What Everybody Ought To Know About Trading Options

Curious about Options? Wondering if the Greeks are the people fighting about austerity packages or that frat which always had hot girls at their parties? . What if your interviewer asked you what it means to Long a put or write a call? Let's take a look at the fundamental basics of options that you should know as you gear up for recruiting.

Options are everywhere. Every decision you make and risk you assume is a derivative that is being priced, bought or sold by somebody. How do you decide what school to attend, where to live, what job to take? It may not seem like these decisions contain embedded options, but each has a level of risk, reward and cost associated with it. Each has a variable range of favorable or unfavorable outcomes that may or may not be within your control.

Consider purchasing a piece of artwork from an unknown artist as an investment. The initial outlay is relatively small and the probability that the artist will be recognized is relatively slim. However, if the artist does become famous, your small initial investment may appreciate significantly. This is a call option. The investor participates in the potential upside in exchange for a small initial financial payment.

Call Option (Buyer or holder): The buyer of a call option has the right (but not the obligation) to buy a security(St) at a pre-specified time (expiration) and price (strike=K) . The buyer pays a fee (premium=P) to the seller to receive this right. Buyer's payout = (St-K)-P

Call Option (Seller or writer) : The seller of a call option has the obligation to sell a security(St) at a pre-specified time (expiration) and price (strike=K). The seller receives a fee (premium=P) from the buyer to take on this obligation. Seller's payout = -(St-K)+P

*Calls provide the buyer and seller full exposure to price movements above the strike. Like buying a speculative stock or that piece of artwork by the unknown artist, the initial outlay (premium) is small relative to the potential gain.

Put Option (Buyer or holder) : The buyer of a put option has the right (but not the obligation) to sell a security(St) at a pre-specified time (expiration) and price (strike=K). The buyer pays a fee (premium) to the seller to receive this right. Buyer's payout = (K-St)-P

Put Option (Seller or Writer) : The seller of a put has the obligation to buy a security(St) at a pre-specified time(expiration) and price(strike=K). The seller receives a fee (premium=P) from the buyer to take on this obligation. Seller's payout = (K-St)+P

*Puts provide the buyer and seller full exposure to price movements below the strike. Like purchasing insurance the premium paid provides protection from losses due to declining prices.

The difference between European and American Options include :
European Options may be exercised only on the expiration date
American options may be exercised at any time before expiration. (We will be focusing on American options)

Examples:
Let's say the investor paid a $2 premium and is long a call on NFLX(netflix), Strike(K) = $85 expiration Dec 21 2012. If, at expiration NFLX is at $88. The investor would have made (St-K)-P = ($88-$85)-$2 = $1.
*Note that in the real world there are 100 shares per option contract so do you see what the $1 profit translates into.

Remember that the maximum loss for a buyer of a call option is the premium paid and the maximum gain is unlimited. The reverse is true for the seller of a call option.

Homework Q1) If you paid $2 premium and are long the put on NFLX, K=$81 expiration Dec 21 2012. If, at expiration NFLX is at $78. How much did I make or lose? (FYI you are a put buyer here)

Remember that the maximum gain for a buyer of a put option equals strike less the premium if the stock price goes to zero. The maximum loss is the premium paid.

Here are some simple shorthand descriptions to reflect the option's risk profile.
ATM: No this is not your father/Sugar Mommy/Sugar Daddy!
At the Money options simply mean the Strike price is he same as the spot/stock price (K=St)

ITM Calls: In the money calls are when the strike price is below the the spot price (KTM Puts: In the money puts are when the strike price is above the the spot price (K>St)

OTM Calls : Out of the money calls have strike price above the spot price (K>St)
OTM Puts: Out of the money puts have strike price below the spot price (K

Q2a) In the NFLX long call example, was it ATM , ITM or OTM
Q2b) Is HW Q1 ATM, ITM or OTM

So what happens if we buy a call and sell a put at the same time? This is called a Combo. Depending on the strike prices used in the combo, our initial cash outlay (or premium will change). If stock is trading at $20 and we purchase the ITM call at Strike (K) = $15 and sell the OTM K=$15 put, we have locked in the right and obligation to purchase the stock at $15. Since the stock is currently trading at $20, this combo must be worth $5 to us. This concept is called Parity.

Put-Call Parity
Combo = Call - Put (C-P)
Parity = Stock - Strike (St-K)
Carry= Interest - Dividends

***** COMBO = PARITY + CARRY *****
C-P = (St-K)+ (Int-dvd)
By rearranging the above equation, we can solve for calls and puts in relation to each other.
C= (St-K) + (Int-dvd) + P

HW Q3) What is the value of parity for the put given the following?
Call (C) = 1.01 , Put (P) = 3.52, Stock(S) = 37.45, Strike(K)= 40, Interest(int)=0.04 and Dividends(dvd)=0

HW Q4) If the spot of an underlying asset increases, how does it affect the value of a call option vs that of a put option ? (*Hint, if St increases what happens to P & C)

HW Q5) Assume two call options have the same underlying security and the same strike but different expirations. Which would have a higher premium? (The one with expiration in 6mths or 1 year?)

If you understood the material post your answers to Q1-Q5 below and I'll be happy to reveal the answers.

If you are an options whizz give the others a chance to learn as Practice makes perfect!

**For more advanced Options Theory, Check back in next Tuesday as we take a look at the Option Greeks (Delta, Gamma, Theta, Vega and Rho)

Comments (107)

Nov 26, 2012

1) $1
2)a.ITM
b.ITM
3)2.55
4)Put value decreases, call value increases
5)1 yr because of theta decay

Nov 28, 2012

Love this! I am considering to start trading options (never traded anything before) starting next month. Definitely will follow your series

Nov 28, 2012
Mr.Saxman:

Love this! I am considering to start trading options (never traded anything before) starting next month. Definitely will follow your series

Read Natenberg before you make that decision - don't base it off an abbreviated and oversimplified series like this

Nov 28, 2012
gammaovertheta:
Mr.Saxman:

Love this! I am considering to start trading options (never traded anything before) starting next month. Definitely will follow your series

Read Natenberg before you make that decision - don't base it off an abbreviated and oversimplified series like this

Absolutely read Sheldon Natenberg's book! Brilliant work!
http://www.amazon.com/Option-Volatility-Pricing-St...
In fact having an understanding of the basics of options will certainly help when you read his book

~~ Fortune favours the brave ~~

My WSO Blog

Nov 28, 2012
Mr.Saxman:

Love this! I am considering to start trading options (never traded anything before) starting next month. Definitely will follow your series

Did you do the homework qtns?

~~ Fortune favours the brave ~~

My WSO Blog

Nov 28, 2012

- deleted

Nov 28, 2012

What are the answers though?

Nov 28, 2012

Can you explain the last part of the parity? I understand everything else no problem, but I don't understand the part where the parity has to be worth $5 to us. Can you go a little more in depth here?

Nov 28, 2012
dest149:

Can you explain the last part of the parity? I understand everything else no problem, but I don't understand the part where the parity has to be worth $5 to us. Can you go a little more in depth here?

Sure, Let's take a look at the current stock price as seen above in the Put-Call Parity explanation. Since Parity= Stock - Strike and the stock price is $20, Strike Price(K) is $15, Parity is $5. Are you confused about the ITM/OTM parts?

~~ Fortune favours the brave ~~

My WSO Blog

Nov 28, 2012
LaFemmeFinanciere:
dest149:

Can you explain the last part of the parity? I understand everything else no problem, but I don't understand the part where the parity has to be worth $5 to us. Can you go a little more in depth here?

Sure, Let's take a look at the current stock price as seen above in the Put-Call Parity explanation. Since Parity= Stock - Strike and the stock price is $20, Strike Price(K) is $15, Parity is $5. Are you confused about the ITM/OTM parts?

Right I understand the math of it. I guess I what I was trying to ask is what a parity actually is. Not how it is calculated. For example, the parity is $5, but what does that $5 signify? Is that profit per option so you get $500 (since 100 shares/contract) is it a sort of premium that you would implement if you think the shares are going no where? Yes I understand ITM and OTM, although I am not sure what the point of buying ITM is....

Nov 28, 2012

... not another presentation deck to summer interns please...

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Nov 28, 2012

Am an options market maker - if you are a retail investor or a sole investore, DONT trade options, you haven't got the pockets to make the strategies work.

Furthermore, aside from german equities and a few index options, bid offer spreads are too wide

1percentblog.com

Nov 28, 2012
redrut:

Am an options market maker - if you are a retail investor or a sole investore, DONT trade options, you haven't got the pockets to make the strategies work.

Furthermore, aside from german equities and a few index options, bid offer spreads are too wide

What advice do you have for the students who want to be brokers/market makers or trade for example fx/equity options at a large Inv. bank's trading desk?

~~ Fortune favours the brave ~~

My WSO Blog

Dec 7, 2012
redrut:

Am an options market maker - if you are a retail investor or a sole investore, DONT trade options, you haven't got the pockets to make the strategies work.

Furthermore, aside from german equities and a few index options, bid offer spreads are too wide

Disagree, options can be very useful when executing levered directional bets in certain equities. Selling covered calls is also a tried and true retail strategy for the buy and hold investor. However, market making in vol requires deep pockets yes.

Nov 29, 2012

Advice for getting into options on a inv bank market making or broking desk...I work for a smaller market maker and we play in listed derivatives only.

Derivatives volumes are heavily down, there isn't as much money in the system as there used to be, the overload of brokers and mkt makers have tightened prices quite signficiantly. It's a very cyclical business where the gov bond desk is having a great year but the Equities is doing F all.

My advice, steer clear of single stocks derivs desks, closing down at a fast rate. Short end used to be great but with interest rates bounded to 0 for the considerable future, there may be less reason for trades to be put on, so less edge for a market maker.

For a market maker, practice your short and medium memory skills. Not joking at all! We quote every 40 seconds for strategies (I am on the govt bond desk) over 10 products each with for active months. We have to know whats trading, how much of it, whats the current market position - you can use software aids to help but you need to be quick with pricing so you need a good recall of numbers.

Brokers - I can't comment, interdealer brokers seem to be earning a lot more than you would think considering they take no risk but if you want to use your brain, this is probably not the job for you.

Finally be aware that more complicated derivatives may see vastly reduced markets in the future while you should keep an eye on the swaps/swaptions market as it slow comes on exchange.

Sorry I have nothing specific

1percentblog.com

Dec 5, 2012

This is a great post and so is your subsequent post on options. Really appreciate it, even if only for personal interest.

It would be great (and forgive me if this already exists and I just haven't found it) if WSO could have an educational, or basic finance forum for great stuff like this.

Dec 8, 2012

There's a problem with the analogy - you purchased the underlying asset (the artwork). Had you simplistically agreed via a contract to purchase the artwork at a specific price at a future date, now that's an option!

Dec 8, 2012
motionfx:

There's a problem with the analogy - you purchased the underlying asset (the artwork). Had you simplistically agreed via a contract to purchase the artwork at a specific price at a future date, now that's an option!

That's actually a forward. It only becomes an option if you pay for the right, but not the obligation, to purchase that artwork in the future.

Dec 8, 2012

SirTradesaLot, yes you are right, I accidentally left that bit out!

Dec 8, 2012

it wont ever be priced like that because itll be arb'd out due to the theta + instrinsic value should be over 4

Dec 8, 2012

the example i used is on AA

Dec 8, 2012

alcoa

Dec 8, 2012

Someone should create a Trading Options 101 thread and let everyone build on it. Not me, but someone should.

Dec 8, 2012

I wouldn't start with such a small amount. Additionally, not to be a dick, but reading your comment "i pretty much know how they work and everything" means you're going to lose it all within a month. Options are a beast unto themselves. I've been doing it for four years on my own and every time I think I have something down I get surprised with some odd twist.

Options are like chicks. As soon as you think you understand them you get screwed.

But they're fun as hell to trade.

Dec 8, 2012

yeah probably lol

hey tyrets... start a thread if your knowledgeable?

Dec 8, 2012
f1mpladed:

yeah probably lol

hey tyrets... start a thread if your knowledgeable?

I'll start a forum topic Options Trading 101 and build from there. Corrections and further insight would be appreciated as this will help me as well review some stuff i should probably pay more attention to while trading.

Let's see how it goes...

Dec 8, 2012

Trading options is a good way to get your dick shot off. Pretty much no one makes money, the trades have humongous spreads (which are traded very opaquely), and in general it is a very very bad deal. If you have a feeling about a stock you're better off putting down a very large (for you) position on it. That way if the trade goes south you still have your money.

Dec 8, 2012
monkeysama:

Trading options is a good way to get your dick shot off. Pretty much no one makes money, the trades have humongous spreads (which are traded very opaquely), and in general it is a very very bad deal. If you have a feeling about a stock you're better off putting down a very large (for you) position on it. That way if the trade goes south you still have your money.

Depending on the product, many spreads are incredibly tight. Look at Spyders or any options on currencies or certain bond markets. Most trades are done on both of those for pretty much value (most people don't just hit the bid or offer).

Dec 8, 2012

Its all been said, and im glad to agree with most everyone above: do NOT trade options if you admit youre new yet think you "pretty much know how they work and everything"

What is the I.V of the Jan 11C?

Are you theta-neutral?

Until you can explain to me those 2 things, do not trade options. Both of those will kill you (not to mention the other Greeks) if youre unsure and are simply placing a 1-directional bet on a company.

Stick with a short or long position in the stock and youll be fine. Yes the cheap option price is attractive, but its mostly the big boys that use options to hedge their current exposure to their book and hence you are dealing with a much more sophisticated player than a machine selling you 100shares.

Dec 8, 2012

@ f1mpladed

I trade options on futures (only commodities, forex, indices). If you ever decide to go that route PM me.

Happy Trading

Dec 8, 2012

yeah i agree they are dangerous, but i would like to try it and learn more (anysites u reccomnd, and the thread will be of help)

I am going to experiment with in the money long calls and see how i do... its not like ill be putting up that much money anways

Dec 8, 2012
f1mpladed:

I am going to experiment with in the money long calls and see how i do... its not like ill be putting up that much money anways

You will probably lose all your money since you dont realize stocks would do the same thing for you.

But, and in my experience as well, the harsh experience is typically the best lesson. Then you will learn. Best of luck.

Dec 8, 2012

I don't think you're ready to trade options till you actually understand what they're most useful for. Essentially, the beauty of an option is that it can be analytically decomposed into dependence on a few factors (aka delta, gamma, vega, theta..the other greeks shouldn't matter for a small time player). You can use options in the following ways:
- Trade direction (delta), acceleration of direction (gamma), volitlity (vega), or combinations of these.
- Hedge out exposure to any of the above. This is what options were first created for, and what I exclusively use them for (volitlity bets aside).

If all you want to do is trade direction, you're best off just trading an instrument with a delta 1. The only time IMO it makes sense to use Options to trade direction is when you expect a really short term movement that's not been priced in (also an easy way to get burned if you're bet goes wrong).

Dec 8, 2012

such as?

Dec 8, 2012
f1mpladed:

such as?

You mean delta 1 instruments? The stock itself :). But generally, anything that is an obligation and not an option is almost always delta 1 (unless it's an obligation to say exchange vols or something like a Vol Swap which would then be Vega 1, but I think you get my point). Futures, forwards, equity swaps are all delta 1.

Dec 8, 2012

well i look forward to picking yalls brains lol

Dec 8, 2012

any websites you would reccomend ?

Dec 8, 2012
f1mpladed:

any websites you would reccomend ?

investors.com, optionetics.com should be your first two stops. seekingalpha.com is very good too, but that is a blog and not primarily a resource website such as the former two.

Go read The Options Course and The Volatility Course from start to finish and then read it again.

Dec 8, 2012

How much math do you know? The best way to learn how to trade options is understand how they're priced. Ideally, you should start by reading Hull and understand the contributors' to an Option's Price and how they're factored in. Most firms use varants of BS, but at the end of the day, understanding the basics is key.

If you're math background isn't strong, just read a few qualitative books that tell you how to interpret the greeks (Trading Option Greeks is a good one).

Dec 8, 2012

hahah thanks for the help...

tyrets start that thread! lol

Dec 8, 2012

IMO, if you are not an institutional using options for hedging, they are best for trading vol.

Understanding vol and of course the greeks is only the starting point and unless you learn how to use options in a professional environment it is almost impossible to get to know how to work properly with them.
Having a view on vol and not simply whether a currency will appreciate e.g. is something entirely different.
Understanding the dynamics of currencies is something a beginner should learn, and not how to use options to exploit it. That is much more advanced and only creates more confusion in the beginning!

Also, you have to have the IT that let's you screen your greeks etc. I don't know if all that is implemented in the software of a broker like IB, e.g.

In the beginning, you should stick to the basics - get a view and have a tight money management. You could still always have a look at the smiles of different assets to get further impressions of what the market is expecting.

Dec 8, 2012

Read stuff about option basics on Investopedia

Dec 8, 2012

PM me ur email address and I will send you the BS model which calculates D,G,V,T,R.

Dec 8, 2012

since i dont have much capital, whats wrong in buying some call options say (5contracts=500) on say alcoa?

key word being cash limited

Dec 8, 2012

You're paying for time premium with options, which is the main problem, since it may not raise enough in value to make your purchase worthwhile. Options can be used for leverage, but it has costs. And if you're buying some options that are that cheap, you're probably going to buying 5-10delta calls if they are further back options, so they may not even rise close enough to breakeven.

Dec 8, 2012

If you ever see a call option trading at intrinsic, buy it

A put is a bit more iffy. Have to be careful about when you can exercise and if there's any dividends coming up.

Dec 8, 2012

How would you hedge out vega on a long call? Sell a call at a higher strike? I am not familar with how to trade the greeks but I do know all the basic option strategies.

"Oh the ladies ever tell you that you look like a fucking optical illusion" - Frank Slaughtery 25th Hour.

Dec 8, 2012
trade4size:

How would you hedge out vega on a long call? Sell a call at a higher strike? I am not familar with how to trade the greeks but I do know all the basic option strategies.

lol and these are the people that argued trading on this site and know option strategies... yep

If you sell a call at a higher strike... yeah, that will take out some vega, but then you're just entering a long c$ and in this case, financing a purchase of the near strike through a sale of a further strike. You could end up net flat/long/or short vega depending on the skew/strikes/etc. If you're doing small size or trading direction through options (if you were trading pure volatility, whether it is a call/put doesn't matter), it is going to be irrelevant since you don't really need to hedge vega and legging into a spread is mostly to finance your original purchase more than anything else.

Dec 8, 2012
trade4size:

How would you hedge out vega on a long call? Sell a call at a higher strike? I am not familar with how to trade the greeks but I do know all the basic option strategies.

There are a ton of different ways to hedge vega of a long call, but in short it involves selling options.

For Vanillas: Options have peak vega atm and the longer the maturity the more Vega on the option (holding strike/delta constant). Long options are always long Vega, the only way to sell Vega is to sell options.

I can do a lot more detail on things like this, would be happy to, but if you have more specific (or general) questions about options/greeks just ask.

Dec 8, 2012
f1mpladed:

Hey all, so i am approaching my first time trading options, i pretty much know how they work and everything

heres a few questions have

say XYC is trading at $15, i buy Jan call option of $11 for $4....... since it is in the money
is this a profitable strategy just doing that ( i guess a lot has to do how the stock ends up doing at the strike date)

and also im just a small time trader (student) with less the $10k how much do you fellow wallstreetoasiers trade in options 1-5 contracts

?

It is a profitable strategy, although you have to add transaction costs + slippage.

Im also guessing that you saw those quotes while the market was closed?

Btw, I would pay big money to see a new SA or grad show up on a desk and say "i pretty much know how they work and everything". Instant book lol.

Dec 8, 2012
derivstrading:
f1mpladed:

Hey all, so i am approaching my first time trading options, i pretty much know how they work and everything

heres a few questions have

say XYC is trading at $15, i buy Jan call option of $11 for $4....... since it is in the money
is this a profitable strategy just doing that ( i guess a lot has to do how the stock ends up doing at the strike date)

and also im just a small time trader (student) with less the $10k how much do you fellow wallstreetoasiers trade in options 1-5 contracts

?

It is a profitable strategy, although you have to add transaction costs + slippage.

Im also guessing that you saw those quotes while the market was closed?

Btw, I would pay big money to see a new SA or grad show up on a desk and say "i pretty much know how they work and everything". Instant book lol.

Yeah, except you're never going to be able to buy them @ intrinsic until maybe on expiration day (doubtful even then). It is the equivalent as buying the OTM put for $0.

Dec 8, 2012

I would lift that all day (ignoring transaction costs). TINSTAAFO haha.

Dec 8, 2012

Jerome I am not an options mm I never claimed to be one. The options trading we do is purely execution of very large orders in effect its just one of the ways we are getting paid for other services we are giving. I was asking that question more for personal trading. Please dude you act like you know everything you would be just as clueless in risk arb as I am at knowing how to trade the greeks.

"Oh the ladies ever tell you that you look like a fucking optical illusion" - Frank Slaughtery 25th Hour.

Dec 8, 2012

hey all i am a math major btw

i saw that list price when the market was open

yes i know i was going to take heat for saying i pretty much know... "

basically to sum it up, say BAC is releasing their earnings next 3 months, i am very confident that it is going to be favorable, i do not have much money to purchase a thousand shares, so i purchase 10 contracts +3 month out call options say a stike price of 1 dollar more

if it finishes above that price i make a profit, i dont rely see the risk aside from being wrong and me just lossing the money i had put in.

Dec 8, 2012

I guess if you're using it purely as a hold-to-maturity punt then your logic is fine, as long as your not paying up too much in vol terms. The greeks really only matter on a dtd and mtm basis, so if you are using it purely as a spot punt at maturity and not trading the contract I guess it's not as important.

Dec 8, 2012

"if it finishes above that price i make a profit, i dont rely see the risk aside from being wrong and me just lossing the money i had put in."

don't you still have to make up the cost of the calls in order to make a profit? i'm assuming you mean that if it finishes above the strike price then you make a profit

Dec 8, 2012

strike + option price + transaction costs technically

Dec 8, 2012

what if you buy it now and it goes down to 20.

Dec 8, 2012
njmonkey46:

what if you buy it now and it goes down to 20.

I understand the purpose of this to lower the risk but if you firmly believe the stock will eclipse 35 then why wouldn't you buy the stock over the option. I know it has a chance of going down.

"Look, you're my best friend, so don't take this the wrong way. In twenty years, if you're still livin' here, comin' over to my house to watch the Patriots games, still workin' construction, I'll fuckin' kill you. That's not a threat, that's a fact.

Dec 8, 2012

In one of those scenarios you made 400% on your money.

When you bought the equity you made 24% on your money.

See the difference?

Dec 8, 2012
andyinsandiego:

In one of those scenarios you made 400% on your money.

When you bought the equity you made 24% on your money.

See the difference?

Leverage is a beautiful thing.

Dec 8, 2012

You don't have to actually exercise the option, you can resell it without buying the underlying. Therefore it requires a lot less capital to make 400% vs 24%

Dec 8, 2012

You can spend $100 to potentially make $400 or spend $3219 to potentially make $781 (assuming it even goes to $40)

Dec 8, 2012

Ok I understand all of this but:

if I think the stock is going to increase from its current price of 32.19 to $40 wouldn't it be better to buy the 100 shares now and when they hit 40 my profit is $781 as opposed to 400.

Because if I buy the call option for 35 and it only gets to 34.50 I lost 100 bucks. But if I bought the stock, I am still up a few hundred.

"Look, you're my best friend, so don't take this the wrong way. In twenty years, if you're still livin' here, comin' over to my house to watch the Patriots games, still workin' construction, I'll fuckin' kill you. That's not a threat, that's a fact.

Dec 8, 2012
Will Hunting:

Ok I understand all of this but:

if I think the stock is going to increase from its current price of 32.19 to $40 wouldn't it be better to buy the 100 shares now and when they hit 40 my profit is $781 as opposed to 400.

Because if I buy the call option for 35 and it only gets to 34.50 I lost 100 bucks. But if I bought the stock, I am still up a few hundred.

You need to pick up an intro to options book or something...Think about your returns as a % of your initial investment. You have no grasp of the most basic concepts, I don't think anyone will want to waste their time in explaining this and then argue with you about it in the process.

edit
Not trying to be a dick by the way, just think you could gain a lot from looking into some basic material first.

Dec 8, 2012
Will Hunting:

Ok I understand all of this but:

if I think the stock is going to increase from its current price of 32.19 to $40 wouldn't it be better to buy the 100 shares now and when they hit 40 my profit is $781 as opposed to 400.

Because if I buy the call option for 35 and it only gets to 34.50 I lost 100 bucks. But if I bought the stock, I am still up a few hundred.

lol, fine. why not buy an option with a strike price of 25? Assuming you're close to maturity, your delta is basically 1 and you're not paying a lot of theta. You can probably buy a contract for 800 (assuming the spot is 32), and have the same access to the 780 upside you're talking about...

Dec 8, 2012

You're obviously trolling, but why don't you take that 3200 and buy 32 contracts and thus make a profit of $12,800... thats a little bit more of an absolute profit than $781.

Dec 8, 2012

There are some good explanations on this thread as well...

http://www.wallstreetoasis.com/forums/unexercised-...

Dec 8, 2012

troll gonna trolololol

Dec 8, 2012

think of the stock as an option with delta 1 and theta 0.

Dec 8, 2012

You're funny. There is no "case" you're just being a retard.

Dec 8, 2012

It's not the same because the payout graph is different. If you have a max loss per contract, you can buy a hell of a lot more options contracts for the same amount. It's about % return, not absolute return. As others have said, invest the identical amount, and you'll see the difference.

For example, if you knew some stock was going to pop dramatically after earnings, which one do you think would be better, to buy stock, or buy out-of-the-money call options? If you model it out it should be obvious to you what's going on.

Dec 8, 2012

Options, like most derivatives, are used for either hedging or speculation. You might use an option to hedge risk (as you mentioned before), instead of purchasing the underlying security. Or you might purchase a put option at a certain strike to hedge against a stock you are long in, just in case. The fact of the matter is, no investor is certain that a stock will raise in price from 32.91 to 40 (or whatever your example numbers are), so purchasing the underlying option is a much safer bet.

As for speculation, options are used, as the above posters mentioned, by profiting from the purchase and sale of the underlying option. The value of the option depends upon its market value, and it rises and falls in price based upon several different risk factors (which you should be familiar with if you read books on the subject, as you said you have)

You are assuming that the investor is CERTAIN that he or she will see the price of a stock rise from 32.91 to 40.00. This never happens (unless the investor has inside information). So now let us use that as an example. If the investor has inside information, he knows the stock price should rise to 40 (say he knew the details of a proposed merger or something). If the investor knows that the security is going to rise in price, he could make much more money buying $3291 worth of options instead of buying 100 shares at 32.91. Thus, when the stock trades up to 40, he is making $13164 instead of $781.

Dec 8, 2012
LIBOR:

Options, like most derivatives, are used for either hedging or speculation. You might use an option to hedge risk (as you mentioned before), instead of purchasing the underlying security. Or you might purchase a put option at a certain strike to hedge against a stock you are long in, just in case. The fact of the matter is, no investor is certain that a stock will raise in price from 32.91 to 40 (or whatever your example numbers are), so purchasing the underlying option is a much safer bet.

As for speculation, options are used, as the above posters mentioned, by profiting from the purchase and sale of the underlying option. The value of the option depends upon its market value, and it rises and falls in price based upon several different risk factors (which you should be familiar with if you read books on the subject, as you said you have)

You are assuming that the investor is CERTAIN that he or she will see the price of a stock rise from 32.91 to 40.00. This never happens (unless the investor has inside information). So now let us use that as an example. If the investor has inside information, he knows the stock price should rise to 40 (say he knew the details of a proposed merger or something). If the investor knows that the security is going to rise in price, he could make much more money buying $3291 worth of options instead of buying 100 shares at 32.91. Thus, when the stock trades up to 40, he is making $13164 instead of $781.

This is the answer I was looking for. Thank you. SB for you sir.

"Look, you're my best friend, so don't take this the wrong way. In twenty years, if you're still livin' here, comin' over to my house to watch the Patriots games, still workin' construction, I'll fuckin' kill you. That's not a threat, that's a fact.

Dec 8, 2012

I couldn't have explained it any better than Libor.

Dec 8, 2012

Also, what if you have 10k in your account, will they let you buy 5 options with a strike price of 35? Because thats 500 shares at 35 each so that will definitely eclipse your 10k amount. that's why I ask if it would be better to buy the shares instead

"Look, you're my best friend, so don't take this the wrong way. In twenty years, if you're still livin' here, comin' over to my house to watch the Patriots games, still workin' construction, I'll fuckin' kill you. That's not a threat, that's a fact.

Dec 8, 2012
Will Hunting:

Also, what if you have 10k in your account, will they let you buy 5 options with a strike price of 35? Because thats 500 shares at 35 each so that will definitely eclipse your 10k amount. that's why I ask if it would be better to buy the shares instead

You need to get your money on those "numerous" books back, dumbass. You don't have to exercise the option and actually take delivery of the stock. You can close out your position by selling your options when they are in the money (at or close to intrinsic value the closer you get to the expiration date).

Dec 8, 2012

And I'm telling you that you don't need to actually excercise them. The payoff will be the same in both cases, whether you excercise or close out your position, you f*cking idiot. It is one of the basic advantages of using options, you don't need as much capital as you would if you were to actually buy the underlying security. Don't lie to me and tell me you know the subject when you're clearly a jackass.

Dec 8, 2012

Lol, this is the most noob question I've ever heard. First of all, the only thing you stand to lose is the premium you paid for the option. Second, say in your example the the option matures in one month. If you buy the stock, you have tied up your capital 3200 for a whole month. In the case of the option, you are only tying up 100 dollars for the month, and even if the option doesn't cash settle and you need to physically settle it, you are only buying the stock for 3500 dollar on the date of maturity, a month later, and then you can sell it right away. So if you want to measure rate of return based on the capital used to buy the stock (and not the option in the option case), your annualized return is still considerably higher in the case of the option. 3200 --> 4000 in a month vs 3500--> 4000 in a few seconds.

Dec 8, 2012

ok thanks guys. Appreciate the input.

"Look, you're my best friend, so don't take this the wrong way. In twenty years, if you're still livin' here, comin' over to my house to watch the Patriots games, still workin' construction, I'll fuckin' kill you. That's not a threat, that's a fact.

Dec 8, 2012

Yes. Way more difficult than buying shares of a stock. I do not recommend trying to trade options until you have read quite a few books on the subject. Try to use a mock trading account to see with your own eyes how they work. Also, do not trade options until you understand the entry, the target, and most importantly the STOP. Buying & selling shares of stocks/bonds is very different compared to options.

Dec 8, 2012

Options are an entirely different ball game compared to stocks. I mean by their definition they derive their value from the movements in value of something else. That fact alone means that you have to have both an understanding of the underlying securities value as well as the value of the option itself. That isn't to say you have to be an expert on the underlying stock, but there are certainly more factors to consider when trading options. As far as easy/hard compared to anything else, trading is not easy. Period. If you begin believing a strategy is easy you will get blown out quickly. It is just as important to learn how to trade as it is to learn the product you are trading. Just because you are a stock valuation genius does not mean you can trade stocks. Same goes with Options, Bonds etc.

I usually trade options to take advantage of mispricings due to headline risk or really strange situations where I deem there is asymmetrical risk in one direction or another. The issue with options is that you not only need to get the direction right but you also need to get the timing right. One without the other many times leaves you with less money than you started with. I think to trade options successfully you need to get away from text book theory and trade them. Start out small with 1 contract or even paper trade them. Even if you assume you will lose 100% of what you start with it is a cheap lesson.

Dec 8, 2012

I agree with Jbone, It is very important to have the fundamental knowledge of investment before trading at marketplace.

Dec 8, 2012

I've been working with equity options for many years now (started in a grad program at a BB, now still doing options many years on...)
It's pretty straight forward, you have to think of only one thing: volatility. You buy or sell vol, and you usually make money by selling vol, sometimes it blows up in your face; you wait a year or two and just raise money for a new fund and ride the wave until the next crisis! Buying options is for mugs, you just piss premium away.

Jokes apart; the problem is you are playing against very large dudes in the market - and they know a lot more than you do. You can get carried out very easily.

I am a bit tired and just rambling on, but stick with me.

You buy an option for $10, you can potentially make another $10 if you are lucky making a profit of 100%, or you can lose the whole premium which happens very often and your loss is 100% in this case.

Options are a very dangerous animal, i've seen a fair share of funds blowing up having worked throughout the last major subprime crisis.

Just stay away - buy stocks for a start. When you are confidant enough start overwriting your PA to monetize it a bit. If you are sure enough about a stock and it's timing, buy an option then; but only after having invested a lot of your money on the stock market first.

Dec 8, 2012

Apparently a great way to make money from options is to bet against Cramer: http://online.barrons.com/article/SB123397107399659271.html#articleTabs_article%3D2

Dec 8, 2012

That's my strategy for stocks anyways ;)

"Hold on a sec...you mean they made all this money without doing IB --> PE --> HBS --> PE --> God?
How is this possible?!?!?!!??" - TheKing

Dec 8, 2012
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Dec 8, 2012
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I win here, I win there...

Dec 8, 2012