What is an option ?
Let me describe two scenarios that will explain options.
Scenario 1: Let us suppose that you want to buy a house. The house at the moment costs $100k in the open market. You do not have so much money at the moment. But you will have it in, say, six months. The problem is that the price of the house may go up in six months. This you want to avoid. So, the nice seller writes you a contract that he will sell the house to you within the next six months at the price of $100k. This contract also gives you the right to buy the house, but not the obligation. You can back out of the deal if you want. It is easy to see that in this case the seller will take all the loss. If the price of the house goes up to, say, $120k, you will buy it and sell it on the open market to make a tidy profit of $20k. If the price of the house goes down to $80k, you will not buy the house and maybe buy a similar house in $80k. So, the seller loses either way. To make the playing field more even, you have to pay a “premium” for this contract. This in a nut-shell is the call option. A call option is already being used by airlines to sell airline tickets. For example, KLM lets you block a ticket for three days at the current price for only a fraction of the value of the ticket. You can decide to either take the ticket at the end of the period or decide to not take it. If you do not take it, you lose the premium you paid for the blocking. This is exactly how calls work. Let us reiterate what you have learned so far.
Scenario 2: Let us suppose that you own a house, which you bought for the sole purpose of selling it when you retire. You will use the proceedings of the sale to fund your retirement. At the moment the house will sell for $100k on the open market. What if the prices of the houses fall? There is a collapse in the prices of real estate?
Well, in this case you stand to lose a lot of money and may end up ruining your retirement. It will be awesome for you if someone will make a contract with you to buy the house at, say, $80k, come what may, if you decide to sell. Again, note that you have the right to sell it at $80k but no obligation. Again, the guy who makes this contract is the one losing here. If the house price goes up to $120k, you make money. If the price of the house goes down to, say, $60k, then you sell it for $80k. For this nice deal which takes away your downside risk, but you must pay a premium. This is called a “put” option. A put option is a way to limit the downside risk by paying a premium/insurance for this privilege.
What are the buzzwords I should know?
Some of the terms used in the options market are:
Strike price – The strike price is the price at which the owner of an option can purchase (in case of a call) or sell (in case of a put) the underlying security/commodity.
Covered Call – A call option that has been sold and is backed by an equivalent number of shares in stock.
Premium – The price of an option.
Uncovered Call – A call option sold without owning the underlying. Also called a naked call.
Underlying – The asset from which the option derives its value. It is what the call owner may buy, or the put owner may sell. It could be a commodity, security, a house or a ticket.
Write – Sell a call when owning the underlying stock.
How are options priced?
To use options, it is very important to understand how they are priced. The four primary drivers of the price of an option are: the current stock price, the intrinsic value, time to expiration (also called time value) and volatility (really a part of the time value). Let us go over these one by one
Current price – This is fairly obvious. The current price of the underlying when shoots up, the buyer of the call options are happy (the price of the call option will go up) and the buyer of the put options are sad (they will be kicking themselves for thinking that they need protection from the price of the stock falling down, i.e., the price of the put option will go down). The opposite is true if the price of the stock falls. The movement of the stock price may not have an equal effect on the price of the options though.
Intrinsic value – This is the value any given option has if it was exercised now. For example, if the current GE price is $15, then a $10 call option has a value of $5. The call option, if exercised will let one buy a GE share for $10, which can be sold (or kept) on the open market for $15. This is called an in-the-money option. The following two equations can be used to find out the intrinsic value of options.
Call option intrinsic value = Stock's current price - Call strike price
Put option intrinsic value = Put strike price - Stock's current price
Generally when buying an option, the buyer pays a premium and a commission to the broker. So, to make a profit from the call option the price of the stock must go above the strike price+premium+commission. Similarly, a put option is in the money when the price of the stock goes below the strike price-premium-commission. An option which is at the money or out of money has no intrinsic value. In a different example, a GE $20 call option will have no intrinsic value if the price of GE stock is $15, as $15-$20=-$5. But a GE $15 put option will have an intrinsic value of $20-$15=$5.
Time Value – The time value of an option is the amount by which the price of the option differs from the intrinsic value. The formula for calculating the time value is pretty easy
Time Value = Option price - Intrinsic value
The more time an option has until it expires, the greater is the chance that it will be usable in the future. The actual way to determine the time value is a fairly complex equation. But a general rule of thumb is that the option loses one third of its value in the first half of its life and the rest in the second half (this is called an exponential decay). Time value can also be explained by the risk which the seller takes by selling the option. It is like an insurance premium for letting the buyer do what he wants to (buy/sell) in a specified period of time. The higher the risk, the higher is the cost of the option.
Volatility – This is actually part of the time value, but needs a separate discussion. The volatility of a stock is measured by what the academics call. What is it? It is a way to measure risk-vs.-return. An investor/speculator will want higher return for taking higher risk and will expect a lower return for lower risk. This is why Treasuries give low returns (inherently less risky) than stocks (inherently more risky). Think of the broad stock market which equals 1. Now, a security which equals 0.5 will be expected to move half of what the market moves. So, for example if the market moves 2%, this security will move 0.5*2=1%. For large-cap stable stocks this is generally less than 1. For Johnson & Johnson (JNJ, Financial) it is 0.62 and for Micron Technology (MU, Financial) it is 1.11.
An options time value is hence highly dependent on the volatility the market expects from the stock. For a low volatility stock, the options time value will be relatively low. For stocks with high beta, this will be high.
For now, this is enough. In the second part of the series I will discuss how options are used and how a long-term investor can boost returns on stable stocks like J&J by using options in a safe way.
Let me describe two scenarios that will explain options.
Scenario 1: Let us suppose that you want to buy a house. The house at the moment costs $100k in the open market. You do not have so much money at the moment. But you will have it in, say, six months. The problem is that the price of the house may go up in six months. This you want to avoid. So, the nice seller writes you a contract that he will sell the house to you within the next six months at the price of $100k. This contract also gives you the right to buy the house, but not the obligation. You can back out of the deal if you want. It is easy to see that in this case the seller will take all the loss. If the price of the house goes up to, say, $120k, you will buy it and sell it on the open market to make a tidy profit of $20k. If the price of the house goes down to $80k, you will not buy the house and maybe buy a similar house in $80k. So, the seller loses either way. To make the playing field more even, you have to pay a “premium” for this contract. This in a nut-shell is the call option. A call option is already being used by airlines to sell airline tickets. For example, KLM lets you block a ticket for three days at the current price for only a fraction of the value of the ticket. You can decide to either take the ticket at the end of the period or decide to not take it. If you do not take it, you lose the premium you paid for the blocking. This is exactly how calls work. Let us reiterate what you have learned so far.
- A buyer buys a call option when he thinks the price of the underlying commodity will go up quite a bit but does not have the necessary capital to invest by buying the commodity outright. Buying a call is like having a long position on the commodity.
- The seller of the call option trades the upside of the commodity with the premium he gets. The seller has to own the commodity to write and sell call options on them (or he will have to buy it on the open market if the call is exercised).
Scenario 2: Let us suppose that you own a house, which you bought for the sole purpose of selling it when you retire. You will use the proceedings of the sale to fund your retirement. At the moment the house will sell for $100k on the open market. What if the prices of the houses fall? There is a collapse in the prices of real estate?
Well, in this case you stand to lose a lot of money and may end up ruining your retirement. It will be awesome for you if someone will make a contract with you to buy the house at, say, $80k, come what may, if you decide to sell. Again, note that you have the right to sell it at $80k but no obligation. Again, the guy who makes this contract is the one losing here. If the house price goes up to $120k, you make money. If the price of the house goes down to, say, $60k, then you sell it for $80k. For this nice deal which takes away your downside risk, but you must pay a premium. This is called a “put” option. A put option is a way to limit the downside risk by paying a premium/insurance for this privilege.
- A buyer buys put options to limit the downside of the commodity. Buyer has to own the commodity to buy put options (or he will have to buy it on the open market before exercising the put option). Buying a put option is like having a short position on the stock. If the stock price goes below the price for which the put was bought then the buyer of the put can buy the commodity at the lower price from the market and sell it to the seller of the put at a higher price, pocketing the difference.
- The seller of the put option trades the risk of declining commodity price with the premium he gets.
What are the buzzwords I should know?
Some of the terms used in the options market are:
Strike price – The strike price is the price at which the owner of an option can purchase (in case of a call) or sell (in case of a put) the underlying security/commodity.
Covered Call – A call option that has been sold and is backed by an equivalent number of shares in stock.
Premium – The price of an option.
Uncovered Call – A call option sold without owning the underlying. Also called a naked call.
Underlying – The asset from which the option derives its value. It is what the call owner may buy, or the put owner may sell. It could be a commodity, security, a house or a ticket.
Write – Sell a call when owning the underlying stock.
How are options priced?
To use options, it is very important to understand how they are priced. The four primary drivers of the price of an option are: the current stock price, the intrinsic value, time to expiration (also called time value) and volatility (really a part of the time value). Let us go over these one by one
Current price – This is fairly obvious. The current price of the underlying when shoots up, the buyer of the call options are happy (the price of the call option will go up) and the buyer of the put options are sad (they will be kicking themselves for thinking that they need protection from the price of the stock falling down, i.e., the price of the put option will go down). The opposite is true if the price of the stock falls. The movement of the stock price may not have an equal effect on the price of the options though.
Intrinsic value – This is the value any given option has if it was exercised now. For example, if the current GE price is $15, then a $10 call option has a value of $5. The call option, if exercised will let one buy a GE share for $10, which can be sold (or kept) on the open market for $15. This is called an in-the-money option. The following two equations can be used to find out the intrinsic value of options.
Call option intrinsic value = Stock's current price - Call strike price
Put option intrinsic value = Put strike price - Stock's current price
Generally when buying an option, the buyer pays a premium and a commission to the broker. So, to make a profit from the call option the price of the stock must go above the strike price+premium+commission. Similarly, a put option is in the money when the price of the stock goes below the strike price-premium-commission. An option which is at the money or out of money has no intrinsic value. In a different example, a GE $20 call option will have no intrinsic value if the price of GE stock is $15, as $15-$20=-$5. But a GE $15 put option will have an intrinsic value of $20-$15=$5.
Time Value – The time value of an option is the amount by which the price of the option differs from the intrinsic value. The formula for calculating the time value is pretty easy
Time Value = Option price - Intrinsic value
The more time an option has until it expires, the greater is the chance that it will be usable in the future. The actual way to determine the time value is a fairly complex equation. But a general rule of thumb is that the option loses one third of its value in the first half of its life and the rest in the second half (this is called an exponential decay). Time value can also be explained by the risk which the seller takes by selling the option. It is like an insurance premium for letting the buyer do what he wants to (buy/sell) in a specified period of time. The higher the risk, the higher is the cost of the option.
Volatility – This is actually part of the time value, but needs a separate discussion. The volatility of a stock is measured by what the academics call. What is it? It is a way to measure risk-vs.-return. An investor/speculator will want higher return for taking higher risk and will expect a lower return for lower risk. This is why Treasuries give low returns (inherently less risky) than stocks (inherently more risky). Think of the broad stock market which equals 1. Now, a security which equals 0.5 will be expected to move half of what the market moves. So, for example if the market moves 2%, this security will move 0.5*2=1%. For large-cap stable stocks this is generally less than 1. For Johnson & Johnson (JNJ, Financial) it is 0.62 and for Micron Technology (MU, Financial) it is 1.11.
An options time value is hence highly dependent on the volatility the market expects from the stock. For a low volatility stock, the options time value will be relatively low. For stocks with high beta, this will be high.
For now, this is enough. In the second part of the series I will discuss how options are used and how a long-term investor can boost returns on stable stocks like J&J by using options in a safe way.
