What is an option?
An option is a contract to buy or sell a specific financial product officially known as the option’s underlying instrument or underlying interest. For equity options, the underlying instrument is a stock, exchange-traded fund (ETF), or similar product. The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted on. And it has an expiration date. When an option expires, it no longer has value and no longer exists.
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.
Buying & Selling
If you buy a call, you have the right to buy the underlying instrument at the strike price on or before the expiration date. If you buy a put, you have the right to sell the underlying instrument on or before expiration. In either case, as the option holder, you also have the right to sell the option to another buyer during its term or to let it expire worthless.
The situation is different if you write, or “sell to open”, an option. Selling to open a short option position obligates you, the writer, to fulfill your side of the contract if the holder wishes to exercise. When you sell a call as an opening transaction, you’re obligated to sell the underlying interest at the strike price, if you’re assigned. When you sell a put as an opening transaction, you’re obligated to buy the underlying interest, if assigned. As a writer, you have no control over whether or not a contract is exercised, and you need to recognize that exercise is always possible at any time until the expiration date. But just as the buyer can sell an option back into the market rather than exercising it, as a writer you can purchase an offsetting contract, provided you have not been assigned, and end your obligation to meet the terms of the contract. When offsetting a short option position, you would enter a “buy to close” transaction.
At a Premium
When you buy an option, the purchase price is called the premium. If you sell, the premium is the amount you receive. The premium isn’t fixed and changes constantly – so the premium you pay today is likely to be higher or lower than the premium yesterday or tomorrow. What those changing prices reflect is the give and take between what buyers are willing to pay and what sellers are willing to accept for the option. The point at which there’s agreement becomes the price for that transaction, and then the process begins again.
If you buy options, you start out with what’s known as a net debit. That means you’ve spent money you might never recover if you don’t sell your option at a profit or exercise it. And if you do make money on a transaction, you must subtract the cost of the premium from any income you realize to find your net profit.
As a seller, on the other hand, you begin with a net credit because you collect the premium. If the option is never exercised, you keep the money. If the option is exercised, you still get to keep the premium, but are obligated to buy or sell the underlying stock if you’re assigned.
The Value of Options
What a particular options contract is worth to a buyer or seller is measured by how likely it is to meet their expectations. In the language of options, that’s determined by whether or not the option is, or is likely to be, in-the-money or out-of-the-money at expiration. A call option is in-the-money if the current market value of the underlying stock is above the exercise price of the option, and out-of-the-money if the stock is below the exercise price. A put option is in-the-money if the current market value of the underlying stock is below the exercise price and out-of-the-money if it is above it. If an option is not in-the-money at expiration, the option is assumed to be worthless.
An option’s premium has two parts: an intrinsic value and a time value. Intrinsic value is the amount by which the option is in-the-money. Time value is the difference between whatever the intrinsic value is and what the premium is. The longer the amount of time for market conditions to work to your benefit, the greater the time value.
Several factors, including supply and demand in the market where the option is traded, affect the price of an option, as is the case with an individual stock. What’s happening in the overall investment markets and the economy at large are two of the broad influences. The identity of the underlying instrument, how it traditionally behaves, and what it is doing at the moment are more specific ones. Its volatility is also an important factor, as investors attempt to gauge how likely it is that an option will move in-the-money.
Benefits and Risks
Most strategies that options investors use have limited risk but also limited profit potential. For this reason, options strategies are not get-rich-quick schemes. Transactions generally require less capital than equivalent stock transactions, and therefore return smaller dollar figures – but a potentially greater percentage of the investment – than equivalent stock transactions.
Even those investors who use options in speculative strategies, such as writing uncovered calls, don’t usually realize dramatic returns. The potential profit is limited to the premium received for the contract, and the potential loss is often unlimited. While leverage means the percentage returns can be significant, here, too, the amount of cash changing hands is smaller than with equivalent stock transactions.
Although options may not be appropriate for everyone, they’re among the most flexible of investment choices. Depending on the contract, options can protect or enhance the portfolios of many different kinds of investors in rising, falling, and neutral markets.
Reducing Your Risk
For many investors, options are useful as tools of risk management, acting as insurance policies against a drop in stock prices. For example, if an investor is concerned that the price of his shares in LMN Corporation is about to drop, he can purchase puts that give him the right to sell his stock at the strike price, no matter how low the market price drops before expiration. At the cost of the option’s premium, the investor has insured himself against losses below the strike price. This type of option practice is also known as hedging. While hedging with options may help you manage risk, it’s important to remember that all investments carry some risk, and returns are never guaranteed. Investors who use options to manage risk look for ways to limit potential loss. They may choose to purchase options, since loss is limited to the price paid for the premium. In return, they gain the right to buy or sell the underlying security at an acceptable price for them. They can also profit from a rise in the value of the option’s premium, if they choose to sell it back to the market rather than exercise it. Since writers of options are sometimes forced into buying or selling stock at an unfavorable price, the risk associated with certain short positions may be higher.
Many options strategies are designed to minimize risk by hedging existing portfolios. While options can act as safety nets, they’re not risk free. Since transactions usually open and close in the short term, gains can be realized very quickly. This means that losses can mount quickly as well. It’s important to understand all the risks associated with holding, writing, and trading options before you include them in your investment portfolio.
Risking Your Principal
Like other securities – including stocks, bonds, and mutual funds – options carry no guarantees, and you must be aware that it’s possible to lose all of the principal you invest, and sometimes more. As an options holder, you risk the entire amount of the premium you pay. But as an options writer, you take on a much higher level of risk. For example, if you write an uncovered call, you face unlimited potential loss, since there is no cap on how high a stock price can rise. However, since initial options investments usually requires less capital than equivalent stock positions, your potential cash losses as an options investor are usually smaller than if you’d bought the underlying stock or sold the stock short. The exception to this general rule occurs when you use options to provide leverage: Percentage returns are often high, but it’s important to remember that percentage losses can be high as well.
Main Components of an Options Premium
The premium of an option has two main components: intrinsic value and time value.
Intrinsic Value (Calls):
When the underlying security’s price is higher than the strike price a call option is said to be “in-the-money.”
Intrinsic Value (Puts):
If the underlying security’s price is less than the strike price, a put option is “in-the-money.” Only in-the-money options have intrinsic value, representing the difference between the current price of the underlying security and the option’s exercise price, or strike price.
Prior to expiration, any premium in excess of intrinsic value is called time value. Time value is also known as the amount an investor is willing to pay for an option above its intrinsic value, in the hope that at some time prior to expiration its value will increase because of a favorable change in the price of the underlying security. The longer the amount of time for market conditions to work to an investor’s benefit, the greater the time value.
Factors Influencing Options Premium
The factors having the greatest effect are: A change in price of the underlying security Strike price Time until expiration Volatility of the underlying security Dividends/Risk-free interest rateDividends and risk-free interest rate have a lesser effect.
Changes in the underlying security price can increase or decrease the value of an option. These price changes have opposite effects on calls and puts. For instance, as the value of the underlying security rises, a call will generally increase and the value of a put will generally decrease in price. A decrease in the underlying security’s value will generally have the opposite effect.
The strike price determines whether or not an option has any intrinsic value. An option’s premium (intrinsic value plus time value) generally increases as the option becomes further in the money, and decreases as the option becomes more deeply out of the money.
Time until expiration, as discussed above, affects the time value component of an option’s premium. Generally, as expiration approaches, the levels of an option’s time value, for both puts and calls, decreases or “erodes.” This effect is most noticeable with at-the-money options.
The effect of volatility is the most subjective and perhaps the most difficult factor to quantify, but it can have a significant impact on the time value portion of an option’s premium. Volatility is simply a measure of risk (uncertainty), or variability of price of an option’s underlying security. Higher volatility estimates reflect greater expected fluctuations (in either direction) in underlying price levels. This expectation generally results in higher option premiums for puts and calls alike, and is most noticeable with at-the-money options.
The effect of an underlying security’s dividends and the current risk-free interest rate have a small but measurable effect on option premiums. This effect reflects the “cost of carry” of shares in an underlying security — the interest that might be paid for margin or received from alternative investments (such as a Treasury bill), and the dividends that would be received by owning shares outright.
*Courtesy of The Options Industry Council