An Options Education

Like many Americans, Mill Valley, Calif.'s Jacki Fromme began investing in stocks about two years ago as bull-market fever swept the country. She'd played mostly tech stocks. But in June she began wondering how best to use options.

Fromme was looking to options for leverage but wasn't on firm ground with the basics. She needed help on concepts that kept popping up whenever she read about puts and calls. Seeking some explanations and clarification, she wrote to the Options Forum. We were more than happy to help, and since we figure many of you have the same questions, we also decided to publish our correspondence with Jacki.

The back-and-forth should provide a good primer for other options newbies plus a refresher for the sophisticates among you. And if you've still got more questions, please send them, with your full name, to the Options Forum.

Here goes.

July 19

Hi, Dan,

I'm an active equities trader and an avid reader of TSC since its inception. I'm just learning how to trade options and have found the whole subject complicated and frustrating, but with some software from the Chicago Board Options Exchange, or CBOE, and subscription to Option Advisor, I am making headway and getting my feet wet.

For something as simple as finding an option's symbol and then the prices for a specific month -- Compaq (CPQ Quote) options for Aug. 30 calls, for instance -- I can't seem to locate a source on the Web. I'd like to input the equity trading symbol or company name, get the option symbol and then input the call or put, month, et cetera, and get the price. I hope this is clear since options seem shrouded in nothing but mystery to me.

Can you be of assistance and direct me?

Jacki Fromme

Jacki,

First off, thanks for being a loyal reader.

The CBOE Web site has a price area where, if you input the stock symbol, you'll get the entire option string, the last prices, the bid, ask, net change, volume and open interest.

Do me a favor as well: Stay in touch and feel free to ask any questions of us. Sometimes options stuff can go right over an investor's (not to mention a reporter's) head so you can help keep us honest and grounded in the basics.

Thanks (and good luck),

Dan

Put/Call Predicament, Part One

July 20

Hi, Dan,

And thanks for your response and the link. I know many TSC readers are options savvy, but for those of us who are not: my next question.

I subscribe to the CBOE Investor Service end-of-day statistics (i.e. CBOE Market Stats for July 20, 1998; Put/Call Ratio:.55). I need help in reading these. In the case of the S&P 100 Index, can I assume that since there are more puts than calls, that there are more people who feel the index is going to go down in whatever the time frame is?

Most of the indexes that I posted here seem to have more put contracts than call contracts

I am not sure I am reading this info correctly since I think I heard Monday that investor sentiment was very high.

Thanks,

Jacki

Jacki,

Good question. When you're dealing with index options, you'll often see more puts trade than calls because institutions typically use them to hedge long positions and thus tend to buy more puts as protection from a sudden drop. So seeing more put volume doesn't necessarily indicate that more people think the market is heading for the tank.

An institution might own Citibank (CCI Quote), GE (GE Quote) and IBM (IBM Quote) shares, and instead of buying put positions on each of them (prohibitively expensive) they buy a put on the index. Index options -- primarily the S&P 500, S&P 100 and other sector groups -- are used mostly by institutions to hedge their far-flung portfolios.

If you're trying to gauge investor sentiment, you should look at the equity put/call ratio, which doesn't include index trading. When dealing with specific names, there's enough speculation on both sides of the aisle (puts and calls) to get a more equitable reading of the climate.

Either way, it's tough to read the action so literally. At this point in your options education, you don't want to get tied to numbers or short-term broad indicators. Look for a stock with fundamentals that you love or hate and then use the options to your advantage. Save the put/call ratio as a gauge of sentiment.

Cheers,

Dan

Why Write Calls?

Aug. 15

Hi, Dan,

A lot of the reader questions in your column are over my head at this point, so I do go to other sources for more elementary education, especially with options. I have copied the following from another Web site but need clarification:

Selling Calls

Selling or Writing calls are interchangeable terms. If you have bought a stock and the stock has appreciated in price, but you are not sure that the stock can keep its upward movement, then you may want to lock in some of your profit. You may do that by selling or writing calls. You sell Calls if you are bearish on a stock. This is how it works.

Let say that you have bought Pfizer (PFE Quote) stock for $70 and stock is trading at $100 now. You can sell June 95 Calls on PFE and receive $10 per share in premium. You now have reduced your cost of the stock to $60 ($70 minus $10). In exchange for receiving the $10 premium, you agree to sell your stock for $95 by the third Friday in June. You now have locked in some of your profit, regardless of what happens to the stock price, you keep the $10 premium. In turn, your broker requires you to deposit your stock with him since you now have placed a restriction on your stock.

Besides end-of-year tax manipulation, why would I sell calls on Pfizer when I could just turn around and sell my shares in the open market at the $100 price and just take my gain? Does the above mean that by selling the call, I really don't have to sell my shares in the stock by the third Friday in June?

Thanks for any clarification you can give me.

Jacki Fromme

Jacki,

Good to hear from you again.

You make a very good point about why should you even bother writing calls instead of just selling stock in the open market. I don't think the word "bearish" applies universally when you're writing calls, especially covered calls (the only kind you should be writing at this point in your investing career). You're only bearish when you write naked calls.

First, the difference between naked and covered call writing. When you write a call, you're getting paid a certain amount to take a certain amount of risk -- essentially that you can deliver certain shares at a certain price at a certain time. If you own the underlying stock and write a call, that's covered. If you don't own the stock and write a call, that's naked.

Realize the difference is more than terminology. Let's say you sell an IBM October 150 call, and the stock runs to 160 by expiration. If you're naked, you have to go out and buy IBM at 160 but get paid only 150 by the call buyer. If you were covered and bought the stock at 125, then you've made a ton on the stock increase and already have the shares on hand to fulfill your end of the contract.

A good way to think about covered call writing is that you may "like a stock but not love it." You may have loved Pfizer at 70 and reveled in any run-up, but at this point you may think the stock is out of gas. The key word in there is "think." You're not sure, and maybe you're not ready to sell Pfizer.

So, what to do? You sell an out-of-the-money call with maybe two months until expiration. (An out-of-the-money call is a call option with a strike price higher than the current price of the underlying shares.) You should almost never sell the current expiration month because options prices decline as they get closer to expiration and you shouldn't go too far out of the money because, again, you won't get as much for the option you sell.

Let's say you bought 200 shares of Pfizer at 70; it's run to 100. You sell one September 105 call for $4 for every 100 shares you own. That brings you an additional $800. (Remember, in options there are 100 shares in most contracts so the $4 price you see in tables is really $400).

Now, if Pfizer gets to 109 (105 strike price + $4 premium), the calls you sold will likely get assigned at expiration (meaning the buyer of the contract will exercise -- he can make money on the deal). You've no longer got the stock, but you've made $39 a share on the stock at the bare minimum and you get to keep the $800 premium.

If Pfizer doesn't get to 109, the contract will essentially be worthless (yep, the same contract you made $4 on) and then you can sell your shares in the open market, keeping both the stock appreciation and the options premium you received. Or do nothing with the shares and just keep the $800 in premium that was paid to you.

In the event that PFE goes down, then the options contract really has no chance of getting exercised and you keep the premium, using it to cushion whatever losses you've taken in the stock.

If you're truly a bear on PFE and want simply to sell naked calls (meaning you own none of the underlying shares) to those naive enough to think it can go up further, that's a tremendously risky strategy.

Remember, if you don't own the stock and if PFE makes a run, you'll have to go out and buy the shares at the current market price. If you sell the options so far out-of-the-money that they'll never get assigned (the buyer has exercised), you probably won't make enough money to make the whole endeavor worthwhile.

Be careful out there, and stay in touch

DC

Mispriced Intentions

Aug. 19

Hi, Dan,

I was reading through Cramer's chat on Yahoo! this a.m., and he made a comment regarding options that sounds like something I should understand. He noted that he has been trading options for 20 years, and he has a feel for when an option is "mispriced." Is there any way a trader can evaluate the correctness of the price of an option besides "having a feel" for it.

Jacki

Jacki,

Mispricing, like beauty, is in the eye of the beholder. I spoke to John Power at the Options Institute in Chicago. He stressed that options are priced on future unpredictability of the underlying shares.

As a result, you need to determine how much you think is fair -- or how much you think the stock will move -- before you determine what is mispriced.

And that's not an easy task. When Cramer said he has a feel for it, he's developed that from experience. Others, Power said, spend millions of dollars and thousands of man-hours to develop trading systems that hunt down mispriced options. "It's a very individual decision," Power said.

Put/Call Predicament, Part Two

Aug. 24

Hi, Dan,

Can you help explain the Put/Call Ratio--it stood at .70 at the end of the day today. I got this from the CBOE. Could you also include some other examples so I get the gist of how this flows.

Thanks,

Jacki

Jacki,

The Put/Call ratio is simply the ratio of the volume of put options to the volume of call options. The .70 put/call reading you mention means that investors have traded 70 puts for every 100 calls. At one point during the Aug. 11 market tumble, the index put/call ratio hit 1.65, meaning that 165 puts were traded for every 100 calls that crossed the transom.

There are two put/call ratios: the index p/c and the equity p/c. The first just tracks index options traffic while the other covers all individual equity options.

Many options traders watch the put/call ratio religiously to determine whether the market is ready to experience an upside spurt or a downswing. The important thing to remember is that many options traders belong to the contrarian school of thought, meaning that when they see negative trading patterns, they expect the market to rise.

The philosophy behind using the put/call ratio is that by the time put buying begins, most of the selling is already done, so the market is poised to outperform. By the time an investor purchases a put, says options analyst Bernie Schaeffer, "he would have already sold the positions he had planned on selling so the downside pressure he would have created would then be exhausted." What it shows across broad market activity is that investors don't feel inclined to buy puts when the market is moving up, so put activity typically signals the end of a selling trend.

Many traders depend on the put/call ratio of the S&P 100 index, or OEX. As far as interpreting the put/call ratio, traders tend to loosely follow these numbers:

Any reading less than .36 is bearish because there isn't enough put action

Traders see .47 as high enough to provide a little upward momentum

A .50 or above is a screaming buy because if traders are buying 50 puts for every 100 calls, it is likely that the accompanying action has been selling and increased put buying indicates that it is almost complete.