As the name would suggest, options trading can provide investors with greater choice and flexibility.
Options are a type of derivative that can be used to make money from both rises and falls in asset prices. They can be used for speculation or as part of a strategy to control risk.
Options are contracts giving the holder the opportunity to buy or sell an asset at a pre-determined price (strike) and date (expiration). The word “opportunity” is important as the holder is not under an obligation to exercise their contract rights. They can simply choose to let the contract “expire” unexercised.
Once a strike price has been reached, few options buyers execute the option and buy/sell the underlying asset (perhaps just one in ten do this). Instead, the option is sold, often with the option writer offering a good price to buy the options back, closing the trade. If the option never reaches its strike price, it becomes worthless.
Once you cut through some of the jargon associated with options trading, you should be better placed to gain an understanding of how options can be effectively used. The key thing to remember with any derivative is that you don’t actually own the underlying asset.
Contract rights come at a price, with the holders of options contracts paying a non-refundable fee known as a “premium” at the initiation of their contract.
This premium, and the value of the option, are determined by the stock price, strike price, time remaining until expiration (time value) and the price volatility of the underlying asset in question – all things we’ll cover. It is hugely complex and changes over time.
The key is that the value of the option tends to increase the more likely an event becomes and decrease the less likely it is. Higher volatility increases the likelihood of a specific strike price being reached, for example. Conversely, an asset that has not fluctuated much might see its option value decline the closer to the deadline (expiration) as it becomes less likely a sudden price change will occur.
The option premium paid is crucial to calculating the profit generated from options trading as most trades are closed with the buyer selling their option at a different value.
On the bright side, our maximum loss is always limited to the premium. However, the premium’s non-refundable nature means we still lose it, even when there’s been very little movement in the underlying asset price.
Long call options
Buying a call option, known as a long call, enables the holder to use options trading to profit from rises in a given asset. Long-call contracts on a company’s stock provide the opportunity to theoretically buy its shares at a given price and within a fixed time frame.
For example, assume an option contract gives the holder the right to buy 100 shares of ABC company at a price of £180 until 30 December 2017, and suppose the stock is currently trading at £170 as of 30 October 2017. The option premium happens to be £5 per share, so £50 per option (100 shares).
In this case, £180 is the so-called “strike” price, while 30 December 2017 is the contract “expiration”. If the ABC shares move above the strike price at some point up to the 30 December then there is the potential for the holder to make a profit by closing the option – selling at its new price.
However, to calculate the profit, the option premium paid at initiation of the contract must also be factored in.
In the example of ABC, 10 long-call contracts covering 1,000 shares on 30 October would cost £5,000 (10 x £50 x 10).
Suppose the ABC share price has risen to £190 as of 5 December, and the call options have more than doubled in price to £10.50 per share.
If we were to close the position at this point, our profit from options trading would be: (1,000 x £10.50) - £5,000 = £5,500
In this example, options trading has enabled us to greatly magnify the profit impact from a rise in the shares of ABC. Although the share price only rose 5.5%, we more than doubled our initial £5,000 investment.
Long put options
Buying a put option, or taking out a long-put contract, is the opposite of buying a call option. A long-put holder can use options trading to profit from declines in the underlying share price.
For example, suppose an option contract gives the holder the right to sell 100 shares of ABC at a price of £160 until 30 December 2017, and assume the stock is trading at £170 as at 30 October 2017. The price of the option, or option premium, happens to be £5 per share, so £50 per option (100 shares).
As in the earlier example, 10 long call contracts covering 1,000 shares on 30 October would cost £5,000 (10 x £50 x 10).
Imagine the ABC share price has fallen to £150 as of 5 December, and the call options have more than doubled in price to £10.50 a share.
In the money (ITM)
In the two examples above, the options contracts are said to have been in the money (ITM) as the underlying share prices moved in the direction that the contract holder had hoped for.
However, when a contract is ITM, the holder will not always profit from exercising the contract. This is because the premium paid at initiation must be factored into the equation.
For example, imagine in the previous options trading example of the long put that the share price had fallen to £156. Suppose the options are now priced at £4.50 per share.
If we were to close the position at this point, the payoff would be: 1,000 x £4.50 = £4,500
However, although the put options contract is ITM (the share price is below the £160 strike price) if we were to exercise the contract at this point we would make a loss. This is because the premium paid at initiation was £5,000.
(1,000 x £4.50) - £5,000 = £500 loss
At the money (ATM)
When an option’s strike price is equal to the underlying stock price, an options contract on a company’s shares is said to be at the money (ATM).
We would not choose to exercise the contract in this scenario as we would lose the entire contract premium that we paid at initiation. Up to the point of contract expiration, there is still a chance that the option contract will move into an ITM position.
Bearing this in mind, both volatility and time can be thought of as the friend of an option contract holder. When share price volatility is higher, and/or there is longer to go until contract expiration, the holder has a better chance of making money from options trading.
If the stock price remains unchanged or virtually unchanged by the time of contract expiration, the holder has still lost the contract premium.
Out of the money (OTM)
As the term would suggest, an out of the money (OTM) option describes the situation where an option contract has moved against the holder.
For a long call, this means the underlying stock price is below the strike price, while for a long put the share price would be above the strike price.
If the option was still (OTM) at expiration, then the contract would expire unexercised. Again, it’s important to note that the options trading loss for the contract holder is always limited to the contract premium.
If an option is ITM, it is said to hold intrinsic value. In the options trading case of an ITM contract, the intrinsic value per share is simply the difference between the underlying stock price and the strike price of the options contract.
In the example of our long-call contract from above, the intrinsic value per share on 5 December is:
£190 - £180 = £10
If an option contract happens to be OTM or ATM, the intrinsic value is always zero. It can never be negative, as losses for the contract holder will not exceed the contract premium. OTM or ATM options expire worthless for the holder.
In options trading, a time value generally applies to an option when it is trading above its intrinsic value.
Therefore: time value = current option price – intrinsic value
In the example of our long-call contract from above, the time value per share on 5 December is:
£10.50 - £10 = £0.50
Putting it another way, the time value is a premium that investors are prepared to pay at a given point in time to acquire the option over its current exercise value.
Why would investors pay a premium, defined as time value? Because the longer an option has until its expiry, the more chance there is that the underlying share price will have moved to the contract holder’s advantage.
Thus, time value and the overall value of an option diminish the nearer a contract gets to expiration.
The type of options that most of us will encounter in options trading, and the examples given earlier in this article, are defined as being “American” options.
An American option is simply one that can be exercised at any point up to and including the date of contract expiration.
The term does not relate to geographical location. For instance, most of the options traded in Europe are also American options.
Conversely, the so-called “European” option has a lot less flexibility in options trading terms versus an American option. European options therefore tend to be less valuable.
Unlike American options, European options can only be exercised at contract expiration.
Given the constraints, European options are niche products that tend to be the domain of over the counter trades between institutions. Again, the term has nothing to do with geographical location.
A Bermuda option combines some of the options trading traits of both American and European options.
Just like European options they can be exercised at expiration. However, they do exhibit some of the flexibility enjoyed by the holders of American options in that they can also be exercised on specific dates during the contract term.
This situation still falls well short of the opportunities afforded by American options, which can be exercised at any time during the term of the contract.
In options trading valuation terms, Bermuda options sit somewhere between American options at the top and European options at the bottom.
The earlier options trading examples in this article dealt with the more common scenarios where investors choose to purchase contracts to benefit from potential upside or downside in share prices.
However, it is also possible to become the seller of a put or call option, or the “writer” of such contracts as the practice is termed.
As the writer, we always get to keep the premium the buyer pays at the initiation of the contract. However, writing options is certainly not for widows and orphans.
Becoming the writer of a call option means our losses from options trading are potentially unlimited.
In theory, there is no limit to an asset price’s upside. While this is good news for the buyer of a call option, it represents significant downside risk for the writer of the same contract.
As the writer of a put option, our potential losses are again, eye-wateringly large. There is, however, an upper limit to our losses in this situation, simply because an asset’s price cannot fall below zero.
There are numerous strategies that can be used in options trading.
One of the most popular of these is the protective put strategy. It can be thought of as a sort of insurance policy against falls in an asset that we own.
From the earlier example in this article, we know that acquiring a put option can enable us to profit from falls in share prices.
Suppose we hold a stock in our portfolio that we think could fall because of an upcoming company announcement. We believe the shares are a good investment in the long-term, so we do not choose to sell our holding outright.
Buying put options on the shares that we simultaneously own means we can offset losses from any short-term price weakness through the profits generated by our long-put position.
In this case, the cost of purchasing the put option is akin to an insurance premium.