A Week for the Greeks

This week at the Not-so-implied Volatility blog we're going to talk about the 'Greeks.' You might be wondering: "why do I care about a bunch of hairy men?" Luckily for us, hairy men have nothing to do with it! The Greeks are a set of analytical calculations for option positions! Here's the bunch of 'em:

• Delta
  
• Gamma
  
• Theta
  
• Vega
• Rho
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  

Five Greek symbols will make for a lot of learning, so make sure to stop back on by!

Talk to you soon,

Spencer Sundahl

The Calendar Spread

Last time we spoke I introduced you to volatility. Now after a break for the holidays, I'm going to teach you how to take advantage of it! Today, we're going to talk about a new option strategy that takes advantage of both rising volatility and time decay, called the calendar spread.

Just a Matter of Time…

So what is the calendar spread? And why is it a useful option strategy to know about? The calendar spread is an interesting strategy. In many ways it's a mix of writing a covered call and buying a call with a different expiration date at the same time. Let me break it down for you.

A calendar spread can be constructed with both calls and puts depending on your general opinion of the market or stock. However, for the sake of clarity we will only consider a spread involving calls. Because we are considering calls, we have an overall bullish opinion of the stock we are constructing the spread with. However, with a calendar spread we are neutral in the short-term. So what exactly does a calendar spread entail?

To create a calendar spread you buy a long-term option and sell a short-term option of the same strike price. The idea is that you will take advantage of the heightened time decay of the short-term option and make substantial profits when it expires (hopefully worthless.) After that time you can either close the position, or keep your long-term option (which you've now obtained at a nice discount), and let your view of the market take its course.

Another nifty feature of the calendar spread is how an increase in implied volatility affects the position. As implied volatility increases, the price of both calls and puts also increase. This increase in price has a larger effect on long-term options than short-term options, thus when this happens a calendar spreader benefits, and sometimes quite substantially.

Personally, I find the calendar spread an incredibly attractive strategy. Not only does it limit your risk exposure (your maximum loss is the amount paid to open the position), but it also allows for a very hefty profit. At times the shorter term option will expire and leave your longer term option with 100%+ in gains! What surer profit is to be had in the option's market than that gained from time decay?

Until next time,

Spencer Sundahl

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An Introduction to Volatility

Now that we've covered some of the more basic option strategies, it is time to introduce volatility. Volatility is a key factor when trading stock options. What exactly is volatility? And how does it affect stock options?

Defining Volatility

There are some very technical definitions of volatility, and if you're interested in reading them you can at: http://www.investopedia.com/terms/v/volatility.asp. However, I would like to define volatility in a less technical way. If a stock tends to decline or appreciate in rapid bursts it is considered to be volatile. That is, we can expect the stock to move a decent amount (either up or down) percentage-wise during our time holding it. On the other hand, Blue chips and other slow moving stocks aren't very volatile. They move with the market, and they don't move very fast in either direction. Because some stocks are more likely to change prices rapidly their options are more expensive than those of a slow moving stock. However, there is a catch to this. At times you may notice a stock that hasn't moved much at all recently, and yet their options are incredibly pricey! This stock might look like a good candidate to sell calls against, but doing so may be unwise.

Two Types of Volatility

Although, the previously mentioned stock may have seemed to be an incredible opportunity to write covered calls, there was likely another reason for the overpriced options that would put your position at risk. The market considers two types of volatility: historical and implied. Historical volatility is a measure of how volatile the stock has been in the past. This statistic can be very telling, especially when determining how much to pay for an option. However, implied volatility is what is actually used when pricing options. What is 'implied' volatility? Implied volatility is how much the market expects the stock to move over the life of the option. If a biopharmaceutical company is waiting for some huge drug decision by the FDA their options will be incredibly pricey; when the decision is finally made the price of the options will collapse, but their stock price may too. In a sense it is excitement that drives options to become overpriced. When the excitement is gone, your money is too! Be wary of overpriced options!

Next time we'll talk about calendar spreads and learn more about volatility. After that I'll introduce you to a few option pricing calculator and more complex strategies involving options.

Until then,

Spencer Sundahl

Bull and Bear Spreads; Which Flavor’s for You?

Yesterday, we talked about credit and debit spreads. We learned the pros and cons of each, and today we are ready to tackle a new aspect of spreading risk with bull and bear spreads. Although, many different setups can be created, there are basically two different risk appetites that can be achieved with bull and bear spreads.

Phil and Bob Follow Buffet

Our good friends Phil and Bob have yet again discovered a trade they like. Recently, Warren Buffet's company Berkshire Hathaway has acquired a large stake in the oil giant Exxon Mobil (Stock Symbol XOM.) Warren thinks inflation will soon set in and commodity prices will soar. Bob and Phil think Warren might be right, so they have decided to take up an option position in XOM. To best take advantage of this opportunity, Bob and Phil are both going to set up bull spreads. However, Bob and Phil aren't really sure how high XOM will go. Bob, the more conservative of the two, sees 80.00 by January, a large, but realistic move for XOM. On the other hand, Phil finds such a target likely, but believes the momentum will build and it will take XOM beyond its fundamental limits, all the way to 85.00.

Bob will set up a 75.00/80.00 spread. He will buy XOM January 75.00 calls, and sell January 80.00 calls for a net debit of 1.85. If XOM is at our beyond 80.00 when the option expires in January his profit will be 3.15, a significant amount for what seems to be a reasonable trade. Phil will take a different route. Phil will buy the January 80.00 calls, and sell January 85.00 calls for a net debit of .55. If XOM is at or above 85.00 when the options expire in January, Phil will have a large profit of 4.45! A very significant profit for such a small debit, but such a profit would require a very large move. A move that is unlikely for XOM.

As you can see, bull and bear spreads come in two different flavors. When the option you buy is more than one strike price away from the current price it is considered a more speculative and aggressive position (a Phil position, if you will.) In contrast, when the option is nearest the current strike price, it is considered a standard level of risk for a bull or bear spread, and a less risky position than simply buying a call or put.

You now know a good deal about bull and bear spreads. You can set them up in a variety of ways, debit or credit, aggressive or not-so-aggressive, bull or bear. As always, practice in a virtual account before you trade such spreads in a live account, it will save you money in the long run. Next, I will introduce you to one of the most complex and important topics in the world of options: volatility. Along with this, we will talk about the calendar spread. The calendar spread is a particularly useful strategy that offers a variety of unique opportunities.

Until next time,

Spencer Sundahl

Debit and Credit Spreads

Today we are going to explain the difference between a credit and debit spread. Overall, it is a simple concept, but must be explained before we continue talking about spreading risk.

Learning to Speak Optionese: Debit and Credit Spreads

With every spreading strategy there are two different setups, the credit spread or the debit spread.

A credit spread is created when you sell a call or put and buy a call or put of lesser value. Thus when you set up the spread you take in a net credit. If you're a bull you'll sell a put and buy a cheaper put. If you're a bear you'll sell a call and buy a cheaper call.

A debit spread is created when you buy a call and sell a call of lesser value. To open the position you must pay out a premium, or 'debit.' This is the classic spread I talked about when describing bull and bear spreads. Generally, people tend to open debit spreads. However, both types of spreads offer different advantages.

Which Spread Suits You?

Although debit spreads are used most often, you might prefer to use a credit spread. Let's start by talking about the advantages of using a credit spread.

Credit spreads make money when the trade moves in the direction you anticipated, which is to be expected. On top of that, if the underlying stock sits and does nothing all the way into expiration you make money off of the time decay! This is the sort-of double whammy that makes credit spreading very attractive. In two out of three market environments, credit spreads make money; it's good to have the odds on your side! Also, credit spreads don't cost anything to set up. Because you are taking in a credit, you don't have to pay any money to open the position! A lot of people like the idea of this, but I believe this is often deceiving. What you must have to set up a credit spread is margin (money in your account to back up the potential loss.) You must meet the margin for the maximum loss your position can suffer. What is the maximum loss? At expiration, your max loss is the distance between the two strike prices minus whatever time premium you received, (in the case of a call spread, higher strike price – lower strike price – time premium). This can be a substantial amount of money! If the spread between the strikes is a dollar you're talking about 100 bucks per spread, but more likely it will be 5, a whopping 500 dollars per spread! For this reason, I tend to stay away from credit spreads. I am not saying that credit spreads aren't great, they are - I even trade a particular strategy revolving around them – however, under most circumstances they are a bit too risky for my taste.

Generally, I create debit spreads. Debit spreads suffer from time decay, and if the position does not move in your favor, you can lose all the money you originally put out to open the position. Another problem I often have with debit spreads is liquidity issues with the call or put I am selling (the one of lesser value), I often ended up overpaying to open the position (buying at the ask for one call/put, selling at the bid for the lesser call/put), and then overpaying to close the position! Despite this, when the options have enough liquidity a debit spread is a great strategy to minimize capital exposure.

Overall, both credit and debit spreads offer unique opportunities; although, I prefer debit spreads you may prefer the prospects of credit spreads. Both spreads have their perks and pitfalls, and they can be rather quirky. I recommend experimenting with both types of spreads in a virtual account before you actually begin trading them. Tomorrow we're going to talk a bit more about spreading, and later this week we'll move on to talking about trade adjustments and how you can hedge and protect positions using options.

Until next time,

Spencer Sundahl

Bull Spread and Bear Spreads, an Introduction

Today, we're going to talk about bull and bear spreads. This week we've already learned about buying puts and calls. Now we're going to build off of our previous knowledge and talk about spreads. Generally, the bull spread is a strategy that uses calls. A bear spread, on the other hand, uses puts. We will start by talking about bull spreads.

What is a bull spread? A standard bull spread requires the purchase of a call and the sale of a call with a higher strike price. Doing this limits profit potential, but because you take in the premium for selling the call with the higher strike price, your downside is limited.

So when should you buy a bull spread over a simple long call? Generally, bull spreads underperform long calls in a rising market. However, as expiration gets near, or when the position does not move in your favor, a bull spread is superior. Personally, I like bull spreads because they risk less capital than a simple long call. However, because I momentum trade, I generally just purchase long calls.

Another reason bull and bear spreads are attractive is that they take advantage of time decay. Because you are short a call at the same time that you are long a call your overall time decay is significantly less than were you just long a call. This is especially nice during option expiration week!

Now, let's introduce the bear spread.

What is a bear spread? A standard bear spread requires the purchase of a put and the sale of a put with a lower strike price. Doing this limits profit potential, but because you take in the premium for selling the call with the higher strike price, your downside is limited.

Conceptually, bull and bear spreads share the same perks, and suffer from the same pitfalls. We'll talk more in depth about the advantages and disadvantages of different spreads in the next post. After that, we'll discuss credit and debit spreads, and other spreading strategies.

Until then,

Spencer Sundahl

Buying Calls in Anticipation of Gains

A few days ago we talked about buying puts to bet on a decline in the value of a stock. Today we're going to talk about buying calls when you're anticipating an increase in the value of a stock. Aside from the fact that buying a put is a bearish strategy and buying a call is a bullish strategy, the two strategies are nearly identical.

Learning to Speak Optionese: Buying Calls in Anticipation of Gains

When you think a stock is going down you should buy puts, and when you think a stock is going up you should buy calls. Creating a position is as easy as simply buying one or the other! The mechanics are the same, but calls profit from a stock's price increasing (as opposed to puts profiting from when a stock's price decreases). When the option expires, if the strike price is below the stock's current price then you make the difference. For the purpose of clarity, I am going to retell the story of the traders Bob and Phil, except this time, Bob and Phil are bulls!

Bob and Phil Go Long on PALM

After PALM's most recent quarterly earnings the stock hit a fresh 52 week high. However, as the hype died, the rally died with it. Soon the bears took control and PALM began a significant decline of over 30%.PALM hit bottom at around 10.50 a share and has stayed there since. It now seems that PALM may start moving back up again, and so call options have become more attractive.

Traders are unsure of exactly where PALM's stock price will go in the two weeks before expiration, but with a few well purchased calls they can easily profit from PALM's potential rally. One trader, Phil, believes PALM will rally all the way into the 14's before expiration. He thinks PALM will easily trade in the mid teens by the end of the week. However, his coworker Bob disagrees. "If PALM does rally," says Bob, "the 12's will hold the bulls back until after November expiration." Yet again, Bob and Phil disagree on what to expect out of a trade. Despite their disagreement, their opinion of PALM is bullish, and so their trades will be fundamentally similar. Let's look at what call's they should buy to best profit from their positions.

First, let's consider what Phil should do. Phil believes PALM will go to the high 13's or low 14's. Both the 11 and 12.50 call options are well priced in the case of PALM, but if PALM is going to 14, what will give Phil the maximum profit? In Phil's case, despite the fact that the November 12.50 calls only have time value, he should be a buyer of the 12.50's. If PALM does go to 14 before expiration, Phil will make 1.33 a contract, or an incredible 782.35% return! Despite how great that large percentage looks, if PALM stays in the 10's, 11's, or anywhere under 12.50 Phil will lose all the money he spent on the November 12.50 call's when the options expire! Surely Bob will make fun of him if that happens.

On the other hand, Bob will likely buy the November 11 calls. He is bullish on PALM. He even thinks PALM will eventually rally beyond 12. However, Bob likes the November 11 calls because the strike price is very close to the current stock price, and once they gain intrinsic value (which they should quite soon), his trade will be a surer thing then the November 12's. Plus, if PALM doesn't do much before November's option expiration, he can still manage to get some of his premium back.

As Bob and Phil have yet again shown us, when trading options there are many factors to consider. Most importantly, we have to decide how much risk to take on (the November 11's or the November 12.50's?) and what our price target for the underlying stock is (12 or 14?), once we have decided on these things we can structure a trade that will maximize profit. Calls are an indispensable tool to any trader who wants to have all the advantages of being long stock with less risk and more leverage. As with all options, your maximum loss is only the premium you paid for them. Whether you're a conservative trader like Bob or a risk-taking speculator like Phil there are call contracts that will fit well with your trading strategy.

Until next time,

Spencer Sundahl

Learning to Speak Optionese: Week 2

Hey guys, this week we'll finally be covering some basic option positions! I put the post about buying puts to bet on a decline up a little early but I'd just like to overview what we'll be talking about this week.

• Buying Calls
  
• Bull Spreads
  
• Bear Spreads
  
• The difference between credit and debit spreads
  
• Calendar Spreads and an Introduction to Volatility
  

Something else to note, I've decided to wait to talk about how options are priced until we cover the Greeks. That information will fit better there, and hopefully, help you understand it better.

See you soon,

Spencer Sundahl

Using Puts to Bet On a Decline

Today, we're going to talk about how you can use a put to bet on a decline in a stock. Before we start, let's review what a put is; a put gives the buyer the right, but not the obligation, to sell a stock at a specified price.

Learning to Speak Optionese: Using Puts to Bet on a Decline

So how do you make money when you buy a put? Since put's give the buyer the right to sell, they want the stock to move below the strike price of their put to make a profit. When you can sell a stock for more than what you can buy it for, you make the money in between the two prices. Buying a put is similar to shorting a stock, with one very important difference: when you buy a put you can only lose the premium you paid when you opened the position. In contrast, when you short a stock, your potential loss is unlimited.

Let's look at an example,

Puts and Motorola

After Motorola (MOT) beat earnings this quarter it began to rally. The profits were ripe on the long side, and the bulls prevailed. Sadly, the rally began to run out of steam at an unfortunate moment. As MOT closed on November 5^th, it sat at a familiar peak. MOT had formed a double top! The next trading day MOT fell 5%, confirming to those watching the charts that the MOT rally was likely over. As the market closed this past Friday, MOT puts were particularly attractive. MOT puts expiring in November with a strike price of 9 traded at .39 and November 8's were trading at .07.

Traders are unsure of exactly where MOT's stock price will go in the two weeks before expiration, but with a few well purchased puts they can easily profit from MOT's potential decline. One trader, Phil, believes MOT will fall well below 8 before expiration. He thinks MOT will easily trade in the low 7's by the end of the week. However, his coworker Bob disagrees. "If MOT does indeed decline," says Bob, "the 7.70's will be the bottom." Bob and Phil have two different opinions of where MOT is going. Let's look at what put's they should buy to best profit from their positions.

First, let's consider what Phil should do. Phil believes MOT is going to the low 7's. Both the 9 and 8 put options are well priced in the case of MOT, but if MOT is going to 7, what will give Phil the maximum profit? In Phil's case, despite the fact that the November 8 puts only have time value, he should be a buyer of the 8's. If MOT does go to 7 before expiration, Phil will make .93 a contract, or an incredible 1328.57% return! Despite how great that large percentage looks, if MOT stays in the 8's Phil will lose all the money he spent on the November 8 put's when the options expire! Surely Bob will make fun of him if that happens.

On the other hand, Bob will likely buy the November 9 puts. He is bearish on MOT. He even thinks MOT will fall below 8. However, Bob likes the November 9 puts because they already have some intrinsic value, and will lose their time value slower than the November 8's. Plus, if MOT does not fall as much as he expects he will still be able to get out of the trade a winner!

As you saw in the case of Bob and Phil, when purchasing puts you must consider your price target and risk level. The puts that are farther away from profit when you purchase them are riskier than puts near the current strike price. Despite the risk, puts such as the MOT November 8's offer significant rewards for a speculator like Phil who is anticipating a steep drop in the price of a stock. The puts closest to the current price of the stock are a little safer (although, in both situations you could quickly lose your entire premium). These sorts of puts are ideal for a more disciplined, realistic trader like Bob. Overall, puts are a superior alternative to short selling, which can be utilized for large returns without unnecessary market exposure.

Until next time,

Spencer Sundahl

Trading Options Virtually

A word of caution,

Before you start applying your knowledge of the options market to your investment portfolio or trading strategy I recommend you open a virtual account and experiment with options for yourself. Having a virtual account will be especially useful when we start discussing more complex options positions next week.

I am recommending Optionshouse.com for a virtual trading, they have lower commissions and web based software that fits me well. However, if you are planning on trading with another broker - open a virtual account there, different commission structures make different trades more or less attractive.

Link to open a virtual account at Options House: http://www.optionshouse.com/virtual/

-Spencer Sundahl

Analyzing the Covered Write

Last time we talked about what it means to write a covered call, explained the difference between intrinsic and time value, and discussed the reasons for writing a covered call. In case you missed it, here's a quick review:

• When you write a covered call you are selling a call option contract against a stock you already own.
  
• If you exercised an option right after buying it the intrinsic value is all you would receive.
  
• The time value of an option is the portion of the value that is not intrinsic value.
  
• Covered calls are generally written for income, to hedge a position, or because you think the options are over-priced.
  

Learning to Speak Optionese: Analyzing the Covered Write

When it comes right down to it, we're all in the market to make money. Not just you and me, but others who are smarter, and perhaps faster than us. That is why it is important for us to thoroughly analyze a position before entering into it; we don't want to get screwed by the big guys! It's important to play smart, because stupid mistakes can cost a lot of money.

Considering the Risks

To better understand the risks of writing a covered call we're going to look at writing covered calls against BAC. I have created a chart to break down my analysis for you.

BAC Calls
BAC's Current Price	Strike Price	Price
$15.05	$14.00	$1.23
	$15.00	$0.54
	$16.00	$0.18
Intrinsic Value	Time Value	Breakeven Downside
$1.05	$0.18	$13.82
$0.05	$0.49	$14.51
$0.00	$0.18	$14.87
Breakeven Upside	Return as a percentage	% Decline to Break Even
$15.23	1.20%	8.17%
$15.54	3.26%	3.59%
$16.18	1.20%	1.20%

Alright, so you might be wondering what this all means, let's break it down:

In this particular situation we are going to write calls against BAC. However, we can't decide exactly which calls to write! We want a good mix of risk protection and return, so we decide to consider the risks.

Let's take a look at the comparison chart. It breaks down a number of things. Under the 'call' header are the three strike prices we are considering, 14, 15, and 16. Both the 14's and 15's have a bit of intrinsic value, the 16's have none. The more intrinsic value an option has, the safer it is to sell against a stock position, and the more likely that the stock gets called away from you when the option expires.

Why is it safer to write a covered call that has intrinsic value? As you can see on the chart, the breakeven downside for the 14 is the farthest away from the current stock price. It also possesses the greatest amount of intrinsic value. The reason this call is safer to sell? It is safer to sell because you are selling some of the value of the stock with it. Since the striking price is 14, the buyer can immediately exercise this option and receive 1.05. Because of this, they have to pay extra for the option. This extra money is nice, because if the stock declines to or a tad below the strike price you still break even! Unfortunately, for the same reason, the actual premium you receive is much smaller, a mere .18 of time value! If the stock moves a little over 1% upwards, you're actually losing out on money. With great downside protection, comes limited reward.

So selling the 14 sounds good, but damn it, BAC is going to the moon! Maybe not the moon, but at least to 16.00! What should you do then? Sell the 16's, of course! That doesn't seem right, you barely get any premium for the 16's, the time value is only .18, I'd get that for the 14! You're right, but if the stock moves to 16 and you had sold the 14 when BAC was trading at its current levels you wouldn't get any of the gains from the stock, you would have given them all up by selling the 14 call! However, if you sold the 16, you'd get the .18 in premium and .95 of appreciation. That's a decent percentage return. The downside protection is obviously limited, but that's why this sell is for the bulls. Though, if you really think BAC is going to the moon, perhaps it would be better to simply hold the stock.

Alright, it seems there are higher risk covered writes and very low risk writes… but what if I want something in between? I'm not particularly bullish, nor am I bearish, at least for now. I believe in the fundamentals of the company in the long run, and I'm going to hold their stock until I retire, but there isn't anything exciting going on to move the stock in the near future! In a case like this, you should look at selling the 15, which is closes to the stock's current price. Selling this particular call offers the best mix of risk and reward on both sides. Because it is so close to the stock's current price it is more expensive, if the stock moves upward it will appreciate rapidly. If it moves downward it'll lose value in a jiffy. Luckily, with a 3.5% buffer on both sides, stock movement won't upset you too much! Generally speaking, selling the calls closest to the current price of the stock offers the best mix of risk and reward.

Let's Review

The options with no intrinsic value (also known as out-of the money options, because they have no intrinsic value) are very attractive to sell, because they will likely expire worthless. However, the return as a percentage is somewhat low. This is somewhat deceiving. If the stock does increase in value and surpasses the strike price, or remains just under it, you will have made even a greater percentage of return, as you will also receive the capital gains up to the strike price! The downside of this is that your downside is not well protected, and if the stock ends up performing poorly into expiration you may quickly acquire a loss. For this reason, selling call options with strike prices that are further away from the stock's current price is considered a more bullish covered write.

The options with strikes closest to the stock's current value (also known as at the money options, because they are close to having intrinsic value) offer the best mix of both risk and reward. If you are neutral on the stock overall, those are the calls you should be selling!

For the more conservative or cautious investor, it is best to sell options with a bit of intrinsic value (known as in the money options). If you are bearish on a stock or simply want a better chance of going into expiration with a profit then this sort of covered write is worth considering.

Selling calls at different strike prices create positions with better downside protection, more reward, or a mix of both!

Covered calls offer an attractive opportunity for any investor or trader looking for a manageable amount of risk exposure. With such a great mix of risk and reward, even a rookie can properly execute this strategy (although he should practice in a virtual account first!). On top of this, the covered write is a safe way to take advantage of 'excited' options and time decay. With a little research, and proper analysis, you can make decent percentage gains or generate income by selling calls against stocks you already own!

Until next time,

Spencer Sundahl

p.s. To simulate how writing a covered call will work out over time, and to create profit and loss graphs, check out these analytical tools:

Strategy Screener:
http://www.888optionsnet.com/investigator_2/wi_strategyExplorer.asp
Click on the covered call strategy

Position Simulator:Position Simulator: http://www.888optionsnet.com/investigator_2/wi_positionSimulator.asp Enter what stock and option positions you would like to simulate, and see how the position reacts to movements in the stock and as time passes.

Writing Covered Calls for Income

Learning to Speak Optionese: 
Writing Covered Calls for Income

Today we’re going to discuss writing a covered call. It is considered the most basic option strategy where one writes a call option against a long stock position.

Let’s go back to our previous example about the enchanted necklace. As you may remember, the owner of the necklace struck a deal with you (the potential buyer) that was very similar to a call option contract. It gave you the right, but not the obligation, to buy the necklace at a certain price for a specified period of time. For a small premium, you gained all the appreciation potential of the necklace, and took on a very limited risk. If the necklace turns out to be worthless, you only out the premium you paid for the call! So you might be wondering, why would anyone in the world write a covered call?

Considering the current market condition and the volatility that has persisted in the markets in the recent past, it may seem unwise to be writing covered calls. However, despite the recent turmoil, writing covered calls is still a very attractive and effective strategy.

So why write a covered call?

Why does the owner of the necklace sell you a call? It’s simply a matter of attrition. The owner knows it is likely the call will go unexercised and he will retain ownership over the necklace as well as the premium you have paid. As I mentioned previously, options are wasting assets, meaning, they decay with time. However, along with time value, options also carry intrinsic value. This may not seem pertinent to the question at hand, but you will see how time value and intrinsic value affect the price of an option make some covered calls very worth selling.

Let’s say stock XYZ is trading at 45 dollars. XYZ is a relatively boring stock, and has been trading in the 40’s for many months. Market participants agree it is likely to stay in that range until at least the next earnings announcement, which is two months away. Because no one is making any big bets on a large increase in the price of XYZ, call options are moderately priced. One day you acquire 1000 shares of XYZ for 43.00 dollars a share. 


Out of curiosity you look at XYZ option prices for the closest expiration date. You see that calls expiring in a month with a 40.00 strike price (meaning the owner of the call may purchase 100 shares of XYZ for 40.00 a share) are trading for 4.00. Also expiring in a month are XYZ calls with a 45.00 strike price (meaning the owner of the call may purchase 100 shares of XYZ for 45.00 a share), those options are trading for .80. At first glance the XYZ 45.00 calls may seem like the best deal, for .80 you get a great deal of profit potential. However, if, in a month, XYZ has not moved over 45.00 the call is worthless. That is, the entire .80 you paid for the option was time value, or premium paid for the potential appreciation of a stock over the life of the option. The stock would have to move over 45.80 before you had anything to show for it, (strike price + premium paid = breakeven point). 


On the other hand, the XYZ 40.00 calls have an intrinsic value of 3.00 at the time of purchase, meaning, if you exercised the call (when you exercise a contract you buy, or sell in the case of a put, 100 shares of the underlying stock at the specified strike price) you would instantly realize a profit of 3.00 a share.


To find the time value you simply subtract the intrinsic value from the premium you paid (4.00 – 3.00 = 1.00), so the intrinsic value of the option is 1.00. If XYZ moves anywhere over 44 (strike price + premium paid = breakeven point), then you make a profit on the option. If it is anywhere above 40.00 at the time of expiration then your option still has value. I will cover more about how to price an option later this week, but for now knowing the difference between intrinsic and time value will get us through.

Perhaps, you’re catching on, but if not, I will explain. Let’s say you own stock XYZ, it pays a decent dividend, but it rarely moves. You look and see that options without any intrinsic value are trading at a decent premium and would require XYZ to move over 5% in a month to be worth anything at expiration. That sounds pretty attractive doesn’t it? If XYZ does move the 5%, your stock will get called away from you (the purchaser of the call will ‘call’ your stock out of your account and into his own). You’ll get to keep the premium, and the 5% in capital gains. Let’s say XYZ declines a bit instead. The premium you gained from selling the calls will protect your downside (stock price – premium = break even for a call seller). 


Selling covered calls may not be the most exciting investment strategy, but it is considered the safest options strategy, and has a good track record of producing returns. Also, when the market seems to be overvalued selling covered calls can be a great way to hedge (protect against) a potential decline in the share price of a stock.

Next, I will…

• Delve further into the strategies behind writing covered calls
• Show you a covered call profit/loss graph and explain how to make one
• Show you three attractive stocks to write covered calls against, and explain the risks and rewards involved in each.
• Set you up with a virtual account where you can experiment with writing covered calls and the other options strategies I will be explaining next week!

Until Tomorrow,

Spencer Sundahl

An Introduction to Options

Learning to Speak Optionese: An Introduction to Options

Today We’re going to talk about what an Option is, and the two different kinds of options: Calls and Puts.

First, consider this scenario: you want to buy this really badass necklace. However, you’re not sure how much it’s worth. The vendor is trying to charge you one-thousand dollars, but you tell him that the necklace isn’t worth nearly that much. “You’re wrong,” the vendor says, “this necklace is enchanted!” The vendor claims that the necklace will give you good luck. He also says the effect will not be apparent instantly. Knowing it to be unlikely that the necklace is actually enchanted, you are skeptical and reluctant to purchase it.  Even still, there is a small chance the necklace is truly enchanted. If that were the case, the necklace would be worth far more than one-thousand dollars. It could be worth one-million! So you strike a deal with the man; for a 5% premium on the asking price (fifty dollars), he will hold the necklace for you for a year. During which time you can uncover its actual worth. If you decide you want to buy it the deal also guarantees you a buying price of one-thousand dollars, but if the necklace turns out to be a phony, as you suspect, then you don’t have to purchase it. This ‘deal’ is the equivalent of a call option contract.

So what’s the definition of an option? An option is a contract that gives the buyer the right but not the obligation to buy or sell one-hundred shares of the underlying security (stock) at a specified price known as the striking price. Each option contract expires on a certain date, and so they are what is known as a wasting asset (they lose value as time passes). In return for this privilege the buyer pays the seller a premium. The buyer is happy to have the potential of unlimited gains that a stock option warrants, and the seller is glad to have gained guaranteed income simply holding stock he already owns. The seller’s strategy is known as writing a covered call, which will be covered in the next post...

So what are the two types of options?

-A Call gives the buyer the right, but not the obligation to buy 100 shares of the underlying stock at a specified price.

-A Put gives the buyer the right, but not the obligation to sell 100 shares of the underlying stock at a specified price.

People who think the price of a stock will increase, or “bulls”, generally purchase calls, where as people who think the price will fall, or “bears”, are generally purchaser’s of puts.

Along with simple purchases, there are more intricate multi-option positions which will be covered in the future.

Side Bar:

Why Options? Some of you may be wondering, why would I buy a stock option when I could simply buy the underlying stock. Options offer a trader or investor more dynamic positions than a simple stock purchase. The investor or trader can easily protect portions of their capital or take on greater risk by properly using the built in leverage an option offers. Take for instance this example: You are bullish on stock XYZ. XYZ trades for forty-five dollars a share, and options to buy the stock at fifty-dollars in January trade for a mere fifty cents (or fifty-dollars a contract). For only $50 you control $4,500 in stock. Not too shabby. If, as you suspect, XYZ is above $50 in January, you will make money, and if XYZ goes bankrupt, has a decline in share price, or does absolutely nothing you only lose your $50. With proper money management, options can fit all risk appetites.

A Note On Purchasing Options: Option contracts cost more than they are quoted for, an option trading for  1.00 will actually cost you $100, you pay a dollar for each share you control through the option. I will talk more about how options are priced later this week.

Now, the scenario with the enchanted necklace may sound silly, but in life and in the financial markets everyone is always looking for a ‘get rich quick scheme.’ Despite the fantastic leverage options offer (usually 100 shares per contract), there is still a great amount of risk involved. I’m afraid there is no magic necklace of riches. If there were, why would someone knowingly sell it? Making money in the options market may seem easy at first, but it is a zero sum game, and it is just as easy to lose money as it is to make it. Stay the course, let’s learn to walk before we run!

Still to Come This Week:

·         The Covered Call

·         Option Pricing Basics

Until Then,

Spencer Sundahl