FFO Options 7: Stock Vs. Options

Dr. Scott BrownStock Options

Stocks vs OptionsOptions

Are sensitive to:

The direction of the underlying stock.

The time remaining before expiration date

Volatility of the underlying stock.

Stocks

Can only move up or down.

Their cost doesn’t include the commission.

Its market value can increase or decrease through time.

They have an infinite lifespan.

Makes Money:Choosing the strike price that maximizes profits.

Makes Money:They wait (hopefully) until their market value is higher than their cost.

Relationship between the strike price and the underlying stock.Call options

Strike Price> Stock market value. Out of the money

The Strike price is the same as the stock market value At the money

Strike price< Stock market value In the money

Put options

Strike Price< Stock market value. Out of the money

The Strike price is the same as the stock market value At the money

Strike price> Stock market value In the money

Advantages of buying options instead of stocks.With options you have available leverage

You pay a fraction of the cost to control the a 100 shares.

Hence, you can control thousands of stocks with hundreds of dollars.

You choose the strike price that gives you the best leverage and execute it before its expiration date.

With stocks you have a limited leverageyou pay 50% of the cost if you trade the margin or you pay the cost of the 100 stocks and its commission to control them

Decide when to sell, hopefully when its price is above your break even cost

Options purchasing scenariosAssume the market value of a share of Microsoft stock is $27.50 and the option chain is the following:

symbol last change "bid" "ask" Imp. Vol. delta 'strike''MAY 06 calls (31 days to expiration) MSFT@ $27.22

MQFEU 20.00 0 19.70 19.80 1.00 7.50MQFEB 17.70 0 17.20 17.30 1.00 10.00MQFEV 15.20 0 14.70 14.80 1.00 12.50MQFEC 12.70 0 12.20 12.30 1.00 15.00MQFEW 10.00 0 9.70 9.80 1.00 17.50MQFED 7.50 0 7.20 7.40 1.00 20.00MSQEX 4.40 -0.1 4.70 4.90 1.00 22.50MSQEJ 2.40 0.35 2.30 2.40 18.5 0.95 25.00MSQEY 0.40 0.1 0.40 0.45 15.9 0.46 27.50MSQEK 0.05 0 0.00 0.05 18.3 0.04 30.00MSQEZ 0.05 0 0.00 0.05 30.4 0.03 32.50

Options purchasing scenarios(Cont)Delta describes the option's price movement

in conjunction with the price movement of the stock therefore a wise decision is to buy options with a 90% or greater delta.

You want to predict how much the option's price will move in relation to the stock's price movement.

ExampleScenario #1: buy the $30 call option:

Our option cost is: $.05 X 100 shares = $5.00 VS with stocks our cost is: $27.22 X 100 shares = $2,722.00

To make money the stock has to go up above $30.05 in the next 31 days it has to go up $3.00 in the next 31 days

Example (Cont)Our delta for the $30 call is 4% This means: if the stock goes up $1 the option

goes up about 4% or about $.04 The stock investor will make $100 ($27.22 X

100 - $28.22 X 100)

Verify Analysis With An Options Calculator

Style: American

Price: 27.22

Strike: 30

Expitation Date: FLEX

Days to Expitation: 31

Volatility %: 18.3

Interest Rate: 5.0245Dividends

Date (mm/dd/yy):5/15/06

Dividends Amount:0.09

Dividends Frequency:Quarterly

Symbol: N/AOption Value: 0.0214

Delta: 0.0377

Gamma: 0.0568

Theta: -0.0021

Vega: 0.0065

Rho: 0.0009

Results:The calculator values the $30 option at $0.02The value of the delta is 0.0377 almost 4%

Verify Analysis With An Options Calculator (Cont)Style: American

Price: 28.22

Strike: 30

Expitation Date: FLEX

Days to Expitation: 31

Volatility %: 18.3

Interest Rate: 5.0245Dividends

Date (mm/dd/yy):5/15/06

Dividends Amount:0.09

Dividends Frequency:Quarterly

Symbol: N/AOption Value: 0.1008

Delta: 0.1359

Gamma: 0.1454

Theta: -0.0058

Vega: 0.0179

Rho: 0.0032

Results:A $1 increase in the stock value ( from $27.22 to $28.22) causes the $30 option to be worth $0.10

the stock holder will make $100 ($28.22 X 100 - $27.22 X 100)

The option holder will make $5 ($0.10 X 100 - $0.05 X 100)

the reason for this is because acoording to the probability calculator

The probability of the stock getting above $30.05 is 3.80%

ExampleScenario #2: buy the $25 call option: Our option cost is: $2.35 X 100 shares =

$235.00 vs with stocks our cost is: $27.22 X 100 shares = $2,722.00

To make money the stock has to go up above $27.35 in the next 31 days it has to go up $0.13 in the next 31 days.

Verify Analysis With An Options CalculatorStyle: American

Price: 27.22

Strike: 25

Expitation Date: FLEX

Days to Expitation: 31

Volatility %: 23.99

Interest Rate: 5.0245Dividends

Date (mm/dd/yy):5/15/06

Dividends Amount:0.09

Dividends Frequency:Quarterly

Symbol: N/AOption Value: 2.3548

Delta: 0.9104

Gamma: 0.0952

Theta: -0.0086

Vega: 0.0135

Rho: 0.0135

Verify Analysis With An Options Calculator (Cont)

Style: American

Price: 28.22

Strike: 25

Expitation Date: FLEX

Days to Expitation: 31

Volatility %: 23.99

Interest Rate: 5.0245Dividends

Date (mm/dd/yy):5/15/06

Dividends Amount:0.09

Dividends Frequency:Quarterly

Symbol: N/AOption Value: 3.2988

Delta: 0.9737

Gamma: 0.0381

Theta: -0.0057

Vega: 0.0057

Rho: 0.0125

Analysis & ConclusionAnalysis:

Our delta for the $25 call is 95%

This means: if the stock goes up $1 the option goes up about 95% or about $0.95

Our option value will be about $3.30, so we make $95 ($330 - $235)

The stock holders will make $100 ($27.22 X 100 - $28.22 X 100)

Conclusion:

the option return is 40% (95/235)

the stock return is 3.7% (100/2700)

the reason for this is because according to the probability calculator the probability of the stock getting above $27.35 is 49.60%

Disclaimer DISCLAIMER: THE DATA CONTAINED HEREIN IS BELIEVED TO BE RELIABLE BUT CANNOT BE

GUARANTEED AS TO RELIABILITY, ACCURACY, OR COMPLETENESS; AND, AS SUCH ARE SUBJECT TO CHANGE WITHOUT NOTICE. WE WILL NOT BE RESPONSIBLE FOR ANYTHING, WHICH MAY RESULT FROM RELIANCE ON THIS DATA OR THE OPINIONS EXPRESSED HERE IN. DISCLOSURE OF RISK: THE RISK OF LOSS IN TRADING FUTURES, FOREX AND OPTIONS CAN BE SUBSTANTIAL; THEREFORE, ONLY GENUINE RISK FUNDS SHOULD BE USED. FUTURES, FOREX AND OPTIONS MAY NOT BE SUITABLE INVESTMENTS FOR ALL INDIVIDUALS, AND INDIVIDUALS SHOULD CAREFULLY CONSIDER THEIR FINANCIAL CONDITION IN DECIDING WHETHER TO TRADE. OPTION TRADERS SHOULD BE AWARE THAT THE EXERCISE OF A LONG OPTION WOULD RESULT IN A FUTURES OR FOREX POSITION.HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL, OR IS LIKELY TO, ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM, IN SPITE OF TRADING LOSSES, ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS, IN GENERAL, OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS. PS.  In our opinion, we believe, it may be possible, that heavy smoking and drinking may be hazardous to your health.  If you choose to smoke and drink while trading, The Delano Max Wealth Institute nor Dr. Scott Brown is liable for any damage it may cause.  If you slip and fall on the ice, we're not liable for that either.