How to Price and Trade Options - Sherbin Al

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the risk that our federal government cannot pay its debt. And that risk seems to be a bit higher of late.) As long as you are “paid” more than you perceive your additional risk to be, risk becomes your means of making money. In other words, you need to stop thinking of risk as something to be avoided and start embracing risk as your means of making money. It is half of the risk versus return trade-off that should play a part in every trade you make. By means of illustration, let’s look at the prospect of selling hurricane insurance. If I offered to pay you $4,000 to insure my $1,000,000 condominium on the coast of Florida when a hurricane is bearing down on it, would you do it? If you answered “Yes,” you may want to rethink your answer, or rethink taking up trading. But if I offered you the same $4,000 to insure my Chicago area home against hurricanes, you should jump all over the deal. In this case, the return was the same, but the risk differed. Now, if I offered you $900,000 to insure my Florida condo and $4,000 to insure my Chicago home, we have a different picture. Here we have differing risks for differing returns. Each of those insurance policies is different. Which is better? I would consider the Chicago home “free money,” or as close to free as could be. Chicago has never seen a hurricane to the best of my knowledge. But if I believe the chances of the condo being damaged are 50 percent and the amount of any damage exceeding $900,000 as being very slim, the condo might be the better “trade.” Even though the risk is higher, the return may be more than commensurate with the risk. The increased risk led the insurance buyer to pay too high a price, in your eyes. Of course, all risk is not good risk. The types and amounts of risk you take on in your portfolio should depend on your particular situation. Inputs to this decision include how old you are, how capable you are of withstanding drawdowns (and replacing those lost funds), how well you understand riskier trades, how much edge you perceive in the trade, and on and on. One powerful piece of information options tell you is how much risk the options market participants as a whole perceive in a given trade. So, you have millions of investors’ collective opinion at your disposal to aid you.

      Getting back to leverage, you don’t remember saying you wanted to borrow any money, do you? Maybe your credit rating is not up to snuff. Or maybe you just do not want to make those monthly payments. No worries! You have two means of achieving leverage with options without having to submit yourself to a credit check each time you borrow and without receiving those fat coupon books in the mail. First, when you open a margin or portfolio margin account, you are in fact setting up a mechanism for borrowing money. You do not even need to ask to borrow from then on. If you exceed the capital in the account, your broker will automatically lend you additional funds and charge your account only for interest on the amount utilized. How much can you borrow? You can borrow quite a bit, actually. We will look in more detail at that later.

      More to the point is that options are levered instruments in and of themselves. If you want to purchase 100 shares of GOOGL (Google) stock ($590) in your IRA (no leverage), you would currently have to come up with around $59,000. But for a mere $3,300, you could command the same 100 shares for the next 189 days, by purchasing a Mar 15 60 °Call option. Sure, the option has a different risk profile and profit and loss profile, but above a certain price ($633), you will fully participate in the stock’s upside. After those 189 days, you will either need to cough up the remainder of the money to hold the stock, or sell out your options to lock in your profit without ever having to come up with the additional money. Now, that’s leverage! Where else can you borrow that kind of money without a credit check? And have you tried to borrow money lately? Even my sister requires fingerprints and a full financial statement for me to borrow $20.

Going a bit deeper into what options leverage means to your returns, let’s say GOOGL stock moves up to $650 at expiration of the options. While it is true you will make more money with stock in this example, let’s examine the ROC (return on capital) for each trade (see Table 1.1).

TABLE 1.1 Return on Capital for Google Stock versus Call Options

      As you can see, the nonannualized ROCs for the two strategies are 10.17 percent for the stock purchase and 51.52 percent for the purchase of the call options. Quite a difference! And one that may make a trade in GOOGL possible, considering not everyone has $59,000 to plunk down for 100 shares of stock! This is the power of leverage that options provide. Multiply that power by the loan you automatically receive in your margin or portfolio margin account and you have the framework for some handsome returns!

Options Are a Decaying Asset

      You know the old saying that a new car loses 30 percent of its value the second you drive it off the lot? Though that might be exaggerated a bit, the concept is clear. Options are much like cars, though an at the money option’s depreciation starts out slow and accelerates the closer it gets to the end of its “life.” At least you can make use of cars while they depreciate, but you can’t drive your option to the store to buy a gallon of milk or a cup of yogurt. So, what good are options? To the owner of an option, its decay leads to a bit of impatience in hope of seeing your option grow in price before the decay “gets you.” But to the seller of the option who took on the risk of the short option, decay is their friend. So why would you ever purchase an option if you know it will decay away over time and serve no useful purpose while doing so? Well, options are not quite that simple. There are two parts to the value of an option, and they are called intrinsic value and extrinsic value. We will discuss this in more detail later, but for now, you need to know only that extrinsic value decays, whereas intrinsic value does not. So, back to the car analogy: Sometimes your option ends up in the junkyard and other times it becomes a collector’s item! It all depends on the option’s intrinsic value at expiration.

      One other point needs to be made about the decaying nature of an option. When you purchase an option, you are paying more than the option is (intrinsically) worth at that time. In other words, you are paying some premium (often called time premium or insurance premium) for the right the option provides. Let’s look at an example. Let’s say XYZ stock is trading for $48.50 and the $47 call is trading for $2.25. If you bought the call, exercised it immediately and sold the stock out you received from the exercise, you would receive $1.50 for your trouble, exclusive of fees. Let’s walk through this. When you exercise the $47 calls, you get to buy the stock for $47 and sell it out at the market price of $48.50. That means you keep $1.50. This is your intrinsic value. But you paid $2.25 for that call, so you are still out $0.75. This is the extrinsic value, or time premium, which you paid for. It is this amount of $0.75 that will decay away unless the stock rallies. And if you purchase an out of the money option, it is all extrinsic value by definition. This means that if you buy an option, your probability of profiting from it is less than 50 percent. So, why purchase it? A long option has limited loss (what you pay for it) and unlimited profit potential. Does that make it worth the money or should you be selling options instead? For the first part of that discussion, we will examine the nature of long and short options in a bit more detail. But there will be much more of this discussion to come later in the book!

Insurer or Insured?

      Have you ever wished you could make money like insurance companies do? Rather than paying for insurance each month, you could figure out how to collect enough premiums over time to pay for the catastrophic events that might occur plus a bit extra (or a lot extra) as profit? Or are you content to pay those premiums so you do not have to worry about things, even if it proves to be a bad financial decision? Once again, as we have discussed, every trade is about transference of risk. When you buy an option, someone is taking on your risk and collecting a fee for their trouble (much like you buying insurance). More often than not, that seller will be the one profiting from the transaction (much like an insurance company). And that profit maxes out at the premium you paid (and they collected). But at times, you get to cash in on your policy in a big way. So, over time, who comes out ahead? The answer is a definite, unqualified “It depends!” Wouldn’t it be nice if you could figure out the probabilities of an event occurring and its cost beforehand? Just like an insurance company utilizes actuaries to calculate the probabilities and costs of losses and sets premiums accordingly, option sellers do the same thing! But you may feel like you will never be able to figure that out. The math is daunting and the concepts beyond reach. Thanks to some incredibly powerful and easy-to-use software provided free of charge by a good broker, it is actually pretty easy! Thus, if a trader

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