where you learn new ways to understand the latest market trends, gain strategy insights, and learn from the experts.My name is Rod Mahnami and I’m grateful that you’ve given me this opportunity to join you on your investment journey.
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When it comes to trading and investing in the markets the advantages that options bring are numerous. The role options can play range from being an insurance product designed to limit or hedge risk. Or, as a capital management tool which allows you to hold synthetic stock positions at a fraction of the cost compared to buying the stock in the traditional way. Another incredible advantage that options offer is the ability to create cash flow from the investment. This can be use to supplement your lifestyle or reduce the cost of your investments. In fact, when it comes to this attribute, outside of perhaps real estate investing, nothing in the investing world can touch options. And, when comparing the multitude of challenges involved with real estate investing the ease of use that options bring to the table leaves real estate investing in the dust.
The cash flow creating characteristic that selling options provide is what drew me to them many years ago and, to this day, is one of my favorite things about this wonderful asset class. Learning the qualities that make up the option contract is the first step on the road to learning how to successfully use options for this or any of their many purposes and is the subject of this edition of Profit Talk.
Call & Put Basics
Let’s review the building blocks that make up every option strategy in existence. There are just two types of equity options. The two types are Call options and Put options. Just like stocks and futures, options can be purchased or sold short. Buying an option gives you the attributes associated with that particular option. Selling or shorting an option gives you the opposite characteristics that buying the particular option gives.
First up, let’s take a look at buying a Call option. A Call option is a financial contract between two parties, the buyer and the seller of the option. The buyer of the Call option has the right, but not the obligation to buy an agreed quantity of a particular equity, future, commodity or other financial instrument (the underlying) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price).
The seller (or "writer") is obligated to sell the particular equity, future, commodity or other financial instrument to the buyer if the buyer so decides. The buyer pays a fee (called a premium) for this right. When you buy a call option on a stock, you are buying the right to buy a stock at the strike price, regardless of the stock price in the future before the expiration date. The quantity of stock associated with a standard option contract is 100 shares.
The characteristics of a purchased or “long” Call option are:
All else being equal, the value of a long Call option rises and falls with the rise and fall of the underlying stock price. The long Call holder therefore gains the ability to participate in the upside movement of the stock. In it’s simplest description, owning a Call is like owning the stock. It is a “synthetic” way of doing so. It is considered a bullish strategy. Just remember Long Calls = Long Stock
The advantage to the long Call holder compared to the straight stock buyer is the greatly reduced cost and risk associated with holding the position. The cost of buying a Call is a fraction of what buying the equivalent amount of stock would be. This allows the option trader to use far less capital for the same investment. Plus, just like with stock, the amount of money used to purchase the option is the most that can be lost on the investment. So, this vastly reduced cost reduces the amount of money at risk in the investment by the same measure.
The disadvantage associated with buying a long Call compared to buying stock outright is in the time decay associated with a long option. All long options suffer from time decay. This means, all else being equal, the option value will fall everyday. This is because it has an expiration date and everyday that passes is a day closer to its inevitable end. This leads to time decay. The good news about this disadvantage is it can be overcome with a variety of techniques. When an option trader is interested in obtaining the benefits that long Calls provide they will use the technique that best fits the particular situation.
Selling a Call Option
A Call option can also be sold, or shorted. Shorting is what occurs when you sell an option, stock or future you don’t own. Shorting a Call option provides the opposite characteristics than buying the option does. For one, the short Call option value moves in the opposite direction of the underlying stock. As the stock goes up, the short Call position will incur losses. As the underlying stock goes down in price, the short Call option profits. It’s the exact opposite of being long the Call. If long Calls are like being long the stock, then short Calls are just like being short the stock. This make selling calls a bearish strategy on the underlying stock because the option value will fall with the stock price as the chance of exercise diminishes with the move. Just remember Short Calls = Short Stock
Let’s back up for a minute and remember how profit is made when trading. We are all familiar with the idea of buying low and selling higher for a profit. This is when a trader thinks the price is going up. They are bullish. In this case, they buy the asset first with the intent to sell it in the future at a higher price and then pocket the difference.
On the other hand you have the short trade. A trader shorts an asset when they have the opposite outlook as the bullish trader. The short trader thinks the asset is going to fall in price. They are bearish. The process involves selling the asset first with the intent of buying it back at a lower price and pocketing the difference. The short trade profits as the price of the asset shorted falls.
Short Option Time Decay Benefit
Short Calls can drop in price and therefore bring the position profit in two different ways.
The position profits when the stock price of the underlying falls because the chance of exercise also falls. In addition, the position profits as time passes. Remember the option will eventually expire, it is a decaying asset. The short option position benefits from this fact because every penny of lost value in the asset increases the difference between the sold or shorted price and the price at which they buy back the asset to close the trade. The trader gets to pocket the difference.
It doesn’t matter whether the value decrease in the option is from time passing or from the price of the underlying falling. The short seller wants the asset to fall as far and as fast as possible. The ideal price for the asset they sold is zero. All else being equal, everyday closer to expiration brings a lower value for the option, which means the P&L on the position rises.
Short Option Risk
The short Call option holds another characteristic that is opposite of the long Call. Remember, the Call option buyer has the right, but not the obligation to buy the stock at the strike price. They pay a premium for this right. The option seller receives that premium and is therefore obligated to supply the buyer of the Call the stock at the strike price should the buyer exercise the option. Upon exercise, if the account holding the short Call does not have the shares, the brokerage will provide the shares and the account will reflect being short the shares.
This makes the risk of a short call much different than a long Call. The long Call has no obligation just a right to buy the stock. The only thing at risk for the Call option buyer is the premium paid for the Call. The Call seller is synthetically short the stock shares. They are on the hook for providing shares they’ve already pledged to sell at the strike price. If they are short any shares, they have to buy shares to close the trade. Every penny higher in the stock brings more loss to the short stock position. This makes the risk unlimited.
Fortunately, there are a variety of techniques that can be used to mitigate or avoid this risk altogether. We’ll cover one method later in this Profit Talk issue.
In the Money | Out of the Money
The risk for loss, probability for profit and amount of time decay an option carries is greatly influenced by whether or not the option is in the money or out of the money and to what degree. Let’s look at the option chain so I can demonstrate this visually.
Here you see the option chain for FXE which is the Euro dollar exchange traded fund. (Figure 1) It’s currently trading for $101.08. The Call options with strikes above the current price are “out of the money” (OTM) Calls. (Figure 2) The Call options with strikes below the current price are “in the money” (ITM) Calls. (Figure 3) The options trading closest to current price are “at the money” options.
The buyer of the option has the right to buy the stock at the strike price. At expiration this right ends. Think about this, looking at this OTM option at the $102 strike price. (Figure 4) Would anyone exercise a right to buy a stock for $102 when it is currently trading for $101.08?. If so, they would be paying 92 cents more per share than they could buy it for on the open market. Nobody would ever do that. This makes the OTM option worthless on expiration. Any value OTM options contains is “time value” or extrinsic value based on the probability the stock will move up in price enough to give the option real, intrinsic value. (Figure 5) On expiration this probability ends for OTM options and all the time value contained in them evaporates.
The ITM Call options which are located below current price contain real, intrinsic value. (Figure 6) The in the money portion of the option is the intrinsic value. It’s the exercise value of the option. For example, the 100 strike Call gives the holder of the long option the right to buy the stock at $100 per share. The stock is currently trading for $101.08. The strike or exercise value is $1.08 lower than how much you can buy the stock for currently. This amount is the intrinsic value value of that option. It’s the difference between the current trading price and ITM strike price.
Take a look at the price the 100 strike Call option is trading for. It is currently trading for $2.46. (Figure 7) We know that the intrinsic value of the option is $1.08 but the option is actually trading for $2.46. The difference between the current selling price of the option and the intrinsic value of the option is the extrinsic value of the option. It is the time value portion of the option. In this case the extrinsic “time value” of the option is $2.46 - $1.08 = $1.38
To sum up OTM and ITM Call options. The OTM Call options are the strikes above current price and their value is 100% extrinsic (time value). The ITM Call options are below current price and contain both intrinsic and extrinsic value. Upon expiration, only intrinsic value remains.
Here’s some key takeaways for you concerning what was just explained. First, think about the goal of a short trade. The asset is sold first with hopes of buying it back at a lower price sometime in the future. Keeping this in mind, think about which strike type would offer the best chance for success when it comes to shorting them. The ITM or OTM options? The answer is the OTM options, which are made of pure extrinsic value and will expire worthless if still OTM at expiration. These strikes offer the highest probability for profit when short selling them. This means, when it comes to selling options for profit we always sell OTM options.
On the other hand, what about buying options, going “long” the option? The buy trade strategy we know profits from buying an asset at one price with hopes of selling at a higher price in the future. You typically would not want to buy something that was going to become worthless in the near future and that’s exactly what OTM do. This is why, when it comes to buying options, ITM options offer the highest probability for success.
A Put option is a financial contract between two parties, the buyer and the seller of the option. The buyer of the Put option has the right, but not the obligation to sell an agreed quantity of a particular equity, future, commodity or other financial instrument (the underlying) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The quantity of stock associated with a standard option contract is 100 shares.
What this means to an option trader is, the long Put option equals is the same short stock It’s the opposite of the Call. Buying a Call is like buying the stock. Buying the put is like shorting the stock.That’s because the Put contract gives the owner the right to sell the stock. It simply means, buying a Put makes you short the stock. Traders buy Puts on stocks when they are bearish, they think the stock is going down.
Just like with Calls, selling Puts provides the opposite directional exposure than buying Puts does. This makes selling Puts like buying stock. Selling Puts is a bullish strategy. It’s done when the trader thinks the stock is going up or sideways and profits from these conditions.
When referring to Put strikes, which are directionally opposite of Calls, the ITM options are in the strikes above current price (Figure 8) and OTM options are in the Put strikes below current price. (Figure 9)This means the intrinsic value follows. The intrinsic value is always contained in the ITM options. Intrinsic value for the Put is contained in the strikes above current price because owning the Put gives you the right to sell the stock at the Put strike price. Doing that would produce a profit from the difference between the current price and the strike price of the option. This is the intrinsic value.
The bottom line with intrinsic and extrinsic value is the exact same logic applies to both Puts & Calls. When buying an option as the strategy, always buy ITM options and when selling the option as the strategy, always sell OTM options. This is because you always buy intrinsic value and sell extrinsic value.
Put Contract Risk
The risk to a long Put option is the same as with any option you buy, Put or Call. The most a long option can lose is the price paid for the option. The long option has limited risk.
The short option is based on the obligation the option brings. In the case of the Put option, the obligation of selling the Put is you must buy the shares. The risk is the same as buying the shares at the strike price minus the credit. Those of us who enjoy buying and owning stock like this obligation. It offers a wonderful way of buying stocks, sectors, currencies, precious metals and other commodities at a discount.
Let’s go over the main takeaways from this lesson.
First, there are only two types of options in existence, Calls & Puts. Long Calls are like long stock. Long Puts are like short stock.
Second, selling the option provides opposite attributes from buying them. Short Calls=short stock and short Puts = long stock.
Third, with both Calls & Puts, when the option is the profit driver, meaning it’s not a hedge option or offset option, it’s the profit driver of the strategy, always consider the intrinsic and extrinsic value of that option. Use ITM options for buy strategies and OTM options for sell strategies.
Market Recap & Outlook
Last week’s outlook we talked about the hopes of some market weakness which may provide an opportunity to join the trend in the broad market. On Monday of last week the broad market S&P 500 was bumping up against a trend line. (Figure 10)The market managed to break above the briefly but has since fallen back. I would like to see it drop back to one of these demand zones here. Although, I liked the setup better last week when the trend 20 period moving average zone and the horizontal demand zone here lined up with one another. The market has since moved up, pulling the average with it. These horizontal demand zones act like magnets. (Figure 11) If price does drop back to the 20 period average zone (entry zone 1), there is a good chance it will bring a bit more weakness as buyers may not come in until price enters the horizontal zone (entry zone 2).
There is a bit of a physiological battle going on. The broad markets are at all time highs and the Dow Jones Industrial average is just below the 20,000. (Figure 12) These big round numbers attract price. It ran up to 19,983 and pulled back. There may be some push to test the 20,000 number before attracting enough sellers to bring prices down. It’s hard to look at the chart and not see what looks like an over extension of price. Remember, this is the Dow Jones, not NFLX or TSLA or something that. Look at that chart!
This week there are a few high impact government reports coming out. Monday the 19th Janet Yellen has a speech scheduled. The fed chair person speaking always has the potential to move the market, but I wouldn’t expect much from this speech. Thursday, the “Core Durable Goods Orders”, “Final GDP” and “Unemployment” numbers come out. If there is a surprise among any of them, the market will most likely react accordingly.
A Look Ahead
Looking ahead to next week's Profit Talk, we’ll build on what was covered in this edition by learning to apply a new strategy. This strategy was my first and is still one of my favorite strategies. I call it the “Bull Round Trip”. This is a great first strategy that will allows you to create cash flow on any market you apply it to. It’s easy to implement and manage, plus you’ll use much of the knowledge gained in this edition of Profit Talk.
I hope this has been helpful for you. If you have any questions or comments, please leave them below or reach out on social media. You can also email me directly with any questions or comments at firstname.lastname@example.org.
Thank you so much for being a Profit Talk subscriber. I look forward to joining you for next week’s edition of Profit Talk. Until next time keep trading and investing the Profit Effect way proven, consistent and stress free, just the way trading is supposed to be.