So You Want To Learn Options?

Hi, some have asked me about options so I thought I'd pass on some things I've learned about them. Please excuse the appearance as I am copying some notes I saved. I'll try to clean it up when I get a chance.

Options Levels
L1=Covered Calls
L2=Long calls and Puts
L3 Spreads
L4 Short Calls and Puts
L5 Short Index Options

Basics
An option is a contract that gives the owner the right, but not the obligation, to buy or sell a stock at a set price by a set date.
An option is a piece of paper that allows you if you own the contract to buy or sell a stock at a set price before the contract expires, or to buy or sell the contract at any time prior to expiration..
ctrct=contract
a Purchased Call option gives you the right to buy a stock a t a set price for a set period of time.
A Purchased Put option gives you the right to SELL a stock at a certain price by a set date.
Option carry the risk of total loss of your investment.
Options have leverage. When you buy 1 contract, you control 100 shares of the stock at a fraction of the price
5 Ingredients to Option Pricing
The current stock price.
The strike price you are trading.
The time till the option expires.
The cost of the money.
The stocks volatility.
Every Option has 2 Parts
Intrinsic vale
Value if the current value of the opt if it were to be exercised today.
Time value
Value if the amount you pay to exercise your contract within the next few months.
Time Value(TV) is the additional amount the MM's add to the premium, it's like a car dealers mark up price.
Example
a. Intrinsic value + Time value = option price
b. Stock=$26
c. I want to buy the $25 calls
d. The intrinsic value = $1 (26-25)
e. If the option quote price of the $25 call is 2.50, then the time value is $1.50 (see F)
f. 2.50-1.00=1.50
g. If stock is $27, Intrinsic Value=$2.00
h. Option Quote - Intrinsic Value = Time Value

Theoretical Value
1. Is the fair value of an option.
2. It not only tells us if the stock is overvalued or undervalued, but it also tells us exactly what price we should be paying for an option.
3. This T-value is derived from the BSC.
Example
a. Lets say we are looking at a 60.00 stock and the Tval is listed at .65.
b. Ask price for the strike price and the exp month is .70 for the Nov 60.00 call option.
c. If we pay .70 to buy the option and the Tval is .65 we will pay 7.6% more than we should.
d. There is a normal premium built into most options as the MM's will try to see how much more you are willing to pay.
e. As a general rule of thumb, make sure the ask price of an option is not trading more than 20% premium of the T-Val.

Decision Factors
A huge factor in deciding whether or not to purchase an option rests in the expected volatility (price movement) vs. the stock's historical volatility.
Volatility = magnitude of a stock move, this can be up or down.
If stock has low historical volatility, that means investors are willing to hold the stock and not trade it.
This usually indicates the stock will see low volatility in the future.
The 12m calculation for historical volatility is a good indicator.
Implied volatility measures the current expected volatility of the stock.
When we measure the historic against the implied, we can see if the stock's expected (implied) volatility is above or below normal historical volatility.
If implied volatility is higher than historic volatility, the option is overvalued.
If implied volatility is lower than historic volatility, the option is undervalued.
If implied volatility is close to the historic volatility, the option is fair valued.
All of this is done for you with a calculator called the Black Shoales Calculator.
The BSC allows you to project the future value of an option by allowing you to manually change the Strike price, share price , time to expiration, volatility, annual interest rate.
http://www.blobek.com/black-scholes.html.
Forecasting
Each time you invest, you must choose a strategy that takes advantage of your forecast for the market or a particular stock.
This is a tremendous challenge and is impossible to be right 100% of the time.
To make a forecast, use the best available info and tools and then apply your individual; interpretation of them.
Always forecast before making a trade. Most option traders focus on short time frames for their forecasting (generally 3 months or less).
As option traders we try to use the leverage of an option to profit from a short term move in the market or individual stock.
Rules
The Trend is your friend. Never buck the trend or you lose.
Spot trend of the major indexes first: DOW<S&P500,NASDAQ.
Keep in mind that the trend tells you WHAT to do, and the Indicator tells you WHEN to do it.
ALWAYS - check the trend before you check the indicator.

Buying a Call
You pay a premium for the right, but not the obligation to buy a stock at any time before the expiration date.
You also have in your contract the right to sell that contact ANY TIME before expiration date.
Your 5K premium is known as “as risk.” You can lose all of this investment.
So in order to make money when we purchase a call option, the price of the stock must go up over the stock price + the premium we paid per share.
Buying A Put

Same procedure as buying a call except you are betting that the stock will decrease in value. Profit is made once the stock price goes below the Strike price + the cost of your premium.


Example of Buying a Call (real estate example)
1. On August 23rd you pay a 5K nonrefundable premium to buy my house for 100K on January 1st, 2008.
2. When Jan 1st comes, if my house is worth 150K, you have the option to buy it for 100K and sell it for 150k, resulting in a 45k gain using a 105k investment. This is a gain of 43%.
3. When Jan 1st comes, if my house is worth less than 100K, you do NOT have to buy it. You would lose the premium.
4. If anytime before Jan 1st my house is worth more then 100K, you can sell the contract and take the profit. Using the example above, we can sell the option for 50k and make a 45k profit. This is the beauty of options. You use 5k to make a profit of 45k (a 900% gain) instead of using 105k to make the same profit.You make the same profit without having to purchase and sell the equity. This is known as leverage.

Selling a Put
You are credited the premium when you sell the contract.
As long as the stock stays above the strike price, the contract will expire worthless and you will make the premium.
So in order to make money, when we sell a put, we want the stock price to stay above the strike price.
You only sell Puts when you are comfortable owning the underlying stock (at a discount)
Example of Selling a Put
1. The current price of LEND is at $6 a share.
2. We sell the $2.50 strike price put for September. The premium on this sell is .80 cents per share (.80/share).
3. We sell 100 contracts (100 contracts * 100 shares = 10,000 shares).
4. The amount credited to our account for the sell is 10,000 shares X .80/share = 8,000 dollars.
5. As long as the price of LEND stays above $2.50, we get $8,000 on the expiration date.
6. Now what happens if the stock drops to $2.50? We have to buy the stock back!
7. We buy the stock back at the Strike Price – Premium.
8. For LEND that would be 2.50 - .80 = $1.70 per share.
9. The JUICY part is that when the stock fell to $2.50, we bought it at $1.70, which means that we can turn around and sell the stock at the market price of… lets say $2.45… and still make a sizeable profit (7,500).
10. (2.45-1.70) * 10,000 shares = 7,500.

Credit Spreads

Basics
Credit spreads have a maximum profit potential.
Credit Spreads require level 3 options trading authority
Tip: If you think the stock is going to make a dramatic move up, you would be better playing a long call
But what is really cool is that you can make money with a credit spread even if the stock stays flat and may even take a small profit even if it goes down only a little bit
Spreads have a max loss potential
Spreads have a max profit potential
When playing options, you should ALWAYS have your stop set as soon as you place your order
The are two different types of Credit Spreads
Bull Put
i. Bull Put= stock should be trending up or at least sideways
ii. So the same rules would apply to playing a bull put spread as if you were buying a bullish stock (You would want to enter the trade at support and exit at resistance)
iii. You will most likely achieve the max profit in a Bull Put spread if the stock is trending up.
iv. Because one of the two positions in a bull put spread is naked, you should enter the long side first
v. You can then enter the short side without needing naked option writing approval
vi. many platforms allow you to make a single credit spread now where both are executed simultaneously
How to play a Bull Put spread
Buy a put on a bullish stock, with a strike price below the current trading price of the stock.
Sell a put on the same stock with a strike price above the strike price that you bought the first put.
Example
a) Lets say a stock is bouncing off support at $54
b) You buy the 50 put and sell the 55 puts
c) When you buy the 50 puts- you pay .25
d) When you sell the puts at 55 you bring in 2.50
e) 2.50-.25=2.25/sh
f) Your max profit is your credit, so the max profit=225/contract
g) Max Loss = Difference between the spread less the net credit
h) 55-50=5.00
i) 5.00-2.25=$2.75/sh or -$275.00 /contract
j) If the stock closes 55.50 on exp date
i. Both puts expire worthless
ii. and you keep max gain of 225/contract
k) If the stock closes at 35
i. You would assume the max loss of $ 275/contract
l) The reason you get max gain is because both options expire worthless= $0.00 in commissions
m) Breakeven= Higher Strike price - Net credit= 55.00- 2.25=$52.75 assuming all options are worth their intrinsic value at expiration.