Options
Option Examples and Terminology
An option’s value is determined or derived from the underlying asset. Options not only exist in the financial market. For example, insurance purchased for your car or for your home is a form of an option. You pay a premium to safeguard yourself against further cash expenditure in the event of an accident. In the case of insurance, the risk of loss from the owner is transferred to whoever sells the insurance policy. You would be entering into a put option in case of insurance.
Leverage
The leverage level describes how much profit or loss is a potential when compared to the amount invested. Leverage also increases the risk associated with an investment. For example, an investor who owns a call option can benefit from the share price movement of a large number of shares even though the have not bought the shares outright. However, the investor can also lose money if the share price goes down instead of up.
To understand the concepts further, let us consider a more detailed example.
Example 1
An investor purchases 100 shares at a cost of $16 per share. The investor’s total cost is $1,600. If the stock price increases $5 to $21 while the investor owns the shares, the investor would gain $500. The stock increases 31% in value.
As an alternative, consider the situation where the investor purchased an option to buy 100 shares of stock. The option premium was $1.50 per share. The investors total cost was $150. If the premium rises to $4 to $5.50 per share, the option is now worth $550 for an original cost to the investor of $150. The investment has had a gain of $400 or a 267% return.
A stock purchase will have a higher absolute dollar profit. However, the option purchase will have a higher return.
Diversification of Options
It is important to understand how an option works before you charge ahead and try to take advantage of the leverage that is made available to investors by options. Options can look very attractive because of the high leverage returns that are available. However, high leverage losses could also be the result. Leverage works in both directions.
Options allow investors to make money whether the market is moving up or down. The decision concerning how comfortable an individual investor is with the risk associated with an option investment will ultimately depend on the investor.
Let’s look at more details concerning options.
Option Basics
An option is based on, or derived from, an underlying asset. In other words, an option’s value is derived from something else and is, therefore, called a derivative. Two types of options are available to investors – call options and put options.
With a call option, the investor has the right, but not the obligation, to buy the underlying asset that the option is based on at a predetermined price, called the strike price. A put option is the opposite situation. The investor has the right, not the obligation, to sell the underlying asset at the strike price.
A seller, unlike a buyer, is obligated to buy or sell the underlying asset if the option is exercised.
In the case of a call option, the option owner has the right to buy the underlying asset. Because the buyer is obligated to sell, the owner of the option is said to have the right to “call” the stock from the seller. The opposite is true for a put option. In this case, the buyer is obligated to buy the underlying asset of the option. The option owner is said to have the right to “put” the stock with the seller.
In either case, if the option holder does not exercise their right before the predetermined time associated with the option, the expiration date, the opportunity to exercise the option expires.
Typically, an option contract is for 100 shares of stock. The premium, however, is quoted for one share.
Let us take a look at a more detailed option contract to understand how the premium, strike price, and expiration date all come into play throughout the life of an option.
Example 2
Suppose after months of searching that you finally find your dream home, and it is for sale. Unfortunately, the home costs $300,000 which you do not have. However, you will have the money in five months time when your personal circumstances change. You approach the owner and buy an option to buy the house within five months for $300,000. The cost of this option is $5,000.
In this example, the options contract would have a strike price of $300,000. The expiration date is 5 months from the date of purchase. Finally, the premium of the option is $5,000.
To understand what can happen with an option, consider the following two situations that an investor could be faced with during the five month period following the purchase of the option contract described above.
Situation 1: The property rises significantly in value and is worth $500,000. The option is in-the-money. The intrinsic value of the option is $300,000.
Regardless of the current value of the house, the owner is obligated to sell the house to you for $300,000. You, of course, decide to buy it. The total cost of the house is the strike price plus the premium or $305,000. However, the house is worth $500,000. After you exercise the option, you forget that this house was your dream home, and you sell it. Your final profit is $195,000.
Situation 2: The property value decreases to $100,000.
In this case, you have the option to buy the house but not the obligation. In this situation, you decide that you should not buy the house, and you lose the $5,000 premium that you paid for the option.
This example is very similar to what happens with a call option in the stock market.
Stock options are contracts that have strike prices, expirations, and premiums.
- Strike prices are determined by the exchanges that they are traded on and are stated in even increments. For example, a stock price that ranges between $5 and $25 will have a strike increment of $2.50. Initial starting increment will be $5.00.
- Expiration dates are tied to every option. An option is denoted by the month in which it expires. For standard options that have one to nine months expiration dates, the options contract will expire on the Saturday following the third Friday of the month. Trading cannot happen on a Saturday, so the expiration date is considered the third Friday of the month.
- In addition to being the amount the buyer pays to purchase the option, the premium is also the amount the seller of the option collects for assuming the obligation of the contract.
Premium Factors
The key factors that affect the premium price are the time associated with the option contract, the underlying asset price relative to the strike price, and the overall volatility of the underlying asset of the option.
As discussed, options contracts have limited life spans. Their value decreases as the expiration date of the options contract approaches. Therefore, options are considered wasting assets because there is a time value that is directly related to the time remaining until the contract expires.
The time value decreases as the option approaches the expiration date because the possibility of the option’s value increasing is decreased as the date gets closer. The time value decreases to zero as the expiration date approaches. The decline in value accelerates in the last two weeks of the life of a contract.
In-the-Money, Out-of-the-Money, and At-the-Money
In-the-money, out-of-the-money, and at-the-money are three terms used to describe the relationship between an option's strike price and the current price of the underlying stock.
If a share price is above the strike price of a call option, the option is said to be in-the-money. Likewise, a put option is in-the-money, if the share price is below the strike price. The opposite situations apply to an option that is out-of-the-money. Finally, if the share price is at the strike price of the option, the option is considered to be at-the-money.
Intrinsic Value
The intrinsic value of a share is its real value. For an option, the intrinsic value is the total amount the option is in-the-money.
For example, if a stock is trading at $27.50 and the strike price of a call option is $25, then the intrinsic value of the option is $2.50 per share.
An option can never have a negative intrinsic value. However, even if there is no intrinsic value an option can have a time value or an extrinsic value.
Rules of Pricing Options
In-the-money options have more expensive premiums. However, their value also increases more quickly as the price of the stock goes up.
Out-of-the-money options have lower premiums, but their value increases more slowly as the price of the stock goes up.
Delta
Delta is the term used to describe the relationship between the option price movement and the movement in the price of the underlying stock. Delta is the amount of change in an option's price if the underlying stock price moves by 1 point.
For example, consider a call option that has a premium of $5.00 and the underlying stock price is $192. If the stock price increases from $190.42 to $191.42 and the delta value is .54, then the price of the call option will increase by $.54 to $5.54. Delta is positive for call options and negative for put options.
Delta will vary by where the option price is in relation to the underlying stock price. As an option moves further in-the-money, its delta increases. Similarly, the further out-of-the-money the option becomes, the further the delta decreases.
Volatility
One of the most important aspects in determining the value of an option is the behavior of the underlying stock. The real value of a stock, or its intrinsic value, is not always accurately reflected in the actual price of the share though because the market is subject to the opinion of various shareholders. The option traders, like with the underlying stocks, can also disagree about the value of an option. This difference of opinion can actually affect the price of the underlying stock.
Volatility is the measure of stock price movement, or how much a stock price moves up and down. Volatility of the underlying stock is a key factor in determining the value of an options contract. The option’s premium will increase as the volatility of the underlying stock increases because it is more difficult for the trader to predict the behavior of the stock if it is more volatile.
Two types of volatility exist. A measure of the price movement based on the past behavior of a stock is considered historical volatility. Implied volatility is a measure of volatility as associated with the current market.
Understand Time and Volatility
Time and volatility together are defined as time value. As discussed above, an option can have no intrinsic value and still have worth. However, the risk of the investment is higher when the only value of the option is the time value. When almost the entire value of the option is based on time, risk increases significantly.
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