Part 1 – Types and Pricing
Control, Leverage, and Managing Risk
Investors, entrepreneurs, and other wealthy individuals use a variety of tools to control assets, leverage their investments, and manage their risk profile. Often times these are done through various types of contracts called derivatives. Options are my absolute favorite. Welcome to Options Trading for Beginners!
The information provided here is for educational purposes. Neither Investors Compound nor contributors or authors are investment advisers and none of the information herein should be interpreted as financial or investment advice.
Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk. Before trading options, please read Characteristics and Risks of Standardized Options. Copies of this document may be obtained from your broker, from any exchange on which options are traded, or by contacting The Options Clearing Corporation.
Examples in this presentation do not include transaction costs (commissions, margin interest, fees) or tax implications, but they should be considered prior to entering into any transactions.The information in this presentation, including examples using actual securities and price data, is strictly for illustrative and educational purposes only and is not to be construed as an endorsement or recommendation.
No strategy is a guaranteed success, and you are responsible for doing adequate research and making your own investment choices. Please note: All equity options examples represent a standard contract size of 100 shares.Options are not suitable for all investors.
Leverage through Control
“Own nothing, control everything.”
— John D. Rockefeller
John D Rockefeller is known as one of the wealthiest Americans of all time. Learning about his business philosophy shows us the power of options (on a much smaller scale.) While I don’t care to go in to a history lesson about the Rockefeller legacy, it is important to note his opinion of control vs ownership.
What are Options Contracts
An option is a contract to buy or sell an underlying asset or interest in an asset. For equity options, the topic here, the underlying asset is a stock, exchange traded fund (ETF), or stock index. The contract itself establishes a number of assets, specific price (Strike Price) at which the contract may be exercised, or acted on. An options contract has an expiration date and when an option expires, it no longer has value and no longer exists.
For example, let’s imagine that I want to invest in Amazon.com. As of the time of this article, Amazon is just over $1,800. While I love Amazon and think that it is a relatively safe company to invest in… that’s quite a bit of money. Also, because it’s a lot of money… it has to move $18 for a 1% gain. This is a much bigger movement than a stock like GE that is trading around $9. A $1 move is over 10%. Most investors consider Amazon a more solid/predictable choice of GE though.
Instead of investing your small nest egg in a share or two of Amazon.com, you could purchase an options contract for Amazon.com. While you wouldn’t own the actual share of the company, you would control a contract that is related to the value of Amazon for a much smaller price but gain (or lose) from the movement of the price of the underlying asset.
Equity options are contracts that are structured with rights or obligations to buy 100 shares of the underlying asset at a certain price by a certain future deadline. This predetermined price is the “strike price” and the deadline is known as the “expiration date.”
As an example, we will look at a hypothetical company called “A Big Company” or ABC stock. Currently ABC is trading at $100/share and you believe that the price is on the rise and may rise to $120 over the next few months. If you had $500 that you were willing to invest in ABC, you could see an equitable gain in your investment from $500 to $600 if the price rose to $120. Not too shabby.
What if you could purchase 100 shares, or turn $10,000 in to $12,000? That would be even better!
A standard options contract is usually created to control 100 shares of the underlying asset, but this control will cost you a premium. The premiums vary based on a variety of factors, but let’s say that an option to purchase 100 shares of ABC, at $100/share (strike price,) at some point over the next 2 months is going to cost you a premium of $200. Remember, the option is a right and not an obligation, so you do not have to purchase the option if the stock moves against you. This means that the most money that you could lose is $200 if you let the option expire worthless after the expiration date. If the stock moves as expect though, every dollar that the option gains can make that option raise in value of $100. If the stock rises to $120 before expiration, you could gain $2,000 without ever owning the underlying stock.
Now, I know what you’re thinking… where am I going to come up with the $10,000 to purchase the shares in 2 months? Well, you just sell the options contract to someone who wants to exercise the option. More on that later though. This is just one of two types of options… the Call Option. Now this doesn’t take in to account for brokerage commissions, exercise fees, or any other costs that may be associated with trading options, but I recommend checking out the commissions free brokerage, Robinhood, for trading options without having to pay brokerage commissions.
Types of Options
Options come in two varieties, calls and puts, and you can buy or sell either type. You make those choices—whether to buy or sell and whether to choose a call or a put—based on what you want to achieve as an options investor.
Call options give the buyer the right, but not the obligation, to buy the underlying shares at a predetermined price, on or before an expiration date. If you sell (write) a call option, you do have the obligation to sell the underlying shares if exercised though. Call options should raise in value as the underlying asset raises in price.
Put options give the buyer the right, but not the obligation, to sell the underlying shares at a predetermined price, on or before an expiration date. If you sell (write) a put option, you do have the obligation to sell the underlying shares if exercised though. Put options should raise in value as the underlying asset falls in price.
An easy way to remember the difference is a simple mnemonic I’ve created…
“Call them up and Put them down.”
Something to note, is that most of the time it is difficult to invest in the stock market and benefit from the prices falling (shorting the market.) This can only be done by “borrowing” shares to sell at a higher price and purchasing them in the future at a lower price. This can only be done on margin accounts which usually requires much more capital. Investors can now invest in downward trending markets with Put Options.
Understanding Premiums Pricing
Premiums are the purchase price paid to buy the option. If selling an option, the seller receives the premium. Premiums are determined by two major factors.
1. Intrinsic Value
Intrinsic value is the difference between the exercise price of the option and the market price of the underlying shares at any given time. For instance, a call option with a $99 strike price of ABC trading at $100 will be worth $100. This is figured by the difference between the Current Price – Strike Price X Number of Shares controlled by the contract.
At the Money Strike Prices
If a call option, one that gains when the underlying stock goes up in price, has a strike price the same as at the current trading price, it is said to be an “At the Money” strike price. A put option with a strike price the same as the currently traded price is also “At the Money” and will gain in value if the price of the underlying stock falls in value.
In the Money Strike Prices
If a call option, one that gains when the underlying stock goes up in price, has a strke price below the current trading price, it is said to be an “In the Money” strike price. A put option with a stike price above the currently traded price is also “In the Money” and will gain in value if the price of the underlying stock falls in value.
At the Money and In the money options should gain or lose value about of a ration of around 100:1. This means that an In The Money Call Option of $99 of a stock that is currently worth $102 should be worth around $300.
Out of the Money Strike Prices
If a call option has a strike price above the current trading price, it is said to be an “Out of the Money” strike price and has no intrinsic value.
2. Extrinsic Value
The amount of money that you pay for the possibility that the market might move in your favor during the life of the option. The biggest contributors to Extrinsic Value are Time Value and Volatility,
Time Value will vary with In the Money, At the Money, and Out of the Money options. The closer an options contract gets to the expiration date, the less likely that an Out of the Money option will become profitable. The time value declines. This is called time decay. This does not happen at a constant rate, but happens more rapidly, the closer the contract gets to the expiration date. Options with further out expiration dates likely have a greater premium due to a higher time value.
Volatility is a measurement of the degree of fluctuation of the price of the underlying asset. Volatility is computed as the annualized standard deviation of daily percentage price changes of the security and is expressed as a percentage. The mathematics models used to determine various types of volatility can be very advanced, but most brokerages and screeners will display measurements of Volatility
Historical Volatility (HV)
Historical volatility measures the fluctuation of the underlying asset or security in the past. To compute historical volatility, you must first define a look-back period. When the underlying asset’s price moves more than normal, there will be a rise in Historical Volatility. It may be measured anywhere between 10-180 trading days.
Implied Volatility (IV)
Implied volatility is the volatility as implied by the market price of the options contract. The implied volatility is calculated using an option pricing model using a mathematical relationship between the volatility of the options price and underlying security or asset.
Implied volatility is the market’s opinion of the volatility of the underlying asset can be affected by various factors:
- The price of the underlying asset
- The strike price of the option
- The expiration date of the option
- In some instances, interest rates and dividend yield may affect implied volatility
Most trader look to buy options with low implied volatility and sell options with high implied volatility.
Now that we have a better understanding of what options are and how they are priced, we will cover various trading strategies in the next lesson of the series. While options can be purchased as individual, directional investment tools, there are various types of positions (spreads) that can be created to reduce the costs and risks associated with options trading. See you next time.
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