Archive for December, 2012

Options: What they do and how to trade them

December 26, 2012 6 comments

tl;dr version: Fundamentals teach you what to trade, technicals teach you when to trade.

Much has been written online about options, so some of this won’t be novel information, but I’d like to discuss some of the things I learned as I was learning about the stock market.  I’ll admit, learning about options was incredibly daunting; one look at a stock’s option chain ($AAPL, for example) is overwhelming at best.  But options are a great way to leverage relatively small amounts of capital for large gains.  My favorite sites for explaining options and different option strategies are The Options Guide and Option Trading Tips.

In short, buying stock options gives you the right, but not the obligation, to purchase shares of an underlying asset at a specified price (known as the Strike Price).  They are an amazing way to leverage your portfolio to make a higher percentage increase on your investment with every smaller percent increase in the underlying asset.  For example, a small increase in a stock can result in a much larger increase in the option associated with that stock.

When buying normal shares of stock, owning 100 shares of a stock priced at $100, means you’re holding $10,000 worth of shares.  Let’s say that stock price goes up to $105.  It’s now worth $10,500.  Ok, cool, we just gained $500 or 5%

Now instead of owning the stock itself, let’s say we buy 100 call options priced at $1.00 with a strike price of $110.  Keep in mind each call option is “bundled” with 100 contracts, so buying 100 call options (with each option containing 100 contracts) at $1.00 is worth $10,000.

A rise in the underlying asset some amount will result in the call option price to go up.  So let’s say the underlying rises to $105, the call option may rise up to $2.00, possibly more.  At an option price of $2.00, our 100 contracts are now worth $20,000!  We just doubled our investment.  Or realized a 100% gain.  This is the beauty of options.

There is one caveat with options and that is Time Decay, represented by the Greek letter Theta.  In order for an option price to rise, the underlying asset price MUST move (up for Calls, down for Puts).  If it doesn’t, your option price just starts to fall until expiration.  If your option reaches expiration without being “In the Money” (above the strike price for Calls, below the strike price for Puts) it will be worth ZERO.  In other words, your loss will only be what you initially paid for the option in the first place.

I like graphs, so here’s a graph constructed in Excel using OptionEdge’s option trading software (it’s free, I like free).

Call Option Graph, courtesy of

In our example, we spent $10,000 on 100 options priced at $1.00 at a strike price of $110.  The green line represents our current profit/loss potential.  As you can see, when the price of the underlying rises to $105, the option value is $20,000.  If we were to sell, the option would be worth $20,000, thus making $10,000 in profit.

The red line represents what the option is worth at expiration, also known as the intrinsic value.  If the underlying asset fails to reach the strike price of $110, our option is worth nothing.  So going back to our example, let’s say our 100 call options are at a strike price of $110.  But by the expiration date, the underlying stock price only went from $100 to $105.  It’s a 5% increase from where it was, but still not good enough for our option to be In the Money.  So our 100 contracts that we had bought for $10,000, doubled to $20,000, are now worth a big fat $0 because we held on to them for too long and they kept going down in price due to the Time Decay. Bummer.

In other words, when buying Calls or Puts, the maximum profit is unlimited, while the maximum loss is only what you spent on purchasing the option initially.

The difference between the green and red lines is the extrinsic value of the option, also known as the premium.  As the expiration date nears, the price of the option decays and the green curve begins to look more and more like the red curve.

Option Price as Function of Time to Expiration, From

There are other risk measures to keep in mind when trading options, known as The Greeks.  Two important Greeks to understand, besides Theta, are Delta and Gamma.  Delta is a measure of how much the option price changes in response to a change in the underlying.  Gamma represents Delta’s rate of change, that is, how much the rate of change of the option price changes with movements in the underlying.  A detailed look at Greeks is beyond the scope of this blog, but it is important to understand how these metrics affect your profit and loss potential.  Check these resources to learn more: ThinkorSwimInvestopedia, and The Options Guide.

There’s some really interesting strategies one can employ when trading options.  Many are described at The Options Guide.  You can buy (and sell! – but I won’t go into selling options on this post) both Calls and Puts at varying strike prices and at varying expiration dates lending to some pretty complex trading schemes.

Ok, so great, that’s all well and good, but how do you trade them?  Simple.  Pattern recognition.

As you may have noticed in my previous blog posts, I like to do a lot of technical analysis.  Technical analysis might be a dying art, but it helps to try to pick bottoms and tops and predict swings.  It’s pretty remarkable to me how faithfully stocks can follow trendlines and areas of support and resistance, so I try to use the general trends as guidelines for when to enter and exit.  This leads to a lot of tape-watching for the right entry or exit point.

My golden rule is fundamentals tell you what to invest in, technicals tell you when to invest.  For instance, if I notice a stock that has attractive financials (or unattractive, for the bearish traders) has bounced nicely off a trendline, there’s a good chance that will be the bottom (or top) and I’ll buy calls (or puts) accordingly. If I’m almost certain of a price move, I’ll load up on near term OTM/ATM options, which could be an insanely foolish strategy because of the high Theta, but sometimes most lucrative due to the high Gamma, and therefore highest percentage increase in stock option price (relative to other ITM or deep OTM options).

I like real-life examples, instead of made-up scenarios, so here’s one.  A few months ago, I bought 60 AAPL call options for $18.15 with a strike price of $570.  With commission, it cost me $109,024.  When I bought it, AAPL the stock was trading around $568.  When I sold the 60 options the following day, Apple made a move up to $583.  I sold the 60 options for $29.50, now worth $176,875.  A 60% increase. I’ll take those returns any day.  Ok, so I left some profits on the table because after I sold my options, AAPL continued to go up and closed the day at $589.  Those April 570 calls were now worth $37.00.  I missed out on $45,000 of profits because I sold too early!!  But who knows, maybe AAPL could have completely crashed (just look at Feb 15th… aapl rose from 500 to 526 then crashed down to 499).

But this represents my strategy when trading options.  I’d much prefer to take profits than to risk my options being worth nothing if the stock drops or decays into nothingness.

Let’s look at another example.

AAPL Daily,

AAPL Hourly,

S&P 500 Daily,

S&P 500 Daily,

S&P Hourly,

AAPL has been, for the most part, stuck in a medium-term descending trading channel since the highs in September.  The broad S&P 500 index has also been trending downwards in the medium term, despite a long-term uptrend, due to austerity crisis concerns.  The bears certainly have control and both are hitting levels of resistance.  However, I believe they will breakout if and when a deal is reached in Washington.

On Dec. 19th, both the broader markets and AAPL were approaching levels of resistance.  Betting on the fact that we would not see a deal come out of Washington by week’s end, I bought 1000 AAPL 525 Puts expiring Dec. 21st priced at $3.75.  Subtracting commissions, the value of the puts I purchased was around $375,000.

AAPL 525 Put Opened 5/19

AAPL 525 Put Opened 5/19

On the morning of Friday, Dec. 21st, AAPL stock dropped to a low of $510.24.  Because of this underlying price drop, the price of the OTM AAPL 525 Puts I bought for $3.75 were now worth over $12.00, because they became ITM.  By 11:00 am on Dec. 21st, the value of the 1000 puts I was holding was worth over $1.2 million.  That’s a pretty good gain.  However, I didn’t sell the puts and chose to hold them through expiration.  AAPL rebounded off a major increasing trendline and closed the day at $520.17.  The puts decreased in value and expired at a price of $5.45 resulting in a total cash value of $545,000.

AAPL 525 Put Expired 12/21

AAPL 525 Put Expired 12/21

Eh, should have closed out my position earlier in the day.  But my overall options strategy is to initially look at the fundamentals of the macroeconomic environment and the specific company I’m trading.  This tells me what to trade.  I then look at the technicals to tell me when I should open and close my positions.

So I hope I’ve been able to explain options somewhat more clearly.  They are a powerful financial instrument to realize huge gains, but you must understand how to properly wield them.  Unlike normal stock, there is a real danger to lose your entire investment when you trade options.  When you’re holding normal shares of a stock and the price drops substantially, you could lose a large portion of your investment, and there’s always a chance the stock price could rebound so you’ll recover your loses, but rarely will you lose your entire investment, which can be common when trading options.

It should be noted that all transactions described on this blog were performed on the Investopedia Stock Simulator and not in the real stock market.  I have no actual positions in any stocks mentioned nor will I be initiating any actual positions in the next 6 months.  Furthermore, the information on this blog should not be considered financial advice.  The main purpose of the blog is to educate its readership, myself included, about concepts and ideas that were previously unknown to me.


2013: A look ahead

December 20, 2012 Leave a comment

2012 was a roller-coaster year.  The S&P Index for the year to date has gained almost 15% (as of Dec. 19th).  Some stocks have hit all time highs, notably AAPL, AMZN, IBM, and GOOG.  While some tech IPOs, such as GRPN and ZNGA, have tanked.  And of course there’s the botched FB IPO.  Now, with the austerity crisis looming, it’s tough to say where the market is heading for 2013.  It might be safe to say much of the uncertainty is already priced into equities as there has been a substantial pullback from these yearly highs, so fiscal deal permitting, we may see a decent bounce.

S&P 500 Daily Chart courtesy of

We saw a Fibonacci retracement from the highs at $1474 on September 14th to the low at $1443 November 16th.  We’re also seeing a short-term top from the descending trendline resulting from the triple-top highs of 9/14, 10/5, and 10/17.  If we do, in fact, see a deal come out of Washington, we’ll most likely see a breakout, however, I give an agreement between Obama and Boehner a 20% chance of occurring this week before the holidays.  The more likely scenario is no deal is made and we hit resistance and start the trek back down to find support at a very major ascending trendline as well as support at $1350.

For 2013, the upside for the markets is certainly there.  Clearly, the markets want to breakout.  We just need to see the macroeconomic environment become more favorable.

Looking ahead, I’d like to offer some predictions for some publicly-traded companies.  I see great things coming out of Alnylam (ALNY).  Their 5×15 program, in which they’re aiming for 5 products on the market by 2015, looks to be on track.  RNA interference is an extremely promising approach for treating diseases and Alnylam’s GalNac-siRNA delivery platform is unmatched.  The RNAi Therapeutics Blog has some great insights about their GalNac-siRNA conjugates on knocking gene expression down.

Next up is Achillion Pharmaceuticals.  The race for an HCV treatment is extremely crowded and also incredibly risky.  Bristol-Myers Squibb effectively dropped out of the race after the failure of BMS-986094, which happened to be a $2.5 billion purchase of Inhibitex’s INX-189.  That’s one heck of an expensive bet that landed on red and not black.  But that just exemplifies how hot the competition is for an HCV treatment.  It is estimated by the US Centers for Disease Control that HCV affects some 3.2 million people in the US.  By the end of the decade, it is estimated that the market for HCV drugs could reach $20 billion (!!).  Companies are willing to pay a hefty premium (see: Pharmasett) for a slice of that and therein lies why I’m bullish on Achillion.  The profile for ACH-1625, now Sovaprevir, looks really good, and, in my view, it’s only a matter of time for major pharma to come knocking. Of course, Gilead’s GS-7977 is the furthest along currently with multiple Phase III studies underway, however, I can’t see all that much upside to the stock as it’s up almost 100% since the beginning of 2012.  I think most of the good news is already priced in.  If I were to get into GILD, I’d wait for a healthy pullback for a reasonable entry point.

Also having a large market are obesity drugs.  According to the CDC, 35.7% of adults are considered obese.  Obesity has been linked to a number of other diseases, notably heart disease and type II Diabetes.  Because of this, weight loss drugs have been gaining a lot of attention both on the long and short side.  Vivus (VVUS) and Arena Pharmaceuticals (ARNA) currently have two of the most promising drugs on the market, Qsymia and Belviq, respectively.  Both drugs were approved this year and both companies saw their respective stock prices ride a roller coaster around the news.  I think the market is undervaluing both stocks and I think now is a great time to ride the increase in sales for either drug once they gain traction.

I’d  also like to highlight a few privately held companies from which I think you’ll hear great things in 2013.

Warp Drive Bio, based in Cambridge, MA, focuses on natural products for discovering therapeutics.  It was founded by world-renowned scientists, including Dr. Gregory Verdine, Dr. George Church and Dr. James Wells.  With backing from funding powerhouses such as Third Rock and Greylock Partners, and a key strategic partnership with Sanofi, Warp Drive Bio’s impact will be difficult to ignore in the near future.

Global Blood Therapeutics, also backed by Third Rock, leverages their team’s blood-based disease expertise to revolutionize treatments for chronic blood disease.  Their approach combines the hot areas of computational biology and ligand modeling with traditional medicinal chemistry to treat certain blood diseases for which there are currently very limited options.

Epigenetics is an emerging field and Constellation Pharmaceuticals looks to be on the forefront of the technology.  Adding another dimension to typical gene expression control, Constellation seeks to develop therapeutics that alter the function of proteins that recognize chemical modifications on DNA and chromasomal proteins.

In August of 2012, Quanterix obtained a key patent for their Small Molecule Array technology (Simoa).  As small molecule microarrays are near and dear to my heart, I am particularly interested in Quanterix’s microarray platform and their ultra-sensitive detection (sub-femtomolar – !) of biomarkers for blood-screening, diagnostics, and biothreat detection.

23andme is an extremely fascinating company out of Mountain View, CA.  23andme gives you access to your own genetic information at an absurdly reasonable price.  They also claim they will update you with information relevant to you based on your genetic makeup.  With access to such a large amount of genetic data, they are also very well-positioned to leverage their platform for personalized medicine, a topic rapidly gaining speed among the scientific community.  One of the major bottlenecks for achieving success with personalized medicine is obtaining and interpreting such large data sets of individual genotypes.  23andme looks to be in a unique position to take advantage of this push for individualized treaments.  You may hear more from this company in the next year.

Last but certainly not least, one company that you will hear more about in 2013 is Cambridge-based, Living Proof.  From the lab of prolific scientist/engineer/serial entrepreneurs Dr. Robert Langer and Dr Daniel Anderson, Living Proof is turning the cosmetics and beauty industry on its head by actually basing their products on real science (!) and not folklore/myths/wives’ tales as is typical with common cosmetic products.  After an endorsement by Jennifer Aniston herself, Living Proof will continue to grow exponentially, and I would not be surprised to see them get some real traction in 2013.

A few other notable mentions I bet you’ll hear partnerships, funding rounds, and overall good news from in 2013 (my version of the Fierce 15):

Kala Pharmaceuticals, InVivo Therapeutics, Bind Biosciences, Selecta Biosciences, Seventh Sense, T2 Biosystems, Zafgen, BlueBirdBio, Hydra Biosciences, and Epizyme.

Also, I’d like to take this time to promise you, my readers, that, in 2013, I will provide updates more often than I have.  Since beginning a new position in June, things have been busy on my end.  But consider this my new years resolution to update Pi-Shaped much more often in the coming year.  So expect great things!

That is all for now.  Wishing you the best this holiday season and looking forward to a bullish and prosperous 2013!

Guy Kawasaki

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