Let’s Begin with an Overview
Basic Definition of an Option
The definition of an option sounds complicated, particularly if this is the first time you’re encountering it, so don’t be too concerned if it isn’t making complete sense right away. This course will help you understand the basics of options.
With that said, here is the general definition of an option:
An Option is a financial derivative that gives a buyer the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date.
Obviously, there’s a lot to learn… so let’s start by learning a little bit more about the general conditions around options. Then we’ll break down the definition above so that you can start to understand it a piece at a time.
Comparing Options with Stocks
Similarities with Stocks
In order to better understand the benefits of trading stock options, you need to first understand some of the similarities and differences between options and stocks. Some of the similarities between stocks and stock options include:
- Similar to stocks, the price of an option rises and falls with the underlying stock price. Options trade like stocks, with buyers making bids and sellers making offers.
- Options are actively traded in a listed market, just like stocks. They can be bought and sold just like any other security.
Differences from Stocks
Some of the differences between stocks and stock options are:
- Options are derivatives. They derive their value from something else, the underlying security.
- Options have expiry dates. There are monthly and weekly options each expiring when they reach their expiration date.
- Options offer increased leverage. Options can be bought and sold at a fraction of the cost of the underlying stock.
- Options convey no shareholder rights. Stock owners that purchase shares of a company have voting and dividend rights.
Options have five main standardised terms by which they are defined:
- Type of option (call or put)
- Underlying security (specific stock or index)
- Exercise (or strike) price
- Expiry date
- Option premium
These five variables distinguish each individual option from every other available option. Each time you enter a trade using options, these five terms define the parameters of your trade. It is essential to understand how these factors affect the nature of each trade in order maximise your chances of success.
As we have already discussed, there are two types of options: calls and puts. A call option gives the buyer the right to buy a fixed number of shares of an underlying stock at the specified strike price on or before the option expiry date. The call buyer hopes the price of the underlying stock will rise prior to the call expiry date. The call seller (or writer) hopes that the price of the underlying stock will decline or remain below the call strike price until expiry.
A put option gives the buyer the right to sell a fixed number of shares of an underlying stock at the specified strike price on or before the option expiry date. The put option buyer hopes the price of the underlying stock will drop prior to the put expiry date. The put seller (or writer) hopes that the price of the underlying stock will rise or remain above the put strike price until expiry.
Typically, each stock option contract provides the right to buy or sell 100 shares of the underlying security. This means 1 option contract represents 100 underlying shares. This may change slightly if there is an adjustment or a reorganisation of capital in the underlying stock. Not all stocks have options. If options are available, they can be bought and sold at a fraction of the cost of the underlying stock. Thus, options provide a high leverage approach that, in many instances, can reap large rewards from minimum risk trades in comparison to traditional buy and hold share investing.
Exercise or Strike Price
The exercise (or strike) price is the predetermined fixed price at which the underlying stock can be purchased (call) or sold (put). Options are available in standardised strike prices at standard intervals. Stocks priced under $2.00 have strike prices at 10 cent intervals. Stocks priced between $2.00 and $10.00 have strike prices at 25 cent intervals and stocks priced above $10.00 have strike prices at 50 cent intervals.
Option expiry dates designate the last day on which an option may be exercised. The actual expiry date for stock (equity) options is usually the Thursday before the last business Friday of the expiry month although this can vary with public holidays and other events. After an option expires, the option buyer loses the right to buy or sell the underlying instrument at the strike price and all the obligations of the option become null and void and the option contract becomes worthless.
There are two styles of options: American and European. American style options can be exercised anytime up to and including the expiry day. Most options traded in the options market are American style. European style options can only be exercised on expiry day. Typically most Index options are European style.
In general, all options for a particular class follow one of the three quarterly cycles that usually extend out nine to twelve months. The three cycles are listed below.
- Cycle 1: January / April / July / October
- Cycle 2: February / May / August / November
- Cycle 3: March / June / September / December
Options are usually listed for the current month and the next three months in the quarterly expiry cycle.
The premium (or price of the option) is the compensation paid by the option buyer to the option seller (or option writer). Option premiums can vary as:
- They near expiry (time value shrinks).
- The price of the underlying security changes.
- Volatility fluctuates.
The actual change of the premium in comparison to the change in the price of the underlying stock is measured by the Greek called “delta.”
The potential loss on a purchased (long) option is limited to the premium paid, regardless of the underlying stock’s price movement. That’s why the purchase of an option enables traders to control the amount of risk assumed.
In contrast, the potential profit on a short (sold) option is limited to premium received, regardless of the underlying stock’s performance.
A call option gives the buyer the right, but not the obligation, to buy a fixed number of shares (typically 100) of an underlying stock at a specific exercise price on or before the option’s expiry date.
Call Option Example
- XYZ Bank (XYZ) shares have a last sale price of $26.90.
- An available standard call option contract would be a XYZ December 27.00 call.
- A buyer of this contract has the right—but not the obligation—to buy 100 XYZ shares for $27.00 per share at any time on or before the expiry date in December.
- For this right, the buyer pays a premium (the purchase price) to the writer (seller) of the option.
- In order to take up this right to buy the XYZ shares at the specified price, the buyer must exercise the option on or before the expiry day in December.
- On the other hand, the writer of this call option is obliged to deliver 100 XYZ shares at $27.00 per share if the buyer exercises the option.
- For accepting this obligation, the writer receives and keeps the option premium regardless of whether the option is exercised or not.
- If the call option is exercised, the shares are traded at the specified exercise (strike) price.
- The last date when an option can be exercised is called the expiry date.
A put option gives the buyer the right, but not the obligation, to sell a fixed number of shares (typically 100) of an underlying stock at a specific exercise price on or before the option’s expiry date.
Put Option Example
- Assume ABC (ABC) shares have a last sale price of $16.50.
- An available standard put option contract would be a ABC September 16.00 put.
- This gives the buyer (taker) the right—but not the obligation—to sell 100 ABC shares for $16.00 per share at any time on or before the September expiry day.
- For this right, the buyer pays a premium (the purchase price) to the writer of the put option.
- In order to take up this right to sell the ABC shares at the specified price the buyer must exercise the option on or before the expiry date in September.
- The writer of the put option is obliged to buy the ABC shares for $16.00 per share if the option is exercised.
- The same as with call options, the writer of a put option receives and keeps the option premium whether the option is exercised or not.
- If the put option is exercised, the shares are traded at the specified exercise (strike) price.
- The last date when an option can be exercised is called the expiry date.
Option Market Concepts
In this section we’ll give you some more context to the way that options markets work and who are the main participants involved.
Types of Options
There are two main types of options: Over the Counter (OTC) options and Exchange Traded Options (ETO). OTCs are privately traded between the buyer and seller and include company issued options. This course focuses on ETOs, so when you see the word options in this course, we are referring to Exchange Traded Options.
Exchange Traded Options
Exchange Traded Options are a derivative product issued over an existing stock or index. Each contract consists of the following standardised components: strike price, expiry date, underlying instrument and contract size. These components are found in all options traded on the exchange and are governed by clearly defined rules. The only variable that remains is the premium—the amount of money the option can be purchased or sold for (i.e. the market price of the option).
Equity or stock options are options traded over listed stocks. In U.S. markets, the standard number of shares covered by one stock option contract is 100.
Index options allow investors to trade in a specific industry group or market without having to buy all the stocks individually. Each index has a specific mathematical calculation to determine the price change up or down. An index option is an option that is tied directly to the change in the value of an index. You will not typically receive a percentage of each stock; rather the index option will have a cash value as represented by the index itself. Broad-based indexes cover a wide range of industries and companies (for example, the S&P 500).
A few indexes were specifically designed for trading futures and options. This contributed to the proliferation and explosive growth of index trading. The philosophy of an index is that a group of stocks—a portfolio—will diversify the risk of owning just one stock. In addition, an index of stocks will better replicate what is happening in an industry or the market as a whole. This allows an investor or trader to participate in the movement of a specific market, to either the upside or the downside.
Throughout the rest of this course, we will examine the basic terminology and use of options. As you start to work with these terms, try to become so familiar with them that they become second nature. A sound understanding of option basics will enable you to build a strong trading foundation.
Margin is a vital key to successful trading as it is the amount of money necessary to cover an option writer’s potential obligations to the market. When an option buyer pays a premium for an option, the premium paid (or the debit), is the maximum amount of money the option buyer can lose. The option buyer has no financial obligations to the market after the premium is paid and therefore there are no margins required. On the other hand, when an option seller writes an option contract, they are creating a financial obligation to the market. To protect the integrity of the market the clearing house, through your broker, will reserve a certain amount of cash or put a hold on the required number of underlying shares from the option writer’s account to act as collateral and cover those obligations.
Some combination option strategies which include written options may also require margin payments. Strategies that include multiple options or a combination of bought and written options typically have the margin calculated on the total risk, meaning one leg of the strategy may offset part or all or the other leg and may serve to reduce the total margin payable. For example, a bull call spread strategy involves the combination of a long call option at one strike price and a short call option at a higher strike price. In this instance, the long option covers the short position, which means no margins are required for the strategy. Remember to check with your broker before placing a combination order to see what margin requirements, if any, are required for the option strategy you are considering.
Margins are calculated on a daily basis to ensure an adequate level of margin cover is maintained. This means that you may have to increase your level of margin cover if the market moves against you, or your margins may be reduced if the market moves in your favour. If the market moves against you, your broker may call you (margin call) to top up your margin cover. Margin calls are usually required to be settled within 24 hours of being advised of the margin call by your broker. If you do not meet your margin call in time, your can take action to close out your position without further reference to you.
Cash is not the only collateral that is acceptable as cover. Your broker/clearing house also accepts certain stocks and bank guarantees. For example, with a covered call position, the broker/clearing house accepts the underlying shares as cover and therefore no cash margin will be required for the written call option. The broker/clearing house will typically apply a discount or haircut to the current market value of some collateral to protect against a sudden fall in the value of collateral held. It is important to always check these requirements with your broker.
Market makers play an important role in the options market by acting as intermediaries between your broker and the market. They are required by the exchange to make a two- sided market by providing both a bid and offer quotes in certain option series. Market makers compete against one another while trading on their own account at their own risk, and derive the bulk of their profits from the bid/ask spread.
- The bid is the highest price a prospective buyer is prepared to pay for a specified security.
- The ask is the lowest price acceptable to a prospective seller of the same security.
- These two prices constitute a quote.
The difference between the bid and ask is called the spread, and that’s where market makers make a good portion of their livings.
Each market maker is assigned two or more stocks in which they must maintain a market in. This involves quoting buy and sell prices for a certain number of option series and/or responding to requests from brokers for prices.
Each security over which exchange traded options are traded has a category designated by the exchange. This determines the maximum spread (the difference between the bid and ask prices) that the designated market maker(s) may quote when making a market and the minimum number of contracts for which the market maker must quote a price for.
Ultimately the market maker’s primary goal is to make money while providing a two-sided market. Market makers exist to ensure liquidity in the market, so that traders are more easily able to trade in and out of their positions.
Brokers act as agents between buyers and sellers of securities and the market. They have direct access to the market via computer systems for the purpose of trading approved instruments (i.e., stocks, options, futures etc.) on your behalf, for which a fee maybe charged. A broker may also offer a range of other products and services including advice on which stocks to buy or sell, or which options strategies to employ. Brokers also raise capital for companies through Initial Public Offerings (IPOs) or stock placements.
Traders and Investors
The words trader and investor are used to describe two distinct styles of investment. An investor is someone like famed US investor Warren Buffett, a classic “buy and hold” kind of guy. He keeps an investment through thick and thin, understanding that wealth can be created over time, provided the company has solid management and is in an industry that’s likely to prosper.
The trader, on the other hand, is seen as a person that buys and sells often, looking for price swings and situations he or she can trade profitably. These are the people that constantly monitor every move the market makes, looking for trends, reversals, breakouts and all manner of price movements.
The two styles are not separate of one another. In fact, it’s common for traders to operate different portfolios incorporating both styles. For example, an individual may operate one portfolio for their short-term trading and another for their longer term investments, such as a self-managed super fund.
Professional and Institutional
Professionals Traders & Investors
Professional traders and investors typically trade stocks on behalf of other people. They are usually employed by institutions, fund managers, stockbrokers and the like or they work under a special arrangement with them. In theory, professionals have the academic and professional backgrounds necessary to make superior stock selections. In reality, many professionals fail to deliver superior results. Nevertheless, professionals trade in large quantities of securities and are an important part of today’s market environment. (Note: Individual traders who derive the bulk of their income from full time trading often refer to themselves as professional traders.)
An institutional investor is a professional money manager whose job it is to put money into stocks and other assets on behalf of private investors. Institutional investors mainly focus on pooled investments such as managed funds and investment trusts. They enjoy greater contact with stockbroking analysts as well as the management staff of the companies in which they invest. It is common for individual investors to follow sizable stock trades initiated by institutional investors since they can have a significant effect on a stock’s performance, not to mention market sentiment.
Individuals Traders & Investors
Individuals who trade and invest in the markets through their own accounts are commonly referred to as retail investors and represent the bulk of the investing public. Traders and investors fall into two categories: long-term and short-term.
Long-term investors enjoy a lower risk and reduced stress approach. Investments are made with the intention of accumulating profits and dividends over the long run. Long-term investors need to do their homework carefully in order to find companies that can potentially double and triple in the decades ahead. Focusing on long-term returns makes long-term investors relatively impervious to day-to-day price fluctuations, which is a much less stressful way to live.
Short-term traders are generally speculators looking to profit from advantageous trends and momentum changes in volatile stocks. Many short-term traders integrate the use of options into their master trading plan to hedge risk and utilise leverage. Time is a big factor for short-term traders. Not just time spent in a trade, but the time required monitoring the market in search of golden opportunities.
Short-term trading can be an extremely active process. It requires specific tools to do the job right including real-time quote services and trading analysis software. If you want to compete in this arena, you have to be prepared. It’s more than a matter of tools. You need to have the right kind of psychological stamina to withstand the tests that will come your way.
In the beginning, options trading will most likely be a little confusing. These sections are valuable and should be reviewed until the concepts are clear. As you read ahead, refer back to these sections for clarity and it will all come together.
Basic Mechanics of Going Long and Short
It is essential to have a good understanding of the terms “long” and “short” before we move further into option strategies.
Describes a position in which you have purchased and own a security (i.e. a stock or an option). For example, if you have purchased the right to buy 100 shares of a security, you are long one call option contract. If you have purchased the right to sell 100 shares of a security, you are long one put option contract. If you have purchased 100 shares of a security outright you are simply long 100 shares.
Describes a position in which you have sold a security you don’t own. In return, you now have the obligations inherent in the terms of the short stock or option contract. For example, if you have sold the right to buy 100 shares of a stock to someone else, you are short one call option contract. If you have sold the right to sell 100 shares of a stock to someone else, you are short one put option contract. When you write an option contract, you are in a sense, creating it. The writer of an option collects and keeps the premium received from its initial sale. Below is a quick guide to the terms and how they relate to options.
Table Opening & Closing Transactions
When you first buy (or write) an option contract with your broker, it is called an opening transaction. If you then sell (or buy) the same option to cancel a position, it is called a closing transaction. For example, an instruction to your broker to buy to open 10 call options in ABC (ABC) expiring in November with a strike price of 30 is called an “opening transaction.”
If, after one month, you decide you do not want to remain in the position, you would instruct your broker to sell to close 10 ABC November 30 call options as a “closing transaction.” Once the closing transaction has been transacted, the initial open option contract is cancelled, and you will have no further rights (or obligations) arising from the ABC call option contracts. It is very important to always tell your broker when placing an option order, whether it is an opening or closing transaction.
Exiting a Trade
Basically, there are three alternatives when exiting an open option transaction:
- offset the transaction;
- exercise the option; or
- let the option expire.
Experience is the best teacher when it comes to choosing the best alternative. Since each alternative has an immediate result, learning how to profitably close out a trade is essential to becoming a successful options trader.
Offsetting is a closing transaction that cancels an open position. It is accomplished by doing the opposite of the opening transaction. There are four ways to offset an option transaction:
The best time to offset an option is when there are gains on the position. Offsetting is also used to avoid incurring further losses. An option can be offset at any time. It does not matter whether it is one second after it has been entered or one minute before expiry. It is very important to know the expiry dates of your open option positions so that you avoid leaving a nice profit on the table. Offsetting an option position is generally the most popular technique of closing an option trade for option buyers.
Exercising a long option position will close your open position by taking ownership (call) or delivering (put) the underlying shares at the option’s strike price.
By exercising a long call option, you close your open call option position by taking ownership of the underlying shares. If you want to exercise your long call option:
- Simply notify your broker, who will then notify the Clearing House.
- The Clearing House. will randomly select a writer (seller) in that series of call options and on the following day notify that writer that their written (sold) position has been exercised and they must deliver to you the corresponding number of shares in the underlying stock.
- If you choose to exercise your call option (you would only do this if the stock price is above the option’s strike price), your trading account will then be debited the purchase price of a 1000 shares (per contract) in the underlying stock at the call strike price. You will now own the underlying shares at the call strike price.
Exercising a long put option will close your open put position by selling your ownership of the underlying shares. If you want to exercise your long put option (rather than close it):
- Simply notify your broker, who will then notify the Clearing House.
- The Clearing House. will randomly select a writer (seller) in that series of put options and on the following day notify that writer that their written (sold) position has been exercised and they must purchase from you the corresponding number of shares in the underlying security.
- If you choose to exercise your put option (you would only do this if the stock price is below the option’s strike price), your trading account will then be credited the value of 100 shares (per contract) in the underlying stock at the put option strike price. Your shares will now be carried away at the put strike price.
You can exercise an American option at any time on or before expiry; but typically, you would not do it (that’s if you exercise it at all) until just prior to expiry. An option writer cannot exercise an option. By writing an option, you are taking the risk of having a buyer exercise the option against you if the market price movement makes it an ITM option.
Letting it Expire
Letting an option expire is used when the option is out-of-the-money (OTM) or worthless close to the expiry date.
Also, for short (written) options, letting them expire is the best way to realise a profit. If you let a short option expire, you get to keep the premium received when you opened the position. To make the most of any option, traders with open positions need to keep track of the price of the underlying security each day. A momentary fluctuation in price can mean the difference between opportunity and crisis. Luckily, computers make this process easier and more efficient than ever before.
Assignment is one of the more confusing processes of an option. Although it occurs infrequently, it is an important part of basic option mechanics. All option traders need to have a solid understanding of assignment in order to maximise their chances for success. Assignment is the term used to describe the option writer’s (seller’s) obligation to sell or buy the underlying stock at the strike price at which they sold the option contract at. The buyer of an option has the right (but not the obligation) to exercise the option (i.e. buy the underlying stock at the strike price for a long call, or sell the underlying stock at the strike price for a long put). Typically, most option writers will not want to be assigned at expiry. Hence, if their short position looks like having any chance of expiring ITM, and thus not expiring worthless, they will close out the short position to avoid the risk of assignment.
Option Trading Summary
Let’s get right to the heart of the issue. In essence, an option is the right, but not the obligation, to do something. Options provide choices for how we wish to proceed. Options serve as a contract between two parties—a buyer and a seller—conveying the right, but not the obligation, to buy (call) or sell (put) a specified underlying security at a fixed price within a predetermined time period for a specific premium.
An option is the world’s most versatile trading instrument. It enables traders to capitalise on the bullish or bearish moves of an underlying market—usually with much less initial investment capital. Buying an option offers limited risk and unlimited profit potential. In contrast, selling an option (also known as writing an option) comes with an obligation to complete the trade if the party who buys it chooses to exercise the option. Selling an option therefore presents the writer with limited profit potential and significant risk, unless the position is hedged in some manner.
Options are the perfect trading instrument for leveraging your capital and hedging your portfolio against risk. They act to protect your investments just as buying insurance would for your car or home. To be successful in today’s markets, you need to evaluate your current positions to see what you can do to be successful as you move forward. Finally, understanding the ins and outs of assignment and how it works in real-world trading is vital to becoming a successful options trader.
The Internet has made the process of reviewing option prices extremely easy. There are dozens of sites that provide quote services. Some of these services provide real- time quotes, but most are delayed by at least 20 minutes. If you want to receive streaming real-time data, you must be willing to pay for it. There are some brokers who will include this as part of their service, so it pays to ask.
Options symbols are generally a five-digit code issued by the exchange. The first three letters will be the same as the underlying stock symbol with the fourth and fifth digit being used to differentiate option series and types. Many options symbols are reused after an option expires.
Options descriptions are also an important part of an option as brokers will use the description to clarify the options parameters and confirm your order. This will circumvent any mistakes made in repeating the option code and also helps to paint a picture of the options parameters.
Whenever discussing options, the parameters should be outlined in the following order: underlying stock, expiry month (and year), strike price and type (call or put). For example, the ‘XYZ Dec20 50.00 call’ is broken down as follows:
Option Quote Components
When you look up an option’s price, you will usually be presented with a variety of information on each option. Let’s review a few of the most popular quote terms.
- Code (or Symbol): The unique code assigned to the option for trading, clearing and settlement purposes.
- Expiry: The last date the option may be exercised. All unexercised options will expire on this day.
- Bid: The bid is the highest price a prospective buyer is prepared to pay for a specified time for a trading unit of a specified security. If there is a high demand for the underlying security, the prices are bid up to a higher level. Retail traders generally sell at the bid price.
- Ask: The ask (or offer) is the lowest price acceptable to a prospective seller of the same security. A low demand for a stock translates to the market being offered down to the lowest price at which a person is willing to sell. Retail traders generally buy at the ask price.
- Bid-Ask Spread: Together, the bid and ask prices constitute the quote and the difference between the two prices is the bid-ask spread. The bid and ask dynamic is common to all stocks and options.
- Last: The last price at which the option traded. For delayed quotes, this price may not reflect the actual price of the option at the time you view the quote.
- Volume: Option volume is total number of contracts traded that day.
- Open Interest: Open interest is the total number of outstanding contracts currently in the market. It also defines an option’s liquidity; the higher the number, the easier it is to move in and out of a trade.
- Margin Price: Margin price is the calculated theoretical fair-value (also known as model price) of the option. This is often used in preference to the last price as it is updated throughout the day. Often the last price may not have occurred on the day and in some cases for lightly traded option could be weeks old.
Liquidity can be defined as the ease with which a security can be converted to cash in the marketplace. Another way to look at liquidity is in terms of supply and demand. When it comes to options, ATM (at-the-money) options usually have the highest supply and demand (open Interest) because they are less expensive than ITM (in-the-money) options and have a better chance of becoming profitable by expiry than OTM (out- the-money) options. Open interest is the number of open option contracts that exist in the market at any one time.
Another factor is options volume. Volume is the total number of contracts traded that day. A large number of open contracts together with high trading volume provides good liquidity and a healthy market.
- Volume: Option volume is total number of contracts traded that day.
- Open interest: Open interest is the total number of outstanding contracts in the market.
Liquidity gives traders the opportunity to move in and out of a market with ease. As stated, ATM options have excellent liquidity because they have a better chance of being profitable than OTM options. An option that is a long way out-the-money is not going to have a lot of liquidity. Most of the strategies we teach must be applied in specific market conditions to be money makers. Liquidity is one of these market conditions. Liquidity is the ease with which a market can be traded. A plentiful number of buyers and sellers increases the volume of trading producing a liquid market.
Reviewing the open interest and volume of a market is an important step of traders and investors. Liquidity allows traders to get their orders filled easily.
It is important to understand how the market determines the value of an option. Mathematical formulas exist to calculate the theoretical fair-value or model price of an option based on various components. A change in any of these components will have an effect on an options value. Listed below are the eight major components that affect an options value:
- Whether the option is a put or a call
- Whether the option is an American or European style option
- The risk-free rate of return (interest rates)
- The price of the underlying security (the stock price)
- The exercise (strike) price of the option
- The volatility of the stock’s price
- Any dividends expected from the stock prior to expiry of the option
- The expiry date (the number of days until expiry)
Let’s take a look at each one in more detail:
Put or Call
Puts and calls are simply the flip side of each other. At any time before expiry, puts and calls that are the same amount ITM or OTM will be priced basically the same.
American or European Style
Whether an option is an American style or European style will affect its price. An American style option permits the exercise of the option at any time prior to expiry, while a European style option permits exercise only upon reaching expiry. As the trader has the ability to exercise the American option at any time, it will carry a slightly higher premium because of the additional benefits of the added flexibility.
Risk-free Rate of Return (Interest Rates)
The risk-free interest rate is a factor, but for near-term options (6 months or less) it is a very marginal one. The actions of the interest rate markets will typically have little effect on the price of an individual option. Higher interest rates can increase call option premiums, while lower interest rates can lead to a decrease in call option premiums. The reverse is true for puts. The risk-free rate is factored directly into the price of the option as a discount rate for the expected future value of that option. Thus, if there is not much time left until expiry, a change in the risk-free rate will not affect the option price that much.
Underlying Stock Price and Exercise Price
The major components involved in the pricing of any option are the price of the underlying stock (4) and the exercise (strike) price (5) of the option. The relationship between these two values determines the intrinsic value of the option, as well as how far in-the-money or out-the-money a given option is located. A move in the price of the stock will have a different effect on the option depending on the strike price you choose. An option that is deep in-the-money or out-the-money will behave quite differently to choosing one that is at-the-money.
Volatility of the Underlying Stock
Volatility is a percentage that measures the amount by which the underlying stock is expected to change in a given period of time. Highly volatile stocks have a better chance of making a substantial move than those that are not so volatile. They offer larger up and down swings in price in shorter time spans than less volatile stocks. Large movements are attractive to option traders who are always looking for big directional swings to make their contracts profitable. This is why the options of volatile stocks generally command higher premiums than those that are less volatile.
Dividends of the Underlying Stock
Although each variable is important, dividends are often overlooked. Dividends can play an important role in the pricing of options especially around ex-dividend time. The price of a stock will typically fall once it goes ex-dividend by the amount of the dividend being paid. At the same time, you will notice that option prices underlying the stock will not usually change after such a drop as you may expect. This is due to the fact that the dividend has already been factored into the value of the options.
Expiry Date (the number of days until expiry)
The amount of time remaining until expiry, also referred to as time value, is an extremely important factor. The longer an option has until expiry, the greater the chance it has of becoming profitable, and hence the higher the option premium.
The options greeks are a set of measurements that quantify an option position’s exposure to risk. Options and other trading instruments have a variety of risk exposures that can vary dramatically over time or as markets move. Each of the option greeks represents a different variable of option pricing. To assess the probability of the trade making money, it is essential to determine the exposure of the position in relation to time, volatility and movement of the underlying security. Changes in the price of the underlying instrument trigger changes in the option delta, which will trigger changes in the rest of the greeks.
Each risk measurement is named after a different letter in the Greek alphabet, including delta, gamma, theta, and vega (vega is not actually a Greek letter, but is used in this context). In the beginning, it is important to be aware of all of the greeks, although understanding the delta is the most crucial to your success. Comprehending the definition of each of the greeks will give you the tools to decipher option pricing. Each of the terms defined below has a specific use in day-to-day options trading.
- Delta: The change in the price of an option relative to the change of the underlying security. Delta helps you to understand how an option’s premium will rise or fall in comparison to the price of the underlying security.
- Gamma: Change in the delta of an option with respect to the change in price of its underlying security. Gamma helps you to gauge the change in an option’s delta when the underlying security moves.
- Theta: Change in the price of an option with respect to a change in its time until expiry. Theta measures the amount an option will lose with the passage of one day.
- Vega: Change in the price of an option with respect to its change in volatility. Vega measures the amount an option will gain or lose with a one-percentage point change in volatility.
When broken down, all of these terms refer to simple concepts that can assist you thoroughly understand the risks and potential rewards of option positions. Having a comprehensive understanding of these concepts will help reduce risk exposure, reduce stress levels, and increase overall profitability as a trader. Learning how to integrate these basic concepts into your own trading programs can have a powerful effect on your success as an options trader. Although we could write an entire manual on the option greeks, in this primer we restrict the discussion to simply introducing the basic concepts.
Delta is defined as the change in the price of an option relative to the change of the underlying security. Another way to think about it is that the delta is the amount by which the price of an option changes for every dollar move in the underlying instrument. This is a very important number to consider when constructing combination positions.
Call option deltas are positive (0 to 1) while put options have negative deltas (0 to -1). If a call option has a delta of 0.5, then that implies that the option will increase by $0.50 for a $1.00 move up in the stock price. Conversely, if a put option has a delta of -0.5 that implies that the option will increase by $0.50 for a $1.00 move down in the stock price.
Generally speaking, ATM options will have deltas of plus or minus 0.50, and deeper ITM options might have a delta of 0.80 or higher. Out-of-the-money options have deltas as small as 0.20 or less. These values will change as the option becomes further ITM or OTM. Just as option prices are not linear, neither are the changes in the option greeks.
When an option is very deep ITM, it will begin to trade like the stocks, moving practically dollar-for-dollar with the underlying stock. In contrast, far OTM options will not move much at all, even if the stock price starts rising or falling. As a general rule, you should usually steer clear of buying options that are far OTM. Your chances of making money buying short-term OTM options are generally pretty small because the option’s premium rapidly deteriorates. You also need a large move in the right direction from the underlying stock price in order to become profitable.
The delta of an option can also be thought of as an option’s chance of being in-the-money by expiry. For example, if a call has a delta of 0.35, it can be said there is theoretically a 35% chance of the call finishing in-the-money at expiry.
The Delta Calculations
Successful option traders are usually proficient at understanding and calculating deltas. While there are several tools on the market that can automatically calculate an option’s delta, you can also calculate them manually by using the following formula:
- (Price Change of an Option) / (Price Change of the Stock) = Delta
Let’s try an example where XYZ is trading at $13 per share and you buy an ATM 13 call option. If the call option increases $0.20 in price while XYZ increases $0.40 per share, the delta would then be: 0.2/0.4 = 0.50. In trading, this is a 50 delta, which means that this particular option will move at 50% of the speed of the stock price.
For those of you who have computer models that do delta calculations, there are other variables involved, but for on-the-run delta calculations, this formula can be used as a good basis. Bottom line, a change in the stock price will cause a change in the option delta, which will cause a change in the overall position delta.
Gamma can be defined as the rate of change in the delta for each one-point move in the underlying instrument. In other words, gamma is the degree by which the delta changes with respect to changes in the underlying instrument’s price. The gamma is a valuable tool because it can help you forecast changes in the delta of an option or an overall position.
For example, a call option with a gamma of 0.03 indicates the option will gain 0.03 positive deltas for each point increase in the stock price. A put option with a gamma of 0.03 indicates the option will gain 0.03 negative deltas for each point decrease in the stock price. Gamma is especially useful when larger positions are in place. It provides a more dynamic risk profile of the option position. Gamma is highest for ATM options because the deltas of ATM options are more sensitive to price moves in the underlying stock.
Theta is a measure of the time decay of an option. Generally speaking, time decay increases as an option approaches expiry. Theta is one of the most important concepts for a beginner option trader to understand. It basically explains the effect of time on the premium of the options that have been purchased or sold. The less time that an option has until expiry, the faster that option is going to lose its extrinsic value.
Theta is a way of measuring the rate at which value is lost. The further out in time you go, the smaller the time decay will be for an option. Therefore, if you want to own an option, it is advantageous to purchase longer-term contracts. If you are using a strategy that profits from time decay, then you will want to be short (sell) the shorter-term options to take advantage of the loss in value due to time decay which can happen quickly.
Vega is defined as the change in the price of an option with respect to its change in volatility. As the volatility of a stock increases, so does the premium for its options. Volatility is one of the most important determinants of an option’s price. The easiest way to understand volatility is to view a price chart over a period of time and look at the price change; the greater the price change, the higher the volatility. Vega measures the amount an option will gain or lose with a one percentage point change in volatility.
Importance of the Greeks
The greeks can help you to explore the various risk exposures of every trade you consider placing. Options have a variety of risk exposures and these risks can vary dramatically with time and market movement. To recognise the probabilities of the trade making money, it is essential to be able to determine a variety of risk exposure measurements. Changes in the price of the underlying instrument trigger changes in the delta, which will trigger changes in the rest of the greeks.
Take time to study the effects that changes in price, time and volatility have on the Greeks and how they interrelate.
It is not important to understand all the mathematics behind the greeks. What is important is that you are familiar with how to interpret the numbers and how these numbers measure how an option or option strategy will behave given certain changes in market conditions.
Since prices are constantly changing, the greeks provide traders with the means to determine just how sensitive a specific trade is to price fluctuations. A solid understanding of the greeks can help you take your options trading to another level.
A Risk Curve, or payoff diagram as they are sometimes referred to, is a graphic representation of the profit or loss of a position in relation to price changes in the underlying security. When drawn with software, risk profiles can also take into account the effects of changes in time and volatility of the position. Risk profiles enable traders to visually assess a trade’s profitability in one glance.
The risk profile shown in Figure 12 is an example of a long call option that has been computer generated by HUBB Software, an options trading and analysis software program. The horizontal numbers at the bottom of the graph read from left to right showing the underlying securities price. The vertical numbers on the right show profit and loss in dollars. The sloping graph line indicates the theoretical profit and loss of the position at various times, including expiry, as it corresponds to the price of the underlying security.
In this risk profile example, we have purchased a call option with a strike price of $28.00 at a premium of 6.70 cents or $670 for one contract. (1 contract controls 100 shares). The max risk is equal to the call premium paid, in this case $670. The maximum reward is unlimited similar to owning the underlying stock.
You don’t need a computer program to calculate the basics of a risk profile; they can be drawn by hand for most option strategies at expiry (the solid line). However, if you want to go that next step and calculate what an options position will be worth at anytime prior to expiry (the dashed lines) or what it will be worth given a change in volatility, then you will need a software tool to calculate and draw it.
Call Options in Details
Call options are an attractive alternative to buying the stock. The list below provides an inventory of a call’s properties.
- Call options give the buyer the right, but not the obligation to buy an underlying stock at the call’s strike price.
- In the US, each stock option typically represents 100 shares of the underlying stock.
- The purchase of a call option effectively locks in a particular price on the underlying stock and allows the buyer to enjoy the same advantage of unlimited profit potential that comes with owning 100 shares of the underlying security.
- A call option holder has the right, if he or she chooses, to purchase a stock, index or futures contract at the option strike price until the option’s expiry.
- The option seller (writer) has the obligation to fulfill that right.
- Options are available in various strike prices depending on the current market price of the underlying security.
- Expiry dates can vary from one month out to a few years.
|Long Call Option Example
||1 x Aug20 XYZ 25.00 Call @ 1.20
|Gives the purchaser the right to buy…
||100 shares of XYZ at $25 per share ($2500 total).
|That right is good until…
||Close of business the day before the last Friday in August 2020.
|The cost to acquire that right is…
||The premium of $1,200 ($1.20 x 1,000 shares = $1,200).
Call buyers have unlimited potential to profit on the rise in price of an underlying stock, but unlike long stock positions, risk is limited to the premium paid for the option. Since calls can be purchased at a fraction of the price of buying the stock,
it is an economical way to leverage trading capital in order to participate in market movement. Be aware though, options are a wasting asset since their value declines as they approach expiry. Owning the underlying stock has no expiry.
Going Long Calls
If you choose to buy or go long a call option, you are purchasing the right to buy the underlying instrument at the strike price you choose up until the day before the last Friday of the expiry month. The premium of a long call option shows up as a debit in your trading account.
- Limited Risk: The maximum risk is limited to the premium paid for the call option.
- Unlimited Profit: Unlimited to the upside beyond the breakeven. The profit is based on the performance of the underlying security. The call profit increases as the price of the underlying security rises above the strike price. Since the stock has no real limit to its upside potential, your potential profit is unlimited.
- Breakeven: Call strike price + call premium
- Risk Profile: Shows an unlimited profit above the breakeven and limited loss below the breakeven, as shown by the solid line in the risk graph below.
A long call option position is taken when the underlying stock is expected to go up in value. The premium paid for the long call option will show up as a debit in your trading account and is the maximum loss you risk by purchasing the call. In contrast, the maximum profit of a long call option is unlimited depending on how high the underlying instrument rises in price (the upside) above the strike price. As the underlying rises, the long call increases in value because it gives the option holder the right to buy the underlying stock at its lower strike price. That’s why you want to go long a call option in a rising or bull market.
Long Call vs. Long Stock Risk Profile
Going Short Calls
Shorting (or writing) a call option can be extremely risky. By selling a call, you grant someone else the right, but not the obligation, to purchase 100 shares of the underlying security at the option strike price. In exchange, your trading account receives a credit in the amount of the option’s premium.
- Unlimited Risk: As the price of the underlying stock rises above the position’s breakeven. If the price of the underlying stock remains higher than the call strike price, the call is not in danger of being assigned and exercised. There is no reason for an option buyer to exercise a call option when he or she can buy the underlying stock at a lower current market price. However, if the price of the underlying stock rises above the strike price, the call may be exercised and assigned to the call seller. The call seller is then obligated to sell 100 shares of the underlying stock per call contract at the call strike price.
- Limited Profit: Limited to the premium received for selling the call option. Selling a call enables traders to profit from a decrease in the underlying market. If the underlying stock stays below the strike price until the option’s expiry, the option expires worthless and the trader gets to keep the credit received.
- Breakeven: Call strike price + call premium
- Risk Profile: Shows a limited profit below the strike price and unlimited loss above the breakeven, as shown by the solid line in the risk graph below.
The loss on a short call depends on how high the price of the underlying security rises to the upside beyond the call’s strike price. If the underlying stock rises above a short call’s strike price, the call option is in danger of being exercised by the call buyer. The call writer will then be obligated to deliver 1,000 shares of the underlying security at the call’s strike price to the call buyer. The option seller still gets to keep the premium received from originally writing the call, which can be used to hedge the loss on having
Short Call vs Short Stock Risk Profile
to buy the underlying stock at a higher price to fulfil this obligation. This can be quite expensive, which is why we never recommend selling naked or uncovered options. Experienced traders who choose to short call options often do so as part of a hedged combination options strategy.
Selling naked calls is not allowed by many brokerages. Others require you to supply a margin deposit or extra collateral. This demonstrates just how risky naked options can be. However, a short call can be very useful combination options strategies and therefore it is important to understand its basic properties.
Call Strike Prices
Stock options have various strike intervals depending on the price range of the stock. For stocks less than $2, the available strike prices have intervals of 0.1. For stocks between $2 and $10, the intervals are 0.25 and stocks over $10 have intervals of 0.50. In addition, there are normally a number of expiry months for each strike price.
Just as the price of a stock fluctuates daily, so does the price of an option. The relationship between the strike price of a call and the price of the underlying security determines whether a call is in-the-money (ITM), out-of-the-money (OTM) or at-the- money (ATM).
A bullish trader may purchase a call (go long) because they expect the stock to increase in price. The trader will most likely make a profit if the market price of the underlying security increases fast enough to overcome the call option’s time decay.
|Option vs. Underlying Price
|Call Strike Price < Stock Price
||In-the-Money (ITM) Option
|Call Strike Price = Stock Price
||At-the-Money (ATM) Option
|Call Strike Price > Stock Price
||Out-of-the-Money (OTM) Option
Call Option Moneyness
Put options in Detail
Buying a put option is a welcomed alternative to short selling a stock. Although both strategies offer traders the chance to make a profit from a decrease in a market, only buying a put does so with limited risk.
- A put option gives the buyer the right, but not the obligation, to sell 1,000 shares of an underlying security at a fixed price until the option’s expiry date.
- A put option holder has the right, if he or she chooses, to sell the stock at a set price within a certain time period. The option writer has the obligation to fulfil that right.
Just like call options, put options come in various strike prices with a variety of expiry dates. However, unlike call options, if you are bearish (expect the stock price to fall), you might consider going long a put option. If you were bullish (expect the stock price to rise), you might consider shorting a put option.
|Long Put Option Example
||1 x XYZ Jan20 25.00 Call @ 1.20
|Gives the purchaser the right to sell…
||100 shares of XYZ at $25 per share ($2500 total).
|That right is good until…
||Close of business the day before the last Friday in January 2020.
|The cost to acquire that right is…
||The premium of $45.00 (0.45 x 100 = $45.00).
Put buyers have limited potential to profit on a fall in price of an underlying stock (as the underlying can only fall to zero), but unlike short stock positions, risk is limited to the premium paid for the option. Since puts can typically be purchased for less than it would cost to short the underlying stock, it is an economical way to leverage trading capital in order to participate in a downward market movement. Be aware though, options are a wasting asset since their value declines as they approach expiry. Shorting the underlying stock has no expiry.
Going Long Puts
Long Put vs. Short Stock Risk Profile
If you choose to buy or go long a put option, you are purchasing the right to sell the underlying security at a specific strike price on or before the specified expiry date of the option. The premium of the long put option will show up as a debit in your trading account (i.e., you will pay it out of your account).
- Limited Risk: The maximum risk is limited to the premium paid for the put option.
- Limited Profit: Limited potential to the downside beyond the breakeven. The put profit increases as the price of the underlying security falls below the strike price, but has a limited range as the underlying stock can only fall to zero
- Breakeven: Put strike price – put premium
- Risk Profile: Shows a limited profit below the breakeven (as the underlying can only fall to zero) and a limited loss above the breakeven equal to the premium paid to purchase the option.
This position is taken when the underlying stock is expected to go down in value. As the underlying stock falls, the long put becomes more valuable because it gives you the right to sell the underlying stock at the put strike price. That’s why you want to go long put options in a bearish or falling market.
The risk profile shown in Figure 15 shows how a long put option’s risk is limited to the cost of the premium, while a short stock comes with unlimited risk as the stock climbs above its initial price. Both trading instruments have limited profit potential as the underlying stock falls toward zero.
Going Short Puts
Short Put vs. Long Stock Risk Profile
Shorting or writing a put option is risky. By writing a put option, you are selling someone else the right to sell 1,000 shares of the underlying security at the option’s strike price until the expiry date. In exchange, you receive a credit in the amount of the option’s premium. However, shorting a put option also comes with an obligation to buy the underlying instrument if the option holder chooses to exercises the option.
- Limited, but High-Risk: Limited as the price of the underlying stock can only fall to zero. If the price of the underlying stock remains higher than the strike price of the put, you will not be in danger of the put being exercised. There is no reason for a put option buyer to exercise a put option when he or she can sell the underlying stock at a higher current market price. However, if the price of the underlying stock falls below the put strike price, the put may be exercised and assigned to the put seller. The put seller is then obligated to purchase 1,000 shares per contract at the put strike price.
- Limited Profit: Limited to the premium received for selling the put option. By selling a put option, you will receive the option’s premium in the form of a credit into your trading account. The premium received is the maximum reward for a short put position. In most cases, you are anticipating that the short put will expire worthless by expiry.
- Breakeven: Put strike price – put premium.
- Risk Profile: Shows a profit limited to the put premium received and a limited loss below the breakeven (as the underlying stock can only fall to zero).
If your put option is exercised, you are obligated to purchase the underlying shares from the buyer of your short put option at the strike price sold. Experienced traders who choose to go short put options do so in a stable or bull market because the put will not be exercised unless the market falls. There is also a substantial margin requirement for shorting puts.
The risk profile in Figure 16 reveals the difference between how a short put provides limited reward and the long stock offers unlimited reward. Both trading instruments come with limited, but high risk, which is why we never recommend selling naked (uncovered) puts.
Put Strike Prices
As explained under call options, strikes for stock options come in multiples of 0.10, 0.25 and 0.50, depending on the underlying stock value as defined by the exchange.
The relationship between the strike price of a put and the price of the underlying security determines whether a put is in-the-money (ITM), out-of-the-money (OTM) or at-the-money (ATM).
|Option vs. Underlying Price
|Put Strike Price > Stock Price
||In-the-Money (ITM) Option
|Put Strike Price = Stock Price
||At-the-Money (ATM) Option
|Put Strike Price < Stock Price
||Out-of-the-Money (OTM) Option
Put Option Moneyness
A bearish trader may purchase a put (go long) because they expect the underlying stock to decrease in price. The trader will most likely make a profit if the market price of the underlying security decreases fast enough to overcome the put option’s time decay.