The Option Pit Method Stock and Options Outline

The Option Pit Method Stock and Options

Outline • Why options exist • Basic Option Terminology and P&L • Use of Options and Stock together for directional trading • Buying vs Selling of options

The Option • If I were to describe options in 1 word, what word would I use? – Insurance • Calls insure against the loss of dollars in a long position • Puts insure against the loss of dollars in a short position

Long Stock vs Call

Short Stock vs Puts

What Are Options • As you can see calls ‘insure’ against the loss on a stock purchase • Puts, insure against loss on a short stock position • The Price of the option is the price of the policy

TOMIC • When I buy options I am buying an insurance policy, just like when I ensure a car, my house, or my life • When I sell options I become the insurance company

Insurance • Do insurance policies last forever? • If I cancel a policy to I get all of my money back? • Options, like all insurance decay in value over time (this is sometimes called theta)

Decay and a Long Call

Premium Selling This is a chart of ATM option premium time decay: 30 Days vs. 8 Days

Policy Costs? • Are all policies the same cost? • Do we shop for insurance? • Just like any insurance market, prices can be too high, too cheap, or JUST RIGHT! • The key to options is to figure

Pricing • Insurance companies use tables to figure out how much to charge you • Option traders do not have tables to figure out pricing • THEY HAVE VOLATILITY – Volatility Creates the SIZE of the premium over parity

PREMIUM OVER PARITY 228. 36 -220= 8. 36 10. 45 -8. 36=2. 09

Pricing • The premium over parity fluctuates (on top of decaying) • As volatility increases premium over parity increases • As volatility decreases premium over parity falls • This volatility is called IMPLIED volatility

Implied Volatility • Implied volatility is free market price of insurance on a stock or index • It reads like a number but is really a percent • AAPL Volatility of 20. 20 is actually 20. 2%

Implied Volatility Indexes • • The CBOE and other exchanges list IV indexes The most famous is the VIX There are indexes on oil, gold, RUT, NDX ETC There also indexes on individual names and ETF’s like AAPL and EEM

VIX

VXAPL

Selling Options • I do not care what you want to do, covered calls, cash secured puts, spreads if you are not looking at IV you are leaving money on the table • There are options that should be sold and options that should not be sold • DON’T SELL OPTIONS THAT SHOULDN’T BE SOLD

VXAPL AGAIN

Buying Options • There are times options can be a good buy, especially when IV is at year low levels • Often the best time to buy is right after a strong move in a stock after an event – Traders tend to over sell premium

Price IV and Movement

Directional Trading • When policies are cheap buy calls and puts • When policies are expensive use put and call spreads selling net premium – One may also use cash secured puts or covered calls against stock positions

Trade: MA

Trade: NKE

Directional Check List • • What is the Story What is the Directional Opinion What is the Speed What is the Implied Volatility What is the best strike? What is the best term to buy or sell? What is the Best Spread?

Develop a Trade • Lets Develop a trade using steps 1 -4 – (you don’t know how to do step 5 -7)

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