Options trading. This is a term that’s come up time and time again in the news lately, yet its definition is hardly ever explained. There are so many complex terms associated with it such as expiry, puts, calls, leverage, and more that you’ve likely found yourself wondering what a put is and why they call it that. For most who start dabbling in options – especially in the surging retail investor market – they are seen as a higher risk, higher reward way of trading (which they can be, when used alone). Options are a financial device known as derivatives, which means the value of an option contract is derived from an underlying asset. In this case, the underlying assets are stocks in a company. If the underlying asset ceases to exist, so does the derivative.
So How Do They Work?
Options, unlike shares, are sold in bundles, called a contract. The smallest contract you can trade represents 100 shares. Purchasing options doesn’t, in itself, give you any shares of a company; instead, it grants you the right to buy OR sell shares in the underlying company, at a fixed price (which is known as a strike price). Conversely, selling options doesn’t actually involve selling shares of a company, it merely holds you to the obligation to buy OR sell shares in the underlying company at the strike price. These are two sides of the same contract – someone who owns shares in a company grants someone else the right to buy or sell them at a given price.
Just like most other contracts, options have expiry dates. We are going to refer to the price of options as the “premium” paid for the option.
As a general guide:
Buying call options = bullish, paying the premium for the RIGHT to buy
Buying put options = bearish, paying the premium for the RIGHT to sell
Selling call options = bearish, collecting the premium for the OBLIGATION to sell
Selling put options = bullish, collecting the premium for the OBLIGATION to buy
What Roles Do the Option Buyer and Seller Play?
If you are the option buyer, you’ve paid the premium for the options contract, and you have the right to buy or sell shares in the underlying company up until that expiry date.
You have three exit strategies here. Either:
a) sell the contract to someone else before expiry, if you’re in-the-money, or
b) exercise your right to buy the underlying stock at the strike price, which, if your in-the-money, is lower (call) or higher (put) than what the stock is currently trading at, or
c) close the contract with an offsetting trade, if you’re out-of-the-money. This is done by opening an offsetting contract.
Did you know? Offsetting means opening a contract with the opposite transaction, of the same strike price and expiry date. Ex. Offsetting a short call would involve going long on (A.K.A. buying) a call of the same strike price and expiry.
The more that the underlying stock moves in the desired direction away from the strike price, the higher your contract value goes.
As a call option buyer, your ideal scenario is for the underlying stock price to go up, so your contract appreciates in price and your strike price ends up lower than the stock price. This means that you can now snag those 100 shares in your contract at a discount.
As a put option buyer, your ideal scenario is for the underlying stock price to go down, so your contract appreciates in price and your strike price is now higher than the stock price. This means that you can now offload those 100 shares in your contract for a higher price than what the stock is currently at.
In these ideal scenarios, when the underlying stock rises above the strike price (for a call) or below the strike price (for a put) are referred to as “in-the-money” (also known as ITM) When the underlying stock goes in the other direction –so below the strike price (for a call) or above the strike price (for a put) – it is referred to as “out-of-the-money“ (also known as OTM).
Now, the other side of the equation.
If you are the option seller, you’ve collected the premium for the options contract and, in exchange for the upfront money, you now have the obligation to buy or sell the shares in the underlying company up until the expiry date. You have two doors of fate. You either get to sit back and keep the premium without doing anything if the contract expired OTM for the option buyer, or you must now fulfill your obligation to buy or sell the shares signified in your contract because the contract ended up being ITM for the option buyer, and you’ve got assigned.
There is always the offsetting transaction option. However, this will still cost you a premium, which would likely be somewhat offset by the premium you earned selling the option.
So, what if you don’t actually own the shares you sold the options for? Tough luck.
If you sell call options, you have the obligation to go out and buy those shares in the open market and sell them to the call option holder, for the price that they bought the right to buy at.
If you sold put options, you have the obligation to buy the shares from the put option holder for the price they bought the right to sell at.
Not owning shares of a stock before you sell a call or a put on it is called a naked option and is, apparently, a surefire way to have the entire internet market come after you.
Don’t get caught with your pants down.
How Are Options Priced?
Option contracts exist in a spread of different strike prices and expiry dates, with both of these factors affecting the price. Basically, the more unlikely the contract is to come true, the less
Intrinsic value is the portion of the price that fluctuates with the relative value of the strike price vs the underlying stock price. Any options that are sold in-the-money will reflect a premium that will offset that advantage. This means that you can’t just buy in-the-money calls and exercise them at an instant profit. Who would have guessed?
Ex. Tesla is trading at roughly $800/share on January 28th. A Tesla 700 Feb 12 call option would cost at least $100. In this example, 700 is the strike price and February 12th is the expiry date. There are still over 2 weeks left before the contract expires, which in theory, gives the contract more time to become profitable.
The price of an option that exceeds the intrinsic value is known as time value. Based on Chicago Board Options Exchange (CBOE) quotes, Tesla 700 Feb 12 call options would cost around $115. This indicates that the intrinsic value is $100, ($800-$700 = $100) and the time value is $15.
The time value changes with the expiry date. Tesla 700 Feb 5 call options would likely be closer to $100 in price (for example, trading around $110), whereas Tesla 700 April 16 call options would be considerably higher (for example, around $250), thus indicating $100 of intrinsic value and $150 of time value. The less time to expire, the lower the cost.
Options that are sold out-of-the-money also, of course, have a price. While there is no intrinsic value, there will be a premium expressed solely based on time value. For example, CBOE quotes Tesla 1000 March 5 call options at $25.
The price per contract is normally expressed as the price of 1 out of the 100 shares in the contract. So, if you see call options quoted as $7.50, the contract price would be $750, which is the minimum order size.
So effectively, options allow you to control blocks of 100 shares of a company, for a fraction of the cost it takes to own the actual underlying stock. While this leverage allows for higher relative rates of return, it also poses significantly more risk due to the obligations of being exercised as a seller and the fact that you cannot get your premium back if your contract (as the buyer) expires worthless.
Stay tuned for part 2 coming soon, where we go over the different styles and uses for options trading.