Wednesday, February 22, 2012

Understanding The Basic Language of Option Trading

The peculiar vocabulary and concepts inhabiting an options trader’s thoughts are often the source of confusion to visitors to my world. I have often pondered that learning to understand options is a lot like learning a foreign language. When you arrive in the country whose language you seek to learn, you need a functional vocabulary immediately.

In order to be able to understand my world, I thought it would be helpful to discuss a bit of my language since it is helpful to grasp a few basics. I want to touch on some of the basic concepts necessary to form the basis for a functional language we can use to communicate concepts underlying a rational (hopefully) thought process leading to trade design and management.

In ruminations to come we will return to these fundamental concepts and begin to understand their function in the dynamic world of an options trader. The nuances of their specific structures are beyond the scope of this blog.  We will return to consider these factors in virtually every trade because they re-appear each and every day in my world. For today, just shake their hands and remember their names.

One point not often discussed is the way in which options are priced. The quoted option price is in reality the sum of two separate components. These are referred to as the intrinsic and the extrinsic portions of the premium. I think of these as steak and sizzle respectively.

As I type, AAPL has closed at around $395. The January 390 call has 41 days to expiration and could have been bought for $18.90. Of this sum, $5 represents intrinsic premium and $13.90 represents extrinsic or time premium.

This is an important distinction because it is the extrinsic premium which is subject to time decay and change due to variations in implied volatility. We will get to a discussion of implied volatility in next week’s missive.

The intrinsic premium is subject to change solely due to changes in the price of the underlying security. There is no sizzle in the intrinsic premium; you can buy the option today, exercise it to buy stock, sell the stock, and pocket the $5. Of course, your trading career will not last long with that sort of trade, but my point is that the intrinsic premium has an easily calculable true value.

The situation with the extrinsic premium is quite different. The value changes not only with time to expiration but also with the constantly changing implied volatility. It is for this reason that an option trader must be very careful with this extrinsic component. Depending on the specific option under consideration, extrinsic premium may represent all, a portion, or a trivial amount of the entirety of the option premium.

Another important concept is that of the “moneyness” of an option. An individual option can be classified in one of three categories of “moneyness:”
  • At the money
  • In the money
  • Out of the money
At the money options by definition consist of a single strike price. Both in the money and out of the money strikes usually contain several individual strikes within their groups.

In our example of AAPL, the at the money strike is the 395 strike. The in the money strikes consist of all calls with strike prices below 395 and all puts with strike prices above 395. The out of the money strikes consist of all calls above the 395 strike and all puts below the 395 strike.

Obviously since the price of the underlying defines the category into which an option is classified, the category into which an individual option fits is fluid and changes dynamically with the price of the underlying asset.

The reason for taking the time to discuss in some detail this classification of “moneyness” is that there are important reliable characteristics of each type of option.

At the money options characteristically contain the absolute greatest dollar amount of extrinsic premium. In the money options have the least amount of extrinsic premium. Out of the money options consist entirely of extrinsic premium, and therefore only contain sizzle......no steak can be found there.

Because the functional characteristics of these three categories of options differ, it is a basic strategy to combine options of different “moneyness” to achieve trades with the best probability of success and the highest risk/reward scenarios.

For example, buying an in the money call and selling an at the money call gives birth to a call debit spread, a high probability trade structure for the trader who is bullish in the underlying.

Next week we will cover the stealth concept of option trading, implied volatility. Failure to understand the impact of this variable is the most common cause of beginning options traders’ failure to succeed.

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