Options for the intelligent but inexperienced

Question

(Related to "Options for Dummies" and "What are some good options strategies...")

I've been an investor in stocks for the past 14 years and have the confidence that I know what I'm doing. (Not that I can beat the market, but that I know what I'm doing. :-) I'm a long-term investor, who sometimes but rarely sells after less than a year of ownership.

I would like to understand some practical issues in dealing with options as a strategy to reduce risk.

For a stock, I can read the S+P report and look at fundamentals like price/earnings ratio, earnings history, long-term debt, etc. and make my own estimate as to the likelihood of whether the market value of a stock will go up in the next few months/years (therefore decide to buy or hold), or down (therefore decide to sell or not buy). I can make my own estimate of value (with lots of uncertainty, but it's an estimate) and compare with the market value, and decide if I think the market is undervaluing or overvaluing.

I am considering buying put options, to protect my downside risk if the stock I own goes down, or buying call options, to protect my risk if I decide to sell or not buy a stock. (I do not want to get into short positions on options -- too much risk.) But I have no idea how to do the kind of finance analysis for options that I do for a stock.

• How would I decide what strike price and duration of option to buy? (e.g. if I own stock XYZ presently at $50/share, how would I decide whether to buy put options at $45 or $40, and 3 months vs 6 months?)

• How would I decide whether I think the market is overvaluing or undervaluing options?

• How would I decide how many options contracts to buy? (relative to the # of shares of the stock I would feel comfortable buying/selling)

Answer 1

Some thoughts on your questions in order,

• Duration: You might want to look at the longest-dated option (often a "LEAP"), for a couple reasons. One is that transaction costs (spread plus commission, especially spread) are killer on options, so a longer option means fewer transactions, since you don't have to keep rolling the option. Two is that any fundamentals-based views on stocks might tend to require 3-5 years to (relatively) reliably work out, so if you're a fundamental investor, a 3-6 month option isn't great. Over 3-6 months, momentum, short-term news, short squeezes, etc. can often dominate fundamentals in determining the price. One exception is if you just want to hedge a short-term event, such as a pending announcement on drug approval or something, and then you would buy the shortest option that still expires after the event; but options are usually super-expensive when they span an event like this.

• Strike: Strike price on a long option can be thought of as a tradeoff between the max loss and minimizing "insurance costs." That is, if you buy a deeply in-the-money put or call, the time value will be minimal and thus you aren't paying so much for "insurance," but you may have 1/3 or 1/2 of the value of the underlying tied up in the option and subject to loss. If you buy a put or call "at the money," then you might have only say 10% of the value of the underlying tied up in the option and subject to loss, but almost the whole 10% may be time value (insurance cost), so you are losing 10% if the underlying stock price stays flat. I think of the deep in-the-money options as similar to buying stocks on margin (but the "implied" interest costs may be less than consumer margin borrowing rates, and for long options you can't get a margin call). The at-the-money options are more like buying insurance, and it's expensive. The commissions and spreads add significant cost, on top of the natural time value cost of the option. The annual costs would generally exceed the long-run average return on a diversified stock fund, which is daunting.

• Undervalued/overvalued options, pt. 1: First thing is to be sure the options prices on a given underlying make sense at all; there are things that "should" hold, for example a synthetic long or short should match up to an actual long or short. These kinds of rules can break, for example on LinkedIn (LNKD) after its IPO, when shorting was not permitted, the synthetic long was quite a bit cheaper than a real long. Usually though this happens because the arbitrage is not practical. For example on LNKD, the shares to short weren't really available, so people doing synthetic shorts with options were driving up the price of the synthetic short and down the price of the synthetic long. If you did actually want to be long the stock, then the synthetic long was a great deal. However, a riskless arbitrage (buy synthetic long, short the stock) was not possible, and that's why the prices were messed up. Another basic relationship that should hold is put-call parity: http://en.wikipedia.org/wiki/Put%E2%80%93call_parity

• Undervalued/overvalued options, pt. 2: Assuming the relationship to the underlying is sane (synthetic positions equivalent to actual positions) then the valuation of the option could focus on volatility. That is, the time value of the option implies the stock will move a certain amount. If the time value is high and you think the stock won't move much, you might short the option, while if the time value is low and you think the stock will move a lot, you might buy the option. You can get implied volatility from your broker perhaps, or Morningstar.com for example has a bunch of data on option prices and the implied components of the price model. I don't know how useful this really is though. The spreads on options are so wide that making money on predicting volatility better than the market is pretty darn hard. That is, the spread probably exceeds the amount of the mispricing. The price of the underlying is more important to the value of an option than the assumed volatility.

• How many contracts: Each contract is 100 shares, so you just match that up. If you want to hedge 100 shares, buy one contract. To get the notional value of the underlying multiply by 100. So say you buy a call for $30, and the stock is trading at $100, then you have a call on 100 shares which are currently priced at $10,000 and the option will cost $30*100=3,000. You are leveraged about 3 to 1. (This points to an issue with options for individual investors, which is that one contract is a pretty large notional value relative to most portfolios.)

Answer 2

I strongly suggest you read up the Option Greeks. You can be right about a stocks price movement and still not make money b/c other factors come into play from time or volatility.

For a "free" option hedge you can look at collars. Buying puts and selling calls to offset the debit you pay for the transaction. Ex: AAPL is 115, You buy the 110 puts and sell the 120 calls. This gives you a collar around he current price. Your hedged below 110 and can still participate in upside move to 120.

Also look into time value. Time decays exponentially in the last 30 days. If you are long this hurts you, if you are short(selling) this is good. Be sure to take this into account.

Delta: relation of the option to the underlying stock move on a .01-1 scale, .50 is "normal." Deep in the money options have higher deltas. It is possible other factors can offset this delta move. This is why people will lose money on earnings plays even though they are right. EX: Say you buy an AAPL call at 120, earnings comes out and the stock goes to 121. Even though you are "in the money" your contract may still have less value than what you paid because of VOLATILITY collapse. The market place knows earnings move a stock and that is factored into the price of the options expected volatility.

As mentioned watch out for dividend dates. Always be aware of dividend dates and earnings dates and if your contract is going to cover one of these events.

Interest rates have an effect as well but since the Fed has near 0 rates there is little impact at the present. Though this could certainly change if the fed starts raising rates.

Research the Black Scholes Pricing model.

Whenever you trade always think about what the other guys is thinking. Sometimes we forget their is someone else on the other side of my trade that thinks essentially the exact opposite of me. Its a zero sum game.

As far as choosing strikes you can look at calculating the At THe money straddle to see if the options are "cheap"

[stock Price * Implied Volatility (for 30, 60, 90 days Depending on your holding period)* Sq root of days to expiration] / 19 (which is sq root of days/yr)

Add and subtract this number to the current stock price to give you an approximate 1 standard deviation of expected price movement. Keeping with our example. AAPL at 115, lets say your formula spits out a 6; therefore price range is expected to be 109 to 121 for the time period. Helpful for selling options, I would sell the 122 call or the 108 puts.

Hope this helps. Start small and get a feel for things.

Answer 3

Realize this is almost a year old, but I just wanted to comment on something in Dynas' answer above...

"Whenever you trade always think about what the other guys is thinking. Sometimes we forget their is someone else on the other side of my trade that thinks essentially the exact opposite of me. Its a zero sum game."

From a market maker's perspective, their primary goal is not necessarily to make money by you being wrong, it is to make money on the bid-offer spread and hedging their book (and potentially interalize). That being said, the market maker would likely be quoting one side of the market away from top of the book if they don't want to take exposure in that direction (i.e. their bid will be lower than the highest bid available or their offer higher than the lowest offer available). This isn't really going to change anything if you're trading on an exchange, but important to consider if you can only see the prices your broker/dealer provides to you and they are your counterparty in the trade.