite clearly you WOULD NOT exercise your right to purchase the house at a price of $550,000.  your losses on this contract would actually be $60,000, as you have already paid $10,000 for the rights to the options contract, and the value difference of the property is $50,000.

If this was to happen (as it does every day)… then you would let the option expire worthless and you would lose your $10,000.

If the house decreases in value and is now $450,000

Quite clearly you WOULD NOT exercise your right with the option.  once again you’d let the option expire worthless and not purcahse the asset.

In this example, it is also clear that you would be significanly better off by using an options contract as opposed to actually purchasing the underlying house.  if you had purchased the house, you’d now have lost $50,000.  Becuase you only owned the rights to buy the house with the options contract, you were only exposed to the amount of premium you paid for the contract, being $10,000 in this case.

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In any case, there’s a number of things that you should at least have an elementary knowledge of, such as call buying and put buying.  Both of these very simple items are of little consequence as they simply present the tradional stock buying and selling strategies however with options as the vehicle.

Although options are traded on Stocks, Index’s, futures and currencies, the bulk of the focus of this site concerns itself with the options of stock and index’s.

The successful implementation of an investment strategy requires a sound working knowledge of the fundermentals.  Applied knowledge of the fundermentals over time gives experience and then mastery.  It is only by mastery of the techniques outlined on this site that you can build a successful options trading and investment income.  You need to become familiar with behaviours of securities under different market conditions and a general knowledge of how the various markets function in themselves.  The application of the correct strategy in correlation with the market condition will prove to be your ultimate success.

Know what you want at the beginning or outset before making any investment whatsoever.  If your level of sustainible risk is low, and you require an income whilst preserving your initial investment then choosing the right vehicle is our upmost importance.  You may prefer strategies with Bonds as opposed to stocks, or a mixture of options and index’s and not choose derivatives of stocks or stocks themselves.  The suitability of options in your strategy mix therefore would become a direct result of the type of market we experiencing, and your ability to choose the correct strategy for that market.  For instance, if you are slightly bullish on the market as a whole in the longer term, then a call writing strategy on the underlying index may be appropriate.  If the volatility is high (VIX) then you probably want to steer clear of writing strategies completely.  Yes the gains to be made in volitile markets are profound, however so too are the risks and risk of wiping out your initial investment.

To this extent, Option buyers run the risk of losing their entire investment in a very short lenght of time, as all monthly options (as opposed to weekly options which we will come to in later pages) expire on the 3rd Friday of every month.  This means that if your option that you have previously purchased is still in your posetion at this date and is ‘out of the money’ then your option will expire worthless.  Approximately 95% of all options writen expire worthless!!! (this is a very important fact to be aware of, it may give you a clue as to what a safe strategy may be!).

Additionally, Option writers of uncovered options are subjected to huge financial risks, so great they have the potential (and often do) lose an entire fortune in a single day.

The trick to options is balance.  You can only balance when you know all the facts and parts to the equation.

I hope you enjoy reading through the pages at http://tradingstockshop.com

Regards

Gareth