Stock Futures and Options

Fundamentals of Market Investing by Adam J. McKee

In a parenthetical note above, I mentioned that commodities are not the only thing you can trade in futures; you can trade stock futures as well.  Single Stock Futures (SSFs) are an agreement between two investors to deliver a specified number (usually in blocks of 100 shares) of a particular stock at a specified future time for a specified price.  A slightly different investment instrument is a stock option.  With a futures contract, you are required to deliver the goods or securities per the contract when the contract expires.  When you buy options, you are under no such obligation.  Options are in essence contracts that grant the right (but not the obligation) to buy or sell an underlying asset at a set price on or before a specific date.  The right to buy is called a call option, and the right to sell is a put option.

There are options for just about everything these days.  I joked with a colleague that we should start selling options contracts on the daily average temperature in Bemidji, Minnesota.  Hedge fund people could buy them in the summer and short them in the winter to show clients massive gains, and retail investors would take the opposite side of the trade so that they could show considerable losses in their trading accounts just before tax season, then gain their money back in the spring.  Most serious traders trade a limited, well-established basket of option types, often selecting only one that they attempt to master.  Here are some commonly traded option types:

 Stock Options:  As the name suggests, the underlying asset for these contracts are exchange-traded shares (stocks) of public companies.

Index Options:  These are very similar to stock options, but they have an entire index (e.g., the Dow Jones Industrial Averages, the S&P 500, the Nasdaq Composite, and the Russell 2000).

 Forex/Currency Options.  Just as stocks are traded on exchanges, so are currencies.  You can buy, for example, Euros with U.S. Dollars or U.S. Dollars with British Pounds.  The exchange rates vary on an ongoing basis (all of the time), and currency options allow the buyer to lock in a specific price.

 Commodity Options.  The underlying asset for this type of option can be the actual physical asset such as bushels of corn or barrels of oil, but most often, it is a futures contract for the underlying commodity.

The above options all represent similar mathematics for traders relying on probability and statistics for an edge, but the forces that drive markets tend to be largely different.  Because I am such a strong advocate of stocks as the foundation of retirement portfolios, it makes sense for the retail investor (investors that have day jobs that don’t involve financial markets) wishing to trade options to focus on trading stock options rather than any other type.

A requisite for trading any option is that you know how to trade the underlying security.  It is foolishness to buy Forex options if you don’t understand how those markets work and how to profit from such trades.  Trading index options is another related alternative.  You can also trade options on ETFs that mimic the indices (e.g., $SPY, $IWM, and $QQQ).  The advantage is that ETFs trade just like stocks, so you know how to trade the underlying as well as the options once you understand stock options trading.  They will follow the same rules that you already understand.

Note that these contracts trade on the open market much like stocks; you can sell them to another trader using trading strategies that are different from your own.  As a rule, you want to make sure to sell your options before they expire or you will return to your trading account Monday morning to find your options contracts gone and several hundred stocks in their place.  In other words, you have exercised your right to buy the stocks per the contract.  When you own an options contract that is “in the money,” your brokerage will exercise it for you so that you do not lose the value you have gained when your contracts expire worthless.  This is a double-edged sword, and something that you will rarely (if ever) want to happen.

As you’ve probably already guessed, the world of options trading has its own unique language, and some of the strategies and tools used by options traders are extremely difficult to understand if you are not a math savant.  Still, the basics of how they work are simple, and anyone can learn to trade basic options strategies.  The critical thing to understand about options is that they are by definition just contracts, and you are paying a price (called the premium) for those contracts.  All options contracts are for a specified period of time.  When they expire without being used, they become utterly worthless.

If you leave your GE stock sitting in your portfolio without paying attention to it, it will trade within a reasonably predictable range, and you will either profit or lose a small percentage.  With options, you will always lose money as time passes.  This “time decay” is a feature of options that you can’t afford to ignore.  To put it another way, you don’t invest in options, you trade them.

Why would you “invest” in something that always loses value as time passes?  There are many reasons, but the one most commonly cited by options novices is because of leverage.  Options are traded in blocks that represent 100 shares of stock.  Therefore, you can spend a small amount of money and capture the gains of a significant amount of stock—if the stock moves in the right direction!  If the cost of the underlying security goes against you, you can lose most or all of your money very, very quickly.

The mechanics of options trading is very similar to trading stocks.  A significant difference between stocks and options is that (as the name implies) you have many, many options representing a single underlying stock.  The reason for this vast array of different contracts that you can buy and sell is that different investors want different kinds of contracts.  The most noticeable difference between contracts is the strike price.

The strike price is the price of the underlying stock that is specified in the contract (you will never actually see a written contract; all exchange-traded contracts are standardized, and your broker will make you read the rules before you can trade options).  The strike price of a contract cannot change, and this is the benchmark by which movements in the underlying stock’s price are judged.

Recall that the two primary options types are calls and puts.  If you buy a GE call with a strike price of $20, you are betting that the cost of GE stock will rise above $20 before the expiration of the contract.  If you buy a GE put with a strike price of $20, you are betting that the cost of GE stock will fall below $20 per share before the contract expires.  Remember that if you get the direction of the bet wrong and let all of the contract’s time run out, it will expire worthless and you will have lost all of your money.

When considering options, it is important to realize that the price of an options contract has a value derived from two sources, both of which can have a value of zero.  When options traders talk about intrinsic value, they are talking about the money that you’d make if you exercised your option, took control of the stock, and immediately sold it.  In our above example where you bought a 20 GE call, if GE is trading at 21, your contract has an intrinsic value of $1.00.

You probably noticed that $1.00 doesn’t sound like much of again.  That figure is misleading and brings up another aspect of options trading that confuses the novice.  Recall that when you buy an options contract, you are buying the right (but not the obligation) to buy (call) or sell (put) a block of 100 stocks.  Since all of the figures concerning the contract are specified regarding a single share of a stock, you must multiply all dollar amounts by 100 to get the real profit and loss numbers.  For example, if our GE calls above are selling for $1.00, which means that the contract will actually cost you $100 to buy (plus brokerage commissions).

The other component of options prices is what some traders call extrinsic value.  Extrinsic value is also called time value because the number of days remaining in the contract is a crucial determinant of contract prices.  This makes sense because the more time that your stock has to move, the more likely it is that it will run in the direction that you predicted by the amount that you predicted so that you can make a hefty profit.  The less time you have, the less likely you are to win your bet.

A closely related idea that plays heavily into the extrinsic value of options contracts is “market speed,” most commonly referred to as volatility.  There are several ways to get at volatility, and several other ways to think about what it is and how it works.  Perhaps the most common way of measuring it is to use the standard deviation of price changes (expressed as a percentage) of stock movements made during a particular period.  Some stocks are rather placid, much like waves on a calm sea.  There are some slight up and down changes, but these tend to be somewhat predictable and not alarming.  Investors prone to anxiety tend to like low volatility stocks; the subdued price action means that they can sleep well nearly every night.

Investors (speculators) that are in the game for a quick profit tend to like high volatility stocks; these are the stocks that tend to be like waves on a stormy sea.  The waves rise to unexpected heights, and then come alarmingly crashing down again.  Long-term investors tend to hate these types of price movements (or just ignore them), but day traders and options traders often regard volatility as a requisite for fast money.  That is not to say that all options traders (and strategies) need volatility to make money.  Many options trading strategies offer regular, low-risk profits for risk-averse traders.

No matter what kind of options trader you are, you must care about volatility because volatility is a crucial factor in the pricing of options.  The more volatile a stock tends to be, the higher the options contract premiums.  Buyers of options during times of high volatility can get the direction of the underlying stock movement right and still lose money.

If you Google “stock option strategies” you’ll be overwhelmed with ideas on how to get rich trading these fascinating securities.  You’ll also be invited to join online “trade rooms,” buy books, buy DVDs, attend seminars, and sign up for college programs.  You can spend thousands of dollars on access to the “secrets” of options trading.  After months (or years) of intensive study, you’ll eventually learn that there are no “secrets.”  All of the “secrets” you need to know, you probably learned in an undergraduate statistics class and your experiences in trading stocks.

You have to understand percentages, confidence intervals, and probability distributions.  Retail traders that have degrees in math, science, or (especially) the social sciences are at a distinct advantage because they have learned (or should have) the probability and statistics facets of options trading that many investors have trouble grasping.  When your professor told you that it would “pay” to “pay attention” in statistics class, I’ll wager he had no idea that the statement was true in a literal sense!

If you absolutely love games of chance like poker and blackjack because you think you can use your intellect and instincts to “beat the dealer,” then you are a likely candidate for options trading.  Anyone can learn to trade options as an intellectual pursuit, but without the gambler’s curiosity that makes the study interesting, you’ll find it painfully boring and not likely learn enough to be profitable.  If you have a severe math phobia, you will need a therapist to help you get over it before you can learn to trade options.  If you do have the gambler’s curiosity, you will be excited to learn that with options trading the house doesn’t have an edge.

With options trading, the house usually makes its money on commissions, fees, and interest.  They don’t have a stake in the outcome of your hand.  You are playing against other traders, and there are enough “greater fools” out there to take the opposite side of any trade (traders refer to this condition of being able to easily find a trader to take the other side of your trade as liquidity).  As with stocks, however, you should never wager against the “smart money.”  Traders refer to large hedge funds and institutional investors that trade in big enough blocks to move markets as the “smart money.”

Warren Buffet, for example, can send a stock up 10% just by telling a reporter he is thinking of buying it.  When you hear about “unusual activity” in options, it means that someone—or some institution—has purchased a block of options that represents a staggering sum of money.  Many traders will jump in with them, which often creates a sort of self-fulfilling prophecy.  These effects are usually short-lived, and you should not trade this momentum if you are not very, very competent.  They may, however, give you trading ideas that you can substantiate with careful homework.

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