What are Options?
Options allow investors to buy and sell a certain security at a predetermined price in a specific time period.
The value of the option is dependent on the relation of this predetermined price and the price of the underlying security, as well as how much time to expiry is left on the option contract.
Option valuation segregates these two parts as an intrinsic and extrinsic value which when combined, represent the total price of the option.
Stocks that trade above the predetermined price pertaining to that option will have a positive intrinsic value and are said to be in the money.
Further, when the stock price and the option’s pre-determined price are equal, the option is said to be at the money with no intrinsic value.
At this point, the value of the option is composed entirely of the time value or the extrinsic value.
Based on how much the option is in the money, it will mimic the price movement of the underlying stock and will be a good measure of the value of the option.
An option that responds immediately to price changes in the stock will certainly be more valuable than an option that doesn’t move as meaningfully when the underlying stock moves a lot.
While this is a simplistic representation of option pricing and valuation, there are other levers that impact the value of the option and they can be quantified to be evaluated separately.
These are represented by the option greeks and the common ones tracked are Delta, Theta, Vega, Gamma, and Rho.
Option portfolios need to be viewed from these lenses in order to model the impacts of price change on the portfolio and meaningfully manage risk exposure.
A call option allows the call holder to buy a security at a predetermined price (strike price) during a particular window of time.
However, if the stock price stalls or loses value, then the call holder or buyer is under no obligation to go ahead with the purchase of the underlying stock.
The extent of the investor’s losses is limited to the premium paid for these calls.
On the other hand, a call option seller has to part with the shares to the buyer and their holdings will get called away as the call seller or writer is obligated to produce the shares when the call gets activated or exercised by the buyer or holder of the call option.
The payoff profile for a call buyer is unlimited.
But under normal circumstances, anyone long a call will be able to have upside to stock movement less the amount of premium.
However, call writers or sellers will be able to receive a premium or the value of the option and will not gain more than that.
Here is an example of a Shopify call option:
The call above traded for $60.44, which would allow the call holder to buy Shopify stock at $600 a stock before the expiry of May 20th, 2022.
The Call Writer or Seller will receive this premium upfront and will have to produce the Shopify stock upon expiry if the call buyer exercises their call options.
Similar to a call option, a put option provides the right, but not the obligation to sell a stock at a given price in a specific time period to the put holder.
In order to obtain this right, the put buyer or holder has to pay a premium/value of the option to the put seller or writer.
However, unlike a call option, the maximum gain for a put buyer is capped at the strike price sold and premium paid.
On the other hand, the maximum gain for a put seller or writer is the option premium collected.
Here is an example of a Shopify put option:
The put above traded for $59.63, which would allow the put holder to sell Shopify stock at $605 a share before the expiry of May 20th, 2022.
The put writer or seller will receive this premium upfront and will have to absorb the Shopify stock upon expiry if the put buyer exercises their put options.
How Do Options Work?
Options gain or lose value based on changes in price of the underlying stock, time until expiry, expansion/contraction of volatility and other factors such as interest rates.
In order to appreciate how options work, let’s look at a hypothetical example of options on stock ABC in a given expiry cycle.
ABC price on April 8th, 2022: $67
Call premium: $3.30
Expiry: May 20th, 2022
- One option contract usually contains 100 shares of the underlying stock
- Breakeven on this trade is the strike price plus the premium paid ($73.30 or $70 + $3.30)
- Brokerage fees/commissions have been ignored for the sake of simplicity
Here are potential scenarios that can happen prior to and at expiry highlighting how much options can move during that time period:
|Date||April 8||May 10||Expiry|
In the example above, the stock rallied from $67 to $77 in a few weeks and the value of the call option more than doubled going from $3.30 to $7.85.
At that point, there is some time left until expiration and the intrinsic value of $7 ($77-$70) helps us isolate the value assigned on the time value ($0.85).
However, by the time of expiry, the stock has fallen to $64, destroying the value of the option and thereby forcing the option to expire worthless.
The net loss is limited by the premium paid to acquire the options ($330).
Pros of Trading Options
Options allow investors to express opinions in the marketplace using leverage to compound gains and maximize returns if their thesis proves correct.
Using options will allow for cost-efficiency in obtaining the same position size with lesser capital outlay.
2. Risk Minimization
Options are extremely volatile, but can be a great tool to minimize risk when used with discipline and caution, as losses on an option can be defined and fixed.
Unlike equities that can go to $0, investing in options can restrict the loss amount and help stop losses by preventing large drawdowns.
3. Augment Portfolio Returns
By selling options to generate premiums for long term portfolios, investors are able to pick up additional carry on their holdings.
While selling options might appear risky, investors that own the underlying shares will end up parting away with the shares that may get called away in the case calls sold get exercised, but oftentimes such calls expire worthless and investors end up pocketing the premium.
During the recent Russia/Ukraine conflict, it was extremely hard to locate and short Russian equities as there were bans placed on short selling by Russia.
However, options activity picked up allowing market participants to speculate on these names by buying puts/selling calls on the short side.
5. Unlimited Upside
When buying options (especially calls), the call buyer has an asymmetric payoff profile where gains are uncapped and losses are restricted to the premium paid for those calls.
Cons of Trading Options
Options trading requires exposure to technical concepts in option pricing and valuation that are generally intended for sophisticated investors.
Investors starting out are better served by buying equities as they only have to get the direction of the stock price right instead of both the direction and timing in the case of options.
2. Illiquid Market
Most option market activity is focused on large-cap equities, but as investors look at options for small-cap companies there is thin liquidity in these names and bid/ask spreads are wider than they are for large-cap counterparts.
As a result, trading options can be more expensive in terms of execution and slippage costs.
3. Unlimited Losses
Naked option selling entails unlimited risk potential if the option seller doesn’t have the underlying stock to fulfil her obligation when selling options.
Gains are capped to the extent of the premium received while losses are unlimited, creating an asymmetric payoff profile to the downside.
4. Theta decay
Option buyers bleed theta or the time decay on their long option positions as it is entirely unavoidable while paying the premium.
As a result, sophisticated investors structure trades to create pairs of trades wherein they sell short-term options and buy long-term options to ensure they can minimize time decay on their option portfolio.
Did You Know?
GameStop (GME) catapulted from a mere single-digit to several hundred dollars in the course of a week by option-fuelled activities from retail traders banding together on Reddit, prompting a massive short squeeze causing hedge funds such as Melvin Capital to end up in turmoil.
Important Option Terms
Strike Price: The strike price represents the amount that will be exchanged at expiry between the buyer and seller if the buyer chooses to exercise his options.
Expiry: Expiry represents the last day during which the options can be exercised and assignment of the underlying shares can be taken.
In a call, the option buyer will buy the said shares.
In a put, the option buyer will sell said shares.
Premium: The premium represents the value of the option and the price of owning the option that the buyer needs to pay to the seller to receive rights to buy or sell the underlying depending on the option.
Delta: Delta represents the likelihood of the option expiring in the money i.e., that the stock price will be greater than the strike price for call options and vice versa for put options.
The delta also represents the equivalent number of stocks for that option contract.
For example, a delta of 0.71 represents 71 shares of the underlying stock.
In the example of LAC, if LAC moves up by $1, the option will gain $0.71 in premium for a call option.
Gamma: Gamma represents the speed at which Delta changes as the stock price rises or falls.
In the example above, as LAC moves higher, the option’s delta increases as well.
Gamma quantifies the pace of change by which delta will go up when the underlying goes up in value.
Theta: Theta measures the time value that will decay as options exist for a finite time and any premium paid for time value will decay during the course of owning the option contract.
However, as a seller of options, you receive premium and will benefit from the theta exposure.
Vega: Vega stands for the volatility of the stock that is an input for pricing options.
Stocks that move a lot will have a higher vega than stocks that move in tighter ranges.
This is another lever that impacts the price of an option and can be an anti-fragile component to investor portfolios if they own options as any volatility spikes will increase the value of their options despite the market being down, thereby acting as a small buffer in bearish environments.
3 Basic Option Trading Strategies
1. Covered Calls
Investors having long-only portfolios can benefit from selling covered calls at higher strikes and generating premium income for their portfolios.
This strategy has minimal risk as it augments the existing positioning while collecting some option premium.
However, if the strikes sold are close to the existing price, then the shares might get called away which may not be the desired outcome of using this strategy.
2. Cash Secured Puts
Investors that want to acquire a long-term portfolio can begin acquiring these shares by selling cash-secured puts on names they would like to own.
As a result, they can pinpoint the entry point for these companies and collect premiums as a result.
Their cost of acquisition will be the strike sold less the premium received.
A bit of sophistication is needed to exercise this strategy but it works well if investors are disciplined and focused on building a long-term portfolio.
By combining the above two strategies, the investor can begin with cash-secured puts to acquire long term holdings and then implement selling covered calls on those holdings to collect the premium.
Such a strategy is slow and steady without speculating more than necessary and has adequate market exposure, but depends on the quality of companies acquired in the process as well.
Is Options Trading Worth It?
Owning equities without leverage is simpler than trading options as it is mostly buying and holding companies.
Trading options can be more exciting and lucrative but has several moving parts that can be hard to grasp at first.
Trading options comes with a learning curve and is recommended for experienced investors.
Having said that, there are several platforms available to educate novice option investors and help them build their foundations if it’s something that is a right fit for their investment goals and long-term objectives.
Frequently Asked Questions
- What is options trading and how does it work?
Trading options revolves around using leveraged instruments to predict the timing and the extent of a stock move with precision. Options gain value to a greater extent than the underlying stock as options have asymmetric risk/reward characteristics. However, option selling takes the opposite side and risks unlimited losses to make finite gains.
- Is option trading just gambling?
Options can be used for speculation or hedging purposes. Someone that buys short-dated options that are out of the money will experience a lot of these plays expiring worthless. Conversely, the option seller collecting premium will have a high win rate and make steady profits. Options trading, when used systematically as part of a long-term strategy is more than just gambling.
- How do I start trading options?
Trading options requires the investor to have a margin account if they want to sell options or engage in more sophisticated strategies. But if an investor wants to buy options, that can be accomplished with a regular investing account as no margin is needed to put on such trades. Most brokerages support options trading.
- What are derivatives?
Derivatives are instruments that derive value from the underlying security on which they are based and have their own unique characteristics pertaining to the product. Futures, options, and swaps are some examples of commonly used derivatives.