An Overview of Options
With the recent posts this year showing massive option gains on the subreddit “Wallstreetbets”, it may seem enticing to give options a shot as part of your investment strategy. However, options are much more complex than traditional buying and selling of shares. In the next few paragraphs, I will explain what options and how they are priced on the market.
What are options?
Options are a type of contract that allows the buyer to purchase 100 shares of a stock at a predetermined(strike) price. It allows investors to either increase leverage or hedge against volatility of an underlying asset. There are two types of options — a call option and a put option. A call option allows buyers to profit if the price of the stock increase and a put option allows the buyer to profit if the price of the stock decreases. Buying a call/put option is called a long call/put and selling a call/put is called short call/put. Both buying a call and put option requires the buyer to pay a premium for the contract. On the other side, the seller of the contract receives a premium for selling the contract. In a future article I will going into why options are a good way to generate income as the option seller.
Each contract is equivalent to 100 shares in a company. Every option has an expiration date and a strike price. The expiration date is how long the contract is valid for, after that date, the contract is worthless. And the strike price is the set price in which the contract can be bought or sold when it is exercised. For example, if an option has a 30 day till expiration and the strike price is $30 and the current market price is $50. Theoretically, if you bought the call option, your gain would be $20 minus the option premium. As you can see, the strike price guarantees the asset can be bought or sold at that price. Many industries use options as a way to hedge against price volatility such as airliners having option contracts to guarantee they can buy jet fuel at a predetermined price.
What gives an option it’s value?
There are two factors that make up the value of an option contract. Intrinsic value + extrinsic value. I will break down each one below, but both of these together makes up the total value of the option price.
Intrinsic value
The table below shows the relationship between the market price of the underlying stock and the contract’s strike price. A long call or put option (buying a contract) only has intrinsic value when it is in-the-money (ITM). And when the option is out-of-the-money (OTM) is has zero intrinsic value.
The goal for a call is for the stock to rise in value so you can exercise the option at the strike price making you a price of the difference.
Profit = market price - strike price
The profit and loss chart above, is a basic calculation of a long call option. Very simply put in this example when the market price below the strike price, it is out of the money and the contract is losing money. When the market price meets the strike price, it is ATM and will break even, and when the market price is above the strike price, it is profitable. As we will learn later, this simplistic example does not take into account other variables that may influence how the option is priced.
Extrinsic value
Extrinsic value is a little more complicated, because it has multiple factors that affect it. But the main factors are time and implied volatility. Both ITM and OTM options have extrinsic value, but OTM options are purely made up of extrinsic value. At the money (ATM) options are closest to the stock price, and have the most extrinsic value. Extrinsic value is very similar to a normal distribution curve if there is no volatility skew. Extrinsic value is highest in ATM options, and trails off as you go further OTM and further ITM.
The time factor of extrinsic value is known as time decay. Time decay is the concept that an option premium losses value every day as it gets closer to expiration. Option premiums have a larger extrinsic value in the price for expiration dates further out. This is because there is more time for the contract to become ITM. However, as we get closer to expiration, the extrinsic value will diminish. On expiration day, options trade very close to their intrinsic value as there is not much time left until expiration and not a lot of time for the underlying to move in price.
Implied Volatility (IV)
Implied Volatility is directly influenced by the supply and demand mechanics of the underlying options and by the market’s expectation of the share price’s direction. As expectations rise, or as the demand for an option increases, implied volatility will rise. Thus, the higher the implied volatility, the more expensive an option (all else equal).
In the AMC stock price and IV chart below, you can see that every time the stock price rallies in the faint gray line, there is a massive spike in IV in the bold white line. This is due to the the demand and supply price mechanics and the uncertainty it created. Hypothetically, if you were to buy an long call option when the IV is high, say over the 300% spikes in the chart below, you will lost money even if the stock continued to increase. This is because of a phenomenon known as IV crush. IV crush is when the implied volatility percentages drops and thus the extrinsic value of the option will decrease. There would need to be a enormous increase in stock price to offset the lose in IV. On the other hand, if you took the other side of the position by selling a call option instead of buying, you would profit as your goal is for the option to expire worthless by being OTM.
The Greeks
Greek letters are used as variables to describe the different risks involved in an option contract.
Vega (V)
Vega represents the rate of change between an option’s value and the underlying asset’s implied volatility. This is the option’s sensitivity to volatility. Vega indicates the amount an option’s price changes given a 1% change in implied volatility.
For example, an option with a Vega of 0.10 indicates the option’s value is expected to change by 10 cents if the implied volatility changes by 1%.
Because increased volatility implies that the underlying instrument is more likely to experience extreme value, a rise in volatility correspondingly increases the value of an option. Conversely, a decrease in volatility negatively affects the value of the option. Vega is at its maximum for at-the-money options that have longer times until expiration.
Theta (Θ)
Theta represents the rate of change between option price and time. This is known as time decay. Time decay curve follows a non linear curve, meaning the further out the expiration date is, the less time decay there is. Options closer to expiration have accelerating time decay.
For example, assume an investor is long an option with a theta of -0.50. The option’s price would decrease by 50 cents every day that passes, all else being equal. If three trading days pass, the option’s value would theoretically decrease by $1.50.
Somethings to keep in mind is theta increases when options are at-the-money, and decreases when options are in- and out-of-the money. Long calls and long puts usually have negative Theta. Short calls and short puts, on the other hand, have positive Theta.
Delta (Δ)
Delta represents the rate of change between the option price and a $1 change in the underlying asset price. In other words, it is the price sensitivity of the option relative to the underlying stock.
An example is a call option with a delta of 0.50. Theoretically if the stock increased by $1, the option price would increase by 50 cents.
A less common usage of an option’s delta is the current probability that it will expire ITM. For instance, a 0.40 delta call option today has an implied 40% probability of finishing in-the-money.
Gamma (Γ)
Gamma represents the rate of change between an option’s delta and the underlying asset’s price. For those who taken calculus before, this is called a second-derivative price sensitivity. Gamma indicates the amount the delta would change given a $1 move in the underlying security.
For example if a call option has a delta of 0.50 and a gamma of 0.10 and the stock increases or decreases by $1, the call option’s delta would increase or decrease by 0.10.
Gamma is used to determine the stability of an option’s delta. Higher gamma values indicate that delta could change dramatically in response to even small movements in the underlying’s price. Gamma is higher for options that are ATM and lower for options that are in- and out-of-the-money, and accelerates in magnitude as expiration approaches. Gamma values are generally smaller the further away from the date of expiration. This means that options with longer expirations are less sensitive to delta changes. As expiration approaches, gamma values are typically larger, as price changes have more impact on gamma.
Rho (p)
Rho is less important compared to the other Greeks, but it represents the rate of change between an option’s value and a 1% change in the interest rate. This measures sensitivity to the interest rate. For example, assume a call option has a rho of 0.05 and a price of $1.25. If interest rates rise by 1%, the value of the call option would increase to $1.30, all else being equal. The opposite is true for put options. Rho is greatest for at-the-money options with long times until expiration.
Conclusion
Options are a powerful way for investors to leverage or hedge their positions. It can even be used as income generation when taking the other side by selling options. The price of options are very complex, so it is recommend to use an option calculator to see the profitability of a potential contract. Now that you know the basics of how options work, there are dozens of strategies depending on the investors sentiment of the stock and what their goals are.
