Let’s talk about options.

I am going to introduce you to the wonderful world of options through this series of articles. My goal is to popularize the universe of options.

What options are ?

An option is a contract (or a right) to buy or sell a security at a predetermined price when the contract expires or before the contract expires.

There are three parameters linked to options :

  • an option refers to an underlying stock, an index, a future or an ETF.
  • the pre-determined price is the exercise price is called the strike price.
  • the option expires after a period of time this is called the Expiration Date.

A stock option contract covers 100 shares.

There are two types of options :

  • Call,
  • Put.

Why trading options.

Calls and Puts, alone, or combined with each other, or even with positions in the underlying stock, can provide various levels of leverage or protection to a portfolio.

  • Option traders can profit in bull, bear, or flat markets.
  • Options can act as insurance to protect gains in a stock that looks unsteady or when volatility is high.
  • They can be used to generate steady income from an underlying portfolio of blue-chip stocks.

The option Call.

Let see what happens when buying/selling an option Call.

  • The buyer of the option Call pays a premium to have the right (but not the obligation) to buy the underlying security at a specified price (strike price) within a fixed period of time (until expiration).
  • The seller (also called writer) of the option Call receives a premium. The seller has the obligation to sell the underlying security at the strike price if the option is exercised.

Let me introduce you Buyi and Selly, my two option traders.

Buyi is buying an option Call, so he pays a premium to Selly and receives the Call option.
Selly, is selling the Call option to Buyi and receive the premium.

At expiration, the stock price is higher than the Strike Price.
Buyi assigns Selly and receives the stocks paying her the strike price.
The Buyi’s profit is: Current stock Price – Strike Price – Premium paid.

At expiration, the stock price is below the Strike Price.
The option contract expires worthless.
The Selly’s profit is the premium received.

The option Put.

  • The buyer of the option Put pays a premium to have the right (but not the obligation) to sell the underlying security at a specified price (strike price) within a fixed period of time (until expiration).
  • The seller (also called writer) of the option Put receives a premium. The seller has the obligation to buy the underlying security at the strike price if the option is exercised.

Let see what happens when buying/selling an option Put.

Buyi is buying an option Put, so he pays a premium to Selly and receive the Put option.
Selly, is selling the Put option to Buyi and receive the premium.

At expiration, the stock price is below the Strike Price.
Buyi assigns Selly and sells her the stocks at the strike price.
The Buyi’s profit is: Strike Price – Current Price – Premium paid.

At expiration, the stock price is higher than the Strike Price.
The option contract expires worthless.
The Selly’s profit is the premium received.

Call / Put recap.

BuyerSeller
Call optionRight to buyObligation to sell
Put optionRight to sellObligation to buy

American style vs European Style.

There is an important difference between the two styles.
The American style option contract can be exercised anytime before expiration.
The European style option contract can only be exercised at expiration time.

Option Value: Market value vs Intrinsic value.

Intrinsic value.

Intrinsic value is the difference between the market price of the underlying security—such as a stock—and the strike price of the option.
A Call option with a strike price of $20, while the underlying stock is trading at $20, would have no intrinsic value since there’s no profit.

However, a Call option with a strike price of $20, while the underlying stock is trading at $30, would have a $10 intrinsic value.
In other words, the intrinsic value is the minimum profit that’s built into the option given the prevailing market price and the strike.
Of course, the intrinsic value can change as the stock’s price fluctuates, but the strike price remains fixed throughout the contract.

Market value.

Market value = Intrinsic Value + Time (Decay) Value

What Is Time Decay?

Time decay is a measure of the rate of decline in the value of an options contract due to the passage of time. Time decay accelerates as an option’s time to expiration draws closer since there’s less time to realize a profit from the trade. We will learn more about time decay in an other article.

The option price versus the security price.

Behind this title I have some more terms to define. It is the jargon of options. This is quite easy. If you spent time reading articles about options you probably notice these acronym ITM – ATM – OTM and maybe DITM-DOTM. These terms are used when the options strategies are explained. Are you ready ? Let’s go.

ITM – « In the money ».

  • A Call option is in-the-money when its strike price is below the current trading price of the underlying asset.
  • A Put option is in-the-money when its strike price is above the current trading price of the underlying asset.

ATM – « At The Money ».

It is a Call or Put option that has a strike price that is equal to the current trading price of the underlying security.

OTM – « Out of The Money ».

  • Calls are out-of-the-money when their strike price is above the market price of the underlying asset.
  • Puts are out-of-the-money when their strike price is below the market price of the underlying asset.

Easy, is not it ? Do you want more ? Ok Let’s define the two last but you know already everything. It’s just one more detail.

DOTM – « Deep Out of The Money ».

  • Calls are deep-out-of-the-money when their strike price is far above the market price of the underlying asset.
  • Puts are deep-out-of-the-money when their strike price is far below the market price of the underlying asset.

DITM –  » Deep in The Money ».

  • A Call option is deep-in-the-money when its strike price is far below the current trading price of the underlying asset.
  • A Put option is deep-in-the-money when its strike price is far above the current trading price of the underlying asset.

Easy, is not it ? I told you before. Let’s make an illustration to summarize these terms. I am not sure the (Deep) is really measurable so.

Summary

Trading naked or covered options.

More seriously this is very important to understand these terms. Both terms are relevant when you are selling options.

Covered means when you are selling a Call, you already own the underlying securities you will have to sell in case of an assignment. In this case you won’t lose money if the strike price is higher than the price you bought the securities. Of course the security price is higher than the strike price you will miss the difference between the stock price and the strike price.

To avoid a headache here is an example :

  • You bought the stock AAA at 120€.
  • You sell one Call option at the strike price 130€ and you get a premium of 4€.
  • At expiration, your AAA stock price is 133€ so you are assigned and you have to sell the securities at 130€.
  • Your profit is : (130€ – 120€)*100 + 4€=1004€.
  • But you miss the 3€ (*100 stocks) between the stock price (133€) and the strike price (130€).

Naked means you are selling the Call option and you do not own the underlying securities. At assignment time, you will have to buy the securities at a higher price than the strike price of the option. This means you will lose money !

To avoid another headache let’s have the same example :

  • You sell one Call at the strike price 130€ and you get a premium of 4€.
  • At expiration, the security price is 143€ so you are assigned and you have to sell the securities at 130€.
  • You bought the stock AAA at 143€.
  • Your lost is : (143€ – 130€) * 100 – 4€ =1296€.

This is why you should NEVER sell naked options ! The naked Call can be the worst-case because imagine what happens if the stock price double or more. This means in the previous example the loss will be at least 12.996€ !

This is why you will read in the financial literature or nearly everywhere on the internet it is dangerous to sell options. When you buy an option you can lose only the option price but when you sell an option you can lose a lot more than its price.

In another article I will explain how selling options can be profitable. With good money management and risk management, selling options can become a source of income.

That is fine but I heard about the Greeks ?!

Yes, you are right the greeks are involved, let’s define them. I promise I will make it shorter as I can.

Delta

Delta is a measure of the change in an option’s price or premium resulting from a change in the underlying asset.

Gamma

Gamma measures Delta’s rate of change over time as well as the rate of change in the underlying asset. Gamma helps forecast price moves in the underlying asset.

Theta

Theta measures the rate of time decay in the value of an option or its premium. Time decay is the erosion of an option’s value from the passage of time.

Vega

Vega measures the risk of changes in implied volatility or the forward-looking expected volatility of the underlying asset price.

Rho

Rho measures the price change for a derivative relative to a change in the risk-free rate of interest.


Sources

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