Financial Markets - Understanding Stock Option Information - Essay Example

UNDERSTANDING STOCK OPTIONS INFORMATION By Mickey Josephson Nomenclature is the first step to understanding stock options. l. Options: a contract between buyer and seller to buy or sell a stock at a given price. 2. Option writer: the seller, the writer of the option, one who initiates the option. 3. The option holder: the entity, which owns or is the option holder. 4. Call option: the right to buy the underlying stock at a given price. 5. Put option: the right to sell an option at a give price. (Trading and hedging with Agricultural Futures and Options J. Bittman, P. 8) 6. Strike Price is the price specified in the option contract at which the underlying future contract is traded—when and if the option is exercised.) 7. Expiration date: the date when an option expires and has no value. 8. Unit of trade: one single option contract grants the right to buy or sell 100 shares of stock. 9. Premium: money paid by the option holder to the option writer. 10. Exercise or assignment: the act of exercising the right to buy or sell a stock. The physical transfer of stock certificate. 11. Leaps: Long Term Equity Anticipation Securities. Options, which usually are six months out or longer, used mostly for hedging. 12. Time value: the cash premium equals the sum of the time value and the intrinsic value. (Stocks for option trading p. 59 H. Friedentag) 13. Out of the money options: options which (call or put) are written above the strike price. 14. A covered call or put: when the writer of the option physically owns the underlying stock. 14. Uncovered call: The the option writer does not own the underlying stock. UNDERSTANDING GRAPHS AND CHARTS “Technical analysis is the study of specific securities and the overall market based on supply/demand relationships.” (Page 1, International encyclopedia of Technical Analysis, Joel G Siegle, Jae K Shim, Anique Quereshi, Jeffrey Brauchler.) Charts and Graphs are the technician’s tools. They interpolate data and decide using graph trends, volume count, and 50 and 200 day moving average charts. To understand patterns one must observe carefully the breadth and movement of the market. Understand how accumulation or distribution (Accumulation, the buying of stock, distribution is the sale of stock.), forecast the future expectation of stocks or options. (Ascending and Descending tops P. 15 International Encyclopedia of Technical Analysis Page 15 and 16,), these illustrations show ascending and descending price top transitions, from time period- to- time period, that trail stock directions. Volatility charts show extremes —specifically, option volatility charts show relationships between puts, calls, strike prices, and expiration dates. Assumption associations are derived from historical patterns, price patterns, and supply and demand relationship. Historical relationships signal the likeness of direction, whereas, price patterns point to quantity of decrease and increase. “Market factors (Interest rate changes, economic conditions, political factors, announced pending acquisitions.), are already incorporated into current market price per share. If demand exceeds supply, the stock price will increase, and vice versa.” (International Encyclopedia Page 16 and 17, J. Siegel, J. Shim, A Qureshi, J Brauchler) Charts are technical, and fundamentals play little or no roll when the technician makes decisions to buy or sell. He’s only interested in charts — usually 50 or 200 day moving average charts, volume, and the accumulation or distribution of a stock. WHAT ARE OPTIONS? Options have basic uses. One, to hedge—using options to safeguard against the underlying stock reducing in value. Much the same way as an insurance policy pays upon death, a put option pays (Or goes up in value.) as the underlying stock goes down. Two, to speculate: control large stock quantities with little money. Call options give the right to buy at the strike price with the expectation that the underlying stock will advance in price, and visa versa—one buys a put with the expectation the underlying stock will go down in value. It’s the right to buy stock at a fixed price and day. Whereby the purchaser agrees to pay premium to the option writer, who, where after has the right to exercise ownership. “Features of Standardized Equity Options” (Using Options to Buy Stocks Page 6, Denis Eisen.) “1. Product 2. Type 3. Unit of Trade 4. Strike price 5. Expiration date 6. Style.” Products are related to the underlying stock, thus an equity option. Type, a call option holder is not obligated to purchase, nor is the put holder obligated to buy. But the writer is obligated to buy or sell. 100 shares are equal to one contract, a unit of trade. Contracts can be divided into smaller quantities of stock. Strike price: is the demarcation line of plus and minus value. “Strike price intervals for standard equity options are set in increments of $2.50 when the price of the underlying equity (Stock price) is between $5.00 and $25.00, $5 when the stock price is between $25 and $200, and $10 when the stock price is over $200.” (Page 8. The Using Options to Buy Stocks, Denis Eisen.) Options can be used to hedge bonds, commodities, stocks, and derivatives. Writing options, premium collected, requires performance at expiration date. When options are exercised one is taking ownership, much like real estate or any other physical object. In reality people seldom exercise options but opt to sell or buy to close positions. Large quantities of stock are control with little capital when using options. Writing call and put options can be reasonably safe and profitable if one is selling options out of the money providing the option price is moving in the opposite direction. The writer is taking in premium which is kept at expiration date. Of course, the writer may be called to buy the stock or may be called to buy stock at the option price at the expiration date when selling puts. The option house such as CBOE requires substantial equity in portfolio and trading skill before one is permitted to write uncovered calls or puts. Uncovered calls or puts are written when the writer doesn’t own the underlying stock. When writing covered calls the writer is earning dividends (if the stock bears dividends) and collecting premium from the option investor. The combined profit usually returns better than a bank’s interest. Stock values are determined by fundamental and technical observation. The underlying fundamentals—profit and loss statements, balance sheets, etc., demonstrate a companies solvency. Industry sector plays are large part with investing. No demand for product within an industry sector reflects in stock and option performance. The price/ value ratio depends upon strike price value at expiration date. Volatility means uncertainty for stocks. Especially if the chart shows no major movement in direction. It means there is conflicting data. One should sort out on volume, strength of volume, and underlying data. The market anticipates future reality. The option writer collects premium, which he or she keeps if the stock goes up or down. The put-writer must be willing to own the underlying stock when put to him or her at expiration date. Evaluating options is not dissimilar to evaluating the stock. Stock bought in the money well below the selling price is the safest way to sell options. The option usually moves in tandem with the underlying stock as it nears the expiration date. Of course, stocks are fundamental to buying the options. Options will lose value if the underlying stock action is weak. One should consider selling calls when market appears to be going down and put options when the market’s going up.(Collect premium, wait for expiration, and retain the premium.) One can predict the value of options by knowing the ratio of calls to puts. Some experts claim the future direction of options can be derived from this ratio. Option values are time related. As time deteriorates the option reduces in value, thus prediction of value can occur through time passage. Leaps are another way of making money. (Using Options to Buy Stocks page 106, Denis Eisen) “Summary results.” He details selling puts against quality stocks using leaps, (Options, six months or longer, out of the money). “What all this tell us is that by writing out-of-the money leap puts on quality stocks, it is possible to raise option leaps expiring worthless to a level well over 95 percent, and achieve premium retention rates of 90% or more, with account rations as high as 98 percent of the total premium collected. Mind you, these results are calculated from the sale of a random number of out-of- the money leap puts on a random number of these better quality stocks on a random schedule throughout each year over a ten-year period.” It should be noted, however, that one should have done stock appraisals, know market trend, and who’s in the game. Are institutions buying? Are small investors buying? Is there inside trading? That is when company insiders are trading. One can then buy back the options at reduced price, pocket the difference, and sell more leaps and collect additional premium. This procedure has enormous potential for large investor portfolios, —if stocks are called away the investor would retain the premium and the sell the stock at higher price. Conversely, by selling put-leaps the investor must be willing to take stock put to him for purchase, keep the premium, and retain the stock. Use of Margin during trading: “Advantages of Margin,” (Stocks for Option Trading, Harvey C. Friedentag, P. 86) Use of margin during trading advances risk but grants leverage. It’s an opened ended loan agreement whereby stocks can be used to purchase additional stock. Margin allowances vary anywhere from 50% to 75% of stock value and is regulated by the SEC. No specific time limits are established, nor pay down of principal required. The debt is callable at the lender’s discretion. Interest rates vary from brokerage house to brokerage house. “Opening a Margin Account,” (Stocks for Option Trading, Harvey C. Friedentag P. 88) “* Read, understand, complete, sign, and return a margin agreement; *When approved, buy or deposit eligible securities in your account to be used as collateral. *Instruct your brokerage representative to deposit your securities in a type * 2 margin account (type 1 is a cash account); and * Ask your brokerage representative how much cash or additional buying power is available to you.” Margin allows the trader more opportunity to leverage, diversify, and seize opportunities. Margin calls occur when the amount owed exceeds 25% of current value. However, the brokerage house has the option to exceed or decrease those levels as they see fit. Writing covered calls is the safest way to use options. It is simply owning an option-able stock, selling call or puts against it, or both. People with large portfolios can increase their rate of return consistently by using this basic technique. The term, time is money, applies to option trading. When selling options the investor wants time to pass quickly so he can keep the premium, and when buying options the investor want time to go slow, forestalling the diminution of the premium. (The investor hopes of the underlying stock will go up or down, depending upon if a call or put were purchased.) (The Option Course, George A. Fontanills.) “How to Spot Explosive Opportunities,” (Fontanills P. 37), the author demonstrates searching for knowledge and expertise. First, he evaluates criteria for good investment. He searches through vast quantities of information and culls it down to essentials. He reduces complexity to simplicity and starts there. He says, forecasting market direction requires economic, income statements, earnings, sales, assets, and management data. Conversely, he goes on to say (Fantiallis P.43)“On the other hand, I love to find opportunities to do the opposite of everyone else. This is known as the contrarians approach— when all the information is too positive, look for an opportunity to sell, and when it is too negative, look for an opportunity to buy. The moral of the story is: Listen to the market. It will tell you a great deal. Use discerning ear when listening to anyone else.” He goes on to state the majority of people lose money because they have a herd mentality. They cannot see the trend is about to reverse and become the effect of emotion and subsequently loose. The moral here is, observe, evaluate trends, and act. (Fontallsi P. 44) He makes the point here that when interest rates go up and Bond prices are going up, stocks usually go down. So one would be looking for selling opportunities here. (How To Find a Home Run Stock by John Lux P. 27) Mr. Lux expresses a refreshing view of the stock market. He appears to deal from simplicities rather then complexities. For instance, (Lux P. 27-29) “Price, price per share, is the amount of money you have to pay for a stock, or the amount of money you can get for a stock. The practical definition of price is what someone will pay for a stock.” He brings this analogy down to, one can buy a stock for x, sell it for 2 x, and then the company goes bankrupt. Thus, the investor has made1 x on a bankrupt company. He goes on to say, “In the stock market, price is everything.” One sea’s the profit isn’t made from reality. He goes on to say (Lux P.29) fair value is what a stock is worth as opposed to price. This method is used to determine stock worth and price value. “One of the most important Concepts.” (Lux P. 35) He goes on to state, that one important concept is to know there are two most important concepts: price or value. Example: “Picture a rubber band. At one end you put a label ‘price’ and at the other a label‘value.’ The farther apart these two are, the more the tension in the rubber band will create motion pulling them together. Price can be way over value or price can be way undervalue. Either way, if there is a great difference between price and value, something is going to happen. What is going to happen is that price will move. Price always tends toward value in the long run. Value will rarely just because a stock is high priced.” ____________ Work Cited James. Bitterman Trading and Hedging Agricultural Futures 2001 and options H. Friedentag Stocks for Option trading St. Lucie Press 2000 Dennis. Eisen Using options to buy stocks Deerborn, 2000 George A Fontalnills. The Option Course John Wiley & Sons, inc. U.S. & Canada John Lux How To Find a Home Run Stock. 2006 , Clearwater Fla. Read More