learn US options

Hi readers!

If you are new to US stock options and wish to learn more or find out more information, there is a step by step guide in this blog where you can learn from basics. Below is an index of the various posts related to the topic.

(1) What are stock options?

(2) Lesson 1: basic foundation of options

(3)  Lesson 2: stock pick – stock, ETF, warrants, options ...

(4) Lesson 3: Fundamental or technical analysis?

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What are stock options?

Simply stated, a stock option is "a contract that gives the holder the right to either buy or sell the underlying stock at a specific price on or before the expiration date." There is a lot of information in that statement alone, so we will break down word for word to find out exactly what the definition means.

Contract - a stock option contract controls 100 shares of the underlying stock. This key word is control. You do not actually own the stock, but you are able to control 100 shares of it.

The right to buy or sell - this is the main concept behind how options work. When you purchase an option, you have the right to either buy the stock (call options) or sell the stock (put options). Since one contract controls 100 shares, you have the right to either buy or sell 100 shares of the stock. We will go into more details about how call and put options work.

Specific price - this is known as the strike price. These are predetermined stock price levels where the option trader can purchase their options. Strike prices are usually listed in increments of 5, for example, $60, $65, $70,... Your broker will list the specific strike prices for each stock under what is called "option chains."

Expiration date - options expire on the 3rd Saturday of every month, but the last day to trade them is the Friday before. So most people typically say expiration is the 3rd Friday of every month. There are options of different months for you to choose from. For example, if you purchase an option for December 2008, that means your options will expire on the 3rd Friday of December 2008. When your options expire, you no longer have the rights to exercise. Options are also known as "wasting assets" because for each day that passes, a little portion of your option value will decrease due to time decay.

SUMMARY of US stock options glossary

	Call stock option	Put stock option
CONTRACT	Each contract = 100 shares of the stock.	Each contract = 100 shares of the stock.
OPTION BUYER	The buyer (holder) has right to buy 100 shares at x price	The buyer has right to sell 100 shares at x price
OPTION WRITER	Is obliged to sell the 100 shares of the said stock to the holder at the strike price before or on the last day	Is obliged to buy the 100 shares of the said stock to the holder at the strike price before or on the last day
STRIKE	Specific / fixed price	specific price
EXPIRY	Before the expiry date (last day is the 3rd Friday of the month of expiry)
PREMIUM	Intrinsic value (real value) + time value
INTRINSIC VALUE	Stock price (as quoted on the Exchange) less strike price { if amount –ve, then no value}	Strike price less stock price { if amount –ve, then no value}
TIME VALUE	The remaining value from current time until the last day {i.e. the nearer to the last day, the lesser will be the time value – decay}
IN –THE-MONEY (ITM)	Stock price > strike price (higher than strike)	Stock price < strike price
AT-THE-MONEY (ATM)	Stock price = strike price	Stock price = strike price
OUT-OF-THE-MONEY (OTM)	Stock price < strike price (lower than strike)	Stock price > strike price
	stock price strike price description 75 ITM $80 80 ATM 85 OTM	stock price strike price description 75 OTM $80 80 ATM 85 ITM
OPEN INTEREST	Number of contracts opened and trading on the Exchange (prefer at least 300 contracts for each strike you wish to trade the option)
DELTA	The fraction of the stock price movement, that increases as the stock price rises. Delta for call option is from 0 to 1.0 (OTM to ITM) Delta for put option is from -1.0 to 0
IMPLIED VOLATILITY	Volatility of the options Prefer I/V of 60% or lesser

cardinal rule 2: trade without emotions so set sell stops and make all trades mechanical. 

OPEN INTEREST

As opposed to stocks, which have a fixed number of shares outstanding, there’s no minimum or maximum number of option contracts that can exist for any given underlying stock. There will simply be as many option contracts as trader demand dictates.

Every day, The Options Clearing Corporation (OCC) looks at the volume of options traded on any given stock, and they make note of how many options were marked “to open” versus “to close”. And once they have tallied up the numbers, they can determine something called “open interest”.

Simply put, open interest is the number of option contracts that exist for a particular stock. They can be tallied on as large a scale as all open contracts on a stock, or can be measured more specifically as option type (call or put) at a specific strike price with a specific expiration.

Options's Volume is the number of options contracts traded during a given period of time. Hence, volume reflects the numbers of options contracts that changed hands from a seller to a buyer, regardless of whether it is a new contract being created or just an existing contract.

Unlike stock trading, in which there is a fixed number of shares to be traded, option trading can involve the creation of a new option contract when a trade is placed. Open interest will tell you the total number of option contracts that are currently open - in other words, contracts that have been traded but not yet liquidated by either an offsetting trade or an exercise or assignment.

IMPLIED VOLATILITY

Implied volatility is a dynamic figure that changes based on activity in the options marketplace. Usually, when implied volatility increases, the price of options will increase as well, assuming all other things remain constant. So when implied volatility increases after a trade has been placed, it’s good for the option owner and bad for the option seller.

Conversely, if implied volatility decreases after your trade is placed, the price of options usually decreases. That’s good if you’re an option seller and bad if you’re an option owner.

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Lesson 1
Basic foundation - how to set the criteria and pick the right stock to trade its option. There is a summary of the criteria to qualify before we consider buying the option.

http://trendtrader-kk.blogspot.com/2011/08/vii-lesson-1-basic-foundation-of.html

Lesson 1: basic foundation of trading call option

Before buying a call option, it is important to pick the “right” stock to trade option. In this example, Starbucks is chosen as it has qualified the key criteria, namely:
·         Earnings growth (fundamentally strong)
·         Beautiful chart (uptrend and breaking new highs)

Of course we need a few other indicators (Technical Analysis) so that we can time our entry better in anticipation of a bull run (to be discussed in another lesson later).

Chart 1

Chart for SBUX (Starbucks Corp):

As at 8/8/2011, SBUX was trading about $34.04 to $36.52

SBUX has been correcting for a period hence in this example, it is assumed that the indicators signal a strong re-bounce. So, what are the criteria to buy SBUX call option?

Summary of criteria to buy call option:

Expiry month	At least over 60 days and prefer more than 90 days from expiry	e.g. Oct 11 or Jan 12
Open interest	Minimum 300 contracts Some traders prefer over 500
Implied volatility	Prefer below 40% but until 60% acceptable
Bid-Ask spread	smaller better, prefer <10% of mark price
strike	OTM mother share close to next strike ITM or ATM

Option chain extract from Thinkorswim platform on the said date:-
Confusing?

Let me explain one by one. First, assume that the mother share is trading at $35.60 at the moment you wish to take position.

 Expiry month

Upon reaching close to the expiry month, the premium on the call option will fall drastically. Take a look at the next chart.

Chart 2

Option chart for SBUX (Starbucks Corp): Aug 11 35 call 

The above chart shows call strike 35 (option is ITM as the mother share is say, trading at $35.60), expiring in August 2011 or another 11 days.

The pink line is the premium price line. Notice how much it has fallen from high of 6.00 to present value of 1.50

The green line is the open interest and surprisingly, not many have exercised their rights to buy the share.

Comparatively, if it is expiring in Oct 11 and at the same strike of 35, the chart looks different. Look at the next chart.

Chart 3

Option chart for SBUX (Starbucks Corp): Oct 11 35 call

 

Oct 2011 (another 74 days till expiry) at the same strike of 35 (still ITM), the premium dropped from $6.50 to $3.00 only. So do you see the difference due to longer expiry period?

 The main difference is the time value. When the option is getting nearer to its expiry, its time value will drop quickly.

Open Interest (O/I)

 Buying a call option is similar to buying shares. Trading volume must be high enough to determine a strong demand. In the case of options, there must be adequate contracts opened so that we have ready buyers when we want to close our option trades. Many traders look at the increase in O/I as an indicator of demand. High demand attracts higher premium.

 It is also an important criterion that a few strikes ITM must also have reasonable O/I numbers.

(Note: search this site for explanation to the abbreviations used herein)

Strike

 Chart 4

Option chart for SBUX (Starbucks Corp): Aug 11 39 call

 

 On the same day of 8/8/2011, SBUX call option strike 39 when SBUX share is trading about $35.60 means this strike price is grossly OTM. As such, the premium is down from high of $2.80 to $0.20 This is because there is only time value left in the option (for the next 11 days). Intrinsic value (difference of strike and trading share price) appears only if the share is trading above $39.00

 We want to buy call option with both intrinsic value (but not too expensive) and enough time value. Hence, we buy just ITM or ATM (i.e. in this example, if mother share trading at $35.60, then we buy call at strike 35 but if it drops below $35.00, then we pick strike at 34)

 OTM can only be accepted if mother share is close to the next strike (e.g. if share price about $35.90 then pick strike 36). Of course all other criteria (technical indicators in the chart) must be qualified too before we take a position.

Chart 5

Option chart for SBUX (Starbucks Corp): Oct 11 39 call

 

In the chart above, call option at strike 39 (OTM) with expiry Oct 2011 (another 74 days more) has its premium dropped from $3.60 to $1.50 (only time value).

Compare this to the premium in chart 3 above, where both are in the same expiry month (Oct) but different strike price. Notice that the premium is $3.00 (if strike 35) compared to the above at $1.50

The difference is the intrinsic value.

Entry

 Therefore, base on the above, when SBUX is trading at $35.60, we buy the following call option:-

Expiry Oct 11

Strike 35

Click ASK

 Do be careful that you click the correct box ASK and not BID.

You want to buy the call option where your loss is limited to the total premium you paid. BID is sell call option and if you have wrongly done that you become the writer (seller) of the option. You will be obligated to sell the share at the strike price if the stock climb at a higher level (the buyer of the call you sold may exercise his right to buy the share from you at the lower price).

 Call option is the right of the holder to buy the share at the strike price specified when market has run higher.

Well, I hope my sharing here can help you in your trading journey.

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Lesson 2
Explanation of common investment instruments like mutual funds, ETF (Exchange Traded Fund) and warrants. The key to safe investing is to identify the risk. Lowest risk usually earn lesser profits over a longer period. On the other hand, option is a derivative of a stock and has quite high risk unless it qualifies all criteria and technical indicators.  

http://trendtrader-kk.blogspot.com/2011/08/viii-lesson-2-stock-pick-stock-etf.html

Lesson 2: stock pick – stock, ETF, warrants, options, which one?

There are so many counters listed on an Exchange and it is so difficult for a beginner to pick what to invest in. It all depends on one’s risk adversity. As a norm, the higher the return will be a higher risk of losses. The ranking from lowest risk to the highest should be in this order:-

Ø  Mutual funds > ETF > stock > warrant / option > future

Exchange Traded Funds (ETF)

ETF are popular in US stock exchange. In HK, there are a few ETF but most of their the volumes are not exciting. The table below lists selected ETF that are popular and optionable in USA. Of course it is not exhaustive but these ETF usually have good Open Interest in their options.

Commodities
GLD	SPDR Gold
IAU	iShares Gold
OIH	Merrill Lynch Oil Service HOLDRS
SLV	iShares Silver
USO	United States Oil Fund LP
Index
DIA	SPDR Dow Jones Industrial Average
EWZ	iShares MSCI Brazil (Free) Index
IWM	iShares Russell 2000 Index
IYR	iShares Dow Jones U.S. Real Estate Index
QLD	ProShares Ultra QQQ
QQQ	PowerShares QQQ Trust Series 1 (NASDAQ)
SPY	SPDR S&P 500
Sector
GDX	Market Vectors Trust Market Vectors Gold Miners
SMH	Semiconductor HOLDRS
XLB	Select Sector SPDR Materials
XLE	Select Sector SPDR Energy
XLF	Select Sector SPDR Financial
XLI	Select Sector SPDR Industrial
XLK	Select Sector SPDR Technology
XLU	Select Sector SPDR Utilities
XLV	Select Sector SPDR Health Care
XLY	Select Sector SPDR Consumer Discretionary
XRT	SPDR S&P Retail

At times when the broader market is a bit volatile (meaning, one two days up and next day down), it is better to pick ETF. In earnings season (i.e. January, April, July, October) some stocks can become highly volatile and may gap up or down a lot. If the stock you are holding announces poor results or failure to meet estimate target profits, it may gap down and stay low for quite a while. Hence, you may consider buying ETF or its option. You can choose to buy index linked ETF or sector ETF or whichever you prefer.

 Garmin Chart

About end of October 2009, Garmin’s earnings was reportedly not favourable according to the fund managers. Subsequently, the stock price plunged and took quite some time to recover.

 

HK ETF

 Two of the most popular ETF in HK exchange that have reasonably good daily trading volumes:

HK ETF
2823	BGI iShares FTSE A50 China Index ETF (安碩A50中國)
2800	SSGA Tracker Fund of Hong Kong (盈富基金)

Warrants

Basically 2 main types of warrants that are popular with general retail traders:-

·         Company issued warrants

·         Institution issued warrants

Warrants are derivatives of mother stock and quite popular instruments in Asian markets like Hong Kong and Malaysia.

1.     A warrant is a transferable option certificate issued by a company which entitles the holder to buy a specific number of shares in that company at a specific price (or exercise price) at a specific time in the future. It is normally issued by the listed company.

2.     A call warrant (like a call option) also gives investors a right to buy stocks in a company within a fixed period of time. However, call warrants are issued by investment banks.

3.     There are many risks in buying into call warrants. Call warrants have shorter maturity period as compared to warrants. Normally, warrants have maturity period of five years or more whereas call warrants have very short maturity period of less than a year.

4.     Call warrants will be automatically exercised upon the maturity date if the settlement price is higher than the exercise price.

5.     A lot of call warrants are not actively traded in the market. In fact, a majority of them do not have trading volume on a daily basis.

6.     The prices of call warrants are influenced by their intrinsic value and time value.

7.      If the call warrants are getting nearer to their maturity date, the time value will be closer to zero. In addition, if the mother price of the listed companies is being traded at a lower price than the exercise price plus the premium that the investors have paid for the call warrant, the market price of these call warrants will fall below their original issue price. Trading volumes may be very low for some of these call warrants getting nearer to maturity date. Unfortunately, in many instances, investors get nothing upon maturity of these call warrants if their mother price fall below the exercise price.

8.     Majority of the call warrants are European-styled, which means investors cannot exercise them before the maturity date.

  

Genting call warrant chart

This call warrant CU of Genting (casino & resort group) that will expire on 27 September 2011 with exercise price of $10.00 against the underlying share price of $10.06 (at time of capture on 12 August 2011). Notice that the warrant price now has only a small intrinsic value and very little time value left. Also, the trading volume is so insignificant.

 Warrants are derivatives of stocks so DO NOT BUY & HOLD. Trade them for short term gains only.

Futures

Futures trading is very risky and can result in substantial losses if you are not familiar with it.  For instance, we can buy futures contract for an index and pay only a fraction of the value. We get paid a fixed amount for every point rise in the index (if we buy long) but if we are wrong, not only our initial investment is wiped out, we have to top up to stay in. It is somewhat similar to a margin call. 

So folks, choose wisely the type of investment that suit your objectives and never trade with money you cannot afford to lose and respect Mr Market (follow the charts).

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Lesson 3
The importance of technical analysis and lesser emphasis on fundamentals. One should hear less on news or analysts reports. 

There is also a link to a free chart web site.
http://trendtrader-kk.blogspot.com/2011/08/ix-lesson-3-fundamentals-or-technical.html

Lesson 3: Fundamentals or technical analysis?

The important aspect of trading is to pick the “right” stock and buy in at the “right” time but so far, for most of us, it is seldom right. The mind boggling part is to determine which is the best approach:

• read the latest news and analysts’ reports
• check the fundamentals of the stocks worth to buy
• learn technical analysis

But all said and yet so difficult to decipher.

News and reports?

Not me as I think there is not much latest news even though we are in the internet age.

I prefer to know a little – good to know.

Fundamentals?

Yes, possible but not enough. If any good accountant can read fundamentals well, then these accountants would be rich already.

As I know, investors go for companies in evergreen or blue ocean industries, strong earnings growth and high yields. Well managed companies have yearly earnings growth and can pay dividends. So capture these important factors in screening the market for good stocks. How? Read on.

Technical analysis?

Yes, it is still the best approach. The market is a place filled with emotions of fear and greed. There is no fair value. All prices and volumes are perception. So if we can analyze the history, we may anticipate the probable trend direction the next day or period.

So where can we get such information?

TRY THIS SITE:

Finviz.com 

 To scan for good stocks to buy, try these steps:

Screener

• descriptive – dividend yield +ve, average volume >2million, current volume >2million, optionable

•  fundamentals – EPS growth next 5 years +ve, EPS growth past 5 years +ve

•  technical – performance year up,

Now you are left with less than a hundred or so counters and you can keep it in your watch list.

 Example:

http://finviz.com/screener.ashx?v=111&f=fa_div_pos,fa_eps5years_pos,fa_estltgrowth_pos,sh_avgvol_o2000,sh_curvol_o2000,sh_opt_option,ta_perf_52wup

 note 1: at least 2 million shares traded can enhance better as higher volume means more demand.

Note 2: performance of year up ensures we buy up trend stocks

Charts? Where can we get free charts?

Follow either of these:

http://chartnexus.com/software/cnx.php

click DOWNLOAD

Once installed, you can set your charts which look like this -

Of course nothing is absolutely free but this is loaded into your computer with a choice of multiple market data, not just USA! However, you only get 3 years data free of charge and have to download prices daily. You have to pay to get more features.

Or,

http://www.freestockcharts.com/

This is a web based version but only US market.

 Like this -

 

GOTO NEXT LESSON..

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Lesson 4
A step by step guide to pick stock or option.
There is a table on screener filter criteria.

http://trendtrader-kk.blogspot.com/2011/08/x-lesson-4-stock-pick-etf-stock-or.html

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Lesson 5
The continuation of step by step guide on stock picking.

http://trendtrader-kk.blogspot.com/2011/08/xi-lesson-5-stock-pick-etf-stock-or.html

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Lesson 6
Learning technical indicators and chart patterns can help to find the right stock to invest.

http://trendtrader-kk.blogspot.com/2011/09/91-lesson-6-stock-pick-etf-stock-or.html

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How to buy options
Read charts with aid of technical indicators with example on qualifying the criteria for a stock option.

http://trendtrader-kk.blogspot.com/2011/09/94-how-to-buy-options-with-aid-of.html

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How to screen optionable put
Some basic filtering criteria explained in order to search the optionable Put 

http://trendtrader-kk.blogspot.com/2011/10/102-how-to-screen-for-stocks-to-buy-put.html

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Why options? 

http://trendtrader-kk.blogspot.com/2011/08/why-us-stock-options-and-what-is.html

Happy learning!