Inside Trading

The Options

The following is an excerpt from Brian Schad’s The 3-Dimensional Trading Breakthrough

Options were primarily developed as financial tools used to manage business risk, because they allow business operators to pay an up-front defined premium (or fee) for the chance to protect themselves from adverse price movements due to unforeseen circumstances (volatility). Many people mistakenly assume that options strictly exist as speculative instruments and have only been created recently. However, the use of options as risk-hedging tools has actually been in practice for many centuries. In the past few decades, options have become popularized. Options continue to be used as a risk-management strategy by professional traders and large commercial firms. I am going to demonstrate how individual traders can successfully incorporate the use of options into a "low-risk" management trading style used in conjunction with futures contracts.

As you should already be aware, an option is simply a method of paying a limited amount of money for the option to execute a business transaction at a certain price and time. Whether or not the buyer desires to execute the purchased option is completely up to the buyer – in American markets. The seller, however, is obligated to honor the buyer's option at any given price up to the specified expiration date.

The Call Option:

First, there is the call option. When buying a call option, the trader has unlimited profit potential, limited risk. In buying the call option itself, you are "long" the market, and of course, there is the risk limited solely to the premium paid for that option. However, if you sold "short" a call option (because you thought the market may be going down) you have limited profit potential coupled with unlimited risk. Needless to say, if you sold a call option and the market was to go up, the loss potential is unlimited and could be very devastating.

The Put Option:

Next, the put option. When buying a put option, the trader has unlimited profit potential, limited risk. In buying the put option itself, you are "short" the market, and of course, the risk is limited solely to the premium paid for that option. This is not the same as the call option, because each instrument is traded for different directions in the market, and you should know what these directions are.

If you are "bullish" you can: If you are "bearish" you can:

A. Buy "long" futures contract                         A. Sell "short" futures contract
B. Buy call option                                             B. Buy put option
C. Sell put option                                             C. Sell call option

For any speculator strictly trading one-dimensional, these are the only choices available. Each has its own risk/reward profile. Let's learn more about options…

How Options are Different from Futures

At any given time, an option is said to be "in-the-money (ITM)," "at-the-money (ATM)," or "out-of-the-money (OTM)." These three categories, of course, depend on where the underlying asset is trading. If you bought a 5600 call option, and the market is trading at 5725, the option is 125 points "in-the-money" (ITM). If you bought the same 5600 call option, and the market was trading at 5600, this option is "at-the-money" (ATM). If you had possession of the 5600 cellular phone and the market was trading at 5525, the option is considered 75 points "out-of-the-money" (OTM). Whether an option is ATM, ITM, or OTM depends on what strike price the option is and where the market is currently trading.

How Options are Priced with Intrinsic/Time Value

Each option is either ATM, ITM, or OTM. If you examine a table of strike prices and premiums, you will notice each option varies in premium depending on how close the market is relative to the "strike price." For example, let's say that IBM is trading at $110/share. You bought an IBM call option for a premium of 2-3/4, when IBM was trading at $97/share. Now, that same call option is valued at 11-1/2. $10 of that 11-1/2 premium is the "real" value of the option (intrinsic value). The 1-1/2 is the "time value."

Next example: IBM is trading at $110/share. You bought an IBM 100 call option for 4-1/2. When that call option was purchased, it was trading "at-the-money." Since the market was trading at the strike price, there was no intrinsic value in this option. The 4-1/2 premium is strictly "time value." Of course, "time value" is a premium paid depending on several factors:

* How close the strike price is to the "actual market value."

It only makes sense that the closer the strike price is to the actual market value, the higher percentage chance the option has of "realizing" profitability. The underlying asset would have to experience a major market move, in the favored direction of the option, for the deep "out-of-the-money" option to become substantially profitable.

On the other hand, a small favorable market move could easily make a slightly "out-of-the-money", "at-the-money", or "in-the-money" option quickly profitable through actual intrinsic value (or close to intrinsic value).

* The length in time of the option contract.

This should be an easy concept to understand… The longer the option has in time until option expiration, the more time the market has to meet or exceed that strike price.

* The current implied volatility of the market.

In brief, if the market has been fluctuating in price erratically, then the premiums will reflect this dramatic change in price of it underlying asset. If the market has recently been in a well-defined trading range, then the premium may be lower than those premiums of a sporadic market.