Why Trade Options?

Why Trade Options?• With options, a trader can limit and

define their risk

• Options give a trader increased leverage

• Options offer a trader more tools to manage their position or portfolio

To understand how options limit and

define risk, you need to understand some

options basics:

What is an Options Contract?

What is an Options Contract?

An agreement where the buyer, who has paid a premium, has the

option of exercising the agreement and where the seller, who has received a premium, can be

required to fulfill the agreement.

Two types of Options:

Calls and Puts

Call Option: An agreement that gives the buyer

the right, but not the obligation, to buy a specified amount of a stock or futures contracts at a specified price within a specific time period.

Put Option: An agreement that gives the buyer

the right, but not the obligation, to sell a specified amount of a stock or futures contracts at a specified price within a specific time period.

•Specified Price: The Strike Price –the price the where the option will be exercised

•Specific Time Period: The Expiration Cycle – the time between when the option is traded till the time it expires during which the option can be exercised

Option Basics

•Expiration Cycle: Every stock option contract has a date which signifies the month it expires. The contract will then expire on the third Friday of that month. Options on futures expiration depend on the expiration date of the underlying futures contract.

Option Basics

• Contract Size, Stock Options: One stock option contract represents one-hundred shares of the underlying stock. Quoted prices represent cost per share.

• Contract Size, Options on Futures: One options on futures contract represents one futures contract. Quoted prices vary per futures contract.

Option Basics

•Premium: The price of an option

•Options Buyers: Pay premium which is their total risk, have greater profit potential, and have the right to exercise the option

•Option Sellers: Receive premium which is their maximum profit, have greater risk, and are subject to assignment

Option Basics

Option Basics•Exercise: When the owner of a put or call

(a Long position) exercises their right to buy (in the case of a call) or sell (in the case of a put) the underlying instrument.

•Assignment: When someone holding a short position is randomly assigned to sell (when short a call) or buy (when short a put) the underlying instrument. This can occur anytime before the option expires.

•At-the-Money (ATM): Any option, a call or a put, where the underlying instrument is trading right at its strike price

•Out-of-the-Money (OTM): A call whose underlying instrument is trading below its strike price or a put with the underlying trading above its strike price

• In-the-Money (ITM): A call whose underlying instrument is trading above its strike price, or a put with the underlying trading below its strike price

Option Basics

ATM, ITM, & ITM

With XYZ at any price below 60, our 60 call is OTM. At any price above 60, it is ITM. And at 60 it is ATM.

ATM, ITM, & ITM

With XYZ at any price above 60, our 60 put is OTM. At any price below 60, it is ITM. And at 60 it is ATM.

•Intrinsic Value: Any part of an option’s premium that reflects current cash value

•Time Value: The portion of an option’s premium that does not represent current cash value

Option Basics

Intrinsic and Time Value

The chart on the left shows an In-the-Money call position with 2.00 worth of intrinsic value and 2.50 worth of time value.

The chart on the right shows an Out-of-the-Money call position that has only 1.50 worth of time value.

Intrinsic and Time Value

The chart on the left shows an Out-of-the-Money put position with 2.00 worth of time value and no intrinsic value. The

chart on the right shows an In-the-Money put position with 3.00 worth of intrinsic value and 1.00 worth of time value.

How do options increase leverage ?

•In January Buy 200 shares of XYZ @ 58 = $11,600

•If XYZ goes to 82 in July

•Profit is $4,800 (24 x 100)

•APR of 82% !

Buying Calls vs. Buying Stocks

-With a 24 Point Increase

• Buy 10 XYZ July 65 Calls @ 3.00 in February

• 10 x 100 (shares per call) = 1,000 x 3 = $3,000 for options on 1,000 shares

• If XYZ is @ 82 on July expiration, July 65 Calls are worth 17 (intrinsic value)

• 17 x 1,000 = $17,000 – 3,000 = $14,000 profit

• APR of 330% !!

Buying Calls vs. Buying Stocks

-With a 24 Point Increase

•Buy 200 shares of XYZ @ 58 = $11,600

•If XYZ goes to 34 in July

•Loss is $4,800 (24 x 200)

Buying Calls vs. Buying Stocks

-With a 24 Point Loss

•Buy 10 XYZ July 65 Calls @ 3.00 in January

•10 x 100 (shares per call) = 1,000 x 3 = $3,000 for options on 1,000 shares

• If XYZ is @ 34 on July expiration, July 65 Calls are out-of-the-money and worthless

•Loss is the$3,000 paid in premiums

•$1,800 less than the outright stock purchase

Buying Calls vs. Buying Stocks

-With a 24 Point Loss

•10 XYZ July 50 Puts @2.50

•10 x 2.50 x 100 = $2,500

• If XYZ expires @ 34, XYZ July 50 Puts are worth 16

•16 x 100 x 10 = $16,000 –2,500 = $13,500

•APR of 168!

Buying Puts vs. Shorting Stocks

-With a 24 Point Loss*

*(A good thing with puts)

•Buy 10 XYZ July 50 Puts @2.50 ($2,500)

•Short 200 shares of XYZ stock @ 48

•If XYZ goes to 82 we lose $4,800 on our 200 shares short stock sale (plus margin calls)

•If XYZ goes to 82 on expiration, XYZ July 50 Puts expire out-of-the-money and worthless, costing us $2,500

Buying Puts vs. Shorting Stocks

-With a 24 Point Gain*

*(A Bad thing with puts)

How do options offer a trader more tools to

manage their position or portfolio

“The fact nevertheless remains that this financial revolution has effectively divided the world in two: Those who are (or can be) hedged, and those who are not (or cannot be). You need money to be hedged. Hedge funds typically ask for a minimum six or seven figure investment and charge a management fee of at least two percent of your money (Citadel charges four times that) and 20 percent of the profits. That means that most big corporations can afford to be hedged against unexpected increases in interest rates, exchange rates or commodity prices. If they want to, they can also hedge against future hurricane or terrorist attacks by selling CAT (catastrophe) Bonds and other derivatives. By comparison most ordinary households cannot afford to hedge at all, and would not know how even if they could. We lesser mortals still have to rely on the relatively blunt and often expensive instrument of insurance policies to protect us against life’s nasty surprises; or hope for the welfare state to ride to the rescue.”

Many traders when first exposed to options

trading, simply buy and sell puts and calls

There is much more to trading options

than that.

For more information on our options and futures program, Contact:

RoyAlford@thechicagoschooloftrading.comor call us, toll free @ 312.242.1621