Options Trading 101

Speculation is certainly not for everyone, but trading is definitely not a snobbish occupation of an exclusive club of Ivy League graduates. There are many things to be said about trading. However, two points are paramount in becoming a successful trader: a rock-solid discipline and a timely acceptance of the losses.
In a nutshell, investors could have either a bullish or a bearish sentiment. That practically translates in the expectations that the markets will rise or fall within a pre-defined time-horizon. Under a quick classification, any financial instrument could be either a spot product or a derivative product. For instance, when you buy 100 shares of Apple [AAPL] you create a long position in that stock. For every dollar that AAPL share goes up in value you make a $100 in profit. Your profit & loss (P&L) account goes up or down linearly with the underlying product. However, when you trade futures or options products, the relationship does not work anymore. An option is a derivative, as it derives its value from an underlying asset. As the price of the underlying asset, such as a stock or commodity, moves in the marketplace, the price of the option changes in harmony. By definition, an option is the right, but not the obligation, to buy or sell the option’s underlying asset at a certain price for a certain period of time in the future. An option grants you just that, the “option” of deciding whether or not you wish to consummate a certain transaction. You can execute the transaction if it is beneficial to you or choose not to if it is not beneficial to you.
Do not fall asleep yet! The interesting part is coming right now. Let’s take an example and analyze all the mechanics inside! Consider for our exercise the options on AAPL. As the AAPL price is bid up and sold down, the AAPL options prices change right along with it. Options come in two flavors: call options and put options. A call option grants speculators the right, but not the obligation, to buy the AAPL at a certain price for a certain period of time in the future, whereas a put option provides the opposite function, granting speculators the right to sell AAPL. If you believe AAPL is headed higher in the future you will consider buying AAPL call options. Conversely, if you believe AAPL is headed lower in the future you will consider buying AAPL put options. Ultimately the mechanics of buying or selling a call or a put is just like trading any stock. Nonetheless we have to know few more pieces of critical information when trading options:
• First thing we need to decide is whether we believe AAPL share price is heading higher or lower. Let’s assume that we believe that AAPL will go down from here and therefore we enter into a put option contract.
• Next thing we need to consider is the expiration month. This detail will show us for how long we hold the option contract. Stock options expire on the third Friday in their contract month. At expiration options become worthless and the contract no longer exists. Let’s choose the month of October as the expiration month. Since the 3^rd Friday is Oct 16 2009, that gives us 50 days till the option contract matures. As you will notice, for both calls and puts, the longer time-to-maturity the more expensive the options become.
• Now that we have decided to consider puts expiring in October, we need to make a decision on which strike price to trade. The strike price is the contractual price at which we will gain the right to sell (because we are looking at puts) our underlying asset, AAPL stock, until our options expire. Let’s choose a $150 strike for this example. That translates in the right but not the obligation to sell AAPL at $150. As you will notice, the higher strike we choose the more expensive the put options become and the cheaper the call options become.
• With AAPL Oct ‘09 $150 Puts, we are making the bet that the AAPL will trade under $150 before our options expire. As of today close, AAPL stock was quoted at $170. If the AAPL trades under $150 at any time between now and Oct 16^th, our options will be in-the-money (ITM). For example if AAPL were to slide down to $140, our put options would be worth at least $10 per share.

All we have to do is calling our broker for a quote and decide how much capital to invest. His ask price for the AAPL Oct 150 put option is $2.10. We decided to invest $2,100 which gives us the right to sell 1,000 shares of AAPL at $150. If AAPL falls to $140 in the open market, we still have the contractual right to sell AAPL shares at $150. The difference between our $150 strike price and the $140 AAPL market price is $10, so our options alone are now worth $10 whether we exercise or not. If it works out the way we hope, we will earn a massive 376% profit! When the underlying stock fell by 18% only, we gained the prospects of a huge 376% profit by speculating in AAPL puts.
Options prices have two components: intrinsic value and time value. The intrinsic value component of the option is the difference between the options’ strike price and the underlying market price when the options are ITM. A put option is ITM if the market price of the underlying is under the strike price, whereas a call option is ITM if the strike price is under the market price of the underlying. As we discussed above when the AAPL falls to $140 our $150 puts will have $10 of intrinsic value. Since the AAPL Oct 150 Puts have no intrinsic value at this time, why will they still cost us $2.10 to buy? The answer is the second component of options pricing: the “time value”. When a trader buys an options contract, another party has to sell it to him. This counterparty assumes risk by granting the trader the right to sell the option back at any time before expiration. Time value starts off high on an options contract and steadily decays towards zero as expiration draws nearer. The sum of any options’ intrinsic value and time value is known as the option premium, or price. The premium for our AAPL Oct 150 Puts discussed above is $2.10, with zero intrinsic plus $2.10 in time value to compensate the option seller for the uncertainty between now and Oct 16^th.
One might ask: why should we get into these esoteric products that many non-professionals have a hard time understanding? Let’s have a look at the whole picture with both sides in the spotlight: the potential upside and the potential downside. As we noticed, if the AAPL shares go down in value our P&L turns positive and everyone is happy. However, should the stock rise in value, to let’s say $180, a bearish strategy (that is either selling short the stock or buying a put option) would produce different P&L outcomes. By shorting the stock our position would generate a $10,000 loss: 1,000 shares x [170 -180]. By buying the put options our strategy would limit our losses to the $2,100 premium we paid. Since the options end-up out-of-the-money, we will not exercise the options since they became worthless (why selling at the $150 strike when we could sell at the market price of $180). Bottom line, by shorting the stock we are exposed to a theoretical unlimited downside and upside, whereas by buying the put options we get a theoretical unlimited upside but a very limited downside (that is the price of the options). So now we know why we like options.

Keep an eye on AAPL downfall and let’s cross our fingers!