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Strategy Review: Option Trading Fundamentals

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How to Trade the MCM Portfolio

Since we began publishing this newsletter, a number of readers asked us to publish additional information about basic option trading strategies and the various techniques used to select, initiate, and manage the positions in the MCM Portfolio. With that objective in mind, we are going to produce a series of educational articles that will provide less experienced traders with the knowledge and background necessary to profit in the options market. This week's narrative explains the fundamental concepts of derivatives.


Getting Started - Option Basics

Even though expectations and goals differ, every trader's education must begin with an introduction to the terminology of option trading and to the rules and regulations that govern trading activity. Until he has an understanding of the language of options, a trader will find it impossible to communicate his desire to enter new plays or exit existing positions. Without a clear understanding of the terms of an option contract, and his rights and responsibilities under that contract, a trader cannot hope to make the best use of options, nor will he be prepared for the risks inherent in the market.

Options come in two primary forms. They are calls and puts. One call option gives the holder the right, but not the obligation, to buy 100 shares of the underlying stock at a specific price, for a given period of time. One put option gives the holder the right, but not the obligation, to sell 100 shares of the underlying stock at a specific price, for a given period of time. As the holder of an equity option, you can "exercise" your right to buy (or sell - with puts) the underlying stock throughout the life of the option. You can also sell an option that was previously purchased, or buy an option that was previously sold.

An option always relates to the underlying security at a specific price - the exercise or "strike" price. This is the price at which the option holder has the right either to buy or to sell the underlying issue. Strike prices for each option series are generally set at levels above and below the current market value of the stock. Additional strike prices are added when necessary, based on the value of the underlying issue, or in response to investor demand or unusual market conditions. In most cases, listed options generally have strike prices at intervals of:

$2.50 for stocks priced from $5.00 to $25.00
$5.00 for stocks priced from $25.00 to $200.00
$10.00 for stocks priced above $200.00

When the current market value of the underlying stock is at (or very near) the strike price of a specific option, it is said to be "at-the-money." If the strike price of a call option is above the current market value of the underlying issue, or if the strike price of a put is below the current market value of the underlying issue, the option is said to be "out-of-the-money." In contrast, a call option is "in-the-money" if the current market value of the underlying issue is above the strike price of the option. Similarly, a put option is "in-the-money" if the current market value of the underlying issue is below the strike price of the option.

Every option has an expiration date. This is why an option is considered to be a "wasting" asset. Since the option only has value for a fixed period of time, a portion of its value decreases, or "erodes" with the passage of time. Stock options expire on the Saturday after the third Friday of a specific month in the future and they are always available for the current month and the following one. Thus, on January 1, you can buy or sell options that expire in January and in February. On February 1, you can buy or sell options expiring in February and March, and for (specific) additional months throughout the year. As each set of options expire, a new options series with a more distant expiration date is added, hence creating an expiration cycle.

While this arrangement seems simple at first glance, determining the available expiration dates beyond the first two months is somewhat more complex. A given stock option will be assigned to one of three cycles, the January cycle, the February cycle or the March cycle. Each includes four months, one in each calendar quarter. Options on a stock assigned to the January cycle would have expiration dates in April and July, the next two months in the cycle, as well as in January and February. Those on a stock assigned to the February cycle would have
expiration dates in May and August in addition to January and February. Finally, stock options assigned to the March cycle would also expire in June and September.

As if the expiration cycles were confusing enough, there are also two different types of options with respect to exercise. There is a European style option and an American style option. The European style option cannot be exercised until the expiration date. Once an investor has purchased the option, it must be held until expiration. An American style option can be exercised at any time after it is purchased. Today, most stock options that are traded are American style options, however there are many index options which are European style options, and an investor should be aware of this when considering the purchase of any index option.


Option Pricing Fundamentals

In order to identify the most favorable options for a specific strategy or position, it is necessary for a trader to understand the principles related to option valuation. The first step in this process is to become familiar with the individual components that determine an option's price and the mathematical equations used to establish its theoretical value.

Here are the primary factors that determine the price of an option:

1. The price of the underlying stock
2. The strike price of the option itself
3. The time remaining until the option expires
4. The volatility of the underlying stock

There are two, less important factors that also affect the price
of an option:

5. The current risk free interest rate (the 90 day T-Bill
is often used here)
6. The dividend rate of the underlying stock

Each aspect of option pricing is a separate element and they have Greek titles; Delta, Gamma, Theta, Vega, and Rho. As most traders know, the primary influence on an option's price is the movement of the underlying security. This concept relates directly to the first and most important member of the Greeks: Delta. Delta measures the rate of change in an option's price compared to a one point movement in the underlying security. It can be thought of as a percentage of the movement of the stock price. If the stock price moves up $2 while the option on that stock gains $1, it has a Delta of 50 (or 50%). An at-the-money (ATM) call option will typically have a delta of 50. In-the-money (ITM) calls have a higher delta; a greater percentage move, based on the change in the underlying issue. As you might expect, the opposite condition is true for out-of-the-money (OTM) call options; their Deltas are lower.

Gamma is listed next in most contexts and it is equivalent to the change in the Delta of an option with respect to the change in price of its underlying security. In short, Gamma is the "Delta of the Delta" and it is used primarily by professional traders in portfolio hedging calculations. While Gamma is a key factor in managing institutional positions, it is not used regularly by retail option traders thus it warrants no further discussion in this forum.

Theta is the next component and it is most commonly defined as the change in the price of an option with respect to a change in its time to expiration. In laymen's terms, it is a measure of premium decay (or erosion) and thankfully, time value and decay are two of the easiest aspects of option pricing to understand. The time value of any option can be simply expressed as everything but the intrinsic value. More importantly, the "extrinsic" value in an option's price decays each day the option is in existence and the closer the option gets to expiration, the faster it decays. In a strictly mathematical sense, time value decays at its square root and this rate of decay can cost an option trader lots of money. Since more time equals more money, long-term options have more extrinsic value at equivalent strike prices. Another important concept option writers should be aware of is that time value is highest in at-the-money (ATM) options. Time value decreases as options move in- or out-of-the-money (ITM-OTM) and strike prices that are deep in- or out-of-the-money have the lowest time value of all options.

Finally, the two lesser-used components of option pricing theory: Vega and Rho. Vega, which is the change in option price given a one percentage point change in volatility, is used by professional traders in hedging calculations. Rho is a measure of an option's sensitivity to changes in the risk-free interest rate and it is used to help compare the holding costs and risk-reward outlook for various strategies.

The Black-Scholes model and the Cox, Ross and Rubinstein binomial model are the primary pricing models used by most professionals to evaluate equity and equity-index options. For retail traders, it is adequate to know that both of these models are based on similar theoretical foundations and assumptions. However, there are also some important differences between the two, the most important of which is the fact that the Black-Scholes model cannot be used to accurately price options with an American-style exercise (because it only calculates the option price at expiration). Even so, it offers an expeditious means to calculate a large number of option prices in a short time which, in contrast, is the main disadvantage of the binomial model.

Option traders need to have a firm grasp of pricing theory because the primary attraction of derivatives is the leverage they offer. A trader can achieve an exponential percentage profit with only a moderate change in the price of the underlying issue but to attain this goal, he has to know which option provides the best results in a given situation. Choosing the correct time frame for a specific play is also vital to long-term success; consequently traders should have a fundamental understanding of time decay and how it affects the value of an option. Next week, we will discuss probability and the statistical (volatility-based) components of option pricing.

MCM Staff

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