Series 7 candidates often say curious things about options being “hard.” Options are not “hard.” Options are just freaking weird. When you first read about them, the terminology is confusing. Plus, most people can not for the life of them understand why anyone would actually engage in this sort of reckless activity. Believe it or not, the options exchanges were created in order to reduce the risk of a stock position. Seriously. Just as the commodities exchanges allow buyers and producers to pass off some of their price risk to another party, the options exchanges allow stock traders to pass off (hedge) some of their market risk to another party. But, for many traders, the key word here is “party.” See, you can use an option to reduce the risk of a stock position. Or, you can just party or “speculate” as the professionals like to call it. When you buy and sell single options, straddles, or spreads, you are speculating on the short-term movement of a stock, index, or other “underlying instrument.” Of course, most students don’t like to drill down so hard on the concept of an option, but until you dig in and fully understand how options work, you will be one of those poor people trying to create the perfect chart that will act as some universal options question decoder.
Step one is to stop trying to create a magic chart and start trying to understand why a MSFT May 50 put is in- or out-of-the money and where to enter the intrinsic value in the little T-chart. Just keep it simple. A call is the right to buy something at a set price; a put is the right to sell something at a set price. You can buy those rights, or you can sell them. That is the whole story of options. Everything else involves your ability to break down the question.
Let’s look at a question that is similar to what you’ll see on the exam:
An investor buys an XRQ Oct 60 call @4 and an XRQ Oct 60 put @3. If XRQ is trading @54 at expiration and the investor closes both positions for their intrinsic value, what will be his gain or loss?
A. $700 loss
B. $700 gain
C. $100 loss
D. $600 gain
Keep it simple. He paid $7 a share total for this straddle, so the stock will have to rise by more than $7 or drop by more than $7 for him to gain. I like to know the breakeven points before solving the problem, because they provide excellent guidance. For example, I already know that if this stock can’t make it above $67 or below $53, there is a loss here, not a gain. Do you see how knowing that will eliminate two answer choices? Two of the choices say “loss,” while two say “gain”? So, did the stock go above $67 or below $53? No–so he has a loss. Eliminate the choices that have a “gain” in them. Answers “B” and “D” are gone–dismissed.
All right. You should probably use a T-chart here, although, really, at this point you can probably see that the loss is only $100. The stock only missed hitting the breakeven by $1, so he can’t lose all $700. In fact, he could only have lost the full $700 if the stock had remained right at $60. And that makes sense, too–he’s betting on volatility. By definition, if the market sits still, he’s screwed.
But, again, using the T-chart is the fool-proof method. So, in your “debit” or “money out” column, you enter $400 for the call and $300 for the put that he purchased. Now, in your head you have to figure out what the “intrinsic value” of each option is now that the stock has dropped to $54. Many students struggle with this notion that the premium can, like, change. That’s because they’ve never bought an option for $350 and then watched it drop to $10 in, like, an afternoon. Remember that as the stock is jumping around, so is the premium of the option. So, with the stock now trading at $54, the October 60 call is worthless–write a zero in the “money-in” side of the T-chart. The right to sell this stock at $60 would be worth exactly $6, so write “$600” in the money-in column, as well. Add it all up, and you see that he lost $100.
I’d say the dude got off easy, but who am I to judge? Maybe he has his reasons for risking $700 per contract speculating on volatility. To me, it seems a little weird. Like, maybe some counseling might be in order. But, again, it’s not my job to judge. When I’m answering an options question, my job is to try to figure out what’s going on and start eliminating wrong answers. If you can boost your score on options (derivatives), the pressure will come off on some of the other sections. Don’t work on options exclusively, since they account for only about 38 of 250 exam questions. But, get these things down cold–it will boost your confidence big time. And, you can turn what is often a weakness into a strength with just a few extra hours of effort.