Editor's note: Welcome to "Booyah Breakdown," an explanation of certain terms and topics Jim Cramer discusses on his "Mad Money" TV show. Feel free to ask a question if you're confused about something Cramer talks about, but please keep in mind that we do not provide advice on specific stocks.
So many things work in tandem. Take your favorite car. All the different parts need to be working properly to ensure that smooth ride. Recognizing the relationship of those parts can help prevent those horrific roadside breakdowns.
Same goes for the options, equity and futures markets. They all work together, so to understand one, you need to understand the others. We tackle the equity market all the time, and last week we hit on the
futures market. So it's high time we dove into the options world and started to put the pieces together.
We'll save the technicalities of trading on the options market for another day. Today we're going to focus on what you can learn just by watching the options market and its monthly revelry, a.k.a. "options expiration week."
Options expiration week can set off a chain of events, including an increase in volume and volatility in the stock market. Jim Cramer refers to it often. For instance, he
wrote in his
blog on Aug. 23 that the previous week's rally was "no doubt ... exacerbated by options expiration."
How could options expiration affect a rally? Read on.
Let's first understand how options work before we dive into what happens when they expire.
An option is a type of insurance. It's a contract that gives you the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date.
Let's say you're in the market for an old school
1980 Corvette (white, with T-tops, of course). You find one you love, but you really need to have it checked out by a pro. So you give the owner $500 to secure your right to buy the car at his current asking price for the next two weeks. That gives you enough time to get a good mechanic to check it out without having to worry that the owner will jack up his price.
If the car turns out to be a lemon, you walk away. You lost your $500, but at least you didn't buy a hunk of junk.
But let's say the car's immaculate. The owner realizes that so he raises his price. But since you have an insurance contract with him, you're still locked in at the original price. And because the car's hot, you buy it before your two weeks is up and drive away very happy.
So your insurance policy bought you some time to make a sound decision and protect you from any downside.
That's pretty much how the equity options world works too. In our example, your option was the $500. The underlying asset was the fabulous Corvette that's now in your garage.
In the equity option world, the underlying asset is usually a stock or an index.
There are two basic equity types of options: calls and puts. A call gives you the right to buy an asset at a certain price within a specific period of time -- kind of like our Corvette option. Buyers of calls hope that the stock will increase substantially before the option expires because their option gives them the right to buy those same shares at a lower price.
Buying a put option gives you the right to sell a stock at a certain price within a specific period of time. It's a lot like taking a short position. When you buy a put, you're betting the price of the stock will fall before the option expires so that you can sell it at your locked-in higher price.
But you can't hold an option forever, like you can a stock. As a matter of fact, on the third Friday of every month, options actually expire and become worthless.
So the days leading up to that Friday of expiration week become decision time, says Marty Kearney, senior staff instructor at the Chicago Board Options Exchange's Options Institute. In our example, the decision was whether to buy the car. In the option market, it's whether to exercise that put or call, or just let it expire worthless and walk away from the deal.
Pump Up the Volume
All this decision-making can translate into increased volume in both the options and equity markets, says Randy Frederick, director of derivatives at Charles Schwab. That's because the deadline leads to extra buying and selling.
For proof of this increased volume, check out the Options Clearing Corp.'s
Web site during expiration week. You can watch the option volume increase each day until it peaks on Friday.
Be aware that there's activity going on and try to understand what it is. Especially if there are options being traded on a stock you hold. Check out the
Chicago Board Options Exchange's site for that detail.
If you see an increase in calls on your stock, it may be a sign that people are expecting the stock price to rise. If there's an exceptional amount of puts out there, be concerned that traders are essentially shorting your stock because they're predicting that the price will go lower.
Granted, traders buy options for many different reasons, and tons of them trade options without ever owning the underlying stock. A trader could buy a put (a bet that the price is going to fall) on a highflying stock to hedge against a totally different position. So just use these metrics as a gauge.
The increase in options volume brings a similar increase in the equity market. If traders decide to exercise those options, they're probably going to buy or sell the underlying stock at the same time. That's the increased volume in the equities market that Cramer often mentions.
And with increased volume, you may see an increase in trading from large position holders, such as the institutions and mutual funds. If they want to buy or sell a large chunk of stock, they'll get a better price when the volume is high, because that means there are more buyers or sellers in the marketplace, says Frederick.
Then be on the lookout for "triple witching." That's not an insult for being in an exceptionally bad mood. (Although I clearly have my "triple-witch" days.)
It's actually an industry term that refers to the four times a year that futures options expire on the same day as equity options.
Futures options expire once every quarter. So on the third Friday of March, June, September and December, not only are regular options expiring, but some outstanding futures contracts are expiring as well. Expect the volume of everything to be even higher that week.
We have a triple witching coming up on Sept. 15. So pay attention.
No Option Is an Island
While you clearly shouldn't make buy and sell decisions strictly on what's happening in the options market, you can use it as a forecast to help you better understand the sentiment in your stocks, because it's all interrelated, says Tom Boggs, the Chicago Mercantile Exchange's associate director of equity products.
Thanks to the transparency of information, the impact of expiration week doesn't move stocks nearly as much as it used to, notes Boggs. But that doesn't mean there isn't a ton of information you can derive from options trading.
And to learn more about options, check out the
Chicago Board of Trade's Web site. It has a great strategy section that lets you simulate option trades so you can dabble in the options world without risking your paycheck.
Just like you wouldn't just drive that Corvette home without looking under the hood, don't place a bet based strictly on volume changes in the options market. Use it as an additional metric that helps you enjoy the ride.
Tracy Byrnes is an award-winning writer specializing in tax and accounting issues. As a freelancer, she has written columns for wsj.com and the New York Post and her work has appeared in SmartMoney and on CBS MarketWatch. Prior to freelancing, she spent four years as a senior writer for TheStreet.com. Before that, she was an accountant with Ernst & Young. She has a B.A. in English and economics from Lehigh University and an M.B.A. in accounting from Rutgers University. Byrnes appreciates your feedback;
to send her an email.