Options Trading 101

25 Oct, 2012

An option is a contract that gives you the right to buy/sell the underlying asset of the contract at a future date for a significantly reduced cost – if done properly that is. Unlike Futures contracts, which also give you the right to buy/sell the underlying asset, Options do not oblige you to make the transactions. When you buy an option, you are buying the RIGHT to buy the underlying asset, but are not obligated to exercise your right. This is a very important distinction to Futures contracts because it significantly reduces the risk of loss that is incurred by using leveraged derivatives. With Options, the maximum loss you can take is 100%. Now granted, that is a pretty large sum, being your entire trade and all. The distinction is that with Futures contracts you can lose more than 100% because you are essentially borrowing from your broker. If your trade goes against you with Futures, you are in debt to your broker. So in that regard, buying options will never put you in debt (there are exceptions; selling options could make you lose more than 100%).

There are two types of options: Puts and Calls. Calls give you the right, but not the obligation, to buy the underlying asset within a given period of time.  There are three main elements to an options quote: the strike price, the price of the option, and the time of expiration.

Strike Price

The strike price is the price that the underlying asset has to reach in order for you to be able to exercise your option. The strike price is based on the prices of the actual asset, and not the price of the option. Remember, options are just contracts, they are not real things, just agreements to buy and sell at some point in time. Until the underlying instruments price reaches the strike price, you are not allowed to buy the underlying.

Price of Option

The price of an option known as the ‘Premium’ is derived from complex pricing models, most notably the Black-Scholes model, taking into account multiple variables. These variables are known as the Greeks: Delta, Gamma, theta, Vega. There are more, but these four are the most useful to trading. Delta is the rate of change in the price of the underlying asset. Gamma is the rate of change of Delta, or the rate of change of the rate of change in the underlying price. Vega is a measure of volatility. And last but not least is Theta, which is the measure of time-decay in an option.

Time

Options prices are essentially based on the probability of the underlying price of an asset reaching the strike price before expiration of the option. Because of this expiration date, time plays a crucial role in pricing. When time runs out as the date gets closer to expiration, there less chance of the Call option expiring above the strike price if it is still underneath it. Similarly, as time runs out there is a greater probability of the option expiring above the strike price if it is there already. Call options, above the strike price, become more valuable as time runs out, and those that have not yet reached the strike price, become cheaper as time runs out on the contract.

Imagine a few weeks ago, when Google’s stock was trading at around $685/share. If we look at the call options for Google’s stock, it means we are in the market to buy the underlying shares of GOOG. One call option gives us the right to buy 100 shares of Google stock. Since we are BUYING, we therefore want price to move up in order to make money.

Let’s say we decide to buy 1 call option with a strike price of 700. The price of the option is displayed per stock, so we will pay $800 to buy our call ($8.00 x 100 shares).

There are two big implications to this example.

The first is that the price of the options gets cheaper as the strike price increases. This is associated with the probability of Google’s stock reaching the strike price before expiration. If Google is trading at $685, it is more likely for Google to be above $670 at the time of expiration than $700. In options trading there are two terms you should know: In-the-Money and out-of-the-Money. (ITM, OTM). When an call option is ITM, the price of the underlying asset is above the strike price. ITM options are able to be exercised at the time of expiration. OTM options however are when the underlying assets price is below the strike. If an option expires Out-of-the-Money, it will expire worthless because we are unable to exercise our right to buy the underlying asset. The more ITM an option is when you buy it, the more expensive it will be. So there is always a tradeoff between the likelihood of the option being in the Money at the time of expiration and the price one has to pay for the option. Less risk, less reward.

The second implication is that we are controlling 100 shares of Google, worth $68,500 ($685/share x 100 shares), with $800, representing about  1% of the total value of the asset. This is what is known as leverage. We have leveraged our position 100 to 1 using options. So what’s the catch? There’s a pretty big one. If Google’s stock does reach the price level of $700 and so we stay OTM, we never get to exercise our option, and therefore lose 100% of our investment. Google is trading at $685 in mid-October and has to move $15 dollars to 700 by mid-November. The question is, do you think GOOG can move up 2% in price in one month? While this is drastically simplified, the basic logic is that you are betting on a price movement to a certain level within a specific amount of time. The riskiness of options is that timing is so crucial. If you’re off by a month, BAM!, 100% loss. Again, this is a simplified version of reality.

But let’s say price does in fact make it to the 700 strike price by November and is now trading at $715. That is a price move in Google’s stock of 4% from 685 to 715. Now you have the option to buy 100 shares of Google, which are priced at $715 for the price of $700! Assuming you have the $70,000 necessary to buy your shares at $700, you can instantly turn around and sell them at $715 each for a total of $71,500. This means you made $1,500 on your trade. Of course we have to subtract the price of the option itself which was $800, so we are left with a profit of $700 before commissions.

So where is the beauty in options? It’s in the fact that you made a 87.5% return on investment from a 4% move in Google’s stock. Mind-blowing, I know.

Options can get very complicated as investors build complex positions involving multiple derivatives. By doing so, they can reduce risk by hedging, they can bet on changes in volatility, and they can eliminate price direction bias from a position. The article above describes trading of naked options, meaning one basic options position. This was a demonstration of the basics and most institutional traders will not trade in this fashion as it involves way too much risk, which they can effectively eliminate by building options positions.

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