Tactical Execution

Hello and welcome to Financial Audio, an information series providing listeners with detailed and tactical guidance on today’s complicated financial world. My name is Patrick and I’m your host. You can find written versions of these podcasts at FinancialAudio.com and I encourage your candid feedback at the same location. Today, we’ll be looking at the options market so let’s get started.

Options represent the absolute scariest aspect of today’s financial markets for many investors and non-investors alike. Although most people don’t fully understand how they work, the little bits and pieces of information people have heard is enough to leave them running for the hills. In fact, some even get down right angry that such “investments” even exist. But a little knowledge goes a long ways with options and they’re really not as bad as most people think. Let’s start with some definitions.

The term “options” covers two different types of securities: calls and puts. And neither of these carries any tangible value; they are merely contracts. By that, I mean they are just “a legal option” to do something in the future. Let’s look at an example. A CALL option is an option to BUY a particular stock in the future and a PUT option is an option to SELL a particular stock in the future. So assume we’re talking about a stock that’s trading between $20 and $25 and you could buy a call option with an exercise price of $22.50. How much do you think that would be worth? Let’s take a look.

Well, it really depends on the current trading price of the stock, doesn’t it? If the stock is trading at $20, the call isn’t worth anything, is it? I mean; who would pay money for the option to buy a stock at $22.50 when you could get it on the open market TODAY and for $2.50 less?? In that scenario, the contract has no value at that time. But what if the stock is trading at $24? Well, now we’ve got some real value. If you had that option, you could buy the stock for $22.50 and then turn around and sell it immediately for $24, leaving you with a $1.50 profit. In other words, that option would have a value of $1.50 TODAY because the ACTUAL price is $1.50 higher than the exercise price. Make sense?

Now, the pricing of options is actually a lot more complicated than this but our example is a good place to start. As it turns out, there are actually five variables that play into an option’s price and we’re going to try and work our way through some of them here.

I know you are trying to keep it simple, but I think it is important to understand that each strike has a different delta and the delta determines how much that option will change in relation to a change in the underlying stock price. An option deeper ITM will have a higher delta and therefore a greater correlation in price movement. This means that the premium of the ITM option will increase or decrease by a greater amount for every $1 move in the underlying stock than the OTM option. Remember, the highest correlation between the option price and the stock price is 1/1, which means the option will move $1 for every $1 move of the stock and this is only possible at strikes that are deep ITM. OTM options have deltas less than 0.5 which means they would change at most $1 for a $2 move in the underlying stock.

So let’s throw another factor into the mix. Calls and puts all have expiration dates on them so in the last example, you can’t buy the underlying stock at $22.50 forever. The contract allowing you to do so will come with an expiration date. These expiration dates can range from the current month to several months out and in some cases, even years into the future. So let’s look at our example again.

If the stock is trading at $20, you’d think the option has no value. Why buy an option to purchase a stock for $22.50 when you could get the same stock on the open market for $20?? But somebody might THINK the stock will go up in value BEFORE the expiration date, giving the option some POTENTIAL value. For example, what if the stock went up to $24 before the option expired? Well, in that scenario, the option will have a value of $1.50 just before it expires. So even though the actual price is LOWER than the exercise price TODAY, the option may still have some value. And that value will be determined by the amount of time remaining before the option expires.

Now, if the stock is trading at $24, you’d think the option would be worth $1.50 but someone might think the stock price will go up further before the expiration date, and that will push the value of the option higher than $1.50. Maybe it would be worth $1.75 or $2.00 or even $2.50. It all depends on the volatility of the underlying stock and the time remaining to the option’s expiration date.

In the end, an option’s value is comprised of two components: intrinsic value and time value. The intrinsic value is the difference between the actual price and the exercise price (with a minimum of zero – an option never has a negative value) and the time value is the premium paid for the amount of time remaining on the contract. And it follows that the time value diminishes as the expiration date approaches. If the option is still valid for another 2 months, the time value might be significant. But if the option expires in 3 days, the time value is almost nothing.

I just mentioned that the intrinsic value is never less than zero. In other words, if the stock is trading at $20 and the exercise price is $22.50, the intrinsic value doesn’t go to negative $2.50. It’s just worthless, that’s all. Well, if an option is in this situation, it’s said to be “out of the money”. On the other hand, if the stock is trading at $24 and the exercise price is $22.50, the option is said to be “IN the money”. So if the option is out of the money, it means it has absolutely NO intrinsic value; it ONLY has time value. And if the option is IN the money, it has both intrinsic value AND time value.

Obviously, an option can be out of the money at one point and then get INTO the money later. The option may have been issued when the stock was trading at $20. At that point, it was out of the money. But then, if the underlying stock went up in value – say all the way up to $24 – then the option would’ve have climbed INTO the money. And you can bet its value went up a ton. In fact, if the actual trading price is 10% below the exercise price and depending on the volatility of the underlying stock, you might only pay 50¢ or less for the option. But if before the expiration date, the underlying stock’s value went up to $24, the option would have a new value of AT LEAST $1.50, maybe more. Well, the stock only went up by 20% (from $20 to $24) but the option went up by 200% (from 50¢ to $1.50).

The message here is hopefully pretty clear. Because of the nature of options, their volatility is exponentially higher than stocks. Now, by the way, finishing the previous example, if the stock’s trading price climbed to $24, the person holding the option doesn’t ACTUALLY have to exercise the option, buy the underlying stock and then resell it on the open market. No. Most options are never actually exercised. The value upon expiration is simply the intrinsic value and the exchange clears everything out afterwards. So the person holding the option would simply sell the option as it approaches expiration and the exchange would clear it out.

Anyway, the point stands. Options have incredible price volatility and that’s why some investors are attracted to them. If you’re on the right side of the market, you can make a fortune overnight. And if you’re on the wrong side of the market, you can lose your entire investment quickly. In fact, in some cases, you can lose far more than you ever invested and we’ll be talking about that in a minute.

At the beginning, I mentioned there are two types of options; calls and puts. So far, we’ve only been talking about calls. Well, a PUT is an option or a contract to SELL an underlying security. So let’s assume the stock’s trading at $24 and you’ve got a put with an exercise price of $22.50. With a trading price of $24, the option would have no value. I mean; who would pay money for an option to sell something at $22.50 when you could sell it on the open market for $1.50 more?? But if the stock was trading at $20, now you’ve got some real value. You could buy the shares at $20 and then use the option to sell them at $22.50. So the put option would have an intrinsic value of $2.50 in that scenario. And again, there would probably be some additional value depending on the time left until expiration.

It’s worth noting that both calls and puts, options in general, fall into the category of “derivatives” and there are other things that fall into the same category. A derivative is any financial instrument that derives its value from an underlying security. It’s an agreement. It’s a contract. In our examples thus far, it’s an option. None of these things have tangible value. Their value is based on the value of something ELSE like a stock. Also in this category are futures. These are contracts to buy something in the future at a specified price. The biggest difference between a call and a future is that a call is an option whereas a future is truly an agreement to buy. You’re making a commitment to buy.

Most futures involve actual products or commodities like coffee or pork bellies and the companies who purchase futures generally deal in that underlying product. They buy these futures contracts to hedge themselves against price fluctuations. Take copper, for example. Copper has gone up in value a lot during the past few years and a company could’ve purchased futures contracts before that price increase, guaranteeing their supply at the earlier prices as a result. Likewise, Southwest Airlines recently boasted industry-leading profits because they purchased tons of fuel futures before the price of oil went up so much. So while the other airlines were paying much more for their fuel, Southwest was still paying the older & lower prices.

Anyway, we’ll focus mainly on calls and puts because that’s what most investors use in their investment strategies. And there are basically three ways of using options as part of an investment strategy. At the first level, you can simply buy calls or puts. If you’re expecting a stock to go up in value, you can buy calls and ride the wave up. And if you’re expecting a stock to go down, you can buy puts and profit from any downward movement. And if you’re right, you’ll probably do really well. That’s the first strategy.

The second is to sell covered calls and puts. That means you’re SELLING the option to buy or sell a particular security to someone ELSE. You’re giving someone else the right to buy or sell a security at a particular price. The word “covered” means that you already OWN the security in question. So, for example, if you owned 100 shares of Microsoft and then sold a call option for 100 shares of Microsoft at a particular exercise price, you’re covered. You’ve already got those shares. So if the person buying the call decides to exercise option, you’ve got the shares to sell.

There are a lot of people looking to make a steady return by selling calls every month on the same shares. In other words, they sell a call – that’s an option to BUY – on their shares just a little bit OUT of the market – so the exercise price is ABOVE the current trading price. Then they hope the underlying stock does NOT rise above the exercise price. If they’re right, the options will eventually expire worthless and they would be left with the premium – the price they originally sold the calls for – as a profit. People like this try to sell options on their portfolio shares on a monthly basis, essentially RENTING the rights to their shares month after month.

The third strategy is to sell calls or puts NAKED. That means you do NOT own the underlying shares. So if someone exercises the option you sold, you’d have to go out and BUY the stock at the market price and then SELL them at the exercise price in the case of a call or BUY the shares at the exercise price, regardless what the actual trading price, in the case of a put. Either way, these naked options would ONLY be exercised if they were IN the money. In other words, if they get executed, it means you LOSE money. People who sell naked calls or puts are hoping the options never get exercised and expire worthless. They’re hoping they can just sell these contracts month after month and collect all that premium without ever having to buy any of the underlying security.

So let’s look at the risks quickly. If you sold a naked call for a stock that’s currently trading at $20 and your exercise price is $22.50, the call would have absolutely NO intrinsic value but it probably WOULD have some time value. Let’s assume you sold the call for 50¢ and that premium would get deposited into your account. Then, let’s say the stock price jumps up to $25 and the holder of the call exercises the call. At that point, you would have to BUY the stock on the market for $25 and then SELL it to the holder of the call for $22.50, losing $2.50 on each share. Originally, you collected 50¢ in premium so you’d end up losing $2.00 per share. Point is; you never had any money invested so the potential loss percentage is infinite. You could lose everything.

I don’t mean to paint these options so badly. I’m the one who started off saying people are overly intimidated by options – and I truly believe that – but it’s important to realize there are real risks involved and you have to be careful. In fact, most brokerage houses will have different account classifications and they’ll only allow certain options trading activity within each. In order to qualify to do riskier options trading, you have to meet certain qualification requirements first. Now as it turns out, there actually ARE some brokerage houses these days that will let anyone trade options but they’re still the minority.

The fascinating part of options comes in combination strategies. For example, you can buy an actual stock long for $50 per share and then purchase a few put options to hedge against a downturn for 50¢, protecting your investment. In this way, options can be used as an insurance policy. You can also setup what they call “straddle” positions where you buy a call AND a put around a stock’s trading price, allowing yourself to potentially win in either case, provided the stock’s price moves one way or the other.

You can work with different TYPES of “spread” strategies and get into some really sophisticated trading. The end result is that options provide real value for sophisticated investors and real profits if you use them effectively. In fact, by using different options together, you can actually maintain your profit potential with LESS money invested and LESS risk than buying the underlying stock. We don’t have time to get into that in this podcast but there really are some fascinating investing strategies that use options as tools to protect profits and reduce risks.

Again, the most important thing to remember is this: the biggest problem with options is that time is your enemy. Time is your enemy. Whatever you want to happen, whether you want the underlying stock to go up in value or down, it had better happen soon! Because the passage of time ALONE will erode the value of your investment. Now, of course, if you’re SELLING options, time is your friend. You WANT the options to expire. But either way, it’s important to understand that as the expiration date approaches, the time value falls to zero. If you buy options and your anticipated move doesn’t happen before the expiration date, your investment just evaporated. Gone. So please keep that in mind if you plan to use options in your future investment strategy.

If you’d like to see what I’M doing in the market, just create a FREE account and login at FinancialAudio.com and then click on Market Position. Now, it’s important I tell you that I’m NOT a licensed Financial Advisor. This is FREE information and I do NOT accept money to give investment advice. I’m just giving you a little glimpse into my own trading activity, that’s all.

You can also read market commentary on the blog page. If you’d like to see a list of upcoming topics, just click Podcasts on the homepage. If you have a suggestion for a future topic, please use the Contact form to let us know. And finally, all the websites referenced on this podcast have been included on the Links page.

Okay, thank you very much for listening. If you like what you hear on these podcasts, please tell a friend about them. Modern technology like podcasting can help elevate new and innovative thinkers but we all have to play our part to help spread the word for those who deserve our endorsements. If I am deserving of yours, my thanks.

Again, you can find written versions of these podcasts at FinancialAudio.com and I do offer workshops, seminars and keynote speeches as well as a variety of more advanced information products so please email me at Patrick@FinancialAudio.com for more information. I’m also doing a series on innovative marketing and strategic business positioning. That series is called Tactical Execution and you can find it on iTunes.

Stay tuned. There’s a lot more to come. In the meantime, think big, take action and invest strategically. Bye for now.