A Primer on Options – Part 2

Before I start this post, a reminder to all that the first round of the 2008 Formula One season goes off this weekend. It will take place in the wee hours of the morning for those of us in north America so you might want to record it! I hope some of you get to enjoy it.

This week I am going to expand on the options example I started last week. I will start by focusing on the profitability of the two options I started with last week and then will discuss a bit about what are referred to as “The Greeks”.

Let’s start with a look at a long call. Last week I looked at the Mar $30 for YHOO trading at 0.34 per share ($34 per contract as each contract controls 100 shares). The option buyer will pay $34 for the right to buy 100 shares of YHOO for $30.00 on or before the third Friday of March. Assuming for the moment that they intend to hold until expiration, the option buyer will make money as long as the stock closes above $30 plus the cost of the option ($30.34). Below $30, the option would be worthless at expiration (the holder could buy the stock in the market for less than $30 so would never exercise). So what does that mean? At any price below $30, the option expires and the buyer loses 0.34 per share. Above $30, the option holder has incentive to exercise. For illustration, let’s assume that the stock closes at $35 on the third Friday. The option holder can exercise the option and buy the stock for $30 and immediately sell it for $35 making a $5 profit. Subtract from that the 0.34 that the option cost and the net profit (excluding commissions) is $4.66. A profit chart for the Mar $30 option is shown below. You can see that, the maximum loss is the cost of the option but the profit is unlimited. To the right of the strike price, the profit diagram looks pretty much like stock (although 0.34 lower).

Put contracts operate in reverse. Profit is achieved when the stock goes down. The $30 put that we looked at last week cost $1.85 so breakeven for the trade happens at $30 - $1.85 = $28.15. At any point below $28.15 the put buyer makes money. Above $30, the option expires worthless and the put buyer loses $1.85 per share. Assuming that the stock at expiration trades for a price of $25, the put buyer can buy the stock in the market for $25 and immediately sell it for $30, making a $5 profit. Subtract from that the $1.85 they paid for the option and the net profit is $3.15. The chart below highlights the profit profile of a long put.

These two brief examples show the profitability of options but also the leverage capabilities inherent in the tools. For a 25% move in the stock up (from $28-$35), the call buyer makes 1,370% ($4.66/0.34). But of course, buyers beware. Speculating in options can be very profitable but can also be very costly. If you are right, you win big but if you are wrong you lose 100%. The vast majority of options (something like 80%) expire worthless so you will be wrong a lot more than you are right when speculating (next week I will talk about how you can use options not as tools for speculation but for income and risk management)

The examples above focus on expiration date moves. But what about before expiration? If you buy YHOO Mar $30 calls for 0.34 and the stock moves up a dollar, what happens? This is where the “Greeks” come in. The Greeks refer to the Greek letters given to various derivatives (the calculus version of derivative not the stock market version). The Greeks are:

Delta – measures the rate of change of the option price for a given change in the underlying stock

Theta – measures the rate of change of the option value over time (remember that an option contract has two types of value – time and intrinsic value)

Gamma – measures the rate of change of delta, the second derivative of price sensitivity

Vega – measures the rate of change of the option value relative to the volatility of the stock

Rho – measures the rate of change of the options relative to the interest rate

Assuming a delta of 0.50, a $1 move in the stock would represent a 0.50 move in the option. As a general rule of thumb, an at the money option has a delta of 0.50.

I will cover the Greeks in more detail next week (although I know now that I will not do them justice) and how they can be used in hedging. I will also cover some basic option only strategies.

And before closing, a little bit of OPC (Other Peoples Content). A co-worker sent me this the other day. I hope you get a chuckle out of it.

Thanks for reading…