Updated: Dec 13, 2018
by William Sabin, CPA
Mention the idea of trading options to most investors and you will get comments like ‘those are too risky’ or ‘its gambling’ or ‘I just don’t understand them’. While there are option trades that are very risky (e.g. uncovered index options) which can feel like gambling, there are a number of strategies that an individual can use to have options as part of their portfolio. Below I cover some of the basics.
In almost every option trade, I like to know what my maximum gain and maximum loss is most likely to be. Every prudent investor should know these results before entering into an option trade. In general, most of my option trades are not designed to hit a home run and get rich. Rather, I tend to trade options for smaller gains with limited risk.
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying stock at a specific price on or before a certain date.
The two types of options are calls and puts. A 'call' gives the holder the right to buy an asset at a certain price within a specific period of time. Owning a call is similar to being long (bullish) a stock. While a 'put' gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are similar to being short (bearish) a stock.
Every stock option trade is based on the use of a call, a put, or combination of both.
The price at which an underlying stock can be purchased or sold is called the strike price. This is the price a stock must go above (for calls) or go below (for puts) before a position can be exercised for a profit. All of this must occur before the expiration date.
For call options, an option is ‘in-the-money’ if the share price is above the strike price. The amount by which an option is in-the-money is referred to as intrinsic value.
The cost (the price paid) of an option is called the premium.
There is a lot more to know and that is where the risk comes in. Fortunately, the following items are most likely calculated and presented by your broker, but for a peek under the hood, keep reading.
One might ask how the premium is determined. This is where the complexity begins using things called ‘Greeks’ – delta, gamma, theta, and vega. This premium is determined by a number of factors including the stock price and strike price – the difference between these is called the intrinsic value. Delta and gamma enter into the equation here. In overly simplistic terms, the premium is the value that an option would have if it were exercised today.
Other factors include the time value remaining until expiration (theta) and the sensitivity of the price of an option to changes in volatility (vega). Theta is a measure of the time decay of an option – how much value an option loses each day due to the passage of time. I find theta and vega very useful in my trading.
If you want to get complex, read about the Black Scholes Model.
Thankfully, look up any option chain, and the value (or at least what an option is trading for) is presented to you.