Understanding Options: A Beginner's Guide

OPTION BASICS

FOR many YEARS, options have been a means of conveying rights from one party to another at a specified price on or before a specific date. Options to buy and sell are commonly executed in real estate and equipment transactions, just as they have been for years in the securities markets. There are two types of option agreements: calls and puts. A call option is a contract that conveys to the owner the right, but not the obligation, to purchase a prescribed number of shares or futures contracts of an underlying security at a specified price before or on a specific expiration date. A put option is a contract that conveys to the owner the right, but not obligation, to sell a prescribed number of shares or futures contracts of an underlying security at a specified price before or on a specific expiration date. Consequently, if the market in a security were expected to advance, a trader would purchase a call and, conversely, if the market in a security were expected to decline, a trader would purchase a put. With the advent of listed options, the inconvenience and difficulties originally associated with transacting options have been greatly diminished.

INTRODUCTION TO BASICS

We all know many opportunities exist in trading today. Everywhere you turn, someone is waiting to inform you of the tremendous profits to be realized in the stock and futures markets. However, many people are unaware of the derivative trading possibilities which are available within and across several different markets. Option trading is just one of the many ways to participate in these secondary markets. And contrary to popular belief, this potential trading arena is not limited strictly to the practice of selling or writing options.

Options are an important element of investing in markets, serving a function of managing risk and generating income. Unlike most other types of investments today, options provide a unique set of benefits. Not only does option trading provide a cheap and effective means of hedging one’s portfolio against adverse and unexpected price fluctuations, but it also offers a tremendous speculative dimension to trading. One of the primary advantages of option trading is that option contracts enable a trade to be leveraged, allowing the trader to control the full value of an asset for a fraction of the actual cost. And since an option’s price mirrors that of the underlying asset at the very least, any favorable return in the asset will be met with a greater percentage return in the option. Another major benefit of outright buying options is that an option provides limited risk and unlimited reward. With options, the buyer can only lose what was paid for the option contract, which is a fraction of what the actual cost of the asset would be. However, the profit potential is unlimited because the option holder possesses a contract that performs in sync with the asset itself. If the outlook is positive for the security, so too will the outlook be for that asset’s underlying options. Options also provide their owners with numerous trading alternatives. Options can be customized and combined with other options and even other investments to take advantage of any possible price dislocation within the market. They enable the trader or investor to acquire a position that is appropriate for any type of market outlook that he or she may have, be it bullish, bearish, choppy, or silent.

While there is no disputing that options offer many investment benefits, option trading involves risk and is not for everyone. For the same reason that one’s returns can be large, so too can the losses—leverage. Also, while the potential for financial success does exist in option trading, the means of realizing such opportunities are often difficult to create and to identify. With dozens of variables, several pricing models, and hundreds of different strategies to choose from, it is no wonder that options and option pricing have been a mystery to the majority of the trading public. Most often, a great deal of information must be processed before an in-formed trading decision can be reached. Computers and sophisticated trading models are often relied upon to select trading candidates. However, as humans, we like things to be as simple as possible. This often creates a conflict when deciding what, when, and how to trade a particular investment. It is much easier to buy or sell an asset outright than to contend with the many extraneous factors of these derivative markets.  If an investor thinks an asset’s value will appreciate, he or she can simply buy the security; if an investor thinks an asset’s value will depreciate, he or she can simply sell the security. In these scenarios, the only thing an investor must worry about is the value of the investment relative to the value of the prevailing market. If only options were that easy!

Typically, option trading is more cumbersome and complicated than stock trading because traders must consider many variables aside from the direction they believe the market will move. The effects of the passage of time, variables such as delta, and the underlying market volatility on the price of the option are just some of the many items that traders need to gauge in order to make informed decisions. If one is not prudent in one’s investment decisions, one could potentially lose a lot of money trading options. Those who disregard careful consideration and sound money management techniques often find out the hard way that these factors can quickly and easily erode the value of their option portfolios.

Because of these risks and benefits, options offer tremendous profit potential above and beyond trading in any other instrument, including the underlying security itself. This is the juncture at which option theoreticians enter the picture. Once the benefits have been defined, it is now a matter of determining how to best attain them. Up to now, the vast majority of option techniques have been elaborate mathematical models designed to help identify when option-writing or -selling opportunities exist. However, we hope to break new ground by introducing simple market-timing techniques that will enable traders to buy options with greater confidence and with greater success.

WHAT IS AN OPTION?

Before we devote our attention to more sophisticated option applications, it is important that we introduce a basic option foundation. While this introduction to options will be descriptive in its scope, its coverage will by no means be exhaustive. The sheer magnitude of option terminology and strategy could comprise an entire book on its own, and that is not our primary focus. We understand you did not buy this book to read the DeMarks on basic option definitions. For us to give our interpretation of existing material is much like making an entire career out of singing covers of popular songs of the past. And while it may work for Michael Bolton, we don’t feel it works for us. Therefore, we will only be addressing the items necessary to understanding option basics and the techniques we will be presenting throughout the book. This simple introduction is tailored to those who are unfamiliar with options; for many, this chapter will simply be a review.

Whether they apply to stocks, indices, or futures, all options work in the same manner. Simply stated, an option is a financial instrument that allows the owner the right, but not the obligation, to acquire or to sell a predetermined number of shares of stock or futures contracts in a particular asset at a fixed price on or before a specified date. With each option contract, the holder can make any of three possible choices: exercise the option and obtain a position in the underlying asset; trade the option, closing out the trader’s position in the contract by performing an offsetting trade; or let the option expire if the contract lacks value at expiration, losing only what was paid for the option. We will discuss the benefits and implications of each action later in this chapter.

Option contracts are identified using quantity, asset, expiration date, strike price, type, and premium. With the exception of the option’s premium, each of these items is standardized upon issuance of a listed option contract. In other words, once an option contract is created, its rights are static; the price that one would pay for those rights is not; it is dynamic and determined by market forces. Seeing as there are many items which make up the definition of an option contract, it is important that each be addressed before moving on.

The first aspect of an option contract is the option’s quantity. The number of shares or contracts that can be obtained upon exercising an exchange-listed option contract is standardized. Each stock option contract allows the holder of that option to control 100 shares of the underlying security while each futures option contract can be exercised to obtain one contract in the underlying futures contract.

Another item that identifies the option contract is the asset itself. The asset refers to the type of investment that can be obtained by the option holder. This asset could be a futures contract, shares of stock in a company, or a cash settlement in the case of an index contract.

The type of option is critical in determining the trader’s market outlook. Unlike trading stocks or futures themselves, option trading is not simply being long a particular market or short a particular market. Rather, there are two types of options, call options and put options, and two sides to each type, long or short, allowing the trader to take any of four possible positions. One can buy a call, sell a call, buy a put, sell a put, or any combination thereof. It is important to understand that trading call options is completely separate from trading put options. For every call buyer there is a call seller; while for every put buyer there is a put seller. Also keep in mind that option buyers have rights, while option sellers have obligations. For this reason, option buyers have a defined level of risk and option sellers have unlimited risk.

A call option is a standardized contract that gives the buyer the right, but not the obligation, to purchase a specific number of shares or contracts of an underlying security at the option’s strike price, or exercise price, sometime before the expiration date of the contract. Buying a call contract is similar to taking a long position in the underlying asset, and one would purchase a call option if one believed that the market value of the asset was going to appreciate before the date the option expires. The most a trader can lose by purchasing a call option is simply the price that he or she pays for the option; the most the trader can make is unlimited.

Futures are leveraged assets typically representing a large, standardized quantity of an underlying security which expire at some predetermined date in the future. Each futures option contract allows the holder to control the total number of units that comprise the futures contract until the option is liquidated, but no later than its expiration date.

On the other side of the transaction, the seller, or writer, of a call option has the obligation, not the right, to sell a specific number of shares or contracts of an asset to the option buyer at the strike price, if the option is exercised prior to its expiration date. Selling a call contract acts as a proxy for a short position in the underlying asset, and one would sell a call option if one expected that the market value of the asset would either decline or move sideways. (See Payoff Diagram 2.1.) The most an option seller can make on the trade is the price he or she initially receives for the option contract; the most the trader can lose is unlimited. In order to offset a long position in a call option contract, one must sell a call option of the same quantity, type, expiration date, and strike price. Similarly, in order to offset a short position in a call option contract, one must buy a call option of the same quantity, type, expiration date, and strike price.

A put option is a standardized contract that gives the buyer the right, but not the obligation, to sell a predetermined number of shares or contracts of an underlying security at the option’s strike price, or exercise price, sometime before the expiration date of the contract. A put contract is similar to taking a short position in the underlying asset, and one could purchase a put option contract if one believed that the market price of the asset was going to decline at some point before the date the option expires. The most a trader can lose by purchasing a put option is simply the price that he or she pays for the option; the most the trader can make is unlimited (in reality, it is the full value of the underlying asset which is realized if its price declines to zero). Conversely, the seller, or writer, of a put option has the obligation, not the right, to buy a specific number of shares or contracts of an asset to the option buyer at the strike price, assuming the option is exercised prior to its expiration date. Selling a put contract acts as a substitute for a long position in the underlying asset, and a trader would sell a put contract if he or she expected the market value of the asset to either increase or move sideways. Again, the most an option seller can make on the trade is the price he or she initially receives for the option contract; the most the seller can lose is unlimited (in reality, the most one can lose is the full value of the underlying asset which is realized if its price declines to zero). (See Payoff Diagram 2.2.) In order to offset a long position in a put option contract, one must sell a put option of the same quantity, type, expiration date, and strike price. Similarly, in order to offset a short position in a put option contract, one must buy a put option of the same quantity, type, expiration date, and strike price.

Just remember, call buyers want the market price of the underlying security to go higher so the option will gain in value and they can make money; and call writers want the market to go sideways or lower so the option will expire worthless and they can make money. Put buyers want the market price of the underlying security to go lower so the option can gain in value and they can make money; and put sellers want the market price to go higher or sideways so the option will expire worth- 

Payoff Diagram 2.1 Profit diagrams for a long call and a short call.

Payoff Diagram 2.2 Profit diagrams for a long put and a short put.

less and they can make money. Also remember, option buyers can choose whether they wish to exercise their options; option sellers cannot.

The strike price or exercise price is simply the price at which the underlying security can be obtained or sold if one were to exercise the option. For a call option, the strike price is the price at which the holder can buy the security from the option writer upon exercising the option. For a put option, the strike price is the price at which the holder can sell the security to the option writer upon exercising the option. These option strike prices are standardized, with the strike increments determined by the asset’s price. For most stocks with a market value between $25 and $200, listed option strike prices are issued in 5-point increments nearest to the price of the stock. For stocks that trade below $25, option strike prices are separated into 214-point increments; for those that trade above $200, strike prices are graduated into 10-point intervals. Newly created contracts can only be issued with strike prices that straddle the current market price of the security; however, at any one time, several different previously existing strike prices trade on the open option market. Which of the standardized strike prices the trader chooses depends upon his or her investment needs and capital outlay. Obviously, depending upon the pre-vailing underlying market price, the rights to some option strike prices will cost more than others.

Strike prices for futures options contracts are different than those for stock options. Much like options on stock, the trader can choose from any of the standardized futures option strike prices that are issued. However, the strike prices that are set for the futures options are more contract-specific, contingent upon the market price of the underlying contract, how the future is priced, and how it trades. For obvious reasons, the issued strike prices for Treasury bond options will be different than those for soybean options. Because strikes vary depending on the commodity, it is important that traders familiarize themselves with the option contract and the underlying security before they initiate an option position.

The expiration date refers to the length of time through which the option contract and its rights are active. At any time up to and including the expiration date, the holder of an option is entitled to the contract’s benefits, which include exercising the option (taking a position in the underlying asset), trading the option (closing one’s position in the contract by trading it away to another individual), or letting it expire worthless (if the contract lacks value at expiration). While the trader can choose from any of the listed option expiration months he or she wishes to purchase (or sell), the trader cannot choose the specific date the option will expire. This date is standardized and is determined when the option is listed on the exchange on which it is traded. For most options on equity securities, the final trading day occurs on the third Friday of each month. The actual expiration occurs the following day, the Saturday following the third Friday of the month. The expiration date for futures options is more complicated than that for stock options and depends upon the contract that is being traded. Some futures option contracts expire the Saturday before the third Wednesday of the expiration month while others expire the month before the expiration month. Since an option’s expiration date depends upon the type of asset that is traded, it is important for a trader to know the specific date the contract will expire before investing in the option.

The majority of listed options are issued with expiration dates approximately nine months into the future. In addition to these standard options, there are also options that possess a longer life than the nine-month maximum for regular stock options. These are called long-term equity anticipation options, or LEAPS. LEAPS are issued each January with an expiration up to 36 months into the future. LEAPS allow traders to position themselves for market movement that is expected over a longer period of time: weeks, months, even years. They are more expensive than standard options because the added life increases the likelihood that the option will have value at some point prior to expiration. However, LEAPS can be traded only on stocks, indices, and interest rate classes and not every security offers them.

There are also two option styles that are important in determining when a trader can exercise the option contract to obtain a position in the underlying instrument: European-style and American-style options. European-style options are options that can only be exercised at the end of their life. They can be traded at any time, but they cannot be exercised until the contract’s final trading day. The more common type of option in the U.S. markets is American-style options. These options can be traded or exercised at any point during their lifetime. As you can see, American-style options allow the trader more flexibility and freedom.

There is one additional factor that is crucial to determining the value of an option contract called the option’s premium. The premium is simply the price the option buyer must pay to the option seller for the rights to the option contract. Premium is the only variable of an option and is determined by the forces of supply and demand for both the underlying instrument and for the option itself. As the market price of the underlying asset fluctuates, the premium adjusts to reflect the change in value. Premium is quoted on a unit basis and the dollar equivalent is determined by the number of units that make up the contract. The option premium trades in the same units as the underlying security but typically at a much lower price than that of the asset (for example, an equity option might cost $5 per share, while the underlying stock is trading at a price of $75 per share); please note that an option premium’s price per unit will always be less than the asset’s price per unit because the premium is the amount the trader must pay for the rights to the option contract, not for the rights to the asset itself. This premium is simply the value of the option. This feature of options allows the trader to control the full value of the underlying asset for a fraction of the actual cost.

In the case of stock options, the premium is quoted on a dollar-per-share amount. Since each stock option contract allows the option holder to control 100 shares of the stock, the cost of an option would be the number of shares multiplied by the premium’s price quote. Therefore, if a stock option has a premium of 5, or $5 per share, the cost to the option purchaser would be $500 ($5 x 100). Stock premiums less than 3 points are quoted in one-sixteenths of a point, while premiums above 3 points are quoted in one-eighths of a point.

Calculating the total cost of a futures option contract is more complicated and is a function of the commodity in question and the number of units that comprise each contract. As is the case with equity options, the premium for a futures option is also quoted on a dollar-value-per-unit basis. To arrive at the total cost of the option to the trader one must multiply the cost per unit by the total number of units in the futures contract. Remember that each futures option contract entitles the option holder to one futures contract upon exercising the option and each contract represents a much greater number of units. Wheat futures option premiums, for example, are quoted in cents per bushel with each wheat futures contract (and therefore wheat futures option contract) made up of 5000 bushels. If a trader were quoted a premium of 12'A, or 12Vi cents per bushel, for the option contract, the total cost to the option buyer would be $625 ($0,125 x 5000). The increments in which futures option premiums are quoted also depend upon the futures option contract that is being traded.

In order to complete an option transaction, an option buyer must pay the option seller a premium for the rights to the contract. Without this premium, there exists no incentive for the seller to take on the risk of departing with the underlying security. Once this payment is made by the option buyer, the funds belong to the option writer and the transaction between them is irrevocable. Whether the option expires worthless or is exercised, the option buyer is unable to recover any portion of his or her option payment from the writer. However, an option buyer does possess the ability to trade the option’s rights to another purchaser. The premium that the individual would receive by selling these rights to another would be enough to cover some, all, or more than the initial cost for the option. An easy way to look at things is to treat an option like most other physical goods. Once the buyer pays for the good, the buyer owns it for the rest of its lifetime and, for the most part, cannot get his or her money back. The only way for the individual to recover any of the initial cost is to sell the good to someone else.

Now that we have addressed each option factor thoroughly, let’s bring this information together and examine a call scenario and a put scenario with the information we have presented thus far. An example of a stock option order would be something like, “Buy 1 MSFT Dec 90 Call @ $6.” In this example, the customer wishes to purchase one Microsoft call contract with a $90 strike price and a December expiration month at a price of $6 per option, for a total of $600. In other words, by paying $600 for the option contract, the option buyer has obtained the right but not the obligation to purchase 100 shares of Microsoft stock at a price of $90 any time before the contract expires in December, regardless of the price at which Microsoft stock is trading. The perspective of the option writer is different from that of the option buyer. The option writer’s order would read, “Sell 1 MSFT Dec 90 Call @ $6.” By writing the option, the trader agrees to sell one Microsoft call contract with a $90 strike price and a December expiration month at a price of $6 per option, for a total of $600, to the call buyer. The $600 that the seller receives for the transaction is payment for relinquishing the rights of the option contract. If the owner of the option chooses to exercise the contract sometime before its expiration date in December, the writer is now obligated to sell the buyer 100 shares of Microsoft stock at a price of $90, regardless of where Microsoft stock is currently trading. Obviously, the option holder would choose to exercise the option if it were profitable for him or her to do so, meaning the contract has value and the individual wishes to take a long position in the underlying security. (See Payoff Diagram 2.3.) If either trader’s market outlook were to change, they could offset their position by taking the opposite side of their initial trade.

A futures option order would look something like, “Buy 2 Soybean Nov 550 Puts @ 17.” In this case, the customer wishes to purchase two soybean put option contracts with a $5.50 per bushel strike price and a November expiration month at a price of 17 cents per bushel. Since each soybean futures contract is made up of 5000 bushels, the cost to the option buyer is $850 per contract ($0.17 x 5000), or $1700 total ($850 x 2). By paying $1700 to the option seller, the option holder has the right, not the obligation, to sell two soybean futures contracts to the option writer at a price of $5.50 per bushel at any time before the option expires in November, regardless of the price at which the soybean market is trading.  The opposite side of this order would be, “Sell 2 Soybean Nov 550 Puts @ 17.” Here the option writer agrees to sell two soybean put option contracts with a $5.50 strike price and a November expiration month to the option buyer at a price of $ 1700. If the option is exercised prior to expiration in November, the writer is obligated to purchase two soybean futures contracts from the put option buyer at $5.50 per bushel, regardless of where the soybean market is trading at the time. For offering this benefit, the option writer receives a payment of $1700. Again, the holder would only choose to exercise the option if it were profitable to do so and either party can offset their position by trading the opposite side of their initial transaction. (See Payoff Diagram 2.4.)

OPTION PRICING

As we mentioned earlier, an option’s price, or premium, is the only option value that can fluctuate. And as is the case with any investment, price varies according to 

Diagram 2.3. Profit diagrams for the Microsoft Dec 90 call example.

Payoff Diagram 2.4. Profit diagrams for the soybean Nov put example.

market information and other external factors that affect supply and demand. Pricing of an option is somewhat different than the pricing of other investments. An option’s price is defined as

Option Premium = Intrinsic Value + Time Value

Although this seems to be a simple and straightforward mathematical equation, you’d be surprised to learn that pricing options is a very complicated task, what with the many factors that make up these two components. While it may not be crucial to know the exact value of each factor that affects an option’s price, it is important to understand the impact they have upon the value of the contract over time.

Intrinsic value and time value are most influenced by such factors as the time to option expiration, asset volatility, dividend rates, interest rates, delta and gamma, and the difference between the strike price and the underlying price. Of the two components of option pricing, intrinsic value is an objective measure while time value is more objective, encompassing everything that intrinsic value doesn’t.

The first component of an option’s price is its intrinsic value or what is also known as fair value. An option’s intrinsic value is the only pricing factor that is discernible; it is simply the difference between the strike price and the market price of the underlying asset. This comparison indicates whether the option is considered in-the-money, at-the-money, or out-of-the-money. An option is in-the-money if it has intrinsic value and out-of-the-money if it does not have intrinsic value.

In the case of a call option, if the strike price is less than the market price of the underlying asset, then the call option has intrinsic value and is said to be in-the- money. The intrinsic value is the amount that the option is considered to be in-the-money. Premium will always be worth the intrinsic value of the option at the very least. The portion of an option’s premium that is left unexplained by intrinsic value is devoted to time value. For example, suppose a trader buys 1 DIS July 30 Call @ $5 when Disney stock is trading at $33 per share. Because the option holder has the right to buy 100 shares of Disney stock at a price of $30 per share from the option writer when the stock is worth $33 per share, the call option has intrinsic value of $3 per share and is also said to be in-the-money by $3. The other $2 of premium that is unexplained by intrinsic value is attributed to time value.

When a call option’s strike price is greater than the price of the underlying asset, then the option has no intrinsic value and is said to be out-of-the-money. In this case, the intrinsic value would be zero because the option rights provide no benefits—one could purchase the asset at a higher price than the prevailing market. Intrinsic value will never be less than zero because a long option position cannot have a negative value. In cases when an option is out-of-the-money, any premium is considered to be time value. If a trader buys 1 DIS July 30 Call @ $2 when Disney stock is trading at $27 per share, the call would be out-of-the-money because it enables the trader to purchase 100 shares of Disney stock at $30 per share while the stock is trading at a lower price of $27 per share. Because there is no intrinsic value, the $2 premium is devoted entirely to time value.

When the call option’s strike price is equal to the market price of the underlying security, the option is said to be at-the-money. In this scenario, the option has no intrinsic value and any premium is due to time value. Suppose a trader buys 1 DIS July 30 Call @ $3 when Disney stock is trading at $30 per share. The option gives the holder the right to buy 100 shares of Disney stock at $30 per share when the market is trading at $30 per share, so the option is trading at-the-money. In this example, the intrinsic value would be zero and the time value would be $3.

In the case of a put option, if the strike price is greater than the market price of the underlying security, then the put option has intrinsic value and is said to be in- the-money. Again, the intrinsic value is the nominal amount by which the option is in-the-money. Also, to reiterate, premium will always be worth at least the intrinsic value of the option and the portion of the premium that is left unexplained by intrinsic value is devoted to time value. For example, suppose a trader buys 1 DIS July 30 Put @ $5 when Disney stock is trading at $27 per share. Because the option holder can sell 100 shares of Disney stock at $30 per share to the option writer while the stock is trading at a lower price of $27 per share, the put option has intrinsic value of $3. The option is also said to be $3 in-the-money. The $2 of premium that is unexplained by intrinsic value is attributed to time value.

When a put option’s strike price is less than the price of the underlying market price, then the option has no intrinsic value and the option is said to be out-of-the-money. In this case, the intrinsic value would be zero because if one were to exercise the option at that time, one would be entitled to sell the asset at a lower price than the prevailing market. In cases where a put option is out-of-the-money, all of the option’s premium is considered to be time value. If a trader buys 1 DIS July 30 Put @ $2 when Disney stock is trading at $33 per share, the call would be out-of-the-money because there is no intrinsic value. The put enables the trader to sell 100 shares of Disney stock at $30 per share while the stock is trading at a higher price of $33 per share. Since there is no intrinsic value, the full $2 premium is time value.

Finally, when a put option’s strike price is equal to the market price of the underlying security, the option is said to be at-the-money. In this case, the option has no intrinsic value and all of the option premium is derived from time value. Suppose a trader buys 1 DIS July 30 Put @ $3 when Disney stock is trading at $30 per share. The option gives the holder the right to sell 100 shares of Disney stock at $30 per share when the market is trading at $30 per share, so the option is trading at-the-money. In this example, the intrinsic value would be zero and the time value would account for the full value of the premium.

Bear in mind that in-the-money, out-of-the-money, and at-the-money are all stated from the option holder’s perspective. Also, as a contract moves in-the-money, an option’s premium will increase to reflect the increase in value. As a contract moves out-of-the-money, an option’s premium will decrease to reflect the decrease in value. Intrinsic value is very important to an option’s price and must always be equivalent to its premium, at the very least. If it were not, investors would recognize the arbitrage possibility and the option could be used to create an instant profit with no risk, whatsoever.

As we mentioned, an option’s premium will change with fluctuations in the price of the underlying asset. How much of an increase or a decrease in the premium that can be expected with these changes in intrinsic value depends upon an option’s delta and gamma. While delta and gamma are important to many traders, they are not crucial to the information we will present throughout the book, and for that reason we will simply cover the bare essentials. Delta and gamma provide a rough measurement of how sensitive option price movements are to price changes in the underlying security. Delta is defined as the amount by which the price of an option changes for every dollar move in the underlying asset. Gamma, on the other hand, is defined as the degree by which the delta changes in response to changes in the underlying instrument’s price. Therefore, when the price of an asset changes, delta explains what should happen to the option’s premium while gamma explains what should happen to the option’s delta. Between delta and gamma, delta is the more important and telling of the two. In general, delta increases as an option moves in-the-money and decreases as an option moves out-of-the-money.

The delta of a call option is a number that fluctuates between 0.00 and 1.00. Also, the greater the delta, the more the option premium will react to a given move in the underlying asset. If one were to follow the tendencies of options with different values, one would find that delta increases as an option goes from deeply out- of-the-money to deep in-the-money. Very deep out-of-the-money call options have a delta of 0.00, meaning that even if the price of the underlying asset were to rise by one point, the option’s value would be unaffected. Call options that are out-of- the-money, but not dramatically so, have smaller deltas, such as 0.25. This means that for every one-point move in the price of the underlying asset, the price of the option should increase by / of a point. Call options that are at-the-money have deltas that are slightly larger than the middle of the range because the assets they cover can move more to the upside than they can to the downside. These options have deltas somewhere around 0.55 to 0.60, which means that for every one-point move in the price of the underlying asset, the price of the option should increase by a little more than Vi of a point. Call options that are in-the-money, but not dramatically so, have larger deltas around 0.75 and behave more like the underlying asset. In this case, for every one-point move in the price of the underlying asset, the price of the option should increase by % of a point. Finally, for very deep in-the-money call options, delta equals 1.00, meaning for every one-point move in the price of the underlying asset, the option premium will move by one point. As you could imagine, strike prices that are much higher than the prevailing asset price (which would be out-of-the-money) will have a lower delta because they have less chance of expiring in-the-money.

The delta of a put option is just the opposite of that for a call option and is a number that fluctuates between 0.00 and -1.00. In this case, the lower or more negative the delta, the more the option premium will react to a given move in the underlying asset. Again, if one were to follow the tendencies of options that possess different values, one would find that delta increases as an option goes from deeply out-of-the-money to deep in-the-money. Very deep out-of-the-money put options have a delta of 0.00, meaning that even if the price of the underlying asset were to decline by one point, the option’s value would not change. Put options that are out-of-the-money, but not dramatically so, have smaller deltas, such as -0.25. This means that for every one-point decline in the price of the underlying asset, the price of the option should increase by % of a point. Put options that are at-the- money have deltas that are slightly less than the middle of the range because the assets they cover can move more to the upside than they can to the downside. These options have deltas somewhere around -0.40 to -0.45. This means that for every one-point decline in the price of the underlying asset, the price of the option should rise by a little less than Vi of a point. Put options that are in-the-money, but not dramatically so, have larger deltas around -0.75 and, again, behave more like the underlying asset. In this case, for every one-point decline in the underlying asset, the price of the option should increase by / of a point. Finally, for very deep in-the- money put options, delta equals -1.00, meaning for every one-point decline in the price of the underlying asset, the option premium will increase by one point. As you could imagine, strike prices that are much lower than the prevailing asset price (which would be out-of-the-money) will have a lower delta because they have a lower chance of expiring in-the-money.

One should also understand that as time passes, the delta of an out-of-the-money option will move toward zero. Conversely, as time passes, the delta of an in-the-money option will move toward its maximum of 1.00 for call options and -1.00 for put options.

The second major component of an option’s price is referred to as time value or time premium. These may be slight misnomers in the premium equation because, in reality, many factors are lumped together into this variable. Time value accounts not only for the amount of time that is left before an option expires, but for everything else that intrinsic value does not. In this sense, time value can be explained as the amount that option buyers are willing to pay for the protective benefits provided by the option. Taken by itself, time premium is the effect that time has upon the value of an option contract. The greater the time to expiration, the greater the chance that the option will move in-the-money. Buyers will be willing to pay more for the rights to an option with a distant expiration month because they are entitled to the benefits for a longer period of time, and writers will be willing to sell an option with a distant expiration month at a higher premium because they face a longer period of risk. Therefore, the more time remaining until expiration, the greater the price. Naturally, an option with a closer expiration date will have less time to move in-the-money and will therefore command a lower premium.

As time passes, an option’s time value will decrease. One important thing to keep in mind is that time decay is not linear. As an option approaches expiration, its time value erodes more and more quickly because there is less time for the option to move in-the-money. Clearly, losing one day when the contract has six months to expiration will have a much lower negative impact upon the premium than losing one day when the option has one week to expiration. At expiration, an option’s time value will be equal to zero, with any premium remaining due to intrinsic value. One of the ways traders measure the rate of this decay is by examining an option’s theta. Theta acts much like delta and gamma do for intrinsic value. With theta, traders can get a general idea as to how an option’s value will erode as time passes.

Another factor that affects the time value of an option contract is the volatility of the underlying instrument. Of all the factors that justify an option’s time premium, volatility and time to expiration are certainly two of the most important. Yet, while volatility is significant in determining an option’s price, it is quite difficult to quantify. If an asset is experiencing dramatic price swings over a relatively short period of time, then the asset is said to be volatile. With greater volatility comes a greater possibility that the asset will move in-the-money. In addition, because less time is needed for the option to move, the option will retain more of its time value; conversely, if a market is static, it takes more time for the market to move in-the- money, thereby wasting valuable time. Lastly, with greater volatility comes greater trading risk; if the underlying market is unusually volatile, people may be reluctant to trade the asset and instead turn to options in the hope of limiting their downside risk. Option buyers would be willing to pay more for this protection and option writers would require more for providing this protection, both of which would drive option premiums upward. Therefore, in all cases, the greater the market volatility, the greater the time premium.

Measuring past volatility is relatively simple; what is difficult is predicting future volatility. By applying mathematical formulas to an asset’s prior trading activity, investors can measure that asset’s historical volatility, and from that value can obtain a useful benchmark as to how the asset should trade and perform over time. However markets are constantly changing and it is impossible to know how much price will move in the future. One way that investors predict and anticipate future volatility is by trading options with various expiration dates and strike prices. Some traders examine an option’s vega to determine the effect that volatility will have upon the option’s premium. Vega acts very much like an option’s delta and gamma when examining intrinsic value. It is defined as the amount by which an option’s price changes when the volatility in the underlying security changes. Vega basically states that any increase in an asset’s volatility will be met with an increase in the price of the option while any decrease in an asset’s volatility will be met with a decrease in the price of the option.

One common index that many traders utilize to gauge anticipated market volatility is the Chicago Board of Options Exchange’s Volatility Index, known by its ticker symbol as VIX. The Volatility Index is calculated by taking a weighted average of the implied volatilities of eight at-the-money OEX calls and puts which have at least eight days to expiration and an average time to expiration of one month. Traders refer to this index to determine how future volatility will be affected, and therefore how the price of most stock options will be influenced as option expiration approaches. When the VIX value is high, it indicates that stock option volatility as a whole is high, and therefore premium levels for both calls and puts have expanded; when this VIX value is low, it indicates that stock option volatility is low, and therefore premium levels for both calls and puts have declined.

The level of interest rates is an additional factor that indirectly influences time value. As interest rates fluctuate, so too does option participation. As a general rule, when interest rates are low, option premiums are low; and when interest rates are high, option premiums are high. This can be explained by the fact that as interest rates rise, it becomes more attractive for individuals to invest a larger proportion of their money in these higher interest-bearing accounts. Because individuals are committing more of their funds to these safer investments, they have less with which to trade other assets. Obviously, with the large capital requirements that are necessary to obtain an actual position in an asset itself, it becomes more sensible to invest in options. The smaller capital outlay and lower risk that options provide enable traders to control the same asset and the same quantity of that asset with a smaller financial commitment. As an alternative to purchasing an asset, traders will buy call options; and as an alternative to selling an asset, traders will purchase put options. Therefore, an increase in interest rates should cause an increase in option trading as opposed to trading in the underlying asset itself. Furthermore, the increase in demand for options should also be met with a commensurate increase in option premiums.

The dividend rate is the final factor that influences the time value of an option. One of the most important things to understand with options on securities is that they do not entitle the option holder to cash dividends—dividends are paid only to those who own the security itself.  But the effect that cash dividends have on the price of the underlying security are felt by all those who own the option. This means that when a stock goes ex-dividend, an option’s premium value can be negatively or positively affected, depending upon whether the option is a call or a put.

When the cash dividend rate of a security is high, the price adjustment that occurs in the option will be more significant. Those with call options on the security will experience a decrease in the value of their contract when a stock goes ex-dividend, while those who own the asset outright will not lose any value, as what they will lose in price per share they will receive in the dividend. In this instance, it makes more sense to own the asset, not to control it. For this reason, as a stock’s dividend rate increases, the demand for that security’s call option will decrease, thereby decreasing its premium. Those with put options on the security will experience an increase in the value of their contract when a stock goes ex-dividend, while those who sell the security short will experience no change in the value of their investment, as what they are required to pay to the lender of the stock in dividends is equal to the amount they will realize with the price decrease. In this case, it makes more sense to control a short position in the asset with a put option than it does to actually obtain a short position in the asset. For this reason, as a stock’s dividend rate rises, the demand for that security’s put options will increase, which will thereby increase its premium.

This scenario for cash dividends differs from those for stock splits, reverse splits, stock dividends, and fractional splits. In these cases, a stock’s market price will change but will have no effect upon an option’s premium. Instead, the option’s strike price and quantity are adjusted to reflect the change in the underlying asset. With stock splits, an option holder will receive a larger quantity of the option contract at a lower strike price; with reverse splits, an option holder will receive a smaller quantity of the option contract at a higher strike price. With stock dividends and fractional splits, the option’s strike price is reduced and the number of option contracts will remain the same, with each contract now covering more shares than before.

One last term that is important to know when discussing option premium is parity. An option is said to be trading at parity when the premium is equal to the intrinsic value of the contract. For example, a GM March 70 Call @ $4 is at parity when General Motors stock trades at $74 per share. A GM March 70 Put @ $4 is at parity when General Motors stock is trading at $66 per share. Keep in mind that if the premium is equal to the intrinsic value, then that means there is no time value assigned to the price. This situation arises when the option has just about expired and does not have enough time to make a dramatic move in or out of the money. If an option’s premium is trading at a value below the intrinsic value of the contract, the option is said to be trading below parity. If an option’s premium is trading at a value that is greater than the intrinsic value of the contract, the option is said to be trading above parity.

In summary, by combining all of these factors, we can understand how an option’s premium is generated. Premium is greatly affected by the intrinsic value of the option as well as the time value of the option. Either of the two can have a noticeable impact upon the price of the option. However, when both variables work together, an option’s price can move dramatically, creating substantial returns. With the lower capital commitment that is required to purchase an option contract, returns are most often far greater than those realized by owning the asset outright, providing more bang for your buck. But the opposite holds true as well. When both of these variables work against the option holder’s position, it can decrease the option’s value significantly. Although the trader has the advantage of having invested less to control the desired amount, or paid the equivalent amount to control much more, adverse changes in these variables can decrease the value of one’s option by a much greater percentage than what would be experienced with a position in the underlying asset. The impetus behind these greater returns is an option’s delta, gamma, theta, and vega. These values dictate the degree to which an option’s premium will respond to changes in intrinsic value, theta, time decay, and underlying volatility, respectively.

Obviously, premium is an ever changing variable. Over time, intrinsic value will change and traders will form new opinions as to the significance of each variable of time value, all of which will continually adjust the price of the option. Remember that, as a general rule, as intrinsic value, an option’s time to expiration, asset volatility, and the level of interest rates increase, so will the price of both call and put options. And as dividend rates increase, put premiums will rise and call premiums will decline.

Now that we know the components of an option’s valuation, we can turn our attention to the various alternatives available to traders with respect to options and how a trader can apply what was discussed in this section.

OPTIONS WITH OPTIONS

As we briefly touched upon earlier, an option contract holder is bestowed with three choices—exercise the option, let the option expire, or trade the option. But how does a trader decide which of the three alternatives to choose? A large portion of this decision is contingent upon the value of the option contract (or lack thereof) as well as the amount of time remaining before the option expires. When an option lacks value, meaning it is out-of-the-money, the trader can simply let the option expire worthless. When an option has value, meaning it is in-the-money, the trader can choose whether to trade the contract to another individual or exercise the contract and obtain the underlying asset. The ultimate decision that is made depends upon the individual investor, his or her trading style, his or her trading needs, and the situation at hand.

Exercise the Option

As we just mentioned, one will only exercise a long option contract when one stands to make money from that position, otherwise one could simply let the option expire and lose the premium.  When an option buyer exercises an option, he or she is choosing to take a position in the underlying instrument. Naturally, the position is determined by the option type and whether it is a call or a put. In exercising a stock or futures call option, the holder agrees to purchase the standardized quantity of the underlying asset from the option writer at the predetermined strike price. Because of their contract, the writer is obligated to sell the asset to the buyer at the strike price, regardless of the price at which the market is currently trading. This transaction gives the buyer a long position in the asset and gives the writer a short position in the asset.

In exercising a stock or futures put option, the option holder agrees to sell the standardized quantity of the underlying asset to the option writer at the predetermined strike price. Because of their contract, the writer must purchase the asset from the option holder at the strike price, regardless of the price at which the market is currently trading. This transaction gives the buyer a short position in the asset and gives the seller a long position in the asset.

Exercising an index option, be it a call or a put, is handled differently because index options are settled in cash as opposed to the physical asset. When a call option buyer or a put option buyer exercises an index option, the holder is simply credited the amount by which the option is in-the-money, less any commission that applies. On the other hand, the call option writer or the put option writer is debited the amount by which the option is in-the-money, plus any commission that applies. For obvious reasons, an index option holder would choose to exercise his or her position only if it were profitable to do so, meaning the contract were in-the-money.

The majority of index options today are European-style options, meaning that exercise can only occur at the end of the contract’s life. However, the most widely traded index option, the OEX Index option which covers the S&P (Standard & Poor’s) 100, is an American-style contract, meaning exercise can occur at any point during the life of the option.

On the whole, most traders choose not to exercise an option prior to expiration. Doing so only entitles the investor to the intrinsic value of the option and sacrifices the added effect of time value. Exercising one’s option before the expiration date is not common when it comes to futures. Unless the option is deep in-the-money, where time value has a much lower impact, it generally makes more sense to trade out of the position. Exercising before the expiration date does occur more frequently when it comes to equity call options. Because option holders are not entitled to cash dividends, call options are usually exercised right before a stock goes ex-dividend so no contract value will be lost.

Defining the profit. In each of these cases, exercise will only occur when it is profitable to do so—when the option is in-the-money. However, any time an individual exercises an option, that individual loses the full cost of the premium. Because of this, any gains on the trade will be offset by the losses on the cost of the option. One does not really make a profit on the transaction until the premium is recovered. Therefore, there is a break-even point that occurs with options that are exercised.

With call options, the break-even point occurs when the underlying asset has increased in price to a point where the intrinsic value is equal to the initial cost of the option—in other words, the strike price of the option plus the call premium. Any price above this break-even point would produce a profit on the transaction, if exercised, and any price below this break-even point would produce a loss on the transaction, if exercised. For example, if the premium for 1 Compaq (CPQ) Dec 50 Call is $5, then the break-even point is achieved when the underlying security is trading at $55. In this case, if the holder exercised the option, that individual could purchase the stock for $50 and immediately sell it at $55, for a $5 profit per share or total of $500 profit on the stock trade. However, the trader had to pay $500 for the rights to the option. This means that on the entire transaction, the trader broke even. If the stock were trading at $60 per share, the trader would make $1000 on the stock trade and would lose $500 on the cost of the option, for a gain of $500 on the transaction. If the stock were trading at $52 per share, he or she would make $200 on the stock trade and would lose $500 on the cost of the option, for a net loss of $300 on the transaction. It is a loss, but not as much as the total cost of the premium. If the stock were trading at $45, the option would not be exercised and the total loss would be that of the $500 premium.

With put options, the break-even point occurs when the underlying asset has decreased in price to a point where the intrinsic value is equal to the initial cost of the option—in other words, the strike price of the option minus the put premium. Any price below this break-even point would produce a profit on the transaction, if exercised, and any price above this break-even point would produce a loss on the transaction, if exercised. For example, if the premium for 1 Compaq (CPQ) Dec 50 Put is $5, then the break-even point is achieved when the underlying security is trading at $45. In this case, if the holder exercised the option, that individual could sell the stock for $50 and immediately buy it back at $45, for a $5 profit per share or total of $500 profit on the stock trade. However, the trader had to pay $500 for the right to the put. This means that on the entire transaction, the trader broke even. If the stock were trading at $40 per share, he or she would make $1000 on the stock trade and would lose $500 on the cost of the option, for a gain of $500 on the transaction. If the stock were trading at $48 per share, he or she would make $200 on the stock trade and would lose $500 on the cost of the option, for a net loss of $300 on the transaction. It is a loss, but not as much as the total cost of the premium. If the stock were trading at $55, the option would not be exercised and the total loss would be that of the $500 premium.

Because the trader must lose money in order to lock-in profits, some people choose to forego the exercising of their options and instead turn to the second option alternative.

Trade the Option

The second choice the holder of an option can make is to trade out of the option position before the option expires. Trading one’s option is exactly the same as trading any other asset. To close out a position, one must perform the opposite side of the trade in the same asset. To offset a long option position, be it a call or a put, the holder must sell an option of the same type, expiration month, and strike price. To offset a short option position, be it a call or a put, the holder must buy an option of the same type, expiration month, and strike price. When one initiates a long option trade, the premium that is paid for the option is the entry price and when one liquidates a long option trade, the premium that is received for the option is the exit price. Obviously, if the exit price is greater than the entry price, the holder will profit on the trade. When one initiates a short option trade, the premium that is received for the option is the entry price and the premium that is paid for the option is the closing price. In this case, if the exit price is less than the entry price, the writer will profit on the trade.

To illustrate, if a trader initially purchases a call option for $5 per share and later sells that call option at $8 per share, the trader would realize a profit of $3 per share, or $300. If that same trader sold the option at $2 per share, he or she would have a loss of $3 per share, or $300. Likewise, if a trader were to initially sell a put option at $5 per share and later purchase that put option for $2.50 per share, the trader would realize a profit of $2.50 per share, or $250. If that same trader purchased the option at $8 per share, he or she would experience a loss of $3 per share, or $300.

Trading versus exercising. There is a common misconception that the most profitable way to make money with options is by exercising the contract when it is in-the-money, when in reality, trading out of one’s option can be far more lucrative. There are three reasons why this is so. The primary reason is that exercising an option can only provide the investor with the intrinsic value of the trade, while trading an option position can entitle the investor to the intrinsic value as well as additional time value. How much more the time value will provide is determined by the factors we mentioned earlier, such as time to expiration, volatility, dividend rates, and interest rates. A second reason is that trading one’s position does not force the option buyer to incur the full cost of the premium, which is what occurs when one exercises an option. Since the gains from trading an option are not used to cover the cost of the premium, there is no break-even point, there is simply the entry price and the exit price. Finally, by trading out of one’s option(s), the trader saves on commission costs. This is particularly helpful when a trader has a large option position.

Let the Option Expire

A final alternative available to the option holder is to let the option expire. Simply put, the trader can do nothing with the option and lose only what he or she paid in premium. Naturally, an option buyer will only let the contract expire if it lacks value at expiration, meaning it is out-of-the-money. Once the expiration occurs, the option buyer no longer controls the underlying asset and loses all rights conveyed by the contract. Doing nothing is a luxury that is afforded only to option traders. This eliminates the necessity of offsetting a losing position, thereby serving as an inherent stop loss on the trade. Trading any other type of asset obligates the investor to eventually offset the position, regardless of whether it is profitable to do so.

Example of Exercising versus Trading

Let’s look at an option example and the alternatives an option buyer possesses. In February, a trader buys 1 IBM May 110 Call at $5 when IBM is trading at $108 per share. In late April, when the option is nearing expiration, IBM stock is trading around $120 per share and the option’s premium has increased to $11K. In this example, because the option is in-the-money, the option holder has the choice of either exercising the option contract or trading out of the long call position. If the trader decides to exercise the IBM May 110 Call option contract, he or she must first inform the clearing firm of his or her intentions. The clearing firm then notifies an IBM May 110 call writer that he or she has been exercised and is obligated to sell 100 shares of IBM stock to the option holder at a price of $110 per share.* The option buyer pays the option writer $110 per share for the 100 shares of IBM, for a total of $ 11,000, giving the trader a long stock position at $ 110 when the market is trading $10 higher. In exercising the long call contract, the trader paid $500 for the rights to the option and $11,000 for the 100 shares of IBM stock, for a total cost of $11,500 on the transaction. If the trader were to immediately liquidate this long IBM stock position, by selling 100 shares of IBM at $120, the trader would receive a total payment of $12,000. Therefore, on the overall transaction, the trader realizes a total profit of $500 ($12,000 - $11,500), excluding any commission costs necessary to purchase the call option, to purchase the 100 shares of IBM stock, and to sell the 100 shares of IBM stock.

On the other hand, if the trader were to trade out of this long IBM call option position by performing an offsetting transaction, the process would be much simpler. To offset the long IBM May 110 Call option position, the trader must sell 1 IBM May 110 Call option. With the prevailing market prices, the option buyer paid $5, or $500, for the rights to the call option and can sell the option at $ 1114, or $1150. Therefore, the option buyer realizes a total of $650 of profit on the trade, less any commission that applies for purchasing the call option and later liquidating that option.

In comparison, by trading out of the option position the option holder was able to realize a greater profit on the trade. This is usually the case with options. However, the closer to expiration the option gets, the less a trader will be able to retrieve in premium by trading out of his or her position. It is important that a trader compare the two processes before making a decision as to what to do with the option position.