What is Option TradingAn option is a contract to buy or sell a specific financial product officially known as the option’s underlying instrument or underlying interest. For equity options, the underlying instrument is a stock, exchange-traded fund (ETF), or similar product. The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted on. And it has an expiration date. When an option expires, it no longer has value and no longer exists. Options come in two varieties, calls and puts, and you can buy or sell either type. You make those choices – whether to buy or sell and whether to choose a call or a put – based on what you want to achieve as an options investor.
If you buy a call, you have the right to buy the underlying instrument at the strike price on or before the expiration date. If you buy a put, you have the right to sell the underlying instrument on or before expiration. In either case, as the option holder, you also have the right to sell the option to another buyer during its term or to let it expire worthless. The situation is different if you write, or “sell to open”, an option. Selling to open a short option position obligates you, the writer, to fulfill your side of the contract if the holder wishes to exercise. When you sell a call as an opening transaction, you’re obligated to sell the underlying interest at the strike price, if you’re assigned. When you sell a put as an opening transaction, you’re obligated to buy the underlying interest, if assigned. As a writer, you have no control over whether or not a contract is exercised, and you need to recognize that exercise is always possible at any time until the expiration date. But just as the buyer can sell an option back into the market rather than exercising it, as a writer you can purchase an offsetting contract, provided you have not been assigned, and end your obligation to meet the terms of the contract. When offsetting a short option position, you would enter a “buy to close” transaction.
Buying and Selling Options
When you buy an option, the purchase price is called the premium. If you sell, the premium is the amount you receive. The premium isn’t fixed and changes constantly – so the premium you pay today is likely to be higher or lower than the premium yesterday or tomorrow. What those changing prices reflect is the give and take between what buyers are willing to pay and what sellers are willing to accept for the option. The point at which there’s agreement becomes the price for that transaction, and then the process begins again. If you buy options, you start out with what’s known as a net debit. That means you’ve spent money you might never recover if you don’t sell your option at a profit or exercise it. And if you do make money on a transaction, you must subtract the cost of the premium from any income you realize to find your net profit. As a seller, on the other hand, you begin with a net credit because you collect the premium. If the option is never exercised, you keep the money. If the option is exercised, you still get to keep the premium, but are obligated to buy or sell the underlying stock if you’re assigned.
At a Premium
What a particular options contract is worth to a buyer or seller is measured by how likely it is to meet their expectations. In the language of options, that’s determined by whether or not the option is, or is likely to be, in-the-money or out-of-the-money at expiration. A call option is in-the-money if the current market value of the underlying stock is above the exercise price of the option, and out-of-the-money if the stock is below the exercise price. A put option is in-the-money if the current market value of the underlying stock is below the exercise price and out-of-the-money if it is above it. If an option is not in-the-money at expiration, the option is assumed to be worthless. An option’s premium has two parts: an intrinsic value and a time value. Intrinsic value is the amount by which the option is in-the-money. Time value is the difference between whatever the intrinsic value is and what the premium is. The longer the amount of time for market conditions to work to your benefit, the greater the time value.
The Value of Options
Several factors, including supply and demand in the market where the option is traded, affect the price of an option, as is the case with an individual stock. What’s happening in the overall investment markets and the economy at large are two of the broad influences. The identity of the underlying instrument, how it traditionally behaves, and what it is doing at the moment are more specific ones. Its volatility is also an important factor, as investors attempt to gauge how likely it is that an option will move in-the-money. Options are financial instruments that can provide you with the flexibility you need in almost any investment situation you might encounter. Options give you options by giving you the ability to tailor your position to your own situation.
- You can protect stock holdings from a decline in market price.
- You can increase income against current stock holdings.
- You can prepare to buy stock at a lower price.
- You can position yourself for a big market move – even when you don’t know which way prices will move.
- You can benefit from a stock price’s rise or fall without incurring the cost of buying the stock outright.
Describing Equity Options Trading
- An equity option is a contract which conveys to its holder the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put) shares of the underlying security at a specified price (the strike price) on or before a given date (expiration day). After this given date, the option ceases to exist. The seller of an option is, in turn, obligated to sell (in the case of a call) or buy (in the case of a put) the shares to (or from) the buyer of the option at the specified price upon the buyer’s request.
- Equity option contracts usually represent 100 shares of the underlying stock.
- Strike prices (or exercise prices) are the stated price per share for which the underlying security may be purchased (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract. The strike price, a fixed specification of an option contract, should not be confused with the premium, the price at which the contract trades, which fluctuates daily.
- Equity option strike prices are listed in increments of .5, 1, 2 ½, 5, or 10 points, depending on their price level.
- Adjustments to an equity option contract’s size and/or strike price may be made to account for stock splits or mergers.
- Generally, at any given time a particular equity option can be bought with one of four expiration dates.
- Equity option holders do not enjoy the rights due stockholders – e.g., voting rights, regular cash or special dividends, etc. A call holder must exercise the option and take ownership of underlying shares to be eligible for these rights.
- Buyers and sellers in the exchange markets, where all trading is conducted in the competitive manner of an auction market, set option prices.
Calls and PutsThe two types of equity options are calls and puts. A call option gives its holder the right to buy 100 shares of the underlying security at the strike price, anytime prior to the options expiration date. The writer (or seller) of the option has the obligation to sell the shares. The opposite of a call option is a put option, which gives its holder the right to sell 100 shares of the underlying security at the strike price, anytime prior to the options expiration date. The writer (or seller) of the option has the obligation to buy the shares.
An option’s price is called the “premium.” The potential loss for the holder of an option is limited to the initial premium paid for the contract. The writer on the other hand has unlimited potential loss that is somewhat offset by the initial premium received for the contract. For more information go to our Options Pricing section. Investors can use put and call option contracts to take a position in a market using limited capital. The initial investment would be limited to the price of the premium. Investors can also use put and call option contracts to actively hedge against market risk. A put may be purchased as insurance to protect a stock holding against an unfavorable market move while the investor still maintains stock ownership. A call option on an individual stock issue may be sold, providing a limited degree of downside protection in exchange for limited upside potential. Our Strategies Section shows various options positions an investor can take and explains how options can work in different market scenarios.
The Options Premium
The security – such as XYZ Corporation – an option writer must deliver (in the case of call) or purchase (in the case of a put) upon assignment of an exercise notice by an option contract holder.
The Expiration day for standard equity options is the Saturday following the third Friday of the month. Therefore, the third Friday of the month is the last trading day for all expiring equity options. This day is called “Expiration Friday.” If the third Friday of the month is an exchange holiday, the last trading day is the Thursday immediately preceding this exchange holiday. After the option’s expiration date, the contract will cease to exist. At that point the owner of the option who does not exercise the contract has no “right” and the seller has no “obligations” as previously conveyed by the contract.
Options can provide leverage. This means an option buyer can pay a relatively small premium for market exposure in relation to the contract value (usually 100 shares of the underlying stock). An investor can see large percentage gains from comparatively small, favorable percentage moves in the underlying index. Leverage also has downside implications. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage can magnify the investment’s percentage loss. Options offer their owners a predetermined, set risk. However, if the owner’s options expire with no value, this loss can be the entire amount of the premium paid for the option. An uncovered option writer, on the other hand, may face unlimited risk.
Leverage & Risk
The strike price, or exercise price, of an option determines whether that contract is in-the- money, at-the-money, or out-of-the-money. If the strike price of a call option is less than the current market price of the underlying security, the call is said to be in-the-money because the holder of this call has the right to buy the stock at a price which is less than the price he would have to pay to buy the stock in the stock market. Likewise, if a put option has a strike price that is greater than the current market price of the underlying security, it is also said to be in-the-money because the holder of this put has the right to sell the stock at a price which is greater than the price he would receive selling the stock in the stock market. The converse of in-the-money is, not surprisingly, out-of-the-money. If the strike price equals the current market price, the option is said to be at-the-money. The amount by which an option, call or put, is in-the-money at any given moment is called its intrinsic value. Thus, by definition, an at-the-money or out-of-the-money option has no intrinsic value; the time value is the total option premium. This does not mean, however, these options can be obtained at no cost. Any amount by which an option’s total premium exceeds intrinsic value is called the time value portion of the premium. It is the time value portion of an option’s premium that is affected by fluctuations in volatility, interest rates, dividend amounts, and the passage of time. There are other factors that give options value and therefore affect the premium at which they are traded. Together, all of these factors determine time value.
In-The-Money, At-The-Money, Out-Of-The-Money…
Equity Call Option
- In-the-money = strike price less than stock price
- At-the-money = strike price same as stock price
- Out-of-the-money = strike price greater than stock price
Equity Put Option
- In-the-money = strike price greater than stock price
- At-the-money = strike price same as stock price
- Out-of-the-money = strike price less than stock price
- Intrinsic Value + Time Value
The expiration date is the last day an option exists. For listed stock options, this is the Saturday following the third Friday of the expiration month. Please note that this is the deadline by which brokerage firms must submit exercise notices to OCC; however, the exchanges and brokerage firms have rules and procedures regarding deadlines for an option holder to notify his brokerage firm of his intention to exercise. This deadline, or expiration cut-off time, is generally on the third Friday of the month, before expiration Saturday, at some time after the close of the market. Please contact your brokerage firm for specific deadlines. The last day expiring equity options generally trade is also on the third Friday of the month, before expiration Saturday. If that Friday is an exchange holiday, the last trading day will be one day earlier, Thursday.
- You have the right to exercise that option at any time prior to its expiration.
- Your potential loss is limited to the amount you paid for the option contract.
ShortWith respect to this section’s usage of the word, short describes a position in options in which you have written a contract (sold one that you did not own). In return, you now have the obligations inherent in the terms of that option contract. If the owner exercises the option, you have an obligation to meet. If you have sold the right to buy 100 shares of a stock to someone else, you are short a call contract. If you have sold the right to sell 100 shares of a stock to someone else, you are short a put 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. When you are short (i.e., the writer of) an equity option contract:
- You can be assigned an exercise notice at any time during the life of the option contract. All option writers should be aware that assignment prior to expiration is a distinct possibility.
- Your potential loss on a short call is theoretically unlimited. For a put, the risk of loss is limited by the fact that the stock cannot fall below zero in price. Although technically limited, this potential loss could still be quite large if the underlying stock declines significantly in price.
- Opening purchase—a transaction in which the purchaser’s intention is to create or increase a long position in a given series of options.
- Opening sale—a transaction in which the seller’s intention is to create or increase a short position in a given series of options.
- Closing purchase—a transaction in which the purchaser’s intention is to reduce or eliminate a short position in a given series of options. This transaction is frequently referred to as “covering” a short position.
- Closing sale—a transaction in which the seller’s intention is to reduce or eliminate a long position in a given series of options.
ExerciseIf the holder of an American-style option decides to exercise his right to buy (in the case of a call) or to sell (in the case of a put) the underlying shares of stock, the holder must direct his brokerage firm to submit an exercise notice to OCC. In order to ensure that an option is exercised on a particular day other than expiration, the holder must notify his brokerage firm before its exercise cut-off time for accepting exercise instructions on that day. Once OCC has been notified that an option holder wishes to exercise an option, it will assign the exercise notice to a clearing member – for an investor, this is generally his brokerage firm – with a customer who has written (and not covered) an option contract with the same terms. OCC will choose the firm to notify at random from the total pool of such firms. When an exercise is assigned to a firm, the firm must then assign one of its customers who has written (and not covered) that particular option. Assignment to a customer will be made either randomly or on a “first in first out” basis, depending on the method used by that firm. You can find out from your brokerage firm which method it uses for assignments.
The holder of a long American-style option contract can exercise the option at any time until the option expires. It follows that an option writer may be assigned an exercise notice on a short option position at any time until that option expires. If an option writer is short an option that expires in-the-money, assignment on that contract should be expected, call or put. In fact, some option writers are assigned on such short contracts when they expire exactly at-the-money. This occurrence is usually not predictable. To avoid assignment on a written option contract on a given day, the position must be closed out before that day’s market close. Once assignment has been received, an investor has absolutely no alternative but to fulfill his obligations from the assignment per the terms of the contract. An option writer cannot designate a day when assignments are preferable. There is generally no exercise or assignment activity on options that expire out-of-the-money. Owners generally let them expire with no value.
When an investor exercises a call option, the net price paid for the underlying stock on a per share basis will be the sum of the call’s strike price plus the premium paid for the call. Likewise, when an investor who has written a call contract is assigned an exercise notice on that call, the net price received on per share basis will be the sum of the call’s strike price plus the premium received from the call’s initial sale. When an investor exercises a put option, the net price received for the underlying stock on per share basis will be the sum of the put’s strike price less the premium paid for the put. Likewise, when an investor who has written a put contract is assigned an exercise notice on that put, the net price paid for the underlying stock on per share basis will be the sum of the put’s strike price less the premium received from the put’s initial sale.
What’s the Net?
For call contracts, owners might make an early exercise in order to take possession of the underlying stock in order to receive a dividend. Check with your brokerage firm on the advisability of such an early call exercise. It is therefore extremely important to realize that assignment of exercise notices can occur early – days or weeks in advance of expiration day. As expiration nears, with a call considerably in-the-money and a sizeable dividend payment approaching, this can be expected. Call writers should be aware of dividend dates, and the possibility of an early assignment. When puts become deep in-the-money, most professional option traders will exercise them before expiration. Therefore, investors with short positions in deep in-the-money puts should be prepared for the possibility of early assignment on these contracts.
Volatility is the tendency of the underlying security’s market price to fluctuate either up or down. It reflects a price change’s magnitude; it does not imply a bias toward price movement in one direction or the other. Thus, it is a major factor in determining an option’s premium. The higher the volatility of the underlying stock, the higher the premium because there is a greater possibility that the option will move in-the-money. Generally, as the volatility of an underlying stock increases, the premiums of both calls and puts overlying that stock increase, and vice versa.
Volatility can be a very important factor in deciding what kind of options to buy or sell. Volatility shows the investor the range that a stocks price has fluctuated in a certain period. The official mathematical value of volatility is denoted as “the annualized standard deviation of a stocks daily price changes.” There are two types of Volatility: Statistical Volatility and Implied Volatility.
Volatility and The Greeks
Statistical Volatility – a measure of actual asset price changes over a specific period of time.
Implied Volatility – a measure of how much the “market place” expects asset price to move, for an option price. That is, the volatility that the market itself is implying. The computation of volatility is a difficult problem for mathematical application. In the Black-Scholes model, volatility is defined as the annual standard deviation of the stock price. There is a way in which the strategist can let the market compute the volatility for him. This is called using the implied volatility – that is, the volatility that the market itself is implying. This is similar to an efficient market hypothesis. If there is enough trading interest in an option that is close to the money, that option will generally be fairly priced.
The Black-Scholes formula was the first widely-used model for option pricing. This formula can be used to calculate a theoretical value for an option using current stock prices, expected dividends, the option’s strike price, expected interest rates, time to expiration and expected stock volatility. While the Black-Scholes model does not perfectly describe real-world options markets, it is still often used in the valuation and trading of options. The variables of the Black-Scholes formula are:
The Black-Scholes Formula
- Stock Price
- Strike Price
- Time remaining until expiration expressed as a percent of a year
- Current risk-free interest rate
- Dividends (if applicable)
- Volatility measured by annual standard deviation
Delta: The Delta is a measure of the relationship between an option price and the underlying stock price. For a call option, a Delta of .50 means a half-point rise in premium for every dollar that the stock goes up. For a put option contract, the premium rises as stock prices fall. As options near expiration, in the money contracts approach a Delta of 1. In this example the delta for stock XYZ is 0.50. As the price of the stock changes by $2.00 the price of the options will change by 50 cents for every dollar. Therefore the price of the options will change by (.50 x 2) = 1.00. The call options will have their price increased by $1.00 and the put options will have their price decreased by $1.00. The Delta is not a fixed percentage. Changes in price of stock and time to expiration will have an effect on the Delta value.
Gamma: Sensitivity of Delta to unit change in the underlying. Gamma indicates an absolute change in delta. For example, a Gamma change of 0.150 indicates the delta will increase by 0.150 if the underlying price increases or decreases by 1.0. Results may not be exact due to rounding.
Lambda: A measure of leverage. The expected percent change in the value of an option for a 1 percent change in the value of the underlying product.
Rho: Sensitivity of option value to change in interest rate. Rho indicates the absolute change in option value for a one percent change in the interest rate. For example, a Rho of .060 indicates the option’s theoretical value will increase by .060 if the interest rate is decreased by 1.0. Results may not be exact due to rounding.
Theta: Sensitivity of option value to change in time. Theta indicates an absolute change in the option value for a ‘one unit(calendar day)‘ reduction in time to expiration. Results may not be exact due to rounding.
Vega (Kappa): Sensitivity of option value to change in volatility. Vega indicates an absolute change in option value for a one percent change in volatility. For example, a Vega of .090 indicates an absolute change in the option’s theoretical value will increase by .090 if the volatility percentage is increased by 1.0 or decreased by .090 if the volatility percentage is decreased by 1.0. Results may not be exact due to rounding.
Since there are so many available options – and so many ways to trade them – you might not know where to begin. But getting started is easier than you think, once you determine your goals.
Getting Started in Options
* information provided courtesy of OIC