# Option Basics



## wayneL (27 September 2006)

Hi 

I am getting some PMs about some of the basic concepts in options. I guess we option afficionados tend to to talk over the heads of beginners and this could make them reluctant to ask basic questions.

I don't mind answering PMs, but would rather answer them on the public forum so all beginners can benefit.

So this thread is for the absolute basics. Ask the most basic stuff here, and I, or the other option junkies here will answer.

To kick off:

What is an option? There are two types of course; a call and a put.

The *buyer of a call* option:

...has the *right*, but *not the obligation* to *buy* shares at a set price (the strike price), on or before a certain date(the expity date).

The *seller of a call* option:

...has the *obligation*, if called upon, to *sell* shares at a set price, on or before a certain date.

The *buyer of a put* option:

...has the *right*, but *not the obligation* to *sell* shares at a set price , on or before a certain date.

the *seller of a put* option:

...has the *obligation*, if put, to *buy* shares at a set price, on or before a certain date.

In Australia, the standard contract size is 1000 shares

In New Rome, the standard contract size is 100 shares.

these contract sizes may vary due to corporate action. Always double check the contract size before trading.

All questions welcome.


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## NettAssets (27 September 2006)

One thing I always get asked about is trading company options and people confusing them with call and put options or ETO's.

A company option is traded on the exchange like an ETO (exchange traded option) but it is traded as a normal share, not as an option. This means for a company option you will get a share script from the company's share registry - which you will not with an ETO.

A company option is priced in similar fashion to a call ETO except part of its price is not payable until exercise which you may do at any time up till expiry. With an ETO there is no exercise price so the price you pay up front is the total cost of buying the call.

A company option may still expire worthless if the share is trading at less than the exercise price.
Regards
John

edited for clarity on expiry


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## hissho (2 October 2006)

hi all(Wayne, Modragan and Margaret)

has anyone heard of the following(for US market only)?
optioninvestor
http://www.optioninvestor.com/newsl...id.aspx?aid=194
and
options hotline:
http://dailyreckoning.com/LP/SteveS...onsHotline.html

and the latter even claimed his father was a famous options guru for more than 40 years, by the name "Paul Sarnoff"...



> My dad Paul Sarnoff was one of the legends in options trading for *more than 40 years*. Wall Street turned to my dad for the best in options trading advice. He is to options what Warren Buffett is to stocks - a genius! In fact, it was my dad who started Options Hotline, his private options advisory service available only to a select few, back in 1989.
> 
> *About 30 years ago*, my dad brought me into the "family business" - sort of a Sarnoff & Son. For years, I literally soaked up every word he ever spoke about trading options for big profits. I watched him trade. I listened carefully to his reasons. I analyzed his every pick. I did what he did. It was awesome to watch a master trader at work.
> 
> ...





when was options invented? 50 years ago???? i remember it was invented in the 70s.....

hissho


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## wayneL (2 October 2006)

hissho said:
			
		

> when was options invented? 50 years ago???? i remember it was invented in the 70s.....
> 
> hissho




The first "standardized" exchange traded option was in 1973.

There could have been negotiated contracts prior to that.


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## RichKid (3 October 2006)

wayneL said:
			
		

> The first "standardized" exchange traded option was in 1973.
> 
> There could have been negotiated contracts prior to that.




Just as an aside, and in case someone gets curious, you can look up some interesting historical info on options in this thread.

Feel free to post in that thead if you want to follow up on the historical and socio-economic aspects of options. My guess is Wayne would like this thread to be more about practical questions on trading modern exchange traded options series...


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## stargazer (19 October 2006)

Hi all

Great idea for absolute beginners with options like myself.

I attended a optionetics seminar not long ago and they gave an example of a STRADDLE and made look very easy with very little risk.

Call.....1 contract
Put......1 contract

If price move sideways take a 15% loss at worst.

I have heard they are high risk but on the other hand i have read that they can be a protection from taking a bad loss.

Wayne what i would find helpful would some examples 

I have heard of:
Buying shares then RENTING them or writing a covered call: If this is exercised you lose your shares as the price has gone up.

So how does one set up a situation where you  win all ways if the stock goes down or up?

Cheers
SG


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## wayneL (19 October 2006)

stargazer said:
			
		

> Hi all
> 
> Great idea for absolute beginners with options like myself.
> 
> ...




 Yes they always make it look so easy hey?

There is always risk somewhere unless an arbitrage opportunity surfaces. All options do is repackage that risk and transfer it somewhere else. So the short answer is no. You will have to select where you want your risk to be.

Cheers


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## stargazer (19 October 2006)

Hi Wayne

Thanks for that i understand what you are saying re: arbitrage  

So a stop loss in place is just as effective as anything else. 

Cheers
SG


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## wayneL (19 October 2006)

stargazer said:
			
		

> Hi Wayne
> 
> Thanks for that i understand what you are saying re: arbitrage
> 
> ...




Well that depends. Sure, decide a maximum loss where you will pull the pin (and stick to it  ). But it depends on what strategy you are using, philosophy, use of leverage, and money management as well.

In many instances I don't use a stop at all... the risk management is built into the strategy.

But thats a topic for a different thread  

Cheers


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## Magdoran (19 October 2006)

stargazer said:
			
		

> Hi all
> 
> Great idea for absolute beginners with options like myself.
> 
> ...



Hello stargazer, 


A couple of quick observations.

The Optionetics model for straddles (and strangles) I believe follows specific market situations.  Their focus at one point was on the US market, and the concept was that you aim to locate stocks with a potential to move strongly up or down.  

Key concepts I understand were to locate prospects which fitted this criteria, with one approach suggested was to open a trade early before earnings announcements, and to identify stocks with low volatility.  Their criteria also is to exit the position before either leg reaches 30 days till expiry when around 80% of the theta decay occurs (in theory) in the life of an option.

The idea is that interest in the stock increases on or near earnings pushing volatility up which benefits straddles, and that the stock may move strongly in one direction.

Straddles (and strangles) both require a significant move in any direction to make returns, and they are very susceptible to theta decay since you are long both legs.  Also, the area of a break even can be very wide if the increments between strikes is wide.  

I know of a range of people who have tried this kind of strategy, and the majority could not make it work well.  The problem being that theta decay was a problem, and correctly forecasting IV was a challenge, let alone getting the stock movement right.  Even when big moves happened, and actually beat the break even line, the cost of entry in commissions and the loss in value of the other leg significantly offset the gains in the winning leg.

Say more than half your trades failed out of a sample and made losses, you would need a couple of great outliers in a group to break even or make a profit overall from an expectancy stand point.  Still, there are some who claim this works well, and have specialised in it. It is up to you to determine if you have a gift for getting this kind of trade right.

An alternative approach to this is the ratio back spread.  But in this case you need a good volatility skew for these to work well – low volatility in the bought leg, and high volatility in the sold leg.  Have a look at these and compare the two.  Just remember that these are actually quite involved approaches, and you really need to spend a long time to become proficient in options full stop, let alone with master these strategies.

Straddles and strangles are essentially the opposite of spreads like the butterfly and condor which aim to make money when the underlying trades within a range within a time frame.  Just think about this when you are comparing strategies, and where each approach has application to the market conditions you are expecting.

If you’re new to this, I’d suggest spending at least a year either paper trading or trading very small positions to get the hang of it.  This is a very challenging area, and you need to keep this in mind despite the enthusiasm some people have for options.  They are great… once you know what you are doing.  So, just be careful, and accept that this will take some time to learn, maybe even 3 years or more if you’re totally new to this, if your aim is to make consistent profits using options.


Regards



Magdoran


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## stargazer (20 October 2006)

Hi

Thanks for your replies and greatly appreciate your responses.  

Yes Magdoran that is correct what you said in relation to Optionetics.

Don't know whether they would use you as their presenter..lol 

Well they made it sound so easy about 20 were lined up to purchase the program at around $4000 a pop.

I deduced from reading various material  options is a specialised field and your response has reaffirmed this.

Wayne 
with my limited knowledge at this stage, if one doesn't use a stop loss which i don't at this stage but am considering it but i have heard of stocks being sold off and then the price shoots up.

Mid caps seem to be manipulated at times and stop losses can trigger selling off etc

So how does one incorprate risk management into a strategy if a stop loss is not used.

Cheers
SG


cheers
SG


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## toc_bat (4 December 2006)

hi everyone

I have a few very basic questions:

Just for example, the company JMS has options JMSO. If I look at market depth using Etrade at JMSO all I see is just the depth. Where do I find out:

a. the date at which these options expire.
b. the exercise price.
c. are these company options? or ETOs?

If I go to the asx company research site for JSM it simply states that no ETOs are available for JSM, yet Etrade lists JSMOs for sale. Why would not the asx site mention these?

Just to confirm, are company options just contracts put out by the company, so that if a trader wishes to exercise them they send thier money to the company which then sells them to the trader direct. ETO options, are they options which can be created by traders themselves, and at exercise time the trader must sell buy the shares in question to the holder of an option.

bye all.


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## Mofra (4 December 2006)

Toc,

Looks like JMSO are company issued options, the exercise price & expiry date would be set by the company at issue & they trade on the ASX.

The options we are discussing here are Exchange Traded Options, which are traded seperately and are a different kettle of fish altogether.

Cheers


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## toc_bat (4 December 2006)

Mofra said:
			
		

> Toc,
> 
> Looks like JMSO are company issued options, the exercise price & expiry date would be set by the company at issue & they trade on the ASX.
> 
> ...




Thanks Mofra,

Since etrade and ASX websites do not have JMSO expiry and excercise price info is it a case reading Company anns or websites? Is this situation common?

thanks, bye


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## Mofra (5 December 2006)

Howdy toc,

Companies will have released an announcement with all the relevent info re: the options series, terms of expiry etc.
Company website should also have a list of shares & options on issue, if all else fails most companies have an investor relations contact point which will help you with any questions - they will also provide clarification on fundamental issues relating to the company as well (of course, they wont provide you with anything that has yet to be released to the market - mores the pity  : ).

Cheers & good luck


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## Lismore (11 December 2006)

Hi WayneL (or anyone else)

I am just starting papertrading of options on the ASX after 12 months of on and off research.

At the moment i have a main list of options companies - These have high open interest and low volatility (say < 25%)

AMP, ANZ, BIL, CBA, IAG, NAB, NWS, PBL, QAN, QBE, SGB, SUN, TLS, TOL, WBC, WDC, WES, WOW, WPL. 

My secondary list is options companies with high open interest and high volatility (> 25%).

AMC AWC BHP BSL LHG NCM OXR RIO STO ZFX.

My main question is on price and delta

If a $5.00 share moves up 5% it is worth $5.25.
If a $25.00 share moves up 5% it is worth $26.25

Assuming all else was equal and delta was 100 the 5% move on both options would be worth a lot more on the $25.00 stock.

I understand that there is leverage (say QAN ATM CALL $0.20, BHP ATM CALL $0.40) but this doesn't seem to compensate.

Am i best to concentrate more on $20+ shares rather that less than $10 shares???

Hope this isn't to silly a question   

ps i have read a lot about the problems with volitility..... who takes seriously the implied volitility when trading short term options (say 1-7 days)?

Cheers


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## wayneL (12 December 2006)

Lismore,

I will get to this later unless someone else does


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## ducati916 (12 December 2006)

*Lismore*

This is actually quite similar to the problem that I have encountered myself since starting looking at some of the more esoteric option strategies.
The problem is seemingly with *gamma*

Implied volatility is a guess-timate based on the current volatility, with an eye looking back at aggregate volatilities [or volatility means, looking for a reversion]

Gamma measures the change in the delta, based on the movement in the stock [delta 1.0, & zero gamma]

The higher your gamma value, the higher or more responsive your delta.
Therefore, with a gamma of 30, your delta in theory should alter by 30 to a change in stock price X 

It is all theoretical as, it will alter as time [theta] and volatility [vega] adjust in real time moving into the future. Of the two, vega is the most important and critical, as all the other greeks will key their values off of vega.

Thus the strategies implemented should revolve around vega and estimates, calculations, analysis, best guess, of this variable first and foremost.

If using Options, you are better off going for the higher priced stocks, as a low priced common stock has the hallmarks & advantages of an Option, with none of the drawbacks [theta decay, delta, gamma etc].

jog on
d998


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## Magdoran (13 December 2006)

Lismore said:
			
		

> Hi WayneL (or anyone else)
> 
> I am just starting papertrading of options on the ASX after 12 months of on and off research.
> 
> ...



Hello Lismore,


Your question appears deceptively simple, but underpinning answers to this question is a labyrinth of complexity (kind of like the iceberg below the water).

By fixing the delta at 100 in your question, you are effectively circumventing a cornerstone of how options are valued (and for that matter traded), and to answer your question without addressing this key element would really not be that helpful in reality, and give you a highly theoretical answer with very limited practical use.  Most traders do not buy deep in the money options with a 100 delta, most buy either ATM, OTM, or slightly ITM. 

Ok, having said that, I’ll attempt to answer your question, but in a way that is probably relevant to help you to consider important aspects in real trading scenarios.

In theory, in a situation with all things being equal, there should be very little difference in performance in percentage risk to reward terms between equivalent options for a high priced stock and a lower priced stock – the main differences being that you’d have to buy a different numbers of contracts (hence some difference in OCH fees), and the differential in increments. 

By increments I’m refereeing to the half cent step in option prices, hence the fineness of gradation is slightly better in theory for the higher priced stock, since the option price may be much higher meaning that there are more steps per percentage available for finer price steps.  For example, a half step for a 20 cent option is one 40th of the current value, while a half cent for a $2 option is one 400th.  This may be important in a risk to reward sense to outcomes if precision is required.

There may also be an added cost if you have to buy many contracts, especially if this increases your brokerage fee.  At a simple level, just buy more contracts for lower priced stocks.  But the more important issues I would argue is liquidity, how good your T/A is, and matching the strategy to the situation – volatility, which strike or strikes to buy/sell, and how big a move in what time frame you are expecting.

Valuing options, and attempting to forecast probable derivative values into the future is an art.  It is an art because there are layers of market forces that determine the market value of an option at any given time (supply and demand, market maker activities, trader strategies), and despite the best attempts to develop authoritative option pricing models such as Black and Scholes, and Binomial, these (I would argue) are really a form of sophisticated guestimates when attempting to forecast option prices. 

Options are also very versatile. Because you can combine different options into a strategy, and also morph these strategies as the underlying moves, this opens up a range of issues you may not have considered.

Hence evaluating options is complex.  There are two broad levels of knowledge to master.  One is understanding the Greeks and how options are priced.  The second is in using this basic knowledge to determine strategies.

From your comments you seem to be considering using straight options for directional plays (I do this a lot hence comfortable dealing in this area).  You may want to consider other approaches later such as non directional strategies, volatility plays, or arbitrage as well as the plethora of directional strategies, or even combinations of these approaches.  At least be aware of the fluid nature of option values, and the whole resultant game due to their multifaceted nature both in theory, and in practice.

Where it gets messy is when you add in the concept of delta and volatility (not to mention gamma, theta decay, vega, etc).  By buying an out of the money option, the delta is maybe 30 but as it moves into the money, the delta tends to rise, hence the profit levels can accelerate for long option positions.  The characteristics of out of the money, at the money, and in the money options are quite different in a straight directional play context based on direction, magnitude, and time.

The challenge is to select an option which presents both good risk to reward parameters that you determine, and also a sufficient probability of success which you estimate. This is much harder than it sounds.

Going back to your question on percentage move in two differently priced stocks, volatility can greatly affect the outcome both on entry and exit.  A lot depends on the strike selected (both price and expiry).  Hence it is difficult to find equivalent options to compare, partly because the strikes available to trade may vary from stock to stock.  Gradation of strikes and price increments in options can lead to quite divergent outcomes, let alone option liquidity, market maker spreads, various market actors, all having an impact on the Greeks, notably volatility.

I trade both high priced stocks and lower priced stocks.  Oddly enough I tend to prefer the smaller price levels since the outlays for contracts is less, so I can break my trades into partial positions more easily both scaling into trades, and exiting partials, or re-entering partial positions on counter trends.  But this is a personal preference.  The percentage returns are really determined by the magnitude of the move in a single series option, and the range of inputs such as the individuals ability to enter and exit the position taking into account the Greeks and the market.

Regarding short term positions 1-7 days, volatility is highly important in my opinion to trade successfully in this time frame.  It is easy to pay up for example on a particular day entering long on a reversal, only to see the underlying trade in your direction but the option value fall as volatility crush drags the option value below what you paid for it – even when the stock is moving in your direction.  Theta decay can also be a trap, as can delta if you buy too deep in the money or too far out of the money, or the high IV is at the money… 

I would suggest that from your questions that you have quite a deal of ground to cover both in theory and practice, maybe try Guy Bower’s book on options as a starter, and then look for Natenberg, McMillan and Cottle.  You may also find going through all the option related threads and the different discussions may tease out some of the concepts in this post in more detail.  It’s probably worth spending the time reading these.


Good luck, and I hope this makes some sense to you.

Regards


Magdoran


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## ducati916 (14 December 2006)

*Mag's baby!*



> _Regarding short term positions 1-7 days, volatility is highly important in my opinion to trade successfully in this time frame. It is easy to pay up for example on a particular day entering long on a reversal, only to see the underlying trade in your direction but the option value fall as volatility crush drags the option value below what you paid for it – even when the stock is moving in your direction. _




This is the interesting area for myself.
Should you therefore calculate the two volatilities, the current volatility, the one you are going to pay for today, and the historical volatility to illustrate the volatility *spread*.

Does the volatility crush comes into effect if [as in your example] the common has been trending up, then corrects, falling for say three days, resulting in an increase in volatility [and increased possibly against historical volatility] then, with the end of the reversal, and the common trading higher, the option reverts to a lower implied volatility?

Interested in your response.
jog on
d998


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## sails (14 December 2006)

Magdoran said:
			
		

> ...Your question appears deceptively simple, but underpinning answers to this question is a labyrinth of complexity (kind of like the iceberg below the water)...



So true, Mag!  I have attempted to answer this a couple of times, however, time constraints (due to the early arrival of a baby granddaughter on Sun night) plus realising an answer was going to be lengthy, the replies never got completed.     

Just quick speed reads of ASF is about all I have time for now - will hopefully be able to add to the thread when more time becomes available.


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## jayhfd (14 December 2006)

How do i actually exercise company options? (i know this is an eto thread... but why not have it all in one spot?)   

Do I have to call the company? Or do I do it somehow by calling up my broker? I'm with comsec.

Thanks


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## wayneL (14 December 2006)

ducati916 said:
			
		

> This is the interesting area for myself.
> Should you therefore calculate the two volatilities, the current volatility, the one you are going to pay for today, and the historical volatility to illustrate the volatility *spread*.



My view on this is that it should not be viewed as a "spread" per se'. Rather, I use historical volatility as a "tool" , along with my best "guess" of future volatility, to evaluate the the current (implied) volatility as to whether the price is "fair" and where the greek risks are. 

Using this assesment then determines which strategy I think will best fit.

for e.g. - If I'm bullish and expecting an immediate strong move, IV is in the low part of its range (or I think it's underpriced) and I am expecting an increase in volatility, there is no better strategy than a straight out bought call.

However if IV's are very high and there is a risk of IV crush, the straight out bought call is p###ing into the wind. I might go for a vertical/ratio spread instead and try to benefit from the IV crush.



			
				ducati916 said:
			
		

> Does the volatility crush comes into effect if [as in your example] the common has been trending up, then corrects, falling for say three days, resulting in an increase in volatility [and increased possibly against historical volatility] then, with the end of the reversal, and the common trading higher, the option reverts to a lower implied volatility?




This is certainly true in most instances with index options, but not always true with equity options, not in the normal market swings anyway. Not often enough to use price *direction* as a volatility predictor.


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## ducati916 (15 December 2006)

*enzo*



> _My view on this is that it should not be viewed as a "spread" per se'. Rather, I use historical volatility as a "tool" , along with my best "guess" of future volatility, to evaluate the the current (implied) volatility as to whether the price is "fair" and where the greek risks are. _




Spread, was probably the wrong word, implying a value spread. I am valuing them on historical volatility & current volatility, implied volatility is the future and an outright guess.

Assuming for the example, historical volatility is lower than current volatility, then the ask price for any given option *should* be higher, as all the other greeks key their values from vega [past, present, future] The historical volatility seems to make itself seen in the spread price on the bid.

Therefore the greater the deviation in current volatility from historical volatility, the greater in many [but not all] Option bid/ask spreads. These can [and do] change with tomorrows, or next weeks volatility [future]

Therefore knowns;
*historical volatility
*current volatility

Unknowns;
*future volatility

Can we price future volatility?
Which comes round the houses in a long and roundabout way to the Medical company trade, and the litigation. The future volatility changed quite dramatically with a gap in the shareprice, thus all the greeks changed from the initial values.

This risk, was actually quite elegantly managed via the ratio, calendar, vertical + some common hedging. However, quite a mouthful, never mind actually putting it on.

Hence returning to the valuing on the day of purchase [current volatility] as if you overpay, you will always be on the backfoot in regards to future volatility if it does the unexpected, which must be assumed to be 100%.

If on the other hand, current volatility is underpriced, or fairly priced, you start on level ground with the MM, and can better manage your risk which = future volatility.

jog on
d998


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## ducati916 (15 December 2006)

*enzo*

Just watching the prices currently of ticker ANF, and the common that was trading yesterday at $66.91 is today trading @ $68.51

Option greeks @ $66.91 on a Call Price = $0.40 [ask] which was Fair Value.
*delta 8.8%
*gamma 1.5%
*vega 0.047
*theta -0.014
*rho 0.010

Option greeks @ $68.51 on same Call Price = $0.25 [bid] $0.30 [ask] while Fair Value as calculated should be [Ask] $0.57
*delta 11.4%
*gamma 1.7%
*vega 0.057
*theta -0.017
*rho 0.013

So in your opinion, what exactly do you think is occurring here?

jog on
d998


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## wayneL (15 December 2006)

ducati916 said:
			
		

> *enzo*
> 
> Just watching the prices currently of ticker ANF, and the common that was trading yesterday at $66.91 is today trading @ $68.51
> 
> ...




what strike and expiry?

Meanwhile here is the vol chart for ANF

http://cboe.ivolatility.com/nchart....,R*1,period*12,all*4,schema*options_big&2=x:1


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## ducati916 (15 December 2006)

*enzo*

Strike $85 Expiry February 17 2007

jog on
d998


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## ducati916 (15 December 2006)

*enzo*

Found this on another thread that you populate;



> _An options price yeilds an "implied volatility", and not the other way around. People often say that one option has a higher premium because the IV is higher (ceteris paribus). This is backwards. The IV is higher because the premium under the same conditions is higher. That is why it is called "implied" volatility. It is what the future volatility must be (given the time left till expiry) to justify the current market price of a given option.
> 
> Current market sentiment determines a given option's value and the IV is the result. The price of the underlying and time till expiry are not debatable, they are fact. Thus to justify a higher market price you also need to "imply" a higher volatility, or greater chance that the option will expiry in the money._




Quite straight forward really, embarrassingly so, but solves my little problem quite nicely......now I can identify *potentially undervalued options*in a very logical manner.

jog on
d998


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## Magdoran (15 December 2006)

ducati916 said:
			
		

> *Mag's baby!*
> 
> 
> 
> ...



Hello Duc,


Firstly, I tend to focus on IV (implied volatility) over HV (Historical Volatility – or SV – Statistical volatility).  

HV only gives you an idea of how the underlying has moved in the past, and is backward looking.  It is really a study in statistical standard deviation, and gives you a history of how volatile the stock has been in the past, but only gives a suggestion on how it might react in the future based on your analysis.  Of course some volatile stocks can consolidate for long periods of time, then behave in a very volatile fashion in breakouts.  

Whereas IV is about what the market is factoring into the future, or how the supply and demand is shaping up both from the market maker perspective (widening spreads, and shifting them to where they think they can extract better margins), and from options market participants (if an institution wants to hedge or foreshadow a move into a stock, they may buy or sell up large quantities of a strike or strikes either in a concentrated time frame, or methodically over time – this can push IV around a lot  - up or down, depending on the strategy employed).

This is where good T/A in measuring probabilities is important to trading options in my opinion.  If you can measure the likely length of a consolidation, or recognise when a strong move is likely, you can enter with lower volatility for a single option entry, and take advantage later at exit of higher volatility -usually for puts, or at least not suffer much (if at all) volatility crush with calls.

I tend to look at the IV mainly, and consider the range in a time frame, but in context with what the underlying was doing at the time.  Generally volatility tends to decline in a gently sustained bullish move, or in benign consolidations, and increase on strong moves, but usually to the downside.  Other factors such as potential news items (anticipated announcements, earnings, or media/world events) may effect supply and demand too.

Hence looking at a range of strikes is important to see if there are skews.  Sometimes going a but further out of the money is cheaper because an institution is buying the ATM or slightly OTM strike, pushing the price up, while someone may be doing a spread, and selling the next strike up (scenario is someone attempting a bull call spread), hence you can benefit from a good price in the next strike up if going long a call for example.

This is assuming volatility was low for the IV range in your specified timeframe, and you project a small drop at worst (say the range was 20-30 IV, and IV is 22 - probability may be that it would fall to 18 at worst – but this is contextual, hence studying the IV in line with the way the underlying has moved.  Hence developing the capacity to estimate and forecast/project possible IV scenarios depending on a range of T/A possibilities is an advantage in my opinion.

HV only tells you what the range of volatility in the underlying was in the past.  IV is about what the market is demanding for premium now based on the market makers and market participant’s actual bids now.

Hence I agree with Wayne that you are making your best probability “guess” as to what IV might look like in the future based on your analysis of a range of possible outcomes.  I also agree with his view on selecting the right strategy, high IV conditions sometimes works better with spreads to mitigate IV crush risk.  

Also you can wait for IV to come back, and enter later, even if the stock is moving in your direction (but hopefully not too fast).  A lot depends on if you are trading OTM, ATM or ITM, and how far out in time.  If ITM, the deeper you go, the more  intrinsic value has a bearing, but your exposure is much higher, and your risk to reward reduces, where profits for OTM plays if correct can be much higher, but theta decay and spread risk is higher too.

So learning to assess wether the market maker is jacking the price up temporarily to pad out their margin when they expect demand to go up (or down for that matter – IV up for buying demand up, IV down for selling increase as people exit on stop for instance – both call s and puts) can greatly reduce risk and augment profit.


Hope that helps Duc.



Regards


Magdoran


----------



## Magdoran (15 December 2006)

sails said:
			
		

> So true, Mag!  I have attempted to answer this a couple of times, however, time constraints (due to the early arrival of a baby granddaughter on Sun night) plus realising an answer was going to be lengthy, the replies never got completed.
> 
> Just quick speed reads of ASF is about all I have time for now - will hopefully be able to add to the thread when more time becomes available.



Hello Margaret!


I can relate entirely, I’ve been extremely busy too.  What a bonanza of a market it’s been!

Look forward to reading your comments when you get time to finish them.  I had a burst recently and just hammered these out…

Hope you’re well!


Regards,


Magdoran


----------



## Magdoran (15 December 2006)

ducati916 said:
			
		

> *enzo*
> 
> Found this on another thread that you populate;
> 
> ...



Yup, that’s about the way I look at it too, subtle difference in mindset, but yields quite a different way of looking at the game.


Mag


----------



## Lismore (15 December 2006)

Hey Guys

Thanks for the responses.  
Am still in the learning/paper trading stage so have plenty to learn.  

Cheers


----------



## wayneL (15 December 2006)

> An options price yeilds an "implied volatility", and not the other way around. People often say that one option has a higher premium because the IV is higher (ceteris paribus). This is backwards. The IV is higher because the premium under the same conditions is higher. That is why it is called "implied" volatility. It is what the future volatility must be (given the time left till expiry) to justify the current market price of a given option.
> 
> Current market sentiment determines a given option's value and the IV is the result. The price of the underlying and time till expiry are not debatable, they are fact. Thus to justify a higher market price you also need to "imply" a higher volatility, or greater chance that the option will expiry in the money.




For us at the retail end of the spectrum, this is most certainly true, and it is most useful for us to look at pricing this way, to determine relative under/overvalue.

Therefore the BSOPM (as proxy for whatever model):

Input ===> Share price, strike, expiry, risk free rate, dividend, Volatility
Output ===> Option price

Becomes:

Input ===> Share price, strike, expiry, risk free rate, dividend, Option Price
Output ===> Implied Volatility

I would love to find out if someone, somewhere in the trading universe (initially at least) inputs volatility to get the output price.

MM's I have listened to say no, that outside bids/asks determine the vols. It seems like a bit of a chicken or egg thing to me.

I suppose it matters not, as far as we retail traders are concerned.


----------



## wayneL (15 December 2006)

ducati916 said:
			
		

> *enzo*
> 
> Just watching the prices currently of ticker ANF, and the common that was trading yesterday at $66.91 is today trading @ $68.51
> 
> ...




Can't be too sure without live prices and vols in front of me, but it seems to be a simple case of falling IV. If you have a look st the IV cahrt ling I posted above, IV has been falling the last few days.

Chart below is IV/SV over the last month


----------



## wayneL (15 December 2006)

Lismore said:
			
		

> Hey Guys
> 
> Thanks for the responses.
> Am still in the learning/paper trading stage so have plenty to learn.
> ...




No worries,

Do post as often as possible


----------



## Magdoran (16 December 2006)

ducati916 said:
			
		

> *Mag's baby!*
> 
> 
> 
> ...



Hello Duc,


I just wanted to flesh out some observations about how the options market trades in Australia in addition to my broader comment about IV and HV.

Volatility crush can be deadly when long a call, probably more so for positions entered ATM, then OTM, and to some extent ITM (but this can vary a lot depending on how deep ITM you enter).

Sure, you may see a bullish stock rally up, then pull back sharply in a counter trend, and then resume the bullish trend after 1-4 counter trend days.  With sharp pull backs, the IV can swing up substantially increasing the premium in long calls.

Interestingly, often it is the ATM, and slightly above and below calls (time to expiry is also a factor) in this case that often spike up in value as IV swings up in a pull back (not always though).  

What often happens is a stock pulls back after a bullish drive, somtimes up to half the range of the last drive more or less, then reverses and continue the next bullish leg up.  

Some stock traders buy into this kind of pull back - the really good ones get good at picking their entry near the pivot low, and aim to enter a share position as near to the pivot as possible.  

An options trader has a more difficult task, and may also have a good technical skill here, but there is an added layer of consideration understanding IV in the timing of a straight long call entry.  This includes factoring all the relevant Greeks including IV in terms of anticipated ranges of direction, magnitude and time.

Sometimes a good options player can get set at a better entry price in the option they have identified with the best risk to reward characteristics balanced with probability for success depending on their overall system choices:

 (For example, some traders look for 30% correct positions, but look for positive expectancy from a high enough percentage of outlier winners to derive an overall profitable system.  Others may look for higher percentage correct trades – maybe 50% or more, but with less risk, and lower rewards on winning trades than the more risky outlier system, but aim to make a profit from having a percentage edge biased to the winning trades).

Hence, on the reversal day the IV may spike well up augmenting the premium significantly.  One choice is to consider a spread – bull puts, bull calls, ratio back spread if expecting a strong move and there is a sufficient skew, or even some diagonal spreads depending on your technical outlook.  If considering a long call on the other hand, it may pay to wait 1-4 days for IV to drop to an acceptable level.  If the underlying shoots up 2 days, then crawls for another 2 days with inside days, or slight pull back days, you may find the price of the desired option actually falls below the available entry price on the reversal day.  

So yes Duc, IV crush can happen quite quickly.  Sometimes it pays to sell this in a spread (especially if you can get a good skew in our favour and make IV work for you!).

Variables involved are the strike price (ATM, OTM, ITM) and expiry chosen (current month, one month out, 2 months out etc), and the duration of the trade.  For shorter term trades, the entry day may be the next one after the reversal day for instance, while longer trades, you may get a better entry on the next pull back, and maybe a day or two after that – this requires experience in both T/A and options trading to evaluate – hence it is in a way an art.  

Specifically dealing with straight calls, if the trader’s view is that the underlying is likely to scream up, then a consideration may be to wear the volatility and accept the crush, or maybe move more to ATM to ITM positions in the current month for short sharp moves – although a good OTM position may have the best risk to reward parameters for really big moves in short time frames – there are a lot of variables to consider here, hence having a good modelling tool is vital in my opinion.  But this is highly risky, and not the way I tend to trade.  I prefer a bit more time if possible in the option, looking for more than 30 days time left in the option for when I exit – but this is a personal preference.

I found that trading the current month was dangerous when I got it wrong, and didn’t have the time to get it right, even when my T/A was right in the long term, the theta decay can really hurt short term positions, hence looking for more time although it reduces the percentage returns in risk to reward terms, it also really reduces the losses when you get it wrong, or more importantly allows you to hang through temporary moves against you (counter trends) long enough to reap profits when the main trend resumes (but you have to know enough about the way markets trend to do this).  This presumes a longer term approach, where a trade may last 2 weeks, a month, or even 3 months.

Please note that I’m focussing on bullish plays here with straight calls.  This is just one approach, since both Duc and Lismore seemed to focus on this strategy.  But please be aware that playing straight puts works almost in reverse to playing straight calls, since the IV tends to fall on a bullish counter trend to a bearish trend.  But this is hopefully food for thought for straight options plays – there is a lot just to this, let alone dealing with spread characteristics.


Regards


Magdoran

P.S. Glad this helped Lismore – do read through the various threads on this site on options, you can learn a lot here.  Especially look up all the threads Wayne and Margaret have commented on, and others like Mofra amongst others who have options knowledge.  I suspect many of your key questions may be answered in these discourses.


----------



## ducati916 (16 December 2006)

*enzo & Mag's*

Thank's guy's.
First off IV crush on Call Options is counter-intuitive, and thus initially rather tended to spoil my valuations, which upset me tremendously. That they are intuitive with Put's mollified me slightly.

As per usual, it is simply working with the numbers [values] or greeks enough that you can read the story that they are telling, and more importantly, when the story is a barefaced fabrication.



> _I would love to find out if someone, somewhere in the trading universe (initially at least) inputs volatility to get the output price._




This is exactly what I now calculate, from having my mini-epiphany, for my style, where I am trading on valuations, this is the critical step. So simple, yet so easy to overlook.



> _MM's I have listened to say no, that outside bids/asks determine the vols. It seems like a bit of a chicken or egg thing to me._




I believe them.
Simply because there are some howlers out there, both on overvaluation & undervaluation. In a completely different calculation, market inefficiency is as rife in the Options universe, as it is in the Stock universe.

Price action, as defined within the stockmarket, is responsible for market inefficiency, the exact same phenomena is present in the Options market, driven by price action............stunning!

jog on
d998


----------



## SevenFX (10 January 2007)

Hi Wayne,

If possible this link may help new members if included in your first post, b4 they start reading the thread...perhaps mods can add it...????

Just about to start reading this thread, but thought to post these links for anyone that wants to watch this Little video'(s) of option basics, including many other videos on warrants, sharemarket, etc

Only thing is you need to be registered (simple process) with the ASX site...

Part of their free education when registered.

http://www.asx.com.au/programs/vignettes/lesson4.html

I sure I will have some questions for you later and thanks for starting this thread.

Cheers
SevenFX


----------



## potato (20 January 2007)

hey guys 
in regards to the asx, whats happens when an option expires ITM? does it expire worthless if u dont close it out, or is the intrinsic value of the option settled automatically?


----------



## wayneL (20 January 2007)

potato said:
			
		

> hey guys
> in regards to the asx, whats happens when an option expires ITM? does it expire worthless if u dont close it out, or is the intrinsic value of the option settled automatically?




I'm not sure what happens on the ASX, but in the US, if the option is in the money by a certain amount (i.e. 25c) the option is automatically exercised, unless you specify for it not to be. If no exercise, you will lose the intrinsic value of the option. So be sure to know the mechanics of this.

As a rule, I almost always close out long options before expiry, unless I particularly want the shares (almost never). This is the most efficient way to capture intrinsic value, as once the option is exercised, you are exposed to unlimited risk via the share.

Only cash settled options (such as index options) will be settled in cash on expiry.


----------



## Mofra (20 January 2007)

potato said:
			
		

> hey guys
> in regards to the asx, whats happens when an option expires ITM? does it expire worthless if u dont close it out, or is the intrinsic value of the option settled automatically?



Heya potato,

Most options service providers in Australia offer automatic exercise for long all in the money options, for those on the short side you will be obviously forced to meet any normal obligations as a seller.

Might have to re-visit the fine print in the terms & conditions for your Options account as it is broker specific.

Hope this helps


----------



## sails (20 January 2007)

Potato, I agree with Mofra that brokers in Aus have different policies on automatic exercise, so it would be a good idea to check this with your broker.

However, I was told by someone at the ASX recently that there is no automatic exercise on index options (eg XJO) in Aus.  So if you have an ITM long index option on expiry day, it would appear that the broker needs to be advised that you wish to exercise to get the cash back into your account!  Seems strange when it's cash settled, but I guess they have their reasons.

Spitrader1 - if you are reading this - do you know the reason?


----------



## potato (20 January 2007)

thanks for the reply guys.


----------



## radarz (17 February 2007)

wayneL said:
			
		

> I'm not sure what happens on the ASX, but in the US, if the option is in the money by a certain amount (i.e. 25c) the option is automatically exercised, unless you specify for it not to be. If no exercise, you will lose the intrinsic value of the option. So be sure to know the mechanics of this.
> 
> As a rule, I almost always close out long options before expiry, unless I particularly want the shares (almost never). This is the most efficient way to capture intrinsic value, as once the option is exercised, you are exposed to unlimited risk via the share.
> 
> Only cash settled options (such as index options) will be settled in cash on expiry.




I purchase a put option.  I choose to close out rather than trade this option back into the market.  Is it required that I have the shares ready to sell?


----------



## wayneL (17 February 2007)

radarz said:
			
		

> I purchase a put option.  I choose to close out rather than trade this option back into the market.  Is it required that I have the shares ready to sell?



Yes... unless you are able and want to be short the shares.

The term you should use is "exercise". "Close out" means to sell the puts to close the trade.

Cheers


----------



## sails (17 February 2007)

radarz said:
			
		

> I purchase a put option.  I choose to close out rather than trade this option back into the market.  Is it required that I have the shares ready to sell?



Hi Radarz,  

I'm not sure what you mean by closing out instead of trading back into the market.  If this means you are considering exercising your put option without owning the underlying shares, then this is a question for your broker.  Some brokers will allow it  - usually with strings attached (an example would be a potential requirement to close out the share position by a certain time the following trading day).  However, it really depends on individual broker policies, so suggest you get the answer from your broker.

Cheers.


----------



## radarz (17 February 2007)

Thanks for the quick reply guys!

I know that ultimately I need to seek full clarification from a qualified broker.  I'm just seeking initial advice first so that I don't waste both mine and my brokers time, not to mention helping myself understand the whole scene more completely.

The aim was to buy put options to gear myself against a stock fall, as opposed to simply short selling on margin.  It's a gamble with a set percentage of my portfolio.  For example, I wish to take 10% of my portfolio and buy put options over a set time frame with a calculated gamble that the underlying stock is going to fall in value.  I don't wish to touch the other 90% of my portfolio.  If I get it right (if I get lucky) it should be like I have geared myself to take advantage of a fall.

Does this strategy make sense taking into account that it *is* a non-quantitative calculated gamble?


----------



## Magdoran (18 February 2007)

radarz said:
			
		

> I purchase a put option.  I choose to close out rather than trade this option back into the market.  Is it required that I have the shares ready to sell?



radarz

Here’s something to consider.  If you can’t get a fair price for an option that is about to expire, it is not uncommon for some people to inform their broker (this may be verbal, or can be electronic depending on the broker) that they wish to exercise their option.

In the hypothetical case here, this is a put option.  In the electronic case, the pattern I know is that you exercise the option, then you are required to purchase the exact amount of shares to fulfil the number of shares required to complete your side of the option contract.  My understanding is that this must be fulfilled by the end of that trading day you exercised the option, or you may be subject to fail fees for breeching the contract.

As Margaret (sails) correctly points out, different brokers may have different procedures, and full service brokers may allow a range of alternatives depending on their operational procedures (it is conceivable that some may lend you the shares on the condition you purchase the requisite number of shares at some point).  

In essence it is a kind of shorting the share if you borrow in this case, and the mechanics can vary widely from broker to broker.  Many will not allow you to do this, but if you have a big account, anything is possible, but brokers are very good a eliminating risk where they can, so you will have to have deep pockets, and probably have to commit collateral if they accept.

If you have a portfolio, then it’s simply a case of allocating the correct number of shares from your account to fulfil the contract.

Hope that helps, but have a thorough read of the terms and conditions on the ASX website, and perhaps contact your broker/s for more information.


Regards


Magdoran


----------



## sails (18 February 2007)

Magdoran said:
			
		

> ...
> In the hypothetical case here, this is a put option.  In the electronic case, the pattern I know is that you exercise the option, then you are required to purchase the exact amount of shares to fulfil the number of shares required to complete your side of the option contract.  My understanding is that this must be fulfilled *by the end of that trading day you exercised the option*, or you may be subject to fail fees for breeching the contract....



I had not realised this (my highlight above) was another way of handling the exercise of options (eg those that cannot be closed out for at least intrinsic value) until recently when reading about it on one of the ET forums.  I didn't think of it with my reply to radarz, so thanks Mag, for pointing that out.  It not only removes the risk of fail fees should one be with a broker that charges them, but also removes overnight directional risk.  

I have yet to enquire if the brokers I use are OK to do it this way, but I can't see why they wouldn't due to removal of overnight directional risk.


----------



## radarz (20 February 2007)

sails said:
			
		

> I have yet to enquire if the brokers I use are OK to do it this way, but I can't see why they wouldn't due to removal of overnight directional risk.




Overnight directional risk?


----------



## sails (20 February 2007)

radarz said:
			
		

> Overnight directional risk?



If you simply owned puts (without the underlying shares available to sell) and decided to exercise them, you will find you are short x number of shares the next day in your account.  In essence, a limited risk position (puts) has been changed to an unlimited (upside) risk with the short stock position.  May not be a problem, but definately wouldn't want a takover bid or any other really good news the next day!  Does that make sense?


----------



## radarz (21 February 2007)

Makes sense.

Thanks.


----------



## money tree (21 February 2007)

sails said:
			
		

> However, I was told by someone at the ASX recently that there is no automatic exercise on index options (eg XJO) in Aus.  So if you have an ITM long index option on expiry day, it would appear that the broker needs to be advised that you wish to exercise to get the cash back into your account!  Seems strange when it's cash settled, but I guess they have their reasons.




this is not quite true. it is IMPOSSIBLE to exercise an index option........right?   I mean how can you buy shares in XJO? 

Cash settled means just that. At expiry, if the option has any intrinsic value, the option writer pays the taker this amount. 

Ive been through this process many times. It couldnt be easier or simpler.


----------



## money tree (21 February 2007)

Magdoran said:
			
		

> In the hypothetical case here, this is a put option.  In the electronic case, the pattern I know is that you exercise the option, then you are required to purchase the exact amount of shares to fulfil the number of shares required to complete your side of the option contract.  My understanding is that this must be fulfilled by the end of that trading day you exercised the option, or you may be subject to fail fees for breeching the contract.




There are other alternatives.

If you own a put option, and want to exercise it rather than lose money on the spread, you DONT need to buy the shares in question. This would take a hell of a lot of capital  

You CAN exercise an option (a put in this case) without dealing with the FPO. Simply remove the market risk for your broker, and they will be happy to do the trade on your behalf. How do we remove market risk? In this case, we own a put, so market risk is to the upside. How do we remove upside market risk????

A CALL OPTION !

Which call option? We will be exercising this call option the next day so we dont want to waste money on time premium. Which options have small or no time premium? D.I.T.M ones!

Having said all that, why not sell the option before expiry? Its a hell of a lot cheaper when you consider the buy & sell commissions on two large FPO transactions. 

There is a case where its worth exercising, but only my course readers know it.


----------



## radarz (21 February 2007)

money tree said:
			
		

> Which call option? We will be exercising this call option the next day so we dont want to waste money on time premium. Which options have small or no time premium? D.I.T.M ones!
> 
> There is a case where its worth exercising, but only my course readers know it.




What is D.I.T.M?   Something in the money????

What do your readers read?  Or, should I say, what do you publish?


----------



## Magdoran (21 February 2007)

money tree said:
			
		

> this is not quite true. it is IMPOSSIBLE to exercise an index option........right?   I mean how can you buy shares in XJO?
> 
> Cash settled means just that. At expiry, if the option has any intrinsic value, the option writer pays the taker this amount.
> 
> Ive been through this process many times. It couldnt be easier or simpler.



money tree (Paul),

In defense of Margaret’s comments (sails), my understanding is that XJO index options are European exercise, and are cash settled, but you must exercise these options to get the cash settlement at expiry if you are holding them.

For supporting information, go to:

http://www.asx.com.au/investor/options/index_options_fact_sheet.htm



> •	Index options are usually cash settled, rather than deliverable. Because it is not practical to physically deliver the shares that make up the index, an investor will receive a cash payment on exercising an in-the-money index option.
> •	Index options are European in exercise style, meaning they can only be exercised at expiry.
> •	The exercise price and premium of an index option are expressed in points. A multiplier is then applied to give a dollar amount.
> 
> “Even though index options are cash settled, you still need to exercise”




A point though is that you must have a standing instruction for your broker to exercise ITM XJO index options at expiry (if you hold these through to expiry), or actually instruct them to do so if not.


Regards


Magdoran


----------



## Magdoran (21 February 2007)

money tree said:
			
		

> There are other alternatives.
> 
> If you own a put option, and want to exercise it rather than lose money on the spread, you DONT need to buy the shares in question. This would take a hell of a lot of capital
> 
> ...



money tree,

Your comment conflicts with my experience and understanding of the process.

The original question was specifically about the mechanics of exercising a put option, and what is required specifically in terms of the supply of the shares to fulfil the contract:



			
				radarz said:
			
		

> I purchase a put option.  I choose to close out rather than trade this option back into the market.  Is it required that I have the shares ready to sell?




*Mechanics of Exercise:*

If you exercise a put option, the contract is to deliver the correct number of shares to the option writer/taker at the strike (exercise) price.

The contract stipulates that you must deliver the shares under the ASX rules.  The core question was about the mechanics involved.  Either way, the option writer of the put must receive the correct number of shares as stipulated in the contract to fulfil the terms, this is immutable.

You point about exercising the put, and buying the shares taking up considerable capital also conflicts with my experience and understanding.  Once you have exercised the put, all my brokers allow me to purchase the requisite number of shares without the need to finance the purchase with any capital because they recognise that the exercise of the option ensures the sale of the underlying is exchange guaranteed.  The exercise is considered sufficient.


*Alternative: Buying a Call and exercising it to fulfil the contract*

If you are suggesting buying an ITM (in the money) call option and exercising it, as an alternative to buying the shares; the case for doing so would be that the time value, spread costs, and the cost of exercising the call (and any other transactional costs) were less than the cost of buying the shares.

The problem with this approach is that usually the case for exercising the put in this case may be that the spread is prohibitive, and if this is the case, the same is likely to be true for the call (but not always – hence the situation should dictate the best alternative, shouldn’t it?).  

Also, buying deep in the money calls may actually require significant capital depending on the situation, which might also prove to be prohibitive, especially where buying the shares may not require the capital at all depending on the broker.

Another thing to consider is that you actually receive the shares when you exercise the call in theory (although these immediately fulfil the requirements of the exercised put), hence you usually attract the exercise fee which may be dearer than buying the shares depending on your broker’s fee structure, on top of the transactional costs to buy the call option, hence this may actually be self defeating.  In addition this is especially true if the call spread is disadvantageous as well.


While I agree with your comment that it is usually better to sell an option before expiry (especially when there is time value left  - Wayne, Margaret and I have covered this topic thoroughly in previous threads), the point raised here was specifically about the mechanics of exercising if you choose to do so.  This is also an effective strategy close to expiry if you are trading an illiquid series, and the market maker spread is less advantageous than exercising. Certainly it is not the preferred approach, but I have certainly observed cases where exercise yielded the better financial result, but this is the exception, not the rule.


Regards


Magdoran


----------



## sails (21 February 2007)

money tree said:
			
		

> this is not quite true. it is IMPOSSIBLE to exercise an index option........right?   I mean how can you buy shares in XJO?
> 
> Cash settled means just that. At expiry, if the option has any intrinsic value, the option writer pays the taker this amount.
> 
> Ive been through this process many times. It couldnt be easier or simpler.



Hi Paul,

The only mistake I made in my post was I thought this info came in an email from the ASX when it was actually in one of their articles:  http://www.asx.com.au/investor/options/how/library/2006/get_on_board_xjo.htm.  And here is an excerpt - the highlight is mine:



> Cash settled but not automatically
> 
> Index options are cash settled on expiry however like all options an *instruction* to exercise is mandatory. *Failure to exercise an ITM option will not result in cash settlement.*
> 
> An instruction to exercise can be either manual (call broker) or automatic (have your account set to automatically exercise ITM options on expiry). If you’re not sure of the status of your options account contact your broker today.



This may well be broker specific - perhaps you have a broker that automatically exercises all ITM options at expiry including index options.  

I also agree with Magdoran's comments regarding the buying DITM calls to cover the exercise DITM puts.  IMO, one of the main reasons for exercising is usually because of the difficulty of getting the full intrinsic value (if trying to sell them on the market) due to excessively wide bid/ask spreads.  So it makes no sense to me to go through the cost of exercising *plus* pay slippage and fees on DITM calls as well.  Oh well, each to their own, I guess   

BTW, Not all brokers charge excessive fees on exercise/assignment - OptionsXpress is one that has a flat rate - currently priced at $30 regardless of the cost of the underlying shares.  No fail fees either provided the shares position is closed out the next day.

Cheers


----------



## sails (21 February 2007)

radarz said:
			
		

> What is D.I.T.M?   Something in the money????...



Yes - deep in-the-money!


----------



## money tree (21 February 2007)

thanks for clarifying that Margeret.

Ive used 3 different brokers and in each case Ive never had to say squat about exercising, which we can assume means its automatic for them. I know there are some brokers who dont charge $4k in brokerage for buying & selling $300k worth of FPOs but its rare. Its this huge cost that I based my argument on, so it really does depend on which broker you use. This cost can be a huge surprise and is an important point. I also didnt realise it was hypothetical mechanics rather than practical. My bad.

As for ASX articles, they have a funny habit of "inventing" very similar strategies after I publish mine......


----------



## Magdoran (21 February 2007)

money tree said:
			
		

> thanks for clarifying that Margeret.
> 
> Ive used 3 different brokers and in each case Ive never had to say squat about exercising, which we can assume means its automatic for them. I know there are some brokers who dont charge $4k in brokerage for buying & selling $300k worth of FPOs but its rare. Its this huge cost that I based my argument on, so it really does depend on which broker you use. This cost can be a huge surprise and is an important point. I also didnt realise it was hypothetical mechanics rather than practical. My bad.
> 
> As for ASX articles, they have a funny habit of "inventing" very similar strategies after I publish mine......



Hello money tree,

Actually, that’s a very good point about situations with large parcels of shares, where some brokers charge heavily above a certain value like 1% or above on a 300k position.

In this case I can see the effectiveness of buying an ITM front month call and exercising it if it works out to be cheaper.  Depends a lot on your broker and position size.

I can imagine a 15 contract position for a $20 odd dollar stock being a killer to deal with if your broker is going to charge a percentage.  Not a good way to trade, $4 K is way too much brokerage in my view.  Personally I’d either do a deal with the broker, or fire them. It’s so competitive now, and if they want your business, they’re going to have to play ball.

Speaking more broadly about personal preferences, I tend to wind out single series bought options preferably before 30 days till expiry to avoid the theta decay, and only hang in if the move looks like it is strong once the OTM option had moved ITM… but that’s a personal preference, isn't it?


Regards


Magdoran


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## shares (3 April 2007)

hi everyone

I purchased some Lincoln Mineral Shares a couple of weeks ago and after taking a look at the prospectus I found this:

At this stage, an issue of 1 free Option for
every 2 Shares held by Shareholders on the
register is intended to be made some three
months after Listing on ASX. The Options
will be exercisable at 30 cents each and will
expire 3 years from the date of issue.

I bought 10,000 shares and Lincoln opened on the stock market on the 9th of March.

Does this mean that on the 9th of June (3 months after opening) I will receive an additional 5,000 shares which I will be able to sell at any price over 30 cents?


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## Glenhaven (3 April 2007)

shares said:


> hi everyone
> 
> I purchased some Lincoln Mineral Shares a couple of weeks ago and after taking a look at the prospectus I found this:
> 
> ...





Sorry I don't know the answer, however, I have been trying to find out. I could not find a website for them or any information in the news items. I would normally look in the propectus for clarification, but you have already done that.


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## shares (4 April 2007)

Thanks for having a look GlenHaven  I really appreciate it.


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## bvbfan (4 April 2007)

The offer is this...

Within 3 months of listing (so by June 9) shareholders who are registered as such on the books of Lincoln Minerals at a given day in that 3 month period will be eligible to received the 1 for 2 option offer.
That means you would received 5000 options for no cost.

The option allows you to buy another 5000 LML shares at 30c between being issued the options and the expiry date of the options.
If they list the options on the ASX you can choose to sell the options also, and generally they would have some value above the difference between LML shares and the 30c to be paid (time value for the option)


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## Glenhaven (4 April 2007)

bvbfan said:


> The offer is this...
> 
> Within 3 months of listing (so by June 9) shareholders who are registered as such on the books of Lincoln Minerals at a given day in that 3 month period will be eligible to received the 1 for 2 option offer.
> That means you would received 5000 options for no cost.
> ...





Does anything define "at a given day". The question is that day in the past or yet to be announced. The issue being what you sell or buy now.


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## bvbfan (4 April 2007)

They will announce the day in advance, so people who want it can get in, this should push LML share price up. If the other stocks that have done this are any guide.


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## Glenhaven (4 April 2007)

That's why I was interested. If this is true one should buy now. It does seem odd though that they are to give something away. Reminds of the old bonus issues which never happen now.


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## bvbfan (4 April 2007)

They are asking people to keep money locked into the share, which after the shares goes ex entitlement will drop quite a bit usually so it's a bit of a sweetener to keep holders interested


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## shares (4 April 2007)

thanks for the info



bvbfan said:


> They will announce the day in advance, so people who want it can get in, this should push LML share price up. If the other stocks that have done this are any guide.




hopefully it does go up lots and lots


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## Glenhaven (4 April 2007)

Must say I am still not 100% convinced. Companies do offer loyalty issues, like Telstra where you get a bonus 4% in shares if you hold the installment receipts until the second payment. However, this is only for those that bought in the issue and do not sell, if you purchase the IR's on market you do not get the bonus.

I would understand it if this was the case with Lincoln Minerals, however, you are suggesting that there will be a free options issue to whoever holds the shares at a date to be announced. I would like something that confirms this. Do you have a source. The words in the propectus do not say that a purchaser of the shares on market will get them.


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## potato (15 May 2007)

Hey everyone, I just wanted to know which options are the best to trade in terms of liquidity (ASX stocks) what sort of levels of open interest should you be looking for? any examples would be appreciated. Also what else is popular to trade options with besides stocks here in australia?


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## Higgshr (9 July 2007)

*Re: Option Basics - ASX XJO Adventures*

ASX XJO Adventures 

I have been doing a basic Covered/Buy Write strategy over the last 10 months, and it has done quite well. Now with some market volatility I thought it best to start some "hedging".

My first question to the forum is about ASX XJP Put Options.
ASX articles - Portfolio protection with index puts

My query is regarding the Max. Loss of portfolio. Little unsure how this works, as this would time decay and set by the market, so I am not sure how you can so this is the max protection. 

My understanding is to cash out, you would have to sell out at that point, or await to expiry date. This is a bit fuzzy??? Any first hand experience or views on this, or even other approaches?


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## It's Snake Pliskin (19 July 2007)

What determines the premium in a covered call?

eg; 5,000 x $0.38 = $1,900

Where does the $0.38 come from?

5000 shares purchased at $9.00 and the price is now $13.07. 
Will sell at $14.00.
The premium is *$0.38*. How is this calculated?


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## wayneL (19 July 2007)

It's Snake Pliskin said:


> What determines the premium in a covered call?
> 
> eg; 5,000 x $0.38 = $1,900
> 
> ...



Snake,

When you sell a $14 call option over those shares, you are obliged to sell your shares to the call buyer for $14, if he calls your shares.

Obviously, he will only do that if the shares are trading for greater than $14 at option expiry. Your share could be trading at $18 as an example, so in this case you have lost $3.42 in opportunity cost.

You want to be paid for this risk, that is what the call premium is.

The amount you get paid for taking this risk will depend on the markets perception of this risk of the call expiring in the money (> $14)

* The closer the current price is to $14, the greater the risk of it expiring at > $14, the higher the call price.

* The greater time till expiry, the greater the risk of it expiring at > $14, the higher the call price. (also the greater your carrying costs are)

* The more volatile the share, the greater the risk of it expiring at > $14,  the higher the call price.

This is all calculated via an option pricing model (Cox, Ross & Rubinstein for American style options usually) of which the inputs are:

Current share price
Strike price
Time till expiry
Risk free interest rates
Dividends
Volatility

... to give the theoretical option price.

As the volatility input is an estimate of future volatility, the option price may vary from *your* theoretical price and it is ultimately governed by price discovery via the bid and ask. The price will therefore generally be the result of the consensus of forward volatility by the marketplace as a whole. (Or in the absence of actual traders the market makers).


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## It's Snake Pliskin (19 July 2007)

wayneL said:


> Snake,
> 
> When you sell a $14 call option over those shares, you are obliged to sell your shares to the call buyer for $14, if he calls your shares.
> 
> ...




Hi Wayne,

Thanks for the detailed reply. 
So the risk premium is a combination of this: 
Current share price
Strike price
Time till expiry
Risk free interest rates
Dividends
Volatility

Have I understood this?


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## markrmau (19 July 2007)

wayneL said:


> * The closer the current price is to $14, the greater the risk of it expiring at > $14, the higher the call price.
> 
> * The greater time till expiry, the greater the risk of it expiring at > $14, the higher the call price. (also the greater your carrying costs are)
> 
> * The more volatile the share, the greater the risk of it expiring at > $14,  the higher the call price.



 Pls replace "higher the call price" with "higher the premium"


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## wayneL (19 July 2007)

It's Snake Pliskin said:


> Hi Wayne,
> 
> Thanks for the detailed reply.
> So the risk premium is a combination of this:
> ...



yes


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## wayneL (19 July 2007)

markrmau said:


> Pls replace "higher the call price" with "higher the premium"



For clarification.

The option *price* can be described as extrinsic plus intrinsic value. ( in this case intrinsic value is zero )

The option *premium* can be described as extrinsic value only.

In this specific example, premium is the same as price. But where an option is In The Money, price will be different to premium as there will be intrinsic vale included.


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## Magdoran (19 July 2007)

It's Snake Pliskin said:


> Hi Wayne,
> 
> Thanks for the detailed reply.
> So the risk premium is a combination of this:
> ...



Hello Snake,


Yes, you’ve got it pretty much right in a nutshell, however, here’s something to think about which might add to Wayne’s excellent answer.  

While this subject has been covered elsewhere in the derivative area, essentially the option price is the premium a seller of the option requires like the premium you pay to an insurance company.  Think of it like that and the values will start to make sense.  

Essentially writing (selling) options can be seen as issuing an insurance policy to the other party, or perhaps a bet that the option will go down in price and can either be left to expire worthless or bought back at a cheaper rate later.  Hence the premium (price) demanded is in part a market driven value (included market maker tactics and involvement, especially in less liquid a markets) and in part a theoretical value.

Option pricing is an involved process since you are dealing with a range of concepts simultaneously in order to arrive at a theoretical valuation on one level as you know, and an actual market price on another.

Various pricing models have been developed in an attempt to establish relatively objective methods of valuing an option at a particular price over an underlying financial instrument at a particular time.

The two dominant mathematical models which have pages of formulas involved are “Black and Scholes” and “Binomial” (I prefer Binomial since it tends to be more robust in my view).

The key attributes of each option makes it unique in the way it will perform given movement in time and price.

Hence inputs into the model as you have identified are time to expiry, strike (or exercise) price, value of the underlying the option is over, dividends, and the interest rate component.  In addition this gets complicated because of “volatility” which encompasses the inflation of the theoretical flat price since the effects of supply and demand inflate the option value, and volatility measures this level (this has been covered in detail on many of the derivative threads).

All these inputs result in a theoretical value, and then the market conditions alter this as an expression of volatility.  Hence the price is the base value inflated by the odds the selling side are giving, very much like the way a bookmaker discounts some contenders in a horse race which are unlikely to win, while increasing the cost on others they consider more likely to win, or sometimes in order to hedge their book.

So, in your example, if the option was an out of the money call with 2 months to expiry, with a volatility of “X”, and a specific interest rate, and the underlying was trading at “Y”, you’d arrive at a theoretical value.  Then the fun begins since there will probably be a spread between the bid and the ask, which will be jumping around as the underlying trades – each with its own fluctuating value and volatility measure.

Since no one has a crystal ball, the valuation is based on what the market thinks is likely to happen which is where the shadow falls between the theory and the practice.


Hope that helps!


Regards


Magdoran


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## It's Snake Pliskin (19 July 2007)

Magdoran said:


> Hello Snake,
> 
> 
> Yes, you’ve got it pretty much right in a nutshell, however, here’s something to think about which might add to Wayne’s excellent answer.
> ...




Thanks Magdoran for the detailed post.  I m just exploring using options and have much study to do before I start trading them. As always your help is appreciated.

Regards
Snake


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## Magdoran (19 July 2007)

It's Snake Pliskin said:


> Thanks Magdoran for the detailed post.  I m just exploring using options and have much study to do before I start trading them. As always your help is appreciated.
> 
> Regards
> Snake



You’re welcome Snake,


Incidentally, I forgot to mention exercise type – European which can only be exercised on the expiry day, or American which can be exercised at any time including the expiry day. The American exercise tends to be slightly more expensive...

Mag


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## It's Snake Pliskin (20 July 2007)

Magdoran said:


> You’re welcome Snake,
> 
> 
> Incidentally, I forgot to mention exercise type – European which can only be exercised on the expiry day, or American which can be exercised at any time including the expiry day. The American exercise tends to be slightly more expensive...
> ...




Mags,

Thanks. What are your gut feelings on trading Aussie options?


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## Magdoran (20 July 2007)

It's Snake Pliskin said:


> Mags,
> 
> Thanks. What are your gut feelings on trading Aussie options?



Hello Snake,


Have a look at the links below to the “Options Mentoring” thread which covered a lot of the relevant issues over a year ago, much of which is still relevant if comparing the Australian market with the US.

I have also posted comments on a range of issues with the Australian options market but don’t have time to sift through my posts right now, but if you do some searches and look through the derivative area, there has been a lot of comments in detail about my experience with a range of options strategies, and commentary on trading tactics when dealing with lower liquidity options and market makers.

In terms of equities, I prefer the Australian scenario over the US for the reasons outlined in the discussion in the links (you can browse through that thread, there was a lot of ground covered in it).

But like every market, there are strengths and weaknesses.  In technical analysis terms, I think commodities and indexes tend to trend the best, but sometimes some stocks present attractive opportunities to trade, and I have found my best performance is in the Australian market despite the apparent low liquidity, but the losses tend to be amplified due to spread risk in the less liquid series, especially the “flex options” (they have no market maker obligations to make a market).

I find that generally if using options in Australia that position trading or longer term trading are more suited to this instrument than intra day trading (which is extremely hard to do with options).

Why not try doing a search by member, and have a read through my derivative posts and you’ll get the picture, I put a lot out there...


Hope that helps!


Regards


Magdoran




wayneL said:


> This is a good point Mag'






Magdoran said:


> All the points you make are valid.






wayneL said:


> Yes, I can see exactly what you are saying Mag.






Magdoran said:


> Ok, the point I was making about US Vs Australia is this:






sails said:


> It is a real pleasure to find someone else with such an interest in Aussie options!


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## It's Snake Pliskin (20 July 2007)

Magdoran said:


> Hello Snake,
> 
> 
> Have a look at the links below to the “Options Mentoring” thread which covered a lot of the relevant issues over a year ago, much of which is still relevant if comparing the Australian market with the US.
> ...




Thanks Magdoran.

I shall dig deep and read. 

Regards
Snake


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## ducati916 (21 July 2007)

*Mag.*

The Option strike spreads can be overcome with a hybrid.

jog on
d998


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## Magdoran (21 July 2007)

ducati916 said:


> *Mag.*
> 
> The Option strike spreads can be overcome with a hybrid.
> 
> ...



Absolutely Duc, fully agree – 


I think the suggestion here is that you can use a combination of futures, options, options on futures, CFDs, and a range of other derivative products like swaps and forwards, CMOs, CDOs if relevant…

But this is getting quite involved.  I recognise that there are arbitrage dimensions using this kind of approach, hence it really is a smorgasbord of choice out there, but you really need to know what you’re doing.

What I found was that it helps sometimes not to overly complicate things especially when you’re starting out.  However, there is a “rich” history of clever derivative plays in the past, especially at the institutional level that netted significant sums!

Food for thought!


Mag


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