Options 101

Those who know me are aware that I meander through various online communities within web3 through the application known as Discord. Some of you are familiar with Discord, for others that are not it’s a very robust chat software that allows users to connect and share information in very vibrant formats. It is a great platform for gamers, developers, artists, project managers, and ultimately anyone who wishes to engage and cultivate a community.

What does this have to do with options?

Nothing exactly, but that preamble is why I am writing this article as I started a thread within a Discord community for traders, but it is gated behind a pay wall so I wanted to share that information with all of you here, for free. If you are already familiar with options this 101 article may not be for you, but if you have any knowledge gaps or just want to make sure you have sound fundamentals I’d encourage you to keep reading — you just may learn something new as what I consider 101 perhaps is 201 or 301 to you.

Cyber Samurai 3209

The image above is my entry ticket into the community of traders called Cyber Samurai. If you want to take a look inside you’ll have to purchase one of their digital collectibles here: Browse the Collection.

OK, let’s hop right into it from here and lay the groundwork starting with basic terminology and some example of how options work:

Option: A financial derivative contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (strike price) within a specified period of time (expiry).

Call Option: Gives the buyer the right to buy the underlying asset at the strike price.

Put Option: Gives the buyer the right to sell the underlying asset at the strike price.

Strike Price: The predetermined price at which the underlying asset can be bought or sold.

Expiration Date: The date when the option contract expires and may no longer be exercised.

Premium: The price paid to purchase an option contract.

Buying Options

When you buy an option, you are paying a premium to gain the right to buy or sell the underlying asset at a fixed price (strike price) until the expiration date (expiry). There are two types of options you can buy: call options and put options.

Example of Call Buying

You believe the price of Company XYZ's stock, currently trading at $50, will go up in the next month. You buy a call option with a strike price of $55 and an expiration date one month from now. By purchasing this call option, you have the right to buy Company XYZ's stock at $55. If the stock price exceeds $55, you can exercise your option and buy the stock at the strike price, making a profit. If it does not your contract will expire worthless and the sell will keep the premium.

Typically the trading platform you use will calculate the premium into your breakeven price. If you paid $1 for the contract, then you will need the underlying to rise above $56 to make a profit: $55 Strike + $1 Premium = $56 Breakeven.

Example of Put Buying

If you think the price of Company XYZ's stock will go down, you can buy a put option. The stock is currently trading at $50, and you purchase a put option with a strike price of $45 and an expiration date one month from now. This put option gives you the right to sell Company XYZ's stock at $45. If the stock price falls below $45, you can exercise your option and sell the stock at the strike price, making a profit.

Again, if we assume the buyer of this put paid a $1 premium, the breakeven price of this contract would be $44. Since this is a put option, we subtract the premium from the strike in this example to get our breakeven: $45 Strike - $1 Premium = $44 Breakeven.

Selling (Writing) Options

When you sell an option, you are taking on an obligation. As the seller (also known as the writer) of the option, you receive the premium paid by the buyer, but you may have to fulfill the terms of the option contract if the buyer decides to exercise it.

Example of Writing a Call

You sell (write) a call option with a strike price of $60 on Company XYZ's stock for a premium of $5. If the stock price remains below $65 (strike + premium) until the expiration date it will expire worthless and you will keep the premium, which is paid up front. However, as the writer of a call option your max risk is limitless as there is no limit to how high XYZ stock price may climb. If the buyer exercises the option at $70, your loss will $5. We take the $70 exercise price, subtract the $60 strike price, and then add the $5 we collected in premium for a loss of $5.

Example of Writing a Put

You sell (write) a put option with a strike price of $60 on Company XYZ's stock for a premium of $5. If the stock price remains above $55 (strike - premium) until the expiration date it will expire worthless and you will keep the premium, which is paid up front. However, as the writer of a put option your max risk is the difference between $0 and the strike, less the premium collected. If XYZ goes to zero your loss is $55. We take the $60 strike price, subtract the exercise price — which in this case is zero — and then we subtract the $5 we collected in premium for a loss of $55.

Buying and selling options contracts can be effective ways to magnify the profits for a smaller invested dollar amount. This is commonly referred to as leverage. When you buy an option they are sold in lots of 100. Let me explain what that means a little deeper and how this works in practice with a real life example using the underlying asset: GS, which is the ticker for my alma mater Goldman Sachs.

First, let us look at how it may appear using Fidelity’s options trading platform as that is the custodian where I personally trade. As of the market close on Wednesday, June 7th, 2023 the underlying asset “GS” is valued at $335.75 per share to provide context for the numbers below.

What is shown here is that we are buying 1 call option with an expiration date of July 21, 2023 at the $350 strike price. The current premium I must pay for this contract is the ask price, which is what the seller (writer) is asking. You may also notice there is a bid price, which is referred to as the spread or my cost if I were to immediately buy 1 contract and then sell it back to the market maker I would lose the difference or the spread between the bid and the ask price of $0.20 per contract.

Since options contracts are sold in lots of 100, if I buy 1 contract there are actually 100 shares of the underlying asset packaged into this contract so my cost for buying 1 contract is not $5.35, but $5.35 x 100, or $535.00, plus the minimal fees charged by Fidelity to facilitate the deal, which is only $0.65 in this case so my all-in purchase price, or cost basis, would be $535.65. If I were to turn around and sell this contract immediately I would realize a loss of $20.65, since the bid is $5.15 x 100 = $515.00.

Typically fees are only charged when you buy a contract, not when you sell one, but that will vary by the platform you use and may also vary depending on the value of the underlying contract as well. Most platforms are very low cost these days, but more importantly beyond the basic fees you will also want to evaluate how much volume is traded on the respective platform as that can impact how tight, or wide, the bid-ask spread may be, which can be a much more significant cost than the fees for buying and selling the options themselves. Personally, I feel that Fidelity has one of the best cost structures when taking volume traded and the tight bid-ask spreads into consideration.

Now that you have a deeper understanding of some of the basic terminology let us discuss what you will encounter when viewing and selecting options that you may want to buy, which is referred to as Buy to Open if you are buying the option or as Sell to Open if you are selling (writing) the option. Conversely when you want to close your position before expiration you would Buy to Close or Sell to Close based on whether you were buying or selling (writing) the options contract.

Quick aside, if you wish to write options, especially naked options you will need to gain certain levels of privilege with the custodian you use and they will have a variety of questions to understand your level of experience with trading options and may carry different capital requirements. A naked option refers to selling (writing) a call or a put where you do not own the underlying. This is considered incredibly risky as your max loss is potentially unlimited as you do not own the underlying asset to hedge your option writing.

If you own GS and you write a call option, the risk to you is merely that your underlying position in GS gets “called away” and you must deliver the share(s) of GS to the buying of your option contract upon expiration. This risk is offset by the premium you collect for the given option. If you do not own GS, then your risk parameters are unlimited in the case of writing naked calls as the price of GS has no upside limitation. Writing naked puts has a defined risk parameter, but is still considered extremely risky as your max loss is the difference between the strike price and the premium you collected, which in the example above the market maker is collecting $5.35 per contract (again they are sold in lots of 100) against the current price of GS trading at $335.75 for a max loss of $330.40 per contract, which when multiplied by 100 gives a real max loss of $33,330.40 if they did not own the underlying shares. Market makers frequently hedge their book by buying and selling the underlying assets themselves to protect their options positions based on if they are in-the-money or out-of-the-money.

This takes us to our next graphic below, which is a view of 10 different strike prices for call options specifically, 5 of which are in-the-money as their strike price is below the current price of GS and 5 of which are out-of-the-money as their strike price is above the current price of GS. This would be inverted we were looking at puts and the in the money puts would be those above the current strike and vice versa.

I won’t describe every aspect of this chart since we are sticking with the 101 level information for right now, but the pieces that anyone with a fundamental understanding of the basics of options should be able to discern are the costs associated with each strike price as shown by the bid-ask prices.

One thing to take note of from a very high level is that the relative probability being assigned to these 10 strike prices can be determined by simply looking at the cost of the option. The 315 call option sells for $27.20 per contract, which is much higher than the 360 call option selling for only $2.62 per contract.

What the market is telling us here is that there is a high degree of confidence that these July 21 GS 315 calls are likely to expire in-the-money — sometimes shown in this less appealing format: GS230721C315. Conversely there is a much lower probability that the July 21 GS 360 calls expire in-the-money.

In our Options 201 class I’ll dive into some of the other aspects here, what they mean, and how to use them wisely. Good luck out there and remember not to dive into options trading without fully understanding what you are doing since options are ways to leverage your money to accentuate the gains they also will deepen the downside and are a fast way to go broke if you do not know what you are doing.

Markets Illuminated: The Curious State of the US Economy

As we round out the second quarter of 2023, the U.S. economy presents a very dubious backdrop with the data available to us thus far. The S&P 500 Index, one of the most commonly followed equity indices and general proxy for “the market”, is up over 10% year-to-date, a fact that would typically suggest broad-based growth and prosperity. However, upon closer examination, seven stocks account for more than 100% of the index's total performance, while the rest account for a cumulatively negative performance number.

Simply put, the S&P 500's gains are nowhere close to evenly spread. As of Friday, June 2nd market close: Apple (AAPL) +44%, Microsoft (MSFT) +40%, Amazon (AMZN) +44%, Nvidia (NVDA) +167%, Tesla (TSLA) +98%, Google (GOOGL) +40%, and Meta (META) +114%. If you take their relative index weightings you get a +12.75% performance attribution, which is greater than the entire index performance.

This kind of disparity might make you wonder about the health and stability of the market. It's important to note that such a concentration of returns isn't unprecedented, and it doesn't necessarily spell doom for the market. However, when we look at the EPS (Earnings Per Share) of the SP500 in June 2022 it was at 42.74. Today the SP500 EPS is at 39.61. This equates to a decline of over 7% in EPS and yet the SP500 index performance is up over 2% year-over-year.

What is driving this divergence?

Large companies have been feverishly attempting to protect profit margins by reducing expenditures and one of the main ways to do that is through staff reductions. In the most recent Challenger Report, published on June 1st, we see a few data points that should throw up some red flags about the health and persistence of the YTD market performance. Employers have continued to increase their month-over-month layoffs with May seeing a 20% increase over the prior month, which is a large increase, but when compared year-over-year that is nearly a 300% increase!!

So far this year, companies have announced plans to cut 417,500 jobs, a 315% increase from the 100,694 cuts announced in the same period last year. It is the highest January-May total since 2020, when 1,414,828 cuts were recorded. With the exception of 2020, it is the highest total in the first five months of the year since 2009, when 822,282 cuts were tracked through May.

To dig further into which areas of the economy are increasing workers vs. decreasing, there are only four sectors increasing: Government, Education, Industrials, and Utilities. Every other sector has been decreasing and particularly alarming is the sector leading the performance of the SP500, Technology.

The Technology sector announced the most cuts in May with 22,887, for a total of 136,831 this year, up 2,939% from the 4,503 cuts announced in the same period last year. The Tech sector has now announced the most cuts for the sector since 2001, when 168,395 cuts were announced for the entire year.

While it's never wise to make conclusions based on any single reason, it is worth noting that many companies have been implementing cost-cutting measures to shield profits. In the wake of the pandemic, a substantial number of businesses have shifted towards remote work, reducing the need for large office spaces, and with growth slowing tremendously and inflation and interest rates remaining sticky high the culmination of these forces may be sailing towards an economic cliff.

Image Credit: Bill Rich, Hedgeye Cartoonist

Turning our gaze to the national debt, we find that the contentious issue of the debt ceiling has been postponed until after the next presidential election in 2025. On the surface, this may seem like a positive outcome. It removes the immediate threat of a government shutdown and provides some short-term stability. However, as is often the case, the devil is in the details.

With the raising of the debt ceiling comes an increase in the issuance of U.S. Treasury bonds, which could withdraw liquidity from financial markets. These bonds are a way for the government to borrow money: they sell the bonds, and the buyers provide the government with the funds it needs. So, while avoiding a debt ceiling crisis may provide temporary relief, there is the long-term effect of reduced liquidity in the financial markets to consider.

There are many ominous factors pointing toward a less than favorable back half of 2023. One thing we can say with relative confidence is that there is still a great amount of uncertainty around the future economic picture and that of financial markets. This is the reason why it’s vitally important to have a number of diversified strategies that can work to protect capital and provide valuable sources of income when markets become challenging.

Markets Illuminated: Sell in May?

There's an old adage amongst seasoned investors "Sell in May and go away". 

Where did that saying come from? And does it hold any validity?

Many decades of analysis on the S&P 500 Index shows that there actually is data to support that historically from May to October the index has worse performance than from November to April. 

Does this mean that it's a fail proof strategy? Of course not. 

Educated investors recognize that "past performance is not indicative of future results". However, sometimes it can be fun to look into these seeming anomalies and understand where they come from and why there can appear to be validity to them.

The bulk of the data supporting the "Sell in May and go away" approach comes from an era of investing prior to the mass digitization of information and when stock brokers were elbow to elbow in the trading pits of the NYSE (New York Stock Exchange). Traders would literally go away in May and take their vacations over the Summer and thus volume would dry up and return in the Fall with the literal return of brokers to their day jobs.

Today's environment is vastly different with high speed fiber optic cables running under foot across the country and markets being very close to open 24/7 when you factor in after hours trading, overseas trading, and actual 24/7 markets with crypto trading. Markets move fast, information moves faster, and these days the narrative is that the market front-runs the data. If you are hearing it on CNBC you are already late to the party.

So what does this mean for the impending debt ceiling deadline? 

If we are to believe that the market front-runs the data, and it has some inside edge on information, then it would seem to indicate that the market participants largely believe that this will be a non-factor. However, I like to step away from narratives and stories and look more closely at what the data shows.

If we take a look at the S&P 500 Index for some insights what do we see?

• YTD performance just under 10%

• Top two performing stocks in the Index (NVDA & META) are both up nearly 100% YTD

• Over 50% of the stocks in the index are negative YTD

• Top two stocks in the Index (NVDA & META) are both flat or down last 18-months

• Top 50 stocks in the Index have nearly double the performance YTD

• 5-year performance of the Top 50 and the total Index are extremely close

Sources: Slick Charts & SP Global

A few of my takeaways from looking at this data (in concert with many other data points):

1. Encouraging that the S&P 500 Index is starting the year strong, historical data suggests more often than not this bodes well for positive performance for the year

2. Very discouraging that the majority of the index performance is concentrated in very few names, suggesting a "flight to quality" when compared to the small cap Russell 2000 Index, which is roughly flat YTD

3. Zooming out on the top index performers paints a less optimistic picture if we are indeed in a multi-year bear market, which are incredibly rare: 

   • 1929 - 1932

   • 1939 - 1941

   • 1973 - 1974

   • 2000 - 2002

What we don't know?

What the performance of the S&P 500 Index will be for the year, or any index for that matter. These are matters for speculation that sell newspapers, get viewers to watch TV programs, and make for encapsulating water cooler talk.

Whether the debt ceiling showdown will end like it did in 2011 with a 15%+ loss in the S&P 500 shortly thereafter and a down year for the market, or like it did in 1995 with only two very shallow down months shortly thereafter and nearly 30% return for the index that year.

What do we know?

Having a plan built to weather market downturns and deliver sustainable income will help our mental health and enable us to take advantage of the "8th wonder of the world" according to Albert Einstein... compound interest. The longer term average of the S&P 500 Index is roughly 10% annualized. Investors that are able to remain invested and avoid taking income from securities that are impaired (negative performance) will end up better off than those that have no alternative to selling securities for income during periods of market distress.

It seems very likely to me that this will be a volatile year in the market and if you pay too much attention to financial media you may find yourself spun into a frenzy. So I'll leave you with this last nugget...

Since 1985, the first month of the year has seen the S&P 500 Index with 3%+ gains 15 times. Of those 15 instances, 10 years have ended with the S&P 500 providing positive performance and 4 years have ended with negative performance.

The fifteenth? You'll just have to wait to find out...

Image Credit: Bill Rich, Hedgeye Cartoonist

Rifters: Redux

Could this project overtake the Sandbox?

Have you ever heard of a team minting out the supply, raising 200+ $ETH, and then refunding minters and increasing holder rewards, because the specifics around the mint needed to be improved to enhance the LT viability of the project to benefit holders?! @riftersio #BizEthics

Why? That is the big question. Isn't raising 200+ $ETH a huge success when you minted out the available supply as intended? Yes and no. What was the purpose of the mint? Cash grab? Or building a web3 gaming juggernaut?

#Rifters by many metrics had a very successful day 1 and day 2 of the planned 4 day mint festival. However, the reason the team decided to hit the restart button knowing they were opening themselves to tons of #FUD was actually for the LT good of the project and investors.

BS? Let's start with understanding the vision of Community First Games (C1) and the importance of Rifters to that vision. #Web3Gaming is about bringing communities together and empowering the users of the ecosystem a la #ReadyPlayerOne. How does Rifters accomplish this?

Unlike most games that are gated where you have to buy their NFT to play the game, Rifters sought out 10 major NFT projects on #Solana to start and built a game FOR THEM using their NFTs. No purchase necessary. Oh, and they added a $1,000,000 prize pool for the winner.

What did this do? It created the most interactive and engaging web3 game on Solana in the matter of just two months, raised nearly $3m in their own mint and saw NFTs selling for as much as 75x mint price. Probably nothing...

Solana NFT projects that are participating have already seen a total of 4,000 $SOL sweeps for winning PvP events in the game for @TrippinApeNFT, @HoneylandGameFi, and @Astrals_NFT.

Staking your OG Solana Exiles from Rifters also has been earning you Clovers where you can mint stuff--for free--in their bid-to-earn DVM platform. Yesterday, over 500 $SOL of prizes were minted--for free--using Clovers as a giveback to Exile holders.

Another free Clover only mint will happen again today at 5pm UTC and the team has stated that these will happen more routinely. Can't find an NFT with utility though, right?

Mint: https://dvm.rifters.io

Exiles: https://magiceden.io/marketplace/rifters

Now back to that upcoming mint on Ethereum. When is that happening? TBA, but the early indication from the team is somewhere around 12/23 - 1/3 as they revamp marketing efforts to ensure a smooth traditional mint this go around.

Why is it vital to not just raise capital, but have success in the upcoming mint? And what does success look like? It's necessary for Rifters to continue to grow across multiple blockchains if it ever will become a true #Metaverse. I know... that word gets overused and abused.

However, that's the true concept here and that is what a #ReadyPlayerOne universe looks like. A place where owners of #NFTs from a variety of chains, utilities, and lots of shapes and sizes come together. Not even for a common goal, just a place where they do fun shit.

Rifters has big goals. Being the #1 gaming project on Solana is nice. Being the #1 gaming project on any blockchain is nice. That's not big enough for Rifters. Many people are taking notice and founder @andrew_ringlein has the connections and the chops to make it happen.

Make sure you follow the team and join into as many of the upcoming #TwitterSpaces as you can if you want to learn more about the project. You can also join the discord and immerse yourself there too if that's your thing: https://discord.gg/c1g.

Oh yeah... and as for the FUD after the DVM mint, expectations were that floor price would tank. The team did a global unlock to let people liquidate and guess what happened... yeah... the floor price WENT UP. Definitely nothing...

Thanks for stopping by The Metaverse Illuminated, I trust this edition has brought more to light for you. Remember, you call the shots, take what works for you, discard the rest.

Stay alert for the next edition of TMI, until then you can follow me on my: socials.

The Golden Rule: "Not your keys, not your coins"

gm ☕

Volatility around SOL has migrated along the increasing volatility to push the lower end of my trading ranges down into the mid-single digits. There is much less upside to this trade in the upper teens than there is downside. With ranges this wide you need to be extremely careful if you are utilizing leverage in order to not get liquidated on pumps and dumps since there will be wild swings. We are trading around

CZ tweets something positive and you see the price moon, then come back down to reality on more negative sentiment. People are legitimately panicking around the state of Solana and many are moving assets off exchanges. Could there be more shoes to drop? I don't know. However, the volatility right now tells me that if you are in SOL you should consider a de-risking to USDC.

This is probably a good time to remind folks that even trusted stables like USDC and USDT may be the next black swan event in this crypto crash. These are akin to the money market funds pre-GFC (Global Financial Crisis) where funds were allowed to take on fairly significant default risk in the debt instruments they bought to bring you that nice $1.00 stability of "cash" except it never was cash and it never will be.

Today the money market funds are significantly better, but they still own debt instruments so there is always another potential "breaking of the buck" even potentiality on the horizon. USDC and USDT are like the old money market funds in that they own have significant default risk imbedded in their underlying holdings, at least what they are reporting.

We just saw with SBF that what someone says and what someone does are two very different thing and without proper regulation it's impossible to say for sure what's behind the veil. What does that mean for you and I? Stay safe, get your funds into self-custody off an exchanged whether its a CEX or a DEX, the cardinal rule in crypto is "not your keys, not your coins". This crash is far from over.

Thanks for stopping by The Metaverse Illuminated, I trust this edition has brought more to light for you. Remember, you call the shots, take what works for you, discard the rest.

Stay alert for the next edition of TMI, until then you can follow me on my: socials.