Get Rich with Options E-Book

Lee Lowell

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Agora Series
• Sprache: Englisch

Seitenzahl: 317

Veröffentlichungsjahr: 2009

Beschreibung

A detailed guide to successfully trading stock and commodity options After numerous years as an options market-maker in the trenches of the New York Mercantile Exchange, few analysts know how to make money trading options like author Lee Lowell. Now, in the Second Edition of Get Rich with Options, Lowell returns to show you exactly what works and what doesn't. Filled with in-depth insight and expert advice, this reliable resource provides you with the knowledge and strategies needed to achieve optimal results within the options market. It quickly covers the basics before moving on to the four options trading strategies that have helped Lowell profit in this arena time and again: buying deep-in-the-money call options, selling naked put options, selling option credit spreads, and selling covered calls. * Breaks down four of the best options trading strategies currently available * Explains how to set up a home-based business with the best options trading software, tools, and Web sites * Contains detailed discussions of how options can be used as a hedging or speculating instrument With this book as your guide, you'll quickly see options in a whole new light and learn how to become part of a small group of investors who consistently win.

Leseprobe

Table of Contents

Title Page

Copyright Page

Dedication

PREFACE TO THE SECOND EDITION

Acknowledgements

PART ONE - THE OPTION BASICS

CHAPTER 1 - IT’S ALL ABOUT THE CALLS AND PUTS

OPTION BUYERS HAVE RIGHTS; OPTION SELLERS HAVE OBLIGATIONS

PROBABILITY IS THE KEY

AN OPTION EXAMPLE

THE PROFIT/LOSS SCENARIO

STOCK PRICE AND STRIKE PRICE RELATIONSHIP

SUMMARY

CHAPTER 2 - HOW OPTIONS ARE PRICED

ANATOMY OF A PREMIUM

GOT MOVEMENT?

SUMMARY

CHAPTER 3 - OPTION VOLATILITY

WHAT IS VOLATILITY?

USING VOLATILITY TO YOUR ADVANTAGE

TWO STOCKS, DIFFERENT VOLATILITY

THE SKEW FACTOR

EARNINGS DUD?

SUMMARY

CHAPTER 4 - STOCKS VERSUS OPTIONS

WHAT DO WE DO?

THE DELTA FACTOR

SUMMARY

CHAPTER 5 - OPTION SELLING IS YOUR KEY TO SUCCESS

HOW TO BATTLE TIME DECAY

PROBABILITIES

OPTION SELLING PREREQUISITE

PART TWO - THE STRATEGIES

CHAPTER 6 - BUY ALL THE STOCK YOU WANT FOR HALF THE PRICE

WHY PAY $2,289 FOR SOMETHING WHEN YOU CAN BUY IT FOR $1,120?

MOVEMENT IS THE KEY

DELTA IS YOUR WEAPON

DELTA IN ACTION

CHOOSING THE STRIKE PRICE

A REFRESHER

THE PROBABILITIES

BUYING THE WHOLE MARKET

AN ADDED BENEFIT

EXPIRATION ACTION?

RISK MANAGEMENT

DRAWBACKS?

SUMMARY

CHAPTER 7 - GETTING PAID TO BUY YOUR FAVORITE STOCK

THE STRATEGY

HOW DOES IT WORK?

WHAT HAPPENS WHEN YOU SELL NAKED PUT OPTIONS?

HOW DO WE GET OUR SHARES?

WHY DON’T WE GET OUR SHARES?

PICKING A DIFFERENT STRIKE PRICE

DON’T FOCUS SOLELY ON THE OPTION PREMIUM

A FEW REQUIREMENTS

MARGIN REQUIREMENTS

PUT SELLING ON THE DOWNDRAFT

TOUGH TIMES IN 2008

RISK MANAGEMENT

WRAPUP

CHAPTER 8 - OPTION CREDIT SPREADS: THE ALL-STAR STRATEGY

THE FIRST STEPS

HOW THE OPTION CREDIT SPREAD WORKS

REAL-LIFE TRADE EXAMPLES

RETURN ON MARGIN

RISK MANAGEMENT

2007 AND 2008 CREDIT SPREAD UPDATE

GOLD AND ORANGE JUICE OPTION CREDIT SPREADS

SUMMARY

CHAPTER 9 - A DAY IN THE LIFE OF THE MARKET MAKER

WHO IS THE MARKET MAKER?

MARKET-MAKER SURVIVAL

THE TRADER’S MIND-SET

PIN RISK AND LOPSIDED POSITIONS

THE SLOW DAYS

CHAPTER 10 - PUT YOUR STOCKS TO WORK—SELL COVERED CALLS

WHAT IS IT?

HOW DO WE DO IT?

ASSIGNMENT?

WHAT, ME WORRY?

STRIKE PRICE VERSUS COST BASIS

I GOT MY FOLKS IN ON THE ACTION!

TRADE UPDATE

RISK MANAGEMENT

SUMMARY

CHAPTER 11 - A BONUS STRATEGY: RATIO OPTION SPREADS

MAKING THE TRADE

2009 SOYBEAN UPDATE

RISK MANAGEMENT

ONE OF MY FAVORITE RATIO MARKETS

2009 RATIO OPTION UPDATE

SUMMARY

PART THREE - GETTING READY TO TRADE

CHAPTER 12 - TOOLS OF THE TRADE

CHAPTER 13 - BROKERS AND COMMISSIONS

WHO ARE THE BROKERS?

STOCK OPTIONS BROKERS

COMMODITIES BROKERS

COMMODITY UPDATE 2009

OPTION APPROVAL

LAST WORDS

CONCLUSION

INDEX

Copyright © 2009 by Lee Lowell. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

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Library of Congress Cataloging-in-Publication Data:

Lowell, Lee, 1967-

p. cm.

Includes index.

eISBN : 978-0-470-53085-6

1. Options (Finance) I. Title.

HG6024.A3L69 2009

332.64’53—dc22

2009032181

To my wife, Amy, and my three children—Sydney, Josie, and Griffin—all whom Ilove more than anything in the world

PREFACE TO THE SECOND EDITION

When I was approached recently by the team at John Wiley & Sons about writing a revision for this book, I had already been thinking about how and what I would change if ever given the chance. Now that I have the opportunity, let me fill you in on what you can expect to see in this version.

Before I tell you what has changed, I just want to say thanks to my friends and colleagues for giving me their insight on what they’d like to see be different if I ever revised the book. But I must say, the biggest input on what I needed to revamp has come from the reviews from random readers who were nice enough to post their thoughts on Amazon.com. Yep, that’s right. To date, there have been 44 reviews of my book at Amazon and all have been helpful to me.

The most common remarks from the few readers who didn’t think my book was up to snuff were the problems they had with the title (of all things!). They felt duped by the title and that the book didn’t show them the ways to Get Rich with Options.

I’ve put every bit of my knowledge and experience into this book to show ordinary people how to use options the way that has brought me success over the last 17 years. You can definitely get rich trading options, but you must do it correctly. I’m convinced, though, that these readers just didn’t connect the title with how well the strategies really work to increase your wealth. As you will read in my book, the one fact that I keep advocating over and over again is that you need to be on the sell side of options trading.

I think some of the naysayer reviewers of my book didn’t really understand the concept of selling options as a means of immediate income generation through safer speculation and hedging techniques, or they didn’t really understand how to do it, or maybe they got burned in the past by selling options incorrectly.

My goal was to show you how to trade options the proper way with the four strategies (and a bonus fifth one at the end of the book) that I’ve used continuously over the years. All the money that you can bring into your account by selling options can add up to incredible sums over time. Just think about what you’d be leaving on the table if you never sold options in the first place—you’d be leaving lots of money for someone else to pick up.

So, on that note, I’m going to stress a bit more directly in this edition about how you can get rich with options. None of the strategies that I discuss are different from the first edition of this book. They’re still as sound as the day that I first wrote about them. I’ll just be a little more detailed on how options trading can fatten your wallet.

You’ll also be seeing more examples of two of my favorite strategies—option credit spreads and put-option selling. Since I now run two option advisory services that focus specifically on these two strategies, I am including real-life, archived recommendations that show my members what trades to take and when to take profits.

I’ve also been asked to discuss in more detail the ways in which I find the stocks or commodities that I trade the options, on as well as exit strategies during profitable and not profitable trades. Since the intention of this book was solely to teach the reader how to trade options profitably once they’ve already picked their stock or commodity market, the discussion of how to find the stocks or commodities was kept at a minimum. I will tell you this: Most of my decisions on which stock or commodity to pick is based primarily on chart patterns and, to a lesser degree, the fundamentals of the underlying.

There are parts already within the book in which I briefly discuss how I came to choose the underlying that I did, but I make the effort to expand on it a bit more in this revised edition. There are many great books out there now that can teach you about technical and fundamental analysis to help you get started on being able to pick the underlying, but those lessons are beyond the scope of this book. And as far as discussing exit strategies, I also go over this as much as I can as we discuss each strategy individually.

The last thing I want to say about some the reviews that I received is that you cannot please everyone. Someone will always find fault in whatever you do—and this applies to life in general, not just my book.

I tried to make this book as complete as possible to get you on your way to surviving and profiting in the options market. But by no means is this book the end-all and be-all of options books. No one could provide that to you no matter what the adviser’s background or experience has been. I encourage you to use this book as a great starting point and reference it well into the future.

I hope you decide to stick around and read (or reread) my book because I really tried to make it as fun and enjoyable as I could for you to learn about options trading and how you can get your hands on some of the wealth that is there for the taking in this arena.

—LEE LOWELL

January 2009

ACKNOWLEDGMENTS

I would like to thank the fine folks at Agora and John Wiley & Sons for giving me the opportunity to have this book published.

PART ONE

THE OPTION BASICS

CHAPTER 1

IT’S ALL ABOUT THE CALLS AND PUTS

Let’s start at the beginning. There are only two types of options—calls and puts. It’s really very simple, and it doesn’t have to be any more complicated than that. Call and put options are a direct form of investment and should be seen as such. You can achieve everything you want on an investment basis with options, just as you would with any stock, bond, or mutual fund. That fact is very important to remember.

Every position that is built using options is composed of either all calls, all puts, or a combination of the two. One thing that smart option traders know is that you can sell options as easily as you buy them. That is going to be one of the main themes of this book as you will soon see that a majority of my trades entail the selling of options. Don’t fret if you’ve heard that selling options is risky. The way that I do it has limited risk. One of the great aspects about the financial markets is that you can sell something first that you don’t own yet. Instead of the usual “buy low, sell high,” we can reverse it and “sell high, buy low.” In this case, the sale transaction comes first.

What are call and put options? In short, options are another form of investment that can be bought and sold just like a stock, a bond, or a commodity. They are referred to as “derivative” investments because an option’s value is derived from other sources, which we will talk about later on in the book. If you’ve read some of the mainstream literature that is published about options, you will see the examples given from the buyer’s view of the market. I want to let you know that I’m going to teach you to trade from the short side (selling) as well as the long side (buying) of an options contract. Why limit yourself to one strategy?

The main purpose of buying options is to gain leverage on your investment and to cut down on your initial capital outlay. This is a smart way to use your money. Options allow you to take a directional position in an underlying security using a small down payment. The reward is the potential for a big gain. It’s just like buying a house with your 10 percent down payment. You only have to put up a fraction of the price, yet you get to control the whole house. In simple terms, you’re using options as a substitute for the stock or commodity. But you have to know how to choose your options correctly to maximize your potential gains. And since I’ve found that most option buyers do not do this correctly, that’s why I’m here to help.

OPTION BUYERS HAVE RIGHTS; OPTION SELLERS HAVE OBLIGATIONS

How do options work? In short, a buyer of a call option has the expectation that the underlying security is going to move up. And when I say “underlying security,” I’m referring to the stock or commodity in which you are trading options on. A call buyer has the right to control a bullish directional position of long 100 shares of stock (in the case of stock options) for a specified period of time (until option expiration day) at a certain strike price level (the price at which you will buy the stock). The buyer pays a fee to the option seller for this right, which is called the “premium.” In the case of commodity options, the call buyer has the right to control one long futures contract for a specified period of time at a certain strike price level. The buyer has no obligation to exercise the option contract and turn it into a bullish position in the underlying security if it is not profitable to do so. The option buyer has a limited loss potential equal to the price paid for the option, but also has an unlimited upside gain potential.

The put option buyer has the expectation that the underlying security is going to move lower in price. A put buyer has the right to control a bearish directional position of short 100 shares of stock (in the case of stock options) for a specified period of time at a certain strike price level. In the case of commodity options, the put buyer has the right to control one short futures contract position for a specified period of time at a certain strike price level. The put buyer has no obligation to exercise the option contract and turn it into a bearish position in the underlying security if it is not profitable to do so. The put option buyer has a limited loss potential equal to the price paid for the option, but also has an unlimited upside gain potential.

Sometimes it’s difficult to understand the put-buying side of options. Most people understand call option buying because we’re all so used to going long the market. I think people get caught up in the terminology of buying something to sell it. It sounds confusing. When you buy a put option, you’re giving yourself the opportunity to sell something at a certain price for a specified period of time, no matter where the price of the underlying security may be. As I have already mentioned, the financial markets allow you to sell something that you don’t own first. That’s a hard concept to grasp. If you own a stock and are willing to sell it, either you can just sell your shares or you can buy a put option contract, which allows you to pick the price level at which you may want to sell the stock and the expiration date of when to do it.

On the flip side, sellers of calls and puts have different views and obligations. The seller of a call option has a neutral to bearish view of the underlying security and has an obligation to fulfill the terms of the contract if the option buyer decides to exercise the option contract. The seller of a put option has a neutral to bullish view of the underlying security and has an obligation to fulfill the terms of the contract if the option buyer decides to exercise the option contract. In short, the option seller is at the mercy of the option buyer with regard to exercising the option contract. The option seller has a limited gain potential equal to the price paid for the option by the buyer, but also has an unlimited downside loss potential.

PROBABILITY IS THE KEY

Why would anyone want to sell options if the loss potential is unlimited? That’s a great question and one that’s asked just about every time I discuss options trading. The reason that option selling is such a useful strategy if used correctly is because of the probabilities involved. Option trading is all based on probability and statistics. Many investors or option buyers tend to see options as a lottery type of trade where they know it will cost them only a few dollars to play. If the stock or commodity makes the big move, then they’re headed for Easy Street. But how often does that happen? As often as you win the lottery—which is practically never.

Those are low-probability trades and most of them are the “close-to-expiration, far out-of-the-money (OTM)” options. But people are still drawn to the gambler mentality, which of course is fun from time to time; but if you continually lose, you won’t last in the game very long. As smart option sellers, we want to be the ones who take the other side of those low-probability losers and turn them into high-probability winners for us. To reiterate, selling options can be profitable because of the high probability of success if used correctly. Three out of the four strategies I will show you in the book are of the selling type, and I will give many examples later on down the road.

Buying OTM options is the speculation game pure and simple (don’t worry, I’ll tell you more about what OTM means very soon). We all like to speculate because the payoff can be great, especially with options where leverage plays a big part. Where else can you plunk down $100 to control a few hundred shares of stock for a limited time? This is the options market. You get to control something very large for a small amount of money. Unfortunately, this is where I believe the option market advertising went off track. A majority of people only see options as a lottery type of investment and continue to focus on buying the low-probability trades.

You need to remember that options are not an investment unto themselves. An option’s value is derived from other sources; hence, options are considered derivative investments. The most important of these other sources is the prediction of the direction you think the underlying security is going to move in the time allotted before option expiration. For one reason or another, many investors believe they can predict where a stock or commodity is headed in a very short time frame. They are lured into playing that hunch by buying the cheap options that have little chance of success. So once again, we’re going to focus on how we can take advantage of those probabilities and turn those opportunities into our gains.

Even though I like to focus on selling options to take advantage of the buyer’s low probability of profit, I also know how to buy options correctly as a form of investment. There’s a certain way to buy options correctly as a substitute for a stock or commodity, and when I’m interested in purchasing options, there’s only one way I do it. That way is to buy deep-in-the-money (DITM) options, which I’ll explain later.

AN OPTION EXAMPLE

Figure 1.1 is a screenshot of a typical option chain from one of my options brokers, optionsXpress (www.optionsXpress.com). The strike prices are listed down the “Strike” column and the bid/ask market for the call options is in the middle of the graphic. Our five-month option would take us to the July 2006 options, where the $25 call can be bought for $.40.

Figure 1.1 INTC Option Chain, July 2006 Expiration

Source: optionsXpress.

The advantage of buying options instead of the stock is the leverage you get. You only have to spend a little money up front to control the 100 shares. Instead of paying $2,100 to buy 100 shares of INTC outright, we only have to pay $40 today by using options. That’s the key.

Eventually, if INTC gets above our breakeven price of $25.40, we will be faced with a decision: We can either sell the option back to the marketplace and pocket our gain, or “exercise” the option and turn it into actual stock shares.

If we decide to exercise, then we must pay the full stock purchase price. It’s like making a balloon payment at the end of a loan. In this case, we’d have to come up with the extra $2,500 to pay for the 100 shares of stock we just exercised. I will go into this in more detail when I discuss buying deep-in-the-money (DITM) options.

You have to understand, though, that you’re buying something that has no “real” value right off the bat. You’re entering into a contract to buy INTC at $25 per share. Why would you want to buy INTC at $25 per share when you could buy it today for $21 per share? Good question. The answer, I believe, comes down to “hope and cheapness.” Many people don’t want to plunk down the $2,100 today to buy INTC but they feel okay spending only $40 for the chance that INTC will get above the breakeven price of $25.40 within five months. Some people would rather spend a little money today hoping that the stock will go up and become profitable, rather than buying the stock at current market prices.

THE PROFIT/LOSS SCENARIO

Regardless of which strike price you choose, let’s see what the profit/ loss (P/L) scenario looks like graphically for a typical “long call” strategy. It helps to visualize your position with the use of P/L charts as seen in Figure 1.2.

Our P/L chart plots our position with the stock price on the bottom and our potential dollar gain/loss on the left side. The vertical line represents the price of the stock today ($21) and the thick line represents our long call position. Since the call cost us $40, that is the maximum we can ever lose as indicated by the thick horizontal line that stretches from $0 to $25. As mentioned earlier, when you buy options you have limited risk, $40 in this case, and unlimited profit potential. The thick line starts to bend upward at our strike price of $25 and crosses the $0 P/L line at $25.40—which is our breakeven price. Once INTC gets above $25.40, we’re making money for as long as INTC heads higher. As the price of the stock increases, our profit goes up indefinitely.

Figure 1.2 Call Option Profit/Loss Chart

The question is, will INTC get above $25.40 in the next five months? Nobody knows, but that’s what you’re hoping. Remember that word “hope.” Are you in an investment based on hope? When you buy the INTC $25 call option, you’re really holding something that has no value right off the bat. It becomes valuable only when INTC goes above the breakeven price of $25.40 (if held until expiration). That’s over $4 higher than where INTC is trading in the marketplace today. So, do you want to pay $2,100 to own 100 shares outright of INTC stock, or do you want to shell out a measly $40 and hope INTC goes up another $4 in the next five months? Only you can make that decision. Sure, it costs you only $40, but what’s the probability of INTC getting to your breakeven price? Luckily for us, we have tools that can help figure out that probability. Using my probability calculator shown in Figure 1.3, our fictional INTC $25 call has a 21.9 percent chance of hitting breakeven by option expiration. Is that a high enough probability for you to take this trade?

When looking at the probability calculator in Figure 1.3, you want to focus on the box that reads, “Finishing above highest target.” This is the box that tells us our chances of INTC being above our breakeven price of $25.40 at the time of option expiration based on the price of INTC, days to expiration, and the level of volatility that exists at the time of the trade. (As we get into Chapter 5, I will tell you why it’s important to focus on the box that says, “Ever touching highest target.”)

When you see it graphically in front of you that your investment has a 21.9 percent chance of being profitable, you might think twice about it. I know it’s only $40, but it could be larger than that in some cases depending on how many option contracts you buy. Do this enough times with those small chances and you’ll end up walking away in disgust from the options market.

Figure 1.3 Probability Calculator

Source: © Copyright Optionvue Systems International, Inc.

The problem here is that many investors tend to pick strike prices too far away from the current price of the stock and/or an expiration period that’s too close in time. These investors think that they can predict the very short-term moves with pinpoint accuracy in the short time allotted. Nobody is that good. Later on when I discuss DITM options you’ll see how we use them in lieu of buying the stock and how you will get all the same movement of the stock, plus the leverage and at least a 50 percent risk reduction to boot.

Let’s see what a P/L chart looks like for a “long put” strategy. (See Figure 1.4.) When you buy a put option, you’re betting on the price of the stock or commodity to go down. As with the long call strategy, your risk is limited to what you pay for the option and your reward is unlimited up to the point of the stock or commodity falling to zero. But like the long call, investors tend to concentrate on buying the low-probability, OTM, close-to-expiration options.

Figure 1.4 Put Option Profit/Loss Chart

In this case, the chart looks reversed. This is because your profit goes up when the stock goes down. In this example of a put option purchase, the stock was at $38 and we bought a $35 put option for $.35 ($35 in actual dollars). The horizontal part of the thick line represents the maximum we can ever lose, which is $35. No matter how high this stock may trade, we can never lose more than $35. On the upside, our profit is unlimited as you can see in the thick line extending upward to the left. We can make as much money as possible to the point of the stock falling to $0 per share.

STOCK PRICE AND STRIKE PRICE RELATIONSHIP

The next thing we need to understand about the basic principles of options trading is the relationship between the strike price you choose and the current price of the underlying security. There are three terms you need to know. They are: in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM). Unfortunately, the options game does come with its own language so you need to know some of these terms to get a grasp of how to effectively navigate the battlefield. I’ve touched on some of these terms already, but I want to give the textbook definitions of each. We’re just going to scratch the surface here with these terms and later on we’ll dig deeper to see how they can affect your trading profitability.

For call options, if the strike price is higher than the current price of the stock or commodity, it is called OTM. For example, if INTC is at $20 then all strikes above $20 are OTM. Any strike that is priced near the current price of the stock is called ATM. The INTC $20 strike would be considered ATM. Lastly, all call strike prices that are below the current price of the security are ITM. If INTC is at $20, all strikes below that would be ITM.

Put options are the opposite. Any option whose strike price is lower than the current price of the stock or commodity is considered OTM. For example, if INTC is at $20, then all strikes below $20 are OTM. Any strike that is priced near the current price of the stock is considered ATM. The INTC $20 strike would be considered ATM. Lastly, any put option strike price that is above the current price of the security is considered an ITM put option. If INTC is at $20, all strikes above that would be ITM.

It’s important to know these terms because each one will act differently due to the degree of the option being in-, at-, or out-of-the-money. We will talk extensively about how each of these types of options can affect the profitability of your position. It also helps to know the terms because you might be working with a full-service broker who can help you tailor your investment ideas to the types of options available.

SUMMARY

We learned the basics of options in this chapter—specifically what call options and put options are. They can be used as a substitute for taking a position in an outright stock or commodity trade.

The relationship between the price of the stock and the strike price is the key to determining whether the option is out of the money (OTM), at the money (ATM), or in the money (ITM). Picking the option’s correct strike price will ultimately help decide the probability of profit for your trade—something we dive in to more deeply in subsequent chapters.

CHAPTER 2

HOW OPTIONS ARE PRICED

Options are not independent investments, so to speak. Yes, you can buy them individually, but their values are based on and derived from other variables, the most important of which is the movement of the underlying security. Hence, options are classified as “derivative” products.

When you look to buy or sell an option and you see its price, do you ever wonder how that price was calculated or where it came from? If you don’t, then you may be either overpaying for it when you buy or underselling it at too cheap a price. There’s a certain formula that’s used to calculate an option’s premium, and if you want to be a smart option trader, then you need to familiarize yourself with how it’s done. The option’s price doesn’t just magically appear out of thin air. The market makers on the options exchanges use very precise software to price each and every option according to all the conditions that exist at that very moment in time.

The price, or “premium,” of an option is dependent on several variables. They are:

• Intrinsic value.

• Current price of the underlying security.

• Strike price of the option.

• Extrinsic value.

• Days left to option expiration.

• Volatility (historical or implied).

• Interest rates.

• Dividends (stock options only).

You then take these numbers and enter them into an option pricing calculator. Most option pricing calculators and software will use a formula like the standard Black-Scholes option pricing model, which is named after the gentlemen who created it, Fischer Black and Myron Scholes. The software will then produce a result that tells you what your option should theoretically cost. I say “theoretically” because what you get from your option calculator might be quite different from what the option is trading for on the exchange. I will explain that discrepancy when we talk about the volatility component.

Finding and inputting these numbers is quite simple, with the exception of the volatility component, which can get a little tricky. I say this because it is the only input that is not readily agreed upon by all market participants or set by the exchanges. When using an option calculator, it’s easy to find all the other input numbers. We can always get a current quote for the stock or commodity, the exchanges set the strike prices and days to expiration, and interest rates and dividends are all widely disseminated; you can find them online or in any financial newspaper. And just to cut through some of the bull, I’m here to tell you that the first two intrinsic and the first two extrinsic items on the list are the only ones that really matter when it comes to pricing out options. Dividends and interest rates play such a minor role that we never need to be overly concerned with them.

I need to explain the two option-jargon concepts above that relate to the option pricing inputs: intrinsic value and extrinsic value.

Intrinsic value explains the relationship between the price of the underlying security and the strike price of the option. We went over these earlier and referred to them as out-of-the-money (OTM), at-the-money (ATM), and in-the-money (ITM). Intrinsic value tells us whether an option has any “real” or “true” value to it. Only ITM options, whether they are ITM calls or ITM puts, can have intrinsic value. An example will help:

What’s extrinsic value? Extrinsic value is what’s left over after you subtract the intrinsic value. The last four items on the list make up the extrinsic part of an option (days to expiration, volatility, interest rates, and dividends).

Another way to tell if an option has intrinsic value is by seeing if it would have any real value if it was exercised. Exercising an option means that you turn it into actual shares (futures contracts) of the stock or commodity.

Let’s say that INTC is still at $27 per share. The $25 call option (which has its strike price below the current price of INTC) can be exercised right now, which means we can buy shares of INTC for $25 per share ($2 below its current price). If we immediately turned around and sold the shares in the open market, we could get a minimum of $2 per share extra for our trade. That option then has $2 of intrinsic, or real, value.