Investors can use options to get income from non-dividend-paying stocks or to purchase a stock and limit its risk. Traders can use options to add leverage with an acceptable level of risk that is truly limited, as well as to trade up, down and range-bound markets.
Despite these benefits and continuously growing volume (more than 15% compound volume growth since 1973), options are still in their infancy regarding public understanding and acceptance.
Here are 10 key principles that newcomers to options should keep in mind as they approach the options arena. While the potential list of principles is considerably longer, a good number to start with is 10.
1. Know the difference between using options to invest and using options to trade: Investors focus on the benefits of long-term stock ownership, and they should use options to buy, sell, or protect stock positions, or to increase income from stock positions. Consider an investor planning to buy stock when he receives a year-end bonus. This investor can buy one call today for each 100 shares he plans to purchase. A call option is a contract that gives the buyer the right to buy the underlying stock at the strike price at any time until the expiration date. Essentially, for paying the cost of a call plus commissions today, the investor locks in a purchase price for the stock equal to the strike price of the call for the life of the contract (see "Keeping it simple"). If the stock price is higher when the investor receives the bonus, then he still can purchase the planned-for number of shares. Without the call, the number of shares would have to be reduced given the higher stock price.
The covered call is another common investment-oriented option strategy that enables investors to get income from non-dividend-paying stocks. In this strategy, calls are sold on a share-for-share basis against purchased or owned stock. The seller of a call, in return for the premium, assumes the obligation to deliver the stock at the strike price if the call buyer exercises the right.
Traders, in contrast to investors, are short-term market timers with little interest in owning the underlying stock, and they often use a high degree of leverage. Purchased options give traders the potential for considerable leverage with limited risk, the so-called "home run." But the risk is real. Options can lose 50% or more of their purchase price in a short time if the price of the underlying stock moves the wrong way. Also, out-of-the-money options expire worthless at expiration for a total loss of the price paid, plus commissions.
2. Investors who use options need a plan: Will a purchased option be exercised or sold if it is in-the-money at expiration? Covered writers must know whether or not they are willing to sell the underlying stock. If not, it is best to decide in advance at what price the call will be repurchased or rolled to
3. Understand how and why option prices change: Option prices change differently than stock prices, so option traders need to plan differently than stock traders. A typical complaint from newcomers to options is: "The stock went up, but my call didn’t!" Understanding how prices change is essential to using options successfully.
"The value of time" (below) presents theoretical values of a 50-strike call at different stock prices and different days to expiration given the stated assumptions about interest rates, dividends and volatility. Each of the rows in the table is a different stock price, and each of the columns is a different number of days to expiration. It reveals two important concepts about option prices — the concept of "delta" and that of "non-linear time decay."
The concept of "delta" is that for a $1 change in the underlying stock price, the value of a call will change by less than $1. In "The value of time," if the stock price rises from $50 to $51 at 90 days, the $50 call rises by 50¢. Delta describes the expected change in an option’s price for a $1 change in the underlying stock’s price, so this call is described as having a delta of "0.50."
Regarding time decay, the table illustrates that option prices do not decrease at the same rate as time passes to expiration, assuming factors other than time to expiration remain constant. Consider the center row in which the stock is $50. As time to expiration decreases by 50% from 90 days to 45 days, the value of the $50 call decreases by approximately 31% from $3.20 to $2.25. This is what "non-linear time erosion" means.
Looking across any row, you will observe that the decrease in option value from the passage of time, so-called time erosion or theta, varies depending on whether an option is in-the-money, at-the-money or out-of-the-money.
4. Option traders need discipline in taking profits and losses: First, have a profit target and close or reduce the size of a position if that price is reached. Second, have a stop-loss point and close or reduce the size of a position at that price. Third, have a time limit and close or reduce the size of a position if neither the profit target nor the stop-loss point are reached by the end of the time period.
5. Do not get freaked out by volatility: Conceptually, options are similar to insurance, and the volatility factor in options corresponds to the risk factor in insurance. It is an important factor, but it is not the only factor. While the concept of volatility is not intuitively obvious to newcomers, it can be learned if one is patient.
6. Have realistic expectations: Mastering the concepts of delta and theta (time decay) is an important step toward the goal of developing realistic expectations about how option prices might and might not change and how much profit potential and risk each strategy has.
7. "Buying under-valued options" and "selling over-valued options" are not sufficient strategies: "Value" is a subjective determination that every trader must make individually. Option traders must focus on their three-part forecast as much as or more than the "value" of an option.
8. "Selling options" is not a better strategy than "buying options": It is a myth that 80-90% of options expire worthless. Approximately one third, or 33%, of options expire worthless while 10-15% are exercised. The rest are closed prior to expiration. While option writing (selling) can be a successful strategy, newcomers often misinterpret it. There is a reason there is a premium for taking on more risk. There is no secret to it — option buyers pay a premium of defined risk and option sellers receive a premium for taking on that risk.
9. Leverage is a double-edged sword: Option traders should manage their capital differently than stock traders. The decision to purchase 200 shares of a stock trading at $50 per share is very different that the decision to purchase 100 call options trading at $1 each, even though both trades involve an investment of $10,000, not including commissions. Typically, option traders will devote a smaller portion of total capital to each trade. Option traders, however, might have more open positions than stock traders.
10. Develop a market forecasting technique by starting small, realizing profits and losses and by working at a steady pace: Traders should be able to explain their trade-selection process in a few sentences. Beginners should enter trades that have only small potential profits and losses, because this will increase their chances of maintaining objectivity. Trades must be initiated and closed so that a "trading rhythm" is developed.
Almost anyone can learn to trade options if they spend a few hours every week developing their technique. But you can spend years without mastering options. Learn these principles and take it one step at a time. Options are like layers of an onion — there is always something new to learn. Don’t became frustrated and, more importantly, don’t become over confident and think you know it all because that is when you can get burned.
James Bittman is a senior instructor at the Options Institute at CBOE and author of "Options for the Stock Investor" and "Trading Options as a Professional."