Options are contracts that give option buyers the right to purchase or sell a security at a predetermined price on or before a specified day. They are most commonly used in the stock market but are also found in futures, commodity and forex markets. There are several types of options, including flexible exchange options, 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 and more specifically, their pricing.
Who's Buying Options and Why?
A variety of investors use option contracts to hedge positions, as well as buy and sell stock, but many 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 an edge when buying options.
A common mistake some 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 realize. Investors, traders and market makers are usually aware of upcoming events and buy up option contracts, driving up the price, costing the investor more money.
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 $49 per share. We will say that we own a call with a strike price of $45 and the option premium is $5. Because the stock is $4 more than the strike's price, then $4 of the $5 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 (5 + 45 = 50). Our break-even point is $50, which means the stock must move above $50 before we can profit (not including commissions).
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.
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. There are also influences from interest rates and stock dividend changes. However, 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 for a certain period. 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.
Another major portion of extrinsic value is implied volatility – also known as vega to option investors. Vega 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. These are all reasons why an investor needs an edge in option buying.
The Bottom Line
Options can be useful to hedge your risk or speculate since they give you the right, not obligation, to buy/sell a security at a predetermined price. The option premium is determined by intrinsic and extrinsic value. There are numerous ways to benefit from using option contracts.To learn more about option strategies that you can take advantage of, please read our other option articles.