Options Basics

An option is one of the more advanced trading vehicles.  Most investors focus on stock trading, but few know of the power that options provides to a trader, or investor.  There are two types of options, puts and calls.  Put and call options are polar opposites of each other.  Put options allow the buyer to force the seller to purchase shares at a predetermined price at some point in the future while call options allow the buyer to acquire a stock at a predetermined price.  Puts and calls are bought and sold as a contract, where each contract represents 100 shares of the underlying security.  Call options increase in value as the underlying security moves higher while put options increase in value when the underlying moves lower.

Traditionally; options are used to hedge against unforeseen risk, but many speculators attempt to use the leverage of an options contract to their advantage and speculate on market movement.  For example, if you buy a June $100 (1 month from current date) call option on IBM for $2, you will pay $200 (100 shares * $2) for the option to buy 100 shares of IBM one month from now at $100.  If the stock is at $110, your option will be worth $1000, for a profit of $800.  Notice how a $200 options investment yielded the same amount of profit as a $10,000 investment in the stock would have.

Put Call Ratio

The buying and selling activity for puts and calls can be used to help gauge investor sentiment in the market.  The put call ratio measures the relationship between the number of puts being bought versus calls being bought.  Some traders or investors will refer to this ratio as the call put ratio, but this terminology is incorrect.  This is because the formula is calculated by taking the total count of puts and dividing it by the total number of calls.  This relationship takes into account all of the equity and index options on the Chicago Board of Exchange.  If there are a large number of puts relative to calls, this is a sign that investors are bearish on the market.  However, this indicator has gained popularity in its application as a contrarian indicator.  When there is a large number of puts being bought, this usually indicates that there is fear in the market and that a bottom may not be that far off.  The opposite is true for a very low put call ratio reading. 

There is one caveat to the ratio.  Some traders like to remove the put call data on index options because it is biased towards puts.  This is because many large institutions and hedge funds will purchase puts on index options insurance against long positions.  So, some traders like to focus on the put call ratio of equity options as this represents the bullish and bearish sentiment of the issues on the exchange.
 
Additionally, with the advent of inverse ETFs and the explosion of volume in these trading vehicles, it has become increasingly difficult for investors to gauge the relevance of a high or low put call reading.  A large number of puts and calls are being bought on these securities which actually bet against the market.  Therefore, a large number of calls being bought on the SDS (inverse S&P ETF) will indicate a bearish posture and cause technical analysts to misread the message of the put call ratio.

Weekly Timeframe

Looking at the put call ratio on a daily basis can generate a number of false signals.  This is because the volume of puts and calls traded on a daily basis can fluctuate widely during volatile trading periods in the market.  On strong up days, there is a spike in call volume.  While, on large down days, the put volume while explode and one-day moves that spike over 1.  The best method for monitoring the relationship between puts and calls is to perform analysis on a weekly basis.  This is because market sentiment can not be quantified in a day, but rather takes a number of snapshots over a period of time in order to determine the true nature of the market.  In recent years, a weekly put call reading greater than .75 has marked significant market bottoms, while readings below .5 have marked market tops.  However, the bear market of 2007 – 2008 set new weekly records for the put call ratio.  The relationship to put and call options during the credit crisis sent the ratio over 1.4 on three occasions in a 12-month period.  As you can see in the below chart, the line graph of the CBOE put call ratio resembles that of an EKG reading.  Many traders will overlay a simple moving average or exponential moving average to smooth out the line to better identify the trend of puts and calls in the market.  Most free charting platforms will provide the put call ratio as a market breadth chart.  Traders that use their own custom applications can receive daily and historical put call volume data directly from the CBOE. 

Contrarian Trading Approach

Another method for profiting from the put call ratio is to go counter to the broad market when extreme readings are hit.  One of the key components for doing this effectively is to also monitor divergences with technical analysis indicators.  So, if a trader sees that the market is making lower lows while the RSI is making higher highs and this falls inline with a put call ratio greater than 1.4, there is a good shot the market will bottom in the coming days or weeks.  Like any other technique in the market, a trader can not solely rely on the relationship of puts and calls, but it does fit into the bigger picture of the sentiment of the market.

Summary 

To recap this article, puts and calls provide the means for limiting risks, but still provide the ability to make decent profits with low risk.  Another method for trading with options is to monitor the put call ratio to gauge market sentiment.  So, if you are in a winning short position and you see the put call ratio exceeding 1.4, it is probably wise to take some money off the table.   Conversely, if the ratio of puts and calls drops below .4, it is probably a good idea to sell some of your long position.  Remember that the market is ever changing, so last years extreme reading is this year’s normal reading.  So be sure to monitor the put call ratio over the last five to ten years in order to put the ratio in the context of the market you are facing on a daily basis.

Option Risk Profile

We went over the basics of puts and calls in our introduction to options.  Now, we want to build on that and cover the option risk characteristics of a call and put. 

Long Call Risk Characteristics

Let's cover the risk profile of a call first.  I believe examples in this section would be the best way to cover this topic.  We are going to start with a LONG CALL example. 

In this scenario, we would be buying deep in the money calls for $5.25, $4 in intrinsic value and $1.25 for 3 months of time premium.  The buyer of this call option is anticipating that the underlying security will be higher than $25.25 ($20 exercise or strike price + $5.25 option premium) within 3 months of time.  Therefore, in our diagram below, the strike price is $20 while the breakeven price is $25.25.  As the stock moves above point b* or breakeven, the call buyer is in a profit position.  For example, assume the stock reaches $30 at expiration; the call buyer would be able to buy the stock at 10 point discount while only paying $5.25 for that option.

Once the underlying security is above the strike price, the option will move penny for penny with the security.  The reward for the call buyer can be unlimited as the security can go as high as it wants to. 

Short Call Risk Characteristics

When someone is buying an option, there is obviously a seller on the other side who believes that the stock will not go above $25.25 within the next 3 months.  Let's now take a look at the option risk profile of an option writer.  For the sake of clarity, the term "write" refers to shorting or selling an option.  Using the same example from above, the writer of the option has received a premium of $5.25 and will continue to remain in a profit position as long as the stock does not move above $25.25.

Shorting an option brings added risk, especially if the seller is "naked".  The term "naked option" refers to the idea that the seller of the stock does not own the underlying stock that may eventually end up being called away by the purchaser of the option.  Just like the naked put option, selling naked calls is a risky proposition and should be done only after much experience since there is no limit to the option based risk. 

The most common use for selling a call is part of a common options strategy known as the covered call.  We will cover this strategy in far more detail, but the short story is that covered calls limit your downside exposure and add that extra bit of insurance and cushion to your long position. 

Long Put Risk Characteristics

Lets start with a new example for the put section:

When initiating a long put option position, the option holder is looking to cover his/her downside risk in the event the stock takes a larger than expected hit.  Puts allow the put buyers the ability to force the writer of the option to buy the underlying stock at the strike price.

You may be asking what the difference between selling a call and buying a put is.  They both limit your downside risk, right?  Yes, but there are two key differences.  Puts protect you against disastrous or rapid declines in a securities value; calls will only limit the downside up to the value of the premium you received for selling that call.  The second key difference lies in the fact that selling a call results in a net debit to your account balance while buying a put will result in a net credit, or a cash outlay.

By going long the put option for $5 with a strike price of $40, the breakeven price would be ($40 + $5), or $45.  As the stock moves lower, the put buyer moves into a profit position, penny for penny.

Short Put Risk Characteristics

Finally, let's take a look at the short put risk chart.  When you write a put option, or go short, you are selling premium in anticipation that the stock will move higher and therefore you will be able to eat the entire option premium.  Alternatively, a potential buyer of a stock may want to get long a stock and will sell puts to do it.  Essentially, taking our example above, instead of buying the stock at $40 a share, the investor could short the put option for $5 and be forced to buy it at $40 if the stock moves lower at expiration.  The bet here is that the stock wont drop below $35 a share.  If the stock moves above $40 at expiration, the writer of the option would have made $5 per share as the option would never be exercised by the purchaser. 

In our example below, the breakeven for this scenario would be ($40 - $5), or $35.  As the stock moves lower, the price of the put moves higher and this results in greater losses for the writer of the put. 

Conclusion

The concepts we discussed above are the basic profit/loss characteristics of put and calls.  Study these charts carefully and commit them to memory.  Once you master these basics, you will be able to more fully understand the options strategies that we will cover.

VIX Definition

The VIX is used to gauge the bearish or bullish nature of the broad market.  The VIX does this by measuring the implied volatility of the S&P 500 index options.  The VIX displays the expected volatility of the market 30 days out in the future.  It is believed that the VIX is a good indication of the fear in the market.  This is because if the VIX reaches extreme levels, it implies that a number of traders have purchased puts as insurance against a falling market. 

History of the VIX

The VIX was first published in 1993 by Robert E. Whaley, a professor at Duke University.  Dr. Whaley was able to create the first index used to track the volatility associated with underlying exchange traded futures and options.  The VIX is calculated by analyzing a large number of in the money and out of the money call and put options of two expiration months for the nearest 30-day period.

VIX vs VXO

The VIX went under a major algorithm change in 2003.  Originally the VIX was calculated by measuring the implied volatility of the at the money options of the S&P 100 using the Black Scholes Model and was known as the VXO.   The VXO had a number of flaws due to the fact it was based off a small number of issues and not reflective of the market at large.  The VIX corrected this issue by basing it off the S&P 500, which is a better representation of the market. 

VIX Trading Strategy

The VIX is not like an oscillator, so in theory it has no cap on how high it can go.  A basic rule of thumb is that a move above 30 indicates increased volatility.  Conversely a reading below 20 indicates a passive nature in the market, with little to know volatility.  The VIX was not followed much until the late 90's when there was a dramatic increase in the options market as result of the bull market and more retail participants getting involved in the market.  Markets fall harder than they rise, so bear market moves often terminate with a high VIX reading.  A basic trading strategy is to look for a fire sell in the broad market when the VIX indicator is over 40.  Recently the VIX reached an intra day high of 75.92 on October 10, 2008, but this extreme reading was a result of the most volatile trading week in U.S. History.

VIX & Market Bottoms

Below is a chart of the VIX over the last two years.  Notice how high VIX values lead to a number of market bottoms.