The Basics Of Buying Options
Options are contracts that allow option buyers to purchase, at a fraction of the price each share would cost, or sell a security at a certain price on or before a specified day. They are most commonly used in the equity or stock market but are also found in futures, commodity and forex markets. There are various types of options known as FLEX or exotic options, as well as stock options you may receive from an employer as compensation, but for our purposes here, our discussion will focus on options related to the stock market. (To learn more about exotic options, check out Exotic Options: A Getaway From Ordinary Trading.)
Who's Buying and Why?
A variety of investors use option contracts to hedge positions, as well as buy and sell stock, but the majority of option investors are speculators. These speculators usually have no intention of exercising the option contract, which is to buy or sell the underlying stock. Instead, they hope to capture a move in the stock without paying a large sum of money. It is important to have some type of an edge when buying options. A big mistake that option investors make is buying in anticipation of a well-publicized event, like an earnings announcement or drug approval. Option markets are more efficient than many speculators expect. Investors, traders and market makers are usually aware of upcoming events and buy up option contracts, making the contracts cost more. When this happens, you can be right on the stock's direction and still not make money or at least a lot less money than desired.
Stock buyers who use fundamental analysis often review company balance sheets and financial statements to determine what they believe to be the stock's "intrinsic value." When analysts upgrade a stock, as you may have seen on the news, they may also issue a price target for the stock. While they often give a price target, they often provide a vague time frame. So these types of option buyers commonly choose long-term contracts of six-12 months in length. (For more on fundamental analysis, check out our Fundamental Analysis Tutorial.)
Many option buyers turn to technical analysis to determine a specific price movement. These chart readers identify areas of supply and demand, called support and resistance, for stock shares. Stocks, in general, move up because there is a higher demand for shares and move down when there is an over-supply of shares. Developing the ability to identify supply and demand changes for shares can make a difference to option buyers because this ability will not only help define the move but also the time frame. (Refer to our Technical Analysis Tutorial to learn more about technical methods.)
Changes in Intrinsic Value
When purchasing an option contract, the biggest driver of success is the stock's price movement. A call buyer needs the stock to rise, whereas a put buyer needs it to fall. The option's premium is made up of two parts: intrinsic value and extrinsic value. Intrinsic value is similar to home equity; it is how much of the premium's value is driven by the actual stock price.
For instance, we could own a call option on a stock that is currently trading at $47 per share. We will say that we own a call with a strike price of $45 and the option premium is $3. Because the stock is $2 more than the strike's price, then $2 of the $3 premium is intrinsic value (equity), which means that the remaining dollar is extrinsic value. We can also figure out how much we need the stock to move to profit by adding the price of the premium to the strike price (3 + 45 = 48). Our break-even point is $48, which means the stock must move above $48 before we can profit (not including commissions). (Extrinsic value is also commonly known as the time-value component of the option price, learn more about it in our article The Importance Of Time Value.)
Extrinsic value is the extra cost paid for the privilege of owning the option above and beyond its intrinsic value. Options with intrinsic value are said to be in the money (ITM) and options with no intrinsic value but are all extrinsic value are said to be out of the money (OTM). Options with more extrinsic value are less sensitive to the stock's price movement while options with a lot of intrinsic value are more in sync with the stock price. An option's sensitivity to the underlying stock's movement is called delta. A delta of 1.0 tells investors that the option will likely move dollar per dollar with the stock, whereas a delta of 0.6 means the option will move approximately 60 cents on the dollar. The delta for puts is represented as a negative number, which demonstrates the inverse relationship of the put compared to the stock movement. A put with a delta of -0.4 should raise 40 cents in value if the stock drops $1. (For a more comprehensive explanation of delta, see Options Greeks: Delta Risk and Reward.)
Changes in Extrinsic Value
Extrinsic value is often referred to as time value, but that is only partially correct. It is also composed of implied volatility that fluctuates as demand for options fluctuates, but there are also influences from interest rates and stock dividends changes. Interest rates and dividends are too small of an influence to worry about in this discussion, so we will focus on time value and implied volatility.
Time value is the portion of the premium above intrinsic value that an option buyer pays for the privilege of owning the contract. Over time, this time value premium gets smaller as the option expiration date gets closer. The longer an option contract is, the more time premium an option buyer will pay for. The closer to expiration a contract becomes, the faster the time value melts. Time value is measured by the Greek letter theta. Option buyers need to have particularly efficient market timing because theta eats away at the premium whether it is profitable or not. Another common mistake option investors make is allowing a profitable trade to sit long enough that theta reduces the profits substantially. A clear exit strategy for being right or wrong should be set before buying an option. (Refer to Options Greeks: Theta Risk and Reward to learn more.)
Another major portion of extrinsic value is implied volatility – also known as vega to option investors. Vega moves up and down, depending largely on supply and demand. An influx of buying for an option contract forces the option price higher to entice option sellers to take the other side of the trade. Vega or demand will inflate the option premium, which is why well-known events like earnings or drug trials are often less profitable for option buyers than originally anticipated. The key for dealing with vega is to either eliminate it as much as possible by going ITM or anticipating the inflation of the premium and buying ahead of the demand. If demand drops off and supply increases, vega will diminish and deflate a portion of the extrinsic value significantly. These are all reasons why an investor needs an edge in option buying. (See Options Greeks: Vega Risk and Reward for more.)
Putting It Together
There are two ways to be profitable when buying options; the first is to determine an entry point before the price moves and the second is to buy the option before implied volatility inflates. There are numerous ways in which traders and investors attempt to determine when and how much a stock will move, but it is important to note that implied volatility usually inflates most during bearish turns. This may actually give put buyers an advantage over call buyers. Either way, the contract gives you the right to act on the shares for a fraction of the price.
For a related reading, take a look at our article The Four Advantages Of Options.
Who's Buying and Why?
A variety of investors use option contracts to hedge positions, as well as buy and sell stock, but the majority of option investors are speculators. These speculators usually have no intention of exercising the option contract, which is to buy or sell the underlying stock. Instead, they hope to capture a move in the stock without paying a large sum of money. It is important to have some type of an edge when buying options. A big mistake that option investors make is buying in anticipation of a well-publicized event, like an earnings announcement or drug approval. Option markets are more efficient than many speculators expect. Investors, traders and market makers are usually aware of upcoming events and buy up option contracts, making the contracts cost more. When this happens, you can be right on the stock's direction and still not make money or at least a lot less money than desired.
Stock buyers who use fundamental analysis often review company balance sheets and financial statements to determine what they believe to be the stock's "intrinsic value." When analysts upgrade a stock, as you may have seen on the news, they may also issue a price target for the stock. While they often give a price target, they often provide a vague time frame. So these types of option buyers commonly choose long-term contracts of six-12 months in length. (For more on fundamental analysis, check out our Fundamental Analysis Tutorial.)
Many option buyers turn to technical analysis to determine a specific price movement. These chart readers identify areas of supply and demand, called support and resistance, for stock shares. Stocks, in general, move up because there is a higher demand for shares and move down when there is an over-supply of shares. Developing the ability to identify supply and demand changes for shares can make a difference to option buyers because this ability will not only help define the move but also the time frame. (Refer to our Technical Analysis Tutorial to learn more about technical methods.)
Changes in Intrinsic Value
When purchasing an option contract, the biggest driver of success is the stock's price movement. A call buyer needs the stock to rise, whereas a put buyer needs it to fall. The option's premium is made up of two parts: intrinsic value and extrinsic value. Intrinsic value is similar to home equity; it is how much of the premium's value is driven by the actual stock price.
Extrinsic value is the extra cost paid for the privilege of owning the option above and beyond its intrinsic value. Options with intrinsic value are said to be in the money (ITM) and options with no intrinsic value but are all extrinsic value are said to be out of the money (OTM). Options with more extrinsic value are less sensitive to the stock's price movement while options with a lot of intrinsic value are more in sync with the stock price. An option's sensitivity to the underlying stock's movement is called delta. A delta of 1.0 tells investors that the option will likely move dollar per dollar with the stock, whereas a delta of 0.6 means the option will move approximately 60 cents on the dollar. The delta for puts is represented as a negative number, which demonstrates the inverse relationship of the put compared to the stock movement. A put with a delta of -0.4 should raise 40 cents in value if the stock drops $1. (For a more comprehensive explanation of delta, see Options Greeks: Delta Risk and Reward.)
Changes in Extrinsic Value
Extrinsic value is often referred to as time value, but that is only partially correct. It is also composed of implied volatility that fluctuates as demand for options fluctuates, but there are also influences from interest rates and stock dividends changes. Interest rates and dividends are too small of an influence to worry about in this discussion, so we will focus on time value and implied volatility.
Time value is the portion of the premium above intrinsic value that an option buyer pays for the privilege of owning the contract. Over time, this time value premium gets smaller as the option expiration date gets closer. The longer an option contract is, the more time premium an option buyer will pay for. The closer to expiration a contract becomes, the faster the time value melts. Time value is measured by the Greek letter theta. Option buyers need to have particularly efficient market timing because theta eats away at the premium whether it is profitable or not. Another common mistake option investors make is allowing a profitable trade to sit long enough that theta reduces the profits substantially. A clear exit strategy for being right or wrong should be set before buying an option. (Refer to Options Greeks: Theta Risk and Reward to learn more.)
Another major portion of extrinsic value is implied volatility – also known as vega to option investors. Vega moves up and down, depending largely on supply and demand. An influx of buying for an option contract forces the option price higher to entice option sellers to take the other side of the trade. Vega or demand will inflate the option premium, which is why well-known events like earnings or drug trials are often less profitable for option buyers than originally anticipated. The key for dealing with vega is to either eliminate it as much as possible by going ITM or anticipating the inflation of the premium and buying ahead of the demand. If demand drops off and supply increases, vega will diminish and deflate a portion of the extrinsic value significantly. These are all reasons why an investor needs an edge in option buying. (See Options Greeks: Vega Risk and Reward for more.)
Putting It Together
There are two ways to be profitable when buying options; the first is to determine an entry point before the price moves and the second is to buy the option before implied volatility inflates. There are numerous ways in which traders and investors attempt to determine when and how much a stock will move, but it is important to note that implied volatility usually inflates most during bearish turns. This may actually give put buyers an advantage over call buyers. Either way, the contract gives you the right to act on the shares for a fraction of the price.
For a related reading, take a look at our article The Four Advantages Of Options.
by
Ryan Campbell
Ryan Campbell, CMT has worked in the financial industry for approximately a decade. He has worked as a full-service broker, a banker and is currently a content producer for Investools.com. He writes a daily market commentary and develops courses on trading equities, options, futures and currencies. He has contributed as a columnist to other financial publications. Ryan is also an active member of the Market Technicians Association and was the recipient of its prestigious Chartered Market Technician designation.
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