Options Basics for Buyers
Learning how to trade options is something best digested in small bites. Let’s start with a quick review of options basics. A standardized option contract is a two-sided contract where one side (buyer or holder) has the right to buy or sell 100 shares of common stock, index or ETF, and the other side (seller or writer) has the obligation to buy or sell 100 shares of common stock, index or ETF . The particulars of every options contract are:
- Call or Put. From only the buyer’s perspective – a call option is the right to buy the underlying shares of a certain common stock, stock index or ETF at the Strike Price, and a put option is the right to sell the underlying shares at the Strike Price.
- Expiration Date. All money owed is automatically settled on the Expiration Date between OCC and its clearing members. and all rights and obligations with respect to that options contract, and the options contract itself, expire and cease to exist at the close of business on the options expiration date.
- Strike Price. The price per share at which the common stock, stock index or ETF can be bought or sold. Also called the Exercise Price.
- Option Price or Premium. The amount paid (buyer) or received (seller) at any particular time to establish the options contract. With very few exceptions listed options represent exactly 100 shares of the underlying security so multiply the Option Price x 100 to get the actual Premium, i.e. 4.15 = $415.00.
All option contracts traded on the various securities exchanges in the United States are issued, guaranteed and cleared by the Options Clearing Corporation (OCC). This guarantee eliminates counterparty credit risk and provides transactional liquidity to both buyers and sellers.
Options are listed securities and can be bought and sold in a securities brokerage account just like common stock. Transactions take place in a competitive auction market with bids and offers. Option prices are quoted throughout the trading day by brokerage firms and by many other equity data providers.
Swing Traders Avoid Options Exercise
Standardized option contracts are American style options. Either the buyer or the seller can close out his position before the Expiration Date by making an offsetting transaction of an identical option contract. A closing transaction cancels out all the rights and obligations of that options trader with respect to the original transaction. Swing traders who use options as a substitute for stock will almost always close out their positions before expiration to avoid the hefty transaction costs associated with exercise.
Understanding Option Pricing
An option’s price (premium) at any moment in time is derived from a mathematical formula published in the early 1970s called the Black-Scholes model. There are six inputs to the model. The four most essential inputs to the Black-Scholes model are:
- Price of the underlying security
- Strike Price of the option
- Days remaining until expiration
- Implied volatility
You never have to know the actual equation to learn hot to trade options successfully but you must have a solid understanding of how each of these variables affects option pricing. Since we’re working on small bites our explanation will cover these four options pricing variables only from the perspective of an option buyer who is using the option as a substitute for trading directly in the stock, index or ETF.
Buying a Call option is a long trade. You can benefit only if the price of the underlying security increases in price. Buying a Put option is a short trade. You can benefit only if the the price of the security decreases.
Just like buying or selling the stock, index or ETF but with one huge difference. Option prices almost never increase/decrease 1:1 with the underlying security prices. Perhaps you have purchased a Call option and watched the stock price increase by $1.00 only to see that the option price has increased by only a couple pennies, or maybe even decreased by the same amount. What’s that all about?
Delta is the amount an option premium can be expected to change for every $1.00 change in the underlying security. Delta values range from 0.00 to 1.00 for Call options and 0.00 to -1.00 for Put options. Delta is often expressed as a percentage. For example, if you buy a Call option with a 30% Delta and the underlying stock increases by $1.00 you can expect the option premium to increase by $.30 ( everything else being equal).
Delta is about .50 for an at-the-money Strike Price, e.g. APPL stock is 150.00 and the Call option is the 150 Strike. Delta gets lower the further the Call Strike is above the stock price (out-of-the-money) and higher the further the Call Strike is below the stock price (in-the-money).
Delta is a very important element of learning how to trade options. It also has some other really special characteristics that you have to know about. We will cover those in additional articles.
Option Theta (Time Decay)
Every options contract has an expiration date. As the option moves closer to its expiration date the statistical probability that the underlying stock will increase or decrease X amount from its current price decreases.That means that the option premium will decrease by some amount each and every day closer to the expiration date regardless of the additional effect of movement in the stock price. The amount of that consistent decrease in the option premium is called Theta and it is calculated from the pricing model.
Theta increases (option premium loses value) as a dollar amount and as a percentage amount of the option premium each day closer to expiration. This is not the formula but it is a handy way to look at Theta. If an option price at $1.00 has 30 days until expiration then expect that option price to be 1/30 (-3.3%) less tomorrow. If there were 20 days to expiration then expect a decrease of 1/20 or -5%. Theta never-ever increases the option price. Time decay of option prices is a one way, downhill trip to 0.00.
Option Implied Volatility
We mentioned there were six inputs to the option pricing equation. The two missing inputs are the short term interest rate and the dividend yield on the underlying security. We bring them up now only to make the point that out of the six inputs to the options pricing formula five can be objectively determined from easily obtained data. The one that cannot is implied volatility, and it’s a doozy.
When it comes to options pricing you often see the qualification “all other things being equal.” That’s mostly because the premium of an options contract is a constantly moving target, or six moving targets. Implied volatility is the market’s best guess at how far and how fast those other five targets will move during the life of the option contract.
Implied volatility can have a huge impact on option premiums “all other things being equal.”