Options are contracts that give option buyers the right to buy or sell a security at a predetermined price on or before a specified day. The price of an option, called the premium, is composed of a number variables. Option traders need to be aware of these variables so they can make an informed decision about when to trade an option.
Options are commonly used in the stock market but are also found in futures, commodity, and forex markets. Our discussion will focus on stock market option prices, although similar concepts apply to options in other markets.
Why Trade Options
A variety of investors use option contracts to hedge positions, as well as buy and sell stock. The buyer of a call option is given the right to buy stock at a certain price while a put buyer is given the right to sell stock at a specific price, before the options expire. These option buyers can exercise their right to buy or sell at the specified price, called the strike price, which means they acquire or dispose of the underlying stock at that price.
Other option traders are speculators. They have no intention of exercising the option contract. Instead, they hope to profit from a change in the premium of the option. If they can buy an option for $1 and sell it $5, that is a great return. Options typically trade in 100 share blocks, so a $1 option actually costs $100, plus commissions.
One of the advantages of buying options is a trader can participate in the potential price moves of a stock, without actually having to lay out the cash to buy or short the stock. For example, if a stock is trading at $30 and you think it will rise to $35, you could buy 100 shares of stock which will cost $3,000. Alternatively, you could buy a call option with a strike price of $32 that expires in two months. The cost of the option is $0.60, or $60 ($0.60 x 100). The cash outlay is much lower, which means if the price does go to $35 the potential gain is much larger relative to the capital deployed.
The downside is that if the stock does not move above $32 (strike price), then you lose the option premium you paid. Also, the stock must make the favorable move before the option expires.
If the stock does go to $35 just before expiry, the option is worth $35 - $32 = $3. The trader paid $0.60 for the option, so they make $2.40 x 100 shares = $240, only having spent $60. If the stock price remains below $32 and expires, it is worthless and the option buyer loses the premium paid.
Let's dig deeper into why an option costs what it does, and why the value of the option changes.
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 how much of the premium is made up of the favorable price difference (from the view of the option buyer) between the current stock price and the strike price. For instance, assume you own a call option on a stock that is currently trading at $49 per share. The strike price of the option is $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, which means that the remaining dollar is extrinsic value.
We can also figure out how much we need the stock to move in order 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 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 for dollar with the stock, whereas a delta of 0.6 means the option will move approximately 60 cents for every dollar the stock moves.
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 dividends.
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, the time value gets smaller as the option expiration date gets closer. The further out the expiry date, 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. A common mistake option investors make is allowing a profitable trade to sit long enough that theta reduces the profits substantially. For example, a trader may buy an option at $1, and see it increase to $5. Of the $5 premium, only $4 is intrinsic value. If the stock price doesn't move any further, the premium of the option will slowly degrade to $4 at expiry. A clear exit strategy should be set before buying an option.
Implied volatility, also known as vega, can inflate the option premium if traders expect volatility. High volatility increases the chance of a stock moving past the strike price, so option traders will demand a higher price for the options they are selling.
This is why well-known events like earnings are often less profitable for option buyers than originally anticipated. While a big move in the stock may occur, option prices are usually quite high before such events which offsets the potential gains.
On the flip side, when a stock is very calm, option prices tend to fall, making them relatively cheap to buy. Although, unless volatility expands again the option will stay cheap, leaving little room for profit.
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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. Intrinsic value is the moneyness of the option, while extrinsic value has more components. Before taking an options trade consider the variables in play, have a plan for entry, and have a plan for exiting.