Welcome to the Options Trading section of Young Money. Each week, I’ll start by covering some topics that will educate you on options trading, and then I’ll list a trade or two that I did during the week with an explanation of why. I will post actual trades that I make so you can keep track of them and determine if I’m successful or not.
I highly recommend visiting a brokerage site and opening a “paper” account or fake money account (think downloading poker software and playing at the fake money tables). This way you can understand how the strategies work and you can get comfortable with the software at the same time. If you ever decide to load the account with your hard-earned dollars and pull the trigger, that’s up to you.
A. Trade while you’re at work
B. Keep the shirt on your back
C. Put a Porsche in the garage of your future home
Ready? Now, let’s translate that strategy into investment speak.
Q: I want returns larger than the diversified ETF portfolio my Dad keeps telling me about, but I’m not a day trader and I don’t work on Wall Street. Got any suggestions?
A: First, get rid of that Porsche idea. You trade to trade well—which means you write up your game plan and you stick to it. Yes, there is money at risk, and agreed, we’re not learning to trade options to promote world peace; but we’ve got to be in the right mindset. The strategy we’re going to use is about grinding out our gains by hitting singles and doubles. We’re not looking for that “three-bagger” you keep hearing about on Mad Money and we’re not trying to overhear hot stock tips in the hopes of finding the next “Google when it was at 80.”
We’re going to go over two basic strategies—vertical spreads and calendar spreads, which is options trader’s language for simultaneously buying and selling options with different strike prices and expirations in order to take advantage of premium decay, while limiting or defining our risk so that we always have strict control over how much capital we could lose at all times.
Week 1: The Basics
The majority of option traders make money by employing strategies that allow them sell premium. An October 120 Call option in IBM trades for $7.30—if IBM is trading at $124.60 that means that the option is “in the money” by $4.60 ($124.60 less the $120 strike price). The “in the money” portion is also referred to as “intrinsic value.” For our $7.30 option this means that $2.70 (which is $7.30 less $4.60) is “out of the money.” The “out of the money” portion is also referred to as “premium” or “extrinsic value.” If we look at another IBM option—the October 125 Call, trading at $4.15, we notice that the entire value of the option is “extrinsic” or “out of the money.” If you were to buy this 125 Call option you would need IBM to close above $129.15 at expiration to make money. Or you could sell the 125 Call and pray that IBM closes below $125 upon expiration and you get to keep the $4.15 of premium.
An option price—and hence the amount of premium—is determined by four factors:
1. price of the stock or underlying security
2. amount of time until the option’s expiration
3. volatility of the underlying stock or security
4. interest rate
Let’s ignore interest rates for now and look at the other three factors.
1. The price of the underlying security.
The closer the underlying stock or security price is to the option’s strike price, the more premium the option will have. You will pay a higher premium for an IBM call with a 125 strike than you will for an IBM call with a 140 strike. This is because there is higher likelihood of IBM closing above 125 at expiration than of closing above 140 at expiration.
2. Time until expiration.
When comparing two options in the same underlying with the same stock price, you will always pay more for the option with more time until expiration. This is because the longer you have until expiration, the greater likelihood there is of the underlying exceeding the strike price. The Oct 125 Call in IBM trades at $4.15, while the Jan09 125 Call trades at $7.40. You will pay $3.25 more for the extra three months until expiration. One of the key features about an options’ time decay is that the value does not change linearly. As the option gets closer to expiration it begins to lose its time value at a faster rate. For example, if IBM stays at $124.60 for the next four weeks we hold the volatility level constant (unlikely, but go with me on this one) the Oct 125 Call will drop in value from $4.15 to $2.70, a drop of $1.55. The Jan09 125 call will drop from $7.40 to $6.60, a drop of $0.80 over the same four weeks. We’ll come back to time decay over and over—it is one of the fundamental concepts we need to understand.
3. Volatility of the underlying.
Volatility is the big “black box” of the options price and the most important piece of the option price puzzle. An option trades in the market so we know the price (for our Oct 125 Call the price is $4.15), we know the time until expiration (50 days as of the time of this writing), we know the underlying stock price $124.60, and we know the interest rate (usually calculated off of the 10 year treasury yield, which is 3.80% as of the time of this writing). We can now back into the volatility which in this case is 23.5%. Despite my good looks and ample intellect, I assure you I didn’t calculate the volatility by hand; I let my option trading software do it for me (we’ll get into trading platforms and software later).
Week 1 Trades: August 28, 2008
I bought the SPY Sept30 (Quarterly) / Nov 127 Put calendar spread for $2.04. (SPY was trading around $129.50)
I bought the IWM Sept30 (Quarterly) / Nov 72 Put calendar spread for $1.53. (IWM was trading around $74.00)
There you have it—two trades and we’re off to the races. The market has been rallying the last few days and volatility levels have been dropping (the VIX was below 19.50 and the RVX was below 24.50—we’ll cover what the VIX and RVX are in future weeks, but keep an eye on them throughout the day and see how they react when the market moves up and down. You’ll tend to see them both rise as the market drops).
Both of the trades we did were calendar spreads, meaning we sold an option with a relatively close expiration and simultaneously bought an option with the same underlying and strike price, but with an expiration date further away in time. There are 33 days until the front month options expire and 85 days until the back month options expire. As time passes the front month options will decay or lose value faster than the back month options lose value (remember our two IBM options above).
Our goal is to keep this position open for about three weeks and then close it when the market makes a move that sends SPY near 127 and IWM near 72. My goal was to set up two trades that will benefit if the market drops and volatility rises back up—this is the “one-two-punch” scenario that will make this trade successful. My hope here is that the market doesn’t rally too much more between now and the end of September (when the front month options we sold expire) and that I can sell these two spreads when the market makes a move down and volatility goes up. Remember that there is more premium in the back month option because there is more time until expiration, so the back month option will benefit more from a rise in volatility than our front month option will. Since I’m short the front month, and long the back month, an increase in volatility is a good thing.
Until next week, good luck trading!
Jonathan Weiner is Vice President of Maryland China Company. His work experience includes three years on Wall Street as an investment banking analyst for Wasserstein Perella & Co. in their Financial Institutions and Restructuring Groups.
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