Options are nothing more than a derivative of a stock or stock index. Without an underlying security, an option would not exist. They do not trade independent of the specific security or index that they are attached to. When you understand how simple they work, you can use them to trade in the same way you trade with stocks. The difference is that the initial capital outlay is much lower. And you can set up a position to protect against downside price movements. Thus your risk can be substantially lowered.
For this instance, I will discuss buying options as an alternative to buying stocks. We are not concerned with converting our options into stock. We want to open(buy) a position and then close(sell) it hoping to make a profit as if we were trading the actual stock. Options come in two types: calls and puts. Buying a call is similar to buying stock. Calls are bought to take advantage of an upward move in price. Put options are used to take advantage of a downward move in price or as a hedge to protect an established call position.
Let’s get more specific and look at an example, FedEx Corporation. The stock symbol is FDX, and let’s say the price is around $100 a share. There will be listed options for this stock in $5.00 increments. Calls and puts will be available at $85, 90, 95, 100, 105, 110, and 115. These are called strike prices. There might also be strikes prices below $85 and above $115. Options are then classified as being in-the-money, at-the-money, or out-of-the-money. This table may help understand this concept:
Stock price ABOVE strike: in-the-money out-of-the-money
Stock price BELOW strike: out-of-the-money in-the-money
Stock price EQUALS strike: at-the-money at-the-money
The price that we pay for an option is called the premium. The premium will be made up of two components: intrinsic value and time value. Intrinsic value is the amount that the option is in-the-money. The time value will basically be higher for options that expire farther out into the future. Any out-of-the-money option has its premium based on time value only. One option contract will usually represent 100 shares of stock. Options do expire on a monthly basis. Usually, the third Friday of the month is the last day to trade stock options. Such as the September 2006 options will expire on September 15th.
Looking at FDX, we will assume the price is trading at $100 per share. A September 90 call option would be $10 in the money and cost about $1,100 for one contract. The intrinsic value is $1,000. The time value is $100. This is because the option won’t expire for a few weeks. For an October 90 call option, the intrinsic value will still be $1,000. But the time value will higher since there is more time until expiration. Thus, the option premium will be higher. This would be a deep in-the-money option. The September 100 call option would be at-the-money. The premium would be made up of time value only. The same would be true with the 105 or 110 call options, which are out-of-the-money.
In order to trade options like a stock, we need to use deep in-the-money positions. In this case, that would be the 90 call or even the 85 call. The measure of how much an option will change in value is called the delta. The value can range from 0 to 100. A deep in-the-money option will usually have a very high delta above 80. This in effect means that if the stock moves in price $1.00, then the option will move in price by 80 cents. We need to look for options that have a delta of at least 90. Preferably, a 95 or higher delta should be used. The delta will usually be higher with deeper in-the-money or a closer-to-expiration option.
The delta is basically a risk percentage. A delta of 97 would mean that an option has a 97% probability of ending in the money at expiration. Also, it will move in price 97 cents for each $1.00 move in the stock. This is not etched in stone because delta is also calculated to include the volatility of an option. Volatility is simply the up-and-down rate of price movement. Higher volatility means that the stock price fluctuates in a wider range over a period of time. Delta constantly changes as it can be calculated to four decimal places. The point is that we want to use the highest delta options to correlate to the stock’s price movement.
How do we save money? Buying 100 shares of FDX will cost $10,000 not including commissions. A high delta deep in-the-money option might cost $1,050 to $1,300. Like the FDX September or October 90 call. The September 85 call might cost $1,550 to $1,700. These prices will vary greatly according to how deep the option is in-the-money. And how far away it is until expiration.
Say you want to buy 100 shares of FDX stock for a short term trade of 3 to 8 weeks. It costs $10,000 to open the position and all of that amount would be at risk. Using a high delta option, you can make basically the same trade using roughly $1,700. You would buy the 85 October call with a delta of about 95. It would not expire until October 20th. The option will move the same as the stock. But you have reduced your risk significantly. You would have the remaining $8,300 of capital sitting in your account virtually risk free.
I haven’t talked about put options. But you could buy a put option as a hedge against your call. If for some reason FDX decides to fall in price, you would have some downside protection. The cost might be about $300 for an out-of-the money option like the October 95 put. Still, for about $2,000 you could set up a position that is similar to buying the stock. And at the same time protect yourself from any large drops in price. The majority of your capital remains available to make other trades.
You could also set up the reverse position if you thought that the stock would fall in price. Buy deep in-the-money puts for even less cost than the calls. Like the October 110 put for $1,600. Options give you a way to trade higher priced stocks. Also it is very easy to trade in both directions. Using higher delta deep in-the-money options reduces risk. I have just scratched the surface of option possibilities. There is no need to be afraid of using options to trade with. Once you get past all the fallacy and get to the facts, simple option combinations can be far more efficient than only trading the stock. Capital can be conserved and risk reduced. Take the time to explore options as a trading vehicle. You might be surprised to discover their true worth.