We’ve all heard of options. They may seem overwhelming to think about, but options are easy to understand if you know a few key points. Investor portfolios are usually constructed with several asset classes. These may be stocks, bonds, ETFs, and even mutual funds. Options are another asset class, and when used correctly, they offer many advantages that trading stocks and ETFs alone cannot.
Options are powerful because they can enhance an individual’s portfolio. They do this through added income, protection, and even leverage. Depending on the situation, there is usually an option scenario appropriate for an investor’s goal. A popular example would be using options as an effective hedge against a declining stock market to limit downside losses. Options can also be used to generate recurring income. Additionally, they are often used for speculative purposes such as wagering on the direction of a stock.
The best way to think about options is this:
“Options give you options.”
There is no free lunch with stocks and bonds. Options are no different. Options trading involves certain risks that the investor must be aware of before making a trade. This is why, when trading options with a broker, you usually see a disclaimer similar to the following:
Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss. Only invest with risk capital.
Options belong to the larger group of securities known as derivatives. This word is often associated with excessive risk-taking and having the ability to bring down economies. Even Warren Buffett has referred to derivatives as “weapons of mass destruction.” That perception, however, is really overblown.
All “derivative” means is that its price is dependent on, or derived from the price of something else. Think of it this way: wine is a derivative of grapes; ketchup is a derivative of tomatoes; a stock option is a derivative of a stock.
Options are derivatives of financial securities – their value depends on the price of some other asset. That is essentially what the term, derivative, means. There are many different types of securities that fall under the label of derivative, including calls, puts, futures, forwards, swaps (of which there are many types), and mortgage-backed securities, among many others. In the 2008 crisis, mortgage-backed securities and a particular type of swap caused all the trouble. Options were largely blameless. (See also: 10 Options Strategies To Know.)
If you know how options work, and how to use them appropriately, you can have a real advantage in the market. Most importantly, options can allow you to put the odds in your favor. If using options for speculation doesn’t fit your style, no problem – you can use options without speculating. Even if you decide never to use options, it is still important to understand how companies you invest in use them. For instance, they might hedge foreign-exchange risk, or give employees potential stock ownership in the form of stock options. Most multi-national corporations today use options in some form or another.
This tutorial will introduce you to the fundamentals of stock options. The concepts can be broadly applied to assets other than stocks, too. Many options traders have years of experience, so don’t expect to be an expert immediately after reading this tutorial. If you aren’t familiar with how the stock market works, you might want to check out the Stock Basics tutorial first.
Call and Put Options
Options are a type of derivative security. An option is a derivative because its price is intrinsically linked to the price of something else. Remember: “options give you options.”
If you buy an options contract, it grants you the right, but not the obligation to buy or sell an underlying asset at a set price on or before a certain date. A call option gives the holder the right to buy stock and a put option gives the holder the right to sell stock.
Calls and Puts
Think of a call option as a down-payment for a future purpose. Let’s look at an example:
A potential homeowner sees a new development going up. That person may want the right to purchase a home in the future, but will only want to exercise that right once certain developments around the area are built. For instance, will there be a school going up soon? Or will there be a garbage dump coming? These circumstances would affect their decision to buy the home. The potential home buyer would benefit from the option of buying or not. Imagine they can buy a call option from the developer to buy the home at say $400,000 at any point in the next three years. Well, they can – you know it as a non-refundable deposit. Naturally, the developer wouldn’t grant such an option for free. The potential home buyer needs to contribute a down-payment to lock in that right.
With respect to an option, this cost is known as the premium. It is the price of the option contract. In our home example, the deposit might be $20,000 that the buyer pays the developer. Let’s say two years have passed, and now the developments are built and zoning has been approved. No garbage dump is coming nearby. The home buyer exercises the option and buys the home for $400,000, because that is the contract purchased. The market value of that home may have doubled to $800,000. But because the down payment locked in a pre-determined price, the buyer pays $400,000. Now, in an alternate scenario, say the zoning approval doesn’t come through until year four. This is one year past the expiration of this option. Now the home buyer must pay market price because the contract has expired. In either case, the developer keeps the original $20,000 collected.
Take a look at the example below – it’s an excerpt from my Options for Beginners course introducing the concept of call options:
Now, think of a put option as an insurance policy. If you own your home, you are likely familiar with purchasing homeowner’s insurance. A homeowner buys a homeowner’s policy to protect their home from damage. They pay an amount called the premium, for some amount of time, let’s say a year. The policy has a face value and gives the insurance holder protection in the event the home is damaged.
What if, instead of a home, your asset was a stock or index investment? Similarly, if an investor wants insurance on his/her S&P 500 index portfolio, they can purchase put options. An investor may fear that a bear market is near and may be unwilling to lose more than 10% of their long position in the S&P 500 index. If the S&P 500 is currently trading at $2500, he/she can purchase a put option giving the right to sell the index at $2250, for example, at any point in the next two years. If in six months the market crashes by 20% (500 points on the index), he/she has made 250 points by being able to sell the index at $2250 when it is trading at $2000 – a combined loss of just 10%. In fact, even if the market drops to zero, the loss would only be 10% if this put option is held. Again, purchasing the option will carry a cost (its premium), and if the market doesn’t drop during that period, the maximum loss on the option is just the premium spent.
See below another excerpt from my Options for Beginners course where I introduce the concept of put options:
These examples demonstrate some very important points:
First, when you buy an option, you have a right but not an obligation to do something with it. For stocks and many options on futures, it’s not required to exercise your right to buy or sell stock by expiration. However, if your option has value at expiration, in general, your broker will automatically exercise the option. In our put example above, if the S&P 500 fell to zero at expiration, the 2250 put is worth 2250. At expiration your put option would settle for the cash value, causing a large gain on the hedge. Keep in mind that stocks are physically settled. Now, back to our put example: if the S&P 500 went up to 3000 at expiration, your 2250 put is worthless.
Second, the most you can lose when buying an option contract is the premium spent. This is an attractive trait for many. Limited risk allows option buyers to sleep at night.
Third, an option is a contract on an underlying asset. Its price is derived from the underlying asset’s price. That’s why options are derivatives. In this tutorial, the underlying asset will typically be a stock or stock index, but as mentioned, options are actively traded on all sorts of financial securities, such as bonds, foreign currencies, commodities, and yes, even other derivatives!
Buying and Selling Calls and Puts: Four Cardinal Coordinates
Buying a stock gives you a long position. Buying a call option gives you a potential long position in the underlying stock. Short-selling a stock gives you a short position. Selling a naked or uncovered call gives you a potential short position in the underlying stock.
Buying a put option gives you a potential short position in the underlying stock. Selling a naked, or unmarried, put gives you a potential long position in the underlying stock. Keeping these four scenarios straight is crucial: they relate to the four things you can do with options: buy calls; sell calls; buy puts; and sell puts.
People who buy options are called holders and those who sell options are called writers of options. Here is the important distinction between holders and writers:
- Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights. This limits the risk of buyers of options to only the premium spent. Call writers and put writers (sellers), however, are obligated to buy or sell if the option expires in-the-money (more on that below). This means that a seller may be required to make good on a promise to buy or sell. It also implies that option sellers have exposure to more, and in some cases unlimited, risks. This means writers can lose much more than the price of the options premium.
Don’t worry if this seems confusing – the important thing to know that there are these 4 fundamental scenarios to be aware of.
To really understand options, you need to know the options market terminology.
The strike price of an option contract is the price at which an underlying stock can be bought or sold. This is the price a stock price must go above (for calls) or go below (for puts) before a position can be exercised for a profit. This must occur on or before the expiration date in order to be in-the-money. In our example above, the strike price for the S&P 500 put option was 2250. The index had to fall below 2250 on or before expiration to be exercised for a profit.
The expiration date, or expiry, of an option is the precise date that the option contract terminates.
A listed option is an option that is traded on a national options exchange such as the Chicago Board Options Exchange (CBOE). Listed options have fixed strike prices and expiration dates. Each listed option represents 100 shares of stock (known as 1 contract).
For call options, the option is in-the-money if the share price is above the strike price. For example:
ABC April 50 Call. ABC stock is trading at $55. The Call is $5 in-the-money.
A put option is in-the-money when the share price is below the strike price. For example:
ABC April 50 Put. ABC stock is trading at $45. The Put is $5 in-the-money.
The amount by which an option is in-the-money is also referred to as its intrinsic value. For example:
ABC April 50 Call. ABC stock is trading at $55. The Call is $5 in-the-money and also has $5 of intrinsic value.
An option is out-of-the-money if the price of the underlying remains below the strike price (for a call), or above the strike price (for a put). An option is at-the-money when the price of the underlying is at or very close to the strike price. For example:
ABC April 50 Call. ABC stock is trading at $45. The Call is out-of-the-money and also has no intrinsic value.
ABC April 50 Put. ABC stock is trading at $55. The Put is out-of-the-money and also has no intrinsic value.
ABC April 50 Call. ABC stock is trading at $50. The Call is at-the-money and also has no intrinsic value.
ABC April 50 Put. ABC stock is trading at $50. The Put is at-the-money and also has no intrinsic value.
Remember, the total cost (the price) of an option contract is called the premium. This price is determined by a few factors, including:
- stock price
- strike price
- time remaining until expiration (time value)
Although employee stock options aren’t available for everyone to trade, they are still a type of call option. Many companies use stock options as a way to attract and to keep talented employees, especially management. They are similar to regular stock options in that the holder has the right but not the obligation to purchase company stock. The employee stock option contract, however, exists only between the holder and the company. It typically cannot be exchanged with anybody else. A listed option however, is a contract between two parties that is completely unrelated to the company and can be traded freely.
Why Use Options?
Speculation is a wager on future price direction. A speculator might think the price of a stock will go up, perhaps based on fundamental analysis or technical analysis. A speculator might buy the stock or buy a call option on the stock. Speculating with a call option – instead of buying the stock outright – is attractive to some traders since options provide leverage. An out-of-the money call option may only cost a few dollars or even cents compared to the full price of a $100 stock. As an example:
XYZ stock is $100 per share. An investor who wants to buy 100 shares will do so at a cost of $10,000. An XYZ 102 call option with one month till expiration may hypothetically be priced at $2 per contract. One contract equals 100 shares of XYZ stock, so the total premium spent is $200. With leverage, spending $200 vs $10,000 to potentially control the same amount of stock is a huge difference.
The leverage component of options contributes to their reputation for being risky. It is important to understand that when you buy an option, you must be correct in the direction of the stock’s movement, and also the magnitude and timing of this movement. In other words, to succeed, you must correctly predict whether a stock will go up or down, and you have to correctly predict the magnitude of price change. You also need to accurately predict the time frame within which all of this will happen.
Options were really invented for hedging purposes. Hedging with options is meant to reduce risk at a reasonable cost. Here, we can think of using options like an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn. Critics of options may say “if you are so unsure of your stock pick that you need a hedge, you shouldn’t make the investment.” In reality, there is plenty of evidence that hedging strategies can be useful. This is especially true for large institutions. The individual investor can also benefit from hedging. Imagine that you want to buy technology stocks. But you also want to limit losses. By using put options, you could limit your downside risk and enjoy all the upside in a cost-effective way. For short sellers, call options can be used to limit losses if wrong – especially during a short squeeze. (See also: Bill Ackman’s Greatest Hits and Misses.)
Spreads use two or more options positions of the same class. They combine having a market opinion (speculation) with limiting losses (hedging). Spreads often limit potential upside as well. Yet these strategies can still be desirable since they usually cost less when compared to a single options leg. Vertical spreads involve selling one option to buy another. Generally, the second option is the same type and same expiration, but different strike. Spreads really show the versatility of options. A trader can construct a spread to profit from nearly any market outcome. This even includes markets that don’t move up or down. We will talk more about basic spreads later in this tutorial.
See below an excerpt from my Options for Beginners course where I introduce the concept of spreads:
Combinations are trades constructed with both a call and a put. There is a special type of combination known as a “synthetic.” The point of a synthetic is to create an options position that behaves like an underlying asset, but without actually controlling the asset. For example, if you buy an at-the-money call and simultaneously sell an at-the money put on stock XYZ with the same expiration and strike, you have created a synthetic long position in XYZ stock. You don’t actually own XYZ because you never bought it. But the combination of your long call and short put behaves almost exactly like owning stock.
Why not just buy the stock? Maybe some legal or regulatory reason restricts you from owning it. But you may be allowed to create a synthetic position using options. A synthetic might also be useful if the underlying asset is something like an index that is difficult to recreate from its individual components.
How Options Work
An option is the potential to participate in a future price change. So, if you own a call, you can participate in the uptrend of a stock without owning the stock. You have the option to participate.
In terms of valuing option contracts, it is essentially all about determining the probabilities of future price events. The more likely something is to occur, the more expensive an option would be that profits from that event. For instance, a call value goes up as the stock (underlying) goes up. This is the key to understanding the relative value of options.
Let’s look at an example of a call option on International Business Machines Corp. (IBM) with a strike price of $200 expiring in three months. IBM is currently trading at $175. Remember, owning the call option gives you the right, but not the obligation, to purchase 100 shares of IBM at $200 at any point in the next three months. If the price of IBM rises above $200 at any point within three months, then the call option will become in-the-money.
The less time there is until expiry, the less value an option will have. This is because the chances of a price move in the underlying stock diminishes as we draw closer to expiry. This is why an option is a wasting asset. If you buy a one-month option that is out of the money, and the stock doesn’t move, the option becomes less valuable with each passing day. Since time is a component to the price of an option, a one-month option is going to be less valuable than a three-month option. This is because with more time available, the probability of a price move in your favor increases, and vice versa.
Accordingly, the same option strike that expires in a year will cost more than the same strike for one month.
This wasting feature of options is a result of time decay. The same option will be worth less tomorrow than it is today if the price of the stock doesn’t move.
See below an excerpt from my Options for Beginners course where I introduce the concept of time decay:
Let’s go back to our IBM three-month call example. The most important factor that increases the value of your call is the price of IBM stock rising closer to $200. The closer the price of the stock moves towards the strike, the more likely the call will expire in-the-money. Simply stated, as the price of the underlying asset rises, the price of the call option premium will also rise. Alternatively, as the price goes down – and the gap between the strike price and the underlying asset price widens – the option will lose value. Similarly, if the price of IBM stock stays at $175, the $190 strike call will be worth more than the $200 strike call, because the chance of IBM rising to $190 is greater than the chance of reaching $200.
Volatility also increases the price of an option. This is because uncertainty pushes the odds of an outcome higher. If the volatility of the underlying asset increases, larger price swings increase the possibilities of substantial moves both up and down. Greater price swings will increase the chances of an event occurring. Therefore, the greater the volatility, the greater the price of the option. Options trading and volatility are intrinsically linked to each other in this way.
With this in mind, let’s consider this hypothetical example. Let’s say that on May 1, the stock price of Cory’s Tequila Co. (CTQ) is $67 and the premium (cost) is $3.15 for a July 70 Call. Seeing only “July” with no date indicates that the expiration is the third Friday of July. The strike price is $70. The total price of the call contract is $3.15 x 100 = $315. In reality, you’d need to consider commissions, but we’ll ignore them for this example.
On most U.S. exchanges, a stock option contract is the option to buy or sell 100 shares; that’s why you must multiply the contract premium ($3.15) by 100 to get the total amount you’ll have to spend to buy the call ($315). The strike price of $70 means that the stock price must rise above $70 before the call option has intrinsic value. Furthermore, because the contract is $3.15 per share, the break-even price at expiration would be $73.15 (Strike price + premium).
Three weeks later, the stock price has risen to $78. The call option contract has increased in value along with the stock price and is now worth $8.25 x 100 = $825. Subtract what you paid for the contract, and your profit is ($8.25 – $3.15) x 100 = $510. The call has $8.00 of intrinsic value. Remember that for calls, stock price minus strike = intrinsic value. $78 – $70 = $8.00. The remaining $0.25 is time value (more on this later).
In this scenario, you’ve almost doubled your money in just three weeks! You could sell your call option, which is called “closing your position,” and take your profits – unless, of course, you think the stock price will continue to rise. For the sake of this example, let’s say we let it ride.
By the expiration date, the price of CTQ drops down to $62. Because this is less than our $70 strike call option and there is no time left, the option contract expires worthless. We have no position in the stock and we have only lost the original premium we spent of $315.
To recap, here is what happened to our option investment:
|May 1||May 21||Expiry Date|
So far, we’ve talked about the option holder having the right to buy or sell (exercise) the underlying stock. While this is technically true, a majority of options are never exercised. In our example, you could make money by exercising at $70 and then selling the stock back in the market at $78 for a profit of $4.85 a share ($8.00 stock gain minus $3.15 premium). You could also keep the stock, knowing you were able to buy it at a discount to the present value. However, the majority of the time, holders choose to take their profits by trading out (closing out) their position. This means that option holders sell their options in the market, and writers buy their positions back to close. According to the CBOE , only about 10% of options are exercised, 60% are traded (closed) out, and 30% expire worthless.
Now is a good time to dig deeper into pricing options. In our example, the premium (price) of the option went from $3.15 to $8.25. These fluctuations can be explained by intrinsic value and extrinsic value, which is also known as time value. An option’s premium is the combination of its intrinsic value and its time value. Intrinsic value is the in-the-money amount of an options contract, which, for a call option, is the amount above the strike price that the stock is trading. Time value represents the added value an investor has to pay for an option above the intrinsic value. This is the extrinsic value, or time value. So, the price of the option in our example can be thought of as the following:
|Premium =||Intrinsic Value +||Time Value|
In real life, options almost always trade at some level above their intrinsic value, because the probability of an event occurring is never absolutely zero, even if it is highly unlikely.
A brief word on options pricing. The market assigns a value to an option based on the likely outcome relative to the underlying asset, as in the example above. But in order to put an absolute price on an option, a pricing model must be used. The most well-known model is the Black-Scholes-Merton model, which was derived in the 1970s, and for which the Nobel Prize in economics was awarded. Since then, other models have emerged, such as binomial and trinomial tree models, which are commonly used by professional options traders. In real life, options almost always trade at some level above their intrinsic value, because the probability of an event occurring is never absolutely zero, even if it is highly unlikely.
Types of Options
American and European Options
Now that we’ve talked about the differences between calls and puts, let’s explore some other differences of categorizing options contracts. American options can be exercised at any time between the date of purchase and the expiration date. The example of Cory’s Tequila Co. shows the use of an American option. Most exchange-traded options are American. European options are different from American options in that they can only be exercised at the end of their lives on their expiration date. The distinction between American and European options has nothing to do with geography, only with early exercise. Many options on stock indexes are of the European type. Because the right to exercise early has some value, an American option typically carries a higher premium than an otherwise identical European option. This is because the early exercise feature is desirable and commands a premium.
Options Expiration & Liquidity
Options can also be categorized by their duration. Short-term options are those that expire generally within a year. Long-term options with expirations greater than a year are classified as long-term equity anticipation securities, or LEAPs. LEAPS are identical to regular options, they just have longer durations. Although they aren’t available on all stocks, LEAPS are available on most widely held issues. You should know that LEAPS can be less liquid than shorter term options, so they are not ideal for short-term trading.
Options can also be distinguished by when their expiration date falls. Traditionally, listed options have expirations on the third Friday of the month. However due to increased demand, sets of options now expire weekly on each Friday, at the end of the month, or even on a daily basis. Index and ETF options also sometimes offer quarterly expiries.
Options traded on exchanges are called listed options. In the U.S., there are a number of exchanges, both physical and electronic, where options are traded. For U.S. stocks, there are 15 options exchanges on the last count. Options can also be traded directly between counterparties with the use of an exchange or an ISDA agreement; these are known as over-the-counter (OTC) options. Often, financial institutions will use OTC options to tailor specific outcome events that are not available among listed options.
Market makers exist in order to provide liquidity to options markets. They are required to “make” a two-sided market in an option if asked to quote. Market makers, using theoretical pricing models, can take advantage of arbitrage by exploiting theoretical mis-pricings between the options’ perceived value and its market price.
The simple calls and puts we’ve discussed are sometimes referred to as plain vanilla options. Even though the subject of options can be difficult to understand at first, these plain vanilla options are as easy as it gets.
Because options are so versatile, there are many other types and variations of options. When ordinary listed or OTC options won’t do, there are exotic options. They are exotic because there might be a variation on the payoff profiles from the plain vanilla options. Or they can become totally different products all together with “optionality” embedded in them. For example, binary options have a simple payoff structure that is determined if the payoff event happens regardless of the degree. Other types of exotic options include knock-out, knock-in, barrier options, lookback options, Asian options and Bermudan options. Again, exotic options are typically for professional derivatives traders.
How to Read An Options Table
Trading volume in options has steadily increased over the years. This is because more traders are embracing the benefits options offer. Electronic trading platforms and information dissemination have helped the trend as well.
Some traders use options to speculate on price direction. Others hedge existing or anticipated positions, and others still attempt to craft unique positions that offer benefits not available to trading just the underlying stock, index or futures contract. For example, one can profit from options if the price of the underlying security doesn’t change at all.
Regardless of the objective, one of the keys to success is in picking the right option, or combination of options, needed to create a position with the desired risk-to-reward trade-off(s). As such, today’s savvy option trader is typically looking at more sophisticated information when it comes to options than the traders of decades past.
The Old Days of Option Price Reporting
In “the old days” some newspapers used to list rows and rows of nearly indecipherable option price data deep within its financial section such as that displayed in Figure 1.
Investor’s Business Daily and the Wall Street Journal still include a partial listing of options data for many of the more active optionable stocks and ETFs. The old newspaper listings included mostly just the basics – a “P” for a put or a “C” for a call, the strike price, the last trade price for the option, volume and open interest figures. Open interest means how many open option contract positions there are. Today’s option traders have a greater understanding of the variables that drive option prices simply due to better technology advancing at a rapid pace. Among these are a number of “Greek” values derived from an option pricing model, implied option volatility and the bid/ask spreads. (Learn more in Using the Greeks to Understand Options.)
Below is an understandable way to begin thinking of the concepts of Greeks that I teach in my Options for Beginners course:
Using the Greeks to Understand Options
More and more traders are finding option data through online sources. While each source has its own format for presenting the data, the key components generally include those listed in Figure 2 from Interactive Brokers. The variables listed are the ones most commonly used by today’s options trader.
The data provided in Figure 2 provides the following information:
Column 1 – Volume (VLM): This simply tells you how many contracts of a particular option were traded during the latest session. Typically – though not always – options with large volume will have relatively tighter bid/ask spreads, as the competition to buy and sell these options is great.
Column 2 – Bid: The “bid” price is the latest price level at which a market participant wishes to buy a particular option. What this means is that if you enter a “market order” to sell the September 2018, 105 call, you would sell it at the bid price of $3.55.
Column 3 – Ask: The “ask” price is the latest price offered by a market participant to sell a particular option. What this means is that if you enter a “market order” to buy the September 2018, 105 call, you would buy it at the ask price of $3.65.
NOTE: Buying at the bid and selling at the ask is how market makers make their living. It is imperative for an option trader to consider the difference between the bid and ask price when considering any option trade. Typically, the more active the option, the tighter the bid/ask spread. A wide spread indicates poor liquidity and can be problematic for any trader, especially a short-term trader. If the bid is $3.55 and the ask is $3.65, the implication is that if you bought the option one moment (at $3.65 ask) and turned around and sold it an instant later (at $3.55 bid), even though the price of the option did not change, you would lose -2.74% on the trade ((3.55-3.65)/3.65).
Column 4 – Implied Bid Volatility (IMPL BID VOL): Implied volatility can be thought of as the future uncertainty of price direction and speed. Think of a situation in which a future outcome, like an earnings event, is very uncertain. This would be a situation with high implied volatility. When we have an unclear idea of the future direction of a stock, uncertainty is high and so is implied volatility.
This value is calculated by an option-pricing model such as the Black-Scholes model, and represents the level of expected future volatility based on the current price of the option. It also incorporates other known option-pricing variables (including the amount of time until expiration, the difference between the strike price and the actual stock price and a risk-free interest rate). The higher the Implied Volatility (IV), the more time premium is built into the price of the option, and vice versa. If you have access to the historical range of IV, you can determine if the current level of extrinsic value is presently on the high end (good for writing options) or low end (good for buying options).
Column 5 – Open Interest (OPTN OP): This number indicates the total number of contracts of a particular option that have been opened. Open interest decreases as open trades are closed.
Column 6 – Delta: Delta can be thought of as probability. For instance, a 30-delta option has roughly a 30% chance of expiring in-the-money. Technically, Delta is a Greek value derived from an option-pricing model, and it represents the “stock-equivalent position” for an option. The delta of a call option can range from 0 to 100 (and for a put option, from 0 to -100). The reward/risk characteristics associated with holding a call option with a delta of 50 is essentially the same as holding 50 shares of stock. It also has a roughly 50% chance of expiring in the money. If the stock goes up one full point, the option will gain roughly one half a point (50%). The further an option is in-the-money, the more the position acts like a stock position. In other words, as delta approaches 100 (100% probability of expiring in-the-money), the option trades more and more like the underlying stock. So, an option with a 100-delta would gain or lose one full point for each one dollar gain or loss in the underlying stock price.
Column 7 – Gamma (GMM): Think of gamma as the speed the option is moving in or out-of-the money. Gamma can also be thought of as the movement of the delta. So gamma can answer the question: how fast is my option moving towards becoming an in-the-money option? Technically, gamma tells you how many deltas the option will gain or lose if the underlying stock rises by one full point. For example, let’s say we bought the MSFT September 2018 105 call for $3.65. It has a delta of 65.70. In other words, if MSFT stock rises by a dollar, this option should gain roughly 65.7 cents in value. If that happens, the option will gain 6.5 deltas (the current gamma value) and would then have a delta of 72.2. From there another one point gain in the price of the stock would result in a price gain for the option of roughly $0.722. So, gamma helps us measure the speed of the movement of the option’s delta.
Column 7 – Vega: Vega is a Greek value that indicates the amount by which the price of the option would be expected to change based on a one-point change in implied volatility. So looking once again at the MSFT September 2018 105 call, if implied volatility rose one point – from 17.313% to 18.313%, the price of this option would gain $0.123. This shows us why it is preferable to buy options when implied volatility is low. You pay relatively less time premium, and a rise in IV will inflate the price of the option. It is also better to write options when implied volatility is high – more premium is available, and a decline in IV will decrease the price of the option.
Column 8 – Theta: Options lose all time premium by expiration. “Time decay,”as it is known, accelerates as expiration draws closer. When there’s no time left in an option, there’s no more time value. At this point, the option either has intrinsic value or zero value. Theta is the Greek value that indicates how much value an option will lose with the passage of one day’s time. At present, the MSFT September 2018 105 call will lose $0.034 of value due solely to the passage of one day’s time, even if the option and all other Greek values remain unchanged. Notice how quickly time decay eats away at an option’s value just before expiry.
Column 9 – Strike: The “strike price” is the price at which the buyer of the option can buy or sell the underlying security if he/she chooses to exercise the option. It is also the price at which the writer of the option must sell or buy the underlying security if the option is assigned to him/her.
Like the table for calls above, a table for the respective put options would be similar, with two primary differences:
- Call options are more expensive the lower the strike price is, while put options are more expensive the higher the strike price is. With calls, option prices decline as the strikes go higher. This is because each higher strike price is less in-the-money (more out-of-the-money), so higher strike calls contain less “intrinsic value” than the calls with lower strike prices.
- With puts, it is just the opposite. As the strike prices increase, put options become either less-out-of-the-money or more in-the-money and therefore contain more intrinsic value. So, with puts, the option prices increase as the strike prices rise.
- For call options, the delta values are positive and are higher at lower strike prices. For instance, on a $30 stock, a $20 call may have a 90 delta while a $40 call may have a 10 delta. For put options, the delta values are negative and are higher at higher strike prices. For instance, on a $30 stock, a $20 put may have a -10 delta while a $40 put may have a -90 delta. The negative values for put options come from the fact that they represent a stock-equivalent position. Buying a put option is similar to entering a short position in a stock, hence the negative delta value.
The level of sophistication of both options trading and the average options trader have come a long way since trading in options began decades ago. Today’s option quote screen reflects these advances.
Options spreads are a common strategy and involve buying and selling options of the same or differing types, expirations, and strikes. You can also combine different options strategies, known as combinations. In this section, we will provide a very basic overview of the most common options spreads and combinations.
Long Calls/Puts, Straddles, and Strangles
The simplest options position is a long call (or put) by itself. This position profits if the price of the underlying rises (falls), and your downside is limited to loss of the option premium spent. If you simultaneously buy a call and put option with the same strike and expiration, you’ve created a straddle. This position pays off if the underlying price rises or falls dramatically; however if the price remains relatively stable, you lose premium on both the call and the put. You would enter this strategy if you expect a large move in the stock but are not sure which direction. Basically, you need the stock to have a move outside of a range. A similar strategy betting on an outsized move in a security when you expect high volatility (uncertainty) is to buy a call and buy a put with different strikes and the same expiration – known as a strangle. A strangle requires larger price moves in either direction to profit, but is also less expensive than a straddle. On the other hand, being short either a straddle or a strangle (selling both options) would profit from a market that doesn’t move much.
Below is an explanation of straddles from my Options for Beginners course:
And here’s a description of strangles:
How to use Straddle Strategies
Call/Put Spreads and Butterflies
A bull call spread, or bull call vertical spread, is created by buying a call and simultaneously selling another call with a higher strike price and the same expiration. The spread is profitable if the underlying asset increases in price, but the upside is limited due to the short call strike. The benefit, however, is that selling the higher strike call reduces the cost of buying the lower one. Similarly, a bear put spread, or bear put vertical spread, involves buying a put and selling a second put with a lower strike and the same expiration.
If you buy and sell options with different expirations, it is known as a calendar spread, or time spread.
A butterfly consists of options at three strikes, equally spaced apart, where all options are of the same type (either all calls or all puts) and have the same expiration. In a long butterfly, the middle strike option is sold and the outside strikes are bought in a ratio of 1:2:1 (buy one, sell two, buy one). If this ratio does not hold, it is not a butterfly. The outside strikes are commonly referred to as the wings of the butterfly, and the inside strike as the body. The value of a butterfly can never fall below zero. An example of a butterfly would be to go long a 70 call, short two 75 calls, and long an 80 call. The identical spread could also be made with long the 70 put, short two 75 puts, and long an 80 put. Being long a butterfly profits from a quiet market. Similar to a butterfly are the condor, iron butterfly, and iron condor. The butterfly gets its name from the shape of its profit-and-loss graph.
We addressed briefly how a synthetic position in the underlying can be created from options. Combining options positions with the underlying can also produce synthetic options. This has to do with what is known as put-call parity, where:
Call Price – Put Price = Underlying Price – Strike Price.
Rearranging this equation, we can create a synthetic long call for a given strike price by buying a put and also buying the underlying. Similarly, a synthetic put is a long call combined with going short the underlying. You can also create other combination strategies that include a trade in the underlying, such as a collar or risk reversal.
Because options prices can be modeled mathematically with a model such as Black-Scholes, many of the risks associated with options can also be modeled and understood. This particular feature of options actually makes them arguably less risky than other asset classes, or at least allows the risks associated with options to be understood and evaluated. Individual risks have been assigned Greek letter names, and are sometimes referred to simply as the Greeks.
Again, below is a very basic way to begin thinking about the concepts of Greeks that I explain in my Options for Beginners course:
Using the Greeks to Understand Options
Meet the Greeks
Delta is the change in option price per unit (point) change in the underlying price, and thus represents the directional risk. Delta is interpreted as the hedge ratio, or alternatively, the equivalent position in the underlying security: a 100-delta position is equivalent to being long 100 shares.
An easy way to think about delta is that it can represent the probability that an option has of finishing in the money (a 40-delta option has a 40% chance of finishing in the money). At-the-money options tend to have a delta near 50. Think about it this way, if you buy a stock today, it has a 50% chance of going up and 50% chance of going down. In-the-money options typically have a delta greater than 50, and out-of-the-money options are typically less than 50. Increasing volatility or time to expiration, in general, causes deltas to increase.
Gamma measures the change in delta per unit (point) change in the underlying security. The gamma shows how fast the delta will move if the underlying security moves a point. This is an important value to watch, since it tells you how much more your directional risk increases as the underlying moves. At-the-money options and those close to expiration have the largest gammas. Volatility has an inverse relationship with gamma, so as volatility increases the gamma of the option decreases.
Theta measures the change in option price per unit (day) change in time. Also known as time decay risk, it represents how much value an option loses as time passes. Long-term options decay at a slower rate than near-term options. Options near expiration and at-the-money have the highest theta. Additionally, theta has a positive relationship with volatility, so as implied volatility increases, theta also generally increases.
Vega measures the sensitivity of an option to volatility, represented as the change in option price per unit (percent) change in volatility. If an option has a vega of .2 and the implied volatility increases by 1%, the option value should increase by $.20. Options with more time till expiration will have a higher vega value compared to those nearer to expiration. At-the-money options are most sensitive to changes in vega.
Rho represents the option’s sensitivity to interest rate risk: the change in option price per unit change in interest rates. A position with positive rho will be helped by an increase in interest rates, and a negative rho will be helped by a decrease in interest rates.
We hope this tutorial has given you a practical view into the world of options. Options do not have to be difficult to understand once you grasp the basic concepts. Options can provide opportunities when used correctly, and can be harmful when used incorrectly. Please use this tutorial as it was intended – as a starting point to learning more about options.
- An option is a contract giving the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date.
- Options are derivatives because they derive their value from an underlying asset.
- A call gives the holder the right to buy an asset at a certain price within a specific period of time.
- A put gives the holder the right to sell an asset at a certain price within a specific period of time.
- There are four types of participants in options markets: buyers of calls, sellers of calls, buyers of puts, and sellers of puts.
- Buyers are often referred to as holders, and sellers are also referred to as writers.
- The price at which an underlying stock can be purchased or sold is called the strike price.
- The total cost of an option is called the premium, which is determined by factors including the stock price, strike price and time value remaining until expiration.
- The premium of an option increases as the chances of the option finishing in-the-money increases.
- A stock option contract typically represents 100 shares of the underlying stock.
- Investors use options for income, to speculate, and to hedge risk.
- Spreads and synthetic positions highlight the versatility of options contracts.
- Employee stock options are different from listed options because they are a contract between the company and the holder. (Employee stock options do not involve any third parties.)
- The two main classifications of options are American and European. Options can also be distinguished as listed/OTC or vanilla/exotic, among other classification schemes.
- Long-term options are known as LEAPS.
- Option prices are determined by the Greeks, which allow for an option’s risk to be understood and evaluated.