A Look 'Behind the Scenes' of One of Our Favorite Strategies

Editor's note: The options market is complicated... or so it seems to novice traders.

In today's Masters Series essay – excerpted from a brand-new Retirement Trader special report – Dr. David "Doc" Eifrig breaks down some of the more "advanced" lingo in the options world... and explains why it's not as intimidating as it looks...

A Look 'Behind the Scenes' of One of Our Favorite Strategies

By Dr. David Eifrig, editor, Retirement Trader

Julian Schwinger changed everything we know about light and matter...

His theory predicted exactly how they interact on the subatomic level. His work incorporated both Einstein's theory of relativity and actual experimental results.

His theory of quantum electrodynamics won him the Nobel Prize. Without it, some of today's most incredible achievements would be unimaginable... nanotechnology, quantum computing, and even the basic transistor that brought about the desktop computer.

But Julian Schwinger is a forgotten man...

Schwinger's theories followed in the style of Schwinger himself. He dressed conservatively, was extremely organized, and spoke formally and with purpose at all times.

His framework was diligently mathematical, incorporating pages of formulas, proofs, and complex calculations. It took an organized mind like Schwinger's just to start to get a handle on it.

Almost no one uses his stuff today.

Schwinger split his Nobel Prize with two other guys... If you know about either of these men, chances are it's the second name you recognize (if vaguely)... Richard Feynman.

They didn't work together. Rather, they happened to solve the same problem at the same time, presenting their ideas at the same conference in 1948.

Feynman and Schwinger couldn't be any different...

Feynman wore short sleeves, played the bongos, and cracked safes containing top-secret documents for fun during his work on the Manhattan Project.

He, too, created equations that described light and matter. But rather than pages of difficult formulas and computations, Feynman's work was easily visualized. You could internalize it and gain an understanding of what was happening at a subatomic level.

You could even draw it with a few lines. This became known as the "Feynman diagram" and became the workhorse of quantum physics. It gives physicists a way to visualize a problem quickly. Here's a picture of one...

In this report, we're going to follow Feynman's lead. We're going to take a step back... and share a new way to think about options and understand what's going on "behind the scenes."

We're not going to minimize the jargon and the math. But we're going to explain exactly why options move up and down, and how you can use those moves to make money.

A 'Feynman Diagram' for Options

If you can develop an intuitive understanding of how options move, you'll be a world ahead of others (and many who claim to understand options... some of whom even write newsletters about them).

Options often seem like a foreign concept for many folks who are just starting to trade them. Just like quantum physics, it seems like a strange world with lots of interacting parts. But an internalized understanding of options is invaluable.

You could memorize the Black-Scholes equation for options pricing (which also earned its developer a Nobel Prize)...

Or you could become a whiz with an options calculator... But those efforts aren't necessary to understand how to earn money in the options market.

Whenever Feynman tackled a problem, he always narrowed it down to "first principles" – the unquestioned simple facts – and then built everything from there.

For our exploration of option prices, we have one "first principle" to understand. It is this:

The more likely an option is to pay out, the higher its price will be.

Say that out loud slowly. (Seriously, we'll wait...)

Think about someone who buys a call option expecting a stock to rise. If the option buyer knew that a particular option had zero chance of turning into a winner, then its price would be zero. If the trader could be absolutely certain it would turn a profit, its price would be high.

All the other factors we talk about – strike price, volatility, time – insert themselves into that measure of the likelihood of paying out.

To internalize just how those factors work, we're going to use a mental trick. Rather than talk about stock prices moving a few dollars or slightly different levels of volatility, we'll use my favorite technique for understanding things... We'll take an extreme, almost absurd example.

When you look at extreme examples, it's easier to see how the factors that determine option prices feed into the likelihood of a payout.

In Retirement Trader, so far, we've sold put and call options. For the purposes of this discussion, focusing on call options first is a bit easier and more intuitive. It is more natural to think about stocks going up and the call option rising, rather than stocks going down and the put option rising. Thinking about puts takes a little more mental gymnastics. But it will seem easier once you get call options down.

Remember, we're mostly option sellers. We want to sell for a high price, and we want there to be little chance the option pays out for the buyer. But again, it's a bit easier to think of option prices from the side of the buyer who wants to place a bet on a rising stock price. So we start by focusing on call buyers...

Focus on the Strike Price

The first and simplest determination of an option price is the strike price in relation to the current price.

Let's look at a speculator who is considering buying a call option with a strike price of $100. If the stock rises to, say, $200 on or before expiration, the option buyer will make a profit (technically, depending on the initial purchase price of course). But the option is considered deep in the money. If he paid $4, he's made at least $96.

Conversely, the $100-strike option will be worth very little if the stock is at $10. Clearly, the likelihood of the option paying off is lower if the stock needs to go from $10 to $100.

That's straightforward. But it can demonstrate some interesting properties of options...

What if the stock was currently at $120? Well now, that option is currently worth at least $20 with absolute certainty. That's simply because the owner of that option can exercise it immediately and buy the shares for $100 and sell them in the market for $120. Thus, the "option" has to be at least worth $20.

This measure is called the "intrinsic value." (Any other value that comes from the remaining time is called "extrinsic" or "time" value.)

Or think about this...

Consider when the stock rises from $10 to $11. Would an option buyer consider that a big change in the likelihood that an option with a $100 strike would pay off?

I wouldn't... That option is so far out of the money that a rise in the stock of $1 doesn't make it any more likely the stock is going to reach more than $100.

However, if the stock sat at $98 and rose $1 to $99, that could make a meaningful difference. The likelihood of a payout has changed by a serious amount.

If that doesn't jump out to you, let's make the example more extreme. If the stock moves $10, say from $5 to $15, that doesn't make much difference. However, if it goes from $88 to $98, that clearly does.

The point is that not all changes in the stock price are created equal.

Congratulations, you now understand the concept of "delta."

At a given dollar change in the stock, the delta measures how the option price will change.

In our example, the change from $10 to $11 would have a delta of nearly zero. The change from $98 to $99 would be closer to 0.5 but on its way to one.

Here's a real-world example:

Your broker's platform should list delta. You can also see delta numbers for free at http://www.nasdaq.com.

When we pulled these numbers, Microsoft traded for $57.96 a share. As you can see, the $52.50 calls are likely to pay off, so they have a high delta. For every $1 that Microsoft moves, we'd expect this option to move $0.96.

Meanwhile, you still have a long way to go before the $62.50 call really has a good chance of paying off. If Microsoft shares rise $1, this option will only rise $0.17.

When people first get into options, they look at them as a bet a stock will move in a certain direction. Most can follow that rising stock prices push call prices up and falling prices push put prices up. Grasping delta gives you a little extra understanding for just how much you can gain when a stock moves up or down.

We don't trade direction much, though. We like to sell options with the expectation that stocks won't move down. We prefer that the underlying stock goes up or stays the same price.

Now we understand delta... essentially the probability that the call option will be in the money. In tomorrow's essay, we'll look at some of the other useful measures of option prices to help us even more.

Here's to our health, wealth, and a great retirement,

Dr. David Eifrig, Jr. MD, MBA

Editor's note: Over the last seven years, Doc's Retirement Trader subscribers have closed 94.7% of their trades for a profit... with average annualized gains of 16.4%. If you've been on the fence about signing up, Doc has agreed to throw in an extra year of Retirement Trader... absolutely FREE. Learn more about this offer right here.