Ask any wise man and they’ll tell you becoming pro is not something to take lightly. It usually equals sweat equity and expert knowledge. It’s also true in the case of option trading. Through-out this post you will gain a fundamental insight in the options world which will assist you to follow the footsteps of derivative experts.
From the post on, knowledge and expertise that’s shared in this post will greatly accelerate your journey with options trading and other investment opportunities. Once you understand the dynamics and characteristics of options it will vastly help you to utilize these very potent tools save you lots of time and prevent you from unnecessary losses that might occur during the learning phase.
Call options and put options are usually referred to as plain vanilla options in the finance industry. The reason they are called plain vanilla is because they are the basic products that can be produced and calculated with Black and Scholes Formula but there are other type of option structures that can be created by combining different type of options or tweaking some of their parameters. Some of these are usually referred to as “exotic options” and others have their own names. We will see some of these structures in the following articles.
You can see how call option and put option reacts to the changes in the stock price. Call option gains value as the underlying price increases and put option loses value as the underlying price increases.
Both put and call options have limited loss profiles as once they are out of money you would write them off and the loss would equal to the price you paid to purchase them and nothing more.
Two components of an option price: intrinsic value & time value
Now that you have fundamental knowledge about option pricing and variables that affect the option price. Let’s take a look at 2 main components of an option’s value. This part is generally easier to understand, and it is also very crucial to know.
An option is combined of two different values during its life. These are intrinsic value and time value. At the end of option’s life period (At expiry) time value equals to zero. Time value decreases in value as time passes and option gets closes to its maturity or expiry date. Intrinsic value only changes as the underlying value changes. Let’s take a closer look.
Intrinsic value: We mentioned strike price in the previous post. Intrinsic value has a direct relation with the strike price of an option. This is simply the price difference between the strike price and underlying price.
As you probably already know, a call option is in the money when stock price is above the strike price and put option is in the money when the stock price is below the strike price. Call option gives you a right to buy at the strike price and put option gives you the right to sell at the strike price. (This is important to understand 100%)
Let’s take a look at 4 different scenarios, two with call options and two with put options.
Scenario 1: A call option on Microsoft (MSFT) with 90 days to maturity and $145 strike price. (Suppose MSFT is trading at $160 today)
The intrinsic value of this option is 160 – 145 = $15.
Verdict: In The Money
This is only the intrinsic value of this option.
On top of intrinsic value options can have a time value. Time value indicates the value that the option might create in its lifetime, in this case, a duration of 90 days. As the days pass, its time value decreases because time value is directly a product of remaining time and the opportunities that might arise in the meanwhile. Of course, if the option has 1 day left, the possibilities that can happen in that 1 day will be much less than 90 days or 180 days.
Time value is calculated with more complex mathematical formulas. (For instance, normal distribution model in the Black and Scholes Formula.) As the time value will decreases everyday it will eventually be zero at the expiry date and only remaining value of the option will be the intrinsic value. We will dedicate a whole article to the time value and time related concepts that will help you have a better insight in this important concept.
Scenario 2: Call option on Apple (AAPL) with 90 days to maturity and $160 strike price. (Assume Apple is trading at $150 today)
The intrinsic value of this option is 150 – 160 = 0 (Yes, in the option world this can equal 0 rather than -10, here is why). As soon as this difference is below zero the intrinsic value is also zero because you wouldn’t exercise your option to buy the stock at $160 while its trading at $150.
The key here is that options give you the right to buy or sell but they don’t give you an obligation to do so. So as soon the equation doesn’t make sense, you wouldn’t exercise your option. In other words, your rights would amount to zero value for you. But the option still has a time value. If it expires with the underlying asset’s price remaining at this level, time value will also go to zero on maturity and option’s total value will equal to zero.
Verdict: Out of The Money
Scenario 3: put option on Apple (AAPL) with 90 days to maturity and $140 strike price. (Assume Apple is trading at $150 today)
The intrinsic value of this option is 140 – 150 = 0 (mathematically -10). Again, as soon as this difference is below zero the intrinsic value is also zero as you wouldn’t exercise your option to sell the stock at $140 while its trading at $150 so this right amounts to zero value for you. But the option still has and only has its time value. If it expires like this, time value will also go to zero on maturity and option’s total value will equal zero.
Verdict: Out Of The Money
Scenario 4: put option on Tesla (TSLA) with 90 days to maturity and $430 strike price. (Assume Apple is trading at $420 today)
The intrinsic value of this option is 160 – 150 = 10. Intrinsic value is $10. And the option still has its time value. If it expires like this, time value will also go to zero on maturity and option’s total value will be $10.
Verdict: In The Money
Note: As you probably realized for call options Intrinsic Value = Stock price – Strike and for put options Intrinsic Value = Strike – Stock price
Now let’s looks at some of the dynamics of selling options.
Selling call options
Unlike buying options, selling options puts you in an obligatory situation. When you buy options, you pay a premium and you purchase the right without the obligation. But when you sell options you get paid the premium and if the buyer decides to exercise their right you are obliged to honor the deal. Although it can be very profitable this is the reason why selling options requires awareness, discipline and caution and involves bigger risks.
Both call options and put options have a time value and an intrinsic value. That means no matter what, by time, an option’s time value is expected to decrease given that parameters such as volatility, interest rate and stock price stay the same.
When you sell or short a call option, you give your counterparty the right to purchase an asset at the strike price on a future date no matter what the underlying asset’s price is that day. So, if that asset skyrockets before the maturity you have a huge debt of giving that stock to your counterparty at a much lower price.
This is the reason why a naked call position is very risky. You have limited gains from premiums but unlimited loss potential if the stock price keeps going up. This is the main reason why some of the state of art strategies that will be introduced later in this website can be very helpful to the wise investor.
Selling put options
When you sell a put option, you sell your counterparty the right to sell an underlying at a predefined strike price. In other words, you promise to buy their stock at the strike price. So, if the underlying price keeps going down, you might lose a lot of money as you might have agreed to buy it at a much higher price.
Selling naked put options is somewhat less risky than naked call options. Your upside is the premium you collected. But your downside as the seller of the put option is not infinite. It’s limited to the underlying stock’s price. If your short put has a strike price of $100 and stock goes to zero, you are obliged to buy it at $100, so, your risk is theoretically limited rather than an infinite amount.
In most cases, you might not be a hedge fund manager with massive capital under management, nor an investment guru who can be so sure about the valuation of a stock. You might not have the appetite to take increased risk nor leverage your position. That’s why it’s important to understand not only option fundamentals that are explained so far in this post but also the structured derivative strategies in the upcoming posts that will be very useful to tailor those strategies and outcomes using options.
You will see that by using options you are not limited to only plain vanilla options but can also combine them and design them according to your needs and strategies.
Example 1: Call Option
Let’s observe an option strategy in more detail.
Below we see two call options on Netflix with strike prices of: $320 and $340. Both had the same expiry date of January 3, 2020. You can see their price fluctuation throughout December.
There is so much insight in the two option price charts above. Let’s emphasize some of them.
· Price of Option A surges in the second half of December as Netflix stock price peaks around $335. This option has around $15 intrinsic value at its peak and a few dollars of time value on top of that even though only a few days are left to the expiry.
· Price of Option B also goes up but its movement stays limited since its strike price is a bit higher and it’s still out of the money when NFLX peaks.
· Option A sees a price increase of almost 20X or 2000% in a few days. Then it loses 50% of that value in a few days. This shows the volatile nature of options.
· Option B’s price almost goes to 0 and looks like it will expire worthless as the expiry date is so close and it’s still out of the money.
· Option B needs underlying asset (NFLX) price to go passed $340 before January 3 to turn to in the money. As time passes the chances of this happening is decreasing rapidly and it will continue losing value.
This is why options are radically different than stock investments and you can make ridiculous amounts of profit in a short period of you can lose all the money you have invested in the same period.
However, we will see structured products that make options react in very different ways -sometimes even like stocks or more defensive than stocks-. You should always know the parameters and expected behaviors of the options you’re trading clearly so that you don’t encounter big surprises. It always makes sense to take baby steps and gain ample experience before doing any serious trades or investments with options.
Example 2: put option
Now let’s look at a put example on the same underlying stock.
Below we see two put options on Netflix with strike prices of: $320 and $340. Both had the same expiry date of January 3, 2020. You can see their price fluctuation throughout December.
Here are some points:
· Option A went from nearly $18 to almost $0 in a few days. This happened as the underlying asset NFLX went above $320 and stayed higher than $320. As the expiry approaches this put option remains worthless. (No one would choose to exercise the option and sell Netflix stocks at $320 when it’s trading higher than $325 in the market.)
· Option B also lost its value as NFLX stock price increased. However, it holds its value since it’s strike price is still above the NFLX market price. If it expires in this market level it will expire as an option with value.
· In the last part of the chart you can see how Option B is reacting the the recent fall of NFLX price. If the NFLX price keeps falling in the last few days before expiry this option has a high potential of being profitable.
· For Option A to become profitable, Netflix would have to fall below $320 in a few days which is not a very likely event and it’s reflected in the option’s price.
IMPORTANT bulletins
1 – Options can expire worthless. So, it is fundamentally different than buying a stock or gold or investing in an index. You need to calculate your risk appetite and capital allocation very carefully.
Just as they can go to zero, if you are short an option, you can lose infinite amounts in theory if it’s a call, and you can lose as much as the strike price if it’s a put.
2- Buying options gives you no obligation. It gives you the right to exercise an option. Selling options however can make you obligated if your counterparty decides to exercise their right.
3- Options require high caution. Option prices can move radically especially when the underlying is flirting with the strike price. It can go to zero as well as go up in value in big amounts based on relatively small moves of the stock price. You need to understand these dynamics before you can comfortably trade options.
4- Options can also be used for defensive strategies. It is also true that since options are derivative products, there are many ways to engineer the specific outcomes. Many funds are known to create delta neutral, derivative strategies where they only pocket theta (time value) profits by shorting options. (If you are not very familiar with option greeks, don’t worry, they will be explained in the coming posts)
5- Option selling strategies involve covered and uncovered (naked) scenarios. And they can have very different risk/return profiles. Naked or uncovered strategy means selling an option on an underlying security that is not owned. Naked positions in options can be risky investment strategies and you will be exposed to a wide range of outcomes. But they can also be very powerful if used properly. Some of the main uses of naked positions are hedging, leveraged speculation, decreasing the capital requirements etc. In later posts you will see detailed explanations and examples on covered option selling strategies that can improve and diversify investment strategies greatly.
