Option Contract

A derivative security that is priced based on an underlying asset. In other words, a highly levered financial instrument that can be used to create a profitable portfolio in a number of market
conditions. I am going to explain a number of different options strategies and
terminology from easiest to more complicated.

Some advantages of using equity options in your portfolio:

  • Options require less initial capital outlay
    rather than outright purchasing stock
  • Options can be used to hedge direction and
    systematic risk of an entire portfolio
  • There are option trading strategies that can
    perform in falling, sideways or rising markets

Call Option

A call option is speculative bullish
position that will increase in value if the underlying stock or ETF does. One
option contract is equivalent to buying 100 shares of stock if exercised by the
option holder. The price of an option contract is based on the strike price of
the specific option security and the implied volatility. Call options have a
limited downside which is the price you pay for an option contract. Calls also
have an unlimited upside, meaning that if underlying security continues to
rise, so will your option contract.

 

 

 

 

Call Option on the SPY

Expiration

All equity option contract trade for a definite amount of time. Option contracts have varying amounts of time to “expiration” from as little as one day to two years. An option contract can not be held forever and when the specific option contract is approaching expiration date, the contract will have either exercise or assignment rights. If you hold a long call or put option, you have the right to exercise the contract and either purchase 100 shares of underlying stock for 1 call option contract or sell 100 shares of underlying for 1 put option contract. If you are short a call or put option, you sold a contract with an assignment clause. This assignment clause says you are paid a premium from the option contract to either sell 100 shares of underlying stock at a specified strike price for a short call option or buy 100 shares of underlying stock at a specified strike price for a short-put option. Option expiration for standard equity options is on the third Friday of the month. Option contracts can expire weekly, or semi weekly… It depends on the specific underlying. The more popular an underlying security, a variety of different expiration’s will trade.

 

 

 

The red circle shows various expiration dates

In the money, at the money or out of the money?

If an option is “in the money”, this means the strike price is less than the share price of the underlying when
owning a call option. In the money call options are considered less speculative
than “at the money” or “out of the money” call options.
Depending on the option contracts delta, you can determine how the option
security appreciates compared to shares in the underlying stock. An example is if
you own an “in the money” call option with a delta of 80, the call
option will increase or decrease for every dollar movement in the underlying
stock as if you owned 80 shares of underlying stock. The delta metric also
tells investors what the probability is for an option to expire in the money.
For an option contract with a 80 delta, there is an 80% probability (give or
take a few percent for tail risk) that the option will expire “in the
money”. Options traders use “in the money” call options to
capitalize on a share price appreciation, while outlaying more money (still
less than outright buying shares) to ensure a higher probability the option
contract won’t expire out of the money and capture a levered gain in the option
contracts.

 

 

 

The purple highlighted contracts are in the money

At the Money

An option that is “at the money” means the strike price of the option contract is the same as the underlying
share price. Options that are at the money have a 50 delta or 50/50 probability
to expire in the money, or profitable. At the money call options are considered
a coin flip and used by investors when they want to outlay minimal capital to
capture a levered gain if the share price appreciates.

 

 

 

The blue highlighted contract is at the money

Out of the Money

An option that is “out of the money” means the strike price is greater than the underlying share price.
This is the most speculative option trade because you need the underlying share
price to appreciate “in the money” for your option security to become
profitable at expiration. Often times investors who purchase large amounts of
“out of the money” call options are betting on a large share price
move and are considered gamblers by most knowledgeable investors.

 

 

 

The black contracts are out of the money

Intrinsic Value

Intrinsic value is the value of the option contract that is in the money. This is tangible value in the option contract and will remain once the option contract expires. An example of intrinsic value
is if you own a call option contract with a strike price of $9 per share and
the current share price of the underlying stock is $10 per share as well. The
option contract has $1 dollar of intrinsic value, or value that would remain if
the option contract were to expire today.

 

The option has $1 dollar of intrinsic value

Extrinsic Value

Extrinsic value is theoretical value of an
option contract determined by how much time there is to expiration and the
probability of a specific pricing move in an underlying stock. The options
pricing model is a normal distribution meaning there are probabilities that the
underlying share price can appreciate or depreciate significantly in value over
the course of the option contract. An example of extrinsic value is if you own
a call option contract with a strike price of $12 per share and the current
share price of the underlying stock is $10 per share as well. If you paid $1
dollar for the option contract, the option contract has $1 dollar of extrinsic
value, or “theoretical value”. If the option security were to expire today, it
would be worth $0 dollars because it is out of the money, but because there is
still time to expiration the options pricing model says there is a probability
the option contract will expire in the money.

How an option contract gets priced?

Market makers price in a theoretical premium
into the option contract or value that is excess of the current underlying
share price so they can create a market in options securities. The theoretical
value allows market makers to have a bid ask spread in such a manner that they
will not lose money when making a market in the options. The dynamic metric
that adjusts daily based on future expect movements in a stock price is called
implied volatility. Implied volatility tells investors how big of a move the
market predicts in a stock price over a specified period of time. Time to
expiration is a critical factor in buying or selling options. The longer to
expiration, the more extrinsic value or “time premium” will be priced
into the option security. The stock market and investors are uncertain of the
pricing movements in a share price and investors and market makers add a
significant amount of extrinsic value into an option security to prepare for a
number of different pricing outcomes.

  • The more liquid a specific underlying stock’s
    options are, most times there is a narrow bid ask spread in the option
    securities. 
  • On the other hand, the less liquid an underlying
    stock’s options are, more times than not, the bid ask spread is much wider.
  • The higher an implied volatility, the more
    expensive and time premium is priced into a specific option contract.
  • The lower an implied volatility, the cheaper and
    less time premium is priced into a specific option contract.

Delta

Delta tells investors the reactivity of
pricing for an options contract in relation to 100 shares of stock. A 50-delta
contract would trade similar to 50 shares of underlying. Meaning if you 2
contracts, you would have 100 deltas and options contracts that trade like 100
shares of stock.

Gamma

Tells investors how much the Delta will
change per dollar movement in a stock or underlying security. Delta is dynamic
and constantly changing.

Theta

“Time Decay” Options are a wasting asset and
they lose value over time. Theta tells investors how much value will be lost
with each passing day or gained if they are “short” options contracts.

Rho

Rho is a higher-level Greek, it tells
investors the option pricing reactivity to changes in interest rates. For ever
1% change in interest rates, the option pricing should increase or decrease by
the positive or negative Rho.

Implied Volatility

Implied Volatility or “IV” is an option
pricing measure based on what the market anticipates the stock price moving. It
is also a measure of standard deviation. The higher the IV, the more expensive
the option is priced and the expected move in the stock is large.

Put Option

A put option is bearish position that will
increase in value if the underlying stock or ETF falls in value. One option
contract is equivalent to selling 100 shares of stock if exercised by the
option holder. A put option can be used to protect a portfolio and hedge long
stock positions. One method institutions and professionals hedge portfolio risk
is by purchasing index ETF put options because they go up in value, while the
rest of their portfolio may fall in value.

Bullish Vertical Spread (Debit Spread)

Involves buying a long call option at a
lower strike price and selling a call option at a higher strike price. This
strategy seeks to profit when an investor is confident in the share price
rising and wants a strategy that has a limited loss and limited gain. If the
investor predicts the correct bullish movement in the share price, the investor
will achieve max profitability in the trade. Theta and time decay does not
affect this strategy because the short call counteracts most time decay in the
long call contract. The time decay is most prevalent in the last few days to
expiration as any extrinsic value evaporates and the spread is priced closely
to the share price.

  • The breakeven is the price of the long call
    option minus the price of the short call. Then add this value to the strike
    price.
  • The maximum gain is short strike price minus the
    long strike price, then subtracted from the cost average of the spread
    execution.
  • The maximum gain is achieved if the share price
    trades at or above the short call strike.
  • The maximum loss is achieved if the share price
    trades at or below the long call strike.
  • The maximum loss is the debit paid to purchase the
    spread.

Cash Secured Put Option

Selling cash secured put options is a
strategy where investors secure enough capital to purchase an underlying asset
at a specific strike price and are short a put option contract. This means an
investor is paid a premium to sell short an option contract and either take
assignment of shares if the stock price falls below the strike price or keep
the option premium if the share price doesn’t fall below the strike price.

Example 1: The current price of the S&P
500 ETF SPY is $292.55 per share. You trade SPY ETF on a regular basis and your
outlook is neutral or bullish. You believe the stock will either rise in value
or trend sideways. To be certain your option will expire out of the money, you
decide to sell a 2 standard deviation put option with an expiration date
closest to 45 days. If the option expires out of the money, you will keep the
premium collected by selling the short-put option. If the option expires in the
money, you will be assigned long shares at the specified strike price. Once you
own the shares, you can choose to hold them or sell them. If you hold them, you
can sell covered call options against them.

Bear Vertical Spread (Debit Spread)

Buy a long-put option at a higher strike
price and sell a put option at a lower strike price. This strategy seeks to
profit when an investor is confident in the share price falling and wants a
strategy that has a limited loss and limited gain. If the investor predicts the
correct bearish movement in the share price, the investor will achieve max
profitability in the trade. Theta and time decay does not negatively affect
this strategy because the short call counteracts most time decay in the long
call contract. The time decay is most prevalent in the last few days to
expiration as any extrinsic value evaporates and the spread is priced closely
to the share price.

  • The breakeven is the price of the long put-option minus the price of the short put. Then subtract this value to the strike price.
  • The maximum gain is long strike price minus the short strike price, then subtracted from the cost average of the spread execution.
  • The maximum gain is achieved if the share price trades at or above the short call strike.
  • The maximum loss is achieved if the share price trades at or below the long call strike.
  • The maximum loss is the debit paid to purchase the spread.

This short write up isn’t inclusive of all options strategies and we will be writing more on other strategies. If you have any questions about the content here, write an email to ccanyonllc@gmail.com.

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