Options trading is regarded by many as a high-risk, high-reward investing strategy that can make or break fortunes almost overnight.  However, in my opinion, options are one of the most useful, misunderstood investment instruments for long-term buy-and-hold investors.  By adopting a conservative options writing strategy, a long-term investor can significantly reduce volatility in their portfolio, increase their portfolio’s yield, all without negatively impacting potential long-term returns.

Over the next few weeks, I’ll be producing a few articles on a number of useful options strategies for long-term buy-and-hold type investors.  However, before I get started on explaining actual options strategies, I will first spend some time giving background on options themselves.

Options Trading Overview:
Before diving into options trading, it is useful to gain an understanding of options trading terminology to simplify the process.  First and foremost, an options contract is a derivative instrument.  Though derivatives have got a bad rap from the financial meltdown, this simply means that an options contract has no value in and of itself, but rather derives its value from the price of the its underlying security.  Options can be traded on most established stocks, ETF’s, ETN’s, CEF’s and other security types listed on major exchanges.  However, as a point of caution, options are traded sparsely on many securities which can lead to wide bid-ask spreads.  A careful examination of the risk-reward profile in these situations coupled with the use of limit orders is recommended.

To simplify the discussion of options terminology, I have reproduced part of the option ‘chain’ for Microsoft Corp (MSFT) in Table 1 below.  This table was assembled November 22, 2010 when MSFT was trading at $25.57.

Table 1:  Partial MSFT ‘Call’ Option Chain as of November 22, 2010

The first column in Table 1 contains the option identification string.  This string contains most of the important information on the option contract itself and breaks down as follows:

• MSFT_101218C00026000:  The first letters in the identification string refers to the stock (or security) that this option contract refers to.  In this case, this option derives its value from the stock of Microsoft Corp. (MSFT)
• MSFT_101218C00026000:  The second set of numbers refers to the expiry date of the contract.  In this particular example, the contract expires on December 18, 2010.
  • Options are available with expiries from months to years in the future.  In each case the option contract will be associated with an expiration month.  Options expiry effectively occurs at the close of the markets on the 3^rd Friday of each month (December 17^th in this case) as Saturday is not a trading day.
• MSFT_101218C00026000:  The letter identifier after the expiration date identifies the options contract as either a call option (C) or a put option (P).  Calls and puts are the two types of options contracts that can be traded and will be discussed in more detail below.
• MSFT_101218C00026000:  The last set of numbers is the strike price of the contract.  In this case, it is $26.00 (the identifier carries three decimal places).
  • The strike price is the agreed upon price at which the stock will be bought or sold if the contract is exercised before it expires.  It also is the price that determines whether or not a contract can be exercised.

In dissecting the options identification string, the concepts of expiry, exercising options, strike price, and call and put options were raised.  I’ll come back to address these in a moment after finishing with Table 1.

The last two columns of the table provide the ‘bid’ and ‘ask’ prices.  This is the premium to either buy the contract (ask price) or sell the contract (bid price).  However, as each options contract represents 100 shares of the underlying security, the amount of money required to buy one contract at the $26.00 strike price is actually $0.34 (ask) x 100 = $34.

From the above example, it can be seen that buying options allows individuals to control a significant number of shares with minimal cash outlay ($34 vs. $2557).  This leverage allows options traders to generate massive gains (or losses) very quickly as price movements in the underlying security are amplified and reflected in the options price.  This serves as a warning to investors:  Make sure you completely understand any options trade that you enter into as the potential for permanent capital loss can be greater than investing in the equities themselves.

Options Terminology:
In the above section, the concepts of options expiry, exercising options, strike price, and call and put options, and an options premium were raised.  A lot of the discussion on these topics is linked, so I will address the various points throughout this section, though not necessarily in order.

1.)  Call Options
Calls options are one of the two types of options contracts available.  A call option gives the holder the right (not the obligation) to buy the underlying security (100 shares per contract) from the issuer at the strike price.  This right is granted for a fixed-period of time (until the expiration date is reached) and can only be exercised if the underlying security is trading above the strike price.

In Table 1, it can be seen that with MSFT trading at $25.57, the $25.00 calls could be exercised forcing the issuer to sell the buyer 100 shares of MSFT at $25.00 (which could then be sold at market for a profit of $0.57 per share).  As the strike price is below the stock price, this call option is said to be in-the-money.  Conversely, the $26.00 calls are considered out-of-the-money and cannot be exercised as the stock price is below the strike price.  However, as the expiry date is not for another few weeks (Dec. 17^th), the contract still has value in that MSFT may appreciate over that time to over $26.00 which would then cause the $26.00 calls to be in-the-money.

2.)  Put Options
Puts are the second type of option and function opposite to calls.  A put option gives the holder the right (not the obligation) to sell the underlying security (100 shares per contract) to the issuer at the strike price.  This right is also granted for a fixed period of time (until the expiration date) and can only be exercised if the underlying security is trading below the strike price.

Though I haven’t reproduced a put option table, puts are considered to be in-the-money if the strike price is above the stock price (as you can force the issuer to buy your shares at above the market price) and are considered out-of-the-money if the strike price is below the stock price.  Thus, for the MSFT example above, a $25.00 put would be out-of-the-money and could not be exercised whereas a $26.00 put would be in-the-money and could be exercised at the discretion of the holder.

3.)  Options Valuation
Based on the above discussion of calls and puts, it can be seen that the strike price of the option in relation to the underlying stock price is very important.  Additionally, the length of time before an option expires is important as the farther away the option is from expiry, the more likely that the underlying security can appreciate (or depreciate) adding value to the option.  These two concepts are linked and relate to the value of the option or its premium.

3a.)  Intrinsic Value
The intrinsic value of an option reflects the difference between the strike price and the current stock price.  It also represents the value of the option on the expiry date as options at expiry have no time value left.  Only options that are classified as in-the-money have intrinsic value.  Therefore, calls have intrinsic value only if the stock is trading above the strike price.  Similarly, puts have intrinsic value only if the stock is trading below the strike price.  By definition, if the stock price is equal to the strike price, the intrinsic value is zero.

The intrinsic value of a stock option is easy to calculate.  For calls, it is the greater of either zero or the stock price minus the strike price.  Correspondingly, for puts, the intrinsic value is the greater of either zero or the strike price minus the stock price.

3b.)  Time Value
The time value of an option is based on the remaining length of time before option expiry and the distance between the strike price and the stock price.  As the formula to calculate the time value for a given option is complex, it is most easily calculated by determining the intrinsic value of an option and subtracting that from the premium.  From Table 1 for Microsoft Calls, the time value of the $25.00 calls is calculated to be (0.89 – 0.57) = $0.32 whereas for the $26.00 calls it is $0.33 (as there is no intrinsic value).  Note that options right around the strike price tend to have the highest time value.  If I expanded the MSFT ‘call’ option Table, an in-the-money option at a $23.00 strike price would have a time value of only $0.06.  Similarly, an out-of-the-money option with a $28.00 strike price would have a time value of only $0.04.

One of the important things about time value is that it decreases as the option approaches the expiry date.  By definition, there is zero time value at expiry.  It is also important to note that the decay in time value is non-linear and speeds up as the option gets closer to expiry.  Due to this decay acceleration, options lose over 50% of their time value within the last two months before the expiry date.

Summary:
In the above sections, I outlined the two basic types of options as well as terminology commonly associated with options trading.  Building on this knowledge base, in the next few posts I will use the ideas presented above to outline a few relatively simple options strategies that can be successfully employed by long-term investors.  As options trading can be complex, any questions about the above terminology or options types can be left in the comments and I’ll try to provide clarification where needed.

Until next time,
Nathan @ EngineeringIncome.com

Disclaimer:
The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question.  The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past.  This is generally not true.  It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation.  For more information, please see my disclaimer.

Full Disclosure: Author is short MSFT calls and long MSFT stock at the time of this writing.