All About Options
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Diagonal Spread
A diagonal spread combines in short near-month option with a long later-month option of the same type, puts or calls, for the same underlying stock.
Whereas diagonal spreads are composed of different expiration dates and different strike prices, a calendar spread is composed of two options of the same type, puts or calls, for the same underlying stock with the same strike price, but different expiration dates.
So then, calendar spreads are embedded within a diagonal spread, but are not diagonal spreads by themselves.
The purpose of this strategy is for one option to hedge the risk of the other. When the short option expires at-the-money you keep the premium gained when you sold the option. If volatility rises, as the long call nears expiration, the intrinsic value of the long call will increase further, increasing the profit of the trade.
Use this strategy when you expect the underlying security to make a rapid move in the direction of the spread’s near-month short strike, but not further. By doing this, you give yourself room to enable a substantial roll credit based on time-value differential when you buy to close the near-month short option and sell to pen a later-month short option.
Spreads in general are best used when you are looking to participate in the dominant trend of the underlying with less capital than straight ownership of the underlying.
A call diagonal is described here, but a diagonal put works equally well when you're bearish longer term. A diagonal spread is more aggressive than a straight vertical spread, but offers a potentially higher return from selling additional time value through roll credits.
A diagonal spread combines in short near-month option with a long later-month option of the same type, puts or calls, for the same underlying stock.
Whereas diagonal spreads are composed of different expiration dates and different strike prices, a calendar spread is composed of two options of the same type, puts or calls, for the same underlying stock with the same strike price, but different expiration dates.
So then, calendar spreads are embedded within a diagonal spread, but are not diagonal spreads by themselves.
The purpose of this strategy is for one option to hedge the risk of the other. When the short option expires at-the-money you keep the premium gained when you sold the option. If volatility rises, as the long call nears expiration, the intrinsic value of the long call will increase further, increasing the profit of the trade.
Use this strategy when you expect the underlying security to make a rapid move in the direction of the spread’s near-month short strike, but not further. By doing this, you give yourself room to enable a substantial roll credit based on time-value differential when you buy to close the near-month short option and sell to pen a later-month short option.
Spreads in general are best used when you are looking to participate in the dominant trend of the underlying with less capital than straight ownership of the underlying.
A call diagonal is described here, but a diagonal put works equally well when you're bearish longer term. A diagonal spread is more aggressive than a straight vertical spread, but offers a potentially higher return from selling additional time value through roll credits.
Bear Call Credit Spread
A bear call spread combines a short, lower strike price call and a long, higher strike price call expiring the same month. It creates a credit and replaces a short call with unlimited risk. Again, timing is important in the deployment of this strategy. This is a managed risk strategy with the goal of producing income. It is best applied when implied volatility (IV) is high and there are fewer than 45 days to expiration.
Straddle
A straddle combines a long call with a long put using the same strike price and expiration. It is created when volatility is low and expected to increase and gains when prices move strongly up or down. This is a useful strategy to set up before an important announcement such as earnings or key economic report release. It may be used with an underlying stock in the former scenario and with an ETF in the latter. Because there are two long options, exit the position with 30- days to expiration to avoid time-value decay. The downside to this straddle is the potential for one leg of the trade to move while the other side does not. In order to make this strategy work, it is best to use an underlying that is known to be very volatile in response to events.
Call Ratio Backspread
A call ratio backspread combines long higher strike price calls with a lesser number of short lower strike calls expiring the same month. It is best implemented for a credit and is a limited-risk, potentially unlimited reward position that is most profitable when a strong bullish move far above and beyond the short called strike occurs. It is the least profitable when a small bullish move occurs to the long call strike, but no further. This is an advanced strategy that should be paper traded and carefully analyzed many times before putting it on in real time.
Put Ratio Backspread
A put ratio backspread combines long lower strike price puts with a lesser number of short higher strike puts expiring the same month. It is best implemented for a credit and is a limited risk—limited, but a potentially high-reward position. It is most profitable when a strong bearish move far below and beyond the long put strike occurs. It is released profitable in a small bearish move occurs to the long put strike, but no further. As with its call counterpart, study this strategy carefully before deploying it.
Long Put Butterfly
A long put butterfly combines a bull put spread and a bear put spread expiring the same month for a debit. The two short puts have the same strike price and make up the body. The two long puts have different strike prices (above and below the body) and make up the wings. Time decay helps the trade.
A bear call spread combines a short, lower strike price call and a long, higher strike price call expiring the same month. It creates a credit and replaces a short call with unlimited risk. Again, timing is important in the deployment of this strategy. This is a managed risk strategy with the goal of producing income. It is best applied when implied volatility (IV) is high and there are fewer than 45 days to expiration.
Straddle
A straddle combines a long call with a long put using the same strike price and expiration. It is created when volatility is low and expected to increase and gains when prices move strongly up or down. This is a useful strategy to set up before an important announcement such as earnings or key economic report release. It may be used with an underlying stock in the former scenario and with an ETF in the latter. Because there are two long options, exit the position with 30- days to expiration to avoid time-value decay. The downside to this straddle is the potential for one leg of the trade to move while the other side does not. In order to make this strategy work, it is best to use an underlying that is known to be very volatile in response to events.
Call Ratio Backspread
A call ratio backspread combines long higher strike price calls with a lesser number of short lower strike calls expiring the same month. It is best implemented for a credit and is a limited-risk, potentially unlimited reward position that is most profitable when a strong bullish move far above and beyond the short called strike occurs. It is the least profitable when a small bullish move occurs to the long call strike, but no further. This is an advanced strategy that should be paper traded and carefully analyzed many times before putting it on in real time.
Put Ratio Backspread
A put ratio backspread combines long lower strike price puts with a lesser number of short higher strike puts expiring the same month. It is best implemented for a credit and is a limited risk—limited, but a potentially high-reward position. It is most profitable when a strong bearish move far below and beyond the long put strike occurs. It is released profitable in a small bearish move occurs to the long put strike, but no further. As with its call counterpart, study this strategy carefully before deploying it.
Long Put Butterfly
A long put butterfly combines a bull put spread and a bear put spread expiring the same month for a debit. The two short puts have the same strike price and make up the body. The two long puts have different strike prices (above and below the body) and make up the wings. Time decay helps the trade.
RATE OF RETURN
According to page 63 of Michael C. Thomsett’s book Getting Started in Options, one is guided by the rate of return in all investments. (The book was borrowed from the library, since there's no way in the world I’m going to pay money to carry out what I anticipate will be a totally unnecessary process of educating myself with respect to options, due to the very real prospect of my making more money trading Forex than I am even now imagining—God willing—resulting in little motivation to choose options as a means of diversification.)
In a single transaction involving one buy and one sell, rate of return is easily calculated. One need simply divide the net profit (after trading fees) by the total purchase amount (including trading fees) and the resulting percentage is the rate of return.
But when selling options, the rate of return is more complicated. The sale precedes the purchase, so rate of return is not as straightforward as it is in the more traditional investment. I am therefore jumping to page 165 in the book to see what the it has to say about calculating rates of return when writing calls.
Apparently, I would have three potential sources of income as a covered call writer:
I am too busy to look at the example right now, so I will simply copy it for the time being, and then return to analyze it more closely later when I have the time. Here is the example...
Double-digit Returns:
You bought 100 shares of stock and paid $32 per share. Several months later, the stock’s market value rose to $38 per share. You wrote a March 35 call, and received 8. Your reasoning: the original basis in the stock was $32, and selling the call discounts that basis to $24. If the call were exercised, you would be required to deliver the shares at $35, regardless of current market value of those shares. Your profit would be $1,100 it that occurred, a return of 34.4%.
The option premium at the time you sold contained 3 points of intrinsic value and 5 points of time value. If the stock’s market value remained at the same level without exercise, that five points eventually would evaporate and the call would be closed to purchase at a lower premium.
If the stock’s market value were to rise far above the striking price, you would still be required to deliver shares at the striking price upon exercise; the potential future gain would be lost. By undertaking this strategy, you exchange the certainty of a 34.4% gain for the uncertainty of greater profits later, if they materialize.
According to page 63 of Michael C. Thomsett’s book Getting Started in Options, one is guided by the rate of return in all investments. (The book was borrowed from the library, since there's no way in the world I’m going to pay money to carry out what I anticipate will be a totally unnecessary process of educating myself with respect to options, due to the very real prospect of my making more money trading Forex than I am even now imagining—God willing—resulting in little motivation to choose options as a means of diversification.)
In a single transaction involving one buy and one sell, rate of return is easily calculated. One need simply divide the net profit (after trading fees) by the total purchase amount (including trading fees) and the resulting percentage is the rate of return.
But when selling options, the rate of return is more complicated. The sale precedes the purchase, so rate of return is not as straightforward as it is in the more traditional investment. I am therefore jumping to page 165 in the book to see what the it has to say about calculating rates of return when writing calls.
Apparently, I would have three potential sources of income as a covered call writer:
- Call premium
- Capital gain on stock
- Dividend
I am too busy to look at the example right now, so I will simply copy it for the time being, and then return to analyze it more closely later when I have the time. Here is the example...
Double-digit Returns:
You bought 100 shares of stock and paid $32 per share. Several months later, the stock’s market value rose to $38 per share. You wrote a March 35 call, and received 8. Your reasoning: the original basis in the stock was $32, and selling the call discounts that basis to $24. If the call were exercised, you would be required to deliver the shares at $35, regardless of current market value of those shares. Your profit would be $1,100 it that occurred, a return of 34.4%.
The option premium at the time you sold contained 3 points of intrinsic value and 5 points of time value. If the stock’s market value remained at the same level without exercise, that five points eventually would evaporate and the call would be closed to purchase at a lower premium.
If the stock’s market value were to rise far above the striking price, you would still be required to deliver shares at the striking price upon exercise; the potential future gain would be lost. By undertaking this strategy, you exchange the certainty of a 34.4% gain for the uncertainty of greater profits later, if they materialize.
I just checked out Tasty Trade and could barely stomach their introductory video. It stated that the second video was on buying stocks, which I already did for two or three years between 2007 and 2010, so I think I'll pass on using their website.
I tried Option Alpha next, but after entering information on two different web pages I was still unable to access the first course. I probably needed to go to my email and click on a link or something, but I actually have other work to do, so I'm just going to skip it and get busy on what I already have planned for this morning.
When I have time to look into options further, I'll just go back to the library books I checked out, where I can immediately key in on the information in which I'm interested without any hassles.
At least for the time being, I’ve decided the way I want to go about educating myself with respect to options trading is to go through the examples provided in Thomsett's Getting Started in Options book one-by-one, so I'll return to the one I copied in a previous post a little later.
But even still, I'll have to do a bit of detective work for myself. For instance, in one of the initial examples, "EQUITY FOR CASH," Thomsett writes...
“You purchase 100 shares at $27 per share, and place $2700 plus trading fees into your account. You receive notice that the purchase has been completed. This is equity investment, and you are a stockholder in the Corporation.”
Perhaps I am reading what Thomsett wrote incorrectly, but if not, this is crazy!!!
You are not going to purchase 100 shares, and then afterward, place the money in your account. You're going to have to place the money in your account first, and then you will have it available to purchase the shares.
I don't understand why the example was written the way it was. That doesn't make any sense to me logically. The sequence is illogical. If this is indicative of the way the rest of the examples are written, I'm probably going to end up rewriting all of them in a manner I feel is more rational.
That said, I'm going to start with this one...
PROFITABLE DECISIONS:
You decided two months ago to buy a call. You pay the option price of $200, which entitle you to buy 100 shares of a particular stock at $55 per share. The striking price is 55. The option will expire later this month. The stock currently is selling for $60 per share, and the option’s current value is 6 ($600). You have a choice to make: you may exercise the call and buy 100 shares at the contractual price of $55 per share, which is $5 per share below current market value; or you may sell the call and realize a profit of $400 on the investment, consisting of current market value in the option of $600, less the original price of $200. (This example does not include an adjustment for trading costs, so in applying this and other examples, remember that it will cost you of being each time you enter an option transaction and each time you leave one. This should be factored into any calculation of profit or loss on an option trade.)
If the current value is 6, I suppose the original value was 2, though I am not sure since the author appears to change the phrasing or terminology he is using.
So why doesn't the example include some hypothetical trading costs? Without any, it is of less practical value to me. So I guess I will have to rewrite it, inserting some hypothetical costs on my own.
Also, the stock price and the striking price are both cited as being $55. I would've thought the strike price would be higher than the stock price, and that making a profit would depend on the price of the stock rising to match the striking price, and then keep climbing above that in order to go beyond the premium added on top.
Also, the example doesn't mention a premium. It just talks about the call price. So, I'm going to have to go back, establish a standard vocabulary of terms with matching definitions, and then rewrite all the examples so that the language stays consistent.
So as soon as I finish creating my personal options glossary, I will return to this first example.
(I can't imagine why someone like me would exercise the option as opposed to just pocketing the profit while [still] available.)
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How generous you are with your posts...
Rather than create my own glossary, I'm just going to paste this list from the National Stock Exchange of India Ltd. given that, in looking it over quickly, it seems to clarify all of the issues I have run into vocabulary-wise so far.
I'll take a closer look at it later and make any adjustments/modifications as necessary as I learn more about this topic:
OPTION TERMINOLOGY
- Index options: These options have the index as the underlying. In India, they have a European style settlement. Eg. Nifty options, Mini Nifty options etc.
- Stock options: Stock options are options on individual stocks. A stock option contract gives the holder the right to buy or sell the underlying shares at the specified price. They have an American style settlement.
- Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.
- Writer / seller of an option: The writer / seller of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.
- Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price.
- Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.
- Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.
- Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.
- Strike price: The price specified in the options contract is known as the strike price or the exercise price.
- American options: American options are options that can be exercised at any time upto the expiration date.
- European options: European options are options that can be exercised only on the expiration date itself.
- In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cash-flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.
- At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash-flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price).
- Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cash-flow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.
- Intrinsic value of an option: The option premium can be broken down into two components - intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max[0, (St — K)] which means the intrinsic value of a call is the greater of 0 or (St — K). Similarly, the intrinsic value of a put is Max[0, K — St],i.e. the greater of 0 or (K — St). K is the strike price and St is the spot price.
- Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option's time value, all else equal. At expiration, an option should have no time value.
Hey BlueWaterSailor,
Thank you for this post; it was informative and got me very excited. I am getting my feet wet with options/futures right now, and I am scouring ET and other places to try to find a good resource to start my learning. As is the norm in this age, there is a mountain of information out there, some great, some terrible. This post is definitely on the great part of the spectrum. I won't try to claim I am Expiated in terms of ability to learn, but I am dedicated and fascinated by this world. I am currently working my way through some of the free CME educational pieces, but I worry they are almost a little too introductory, and I could spend my time more effectively if I were using a different jumping-off point.
You mentioned that you mentioned (lol) sites above, but I can't seem to find the ones you referenced? I was hoping you could direct me towards some useful resources for building up enough of a knowledge base to be able to start doing some sim trading. I am in a position right now where I can dedicate a significant amount of time to learning this market.
Thanks again for your post.