I get a lot of questions from readers who are looking to trade options on some of the various ETFs we discuss in this newsletter. (Important note: I welcome questions from readers, but please be aware that I am unable to provide individualized investing guidance via email.) Although a few of my trade recommendations earlier this year involved the use of options, I generally steer clear of them. Here's why:

• Options are difficult for many individual investors to understand and implement. I do not like to make recommendations in products that cannot be easily explained.
• When it comes to options trading, timing is everything. If you are long an option, then you must not only be correct about the direction of the underlying asset, but also about how quickly it will move. You also usually need to understand the movement what is known as "implied volatility" as well (see below for further information on this). 
• The bid/ask spread is much wider in options than in the underlying stocks/funds. For example, the difference between the price to buy or sell the Nasdaq-100 Trust (QQQ) is typically $0.01 for a $35.00 fund. The less-liquid ETFs have bid/ask spreads of just 20-50 cents. However, options typically have 5-10 cent spreads, but for contracts that might only be worth $0.10 to $1.00. That means that even a decent-sized move in the underlying stock in your favor may only garner you a breakeven position.
• Very few ETFs have liquid options. Bid/ask spreads will be even wider in illiquid options markets. Therefore, if you need to exit a position, it will be even harder if the market is not liquid.

DEFINITIONS
The owner of a call option has the right, but not the obligation, to buy or sell the underlying security at a specified price on or before a certain date (technically, the on-or-before is only correct for what are called "American" options, but those are the types of options traded on the major U.S. exchanges). This specified price is known as the strike price. Meanwhile, the last date on which the option holder can decide to exercise his right to buy the stock is known as the expiration date. The act of buying the underlying stock according to the call option holder's right is known as exercising, or calling, the option.

The person who sells the call option short is said to have written a call option. Many retail brokers do not permit clients to write options, and this is never permitted in a retirement account.

The buyer of a call option expects the price of the underlying security to go up. The seller, or writer of the call option expects the price of the underlying security to go down or to stay relatively flat.

Again, if you purchase a call option, it's not good enough to simply be correct about the underlying stock's direction. The stock's price must move higher before the option expires, and it must do so by enough to make your trade profitable.

Now let's shift our attention to put options. A put option holder -- the person who bought the put option -- has the right, but not the obligation, to sell a stock to the put option writer -- the person who is short the put option. The person who writes the put option expects the value of the underlying security to rise. The buyer of a put option expects the value of the underlying security to fall.

IN THE MONEY, OUT OF THE MONEY AND MAKING MONEY
A call option is said to be "in the money" if the price of the underlying security is above the strike price of the call. This means that the option has a value if exercised. A call option is said to be "out of the money" if the price of the underlying security is lower than the strike price. A put option is "in the money" if the underlying security's price is below the strike price. Meanwhile, a put option is "out of the money" if the price of the security lies above the strike price.

The current price of an option can be divided into two parts -- its time value and its intrinsic value. The intrinsic value of an option is that part of the option's price that is "in the money." Time value is the difference between the price of the option and its intrinsic value. It is the amount you pay for the possibility of future gains. There is an arbitrage relationship between interest rates, the stock's price and the value of an option.

Example 1:
Consider a QQQ call option with a strike price of $30.00. Now, let's say QQQ is trading at $32.00 and the price of the option is $3.00.

Intrinsic value of call option = price of stock – strike price.
In this example, the intrinsic value of a call option would be:
$32.00 - $30.00 = $2.00
If this number is negative, then the intrinsic value is $0.00.

Time value = price of option - intrinsic value.
In this case it is:
$3.00 - $2.00 = $1.00.

Example 2:
Consider a Microsoft (MSFT) put option with a strike price of $25.00. For the sake of this example, we'll say that MSFT is trading at $26.00 and the option costs $0.50.

Since this is a put option, the intrinsic value is the strike price – price of stock, or $25.00-$26.00. Since this is a negative result, the intrinsic value is simply $0.00.

The time value, as always, is the price of the option – its intrinsic value. In this case, it is $0.50 - $0.00, or $0.50.

As time marches on, an option's time value falls, all other things being equal. There is less time for the stock to move in your favor each day, so the time portion of the option's value falls. (Technically, this fall in time value is based on the fact that owning an option allows you to use interest rate leverage. You are essentially borrowing money to buy an option as opposed to a cash position in the underlying security. Part of the time value decay is then based on the daily interest you would have to pay if you held a cash position in the underlying security.) This loss of time value is known as time decay. Time decay accelerates as the time to expiration falls below 30 days.

Options that are substantially in the money -- when the stock is far above the call strike price (or well below the put strike price in the case of a put option) -- have relatively lower time values. This is because there is very little risk of the option expiring out of the money. In these cases, the price of the option tends to move almost penny for penny with the price of the stock.

IT'S ALL GREEK TO ME
You've probably heard all about the so-called options Greeks. These are measures that tell you a lot about the risk and reward of holding an option. We've already directly discussed one, though I did not name it. That is theta, and it represents time decay. It shows what percent of the time value of an option will disappear each calendar day going forward. This number grows as expiration approaches.

I alluded to another Greek term earlier as well: delta. Delta measures how much the price of an option will change based on a small change in the price of the underlying stock. It is always negative for a put option and it is always positive for a call option. For deep in the money options, delta tends to hover near 1.00 for a call and near -1.00 for a put. Delta can never be above one for a call or below -1.00 for a put, as the option cannot rise or fall by more than the change in the price of the stock, unless some other part of the value of the option changes (which I will discuss in a moment).

When an option is at-the-money (the price of the underlying security equals the strike price), its delta will be near 0.50 for a call and -0.50 for a put. This means that for every $1.00 change in the price of the underlying stock, the option's price will change by $0.50. Delta rises at an accelerating pace as the option becomes further in the money and falls at a decelerating pace as the option moves out of the money. Though you really do not need to know all that much about this, this price sensitivity is measured by a Greek term known as gamma.

Options that are significantly out of the money and have very little time to expiration will also have very small deltas, say 0.05 for a call or -0.05 for a put. That means that even a very large move in your favor in the underlying stock may not change the value of the option by much. A delta of 0.05 for a call would mean that if the stock rose by $1.00, the option's value would rise by only five cents! It is very rarely a good idea to purchase a deep out of the money option.

The final Greek term that I am going to discuss here is sigma. However, it is rarely ever called by its Greek name, but is usually referred to as implied volatility. In theory, implied volatility ought to have some relationship with how volatile the underlying security is (how much its price jumps around). However, at least in the case of options on stock market index futures, volatility tends to rise as the stock market falls, and tends to fall as prices rise.

Volatility is the one part of an option's price that is unique to the option. The other parts of an option's price: the underlying risk-free interest rate (this is beyond the scope of this article), the price of the underlying stock or security, the strike price and the time to expiration, are all affected directly by the value of the underlying security itself. However, changes in volatility can directly alter the value of an option -- even if nothing else changes. The higher the volatility, the more an option will cost.

For example, a call option on a fictional stock with a strike price of $105.00, a current price of $105.00, expiration in 22 days, and implied volatility of 17%, will cost $1.85. If the volatility jumps to 25%, even if the price of the stock does not change, the option's value would climb to $2.70.

Professional options traders do not purchase options by the cost of the option. Instead, the bid/ask is quoted in terms of volatility. So, in the example above, the bid/ask on the call option would not be, say $1.85/$1.95, but instead would be quoted as 17%/18%. Unfortunately, this "option" is not available to you and me!

SUMMARY
As you can see, understanding options is no simple task. I am sure that you will need to read and re-read this section several times. I once worked with a stockbroker who didn't really understand the importance of volatility. That probably explained why he never made money for himself, or his clients, when trading options!

Good trading!



Steven Poser
Editor
The ETF Authority
New York, NY

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