Options, Options, Options....

I have started looking deeper into options to see what kind of strategy might suit me the best. In the process I have found out more about them than I already knew and this has changed the way I think about trading options.

I am looking at trading call options and put options instead of, or in conjunction with stocks, nothing fancy.

The basic tenets of options are that a call gives the owner the option to buy the stock at the strike price within the time frame of the option. The presumption is that the price will be higher at some point before the expiry date so the option is worth more to trade OR the stock option can be exercised to buy the stock at the lower price than current market. A put gives the owner the option of selling the stock at the strike price in the hope that the price will be lower.

The interesting part is that the trading price of the option is made up of two parts with a correlation factor to the stock price itself.

Intrinsic value, Extrinsic value and Delta

Before that, a single option contract controls 100 shares of the underlying stock so the following example, and any options quote, represents one share value...multiple by 100 to get the actual value of the trade. A $4 options contract will be $400 even if the underlying stock is at $23. This makes it easier to trade options with less capital.

Intrinsic value is the difference between the strike price of the option and the trading price of the stock. If the strike price is $20 and the stock is trading at $23 then the intrinsic value is $3 and it is considered to be In The Money (ITM).

Extrinsic value is the premium that factors in the potential value of the option going forward as well as the time value until expiry. The value that traders are willing to pay in the hopes that the stock price will move in favour of the intrinsic value increasing at a greater rate than the extrinsic value decreases. As time progresses the extrinsic value decreases, although time is not the only factor, and the closer to expiry the faster this extrinsic value erodes. The rule of thumb is that the extrinsic value decreases the fastest in the final three months before expiry.

The $20 strike priced option with the stock at $23 might have an extrinsic value of $1 so the option trades at $4. Even if the price does not move on the stock, holding the intrinsic value at $3 the extrinsic value will drop to zero near expiry thereby losing the owner $1.

Delta is the relationship between the option's intrinsic value an the stock price activity. The number is from 0 to 1. A Delta of 0.5 would indicate that, at the current price, if the stock moves $1 the intrinsic value would move 50 cents. A higher Delta is better for my purposes. I cannot see the moving relationship easily but given the different delta numbers at different strike prices the farther in the money the option is the higher the delta is, up to 1. A higher delta gives a higher stock price to option price correlation which comes closer to being able to use options in place of stocks directly.

It is interesting to note that, as I pointed out, the farther in the money the option is the higher the Delta is. This means that the reverse applies, as the stock price gets closer to the strike price the Delta gets lower. This should mean that losing money on an option trade is progressively slower than being in the same stock directly. An option that may be $15 ITM might have a Delta of 0.9. As the option strike prices are closer to the actual price of the stock they reduce, in one case 0.1 for every $5 down to about 0.5, once the option is out of the money the Delta keeps getting lower. So the option still has some intrinsic value left.

An example, Morgan Stanley (MS) call option expiring in January 2010.

Buying an option with a strike price of $17.50 yields a Delta of 0.93, single contract is $11.40.
Compare buying the stock at $28.56, $2856.00 or the option at $1140.00.
The intrinsic value is 11.06 (stock traded last at $28.56), the extrinsic value is 34 cents. If the stock price moves up $1 the option will move up 93 cents and will be $1 farther into the money. The farther into the money the option goes the higher the Delta, which makes the rate of option value increase non-linearly...on the flipside the rate of decrease, should the price drop, will also decrease in a similar non-linear fashion. This will make the downside easier to take and mean that the potential loss on the option is actually lower than the potential loss on the stock itself as a full $10 stock price drop is a full $10 loss on a stock position but the option will not lose the same $10. There will be value left even if the option is at the money.

I do not have the math to show this definitively but the theory is sound and, worst case, the option has the possibility of losing the same as trading the stock...no real downside.
The current $28 strike option is at $3.72 and is only 56 cents ITM.
Intrinsic value is 56 cents, extrinsic is $3.16 Delta is 0.62.

I presume that such a low extrinsic value may be attributed to the sentiment that the stock is likely to drop before January, if the prospects look good for the stock going forward I would expect that the extrinsic value might be higher...but this is just a guess.
That is just some of the basics glossed over. The real point is that there are, in my thinking, two types of options that can be traded, other than calls and puts. I consider a high leveraged option and a low leveraged option.

The high leverage includes any options that have a very high extrinsic value compared to the extrinsic value even though they are priced extremely low. a $1 option looks like a great deal but the extrinsic value may be 90 cents. This means that, if the price does not move in favour 90% of the trade will be lost at expiration. An option, with a higher intrinsic value like the example, leaves only 25% to be lost at expiration. The key is going to be to buy options that are far away enough from their respective expiry dates that eroding extrinsic value is not really a problem AND that the stock price is likely to move in favour of the trade in the short term...relatively speaking.

An expiry at least 6 months in the future with a trade timeline of two months or less would probably be ideal. A higher intrinsic value than extrinsic would also be good and an underlying stock that is in a good high probability setup for a favorable move just adds to the mix.

So here I mix P&F charting with options trading and I have setup a quick spreadsheet that breaks down the option price into it's two values, compares these to the stock price and gives the option price that should correspond to the trigger price on the stock chart. This saves paying for data link for charting option pricing.

All this to avoid having to be restricted to short selling in my small margin account. I will replace short selling with put options and can trade these in my registered accounts.

Oh, there is an advantage to buying puts instead of short selling as well. A short sell has an unlimited loss potential, in theory, and a stop loss is not a 100% guarantee that the price will not gap up way over the stop...I see lots of cases where this has happened on stocks that I have been trading, most were in my favour. At least with a put the loss is restricted to the cost of the options only, and there still may be some value left in the option at that, if it is saleable afterwards.

Options, here I come. More reading to do and some trial to see how the trading is executed though, spreads are larger than I like so I may have to do some searching but I like doing the research.

Jeff.