Introduction to Options

These days, many investors have portfolios that include investments like mutual funds, bonds, and stocks, yet the range of securities do not end there. Options are another type of security. Options offer opportunities to experienced investors.

 

Options are versatile because they let you adapt or adjust your position depending on the situation. Options can be as cautious or as experimental as you need. Therefore, your options limitless, from protecting a position from a potential decline to complete betting on the movement of an index or market.

 

The flexibility of options is not without costs as options are complex securities and they are very risky, and therefore you will see disclaimers when trading options such as:

 

Options are not suitable for everyone as they can be speculative and carry a substantial risk of loss. Therefore one should only invest with capital intended for risk.

 

Options trading involves risk, even more so if you do not know what you are doing. Because of the risk involved, many may warn you to stay away from options trading.

 

But you may find that by staying away from options trading could put you in a weak position. You do not necessarily need to speculate with options. However, before you decide that investing in options is not ideal for you, you need to understand them correctly. It is crucial to learn how options function before starting to trade in them. By knowing how options work, you could be gaining knowledge about how some of the largest companies in the world work. Many companies today use options as a way to give their employees ownership in the form of stock options.

 

It can take time to be able to gain the experience to become an expert at options trading, and this guide will give you the fundamental information to help you get there.

What are Options?

An option is defined as a contract that gives the right to the buyer, instead of the obligation, to be able to buy or sell a primary asset at a particular price, either on or before a specific date. Similar to a stock or a bond, an option is a security. Options are like a binding contract that has strictly defined properties and terms.

 

Options are present in many situations that occur every day. Take for example, if you find a house that you want to buy, but you will only have the fund in three months. You then negotiate with the owner a deal that allows you the option to purchase the house for a price of $200,000 in three months. With this option, you have to pay a price of $3,000 then.

 

Take into consideration the two hypothetical situations that can occur:

 

  1. You then discover an unknown advantage to the home which increases its market value to $1 million. Because the owner sold the option, he is bound to sell you the home for $200,000, which works in your favour, as you could then make a profit from selling the home for $1 million.
  2. You find that the home has many problems and requires a lot of fixing up, and you consider it to be worth a lot less. Because of the option that you bought, you have no obligation to go through with the sale. You only lose the $3,000, which is the price of the option.

 

From this examples, there are two important points to take note of. Firstly, when you purchase an option, you have no obligation to do something. The option can expire, which then makes it worthless. If this occurs, you will lose 100% of the investment, the money you used to buy the option. Secondly, an option is a contract that deals with an underlying asset. Because of this, options are known as derivatives, meaning that an option derives its value from something else. In the examples, the house is the underlying asset. The majority of the time, the underlying asset is an index or stock.

 

Calls and Puts

There are two types of options: calls and puts

 

  1. With a call, the holder of the option has the right to purchase an asset at a specific price within a particular period. Calls are comparable to having a long position on a stock. The buyers of calls anticipate that the stock may increase significantly before the expiration of the option.
  2. A put allows the option holder the right to be able to sell an asset at a particular price during a given period. Puts are comparable to having a short position on a stock. The buyers of a put anticipate that the stock price will drop before the expiration of the option.

 

Options Market Participants

Four different types of options markets participants depend on the position that they take:

 

  1. Buyers of calls
  2. Sellers of calls
  3. Buyers of puts
  4. Sellers of puts

 

Holders are the people who purchase options and writers are the people who sell options. Buyers have long positions, while sellers have short positions.

 

The important distinction between sellers and buyers:

 

  • Put holders, and call holders are not bound to sell or buy. They have the opportunity to make use of their rights if they decide.
  • Put writes and call writers, on the other hand, are not bound to sell or buy. The seller could be required to carry out the promise to sell or buy.

 

The Lingo

To be able to trade options, the terminology associated with the options market.

 

The strike price is the price of an underlying stock can be sold or purchased. This price that a stock price needs to go above for calls or go lower for puts before the position can be taken for a profit. This all needs to happen before the expiration date.

 

A listed option is an option that gets traded on a national options exchange, like the Chicago Board Exchange (CBOE). Listed options have set strike prices and expiration dates. Each of the listed options represents 100 shares of a company, which is a contract.

 

With regards to call options, the option is thought to be in-the-money if the price of the share goes above the strike price. A put option is in-the-money if the price of the share is lower than the strike price. The intrinsic value is the amount which the option is in-the-money.

 

A premium is the total cost (the price) of an option. The premium gets determined by the factors that include the stock price, strike price, the time that remains until the expiration (time value), and the volatility.

Why Should You Use Options?

The two main reasons for an investor to use options are: to hedge and to speculate.

 

Speculation

Speculation is similar to betting on the movement of a security. The advantage of options is that there is no limit to making a profit only if the market increases. As a result of the versatility of options, one can also make money while the market drops or even moves sideways.

 

Speculation is where money is made, and lost. Using options in this regard is the reason that options have the reputation of being risky. Therefore, when you purchase an option, you need to be correct with determining not only the stock direction of movement but the magnitude and timing of the movement as well. To succeed, you need to predict if a stock will go up or down properly, and you need to be right about how much the price will change and the time frame it takes for all this to happen. Together with commissions, this combination of factors shows that the odds are placed against you.

 

What is the reason for people speculating with options if the odds are against them? Besides for the versatility, it depends on using leverage. If one controls 100 shares with one contract, it does not take that much of a movement in price be to generate significant profits.

 

Hedging

Another function of options is hedging. Its is similar to an insurance policy. The same way that one insures their home or car, options can be insurance for your investments against a possible downturn. Hedging strategies, especially for big institutions can be useful. The individual investor can also benefit. If you use options, you can restrict the downside while you can take advantage of the full upside in a cost-effective way.

 

A Note on Stock Options

Even though employee stock options are not available to all, this type of option can be classified as a third reason to use option. For many companies, the use of stock options seems like a way to attract and keep employees.These are similar to regular stocks options in the way holder has the right but no obligation to purchase the stocks of the company. However, the contract is between the company and the holder, while a standard option is a contract between two parties who are entirely unrelated to the company.

How Options Work

Since we have discussed the basics of options, we will use Company A as an example.

 

If on May 1, the stock price of Company A is $67, with the premium (cost) of $3.15 for a July 70 Call, that indicates that the expiration is the third Friday in July and a $70 strike price. The contract’s total price is $3.15 x 100 = $315. In this example, we do not take into account commissions, but in reality, you will need.

 

A stock option contract gives you the option to buy 100 shares. Because of this, you need to multiply the contract by 100 to get the total price. A strike price of $70 signifies that the stock price needs to rise above $70 before there is any worth to the call option. Also, because the contract is $3.15 per share, then the break-even price would be $73.15.

 

If the stock price is $67, then it is lower than the $70 strike price, so the option does not have any worth. You need to remember that you purchased the option for $315, which is the amount by which you are down.

 

The stock price is $78 three weeks later. The options contract has increased together with the stock price, and it is now worth $8.25 x 100 = $825. The profit is the difference between the amount paid for the contract, which is $510. You have nearly doubled your money in only three weeks. “Closing your position” is when you sell your options, and you take your profits unless you feel that the stock price could continue to increase. In this example, you have decided to let is ride the course.

 

When the expiration date comes, the price has dropped to $62. Due to that this is less than the $70 strike price, and there is no time remaining, then the option contract is worthless. You are now down to your original investment of $315.

 

This table sums up what happened with the option investment:

 

Date

May 1

May 21

Expiry Date

Stock Price

$67

$78

$62

Option Price

$3.15

$8.25

worthless

Contract Value

$315

$825

$0

Paper Gain/Loss

$0

$510

-$315

 

For this contract’s length price swing was $825 from high to low; that may have given double the original investment, which is leverage in action.

 

Exercising Versus Trading-Out

 

In reality, the majority of options are not in fact used.

 

In this example, you can make money if you exercise at $70 and then you can sell the stock back in the market for $78 with a profit of $8 per share. You may decide to keep the stock because you know that you can buy it at a discount to the present value.

 

Since the majority of the time holders decide to take their profits by trading out (closing out) their position, the holders sell their options in the market, while the writers purchase their positions back to close. As stated by the CBOE, approximately 10% of the options get exercised, 60% get traded out, and 30% expire to become worthless.

 

Intrinsic Value and Time Value

In the example, the premium, the price, of the option rose from $3.15 to $8.25. The fluctuations can be explained by time value and intrinsic value.

 

Essentially, the option’s premium is the time value + intrinsic value. The intrinsic value is the amount in-the-money, which for a call option, it means that the stock price equals the strike price. The time value represents the possibility of the increasing value of the option. Therefore, the option price can be explained as following:

 

Premium = intrinsic value + Time Value

$8.25 = $8 +       $0.25

 

In actuality, options almost always trade above the intrinsic value.

Types of Options

There are two option types:

 

  • American options: These types of options can be exercised at any time between the purchase day and the expiration date. In the example of Company A, it is an example of the using of an American option. The majority of exchange-traded options fall into this category.
  • European options: These options differ from American options in that they are only exercised at the end of their lives.

 

The difference between the Americana and the European options does not have anything to do with geographic location.

 

Long-Term Options

 

So far this guide has only discussed options in the context of the short-term. Some options have holding times of one, two, or even multiple years, which could be more appealing to long-term investors.

 

This type of options is known as long-term equity anticipation securities (LEAPS).  By giving the opportunities to be able to control and manage risk or even to speculate, then LEAPS are almost identical to regular options. However, LEAPS provide the opportunities for periods of time that are much longer.  Even though they are not available for all stocks, LEAPS are available for most widely held issue.

 

Exotic Options

 

The simple calls and puts are sometimes referred to as plain vanilla options. Although, at first, the subject of options may be difficult to understand, the basic vanilla options are simple and straightforward.

Due to the versatility of options, there many variations and types of options. The non-standard options are called exotic options. They can either be variations on the payoff profiles of the plain vanilla options, or they are completely different products embedded with an “option-ality.”

How To Read An Options Table

Since there have been more traders learning about the many potential benefits that are available through options trading, the trading volume in options has increased greatly over the years. This growth in the number of options traders has been driven by the onset of electronic trading and dissemination of data. Some traders make use of options to speculate on the price direction, while other use options to hedge existing or anticipated positions and some other continue to make unique positions that offer benefits that are not routinely available to the trader of just the underlying stock, futures contract or index. Despite their objective, one of the most important points to success is to choose the right option or combination of options, that is required to create a position with the desired tradeoff(s) for risk-to-reward. Essentially, traders, today are looking for a more sophisticated set of data when it comes to options.

 

The Old Days of Options Price Reporting

In the past, newspapers used to list rows of option price data in the financial section that was hard to understand.

>>> Insert small newspaper <<<<

Figure 1: Option data from an old newspaper

Some newspapers still print a partial listing the option data for lots of the optionable stocks that are more active. Today, traders have a clearer understanding of the variables that drive the option trades. Some of these variables include some “Greek” values derived from an option pricing model, which implies option volatility and all the important ask/bid spreads.

 

The result from this is that more and more traders find that option data via use of online sources. The table below lists the primary variables for presenting the data. The table lists the options from Optionetics Platinum software. These options are the ones that are the most reviewed by today’s option trader.

 1 2 3 4 5 6 7 8 9 10 11 12
OpSym  Bid (pts)  Ask (pts)  Extrinsic Bid/Ask (pts)  IV Bid/Ask (%)   Delta Bid/Ask (%)   Gamma Bid/Ask (%)  Vega Bid/Ask (pts/%IV)  Theta Bid/Ask (pts/day)  Volume  Open Interest  Strike
IBM MAR10 110 C  16.25 16.70

0.00

0.37 

 19.77

35.15

99.16

92.06 

0.27

1.15 

0.007

0.053 

0.0009

-0.0279 

479  110.000 
IBM MAR10 115 C   11.65 11.80 

0.32

0.47 

25.37

27.68 

90.52

88.67 

1.82

1.90

0.060

0.069 

-0.0227

-0.0290 

47  552 115.000 
IBM MAR10 120 C  7.15 7.30 

0.82

0.97 

21.85

23.30

79.89

78.51 

3.53

3.45 

0.101

0.105 

-0.0344

-0.0385 

360  1179  120.000 
IBM MAR10 125 C   3.40 3.50 

2.07

2.17 

19.04

19.75 

58.20

57.98 

5.65

5.46 

0.141

0.141 

-0.0431

-0.0448 

1268 

5782  125.000 
Stock                      126.33
IBM MAR10 130 C

1.10

1.14

1.10

1.14

17.41

17.73

28.66

29.04

5.40

5.33

0.123

0.124

-0.0349

-0.0358

1868 5947 130.00
IBM MAR10 135 C 0.23  0.25 

0.23

0.25 

16.73

17.08 

8.45

8.91 

2.56

2.61 

0.056

0.058 

-0.0154

-0.0164 

666  6539  135.000 
IBM MAR10 140 C   0.04 0.06

0.04

0.06 

17.04

18.12 

1.82

2.47 

0.72

0.88 

0.016

0.021 

-0.0045

-0.0062

80  4284  140.00 
IBM MAR10 145 C 0.00 0.03

0.00

0.03

0.00

21.03

0.00

1.17

0.00

0.40

0.000

0.011

0.0000

-0.0038

10 1747 145.000

Figure 2: March call options for IBM

 

The data from the table shows the following information:

 

Column 1 – OpSym: This field specifies the underlying stock symbol (IBM), the strike price (110, 115, 120, etc.), the contract month and year (MAR10 is March 2010), and if it is a call or put option (a C or P).

 

Column 2 – Bid (pts): The price of the “bid” is the latest price that is offered by a market maker to purchase a particular option. This means that if you enter a “market order” to sell the March 2010, 125 call, you could sell if for the bid price of $3.40.

 

Column 3 – Ask (pts): The latest price is the “ask” price that a market maker sells particular option. Therefore, if he wants to gain the “market order” to be able to purchase the March 2010, 125 call, you will buy it at $3.50, the ask price.

 

Note: Purchasing at the bid and selling at the ask is precisely how the market makers make money. It is important that an option trader considers the difference between the bid and ask price when considering an option trade. The more action an option is, the tighter the bid/ask spread. A wide spread could be problematic for traders, even the short-term trader. If the bid is $3.40, with an ask at $3.50, then the implication is if you purchased the option one moment (at $3.50 ask) and sold it a moment later (at $3.40 bid). However, the price of the option did not change; you could lose -2.85% on the trade.

 

Column 4 – Extrinsic Bid/Ask (pts): Displayed in this column is the amount of time premium built into each option’s price. From the example, there are two prices where one is based on the ask price, and the other on the bid price. You will want to take note that all the options lose all of their time premium at the time that the option expires. Therefore, the value reflects the whole amount of time premium presently built into the option’s price.

 

Column 5 – Implied Volatility (IV) Bid/Ask (%): The value gets calculated by an option pricing model, like the Black-Scholes model. The model represents the level of the expected future volatility that is based on the most current option price and other known variables for option pricing, which includes the amount of time until the expiration, the actual stock price, the difference between the strike price and an interest rate that is risk-free. The higher the IV Bid/Ask (%), then the more time premium is built into the option price and the opposite. If you know what the historical range of the IV values for the security is, then you can figure out what the current level of extrinsic value is currently on the high end (ideal for writing options) or the low end (perfect for buying options).

 

Column 6 – Delta Bid/Ask (%): Delta (a Greek value) derives from an option pricing model. It represents the option’s “stock equivalent position.” The range of a delta for a call option can be from 0 to 100, and for puts options from 0 to -100. The current reward/risk features associated with holding a call option together with a delta of 50 that is the same as holding 50 shares of stock. If the stock increases up one full point, then the option would gain approximately one half a point. The more an option is in-the-money, then the more the position acts as a stock position. That is to say, as delta approaches 100 the volatility and trade more and more as the underlying stock, meaning an option that has a delta of 100 will lose or gain one full point for every one dollar loss or gain in the underlying stock price.

 

Column 7 – Gamma Bid/Ask (%): Gamma (another Greek value) derives from the option pricing model. Gamma indicated how many deltas the option can gain or lose if the underlying stock increases by one full point. For example, if one bought the March 2010 125 call for $3.50, then it would have a delta of 58.20. That is to say, if IBM stock increases by a dollar, then this option should gain approximately $0.5820 in value. Furthermore, if the stock increases in price today by one full point, then this option will increase 5.65 deltas (which is the current gamma value) and it will then have a delta of 63.85. Then, another one point gain in stock price could result in a price increase for the option that is $0.6385 approximately.

 

Column 8 – Vega Bid/Ask (pts/% IV):  The Greek value Vega shows the amount that the option price is anticipated to rise or fall based entirely on a one point increase in implied volatility. With the March 2010 125 call example, then if the implied volatility increased one point, from 19.04% to 20.04%, this option price would gain $0.141. This shows why it is preferred to purchase options when there is a low implied volatility and to write options when there is high implied volatility.

 

Column 9 – Theta Bid/Ask (pts/day): Similar to the values in the extrinsic value column, by expiration, all options lose all time premium. Also, “time decay” speeds up when the expiration gets closer. Theta (a Greek value) indicates the amount a value option is set to lose with the passing of one day’s time. Currently, the March 2010 125 Call is set to lose $0.0431 of value mainly because of the passage of one day’s time, even if all the other Greek values and the option remain the same.

 

Column 10 – Volume: The volume shows how many contracts of a particular option got traded during the latest session. Often, but not always, options that have large volumes will have a comparatively tighter bid/ask spreads since the competition to sell and buy these options is great.

 

Column 11 – Open Interest: This value shows the total number of contract for a particular option that has been open, but they have not yet been outweighed.

 

Column 12 – Strike: The “strike price” is the price which a buyer of an option can buy the underlying security at if he wants to exercise his option. Also, it is also the price that the writer of the option needs to sell the underlying security if and when the option is used against him.

 

A table that shows the respective put options would be comparable, only with two main differences:

 

  1. A lower the strike price indicates more expensive the call options. The higher the strike price, the higher the put options. With regards to call, the lower strike prices are the ones that have the option prices that are the highest, while option prices drop at each higher strike level. The reason is that each successive strike price is either more out-of-money or less in-the-money. Therefore, each contains less of the “intrinsic value” than the option standing at the next lower strike price.

The opposite is true with puts. While the strike prices rise, the put options become with more in-the-money or less-out-of-the money. Therefore, with puts, the option prices are greater while the strike prices increase.

  1. With regards to call options, the delta values are positive and at a lower strike price are higher. With put options, the delta values are negative and at a higher strike price are higher. Negative values for the put options derive from the fact that the signify a stock equivalent position. Purchasing a put option is comparable to entering a short position in stock, hence the delta value being negative.

Conclusion

While options aren’t for everyone, we hope this guide has given you some sight. It is important to educate yourself before you begin options trading.

 

To summarize:

 

  • With options, as it is a contract, the buyer has the right, yet not the obligation to purchase or sell a specific underlying asset at a set price on or before a particular date.
  • Options derive their value from the asset that is underlying.
  • With a call, the holder has the right to purchase the asset at a particular price within a set period of time.
  • With a put, the holder can sell the asset at a specific price during a set period of time.
  • In the options markets, there are four different participants: buyers of calls, buyers of puts, sellers of calls, and sellers of puts.
  • Buyers are knowns as holders and sellers as writers.
  • The strike price is the price that underlying stocks are purchased or sold.
  • The premium is the option’s total cost. The factors that determine it are the strike price, stock price, and remaining time until expiration.
  • A stock option contract depicts the 100 shares of the underlying stock.
  • Investors both speculate and hedge risk with options.
  • Employee stock options differ from the listed options as they are a contract between the holder and company.  (There are no third parties involved in employee stock options.)
  • American and European are the two primary classifications of options.
  • LEAPS are long-term options.