Trader Network Co

OPTIONS – INSURANCE FOR YOUR PORTFOLIO

In the previous post, we learnt about derivatives and Futures in particular and its use in hedging and speculation. In this article, we shall explore a complex derivative product which enjoys immense popularity as well as hate at the same time and is widely used across the industry for portfolio management as well as for speculation. I am talking about Options.

Options are derivative products that give the buyer a right to transact in the underlying at a fixed price (strike rate) and on a specified date but does not obligate him to do so. The seller of options however is obligated to transact if the buyer exercises his/her right to transact and take the opposite end of the transaction. For e.g. if a buyer of an option exercises the right to buy the underlying stock, the seller has to sell that underlying stock to the buyer at the agreed upon strike on the specified date. However, no right comes for free. To enjoy this right, an option buyer has to pay a premium to the option seller. Like all derivative contracts, options too have a set date on which the contracts expire known as maturity date. If the buyer does not exercise his right and does not transact before expiry, the seller gets to keep the entire premium. This is the basic principle of options.

Now hold on tight and pay attention, because life is not that simple and this won’t be too. There are two types of options: Call Options henceforth referred to as Calls and Put Options henceforth referred to as Puts.

Call Options

A Call Option or Call gives the buyer of this option the right to buy the underlying asset at a fixed strike rate and at a specified date depending on the option in question. For e.g. a call option of Apple with strike $140 expiring in March 2021 (in USA expiries are the third Friday of the contract month, in this case 3rd Friday of March 2021 which is 19th March 2021) allows the buyer of that call to purchase Apple for $140 either on expiry or before depending on the option in question. The seller of that call will have to sell Apple for $140 to the option buyer. 

In options, text can be too confusing. Let us look at certain numbers to understand this well.

For the first example of a call option

Option Type Quantity Strike Premium paid per stock Price of stock at expiry Option Buyer Profit/Loss Option Seller Profit/Loss
Call
100
140
3
130
-300
300
Call
100
140
3
135
-300
300
Call
100
140
3
140
-300
300
Call
100
140
3
143
0
0
Call
100
140
3
145
200
-200
Call
100
140
3
150
700
-700
Call
100
140
3
155
1200
-1200

In the above case, the option buyer pays a premium of 3 per share to purchase a call of Strike $140. The size of one contract is 100 shares. The option seller receives that premium and if the stock price stays below $140 till expiry, he/she gets to keep the entire premium. The option buyer has the option to exercise his/her right to purchase the stock at $140 only when the stock price moves above $140. It would not make sense to exercise it below $140 since he can buy it for cheap in the market. It is only when it moves above $140 that the option buyer can exercise. In the above example, if the stock moves to $145, the option buyer will exercise his right to purchase at $140 and then on receiving the stock, sell it into the market at $145. His net profit however will not be ($145-$140)*100 = $500 but ($145-$140-$3)*100 = $200. The premium that was paid is not refunded. It belongs to the option seller. For the option seller, he has to sell the stock at $140. Assuming he doesn’t have the stock, he will have to purchase it from market at $145 and sell it at $140. His net loss however will not be $500 but ($140+$3-$145)*100 = -$200. He has the cushion of premium. Effectively, profit and loss will be dependent on premium paid. Higher premium paid is a smaller profit for the buyer but a larger profit for the seller and vice versa. Considering the premium paid, the option buyer and seller will technically breakeven when the stock price is $143. He will not be able to exercise the option at $141 or $142 even if it is above $140 because of the premium paid.

Here is the payoff chart for a call option buyer and seller:

Trader Network Co image1 What is Option Trading Essentials
Trader Network Co unnamed What is Option Trading Essentials

As one can see, for an option seller, the profits are limited but losses are unlimited and for an option buyer, profits are unlimited but loss is limited.

Put Options

A Put Option or Put gives the buyer of this option the right to sell the underlying asset at a fixed strike rate and at a specified date depending on the option in question. Let us take the same example, a put option of Apple with strike $130 expiring in March 2021 which allows the buyer of that call to sell Apple at $130 either on expiry or before depending on the option in question. The seller of that put will have to buy Apple for $130 from the option buyer.

In options, text can be too confusing. Let us look at certain numbers to understand this well.

For the first example of a put option

Option Type Quantity Strike Premium paid per stock Price of stock at expiry Option Buyer Profit/Loss Option Seller Profit/Loss
Put
100
130
3
140
-300
300
Put
100
130
3
135
-300
300
Put
100
130
3
130
-300
300
Put
100
130
3
127
0
0
Put
100
130
3
125
200
-200
Put
100
130
3
120
700
-700
Put
100
130
3
115
1200
-1200

The option buyer pays the premium and the option seller receives it. The seller gets to keep the premium if the stock price stays above $130 till expiry. The breakeven point is $127. Once the stock moves below $127, the option buyer can exercise for a profit and the option seller has to deliver it at a loss. Say the stock price has moved to $125. In this case, the option buyer will exercise his right to sell the stock at $130 and the option seller has to purchase it from the option buyer at that price. The profit for option buyer is ($130-$125-$3)*100 = $200. Similarly the loss for option seller is ($125+$3-$130) = $200.

One thing you must have observed from the above two examples is the asymmetric nature of risk in this. The maximum risk for the option buyer is the premium paid. He doesn’t lose any more than that. Suppose you purchase 100 qty. of a stock at $100. Now if the stock falls to $50, you are in a loss of $5,000. However if in the same case you purchase a call option for strike $100 for a $3 premium, your maximum input is $300. If the stock now falls to $50, the maximum you stand to lose is $300. The option seller on the other hand is exposed to unlimited risk. If he has sold a call of $100 for $3. If the stock tomorrow goes to $200, he has to bear the entire loss in this case ($200-$3)*$100 = $19,700. Profits on the other hand are not capped for the buyer. A buyer has purchased a call option of strike $100 and a premium of $3. If the stock goes to $200, the profit of the buyer is $19,700. However the profit of the option seller is capped at the premium received. If the option is not exercised, he gets the premium. 

Here is the payoff chart for put option buyer and seller

Trader Network Co image3 What is Option Trading Essentials
Trader Network Co image3-1 What is Option Trading Essentials

So the summary is for an option buyer: Loss is limited and profit is unlimited. For option seller: Profit is limited but loss is unlimited. Why then, you would ask, does anybody sell options? The answer to it lies in probability of success and failure and risk management, an advanced topic which we shall cover in later posts.

At the Money, In the Money and Out of the Money

Options based on their strike price and the current price of the underlying are described as being In The Money (ITM), At The Money (ATM) and Out of The Money (OTM). To understand this, we must understand what constitutes option premium. In broad terms Option Premium = Intrinsic value + Time value. Time value is the time to expiry for that option contract. Intrinsic value is the value of option that will be realized if it were to be exercised in the market. As usual this shall be better understood with an example. We would like to inform you that option pricing is an advanced subject and we will be exploring that plus option Greeks in later posts but for now we focus on intrinsic and time value. Let us consider a stock trading at $130 and three call options with strike $125, $130 and $135. For the first option with strike $125, the underlying is already trading at $130. So if someone were to buy this option and exercise in the market immediately, they would realize $5 in profit. This option is known as an In The Money option also known as ITM option since this can already be exercised. Its intrinsic value is $5 and it will have little time value since this is already ITM. Similarly the option with strike $130 is considered At The Money or ATM since the strike is at the spot. The premiums of this option have little to no intrinsic value and significant time value. Most of the liquidity in options market is concentrated in ATM options as they tend to have the highest sensitivity to underlying price movements as well as Option Greeks. The option with strike at $135 is considered Out of The Money or OTM option. It has no intrinsic value and its premium consists only of time value. An OTM option is preferred if a significantly large move is expected. On expiry all OTM options become worthless and expire at 0.

American and European Options

There are two styles of options traded in the world today based by their exercise methodology. European options which are traded around the world can only be exercised at expiry. You can trade freely in them, buying and selling them and closing out your contracts at any time until expiry and on expiry ITM options are exercised. This is the most widely used option style across the world. 

American options are those which can be exercised anytime they are ITM. One need not wait till expiry to do so. American options are primarily used only in USA.

Valuation of Options

Options are complex products and there is no concrete way to value them. There are several theories and models based on various statistical assumptions and probabilistic distributions. In fact some of you may come up with your own option pricing model as well and it will succeed too, if it is accurate in representing market behavior. We shall learn in depth about option valuation in subsequent posts, but let me introduce you to one popular option pricing model known as the Black Scholes Model.

The Black Scholes Model was derived by Fischer Black and Myron Scholes for which they were awarded a Nobel Prize in 1997. It assumes market to have a normal probability distribution (the bell curve as we have come to know it) and derives a partial differential equation that gives the value of European call and put options over time. While the equation is too complex to be covered here, it introduces various parameters (known as Option Greeks) that affect the value of options such as Volatility (Implied Vol or IV), time to expiry (Theta), Change in Volatility (Vega), change in price of underlying asset (Delta) and rate of change of delta (gamma) amongst many others.

How options came to be used in the GameStop drama

A lot of hedge funds were short GameStop and the short interest was quite high, about 130% of the available float in the market. Float is the shares available for trading. So in effect, there were about 130 shares that were short for about 100 shares in the market. This is a dangerous scenario for shorts as if a sudden price rise comes, they will have to rush to buy the shares to deliver them back. A bunch of retail traders like you and me realized this and started buying all the shares they could find. So when the short squeeze began, there were just not enough shares available in the market and the price of GameStop began to rise. Those wishing to purchase GameStop and squeeze the shorts more were unable to get their hands on any stock. So alternatively, they started buying Call options. Those that sold call options had two choices, either buy and keep the stock now in case the option is exercised in the future, or buy it at a later date when the price has risen and the option is exercised. It was obvious what the choice was. This became a self-fulfilling prophecy as the call writers also added their stock buys to the existing retail buyers and the shorts who by then had begun to realize the loss they were in and scrambled to the exits.

We shall learn in detail about option pricing using Black Scholes and Binomial model, exotic options and some option strategies in subsequent posts. Options can be traded on the stock exchange through your broker. So if you haven’t opened your brokerage account yet, try out Interactive Brokers and TD Ameritrade. They are reliable, efficient and advanced online brokers with a plethora of advanced analytical tools at your disposal. Go ahead and open one right now and we will see you in the next post where you can apply our strategies using your newly created account.