Understanding Stock Options
Introduction to Stock Options
Stock options are popular with investors and traders alike. Options can be used for a variety of strategies ranging from hedging techniques to stock speculation through to options trading.
There are two types of options, a call option and a put option.
- Call option is a contract which allows an investor or trader to buy stock at a specified price on or before a specified date.
- Put option is a contract which allows an investor or trader to sell stock at a specified price on or before a specified date.
The holder of a call option has the right to buy the stock, but if the stock price is not favorable they are under no obligation to buy the stock.
Similarly, the holder of a put option has the right to sell stock, but if the stock price is not favorable they are under no obligation to sell their stock.
The option buyer is simply paying for the right to buy stock with a call option or paying for the right to sell their stock with a put option.
Stock options were developed in 1973 by the Chicago Board Options Exchange and are referred to as listed options since they are traded on an exchange. There are some similarities between listed options and stocks. Listed options are bought and sold on an exchange just like stocks with bids and asks. However listed options are not bought from NYSE or NASDAQ, but from a variety of options exchanges.
The largest range of listed options are stock options, but there are also listed options over indices such as the DOW and the S&P 500. These are referred to as index options.
In fact, options can be over any financial instrument such as commodities or currency but these option types are not the focus of this series which focuses specifically on stock options.
Investors can buy options over indices, currencies
and commodities – not just stocks
To avoid confusion, stock investors should be aware that there is a difference between listed options and company issued options. Companies will often issue options over their stock and issue these to their key employees as part of their remuneration package as an incentive to improve company profits. The idea is that if the key employees can increase company profits then the stock price will also increase making their options more valuable. These company issued options are call options but they are not the same as listed call options.
Within the stock market, listed options are simply referred to as options.
All options contracts are standardized contracts and state the following information.
Options contract information:
- Call or Put: All options contracts state whether it is a call option or whether it is a put option.
- Underlying: This is the company that the contract is over. For a call option, this is the stock that can be bought. For a put option, this is the stock that an investor can sell.
- Strike: This is the price that the stock can be bought for with a call option or the price that the stock can be sold for with a put option.
- Multiplier: This states how many shares the options contract includes. The majority of option contracts are for 100 shares. This means if an investor buys one call option, the investor can buy 100 shares.
- Expiry date: All options contracts have a time limit that the contract is valid until. Once the expiry date has passed, the option contract is no longer valid.
- Option style: This states whether the option is an American style option or a European style option. This denotes whether an option can be exercised at any time before expiry as with American options or if the option can only be exercised on the expiry date as with European options.
All options have an expiry date after which the option ceases to exist. This means that options have a time limit. The time left till expiry varies considerably with some options having less than one month and others having several years. Basically the longer the time till expiry then the more expensive the option is to buy.
When an investor buys a call option and then decides to buy the stock, the investor must pay the Strike price multiplied by the number of shares (usually 100). This process is known as "exercise" and terminates the option contract. Thus, once the investor buys the stock, a call option contract no longer exists and the investor can no longer sell their call option contract.
The same applies to a put option which is exercised. Once the investor sells their stock to the put option the contract is terminated.
Options can be bought from an options exchange and they can be sold on an options exchange up until the option expires. The investor does not receive a refund after the option expires if they have not sold or exercised their option by the expiry date. This is one of the risks with options, that it will expire worthless.
Most options issued in the U.S. are known as American style options. These options can be exercised at any time up to and including the expiry date. The other style of options is known as European style and these options can only be exercised on the expiry date and not before.
The price paid for an option is referred to as the option premium and is dependant on the Strike price of the option and on how long the option has left till expiry.
Typically most stock options have numerous Strike prices for both call options and put options. The number of strike prices is dependant on the popularity of options with a particular stock. Some stocks only have a couple of Strike prices while others can have well over 50 Strike price levels and some stocks have no options at all.
The list of Strike price levels is known as an options chain and a hypothetical example is shown below in Table 1.
Table 1. Options chain series
From Table 1. above, the Last is the last price for the stock. To buy an option the investor pays the Ask price and has a choice of Strike prices.
When the Strike price for a call option is lower than the last price for the stock, then the option is said to be In-The-Money as the option could be immediately exercised and stock acquired for less than the current stock price. When the Strike price is above the last stock price for a call option, then the option is said to be Out-The-Money as it is currently more expensive to acquire stock by exercising the call option. The converse applies to put options, which are In-The-Money when the Strike price is above the stock price and Out-The-Money when the Strike price is below the stock price.
The Volume refers to the number of option contracts traded on the day. The Open Interest refers to how many contracts are currently held. Usually the options which are closer to the current stock price tend to be the more actively traded options. With the exception of some heavily traded stocks it is fairly common for options to only trade a couple of contracts a day and a lot of options can only have a few trades in a month and some options have no trades at all.
When buying an option with the intention of reselling the option, then the liquidity of the option should be considered. As a general rule the Bid-Ask spread tends to increase as the liquidity decreases.
Stock Option Premiums
What it costs the investor to buy the option
The price paid for an option is referred to as the premium and consists of the time value and the intrinsic value.
The amount of the time value component of the option premium is based on how much time is left until expiry. Options can have numerous contracts at the same Strike price with various times until expiry. For an option with a particular Strike price, the longer there is until expiry then the higher the time value.
When an investor buys an option, the more time there is till expiry gives the stock price more time to move favorably. For a call option this means that a longer time till expiry gives the stock more time to increase in price and thus makes the call option worth more.
The intrinsic value component of the option premium is based on the difference between the Strike price and the current stock price. The intrinsic value must be positive. If the value is negative then the intrinsic value is zero.
The intrinsic value is dependant on whether the Strike price is above or below the current stock price for a call option as follows:
Call option intrinsic value:
- When the Strike price for a call option is lower than the current stock price, the option is said to be In-The-Money. The intrinsic value is the difference between the Strike price and the current stock price.
- When the Strike price for a call option is equal to the current stock price, the option is said to be At-The-Money. The intrinsic value is zero.
- When the Strike price for a call option is higher than the current stock price, the option is said to be In-The-Money. The intrinsic value is zero as it cannot be negative.
The intrinsic value for a put option is determined as follows:
Put option intrinsic value:
- When the Strike price for a put option is higher than the current stock price, the option is said to be In-The-Money. The intrinsic value is the difference between the Strike price and the current stock price.
- When the Strike price for a put option is equal to the current stock price, the option is said to be At-The-Money. The intrinsic value is zero.
- When the Strike price for a put option is lower than the last price for the stock, then the option is said to be In-The-Money. The intrinsic value is zero as it cannot be negative.
The premium for an option is equal to the time value plus the intrinsic value. Since the intrinsic value is zero for At-The-Money options and Out-The-Money options, the premium then is simply the time value.
Example: A call option with a Strike price of $30 and a current stock price of $31.50 gives
Intrinsic value = 31.50 - 30 = $1.50
Example: A call option with a Strike price of $32.50 and a current stock price of $31.50 gives
Intrinsic value = 0 (since call option is Out-The-Money)
The intrinsic value for an In-The-Money call option is simply the benefit a call option holder receives. If the call option holder exercises their option, they could simply sell it immediately at the current stock price. For the above example this means buying at the strike price of $30 and immediately selling the stock for $31.50 thus netting a gain of $1.50. This is why the intrinsic value is added to the premium for In-The-Money call options.
The premium for At-The-Money options and Out-The-Money options is simply the time value as there is no intrinsic value.
Buying an option with a market order means paying the asking price and this then becomes the premium. If a limit order is placed then the order will fill when the option contract trades at the limit price and this then becomes the premium.
For an In-The-Money option, the time value is determined by subtracting the intrinsic value from the premium.
Example: A put option with a Strike price of $27.50 with an asking price of $2.50 and a current stock price of $26 gives
Intrinsic value = 27.50 - 26 = $1.50
Time value = 2.50 - 1.50 = $1.00
Example: A put option with a Strike price of $25 with an asking price of $1.00 and a current stock price of $26 gives
Intrinsic value = 0 (since put option is Out-The-Money)
Time value = $1.00 (asking price)
The intrinsic value for an In-The-Money put option is simply the benefit a put option holder receives. If the put option holder exercises their option, they could simply buy stock from the market and sell it to the put option. For the above example this means buying at the current stock price of $26 and exercising their put option to sell the stock at the strike price of $27.50 thus netting a gain of $1.50. This is why the intrinsic value is added to the premium for In-The-Money put options.
The time value of options decrease as options approach their expiry. This reduction in value is known as time decay. The rate at which time value reduces is not linear but has an exponential characteristic which means as the time remaining approaches zero the rate that the time value reduces speeds up. This means most of the rapid time decay occurs when the option is close to expiry, especially during the last week. The time decay is determined by a theoretical calculation referred to as the Theta value which is one of the Greek values.
The theoretical time value is determined by a calculation using a mathematical model such as the Black-Scholes model which incorporates the time remaining until expiry, Strike price, current stock price, current interest rate and the volatility of the stock. The theoretical time value is added to the intrinsic value to obtain the theoretical premium.
In practice the supply and demand for an option can increase or decrease the premium as it is traded on an exchange. This means the actual time value amount can be different to the theoretical time value. This change in time value effectively is reflected in what is known as the implied volatility. When the implied volatility is used in the Black-Scholes model rather than the volatility of the stock, this gives the actual premium.
Some options have very wide bid-ask spreads. This means that the premium paid to buy an option and the premium received when the option is sold can be significantly different even nothing has changed. This something to be aware of with options since a lot of options are very thinly traded and some options are actually never traded and expire without a single contract bought or sold.
As a general rule the options with Strike prices close to the current stock price tend to be the most actively traded options. As the options go further In-The-Money or Out-The-Money the trading activity diminishes to essentially nothing.
Option Behavior and the Greeks
How stock prices affect option prices
While the price of a stock option is derived from the price of the stock, the option price usually does not directly follow the stock price. If the stock price increases by 10% this does not mean the option price will also increase by 10%.
Analyzing the pricing behavior of options is performed by five theoretical calculations known as the Greeks. These calculations are referred to as the Greeks since their names are letters taken from the Greek alphabet. The five Greeks are Delta, Gamma, Vega, Theta and Rho.
The Greeks give an investor or trader an understanding of why option prices move the way they do. The values for the Greeks are readily obtainable from option calculators such as the one provide by the Chicago Board Options Exchange (CBOE).
Delta measures how the option price will move for a corresponding move in the stock price.
Delta is usually expressed as a number between zero and one which represents how much the option will gain or lose in dollar terms for a one dollar move in the stock price.
Example 1. The price of an option with a Delta of 0.50 is expected to increase by $0.50 when the stock price increases by $1.00. Similarly if the stock price drops by $1.00 then the option price drops by $0.50.
Options with a Delta of 1.00 will move dollar for dollar with the stock and options with a Delta of zero will not change in price.
Delta is the simplest Greek and is the
easiest for investors to understand
Sometimes the Delta is expressed in cents rather than dollars which gives a range of zero to 100 cents. Also Delta are usually expressed with negative values for put options.
Options that are At-The-Money usually have Deltas around 0.50.
As the option goes further In-The-Money the Deltas increase and head towards one.
Example 2. An option that is deeply In-The-Money with a Delta of 0.80 will increase in price by $0.80 when the stock price increases by $1.00.
As the option goes further Out-The-Money the Deltas decrease and heads towards zero.
Example 3. An Option that is slightly Out-The-Money with a Delta of 0.40 will decline in price by $0.40 when the stock price drops by $1.00.
Options that are deep In-The-Money have high Deltas since the premium consists largely of intrinsic value. Options that are deep Out-The-Money have low Deltas which reflect that they have little chance of being exercised.
Delta does not remain constant even if the stock price does not change. As options approach expiry, the Delta increases for In-The-Money options and the Delta decreases for Out-The-Money options.
While Delta is a measure of how much the option price will move for a $1.00 move in the stock price, if the stock price moves $2.00 or $5.00 then another calculation is required.
Gamma measures how much the Delta changes as the stock price continues to move beyond $1.00.
Gamma is the highest for At-The-Money options and progressively declines as the option goes further In-The-Money or Out-The-Money.
Example 4. A Delta of 0.50 with a Gamma of 0.05 and the stock price increases by $3.00 means that the option price is expected to move as follows:
- The first $1.00 stock price increase will add $0.50 to the option price.
- The second $1.00 stock price increase will add 0.50 + 0.05 = $0.55 to the option price.
- The third $1.00 stock price increase will add 0.55 + 0.05 + 0.05 = $0.60 to the option price.
- A $3.00 stock price increase will increase the option price by $0.50 + $0.55 + $0.60 = $1.65
Gamma increases as the option approaches expiration and longer expiration dates have lower Gamma values.
This means that options with longer expiry dates have Deltas that change less as the stock price increases or decreases, and options with short expiries have Deltas that are more variable with stock price movements.
The time value of an option premium reduces as the option approaches expiration and the time value is zero at the expiration date. The reduction in time value is known as time decay.
Theta is a measurement of the daily rate that the time value decays.
Example 5. An option with a Theta of 0.02 will decay by $0.02 over the next day.
The value of Theta is not constant. Options with long expiry dates have Thetas that are lower and are fairly constant form one day to the next. As the option approaches expiry the Theta value increases with each day.
Calculating the time decay with long expiration dates using Theta produces fairly reliable results, even over several weeks. However when an option approaches expiry the Theta can only reliably be used for the next couple of days. In the last week before expiry the Theta value is only reliable for determining the time decay for the next day.
The daily decay also applies to weekends and non-trading days. This is because decay is based on calendar days and not trading days.
Example 6. If an option were bought on Friday and Monday is a public holiday, then on Tuesday the option has decayed for four days and not one day.
Thus, an option with a Theta of 0.01 would have reduced the time value over four days by 4 x 0.01 = $0.04 even though there has only been one trading day.
Vega measures the sensitivity of an options price to changes in the stock's volatility. The volatility of the stock is an input in the pricing models that are used to calculate the option premiums.
The volatility of a stock can change over time. When a stock's price is widely fluctuating the volatility is high and when the stock goes into a tight trading range or a consolidation pattern such as an ascending triangle, the volatility drops.
When the stock's volatility is high then the option premiums are high and when the stock's volatility is low then the option premiums are low.
Vega is highest when options are At-The-Money and Vega reduces as the option goes further In-The-Money or Out-The-Money.
The Vega value is a measurement of how much the premium is expected to change for a 1% change in the stock's volatility.
Example 7. An option has a Vega of 0.40 and a stock volatility of 30%. The stock volatility increases to 31% then option price is expected to increase by $0.40.
Example 8. An option has a Vega of 0.20 and a stock volatility of 25%. The stock volatility decreases to 22% then the option price is expected to decline by 0.20 x 3 = $0.60.
Rho measures the sensitivity of an options price to changes in interest rates. As with volatility, the interest rate is another input in the pricing models that are used to calculate the option premiums.
As interest rates change, the value of an option also changes. High interest rates increase the premiums of call options and reduce the premiums of put options.
Vega values are positive for call options and negative for put options. For an interest rate increase of 1% the premium of a call option increases by the Vega value and premium of a put option decreases by the Vega value.
Example 9. A call option with a Vega of 0.01 and interest rates increased by 1% is expected to increase the premium by $0.01.
Example 10. A put option with a Vega of -0.01 and interest rates decrease by 0.5% is expected to reduce the premium by 0.01 x 0.5 = $0.005.
The Rho values are relatively small for the interest rate changes. For most options Rho has little effect on the option premium as most interest rate changes are only 0.25% or 0.50%. Even for options with longer expiration dates the effect of Rho on option premiums is fairly minimal.
The Greeks are mostly used by options traders rather than stock investors. However having an understanding of the Greeks and their effect on option premiums allows the stock investor to make a wiser choice should they decide to utilize an option for a speculative strategy or hedging strategy.
Investors can earn the option premium - but there are risks
When an investor or trader buys an option, they buy it from someone who is selling their option, but just exactly what does selling mean. Options are actually contracts and are not an ownership of an asset such as a company. Strictly speaking, an option buyer does not buy an option but they enter into a contractual agreement with another party.
Options are contracts set up by the Options Clearing Corporation (OCC) and are standardized contracts for a particular stock with a strike price and an expiry date. Like with any contract, there are two parties that agree on the terms and conditions of the contract.
An options contract can be thought of as an insurance policy agreement. The first party to the contract is the policy holder who pays a premium and has the right to claim on the policy. The second party is the insurance firm who receives the premium and has the obligation to fulfill any claim made by the policy holder. Option contracts are basically the same thing except that the second party is usually another market participant and not a firm but they can be.
With a call option contract, the first party to the contract has the right to buy stock at the strike price on or before the expiry date and the second party has the obligation to provide stock should the first party exercise their right. The first party is referred to as the option buyer and pays a premium. The second party who is referred to as the option seller receives the premium.
With a put option contract, the first party to the contract has the right to sell stock at the strike price on or before the expiry date and the second party has the obligation to take this stock if the first party exercises their right. The first party is referred to as the option buyer and pays a premium. The second party who is referred to as the option seller receives the premium.
Thus the two parties for an option contract are the option buyer who has the right and the option seller who has the obligation.
There are always two parties for a contract,
effectively the buyer and the seller
All listed options are traded on one of the options exchanges. The order books contain all the Bids and Asks for each option series. The Bids and Asks are largely provided by options market makers but are also provided by any market participant who places limit orders through a direct access broker.
When an investor or trader places an order to buy an option, they are actually entering into a contract as the option buyer with another market participant. The other market participant is the second party and is the option seller.
Selling an Option
Should the investor or trader now decide to sell their option, they are actually entering into a new contract as the second party with another market participant. The other market participant is the first party and is now the option buyer. Thus the investor or trader does not sell their option but actually enters into a new option contract as the seller. So at the end of the trading day the investor or trader still has the original option contract and also has a new contract as a seller.
At the end of each trading day all the open option contracts for each market participant are totaled up. An investor or trader cannot have both the right and the obligation for the same contract series. If a market participant has an option contract where they are the buyer and has another option contract of the same series where they are the seller, these two contracts are merged together and the investor or trader is removed from the contracts. This is illustrated below in Table 1.
Table 1. Investor selling their option
As Table 1. above shows, if the investor sells their option they are actually the seller of contract 2 and not contract 1 which is the contract they own. After the market close, the investor is removed as they are both the buyer and the seller of the same contract series (buyer of contract 1 and seller of contract 2).
Short Selling an Option
Short selling with options is treated differently to short selling stocks. This is because an option is a contract and not a physical asset, so there is no asset which needs to be borrowed to short sell. With the above example where the investor sells their option, if the investor did not first own the option they can still be the seller.
With option contracts, the seller is simply the second party to the contract who has the obligation. Short selling an option is when the investor or trader sells an option without owing the option first.
Option short selling is a term more commonly used by market makers and professional market participants. The term Option writing is more commonly used with beginner investors and new traders instead of short selling.
When an investor or trader buys an option they are essentially buying an insurance policy. When an investor or trader short sells an option they are essentially acting as an insurance firm.
Risk Considerations with Options
Traders are attracted to the leverage - but trading options is very high risk
There are some additional risks a stock investor and especially a stock trader need to be aware off with options. The Options Clearing Corporation (OCC) has published a document called "The Characteristics and Risks of Standardized Options" which is available from the Chicago Board Options Exchange (CBOE) in a PDF format.
Most of the risks outlined in the OCC document are common sense but beginner option traders are mostly caught out by these risks.
A distinction is made here in this article between Options Trading and using options for speculative investment purposes.
Options Traders are mostly the general public who engage in what is known as options strategies. These option strategies combine various option positions together to form a strategy. This excludes the Options Market Makers who provide the liquidity so that an Options Trader can transact and obtain their options positions.
Other market participants such as stock traders, stock investors and speculators generally only enter a single option position and do so as either an alternative to physically owing the stock or as a hedging tactic.
Some of the differences between Options Traders and the other market participants are as follows:
Options Traders vs. other market participants:
- Options Traders incorporate complex option strategies involving numerous option positions. This makes it difficult to gauge the performance relative to the stock. The other market participants generally only enter a single option position and the performance is directly and easily monitored against the stock.
- Option traders are exclusively interested in the profit/loss of their option strategies. The other market participants are primarily interested in the price movement of the stock.
- Options Traders utilize their entire account to buy options and to cover the margin requirements of short sold options. The other market participants generally only utilize a small portion of their account for options and most would use less than 10% of their account.
Some stock traders such as swing traders and position traders end up abandoning buying stocks and choose instead to exclusively buy options. Any trader who exclusively buys options, even if it is purely as an alternative to directly owning stocks, is no longer a stock trader but is now an options trader.
Most of the risks associated with options trading are due to their entire account being exposed to options strategies and they have little exposure to benefits of a bull market and thus the long-term investment returns.
Comparing a stock trader to an options trader who simply buys a call option, stock traders typically spend most if not all their time on the long side during bull markets. Stock traders who short sell in bull markets typically endure considerable loss. Option traders with their ease of trading on the short side (by simply buying put options) are notorious for buying put options in bull markets and suffer the same fate.
Another difference with options traders is that stock traders base their stock exiting decisions on the movement of the stock price. They will typically use trailing stops and profit targets. Some options traders base their option exit decisions on the price movement of the option rather than on the stock.
A consideration for stock traders, investors and speculators is that of contract size. If a decision was made to buy 100 shares of a $10 stock then the position would cost $1,000. If instead it was decided to use a call option instead of buying the stock directly, a lot of beginners will try to buy $1,000 worth of options. If the option is priced at $1 per share, they end up buying 10 contracts.
The problem here is that their exposure with options is now for 1,000 shares and not the 100 shares that their decision was initially based on. Thus they are exposed to 10 times the risk.
When choosing options over directly buying stocks, if the analysis was based on stocks and a share quantity was determined, when buying an option it should be for the same number of shares. For the above example this means buying only one call option costing $100 which covers 100 shares.
There are times when an analysis indicates that 10 shares are required. This causes a problem as the standard option contract is for 100 shares. In such a case options cannot be utilized since it will increase the exposure by 10 times.
Another mistake frequently made by beginners is that they utilize too high a portion of their account for options. While there are no formal guidelines, it is generally best if options represent no more than 10% of the portfolio based on stock prices (and not on option prices).
Also beginners should refrain from buying put options in bull markets. While there are specific speculative strategies which involve put options in bull markets, these are best left to when the beginner investor or trader has more experience and market knowledge.
Beginners are also usually caught out by the time decay of options. Even if the stock price does not change, both call options and put options lose value and at expiry the time value is zero. So if an option is bought and then sold later, the option buyer is faced with a loss even though the stock price did not change.
Traders can be caught out by time decay - options
lose value even if the stock price does not change
Also the thinly traded options typically have large Bid-Ask spreads. So in addition to the time decay there is also the loss incurred from the Bid-Ask Spread.
Another consideration to be aware of is options that are Out-The-Money at expiry are worthless and the entire premium paid is forfeited. There are no refunds.
Options are generally the most actively traded when the strike prices are near the stock price. If a call option is bought At-The-Money and the stock rallies, then the option is now In-The-Money and is now probably thinly traded if traded at all. This means that the Bid-Ask spread is now wide and there may not even be a Bid to sell to. While option market makers are obliged to provide Bids and Asks for strikes near the current stock price, they are not obliged for strikes that are away form the current stock price. The option buyer is not guaranteed that they will be able to sell their option.
Short Selling Risks
There are also some considerations with short selling options as they can be exercised at any time prior to expiry for American style options. When the option short seller is exercised it is referred to as being assigned.
For a short sold call option, the short seller must provide the stock and sell it to the call option buyer at the strike price. If the short seller does not own the stock, then the option broker will generally obtain the stock for the option buyer and initiate a stock short sold position to the option short seller. This means that after the option short seller has been assigned they now have a stock short sold position.
For a short sold put option, the short seller must accept the stock and pay the put option buyer the strike price amount. The option broker will simply deduct the amount from the option short seller's account and forward it to the put option buyer's account. After being assigned, the option short seller now owns the stock.
Both of these short sold options can lead to transactions that are at extremely unfavorable stock prices.