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Options are one of the most dynamic types of trading instruments available. They can be used to speculate on the direction and volatility of stock prices (or any other asset prices), and to hedge or compliment other positions.
This post explains what options are, how they work, and how they can be used to profit regardless of market conditions.
How options work
An option is a derivative. Put simply, derivatives are contracts that derive their value from another financial instrument, often referred to as an underlying instrument. An option contract gives the holder the right, but not the obligation, to buy or sell the underlying instrument at a specific price in the future.
Put and call options
Put options give their holder the right to sell the underlying security at a specific price, before or on a specific date in the future.
Call options give their holder the right to buy the underlying security at a specific price, before or on a specific date in the future.
Options that can be exercised at any time before the expiry date are ‘American options.’ Options that can only be exercised on the expiry date are ‘European options.’
Options Trading terminology
Before going further, it's worth noting the following terms that are used in the option market:
The market for the underlying securities/instruments.
The current price of the underlying instrument.
An option gives its holder the right to buy (call option) or sell (put option) the underlying instrument at the option’s strike price.
An option’s intrinsic value is the amount that would be realized if it was exercised at the current spot price.
In the money
An option is in the money if it has intrinsic value. Call options are in the money if the spot price is above the strike price. Put options are in the money if the strike price is above the spot price.
At the money
If the strike price of an option is equal to the current spot price, the option is at the money.
Out the money
If an option has no intrinsic value, it is out the money.
The premium is the price you pay to buy an option.
Options Trading example
A stock is trading at $100. You buy a call option on the stock with a strike price of $110 expiring in three months’ time. The premium you pay is $2.
This option gives you the right to buy the share at $10 higher than the current price – so it is currently out of the money and has no intrinsic value.
If the spot price rises to $110, the option will be at the money. If the spot price is at $110 at expiry the option will expire worthless. You will then have lost the $2 premium.
If the spot price reaches $112, the option will be in the money, with an intrinsic value of $2. You can exercise your option to buy the stock for $110, and then sell it in the spot market for $112, realizing a $2 profit. However, at this level, you will only break even because you originally paid $2 to buy the option.
If the spot price reaches $115, you can realize a $5 profit by exercising the option and selling the stock. Your net profit will be $3 after you deduct the $2 premium you have already paid.
Buying vs selling options
A long option position gives you the right to buy or sell the underlying instrument at the strike price. Whether you buy a put option or a call option, your risk is limited to the premium you pay.
Shorting options, also known as writing options, is very different. When you write an option, your profit is limited to the premium you receive, while your downside is unlimited.
If you write a put option, your maximum downside is equal to the strike price minus the premium you receive. If you write a call option, your potential downside is unlimited.
The risks of written option positions can be offset by holding a corresponding position in the underlying security. A written call is hedged with a long position while a written put is hedged with a short position. A written option position that is hedged is called a covered position, while an unhedged position is known as a naked position.
The two types of options, puts and calls, and the fact that you can buy or write options give you four potential positions:
- Long call – you will profit if the spot price at expiry is higher than the strike price plus the premium.
- Short call – you will profit if the spot price remains below the strike price plus the premium.
- Long put – you will profit if the spot price at expiry is lower than the strike price minus the premium.
- Short put–you will profit if the spot price remains above the strike price minus the premium.
These are the four possibilities for a single option position. However, when you combine more than one option position or combine options with a position in the underlying security, the possibilities are endless.
How options are exercised
The simplest option exercise process is as follows:
- Put option—If the option holder exercises the option, the option writer buys the underlying security from the holder at the strike price. So, the option holder may need to first buy the securities in the spot market.
- Call option—If the holder of a call option exercises the option, the option writer must sell the securities to the holder at the strike price. The option holder is then free to sell the securities in the spot market or keep them.
The actual process of exercising options varies quite a lot. When options are traded on an exchange, the exchange will often act as a middleman when the option is exercised. Some options are settled for cash, with just the intrinsic value of the option changing hands. Exercising a commodity option may involve physical delivery which adds logistical factors like transport and storage to the process. In the real world, most traders avoid exercising options by selling them before expiry.
Option premiums and implied volatility
The theoretical value (premium) of an option is calculated using one of several very complicated formulas. You can access an online option calculator here. Calculating an option requires the following variables:
- Spot price
- Strike price
- Time to expiry
- Interest rate
- Expected dividends (if relevant)
- Type (American or European)
- Implied Volatility
The first six of these seven variables are straightforward. The seventh, implied volatility, is subject to supply and demand. Implied volatility reflects the amount of volatility the market expects. The higher the implied volatility the higher the premium, and vice versa. When expected volatility increases, demand for options increases and so do premiums.
Unlike almost any other financial instrument, options are nonlinear. What this means is that there is not a fixed ratio between the change in the value of an option and the change in the value of the underlying instrument. For example, the sensitivity of an option’s value to the price of the underlying security increases when the spot price approaches the strike price. Options also lose value as the expiry date approaches.
The ‘Greeks’ are a set of quantifiable factors that are used to indicate how sensitive an option’s premium is to the spot price, time, interest rates, and volatility.
Delta is a measure of the sensitivity of an option premium to a change in the spot price. The delta is typically recorded as a value between -1 and 1. If a call option on a stock has a delta of 0.5, it’s value will increase by 0.5% if the spot price increases by 1%.
The delta can be used to calculate the size of an option hedge. Using the above example, 100 call options could be hedged by short-selling 50 shares.
For call options, the delta of an at the money option is close to 0.5, for out the money options the delta approaches 0 as the spot price falls, and for in the money options, the delta approaches 1 as the spot price rises. Put options have negative values that approach -1 as the spot price falls.
Gamma reflects the sensitivity of an option’s delta to changes in the spot price. Gamma increases when the spot price approaches the strike price.
Theta indicates the sensitivity of an option’s value to time. The theta value is the value an option loses each day assuming the spot price doesn’t change. Theta, which is also known as time decay, increases as the option’s expiry date approaches.
The last two metrics, vega and rho, are used less frequently. Vega indicates an option value’s sensitivity to changes in volatility. Rho reflects an option's sensitivity to changes in interest rates.
Options can be used in numerous ways. When you enter a long or short position with an ordinary instrument, you are merely making a directional bet. With options, you can speculate on direction, volatility, timing, and the magnitude of spot price moves.
The following are just a few of the ways in which options can be used:
- Speculate on the direction spot prices will move.
- Trade with leverage – option premiums are a fraction of the spot price, which means you get more exposure with the same amount of capital.
- Speculate on volatility with or without a directional view.
- Hedge a position in the underlying security.
- Generate an income stream by writing options.
- Profit from a long stock position while the stock price consolidates. You can sell call options while using your stock position as a hedge. This is known as covered call writing.
Option trading strategies
Covered call writing is just one of many different option trading strategies. The following are some of the other popular option trading strategies which can be used to profit in a wide range of market conditions.
A straddle consists of a put and a call option with the same strike price. A long straddle will be profitable if the spot price rises or falls more than the sum of the two premiums. Traders use long straddles when they believe an asset’s price is at an inflection point, or that volatility will rise.
A strangle is similar to a straddle, except that the call option has a higher strike than the put option. This makes a long strangle position slightly cheaper, but the spot price needs to move further before the strategy becomes profitable.
If you buy a call spread, you are buying a call option and selling another call option with a higher strike price. The premium you receive from selling the call option partially offsets the premium paid for the other call. A spread has limited profitability but is an effective way to profit from a moderate rise in the price of an asset.
A long put spread consists of a long put and a short put with a lower strike. This is an effective way to profit from a moderate fall in the price of an asset.
A collar consists of a long out of the money put option and a short out of the money call option. In the stock market collars are used to protect the downside for a long stock position. The premium received for the written call partially offsets the premium paid for the put option.
A zero costs collar is structured so that the premium earned writing a call offsets the entire premium paid for the put. This means the underlying position is hedged with no cost, though the upside is capped.
A calendar spread consists of two identical options with different delivery months. A trader can write a call that expires first and buy an identical call that expires later. The value of the written call will decay quickly, while the value of the far dated call will be more sensitive to changes in volatility. The strategy would be profitable if the volatility increases or if the spot price increases after the first expiry.
A butterfly strategy combines a long spread with a short spread to profit from falling volatility or the spot price remaining in a tight range.
If you enter a call butterfly spread position you would buy one in the money call option, sell two at the money call options and buy one out the money call options. Your maximum profit would be earned if the spot price is equal to the strike on the written options at expiry.
A long-put spread consists of put options with the same strikes and has the same payoff profile.
An iron condor is similar to a butterfly spread but consists of a short put spread and a short call spread with four different strikes. This strategy will be most profitable if the spot price expires between the two written option strikes. Iron condors have limited downside, making them a popular strategy for generating income.
Options open up a new world of possibilities for traders. Besides directional bets, you can speculate on the magnitude of a price move, on rising or falling volatility, and on the timing of a price move.
Options do come with their share of risks, and trading options should be approached carefully. It is advisable to paper trade until you have a very good understanding of options and risk management.
Richard Bowman is a writer, analyst and investor based in Cape Town, South Africa. He has over 18 years’ experience in asset management, stockbroking, financial media and systematic trading. Richard combines fundamental, quantitative and technical analysis with a dash of common sense.